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>> Chapter 20 – Financial Instruments — Hedge Accounting
Chapter 20
Financial Instruments — Hedge Accounting
TECHNICAL COMPETENCIES
1.2.3 Evaluates treatment for non-routine transactions
This chapter reviews the basic components of hedge accounting. The chapter follows IFRS. Differences with ASPE are addressed at the end of
this chapter.
Hedge accounting is a process that allows an entity to account for two separate transactions as one linked item. It is intended to offset
temporary profit or loss volatility due to differences in timing or valuation of a hedged item and the hedging instrument. Hedge accounting
satisfies this objective by matching the timing of income recognition of the hedging instrument with that of the hedged item. This chapter
follows the standard as laid out in IFRS 9 Financial Instruments.
Hedge accounting is an accounting policy choice and is not required. Companies may only use hedge accounting when strict criteria are met.
Due to hedge accounting's complexity, many companies will choose not to employ it even when allowed.
Hedge accounting often deals with foreign currency. As a result, knowledge of accounting for foreign currency transactions is needed. For
more information on financial reporting for foreign currency transactions, see the eBook chapter on foreign currency transactions.
Hedging may also occur with items such as commodities, or any item that has a variable component. Due to the common occurrence of foreign
currency and hedging, this chapter will use this as the primary example.
0 Summary
OR0290E_FR_Financial_Instruments_Hedge_Accounting_SUM
1 Key Terms
1.1 Eligible hedged item

An eligible hedged item is an item that the entity wants to protect from exposure to a variable, such as foreign exchange rate changes. Eligible
hedged items fall into one of the example categories below:
• an existing asset or liability position — for example, accounts receivable or accounts payable as a result of a sale or a purchase
• an unrecognized firm commitment — for example, goods that are ordered but not yet shipped or received
• a highly probable future transaction — for example, a future revenue stream
• a net investment in foreign operations — for example, an equity investment in a foreign subsidiary
1.2 Eligible hedging instrument
An eligible hedging instrument is an item that is used to reduce or eliminate exposure from the risk of the variable on the hedged item. Eligible
hedging instruments fall into one of the categories below:
• derivatives such as forward contracts — for example, an agreement to purchase or sell foreign currency at some future point in time from
or to a broker
• non-derivatives such as monetary assets and liabilities — for example, a term deposit or debt denominated in a foreign currency
2 Qualifying Criteria
Per IFRS 9 Chapter 6.5, hedge accounting may only be used if all of the following criteria are met, as summarized below:
1. The hedging relationship must consist of an eligible hedged item and an eligible hedging instrument.
2. At the inception of the hedge, the hedging relationship is formally designated and the hedging relationship and the entity's risk
management objective and strategy for undertaking the hedge are documented. This includes documentation of:
• the hedging relationship
• the objective for undertaking the hedge
• the hedged item and the hedging instrument

• how hedged effectiveness will be assessed
3. The following three effectiveness requirements are met:
• an economic relationship exists between the hedged item and the hedging instrument
• credit risk does not dominate the change in value
• the hedge ratio 1 is the same for both of the following:
o the hedging relationship
o the quantity of the hedged item that the entity actually hedges and the quantity of the hedging instrument
3 Types of Hedges
There are two common types of hedges: fair value hedges and cash flow hedges. Each is explained in more detail below. This chapter will use
foreign currency as the variable.
3.1 Fair value hedge
A fair value hedge is a hedge where cash flows are fixed in terms of the foreign currency, so the fair value of the hedged item fluctuates with
changes in the foreign exchange rate.
For example, existing receivables and payables denominated in a foreign currency have a fixed value in terms of the foreign currency.
However, the fair value of the receivable or payable fluctuates for the entity with changes in the foreign exchange rate. For example, assume
that an entity has an accounts receivable for US$1,000.00. If the spot exchange rate is US$1 = C$1.20, then the fair value of this receivable in
Canadian dollars is C$1,200.00. However, if the exchange rate changes to US$1= C$1.25, the fair value of the receivable increases to
C$1,250.00.
The hedging instrument is used to hedge against fluctuations in the fair value of the hedged item. The entity would, therefore, enter into a
hedging relationship to gain certainty about the Canadian dollar amount to be received or paid.
In basic terms, for the accounting treatment, the gains and losses on both the hedged item and the hedging instrument are recognized in net
income as they arise.
A forward contract is a common way to hedge foreign currency risk (and is discussed in more detail below).
3.2 Forward contracts
A forward contract is an agreement to exchange, at a predetermined future date, currencies of different countries at an exchange rate specified
when the contract is issued.
3.2.1 Key terms
Initiation date — the date on which a transaction such as a delivery or receipt of goods or services is to be effective.
Settlement date — the date on which the monetary asset or liability resulting from the transaction is settled; this is the date on which cash is
received or paid.
Spot rate — the exchange rate for immediate purchase or delivery of foreign currency.
Forward rate — the exchange rate for future purchase or delivery of foreign currency.
3.2.2 Examples of forward contracts
A forward contract may be an agreement to purchase foreign currency forward. On the settlement date, the entity agrees to give a specified
amount of Canadian dollars to the broker in exchange for the amount of foreign currency specified in the contract.
Alternatively, a forward contract may be an agreement to sell foreign currency forward. On the settlement date, the entity agrees to give a
specified amount of foreign currency to the broker in exchange for the amount of Canadian dollars specified in the contract.
3.2.3 New accounts
When using forward contracts, two new accounts are recorded on the balance sheet:
• due to broker — a payable to the broker
• due from broker — a receivable from the broker
Depending on the terms of the contract, either the "due to" or the "due from" broker account will vary with exchange rates.
The other side of the contract will be fixed at the forward contract rate.
Over the term of the contract, the account that varies with exchange rates is updated to the forward rate until the settlement date, at which time
this account is updated to the spot rate on the settlement date.
3.2.4 Examples of forward contracts as a hedge
Hedge a receivable for sale of goods
A company sells goods to a foreign customer in exchange for a note receivable.
The company also enters into an agreement with a broker to sell foreign currency forward. The company agrees to give the broker foreign
currency on the settlement date in exchange for an amount of Canadian dollars fixed by the term of the forward exchange contract.
The company receives foreign currency from the foreign customer and uses this foreign currency to pay the broker.
By entering into the forward exchange contract, the company fixes the Canadian dollar amount it will receive from the receivable or the sale of
goods. Therefore:
• due to broker — variable with changing exchange rates
• due from broker — fixed amount
Hedge a payable for purchase of goods
A company enters into an agreement with a foreign supplier to purchase goods on credit.
The company also enters into an agreement with a broker to buy foreign currency forward. The company agrees to give the broker Canadian
dollars (amount fixed by the terms of the forward exchange contract) on the settlement date in exchange for foreign currency.
The company uses the foreign currency received from the broker to pay the foreign supplier.
By entering into the forward exchange contract, the company fixes the Canadian dollar amount that it will pay for the payable or the goods.
Therefore:
• due to broker — fixed amount
• due from broker — variable with changing exchange rates
3.3 Fair value hedges and forward contracts
The forward contract (that is, the hedge) is entered into after, or at the same time as, the purchase or sale because of concerns associated with
possible future fluctuations in exchange rates. In a fair value hedge, the forward contract is not entered into before the purchase or sale.
Step 1 — Initiation dates (dates may differ)
• Record the fair value of the hedged item.
• Record the fair value of the hedging instrument.
Step 2 — Reporting dates
• Update the hedged item to the spot rate on the reporting date, and record any gain or loss in net income.
• Update the variable side of the hedging instrument to the forward rate on the reporting date, and record any gain or loss in net income.
Step 3 — Settlement date
• Update the hedged item to the spot rate on the settlement date, and record any gain or loss in net income.
• Update the variable side of the hedging instrument to the spot rate on the settlement date, and record any gain or loss in net income.
• Record the settlement of the hedged item.
• Record the settlement of the hedging instrument.
This is demonstrated in the following example:
On June 1, 20X5, ABC Co. purchased inventory from a U.S. supplier for US$100,000. The payable is due July 31, 20X5. ABC has a June 30
year end.
To hedge the risk, ABC Co. invested in a forward contract on June 1, 20X5, to purchase US$100,000 on July 31, 20X5, at a future specified
rate of US$1 = C$0.80.
Exchange rates over the relevant period were as follows:
Spot rates:
June 1, 20X5 US$1 = C$0.82

June 30, 20X5 US$1 = C$0.78
July 31, 20X5 US$1 = C$0.76
Forward rates:
June 1, 20X5 US$1 = C$0.80

June 30, 20X5 US$1 = C$0.77
Step 1 — Initiation dates
Example: On June 1, 20X5, record a purchase from a foreign supplier at the spot rate in effect on the initiation date:
Dr. Inventory $82,000

Cr. Accounts payable $82,000
US$100,000 × C$0.82 = C$82,000
Example: On June 1, 20X5, record the forward contract at the forward rate on the date the contract is entered into:
Dr. Due from broker $80,000

Cr. Due to broker $80,000
US$100,000 × C$0.80 = C$80,000
• Update the hedged item to the spot rate on the reporting date, and record any gain or loss in net income.
Example: On June 30, 20X5, to record an increase in the exchange rate, accounts payable (the hedged item) is updated and a gain is
recorded:
Dr. Accounts payable $4,000

Cr. Foreign exchange (FX) gain $4,000
US$100,000 × (C$0.78 – C$0.82) = C$4,000
• Update the variable side of the forward contract to the forward rate on the reporting date, and record any gain or loss in net income.
Example: On June 30, 20X5, given that this is a purchase of goods transaction, the due from broker will be variable and the due to broker
will be fixed. Therefore, only update the due from broker here:
Dr. FX loss $3,000
Cr. Due from broker $3,000
US$100,000 × (C$0.77 – C$0.80) = C$3,000
Step 3 — Settlement date
• Update the hedged item to the spot rate on the settlement date, and record any gain or loss in net income.
Example: On July 31, 20X5, record an increase in the exchange rate, accounts payable (the hedged item) is updated and a gain is recorded:

Cr. FX gain $2,000
US$100,000 × (C$0.76 – C$0.78) = C$2,000
• Update the variable side of the forward contract to the spot rate on the settlement date, and record any gain or loss in net income.
Example: Given that this is a purchase of goods transaction, on July 31, 20X5, the due from broker will be variable and the due to broker
will be fixed. Therefore, only update the due from broker here:
Dr. FX loss $1,000

US$100,000 × (C$0.76 – C$0.77) = C$1,000
• Record the settlement of the hedged item.

Example: On July 31, 20X5, remove the payable and record the cash disbursed:

Cr. Cash $76,000
• Record the settlement of the hedging instrument.
Example: On July 31, 20X5, remove the due to and due from broker. The difference is adjusted to cash to reflect the change in foreign
currency of the contract.
Dr. Due to broker $80,000

Cr. Cash $80,000
Dr. Cash $76,000

The impact of these transactions on the income statement can be summarized as follows:
Cost of sales (inventory becomes cost of sales) $82,000

Foreign exchange gain (-$4,000cr + $3,000dr - $2,000cr + $1,000dr) (2,000)
$80,000
The net impact on the income statement must equal Canadian cash paid:
Cash paid to settle payable $ (76,000)

Cash received on forward contract 76,000
Cash paid to settle forward contract (80,000)
Net Canadian cash paid ($ 80,000)
If the transaction had not been hedged, the amount paid for the inventory would have been $100,000 × $0.76 = $76,000. By investing in the
forward contract, the entity has fixed the Canadian dollar cost of the inventory at $82,000 and experienced $2,000 in foreign exchange gain,
for a total cost of $80,000, which is equal to the Canadian dollar value of the forward contract.
3.3.1 Test your knowledge
On December 1, 20X1, Martin Inc., a Canadian company with a December 31 year end, purchased inventory from a foreign supplier for
500,000 foreign currency unit (FCU). The amount is due on January 31, 20X2.
On December 1, 20X1, to hedge the risk associated with the transaction, Martin invested in a forward contract to purchase 500,000 FCU on
January 31, 20X2.
Spot rates:
December 1, 20X1 1 FCU = C$0.85

January 31, 20X2 1 FCU = C$0.90
Forward rates:

Required
Prepare the required journal entries for both the payable and the forward contract.
Answer
December 1, 20X1
Dr. Inventory (500,000 FCU × $0.85) $425,000

To record the purchase of inventory at the spot rate in effect on the purchase date.
Dr. Due from broker (500,000 FCU × $0.84) $420,000

To record the forward contract.
December 31, 20X1

Dr. FX loss [500,000 FCU × ($0.93 – $0.85)] $40,000
To update accounts payable to the year-end exchange rate. A loss arises because the
payable has increased in terms of Canadian dollars.
Dr. Due from broker

[500,000 FCU × ($0.91 – $0.84)]
$35,000
Cr. FX gain $35,000
To update the forward contract to the forward rate at year end. When the receivable
from the broker is updated, the foreign exchange gain partially offsets the foreign
exchange loss on the payable, so a net loss of 5,000 is recognized.
To update the forward contract to the forward rate at year end. When the receivable is updated, the foreign exchange gain partially offsets the
foreign exchange loss on the payable, so a net loss of 5,000 is recognized.
January 31, 20X2
Dr. Accounts payable

[500,000 FCU × ($0.90 – $0.93)]
$15,000
Cr. FX gain $15,000
To update accounts payable to the January 31, 20X2, spot rate.
Dr. FX loss [500,000 FCU × ($0.90 – $0.91)] $5,000
To update the forward contract to the January 31, Year 2, spot rate. Again, the
foreign exchange loss on the forward contract offsets the foreign exchange gain on
the payable, so a net foreign exchange gain of $10,000 is recognized in the income
statement.
Dr. Accounts payable (500,000 FCU × $0.90) $450,000

Cr. Cash $450,000
To record the settlement of the payable

Cr. Cash $420,000
Dr. Cash $450,000

Cr. Due from broker ($420,000 + $35,000 –
$5,000)
$450,000
To record the settlement of the forward contract.
Cost of sales (inventory becomes cost of sales) $425,000

Foreign exchange gain (5,000)
$420,000
Cash paid to settle payable $(450,000)

Cash received on forward contract 450,000
Cash paid to settle forward contract (420,000)
Net Canadian cash paid $(420,000)
If the transaction had not been hedged, the amount paid for the inventory would have been 500,000 FCU × $0.90 = $450,000. By investing in
the forward contract, Martin has fixed the Canadian dollar cost of the inventory at $425,000 and experienced $5,000 in foreign exchange
gains, for a total cost of $420,000.
3.4 Cash flow hedge
A cash flow hedge is a hedge to exposure in the variability of cash flows resulting from an asset or liability. In these cases, the value of the
item being hedged has uncertainty, and the entity looks to hedge the risk of that fluctuation in value. In this case, the hedged item may be an
anticipated transaction such as a proposed purchase of inventory, or a forecasted transaction such as sales denominated in a foreign currency.
Generally, the hedging instrument is entered into before the hedged item — this is the key difference between a cash flow and fair value
hedge.
For example, an entity may order goods, and those goods will be delivered to the entity in the future on credit. The purchase of goods is not
recorded in the financial statements until the goods are received. At the time the purchase order is generated, the entity may hedge the
purchase by entering into a forward exchange contract to purchase a foreign currency forward. Note that the hedging instrument occurs before
the hedged item — placing the order for the goods is not an accounting transaction and, therefore, is not recognized; it is on the receipt of the
goods that the hedged item is recognized.
Regarding the accounting treatment, exchange gains and losses on the hedging instrument (such as the forward exchange contract) will arise
prior to exchange gains and losses on the item being hedged; however, these should not be recognized in the income statement prior to
exchange losses or gains on the hedged item. Exchange gains and losses are recorded on the hedging instrument when they first arise as a
component of other comprehensive income (OCI). Once the exchange losses or gains on the hedged item are recognized in net income, the
exchange gains and losses on the hedging instrument are reclassified from OCI to net income to offset the losses and gains on the hedged item.
3.4.1 Forward contract
• Update the hedged item and hedging instrument to fair value, and record any gain or loss in OCI or the income statement, as appropriate.
Step 3 — Derecognition date
• Update the hedging instrument to fair value, and record any gain or loss in OCI.
• Derecognize the hedging instrument.
• Derecognize the hedged item if previously recorded, or record if not already done so.
• Move any gain or loss in OCI to net income by adjusting the hedged item.
This is demonstrated in the following example:
XYZ Co. orders goods from a U.S. supplier on December 1, 20X6, for US$20,000. Those goods will be delivered to the entity on March 31,
20X7, and payment is due on that date. Also on December 1, 20X6, XYZ Co. hedges the purchase by entering into a forward exchange
contract to purchase US$20,000.

Spot rates:
December 1, 20X6 US$1 = C$0.90

December 31, 20X6 US$1 = C$0.92
March 31, 20X7 US$1 = C$0.93
Forward rates:

December 31, 20X6 US$1 = C$0.89
Step 1 — Initiation date
Note that the initiation date of the hedged item and hedging instrument in this example are different. On December 1, only the hedging
instrument is recorded, as the transaction for the hedged item has not yet occurred.
• Initiation date of the hedging instrument — Record the fair value of the hedging instrument.
Example: On December 1, 20X6, record the forward contract at the forward rate on the date the contract is entered into:
Dr. Due from broker $17,600

US$20,000 × C$0.88 = C$17,600
• Update the hedged item and hedging instrument to fair value, and record any gain or loss in OCI.
Example: At December 31, 20X6, the hedged item does not need to be updated, as it is not yet recorded.
For the hedging instrument, given that the example is a purchase of goods transaction, the due from broker will be variable and the due to
broker will be fixed. Therefore, only update the due from broker here:
Dr. Due from broker $200

Cr. OCI $200
US$20,000 × (C$0.89 – C$0.88) = C$200
Example: At March 31, 20X7, given that the example is a purchase of goods transaction, the due from broker will be variable and the due
to broker will be fixed. Therefore, only update the due from broker here:
Dr. Due from broker $800

Cr. OCI $800
US$20,000 × (C$0.93 – C$0.89) = C$800

Example: At March 31, 20X7, remove the due to and due from broker. The difference is adjusted to cash to reflect the change in foreign
currency of the contract.

Cr. Cash $17,600
Dr. Cash $18,600

Example: At March 31, 20X7, record the purchase of inventory and the cash paid at the current spot rate.

Cr. Cash $18,600
Example: At March 31, 20X7, reverse OCI recorded and adjust to inventory. Note that this will result in a decrease in cost of sales when
inventory is sold, which is when this will impact net income.
Dr. OCI $1,000

Cr. Inventory $1,000
Cost of sales (inventory becomes cost of sales) : $17,600
Cash paid for inventory $(18,600)

Cash paid to broker (17,600)
Cash received from broker 18,600
Net Canadian cash paid $(17,600)
If the transaction had not been hedged, the amount paid for the inventory would have been US$20,000 × C$0.93 = $C18,600. By investing in
the forward contract, the company has fixed the Canadian dollar cost of the inventory at $17,600.
On December 1, 20X1, Marvelt Inc. entered into an agreement to sell goods for 800,000 FCU to a customer in a foreign country. The goods
are to be delivered to the foreign customer on January 1, 20X2, and the foreign customer is to pay the amount owing on January 31, 20X2.
Marvelt is a Canadian company with a December 31 year end.
On December 1, 20X1, to hedge the risk associated with the sale, Marvelt entered into a forward exchange contract to sell 800,000 FCU
forward on January 31, 20X2.
Relevant exchange rates are as follows:
Spot rates:
January 31, 20X2 1 FCU = C$0.60
Forward rates:

Assume January 1 rates are the same as December 31 rates of the immediately preceding year.
On January 31, Marvelt will use foreign currency collected from the foreign customer to pay the broker. In exchange, the broker will give
Marvelt Canadian dollars fixed at the forward contract rate. As a result of entering into the forward contract, Marvelt has fixed the Canadian
dollars it will collect as a result of the sale.
Required
Prepare the required journal entries for both the receivable and the forward contract.
Answer
December 1, 20X1

To record the forward exchange contract. The due from broker account is fixed at
the forward rate. Marvelt has entered into a contract to sell 800,000 FCU to the
broker on January 31, Year 2, in exchange for C$528,000.
December 31, 20X1
Dr. Due to broker [800,000 FCU × ($0.63 – $0.66)] $24,000

Cr. OCI $24,000
To update the due to broker account to the forward rate on December 31, 20X1. The
other side of the entry does not impact net income at this time. It is recorded in OCI.
January 1, 20X2
Dr. Accounts receivable (800,000 FCU × $0.65)
$520,000
Cr. Sales $520,000
To record the sale to the foreign customer. Initially, the sale is recorded at the spot
rate in effect on the date of the sale.
To record the sale to the foreign customer. Initially, the sale is recorded at the spot rate in effect on the date of the sale.
Dr. OCI $24,000

Cr. Sales $24,000
To reclassify the foreign exchange gain included in OCI to sales.
The balance in OCI is accounted for as an adjustment to the selling price of the goods. Any foreign exchange gain or loss arising from
updating the due to broker account after this point in time will be recognized in the income statement as a foreign exchange gain or loss and
will partially offset the exchange gain or loss that arises from updating the exposed receivable to new rates. After the sale, the forward
exchange contract becomes a hedge of an exposed receivable.
January 31, 20X2
Dr. Due to broker [800,000 FCU × ($0.60 – $0.63)] $24,000

Cr. FX gain $24,000
To update the due to broker account to the spot rate on the settlement date.
Dr. FX loss [800,000 FCU × ($0.60 – $0.65)] $40,000

Cr. Accounts receivable $40,000
To update the accounts receivable account to the spot rate on the settlement date.
At this point, there is a net foreign exchange loss of $40,000 – $24,000 = $16,000 recognized in income. This is the cost of hedging the
receivable and can also be directly determined as foreign currency times the difference between the spot and forward rate on the date of the
sale: 800,000 FCU × ($0.63 – $0.65) = $16,000.
Dr. Cash $480,000

To record the receipt of the foreign cash from the foreign customer (800,000 FCU ×
$0.60).

Cr. Cash $480,000
To record the payment of foreign cash to the broker. The foreign cash collected from
the customer is used to pay the broker (800,000 FCU × $0.60).
Dr. Cash $528,000

To record the Canadian cash received from the broker (800,000 FCU × $0.66).
By entering into the forward exchange contract, Marvelt has fixed the Canadian dollar amount to be received from the sale at the forward
contract rate.
The bottom-line impact on net income must equal the Canadian dollar amount that is received as a result of the sale.
Amount recorded as sales above: $520,000 + $24,000 $544,000

Net foreign exchange loss recognized in income (16,000)
Canadian dollars received from the broker: 800,000 FCU × $0.66 $528,000
3.4.3 Foreign debt and loans

Instead of a forward contract, an entity may also choose to hedge using debt or a loan receivable..
• " Update the hedged item and hedging instrument to fair value, and record any gain or loss in OCI or the income statement, as
appropriate.
• Update any accrued interest and record in profit or loss.
• Update interest and translate the interest revenue using the average rate for the period and translate the interest receivable at the spot rate.
In order to look at the accounting for this, assume that in the above example (3.4.1) for XYZ Co., instead of hedging its order of inventory
with a forward contract, it entered into a loan receivable agreement where it loaned US$20,000 at an annual interest rate of 6% on December
1, 20X6, and designated this as a hedging instrument. The loan receivable and interest are due on March 31, 20X7. The loan receivable has
been identified as a hedge of the inventory purchase.
Spot rates:
December 31, 20X6 US$1 = C$0.92
March 31, 20X7 US$1 = C$0.93
Additional relevant interest rates:
Average rate for December 20X6 US$1 = C$0.91

Average rate for January to March 20X7 US$1 = C$0.92
Step 1 — Initiation date
Note the initiation date of the hedged item and hedging instrument in this example are different. On December 1, only the hedging instrument
is recorded, as the transaction for the hedged item has not yet occurred.
• Initiation date of the hedging instrument — Record the fair value of the hedging instrument.
Example: On December 1, 20X6, record the loan at the spot rate on the date the loan is granted:
Dr. Loan receivable $18,000

Cr. Cash $18,000
US$20,000 × C$0.90 = C$18,000

• Update the hedged item and hedging instrument to fair value, and record any gain or loss in OCI.
• Update any accrued interest and record in profit or loss.
Example: At December 31, 20X6, the hedged item does not need to be updated, as it is not yet recorded.
For the hedging instrument, the loan is a financial asset and will need to be updated to the spot rate:
Dr. Loan receivable $400

Cr. OCI $400
US$20,000 × (C$0.92 – C$0.90) = C$400
Interest earned on the loan also must be recorded and translated using the average rate for the period:
Dr. Interest receivable $92

Cr. FX gain $1
Cr. Interest revenue $91
Interest receivable = US$20,000 × 6% × 1/12 × C$0.92
Interest revenue = US$20,000 × 6% × 1/12 × C$0.91
Example: At March 31, 20X7, the loan and interest receivable are both financial assets and will need to be updated to the spot rate:
Dr. Loan receivable $200
Cr. OCI $200
Cr. FX gain $1
US$20,000 × (C$0.93 – C$0.92) = C$200
US$100 × (C$0.93 – C$0.92) = C$1
• Update interest and translate using the average rate for the period for revenue and the spot rate for the receivable:

Cr. FX gain $3
Cr. Interest revenue $276
Interest receivable = US$20,000 × 6% × 3/12 × C$0.93
Interest revenue = US$20,000 × 6% × 3/12 × C$0.92
Example: At March 31, 20X7, record the receipt of the loan receivable of the loan and the related interest.
Dr. Cash $18,972

Cr. Interest receivable $ 372
Cr. Loan receivable $18,600
Cash = US$20,400 × C$0.93
Interest receivable = C$92 + C$1 + C$279 or US$400 × C$0.93
Example: At March 31, 20X7, record the purchase of inventory and the cash paid at the current spot rate.

Cr. Cash $18,600
Example: At March 31, 20X7, reverse OCI recorded and adjust to inventory. Note that this will result in a decrease in cost of sales when
inventory is sold, which is when this will impact net income.
Dr. OCI $600

Cr. Inventory $600
Note that in the first example (Section 3.4.1), XYZ essentially locked in the rate at the forward contract rate on December 1 of C$0.88. In this
example, XYZ locked it in at the spot rate of C$0.90, but left itself open to some risk on the interest receivable.
On October 1, 20X0, Irvine Inc. signed a contract to sell goods valued at 304,500 FCU to a company in a foreign country. The goods would be
delivered on December 31, 20X0. Irvine will receive payment for the goods on January 31, 20X1. On November 1, 20X0, Irvine borrowed
300,000 FCU and designated this as a hedging instrument for the goods to be sold. The annual interest rate is 6%. The total of the principal
plus the accrued interest is due on January 31, 20X1. Irvine has a November 30 year end.
Spot rates on relevant dates are as follows:
October 1, 20X0 1 FCU = C$0.95

November 1, 20X0 1 FCU = C$0.99
November average rate 1 FCU = C$1.03
December average rate 1 FCU = C$1.02
January 31, 20X1 1 FCU = C$1.05
January average rate 1 FCU = C$1.01
Required
Prepare all the required journal entries related to the sale of the goods, the collection of the receivable, and the foreign debt.
Answer
November 1, 20X0
Dr. Cash $297,000

Cr. Loan payable $297,000
To record the loan entered into on November 1. 300,000 FCU × $0.99
November 30, 20X0 at year end
Dr. Interest expense $1,545

Dr. FX loss $60
Cr. Interest payable $1,605
Update accrued interest and record in profit or loss.
Interest payable = 300,000 FCU × 6% × 1/12 × $1.07
Interest expense = 300,000 FCU × 6% × 1/12 × $1.03
Dr. OCI $24,000

Update loan and record FX loss in OCI.
300,000 FCU × ($1.07 – $0.99)
December 31, 20X0
Dr. Accounts receivable $295,365

Cr. Revenue $295,365
To recognize the revenue earned on December 31, 20X0.
304,500 FCU × $0.97
Dr. Loan payable $30,000

Cr. OCI $30,000
Update loan and record gain in OCI.
300,000 FCU × ($1.07 – $0.97)
Dr. OCI ($30,000 – $24,000) $6,000

Cr. Revenue $6,000
To close out the OCI and adjust revenue now that the hedged item has been
recognized.
Note that the revenue has been recorded now as $301,365 ($295,365 + $6,000), which is 300,000 FCU × $0.99 + 4,500 FCU × $0.97 =
$297,000 + $4,365.
January 31, 20X1
Dr. Cash 304,500 FCU × $1.05 $319,725

Cr. FX gain $24,360
To record collection of the receivable.
Dr. Interest expense $3,045

Dr. FX loss $75
Cr. Interest payable $3,120
Update accrued interest and record in profit or loss.
Interest payable = 300,000 FCU × 6% × 3/12 × $1.05 – $1,605
Interest expense = 300,000 FCU × 6% × 2/12 × [($1.02 +$1.01)/2]
Dr. FX loss $24,000

Update loan and record gain / loss in FX loss since the loan is no longer a cash flow
hedge.
300,000 FCU × ($1.05 – $0.97)
Note that the FX loss on the loan payable of $24,000 offsets the FX gain on the accounts receivable of $24,360, for a net difference of $360
[4,500 FCU × ($1.05 – $0.97)], which is the FX loss on the amount of 4,500 FCU that was not hedged and at risk.
Dr. Loan payable $315,000

Dr. Interest payable $4,725
Cr. Cash $319,725
Record payment of loan.
4 ASPE Differences
Under ASPE, an entity may account for a hedge when the following conditions are met:
1. The entity must designate and document the hedging relationship.
2. The hedging instrument and the hedged item must have the same critical terms — for example, both the hedging instrument and the
hedged item would need to be in the same currency and for the same quantity. In addition, the forward contract must mature within two weeks
of the date of the hedged cash flow.
3. For anticipated transactions, the expected transaction must be probable — that is, it is likely the foreign currency cash flow will occur at
the amount and at the time expected.
The conditions necessary to apply hedge accounting are less stringent under ASPE than they are under IFRS; however, the situations in which
hedge accounting may be applied are limited. ASPE only allows hedge accounting to be used when:
• A forward contract is used to hedge an anticipated foreign currency cash flow.
• A forward contract is used to hedge an anticipated purchase or sale of a commodity.
• An interest rate swap is used to hedge interest rate risk in a recognized interest-bearing loan receivable or loan payable.
As a result of these restrictions, hedge accounting cannot be applied to foreign debt (or foreign loan receivables) used to hedge foreign sales
(or purchases), as can be done under IFRS.
The accounting treatment under ASPE also differs from IFRS. If the forward contract qualifies for hedge accounting, generally it is not
recognized until it matures, and the gain or loss is recorded as an adjustment against the hedged item, not to OCI or net income. (Note that if
the maturity of the forward contract and the transaction date of the hedged item are not the same, then there is additional guidance provided to
deal with the intervening period.)
ASPE does allow hedge accounting when a forward contract or a loan denominated in the foreign currency is used to hedge the foreign
exchange risk related to a net investment in foreign operations. In this case, the exchange gains or losses on the hedging item are recognized in
a separate component of the shareholders' equity. The eBook chapter on foreign operations provides more detail.
5 Practice Problem 1
Hedge of a forecasted purchase with a forward exchange contract
Minaker Inc. is a Canadian company with a December 31 year end. Minaker often purchases inventory from suppliers in foreign countries. On
November 15, 20X1, it placed an inventory order at a cost of 250,000 FCU with one of its foreign suppliers. The inventory was to be delivered
on January 15, 20X2, and payment was due February 15, 20X2. Management of Minaker became increasingly worried about adverse changes
in the exchange rate; as a result, on December 1, 20X1, the company entered into a forward contract to purchase 250,000 FCU on February 15,
20X2. The inventory was delivered as scheduled on January 15, 20X2.
Relevant exchange rates were as follows:
Spot rates:

January 15, 20X2 1 FCU = C$1.29
February 15, 20X2 1 FCU = C$1.33
Forward rates:

January 15, 20X2 1 FCU = C$1.31
Required
Prepare journal entries to account for all transactions noted above. Assume Minaker reports under IFRS and the forward contract has been
identified as a hedge of the purchase of inventory and chosen to apply hedge accounting.
Answer
The forward contract qualifies as a cash flow hedge.

December 1, 20X1

To record the forward contract at the December 1 forward rate. The due to broker
account is fixed at the forward rate because Minaker wants certainty about how
much it will pay for the inventory. The due from broker account will vary with
forward rates.
December 31, 20X1
Dr. Due from broker [250,000 FCU × ($1.28 $1.26)] $5,000

Cr. OCI $5,000
To update the due from broker account to the December 31 forward rate.
January 15, 20X2
Dr. Due from broker [250,000 FCU × ($1.31 – $1.28)] $7,500

Cr. OCI $7,500
To update the due from broker account to the January 15 forward rate.
Dr. Inventory (250,000 FCU × $1.29) $322,500
To record the purchase of inventory at the spot rate on January 15.
Dr. OCI ($5,000 + $7,500) $12,500

Cr. Inventory $12,500
To close the balance in OCI out to inventory.
February 15, Year 2
Dr. Due from broker [250,000 FCU × ($1.33 – $1.31)] $5,000

Cr. FX gain $5,000
To update the due from broker account to the spot rate on the settlement date.
Dr. FX loss [250,000 FCU × ($1.33 – $1.29)] $10,000

To update accounts payable to the spot rate on the settlement date.
Dr. Due to broker (250,000 FCU × $1.26) $315,000

Cr. Cash $315,000
To record the payment of Canadian cash to the broker. This amount is fixed at the
forward contract rate.
Dr. Cash (250,000 FCU × $1.33) $332,500

To record foreign currency received from the broker.
Dr. Accounts payable (250,000 FCU × $1.33) $332,500

Cr. Cash $332,500
To record the payment to the foreign supplier. The foreign cash received from the
broker is used to pay the foreign supplier.
6 Practice Problem 2
Hedge of proposed sales with a foreign debt
Manion Co. is a Canadian company with a July 31 year end. It forecasted sales of goods for 230,000 FCU to be delivered on October 31,
20X1. The sales would be paid for on November 30, 20X1. To hedge the risk associated with these forecasted foreign sales, Manion borrowed
230,000 FCU on May 1, 20X1. The debt is repayable on November 30, 20X1. The interest rate on the debt is 5% and is payable at maturity.
Manion has identified the foreign debt as a hedge of the foreign sales and decided to adopt hedge accounting.
Relevant spot rates:
May 1, 20X1 1 FCU = C$0.80

July 31, 20X1 1 FCU = C$0.86
October 31, 20X1 1 FCU = C$0.78
May to July 20X1 average rate 1 FCU = C$0.83
August to November 20X1 average rate 1 FCU = C$0.79
Required
Record the necessary entries for 20X1.
Answer
May 1, 20X1
Dr. Cash (230,000 FCU × $0.80) $184,000

To record loan entered into on May 1.
July 31, 20X1, year end
Dr. Interest expense (2,875 FCU × $0.83) $2,386

Dr. FX gain/loss $87
Cr. Interest payable (2,875 FCU × $0.86) $2,473
To record interest expense for the July 31, 20X1, year end. Interest is 230,000 FCU
× 0.05 × 3/12 = 2,875 FCU.
Dr. OCI $13,800
Cr. Loan payable [230,000 FCU × ($0.86 – $0.80)]
$13,800
To update the debt outstanding at the July 31, 20X1, ending spot rate.
October 31, 20X1
Dr. Accounts receivable (230,000 FCU × $0.78)
$179,400
Cr. Sales (230,000 FCU × $0.78) $179,400
To record sales for goods delivered on October 31, 20X1, and record related
accounts receivable.
Dr. Loan payable [230,000 FCU × ($0.78 – $0.86)] $18,400

Cr. OCI $18,400
To update the loan payable outstanding to the spot rate.
Dr. OCI ($18,400 – $13,800) $4,600

Cr. Sales $4,600
To close out the OCI to sales now that the hedged item has been recognized.
The foreign sales are reported as $184,000 ($179,400 + $4,600), which is 230,000 FCU × $0.80 — the exchange rate at the time the hedging
item loan was entered into.
November 30, 20X1
Dr. Interest expense (3,833 FCU × $0.79) $3,028

Cr. FX gain / loss $153
Cr. Interest payable (3,833 FCU × $0.75) $2,875
To record interest expense August to November. Interest is 230,000 FCU × 0.05 ×
4/12 = 3,833 FCU.
Dr. Interest payable $317

Cr. FX gain / loss $317
To update interest payable to the period-end rate.
Total interest payable should be: 230,000FCU × 0.05 × 7/12 × $0.75 = $5,031
Difference to be adjusted: $5,031 – ($2,473 + $2,875) = -$317
Dr. Loan payable [230,000 FCU × ($0.75 – $0.78)] $6,900

Cr. FX gain / loss $6,900
To update the debt outstanding to the spot rate. Note that now the FX gain is recognized
in the income statement and not OCI, since the hedged item has now been recognized.
Dr. Loan payable ($184,000 + $13,800 – $18,400 –
$6,900)
$172,500
Dr. Interest payable ($2,473 + $2,875 – $317) $5,031
Cr. Cash $177,531
To record payment of the loan.
Dr. Cash (230,000 FCU × $0.75) $172,500

Dr. FX gain / loss $6,900
To record collection of accounts receivable.
Notice that the F/X gain on the loan payable of $6,900 eliminates the F/X loss on the receivable of $6,900. This results because the loan
payable was a perfect hedge for the receivable.
7 Supplemental Resources
There are no supplemental resources available for this chapter
8 Practice Multiple Choice Questions (MCQ) Quizzes
Log into the Knotia course in D2L, in the Content section, navigate to the volume of the eBook to find the MCQ quizzes for this chapter.
Footnotes
1 Hedge ratio = Change in fair value of hedging instrument
Change in fair value of hedged item
Financial Reporting >> Chapter 24 – Earnings Per Share
Chapter 24
Earnings Per Share
1.2.2 Evaluates treatment for routine transactions
This chapter reviews the components of earnings per share (EPS) for both basic earnings per share and diluted earnings per share. EPS is only
required for public entities and therefore is only covered under IFRS. ASPE does not require or provide guidance on this topic.
0 Summary
OR0284E_FR_Earnings_Per_Share_SUM
1 Earnings per share
Publicly accountable enterprises are required to disclose earnings

per share (EPS) on their financial statements. Non-public entities
operating under IFRS do not need to report EPS.

EPS is a measure of the amount of earnings available to common shareholders on a per-share basis.
There are two types of EPS that are reported:
1. Basic EPS
2. Diluted EPS
Essentially, basic EPS looks at earnings on a per-share basis for shares that were outstanding during the year. Diluted EPS looks at earnings on
a per-share basis for shares that were outstanding and also for shares that had the potential to be outstanding during the year.
2 Basic EPS
Basic EPS uses two variables in calculating EPS: net earnings available to common shareholders and weighted average common shares
outstanding (WACSO).
Net earnings (loss) available to common shareholders

WACSO
2.1 Net earnings available to common shareholders
Net earnings available to common shareholders are equal to the profit or loss of the entity (that is, net income) less any dividends on preferred
shares.
Dividends on preferred shares are earnings that belong to preferred shareholders and therefore are not available to common shareholders. The
effect of the dividends depends on the type of preferred shares:
• For cumulative preferred shares, deduct the amount of dividends owed in the year, regardless of whether dividends have been declared.
• For non-cumulative preferred shares, only deduct the amount of dividends declared.
2.2 Weighted average common shares outstanding
The number of common shares used in calculating basic EPS is the WACSO during the period. For a more precise calculation, the number of
days rather than the number of months is used to determine weighting periods. If weighting by the number of months provides a reasonable
estimate, the number of months may be used instead of the number of days. For this chapter, the number of months will be used for simplicity.
In determining the shares to use in the calculation, there are two important items to note:
1. Treasury shares, which are issued but not outstanding, are not included in the calculation.
2. Stock splits and stock dividends increase the number of common shares without a corresponding increase in equity or resources. IFRS
requires that additional shares resulting from all stock splits and stock dividends are assumed to have been issued at the beginning of the
earliest period presented. From a practical perspective, this means that the shares outstanding before the stock split or stock dividend must be
adjusted to the number that would have been outstanding had the stock split or stock dividend taken place at the beginning of the period.
It can be helpful to track your WACSO in a table like this:
Date Activity Shares Adjustment Fraction of WACSO

outstanding factor (b) the year (c) (a) × (b) × (c)
(a)

(a) Shares outstanding in total for a specific portion of the year.
(b) Adjustment factor is a simple way to account for stock dividends and stock splits. You would adjust the shares outstanding by any stock
dividends or splits that happen after the point in the year that you are looking at. For example, if a stock dividend of 20% happens in July,
shares outstanding from January to June would have an adjustment factor of 1.2, while those from July to December would have an adjustment
factor of 1. This includes adjusting for splits that occur after year end but before the financial statements are issued.
(c) Fraction of the year is the portion of year that the specific number of shares in (a) were outstanding.
Danforth Inc. has provided the following information related to the current year ending December 31:
• Net earnings after tax: $1,325,000
• Common share information:
o As at January 1, 150,000 common shares outstanding
o March 1, 40,000 common shares issued
o August 1, 30,000 common shares redeemed
o November 1, a 2:1 stock split occurred
• Preferred share information
o 50,000 Class A preferred shares, with a cumulative dividend of $1 per share
o 25,000 Class B preferred shares, with non-cumulative dividends of $2 per share
In the current year, dividends of $100,000 were declared on the Class A preferred shares. Dividends had not been declared on these shares last
year. Dividends of $25,000 were declared on the Class B preferred shares.
Answer
Earnings available to common shareholders:

Net earnings $1,325,000
Dividend — Class A
($50,000 related to current year *) (50,000)
Non-cumulative dividends declared — Class B (25,000)
Net earnings available to common shareholders $1,250,000
WACSO:
Shares Adjustment Fraction of WACSO

outstanding factor the year (c) (a) × (b) × (c)
(a) (b)
Date Activity
Jan. - Feb. Opening balance 150,000 2 2/12 50,000
March - July 40,000 issued 190,000 2 5/12 158,333
Aug. - Oct. 30,000 redeemed 160,000 2 3/12 80,000
Nov. - Dec. 2:1 stock split 320,000 1 2/12 53,333
341,666
Hint: Note that the fraction of the year aligns to the Date column (for instance, March to July is five months, and the fraction column shows
5/12).
Basic EPS = Net earnings (loss) available to common shareholders

WACSO
= $1,250,000 / 341,666
= $3.66 / share
3 Diluted EPS
Diluted EPS is a hypothetical measure of company earnings attributable to each common shareholder assuming all dilutive securities have
been converted to common shares. This chapter will refer to these dilutive securities as potential common shares (PCS).
Net earnings available to common shareholders + income effect of dilutive PCS

WACSO + share effect of dilutive PCS
Diluted EPS is calculated using the following five-step process:
Step 1: Calculate basic EPS (per above)
Step 2: Identify all PCS
Step 3: Calculate incremental EPS for each class of PCS
Step 4: Order the incremental EPS
Step 5: Recompute provisional EPS until diluted EPS is determined
3.1 Step 1: Calculate basic EPS
See the section above.

3.2 Step 2: Identify all PCS
PCS is a financial instrument or other contract found in complex capital structures that may entitle its holder to common shares. Some of the
more common PCS include:
• convertible bonds that entitle the holder to exchange the bond for a predetermined number of common shares
• convertible preferred shares that entitle the holder to exchange the preferred shares for a predetermined number of common shares
• options or warrants that entitle the holder to purchase common shares at a predetermined price
Identifying these and other PCS involves going through the company's financial records and reviewing the terms of its financial instruments
and contracts.
3.3 Step 3: Calculate incremental EPS for each class of PCS
Incremental EPS is used to determine whether PCS are dilutive or antidilutive. Incremental EPS is calculated as the income impact of PCS
divided by the share impact of PCS:
Income impact of PCS

Share impact of PCS
The income impact is the change in after-tax income of the corporation if the PCS are converted to common shares. The share impact is the
number of additional common shares that would be outstanding if the PCS are converted to common shares.
3.3.1 Incremental EPS for convertible bonds
The income impact is the after-tax interest that will not be paid if the option to convert the bonds to common shares is exercised.
Income impact = Bond carrying value × effective interest rate × (1 – tax rate)
The share impact is the number of additional common shares that would be outstanding if the bonds are converted.
If the debt was issued partway through the year, both the income impact and the share impact would be weighted for the part of the year that
the debt was outstanding.
Note that earnings are tax-effected for interest but not for dividends, as interest is deductible from income for tax purposes and dividends are
not.
3.3.1.1 Test your knowledge
Danforth has $1,000,000 in convertible bonds outstanding. The bonds were issued at par and the coupon rate is 5%. Each $1,000 bond is
convertible into 25 common shares. Danforth's income tax rate is 25%.
Required
What is the incremental EPS?
Answer
Income impact: $1,000,000 × 5% × (1 – 0.25) = $37,500
Share impact: (1,000,000 / 1,000) × 25 = 25,000 shares
Incremental EPS: $37,500 / 25,000 = $1.50
3.3.2 Incremental EPS for convertible preferred shares
The income impact for convertible preferred shares depends on whether the shares are cumulative or not:
• Dividends on cumulative convertible preferred shares are considered whether declared in the year or not.
• Dividends on non-cumulative convertible preferred shares are only considered if declared in the year.
The share impact is the number of additional common shares that would be outstanding if the preferred shares are converted into common
shares.
If the preferred shares were issued partway through the year, both the income impact and the share impact would be weighted for the part of
the year in which the preferred shares were outstanding.
Danforth has the following preferred shares issued and outstanding:
• 50,000 Class A preferred shares, with a cumulative dividend of $1 per share; convertible into two common shares
• 25,000 Class B preferred shares, with non-cumulative dividends of $1 per share; convertible into five common shares
Danforth declared full dividends on the Class A preferred shares in the year and declared a dividend of $1 per share on the Class B shares.
Required
What is the incremental EPS for both the Class A and Class B preferred shares?
Answer
Class A:
Income impact: 50,000 × $1.00 = $50,000
Share impact: 50,000 × 2 = 100,000 shares
Incremental EPS: $50,000 / 100,000 = $0.50
Class B:
Income impact: 25,000 × $1.00 = $25,000

Share impact: 25,000 × 5 = 125,000 shares
Incremental EPS: $25,000 / 125,000 = $0.20
3.3.3 Incremental EPS for stock options and warrants
A stock option provides the holder with the right to acquire common shares of a company at a specified price (exercise price).
An option is "in the money" if the exercise price is less than the
current market value of a common share. Only options that are in
the money are considered for diluted EPS because the holder of an
option will not exercise an option that is not in the money.
The treasury stock method is used to determine the incremental impact. Under the treasury stock method, the income impact is nil. The
treasury stock method assumes the proceeds that a company receives from the exercise of an option are used to repurchase company shares on
the market.
As an example, assume the exercise price of an option is $8. When the market price is $10, the holder of the options exercises his or her right
to acquire 1,000 common shares:
• 1,000 shares are issued and the entity receives cash of $8,000 (1,000 × $8)
• 800 shares could be reacquired with the cash received ($8,000 / market price of $10 per share)
• 200 share effect — this is the difference between what was issued and what the company could reacquire with that money on the market
(1,000 issued – 800 able to be reacquired)
The share impact could also have been determined as follows:
= Number of options × (Market price – Exercise price) / Market price
The average market price for the period is used to determine the share impact. As the income impact is nil and the share impact is positive,
incremental EPS for stock options will be nil, so options in the money will always be dilutive.
Danforth has 2,000 stock options outstanding allowing option holders to purchase shares at $20/share. Shares are trading at $24/share at year
end and had an average market price in the year of $25/share.
Required
Determine the share effect, income effect and incremental EPS of the options.
Answer
Income effect = $0
Share effect = 2,000 × ($25 – $20) / $25
= 400 shares
Incremental EPS = $0/400 shares
= $0/share
3.4 Step 4: Order the incremental EPS
The fourth step, ordering the incremental EPS of the various PCS from the lowest (the most dilutive) to the highest (the least dilutive), is
straightforward.
In-the-money stock options will always be the most dilutive, as their incremental EPS is $0.
When you have two or more PCS that have the same incremental EPS (as will always be the case when you have more than one in-the-money
option), then their relative order does not matter. For example, if you have in-the-money options A and B, the ranking can be A (first) and B
(second), or B (first) and A (second).
In the above exercises, you have calculated the incremental EPS for four PCS instruments.
Required
Order the following results from most dilutive to least dilutive:
PCS Income effect Share effect Incremental EPS Order

Convertible bond 37,500 25,000 1.50
Convertible Class A preferred shares 50,000 100,000 0.50
Convertible Class B preferred shares 25,000 125,000 0.20
Stock options — 400 —
Solution
PCS Income effect Share effect Incremental EPS Order

Convertible bond 37,500 25,000 1.50 4
Convertible Class A preferred shares 50,000 100,000 0.50 3
Convertible Class B preferred shares 25,000 125,000 0.20 2
Stock options — 400 — 1
3.5 Step 5: Recompute provisional EPS until diluted EPS is determined
The fifth step in the process is to successively use the ordered incremental EPS to recompute provisional EPS until diluted EPS is determined.
It is important to move from the lowest (and most dilutive) PCS to the highest, as you may incorrectly compute diluted EPS otherwise.
PCS can be dilutive or antidilutive; however, paragraph 31 of IAS 33 Earnings per Share establishes that only dilutive PCS are considered
when determining diluted EPS. In some instances (such as an out-of-the-money stock option or an incremental EPS that exceeds basic EPS), it
is readily evident whether a given PCS is dilutive or not. For other PCS, however, whether they are dilutive or antidilutive cannot be firmly
established until Step 5 when the process outlined above has been completed.
3.5.1 The process
Basic EPS is used as a starting point.
1. Compare the incremental EPS of the first ranked PCS (the most dilutive) to the basic EPS.
2. When incremental EPS is less than basic EPS, include PCS in the diluted EPS computation. Calculate provisional EPS.
3. Compare the incremental EPS of the second-ranked PCS to the provisional EPS just calculated in the immediately preceding step.
4. When incremental EPS is less than provisional EPS, include PCS in the diluted EPS computation. Calculate provisional EPS.
5. Continue the process until all PCS are considered or incremental EPS is greater than provisional EPS.
6. When all PCS is considered or incremental EPS is greater than provisional EPS, diluted EPS is equal to the last provisional EPS.
Using the information from the other exercises above, calculate diluted EPS for Danforth.
Answer
Income Share effect Basic Provisional Diluted EPS

effect EPS EPS
Basic EPS 1,250,000 341,667 3.66
Stock options — 400
Provisional EPS 1,250,000 342,067 3.65
Class B preferred 25,000 125,000
Provisional EPS 1,275,000 467,067 2.73
Class A preferred 50,000 100,000
Provisional EPS 1,325,000 567,067 2.34
Convertible bonds 37,500 25,000
Diluted EPS 1,362,500 592,067 2.30 2.30
4 ASPE Differences
ASPE does not address EPS, as it is not required for non-public entities.
5 Practice Problem
Kingman Crown Inc. (KCI) is a Canadian publicly traded company with a December 31 year end. Information about its capital structure at the
beginning of the current year is as follows:
• Common shares issued and outstanding: 1,000,000.
• Debt with a face value of $2,500,000 and a coupon rate of 6% is convertible into common shares at the option of the holder. Each $100
bond is convertible into five common shares. These bonds were issued at par.
• 20,000 Class B non-cumulative preferred shares are convertible at the option of the holder into two common shares for each preferred
share. The dividend rate is $3.00 per share.
• The CEO of KCI holds options to acquire 220,000 common shares at an option price of $6.00 per share.
Current-year activities:
• On May 1, KCI issued 150,000 common shares for cash.
• On July 1, when the shares were trading at $6.50 per share, the CEO exercised his option to purchase 100,000 common shares.
• On September 1, KCI redeemed 150,000 common shares for cash.
• Dividends of $3.00 and $0.90 were declared on the preferred shares and common shares, respectively.
• After-tax net earnings were $1,800,000.
• The average market price of KCI's common shares was $7 per share.
• KCI's income tax rate is 30%.
Required
Determine basic and diluted EPS for KCI.
Answer
Basic EPS
Earnings available to common shareholders:
Net earnings $1,800,000

Dividends on preferred (20,000 × $3) (60,000)
Net earnings available to common shareholders $1,740,000
Dividends on common shares are distributions of capital; therefore, they have no impact on earnings.
WACSO:
Shares Fraction of WACSO

outstanding the year (c) (a) × (b) × (c)
(a) Adjustment
Date Activity factor (b)
Jan. - April Opening 1,000,000 1 4/12 333,333
balance
May - June 150,000 1,150,000 1 2/12 191,667
issued
July - Aug. 100,000 1,250,000 1 2/12 208,333
issued
Sept. - Dec. 150,000 1,100,000 1 4/12 366,667
redeemed
1,100,000
Basic EPS = Net earnings (loss) available to common shareholders

WACSO
= $1,740,000 / 1,100,000 shares
= $1.58 / share
Diluted EPS
Incremental EPS for PCS
Options Earnings Shares EPS
Income effect $0
Outstanding: 120,000 × (7 – 6) / 7 17,143
Exercised: 100,000 × (7 – 6) / 7 × (6 / 7,143
12)
Incremental EPS $0 24,286 $0.00
The CEO had an option to acquire 220,000 common shares at an exercise price of $6.00. On July 1, he exercised an option to acquire 100,000
shares. As a result, options to acquire 120,000 shares were outstanding for the entire year. The option to acquire 100,000 shares was
outstanding for six months from January 1 to June 30, so the impact on shares is weighted for that period.
Convertible debt Earnings Shares EPS

Income effect: $2,500,000 × 6% × (1 – $105,000
0.30)
Share effect: $2,500,000 / $100 × 5 125,000
Incremental EPS $105,000 125,000 $0.84
If the bonds are converted, KCI will not have to pay interest to bondholders and income will increase by $105,000 per year on an after-tax
basis. In addition, another 125,000 common shares will be outstanding.
Convertible preferred shares Earnings Shares EPS

Income effect: 20,000 × $3.00 $60,000
Share effect: 20,000 × 2 40,000
Incremental EPS $60,000 40,000 $1.50
If the preferred shares had been converted to common shares, the $60,000 dividend declared on the preferred shares would not have been paid
and would have increased earnings available to common shareholders. In addition, 40,000 more common shares would have been outstanding.
Income Share effect Basic EPS Provisional Diluted EPS

effect EPS
Basic EPS 1,740,000 1,100,000 1.58
Stock options — 24,286
Provisional EPS 1,740,000 1,124,286 1.55
Convertible debt 105,000 125,000
Provisional EPS 1,845,000 1,249,286 1.48 1.48
Options are always the most dilutive, so they are adjusted for first. After adjusting for the options, provisional EPS is $1.55. The next most
dilutive security is the convertible bonds with an incremental EPS of $0.84, which is less than revised EPS of $1.55. Once the incremental
EPS of the bonds is considered, the revised EPS is $1.48.
The convertible preferred shares have an incremental EPS of $1.50, so the PCS associated with the convertible preferred shares are antidilutive
and are not considered.
KCI would disclose basic EPS of $1.58 and diluted EPS of $1.48.
There are no supplemental resources available for this chapter

Footnotes
* The $100,000 dividend paid covers $50,000 related to the prior year and $50,000 related to the current year. Only the dividend for the current
year is deducted for cumulative dividends on preferred shares.
Financial Reporting >> Chapter 26 – Business Combinations — Date of Acquisition
Chapter 26
Business Combinations — Date of Acquisition
This chapter reviews the basic components of financial reporting for business combinations at acquisition, often known as consolidation at
acquisition. The chapter begins with IFRS and then addresses ASPE differences, as they are relatively minor.
Business combinations are covered in IFRS 3 Business Combinations and refer to any event where one entity obtains control over another
entity. Business combinations generally happen in two ways:
• purchase of assets of another entity
• purchase of shares of another entity
Two of the important terms related to consolidation are "parent" and "subsidiary." A parent is the entity that controls the net assets of another
entity. Ownership of the other entity is through the purchase of shares (rather than a net asset purchase). A subsidiary is an entity controlled by
another entity. It continues to be a separate legal entity.
At the time that control is acquired, the acquirer (in a purchase of shares, the parent) is required to record the purchase of the acquiree (in a
purchase of shares, the subsidiary) in its own internal financial statements. IFRS requires that the acquisition be accounted for using the
acquisition method.
0 Summary
OR0278E_FR_Business_Combinations_Date_of_Acquisition_SUM
1 Purchase of Net Assets
When an entity acquires another entity by purchasing its net assets, the acquisition process, from a financial reporting standpoint, is relatively
simple. In the same way as in any acquisition of an asset, or assumption of a liability, the acquirer simply records the asset or liability at its fair
value (FV) directly in its financial reporting records. Any difference between the consideration paid and the FV of the identifiable assets and
liabilities acquired is recorded as goodwill. This will be discussed in further detail below, as the concept of the allocation of the purchase price
and determination of goodwill is the same for a purchase of assets and a purchase of shares.
In the case of the purchase of assets, the entry would look like this:
Dr. Accounts receivable (AR); inventory; property, plant, and equipment (PP&E);
and so forth (assets purchased including any goodwill)
Cr. Accounts payable (AP), bank loan, and so forth (liabilities assumed)
Cr. Consideration given up (cash, common stock, debt, and so forth)
This is a one-time entry, and once completed, the acquirer will show all of the assets and liabilities it now owns in its financial records. The
acquiree's records will only show the assets and liabilities that have not been sold. The acquirer and acquiree will no longer have any
involvement with each other. This differs significantly from the situations where there is a purchase of shares, which is discussed next.
2 Purchase of Shares
In the case of the purchase of shares, the steps required are more complicated. On initial acquisition, the entry will look like this:
Dr. Investment in subsidiary

Cr. Consideration given up (cash, common stock, debt, and so forth)
In this case, the acquirer (the parent) records its purchase of the shares of the acquiree (the subsidiary). As the subsidiary still maintains its
own legal status, it will continue to maintain its own financial statements (F/S), independent of the parent. The subsidiary continues to own its
assets and liabilities.
The parent, however, is required to report its investment on a consolidated basis. This means that the parent will present a consolidated set of
statements that reflect what the entity would look like if the two (or more) entities operated as single company. Therefore, a spreadsheet must
be prepared to record the combined entity results. In the spreadsheet, the accounts of the parent and subsidiary(ies) are added together and are
adjusted using elimination / consolidation entries (described further below) to determine the components of the consolidated statements.
3 Acquisition Process
The remainder of this chapter will focus on the acquisition of shares and will start by walking through a number of steps that occur in the
acquisition process:
• Identify the acquirer.
• Determine the date of acquisition.
• Determine the purchase price.
• Analyze the acquisition differential.

o Recognize and measure identifiable assets acquired and liabilities assumed.
o Recognize and measure goodwill at acquisition (or, alternatively, a gain on a bargain purchase).
• Allocate non-controlling interest, if any.
4 The Acquirer
The acquirer, or the parent, is the entity that obtains control over the other entity. This is more complex than simply looking at which company
was "purchased." You will need to determine which of the original shareholders control the new combined entity.
Control can be thought of as the ability to make decisions over the controlled entity without co-operation. Appendix B in IFRS 10
Consolidated Financial Statements provides some factors to consider when assessing control, including the following:
• Which of the original companies' owners have the largest portion of voting rights of the combined entity? An entity that controls more
than 50% of the voting rights is likely able to exert control.
o Potential voting rights from convertible shares, warrants, debts, and so forth should be considered.
• What is the composition of the governing body of the combined entity? An entity with control may have more board members or voting
rights than other shareholders.
• What is the composition of the senior management that governs the combined entity after acquisition? If the combined senior management
all originate from one entity, this could be indicative that the original entity is in control.
• Which entity initiated the business combination? Although not as key as the other factors above in determining the acquirer, if all else is
equal, the entity that initiated the combination could be seen as the acquirer.
Determining who controls whom is key to identifying the acquirer. It often requires professional judgment after an in-depth analysis.
4.1 Test your knowledge
The shareholders of Tailor Inc. (TI) and Hem Inc. (HI) have reached an agreement to merge the two companies and create a new company
called TH Ltd. The agreement is outlined below:
• The new company will purchase all the assets and liabilities of TI and HI. After the sale, the two companies will be wound up.
• Some of TI's senior management will be retained to run the newly formed TH. All of HI's management will be given early retirement
packages.
• The TI shareholders will receive 49% of the voting common shares, along with some convertible preferred shares. If the convertible
preferred shares are converted, it would provide the TI shareholder group with an additional 3% of the voting rights.
• The HI shareholders will receive 51% of the voting common shares.
Required
Based on the information above, determine who the parent is.
Answer
This is a business combination, as control has been acquired over a group of assets. The acquisition method will be used to account for this
merger. The analysis needs to determine who the acquirer is in this scenario.
The shareholders of TI and HI will receive shares in the newly formed TH. The TI group will receive 49% and the HI group will receive 51%.
However, in addition to this, the TI group holds convertible preferred shares in the new company. If the TI group has the ability to convert
these immediately, it would have the ability to hold the majority of the shares (52%). If it cannot convert immediately, it would not have a
majority, in effect, until the point in time that it can convert.
Another factor that should be considered is that TI's senior management will be retained to run the newly formed company, while HI's
management has been let go; this is another indicator of TI controlling TH.
Conclusion: Given that TI's senior management is being retained and the convertible preferred shares held by TI's shareholder group will
eventually position them as the majority shareholders, it would suggest that the shareholders of the former TI company remain in the power
position. It would, therefore, be reasonable to conclude that TI's shareholder group controls the newly created TH. TI would be the acquirer in
this business combination.
5 Acquisition Date
The acquisition date is the date that the parent obtains control of the subsidiary. It usually aligns with the date that the acquisition legally
closes. It is possible for the acquisition date to be earlier than the legal closing — for example, if the voting rights of the parent become
effective before the date that the acquisition legally closes.
6 Purchase Price
When determining the purchase price for the parent, you need to look at how the shares were acquired. The parent may have paid cash, or it
may have issued debt or shares to the subsidiary's shareholders. Regardless of the method of payment, the approach does not change. The FV
of the compensation is used as the purchase price.
The parent may incur transaction costs in buying the shares of the subsidiary. Examples include finder's fees, advisory fees, legal fees,
accounting fees, brokerage fees, and valuation fees. These costs are expensed when incurred and will not impact the purchase price.
The parent may incur transaction costs in issuing its own shares to buy shares in the subsidiary. If the costs are directly related to issuing a
parent's own shares, then the costs are netted against share capital and do not affect the purchase price.
7 Acquisition Differential
Generally, the parent will have paid an amount higher than the book value (BV) of the subsidiary's net assets. Any difference between the
purchase price and the BV of the subsidiary is referred to as the acquisition differential (or sometimes the purchase premium). The reason for
this difference needs to be determined.
It is assumed this occurs for two reasons:
1. FVs: The FVs of the assets and liabilities of the subsidiary at the time of acquisition are different from the BVs of those assets and
liabilities.
If the FV of an asset is higher than the BV, a rational investor would be willing to pay more. It the FV is less than the BV, a rational
investor would pay less.
And
2. Goodwill: Goodwill represents the expected value of future financial performance. The expectation arises because intangible favourable
characteristics of the subsidiary make it likely that the subsidiary will produce higher-than-average earnings. This leads to a value for the
subsidiary that is greater than the total FV of the individual identifiable net assets of the investee.
Examples of why goodwill may occur include location, superior management, or a loyal customer base.
7.1 Identifiable assets acquired and liabilities assumed
When an acquisition has occurred, the first step in allocating the purchase price is to determine the identifiable assets (including intangible
assets) and liabilities of the entity acquired. These assets and liabilities acquired are initially measured at their FV at the date of acquisition,
regardless of whether they were previously recognized by the subsidiary. For example, an internally developed patent may not be recognized
on the F/S of the subsidiary but would be considered an identifiable intangible asset by the parent. If an intangible asset is not identifiable,
none of the purchase price is allocated to it.
The subsidiary may have a goodwill asset on its balance sheet

(B/S) from a prior transaction. Goodwill is, by definition, not an
identifiable asset and is only derived as a result of an acquisition.
Therefore, any existing goodwill on the subsidiary's books should
be given an FV of nil in the assignment of values to identifiable
assets and liabilities and a new amount of goodwill determined for
this acquisition.
7.2 Goodwill (or bargain purchase)
Once the purchase price has been allocated to the FV of the identifiable net assets, any remaining differential is recorded as goodwill. In
simple terms, goodwill is the difference between the consideration given up and the FV of all the identifiable net assets received. It is the
premium that the parent is willing to pay to the shareholders of the subsidiary in order to obtain a company that is worth more than just the net
assets it owns.
To understand this, it may be beneficial to think of a well-known coffee retailer. Think about the equipment used and the leasehold
improvements made. Then ask yourself: Would I be willing to pay more to buy the existing business than it would cost to start a new one, in
order to gain access to the established cash flow? If the answer is yes, the amount that you would pay in excess of the FV of the net assets is
classified as goodwill.
Goodwill is a residual amount — it cannot be valued directly. Rather, when the parent acquires 100% of the subsidiary, goodwill is the excess
of the consideration paid over the FV of the identifiable net assets acquired.
7.2.1 Bargain purchase
Sometimes, after a company has allocated proceeds to the identifiable net assets, it determines that it paid less for the company than the FV of
the identifiable net assets at the date of acquisition. When this occurs, it is referred to as a bargain purchase. This is possible in situations
where the seller is in a hurry to sell, or simply as a result of good negotiations.
When an acquisition is deemed to be a bargain purchase, the first thing to do is revisit the net assets identified and the FVs assigned to them.
You want to make sure that all assumed liabilities have been identified and recorded. Additionally, you want to make sure that the FVs are
appropriate and an asset (or a liability) is not measured at a value higher (or lower) than it should be. Once you have done this, you can be
comfortable that a bargain purchase truly does exist.
In the case of a bargain purchase, there is no goodwill in the acquisition. Any difference between the purchase price and the FV of net assets
acquired is recognized as a gain in the F/S of the parent at the date of acquisition.
7.3 Acquisition differential schedule
An entity generally tracks the acquisition differentials (for both FVs and goodwill) in what is known as an acquisition differential schedule (or
purchase price discrepancy schedule). In this schedule, the differences between the BV and the FV of identifiable net assets and goodwill are
tracked.
Consideration paid
– BV of the investee's net assets
Acquisition differential
+/– FV differentials
Goodwill
Basically, you take the acquisition differential and try to figure out how much of it is due to the fact that some assets or liabilities have FVs
that are different from their BVs. The remainder, if it is positive, is assumed to be goodwill.
An easy way of ensuring that you have the correct sign in

calculating the FV differentials is to set up assets as positive
numbers and liabilities as negative numbers, and then calculate the
FV differential as BV – FV.
7.3.1 Deferred income taxes
Deferred income taxes (DIT) on the FV differentials must also be considered in analyzing the acquisition and determining goodwill.
FV differentials are temporary differences that will reverse over time when they are amortized to income in the consolidated F/S. For example,
when you amortize the FV differential on inventory, you will record an increase in cost of sales (when the FV of inventory is greater than its
BV at acquisition). You anticipate the reversal of the temporary differences and record DIT on those temporary differences at the time of
acquisition. Essentially, you want the FV differentials to be on a net-of-tax basis. Thus, if the FV differential is added in the analysis of the
purchase, the related DIT will be deducted.
Temporary differences are multiplied by the tax rate to determine DIT.
Example
A parent acquires a subsidiary with a depreciable asset that has a tax basis of $60,000 and a net book value (NBV) of $75,000. Assume both
the parent and the subsidiary have a tax rate of 30%. The subsidiary would show a DIT liability of $4,500 [($75,000 – $60,000) × 30%].
The parent determines the asset to have an FV of $80,000. The tax basis remains $60,000. From the parent's perspective, the DIT liability is
now $6,000 [($80,000 – $60,000) × 30%].
Therefore, from a consolidation perspective, you would look at the FV increment for the asset of $5,000 ($80,000 - $75,000) and recognize a
corresponding adjustment to the DIT liability of $1,500 ($5,000 × 30%). From a consolidated entity perspective, the FV will be depreciated
and the full value is a temporary difference.
Accounting Tax value

value to be for CCA
depreciated (B) Temporary
(A) difference Tax rate DIT
(C = A – B) (D) (C × D)
Consolidated statements 80,000 60,000 20,000 30% 6,000
Subsidiary's statements 75,000 60,000 15,000 30% 4,500
Adjustment to consolidated
statements
5,000 1,500
For non-depreciable assets, you also need to consider any potential deferred tax liability — in particular, the fact that capital gains and losses
are only included in taxable income at 50%. As a result, 50% is a temporary difference and 50% is a permanent difference between financial
reporting and tax. This has the following effect:
• For non-depreciable capital assets with a "gain" FV differential (FV is greater than BV), the FV differential is multiplied by 50% in
calculating the DIT effect.
• For non-depreciable capital assets with a "loss" FV differential (FV is less than BV), the FV differential is multiplied by 50% in
calculating the DIT effect.
On January 1, 20X1, Purcell Inc. acquired 100% of Saxton Co.'s 225,000 issued and outstanding common shares for $950,000 cash.
At the date of acquisition, Saxton had the following BVs and FVs:
BV FV
Assets
Cash $ 95,000 $ 95,000
AR 171,000 171,000
Inventory 273,000 392,000
Land 160,000 189,000
Equipment, net 244,000 156,000
Other PP&E, net 852,000 852,000
Customer list 105,000 140,000
Total assets $1,900,000 $1,995,000

Liabilities and equity
AP and accrued liabilities $ 269,000 $ 269,000
Long-term debt 875,000 875,000
DIT 59,000 59,000
Total liabilities 1,203,000 1,203,000
Common shares 251,000
Retained earnings (R/E) 446,000
Total liabilities and equity $1,900,000
Additional information:
• Saxton is not amortizing the customer list, as it is expected to have an indefinite useful life.
• The tax rate for both Purcell and Saxton is 25%.
Required
Determine the value of goodwill for this business combination.
Answer
Purcell has purchased 100% of Saxton's shares and, therefore, is considered the parent. The consideration given up is $950,000 cash.
The calculation of goodwill would be as follows:
Consideration paid $ 950,000

BV of Saxton's net assets:
Common shares (251,000)
R/E (446,000)
Acquisition differential $ 253,000

Allocated to FV differentials: (BV – FV)
Inventory: 273,000 – 392,000 (119,000)
Equipment: 244,000 – 156,000 88,000
Land: 160,000 – 189,000 (29,000)
Customer list: 105,000 – 140,000 (35,000)
DIT on FV differentials (see below) 15,750
Goodwill $173,750
The purchase price is compared to the parent's share of the BV of the subsidiary's net assets to determine the acquisition differential. This is
the amount the parent paid above (or below) the actual NBV recorded on the subsidiary's books.
DIT included in the analysis of the purchase can be determined as follows:
Temporary differences
Inventory $119,000
Equipment (88,000)
Land: 29,000 × ½ 14,500
Customer list× ½ 17,500
Net temporary differences 63,000
Tax rate 25%
DIT $ 15,750
The best way to ensure DIT amounts are correctly included in the analysis of the purchase is to reverse the sign on the FV differential when
you include it in the determination of goodwill. As an example, the FV differential on inventory is deducted in the analysis of the purchase
above, and when it is included in the schedule to determine DIT, it is added. The FV differential on equipment is added in the analysis of the
purchase, so it is deducted in the schedule to determine the impact of DIT.
Only one-half of the FV differentials on the land and customer list is included in temporary differences because only one-half of the increase
in value of the land or the customer list (that is, a taxable capital gain) will be taxed when the land or customer list is sold.
Temporary differences are multiplied by the tax rate to determine DIT. The net result is a positive $15,750. Therefore, that amount is added in
the analysis of the purchase to determine goodwill.
8 Non-Controlling Interest
In the example above, the parent owned 100% of the shares of the subsidiary. However, this is not always the case. Often, a parent owns less
than 100% of the shares but still controls the subsidiary. The shareholders who own the other shares are referred to as the non-controlling
interest (NCI) shareholders. When the parent owns less than 100% of the shares, it is necessary to account for the NCI shareholders' interest in
the equity of the subsidiary separately from the parent's interest. The NCI shareholders' interest in the equity of the subsidiary is reflected in
the balance sheet of the consolidated entity and is classified as an equity account.
IFRS 3.19 allows a choice in the measurement of the NCI, as follows:
• identifiable net assets (INA) approach (partial goodwill approach)
• fair value enterprise (FVE) method (full goodwill approach)
In the INA approach, the NCI is measured as the NCI shareholder ownership percentage of the FV of the identifiable net assets of the
subsidiary. For instance, the NCI value would be calculated as follows: (FV of subsidiary's identifiable assets – FV of subsidiary's liabilities) ×
NCI percentage ownership. In this case, goodwill associated with the acquisition will be goodwill attributable to the parent company interest
only.
In the FVE method, the NCI is measured as the fair value of the NCI shareholder's ownership interest. IFRS 3.B44 addresses the measurement
of the FV of the NCI. If the NCI shares trade in an active market, the quoted market price for the shares may be used as a measure of FV. If
subsidiary shares do not trade in an active market, the FV of the NCI would have to be measured using some other valuation technique.
The price paid by the parent to acquire its controlling interest is not generally a good measure of the FV of the NCI, as indicated in IFRS
3.B45. "The fair values of the acquirer's interest in the acquiree and the non-controlling interest on a per-share basis might differ. The main
difference is likely to be the inclusion of a control premium in the per-share fair value of the acquirer's interest in the acquiree or, conversely,
the inclusion of a discount for lack of control (also referred to as a non-controlling interest discount) in the per-share fair value of the non-
controlling interest if market participants would take into account such a premium or discount when pricing the non-controlling interest."
This is a continuation of the Purcell and Saxton scenario above (Section 7.3.2). Assume all information presented is the same except that
Purcell acquired 80% of Saxton's 225,000 issued and outstanding common shares for $760,000 cash.
Required
a) Calculate goodwill and NCI assuming that Purcell uses the INA approach.
b) Calculate goodwill and NCI assuming that Purcell uses the FVE method and that, in the week after acquisition, Saxton's shares not
owned by Purcell traded at $4.00 per share.
Answer
a) INA approach (partial goodwill approach)
Cost of investment (80%) $760,000

NCI: 20% of FV of INA
($1,995,000 – $1,203,000 – $15,750) × 20%
155,250
Implied transaction value using INA approach $915,250

R/E (446,000)
Acquisition differential $218,250

Inventory: 273,000 – 392,000 (119,000)
Equipment: 244,000 – 156,000 88,000
Land: 160,000 – 189,000 (29,000)
Customer list: 105,000 – 140,000 (35,000)
DIT on FV differentials 15,750
Goodwill $139,000
The NCI is $155,250 and goodwill is $139,000. As the NCI is measured as 20% of the FV of Saxton's identifiable net assets, goodwill of
$139,000 is all attributable to the parent company shareholders. Goodwill of $139,000 is 80% of the goodwill of $173,750 determined for the
example above where the Purcell purchased 100% of the shares of Saxton.
b) FVE method
Cost of investment (80%) $760,000

NCI: FV of Saxton shares owned by NCI
225,000 × 20% × $4.00
180,000
Implied transaction value using FVE approach $940,000

R/E (446,000)
Acquisition differential $243,000

Inventory: 273,000 – 392,000 (119,000)
Equipment: 244,000 – 156,000 88,000
Land: 160,000 – 189,000 (29,000)
Customer list: 105,000 – 140,000 (35,000)
DIT on FV differentials 15,750
Goodwill $163,750
The NCI is $180,000 and goodwill is $163,750. Now, in addition to goodwill of $139,000 attributable to the parent, goodwill of $24,750
($163,750 – $139,000) is attributed to the NCI.
With the FVE method (full goodwill approach), goodwill is attributed to both the parent company interest and the NCI. Note that the FV
differentials and DIT is the same under both methods.
The difference between the INA approach and FVE approach can be summarized as follows:
INA goodwill — goodwill attributable to the parent only $139,000

Goodwill attributable to the NCI 24,750
Goodwill under the FVE approach $163,750
9 Elimination Entry
The starting point for creating the consolidated F/S is to add the parent's and the subsidiary's F/S together. You then adjust this as needed for
any amounts that need to be eliminated or included.
The adjustments referred to above are posted through elimination entries. These entries are similar to journal entries in that the debits must
equal the credits. However, they are different in that they are only used to prepare the consolidation; they are never posted to the general
ledger.
One elimination entry is prepared at acquisition. This entry must:
• Set up goodwill.
o You need to record a debit to goodwill to set up the goodwill calculated in the acquisition differential schedule.
• Set up NCI, if any.
o You need to record a credit in equity for any value of the consolidated entity attributed to the minority shareholders.
• Record FV differentials.
o The parent based its purchase price on FV of the assets and liabilities. Therefore, the parent wants the consolidated B/S to reflect the FV
of assets and liabilities at the time of acquisition. FV differentials show the difference between BV and FV; therefore, you adjust for the FV
differentials to bump up or down the BV of the assets and liabilities to FV.
• Eliminate the subsidiary's common shares.
o Since the parent is already recording all of the subsidiary's net assets, it would be double-counting to also record the subsidiary's common
shares. Therefore, you eliminate the entire subsidiary's common share balance at acquisition.
• Eliminate the subsidiary's R/E.
o The subsidiary's R/E are really earnings of the previous owner. Therefore, the parent cannot record these accumulated earnings in its own
consolidated F/S. As a result, you eliminate all of the subsidiary's R/E at acquisition.
• Eliminate the parent's investment.
o Recall that, on acquisition, the parent would have recorded an investment in its B/S for the subsidiary. You need to eliminate that
investment, since you are basically taking the investment and spreading it around the B/S (by adding in the subsidiary's net assets adjusted for
FV).
This is a continuation of the Purcell and Saxton scenario above (Section 8.1). Purcell acquired 80% of Saxton's 225,000 issued and outstanding
common shares for $760,000 cash.
Required
Prepare the elimination entry assuming that Purcell uses the FVE method for valuing the NCI, and that, in the week following acquisition,
Saxton's remaining shares were trading at $4.00 per share.
Answer
FVE elimination entry

Dr. Common shares $251,000
Dr. R/E 446,000
Dr. Inventory 119,000
Dr. Land 29,000
Dr. Customer list 35,000
Dr. Goodwill 163,750
Cr. Equipment $ 88,000
Cr. Investment in Saxton 760,000
Cr. DIT 15,750
Cr. NCI (B/S) 180,000
$1,043,750 $1,043,750
10 Consolidated B/S
When the consolidated B/S is created at acquisition using the eliminating entries, those entries are "posted" using a worksheet. The F/S of the
parent and the subsidiary are first recorded in the consolidation worksheet. These amounts are then adjusted using the elimination entry above
to arrive at the consolidated B/S.
This is a continuation of the Purcell and Saxton scenario above (Section 8.1). Purcell's F/S can be found below:
Purcell
Assets
Cash $ 120,000
AR 216,000
Inventory 345,000
PP&E, net 1,380,000
Investment in Saxton 760,000
Total assets $2,821,000

AP and accrued liabilities $ 340,000
Long-term debt 1,104,000
DIT 155,000
Common shares 350,000
R/E 872,000
Total liabilities and equity $2,821,000
Required
Prepare the consolidation worksheet for Purcell.
Answer
Elimination entries
Purcell Saxton Debit Credit Consolidated
Assets:
Cash 120,000 95,000 215,000
AR 216,000 171,000 387,000
Inventory 345,000 273,000 119,000 737,000
PP&E, net * 1,380,000 1,256,000 29,000 88,000 2,577,000
Customer list 0 105,000 35,000 140,000
Goodwill 0 0 163,750 163,750
Investment in Saxton 760,000 0 760,000 0
Total assets 2,821,000 1,900,000 4,219,750

Liabilities and equity:
AP and accrued liabilities 340,000 269,000 609,000
Long-term debt 1,104,000 875,000 1,979,000
DIT 155,000 59,000 15,750 229,750
Common stock 350,000 251,000 251,000 350,000
NCI 0 0 180,000 180,000
R/E 872,000 446,000 446,000 872,000
Total liabilities and equity 2,821,000 1,900,000 4,219,750
10.2 Direct calculation
While the method above uses an elimination entry to create the consolidated B/S, a more direct method can be used to determine balances on
the statement. The consolidated amounts for each account can be created simply as follows:
Parent's BV + Subsidiary's BV +/– FV differential
Without using an elimination entry or consolidation worksheet (and only using the parent's B/S, the subsidiary's B/S and the goodwill
calculation), determine consolidated PP&E for Purcell.
Answer
Purcell's BV of PP&E $1,380,000

Saxton's BV of PP&E 1,256,000
Add the land FV differential 29,000
Less the equipment FV differential (88,000)
Consolidated PP&E $2,577,000
You should note that the full amount of the FV differential relating to the account of PP&E is included. The DIT relating to the land and
equipment FV differential is not included in the PP&E account. Instead, the DIT would be included in the DIT account balance on the B/S.
Also note that the FV differential will be amortized over time. As a result, in the future, you will only include the unamortized balances.
11 Steps
In summary, the following steps are required to consolidate a B/S at acquisition:
1. Prepare the acquisition differential schedule.
• If less than 100% ownership, consider NCI in determining implied value of purchase.
• Allocate the acquisition differential to FV differentials and then goodwill.
2. Prepare the elimination entry.
• Set up goodwill.
• Set up NCI equity account.
• Record FV differentials.
• Eliminate subsidiary's common shares.
• Eliminate subsidiary's R/E.
• Eliminate parent's investment.
3. Prepare the consolidated B/S.

• Add together parent's and subsidiary's balances.
• Adjust for the acquisition elimination entry.
12 Intercompany Transactions
Intercompany receivables and payables may exist at acquisition due to transactions between the parent and subsidiary prior to acquisition.
• These should be eliminated upon consolidation.
The parent may also own a portion of the subsidiary's preferred shares.
• The ownership in preferred shares should be eliminated upon consolidation.
• Any dividends payable / receivable should be eliminated upon consolidation.
• The preferred shares should be allocated to the NCI.
The parent and subsidiary are considered one economic entity in the consolidation; therefore, an entity cannot owe itself something. In
addition, it cannot own preferred shares in itself.
Intercompany transactions will be covered in more detail in other eBook chapters.
13 ASPE Differences
The acquisition method is used under both IFRS and ASPE. The process is the same under both.
Under ASPE Section 1591 Subsidiaries, however, the parent has a choice of methods to use for reporting its subsidiary:
• acquisition method (consolidation) — discussed in this chapter
• equity method
• cost method (note that if the subsidiary's shares have a quoted price in an active market, then the FV must be used, not cost)
The equity method is addressed in eBook chapter 25.
14 Practice Problem
Padmore acquired 100% of Starling's 275,000 issued and outstanding common shares for $1,300,000 cash. The B/S of Padmore and Starling
were as follows immediately after the acquisition:
Padmore Starling
Assets
Cash $ 144,000 $ 114,000
AR 259,200 205,200
Inventory 414,000 327,600
PP&E, net 1,656,000 1,507,200
Customer list — 126,000
Investment in Starling 1,300,000 —
Goodwill — 45,600
Total assets $3,773,200 $2,325,600

AP and accrued liabilities $ 408,000 $ 322,800
Long-term debt 1,324,800 1,050,000
DIT 186,000 70,800
Common shares 560,200 301,200
R/E 1,294,200 580,800
Total liabilities and equity $3,773,200 $2,325,600
Additional information:
• Inventory had a FV of $423,600.
• Equipment with an original cost of $695,000 and a NBV of $505,000 had a FV of $604,000.
• Land with an original cost of $265,000 had a FV of $189,000.
• The remainder of PP&E had a FV that equalled BV.
• The customer list had a FV of $150,000. As the customer list is expected to have an indefinite useful life, Starling is not amortizing the
customer list.
• The tax rate for both Padmore and Starling is 30%.
Required
a) Calculate goodwill at acquisition and prepare the elimination entry to adjust the opening B/S accounts.
b) Prepare a consolidated B/S immediately after acquisition.
Answer
See the Excel solution in Supplemental Resources.
Supplemental Resources
Type of Resource Resource Title Reference
Excel Excel Solution OR0278E_FR_
Business_Combinations_Date_of_Acquisition_PP
Footnotes
* Combined land, equipment, and other PP&E for Saxton
Financial Reporting >> Chapter 27 – Business Combinations — After Acquisition
Chapter 27
Business Combinations — After Acquisition
This chapter reviews the basic components of financial reporting for consolidations after acquisition. It begins with IFRS and then addresses
ASPE differences, as they are relatively minor. The applicable IFRS section is IFRS 3 Business Combinations.
This chapter is a continuation of the eBook chapter Business Combinations – Date of Acquisition.
0 Summary
OR0277E_FR_Business_Combinations_after_Acquisition_SUM
1 Summary of Procedures for Post-Acquisition Consolidation
In the following discussion it is assumed the parent uses the cost method to account for the investment in the subsidiary. The impact of income
taxes has been ignored.
Post-acquisition consolidation requires the following consolidated statements: statement of financial position, statement of comprehensive
income, statement of changes in equity, and statement of cash flows. The focus of the discussion below is on the first three statements. The
starting point is to combine the parent and subsidiary legal entity financial statements and adjust the combined numbers for fair value
differentials and the impact of intercompany transactions.
1.1 Fair value differentials
After acquisition, fair value (FV) differentials are amortized to the consolidated income statement over time as follows:
Balance sheet account Income statement account

impacted
Amortization period
Inventory Normally in the first year Cost of sales
after acquisition, assuming
the subsidiary turns over
inventory a number of
times each year
Depreciable capital Over the remaining useful Depreciation or
assets life of the relevant asset or amortization expense or
on impairment impairment loss
Land In the period the subsidiary Gain or loss on sale of land
sells the land
Intangible assets not When the subsidiary sells Gain or loss on sale or
amortized the asset or if it is impaired impairment loss
Long-term debt Over the remaining term to Interest expense
maturity of the debt
Terminology:
Current-period amortization is the amount of amortization of the FV differential recognized in the consolidated income statement of the
current period.
Unamortized fair value differential is the FV differential at acquisition less the accumulated amortization, impairment losses, or disposals
recognized to date on the FV differential.
1.2 Intercompany transactions
Post-acquisition, the parent and subsidiary may engage in intercompany transactions resulting in profits or losses being recognized in the legal
entity (separate) financial statements of the parent and the subsidiary. As the parent and subsidiary are considered one economic entity, and an
entity cannot sell something to itself, the impact of the intercompany transactions must be eliminated from the financial statements.
Intercompany transactions are classified as follows:
Type of sale Description Elimination

Downstream Sale by parent to Impact eliminated 100%
subsidiary against the parent
Upstream Sale by subsidiary to Impact eliminated against
parent the parent and the non-
controlling interest in
proportion to their relative
interests
Terminology:
Unrealized profit or loss is the original amount of profit or loss reported in the legal entity statements at the time the intercompany sale
occurs, less profit or loss realization to date.
Realized profit or loss is the amount of profit or loss realized in a period.
Intercompany profits or losses are considered realized as follows:
Asset Timing of profit or loss realization

Inventory When the inventory is sold outside the
consolidated entity
Depreciable capital assets Over time, as the purchasing entity uses
the asset in normal operations
Land or intangible assets not amortized When the land / intangible asset is sold
outside the consolidated entity
1.3 Preparation of consolidated financial statements
1.3.1 Consolidated income statement
1. Start by adding together 100% of the reported revenue and expenses of the parent and the subsidiary.
2. Adjust income statement accounts for current-period amortization of FV differentials as follows:
Account Impact on income statement

account
Inventory FV > book value (BV) Increase cost of sales
Depreciable capital FV > BV Increase depreciation expense
assets
FV < BV Decrease depreciation expense
Land or intangible FV > BV Decrease gain on sale or increase
assets not amortized loss on sale
FV < BV
Increase gain on sale or decrease
loss on sale
Long-term debt FV > BV Decrease interest expense
FV < BV Increase interest expense
3. Intercompany sales adjust income statement items for current-period unrealized profit or losses or current-period profit or loss realization
as follows:
Type of asset Impact on income statement

Inventory Decrease sales and cost of sales by the
intercompany selling price on goods sold by
the parent to the subsidiary or the subsidiary to
the parent in the current year.
Decrease current-year cost of sales for

unrealized profit in ending inventory of the
previous period.
Increase current-year cost of sales for

unrealized profit in ending inventory of the
current period.
Depreciable capital assets In the year of sale, eliminate the reported gain
or loss from the income statement.
In each year of the remaining useful life of the

asset, adjust depreciation expense for current-
period gain or loss realization (original amount
÷ remaining useful life of the asset):
• gain: reduce depreciation expense
• loss: increase depreciation expense

Land or intangible assets not amortized In the year of sale, eliminate the reported gain
or loss from the income statement.
In a subsequent year, when asset is sold outside

the consolidated entity, adjust the gain or loss
on sale as follows:
• gain: increase the gain on sale or reduce the

loss on sale
• loss: decrease the gain on sale or increase

the loss on sale
4. Eliminate the parent's share of subsidiary dividends declared.
5. If the parent owns less than 100% of the shares of the subsidiary, deduct consolidated net income attributable to the non-controlling
interest (NCI), determined as follows:
Subsidiary legal entity net income $ XXXX

Impact of upstream intercompany transactions (Note 1) +/– XXXX
Current-period amortization of FV differentials (Note 2) +/– XXXX
Subsidiary adjusted net income XXXX
NCI percentage ownership XX%
Consolidated net income attributable to the NCI $ XXXX

Note 1: Impact of upstream intercompany transactions:
Profit in opening inventory realized in the year Add
Unrealized profit in closing inventory Deduct
Gain on current-period intercompany capital asset sales Deduct
Loss on current-period intercompany capital asset sales Add
Current-period gain realization from previous intercompany
capital asset sales
Add
Current-period loss realization from previous intercompany
capital asset sales
Deduct

Note 2: Current-period amortization of FV differentials:
Asset with FV > BV Deduct
Asset with FV < BV Add
Liability with FV > BV Add
Liability with FV < BV Deduct
1.3.2 Consolidated balance sheet
1. Start by adding together 100% of the reported assets and liabilities of the parent and subsidiary.
2. Adjust individual balance sheet accounts for unamortized FV differentials as follows:
Account Adjustment required

Inventory * FV > BV Increase inventory
Depreciable capital assets FV > BV Increase capital assets
FV < BV Decrease capital assets

Land and intangible assets FV > BV Increase asset
not amortized
FV < BV Decrease asset
Long-term debt FV > BV Increase long-term debt
FV < BV Decrease long-term debt
3. Adjust individual balance sheet accounts for unrealized profit or losses on intercompany asset sales:
Account Adjustment required

Inventory Unrealized profit Decrease inventory
Unrealized loss Increase inventory

Depreciable capital assets Unrealized gain Decrease capital assets
Unrealized loss Increase capital assets
Land and intangible assets Unrealized gain Decrease assert
not amortized
Unrealized loss Increase asset
4. Set up unimpaired goodwill.
5. Eliminate the investment account at cost.
6. Eliminate the subsidiary's common shares.
7. If the parent owns less than 100% of the common shares of the subsidiary company, set up the NCI balance sheet account as follows:
NCI at acquisition (see eBook chapter on consolidation at

acquisition)
$XXXX
NCI share of adjusted increase in subsidiary retained earnings
(as set out below)
XXXX
NCI balance sheet account $XXXX
8. Include consolidated retained earnings (calculation described below).
1.3.3 Consolidated retained earnings
Consolidated retained earnings (R/E) are determined as follows:

Parent's share of the increase in subsidiary R/E since acquisition $ XXXX
Impact of upstream intercompany transactions (Note 1) +/– XXXX
Amortization to date of FV differentials (Note 2) +/– XXXX
Adjusted increase in subsidiary R/E XXXX
Adjusted increase in subsidiary R/E attributable to the NCI:
Adjusted increase in subsidiary R/E × NCI percentage ownership
(XXXX)
Adjusted increase in subsidiary R/E attributable to parent XXXX
Impact of downstream intercompany transactions (Note 1) +/– XXXX
Equity pickup since acquisition XXXX
Parent legal entity R/E XXXX
Consolidated R/E $ XXXX

Note 1: Impact of upstream or downstream intercompany transactions:
Unrealized gains Deduct
Unrealized losses Add

Note 2: Amortization to date of FV differentials:
Asset with FV > BV Deduct
Asset with FV < BV Add
Liability with FV > BV Add
Liability with FV < BV Deduct
1.3.4 Consolidated statement of retained earnings
Consolidated opening R/E $ XXXX

Consolidated net income attributable to the parent XXXX
Parent dividends declared * (XXXX)
Consolidated closing R/E $ XXXX
2 Business Combinations (Consolidation After Acquisition)
The intention of consolidated financial statements (F/S) is to present the results of the parent and subsidiary as a single entity, as though they
had operated as a single entity throughout the reporting period.
In looking at consolidations at the date of acquisition, you already know that the basic premise is to start by adding the F/S together. At
acquisition, you then eliminate the parent's investment and the subsidiary's equity accounts. You also adjust for goodwill and the acquisition
differential related to FV differences of the subsidiary at the date of acquisition.
The concepts at the time of acquisition are covered in the eBook chapter Business Combinations (Consolidation at Acquisition). You will
recall in that chapter that one of the key first steps was to prepare the acquisition differential schedule. This outlined the FV differentials, as
well as any goodwill in the purchase of the subsidiary.
In preparing consolidated F/S after acquisition, the premise is largely the same. However, there are several complexities that arise as a result of
the passage of time and the potential for intercompany transactions and balances that need to be addressed.
It is a good idea to have a clear process to walk through when dealing with consolidation after acquisition. This chapter will follow the
approach outlined below:
1. Adjust for amortization of FV differentials
2. Adjust for goodwill impairment since acquisition (if any)
3. Analyze intercompany sales of inventory
4. Analyze intercompany sales of capital assets
5. Analyze other intercompany transactions
6. Directly calculate consolidated ending R/E by calculating:
a. Opening consolidated R/E
b. Consolidated net income
c. Consolidated ending R/E
7. Directly calculate opening NCI (if parent owns less than 100% of subsidiary)
8. Prepare elimination entries
9. Prepare consolidated F/S
This chapter will work through these steps using an example from the eBook chapter Business Combinations (Consolidation at Acquisition).
That chapter looked at Purcell and Saxton, where Purcell acquired 80% of Saxton's 225,000 issued and outstanding common shares for
$760,000 in cash, and, in the week after acquisition, Saxton's shares not owned by Purcell were trading at $4.00 per share. Purcell uses the fair
value enterprise (FVE) approach for NCI.
At the time of acquisition, on January 1, 20X1, the following purchase price allocation was determined:
Cost of investment (80%) $ 760,000

NCI: 225,000 × 20% × 4.00 180,000
Implied transaction value using FVE approach $ 940,000

BV of Saxton's net assets (251,000)
R/E $ 243,000
Acquisition differential

Allocated to FV differentials:
(BV – FV)
Inventory: 273,000 – 392,000 (119,000)
Equipment: 244,000 – 156,000 88,000
Land: 160,000 – 189,000 (29,000)
Customer list: 105,000 – 140,000 (35,000)
Deferred income taxes (DIT) on FV differentials 15,750
Goodwill $163,750

NCI is $180,000 and goodwill is $163,750.
DIT included in the analysis of the purchase above can be determined as follows:
Temporary differences
Inventory $119,000
Equipment (88,000)
Land: 29,000 × ½ 14,500
Customer list: 35,000 × ½ 17,500
Net temporary differences 63,000
Tax rate 25%
DIT $ 15,750
Now, in 20X3, the following information has been provided:
Statement of comprehensive income — 20X3

Purcell Saxton
Sales 2,484,000 1,962,000
Cost of sales (1,490,400) (1,177,200)
Gross margin 993,600 784,800

General and administration expenses (248,400) (196,200)
Selling expenses (84,600) (66,600)
Other expenses (56,700) (44,100)
Interest expense (47,700) (38,700)
Other income 75,400 21,600
Earnings before tax 631,600 460,800

Income tax 157,900 115,200
Net income and comprehensive income 473,700 345,600
Statement of financial position — 20X3

Purcell Saxton
Assets
Cash 290,600 102,600
Accounts receivable 233,100 184,500
Inventory 372,600 294,300
Property, plant and equipment (PPE), net 2,030,400 1,607,400
Customer list — 105,000
Investment in Saxton 760,000 —
Total assets 3,686,700 2,293,800

Accounts payable and accrued liabilities 360,400 266,400
Long-term debt 1,191,600 866,700
DIT 167,400 58,500
Common stock 350,000 251,000
R/E 1,617,300 851,200
Total liabilities and equity 3,686,700 2,293,800
At date of acquisition, Saxton had an R/E balance of $446,000.
Saxton uses the first-in, first-out (FIFO) cost flow assumption to account for inventory.
Both companies use the straight-line method of depreciation.
Assume a tax rate of 25% for all years.
3 Step 1: Adjust for Amortization of FV Differentials
After acquisition, the subsidiary will continue to prepare its own F/S based on BV as if the parent had never acquired a controlling interest in
the subsidiary.
From the consolidated entity's perspective, however, assets and liabilities of the subsidiary should be based on FV at the date of acquisition —
the value that the parent acquired them at. Therefore, it is necessary to adjust for the impact of the FV differentials that existed at acquisition.
An amortization schedule helps to understand the amortization of the FV differentials:
(a) Item (b) (c) FV (d) Accumulated (e) = (c) – (d) (f) (g) = (e) – (f)
Amortization differential at amortization, Unamortized Amortization, Unamortized
period acquisition beginning of FV differential, current period FV differential,
period beginning of end of period
period
(a) The items that had FV differentials, such as land and PPE, from acquisition
(b) The period over which the FV differential will amortize — commonly:
• depreciable assets — amortize over the remaining useful life (consistent with amortization policy for the asset)
• investments and land and intangible assets that are not amortized - amortize as the investments or land or intangible assets are sold
• accounts receivable and inventory — amortize entirely the period after acquisition (current assets are expected to turn over within one
year)
• debt — amortize over remaining period of maturity of the debt
(c) The amount of the FV differential per the acquisition differential schedule (keep the signs the same)
(d) Total amortization of the FV differential from the date of acquisition to the beginning of the period that you are consolidating
• Hint: You may have to draw a timeline to determine how much time has passed since acquisition to the beginning of the period in order to
calculate accumulated amortization.
(e) The FV differential at acquisition less amortization to the beginning of the period
(f) Amortization of the FV differential for the current period (normally a year)
(g) Unamortized FV differential at beginning of the period less amortization for the current period
If you keep the signs the same for your FV differentials from the
acquisition differential schedule, and then keep the signs the same
throughout the amortization table, the remaining consolidation
steps will be much easier.
Similarly, at the time of acquisition, a DIT FV differential must be determined based on the other FV differentials identified. When the DIT
asset or liability is set up at acquisition, it will reverse with the amortization of the related FV differentials.
4 Step 2: Adjust for Goodwill Impairment
At the date of acquisition, the consolidated entity would likely have recorded an amount for goodwill. Goodwill then needs to be tested on an
annual basis for impairment. Recall that impairment in general terms is when the FV is less than the BV. If the goodwill that was acquired in
the acquisition is impaired, it will need to be written down to its current FV.
FV will be provided to you if it is relevant. For example, either the amount of the write-down or the new FV of goodwill will be provided,
which will allow you to calculate the write-down.
This is a continuation of the Purcell and Saxton scenario above. Assume the following additional information:
• Saxton uses the FIFO cost flow assumption to account for inventory.
• Equipment had a remaining useful life of 11 years.
• Saxton sold one-half of the land at a gain of $24,000 during 20X3.
• Saxton is not amortizing the customer list, as it is expected to have an indefinite useful life.
• In 20X3, Purcell determined that goodwill in Saxton was impaired and should be written down to $90,000.
Required
Assess the amortization of the FV differentials (hint: use the amortization schedule provided above). Assume that you are working toward
consolidating the F/S for 20X3. Also assess impairment of goodwill.
Answer
Since acquisition, two years have passed prior to the beginning of the year.
(a) (b) (c) (d) (e) = (c) – (d) (f) (g) = (e) – (f)
Accumulated Unamortized FV Unamortized
FV amortization, differential, FV differential,
Amortization differential at beginning of period beginning of Amortization, end of period
Item period acquisition (for 20X1 and 20X2) period current period
Inventory (1) 1 year (119,000) (119,000) — — —
Equipment (2) 11 years 88,000 16,000 72,000 8,000 64,000
Land (3) NA (29,000) — (29,000) (14,500) (14,500)
Customer list (4) NA (35,000) — (35,000) — (35,000)
DIT (5) NA 15,750 25,750 (10,000) (188) (9,812)
Total — (79,250) (77,250) (2,000) (6,688) 4,688
1. Inventory: It is assumed that inventory that existed at acquisition was sold in the first year after acquisition. Therefore, the full amount of
the FV differential on the inventory is amortized in the first year after acquisition (that is, 20X1).
2. Equipment: The FV differential on the plant and equipment is amortized over the 11-year remaining useful life of the plant and
equipment.
Amortization to the beginning of 20X3: (88,000 / 11) × 2 years = 16,000
Current-period amortization: 88,000 / 11 = 8,000
3. Land: A FV differential on land is amortized when the subsidiary sells the land to which the FV differential relates. Amortization of this
FV differential will be an adjustment to the gain or loss on the sale of land reported by Saxton. During the current year, Saxton sold one-half
of the land to which the FV differential relates.
Current-period amortization: 29,000 × ½ sold = $14,500
4. Customer list: The customer list does not have a finite life, so Saxton is not amortizing it. A FV differential on an unlimited-life
intangible asset will be amortized in the consolidated F/S either when the subsidiary recognizes impairment in value or sells the intangible
asset. For this example, there is no impairment and Saxton has not sold the asset, so no amount of the FV differential on the customer list is
amortized.
5. DIT: Accumulated amortization, beginning of period = (–119,000 – + 16,000) × –25% = 25,750
Amortization, current period = [8,000 + (–14,500 × 50%)] × –25% = –188
DIT is the opposite sign of the FV differential; therefore, multiply

the total FV differential amortization by the negative tax rate (that
is, –25%).

For tax purposes, if land or the customer list is sold, only one-half
of the gain will be taxed as a taxable capital gain; thus, DIT
related to the land and customer list will be one-half of the FV
differentials from the table above multiplied by the 25% tax rate.
Goodwill impairment:
FV – BV = impairment
90,000 – 163,750 = 73,750 impairment
5 Step 3: Analyze Intercompany Sales of Inventory
Before you begin to analyze intercompany transactions, pause and consider the direction of transactions between a parent and a subsidiary.
• When the parent is selling to the subsidiary, it is called a downstream transaction.
• When the subsidiary is selling to the parent, it is called an upstream transaction.
The classification of the transactions matters as you move through the consolidation steps.
To remember the directions of upstream and downstream transactions, think of an organizational chart where the parent sits at the top, with the
subsidiary below:
When an intercompany sale occurs, the entity selling the inventory will recognize revenue and cost of sales. The entity purchasing the
inventory will record the inventory in its F/S at the intercompany selling price of the inventory and use the intercompany selling price as the
basis for cost of sales on subsequent sales to external customers.
Ignoring DIT for the moment, the following accounts in the consolidated F/S will be affected by the intercompany inventory sale:
• Sales will be overstated because the sale is reported twice, once at the time of the intercompany sale and again when the inventory is sold
outside the consolidated entity. The selling price to external customers is the amount that should be reported as sales in the consolidated F/S.
• Cost of sales will be overstated because the entity initially selling the inventory will report cost of sales at the time of the intercompany
sale, and cost of sales will be reported again when the entity that purchased the goods sells the inventory to external customers. The historical
cost of the inventory to the consolidated entity should be reported as cost of sales in the consolidated F/S.
• Inventory will be overstated (assuming an intercompany profit on sale) if some of the intercompany sales remain in inventory on the
statement of financial position date. Consolidated inventory should be based on the historical cost of the inventory to the consolidated entity,
so the intercompany profit on the inventory must be eliminated.
Your goal with consolidation is to reflect the consolidated sales to external parties. Consolidated cost of sales should reflect the cost of sales
from transactions with outside parties.
In this step, you need to determine the following to assist with the remaining consolidation process:
• upstream and downstream profits and losses in opening inventory (to be recognized in the current year, since these are now realized by
selling to an outside customer)
• upstream and downstream profits and losses in ending inventory (to be removed in the current year, since these are unrealized)
• total intercompany sales during the period (to be removed in the current year from sales and cost of sales)
5.1 Examples
Assumption 1: All intercompany inventory has been sold outside the entity.
Facts:
Parent sells inventory to subsidiary:

Original cost of inventory to parent $ 50,000
Selling price to subsidiary 80,000
Selling price by subsidiary to external customers 100,000
Remember that your starting point to create consolidated F/S is to add the parent and the subsidiary accounts together. Without any
adjustments, the following would be recorded:
Parent's books Subsidiary's Consolidated with

books no adjustments
Account
Sales $ 80,000 $100,000 $ 180,000
Cost of sales (50,000) (80,000) (130,000)
Profit $ 30,000 $ 20,000 $ 50,000

Inventory $ 0 $ 0 $ 0
• Consolidated sales should be sales to external customers: $100,000.
• Consolidated cost of sales should be based on historical cost: $50,000.
Both sales and cost of sales are overstated by $80,000, the intercompany selling price of the inventory. You need to reduce both sales and cost
of sales by the intercompany selling price of the inventory.
Subsidiary's books
Account Parent's books Adjustments Consolidated

Sales $80,000 $100,000 (80,000) $100,000
Cost of sales (50,000) (80,000) 80,000 (50,000)
Profit $30,000 $ 20,000 $ 50,000

There is also no impact on income taxes because there is no net impact on consolidated net income; the reduction in sales equals the reduction
in cost of sales.
Since all inventory was sold during the year to a third party, there is no unrealized profit in opening or ending inventory. However, total
intercompany sales were $80,000.
Assumption 2: All goods are not sold outside the consolidated entity in the same period as the period of the intercompany sale — unrealized
profit in ending inventory results.
Facts:
Parent sells inventory to subsidiary:

Original cost of inventory to parent $50,000
Selling price to subsidiary 80,000
20X1 (70% sold to external customers)
Selling price by subsidiary to external customers
70,000
20X2 (30% sold to external customers)
Selling price by subsidiary to external customers
30,000
20X1
Consolidated with no
adjustments
Account Parent's books Subsidiary's books
Sales $ 80,000 $ 70,000 $ 150,000
Cost of (50,000) (56,000) * (106,000)
sales
Profit $ 30,000 $ 14,000 $ 44,000

Inventory $ 0 $ 24,000 * $ 24,000
• Consolidated cost of sales should be based on historical cost: $50,000 × 0.70 = $35,000.
• Consolidated inventory should be based on historical cost: $50,000 × 0.30 = $15,000.
Overstatements:
Sales $150,000 – 70,000 = $80,000

Cost of sales $106,000 – 35,000 = $71,000
Inventory $ 24,000 – 15,000 = $ 9,000
Subsidiary's books

Sales $80,000 $70,000 $(80,000) $70,000
Cost of sales 50,000 56,000 (71,000) 35,000
Profit $30,000 $14,000 $ (9,000) $35,000

Inventory $ 0 $24,000 $ (9,000) $15,000
From the above, you can determine:
• downstream profit in opening inventory: $0
• downstream profit in ending inventory: $9,000 [ = ($80,000 - $50,000) × 30% unsold]
• total intercompany sales: $80,000
20X2
Parent's books Subsidiary's Consolidated with no

books adjustments
Account
Sales $ 0 $ 30,000 $ 30,000
Cost of sales (0) (24,000) (24,000)
Profit $ 0 $ 6,000 $ 6,000

• Consolidated cost of sales should be based on historical cost: $50,000 × 0.30 = $15,000.
Overstatements:
Cost of sales $24,000 – 15,000 = $9,000
Subsidiary's books

Sales $0 $30,000 $ 0 $30,000
Cost of sales 0 24,000 (9,000) 15,000
Profit $0 $ 6,000 $(9,000) $15,000

Inventory $0 $ 0 $ 0 $ 0
From the above, you can determine:
• downstream profit in opening inventory: $9,000
• downstream profit in ending inventory: $0

• total intercompany sales: $0
5.2 DIT
In the above scenario, the overall profit recorded has been decreased. When all of the intercompany goods are not sold outside the
consolidated entity in the same period as when the intercompany sale occurs, the unrealized profit / loss in ending inventory reduces
consolidated net income. As there is a net change in the bottom-line consolidated net income, it is necessary to record DIT on that net change.
Following the example for Assumption 2 above, the adjustment to DIT is as follows, assuming a 30% tax rate:
20X1: Increase DIT asset: 9,000 × 0.30 = 2,700
20X2: Decrease DIT asset: 9,000 × 0.30 = 2,700
This is a continuation of the Purcell and Saxton scenario above. Assume that the entities had the following inventory sales as detailed below:
20X2
• Purcell sold goods that it had purchased for $250,000 to Saxton for $200,000; 20% remained in Saxton's 20X2 ending inventory.
• Saxton sold goods to Purcell for $700,000, which included a 25% gross profit; 40% remained in Purcell's 20X2 ending inventory.
20X3
• Purcell sold goods that it had purchased for $135,000 to Saxton for $170,000; 30% remained in Saxton 20X3 ending inventory.
• Saxton sold goods to Purcell for $360,000, which included a 25% gross profit; 50% remained in Purcell's 20X3 ending inventory.
Assume a 25% tax rate in both years.
Required
Determine the following items for 20X3 (considering deferred tax):
• upstream profit or loss in opening inventory
• downstream profit or loss in opening inventory
• upstream profit or loss in ending inventory
• downstream profit or loss in ending inventory
• total intercompany sales during the year
Answer
Intercompany profit / loss — inventory Before tax 25% tax After tax
Profit/loss in opening inventory (20X2 inventory, sold in 20X3)
Downstream — Purcell selling
($200,000 – $250,000) × 20% $(10,000) $ 2,500 $(7,500)
Upstream — Saxton selling
($700,000 × 25%) × 40% 70,000 (17,500) 52,500
$60,000 $(15,000) $45,000

Profit/loss in ending inventory (20X3)
($170,000 – $135,000) × 30% $10,500 $ (2,625) $ 7,875
($360,000 × 25%) × 50% 45,000 (11,250) 33,750
$55,500 $(13,875) $41,625
Intercompany sales in 20X3 were $530,000 ($170,000 + $360,000).
6 Step 4: Analyze Intercompany Sales of Capital Assets
When the parent or the subsidiary sells an asset to the subsidiary or the parent, the company selling the asset will report a gain or loss on the
sale of the asset in its net income. The company purchasing the asset will record the asset in its books at the price paid.
From the point of view of the consolidated entity, no sale has taken place; thus, no gain or loss on sale should be reported in consolidated net
income, and for depreciable assets, amortization expense should be based on the historical cost of the asset to the consolidated entity.
Therefore, adjustments to the consolidated F/S are required.
6.1 Non-depreciable capital assets
Example
Parent sells land with a BV of $100,000 to its subsidiary for $120,000 on January 1, 20X1.
20X1 analysis — the year of sale
Amounts reported by the parent and the subsidiary:
• Parent reports gain on sale of $120,000 – $100,000 = $20,000.
• Subsidiary reports land of $120,000.
Amounts that should be reported in the consolidated F/S:
• gain on sale: $0, because the asset has not been sold outside the consolidated entity
• land of $100,000
Adjustments required:
• Gain on sale must be reduced by $20,000.
• Land must be reduced by $20,000.
• Assuming a 30% tax rate, DIT must be adjusted as follows: DIT asset (20,000 × 50%) × 0.30 = 3,000.
20X2 analysis — one year after the sale
• Subsidiary reports land of $120,000.
• The gain on sale originally recorded by the parent is no longer included in net income; however, it would be included in the parent's R/E.
Therefore, you will have to remove the unrealized gain from R/E.
• land of $100,000
• Land must be reduced by $20,000.
• Opening R/E must be reduced by $17,000 ($20,000 – $3,000).
In the case of non-depreciable assets, any gain or loss on an intercompany sale is not recognized until the asset is sold to an outside third party.

This is a continuation of the Purcell and Saxton scenario above. Assume that the entities had the following sales of land:
• 20X1: Saxton sells Purcell land with a BV of $15,000 for $35,000.
• 20X3: Purcell sells ¼ of the land acquired at acquisition to a third party for $10,000.
Assume a 25% tax rate.
Required
Prepare a schedule that details the before-tax and after-tax effects of the unrealized profit / loss on the intercompany sale of land.
Answer
Upstream transaction:
25% tax on 50%

of gain
Opening R/E: Before tax After tax
20X1 unrealized gain 20,000 (2,500) 17,500
20X3 income:
Realized gain 5,000 * (625) 4,375
You can recognize ¼ of the intercompany gain (20,000 × ¼ = 5,000).
6.2 Depreciable capital assets
Example
Parent sells a depreciable capital asset with a remaining useful life of five years and a net book value (NBV) of $147,500 to its subsidiary for
$185,000 on January 1, 20X1. Both companies depreciate their assets on a straight-line basis, and the income tax rate is 30%.
20X1 analysis — the year of sale
• Parent reports gain on sale of $185,000 – $147,500 = $37,500.
• Subsidiary reports amortization expense of $185,000 / 5 = $37,000.
• Subsidiary reports NBV at the end of the year of $185,000 – $37,000 = $148,000.
• Gain on sale: $0, because the asset has not been sold outside the consolidated entity.
• Amortization expense should be based on the amount the parent would have recorded if the asset was not sold. Parent's BV / remaining
useful life: $147,500 / 5 = $29,500.
• NBV end of the year: $147,500 – $29,500 = $118,000.
• Gain on sale must be reduced by $37,500.
• Amortization expense must be reduced by $37,000 – $29,500 = $7,500.
• NBV must be reduced by $148,000 – $118,000 = $30,000.
• Also, assuming a 30% tax rate, income tax expense must be decreased and DIT asset must be increased by $30,000 × 0.30 = $9,000.
Amortization expense will be overstated each year due to the higher carrying value of the asset. The NBV will also be overstated at the end of
each year by the unrealized gain on sale at that time. Essentially, what will happen is that the gain will be realized over the life of the asset. At
the end of 20X1, only $30,000 of the gain remains unrealized, as $7,500 is brought into consolidated income through the adjustment to
amortization expense. Notice that the $7,500 is equal to the total original gain divided by the remaining years; $37,500 / 5 = $7,500.
20X2 analysis — one year after the sale
• Subsidiary reports amortization expense of $185,000 / 5 = $37,000.
• Subsidiary reported NBV at the end of the year of $185,000 – ($37,000 × 2) = $111,000.
• The gain on sale originally recorded by the parent is no longer included in net income; however, it would be included in the parent's R/E.
Therefore, you will have to remove the unrealized gain from R/E.
• Amortization expense: $147,500 / 5 = $29,500
• NBV at the end of the year: $147,500 – ($29,500 × 2) = $88,500
• Opening retained earnings = $21,000 ($30,000 - $9,000).
• Amortization expense must be reduced by $37,000 – $29,500 = $7,500.
• NBV must be reduced by $111,000 – $88,500 = $22,500.
• DIT expense increases by, and DIT asset is reduced by, $7,500 × 0.30 = $2,250.
This is a continuation of the Purcell and Saxton scenario above. Assume that the entities had the following sales of depreciable assets:
• 20X2: On January 1, 20X2, Purcell sold equipment to Saxton at a loss of $18,000. The remaining useful life at the time of sale was three
years, and the estimated residual (salvage) value of $0.
• 20X3: On January 1, 20X3, Saxton sold different equipment to Purcell at a gain of $50,000. The remaining useful life at the time of sale
was five years, and the estimated residual (salvage) value of $0.
Both companies use the straight-line method of depreciation. Assume a 25% tax rate.
Required
Prepare a schedule that details the before-tax and after-tax effects of the unrealized profit / loss on the intercompany sales of equipment for
20X3.
Answer
Intercompany profits — equipment Before tax 25% tax After tax

Downstream sale in 20X2
20X2 loss (18,000) 4,500 (13,500)
Realized in 20X2 ($18,000 / 3) 6,000 (1,500) 4,500
Unrealized loss, beginning of 20X3 (12,000) 3,000 (9,000)
Realized in 20X3 ($18,000 / 3) 6,000 (1,500) 4,500

Unrealized loss, end of 20X3 (6,000) 1,500 (4,500)

Upstream sale in 20X3
20X3 gain 50,000 (12,500) 37,500
Realized in 20X3 ($50,000 / 5) (10,000) 2,500 (7,500)
Unrealized gain, end of 20X3 40,000 (10,000) 30,000
7 Step 5: Analyze Other Intercompany Transactions
Intercompany revenues and expenses such as interest revenues (expenses), management fees earned (expenses), and rental revenues
(expenses) do not affect consolidated net income because the respective amounts offset each other. While there is no effect on consolidated net
income, specific line items must be adjusted during the consolidation process to ensure that the consolidated group's revenues and expenses
are not overstated. For example, intercompany interest revenue of $10,000 is revenue for one company and an expense for the other, which
requires $10,000 to be subtracted from both interest revenue and interest expense in the consolidated statement of comprehensive income.
The elimination of intercompany revenues and expenses:
• reduces consolidated income and expenses by the same amount
• does not affect consolidated profit or loss
• does not affect the consolidated net income attributable to the NCI
• does not affect consolidated equity
Intercompany balances include accounts receivable / payable, loans receivable / payable, and various other intercompany balances, including
unpaid management fees. The outstanding balances at the statement of financial position date must be eliminated upon consolidation.
The elimination of intercompany balances:
• reduces consolidated assets and liabilities by the same amount
• does not affect consolidated profit or loss
• does not affect consolidated equity
Moreover, the required adjustments are the same regardless of whether the transaction is a revenue/expense or asset / liability to the parent or
the subsidiary.
8 Step 6a: Calculate Opening Consolidated R/E
You would normally have access to the entity's prior-period consolidated F/S; therefore, you could easily determine the consolidated closing
R/E for the past period and carry this forward as the opening consolidated R/E for this period. However, you should also always understand
how to calculate the opening balance of consolidated R/E by using other available information.
Opening R/E may be calculated as follows:
Parent's opening R/E

– Unrealized downstream profits (or + losses) in opening inventory (Step 3)
– Unrealized downstream gains (or + losses) in opening capital assets (Step
4)
Parent's adjusted opening R/E

Subsidiary's opening R/E
– Subsidiary's R/E at acquisition
Increase/(decrease) in subsidiary's R/E since acquisition
+/– FV differential accumulated amortization, beginning of period (Step 1)
– Goodwill impairment incurred up to beginning of period (Step 2)
– Unrealized upstream profits (or + losses) in opening inventory (Step 3)
– Unrealized upstream gains (or + losses) in opening capital assets (Step
4)
Subsidiary's adjusted R/E
– NCI portion (× NCI percentage ownership)
Parent's share of subsidiary's adjusted R/E
Parent's adjusted opening R/E (per above)
Consolidated opening R/E
From here, you can also calculate the equity pickup. This will be used later in the consolidation.
Equity pickup = Consolidated opening R/E – Parent's opening R/E
Note: All items should be those reflected at the beginning of the year.
You can think of the calculation in two pieces: the first is calculating the parent's adjusted R/E, and the second is calculating the parent's share
of the subsidiary's adjusted R/E.
In preparing the calculation, there are a few key things to remember:
• You deduct unrealized profit and gains. This makes sense because you are "unrealizing" the profit / gain; therefore, to "unrealize" the
profit / gain, it must be a deduction from income or R/E. Likewise, you add back unrealized losses.
• When bringing over the amortization, keep the signs the same as the table in Step 1 (assuming you followed the sign guidance as described
above in Step 1).
• All of the profits / gains, losses, and FV differentials should be net of deferred tax.
This is a continuation of the Purcell and Saxton scenario above. The statements of R/E for Purcell and Saxton for December 31, 20X3, are as
follows:
Purcell Saxton
R/E, beginning of the year $1,363,600 $ 650,600
Net income 473,700 345,600
Dividends (220,000) (145,000)
R/E, end of the year $1,617,300 $ 851,200
At date of acquisition on January 1, 20X1, Saxton had an R/E balance of $446,000.
Required
Considering the transactions in the "test your knowledge" sections above, calculate the consolidated R/E and equity pickup at the beginning of
20X3.
Answer
Opening consolidated R/E:

Purcell's opening R/E $1,363,600
Unrealized downstream loss in opening inventory (Step 3) 7,500
Unrealized downstream loss in capital assets (equipment) (Step 4) 9,000
Purcell's adjusted opening R/E 1,380,100

Saxton's opening R/E 650,600
Saxton's R/E at acquisition (446,000)
Saxton's post-acquisition increase in R/E 204,600
FV differential accumulated amortization, beg. of period (Step 1) (77,250)
Unrealized upstream profit in opening inventory (Step 3) (52,500)
Unrealized upstream gain in capital assets (land) (Step 4) (17,500)
Saxton's adjusted R/E 57,350
NCI portion (Saxton's adjusted R/E × 20%) (11,470)
Purcell's share of Saxton's adjusted R/E 45,880
Purcell's adjusted opening R/E (per above) 1,380,100
Consolidated opening R/E 1,425,980

Equity pickup (1,425,980 – 1,363,600) $62,380
9 Step 6b: Calculate Consolidated Net Income
To arrive at consolidated ending R/E, you need to first determine consolidated net income. This analysis also helps in preparing the
elimination entries for the consolidated F/S.
Parent's net income

– Dividends received from subsidiary
+ Realized downstream profits (or – losses) in opening inventory (Step 3)
– Unrealized downstream profits (or + losses) in ending inventory (Step
3)
+ Realized downstream profits (or – losses) in capital assets (Step 4)
– Unrealized downstream profits (or + losses) in capital assets (Step
4)
Parent's adjusted net income

Subsidiary's net income
+/– FV differential amortization in current period (Step 1)
– Goodwill impairment, current period (Step 2)
+ Realized upstream profits (or – losses) in opening inventory (Step 3)
– Unrealized upstream profits (or + losses) in ending inventory (Step 3)
+ Realized upstream profits (or – losses) in capital assets (Step 4)
– Unrealized upstream profits (or + losses) in capital assets (Step
4)
Subsidiary's adjusted net income
– NCI portion (× NCI percentage ownership)
Parent's share of subsidiary's adjusted net income
Parent's adjusted net income (per above)
Consolidated net income
• The subsidiary may have paid dividends to the parent. These dividends would be included as investment income in the parent's net income.
The payment of these dividends is an intercompany transaction that needs to be reversed. Therefore, you deduct out the dividends that the
subsidiary paid the parent to reverse the income that the parent recorded.
• To realize a profit / gain, you add it to income. This makes sense, as a realized profit / gain should increase consolidated income. Likewise,
you deduct realized losses.
• You deduct unrealized profit / gains. This makes sense, because you are "unrealizing" the profit / gains; therefore, it must be a deduction
from income. Likewise, you add back unrealized losses.
• When bringing over the amortization, keep the sign the same as the table in Step 1 (assuming you followed the sign guidance as described
above in Step 1).
This is a continuation of the Purcell and Saxton scenario above.
Required
Considering the transactions in the "test your knowledge" sections above, calculate the consolidated net income for 20X3.
Answer
Purcell's net income $ 473,700

Dividends received from Saxton (145,000 × 80%) (116,000)
Realized downstream loss in opening inventory (Step 3) (7,500)
Unrealized downstream profit in ending inventory (Step 3) (7,875)
Realized downstream loss in capital assets (equipment) (Step 4) (4,500)
Purcell's adjusted net income 337,825

Saxton's net income 345,600
FV differential amortization in current period (Step 1) (6,688)
Goodwill impairment, current period (Step 2) (73,750)
Realized upstream profit in opening inventory (Step 3) 52,500

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Financial Reporting

>> Chapter 20 – Financial Instruments — Hedge Accounting

1.1 Eligible hedged item

• a highly probable future transaction — for example, a future revenue stream

1.2 Eligible hedging instrument

• the hedging relationship

• the objective for undertaking the hedge

• the hedged item and the hedging instrument

3. The following three effectiveness requirements are met:

• credit risk does not dominate the change in value

• the hedge ratio 1 is the same for both of the following:

o the hedging relationship

3.1 Fair value hedge

3.2 Forward contracts

3.2.1 Key terms

3.2.2 Examples of forward contracts

3.2.3 New accounts

• due to broker — a payable to the broker

• due from broker — a receivable from the broker

3.2.4 Examples of forward contracts as a hedge

Hedge a receivable for sale of goods

A company sells goods to a foreign customer in exchange for a note receivable.

• due to broker — variable with changing exchange rates

• due from broker — fixed amount

Hedge a payable for purchase of goods

• due from broker — variable with changing exchange rates

3.3 Fair value hedges and forward contracts

Step 1 — Initiation dates (dates may differ)

• Record the fair value of the hedged item.

• Record the fair value of the hedging instrument.

Step 2 — Reporting dates

Step 3 — Settlement date

• Record the settlement of the hedged item.

• Record the settlement of the hedging instrument.

This is demonstrated in the following example:

Exchange rates over the relevant period were as follows:

June 1, 20X5 US$1 = C$0.82

June 1, 20X5 US$1 = C$0.80

Step 1 — Initiation dates

• Record the fair value of the hedged item.

Dr. Inventory $82,000

Dr. Due from broker $80,000

Step 2 — Reporting dates

Dr. Accounts payable $4,000

Step 3 — Settlement date

Dr. Accounts payable $2,000

Dr. FX loss $1,000

• Record the settlement of the hedged item.

Dr. Accounts payable $76,000

• Record the settlement of the hedging instrument.

Dr. Due to broker $80,000

Dr. Cash $76,000

Cost of sales (inventory becomes cost of sales) $82,000

Cash paid to settle payable $ (76,000)

3.3.1 Test your knowledge

Exchange rates over the relevant period were as follows:

December 1, 20X1 1 FCU = C$0.85

December 1, 20X1 1 FCU = C$0.84

Dr. Inventory (500,000 FCU × $0.85) $425,000

Dr. Due from broker (500,000 FCU × $0.84) $420,000

December 31, 20X1

Dr. Due from broker