Modern Advanced Accounting in Canada Canadian 7th Edition Hilton Solutions Manual Download

Solution Manual for Modern Advanced Accounting in
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Chapter 6
Intercompany Inventory and Land

Profits
Copyright © 2013 McGraw-Hill Ryerson Limited. All rights reserved.

Solutions Manual, Chapter 6 1
A brief description of the major points covered in each case and problem.
CASES
Case 6-1
In this case, students are asked to illustrate the impact of intercompany sales and unrealized
profits in inventory on the separate entity and consolidated financial statements. Students are
also asked to explain how basic accounting principles are applied when accounting for these
intercompany transactions.
Case 6-2
This case, adapted from a CA exam, involves a change from equity method to fair value method
for an investment in a company that has experienced substantial losses during the period.
Case 6-3
This is a multi-subject case from a CA exam. Students are asked to resolve a number of
accounting issues including revenue recognition, government grants, contingency and
intercompany transactions.
Case 6-4
In this case, adapted from a CA exam, students are asked to identify accounting issues related
to the preparation of consolidated financial statements for an 80%-owned subsidiary and a 40%-
owned investee company. Intercompany transactions and acquisition differential have not been
properly accounted for.
Case 6-5
In this case, adapted from a CA exam, management appears to be manipulating income to
minimize the bonus paid to union employees. Students are required to analyze controversial
accounting issues including the valuation of inventory, purchase returns and goodwill.
Case 6-6
This is a multi-subject case from a CA exam. Students are asked to resolve a number of
accounting issues including revenue and expense recognition, contributions to a partnership,
contingent consideration and offsetting of assets against liabilities.

2 Modern Advanced Accounting in Canada, Sevenh Edition
PROBLEMS
Problem 6-1 (25 min.)
A short problem requiring calculation of selected accounts for consolidated statements when there
are unrealized profits in inventory and an explanation of impact of intercompany transactions on
non-controlling interest.

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

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

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

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

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

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

A parent has three subsidiaries that conduct intercompany transactions with each other and the
problem requires the parent's equity method journal entries and calculations of consolidated net
income and consolidated retained earnings.

A parent has used the cost method to account for its investment and the problem requires the
calculation of consolidated net income attributable to the parent’s shareholders when there are
unrealized inventory and land profits involved.

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

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

A parent has used the equity method to account for its investment. There are intercompany
inventory profits involved. The problem requires the preparation of a consolidated income
statement, a calculation of consolidated retained earnings and an explanation of the impact of
using the parent company extension theory on the return on equity.

This comprehensive problem covers everything illustrated to date and requires the preparation of
a consolidated income statement and consolidated statement of financial position when the parent
has used the equity method plus the calculation of goodwill and non-controlling interest under the
parent company extension theory.
Problem 6-14 (70 min.) (Prepared by Peter Secord, Saint Mary’s University)
A comprehensive problem requiring the preparation of a consolidated income statement and a
statement of financial position when the parent has used the equity method. Also required is a
calculation of goodwill and NCI using the trading price of the subsidiary’s shares at the date of
acquisition. There are intercompany profits in land and inventory.

A comprehensive problem requiring the preparation of a consolidated income statement and the
calculation of specified consolidated balance sheet accounts. Also required is a calculation of
goodwill impairment loss and consolidated net income attributable to NCI when a business
valuator measures the value of NCI at the date of acquisition. There are intercompany
transactions and unrealized profits in land and inventory.
WEB-BASED PROBLEMS
Web Problem 6-1
The student answers a series of questions based on the 2011 financial statements of RONA
inc., a Canadian company. The questions deal with intercompany transactions in inventory and
land and the impact of changes in accounting policies for inventory and land on certain ratios.
Web Problem 6-2

The student answers a series of questions based on the 2011 financial statements of Cenovus
Energy Inc., a Canadian company. The questions deal with intercompany transactions in
inventory and land and the impact of changes in accounting policies for inventory and land on
certain ratios.

SOLUTIONS TO REVIEW QUESTIONS
1. The pants are similar to a single economic entity composed of a parent company and its
three subsidiaries. The transfer of economic resources between the pockets in these pants
simply changes the location of the resources but does not represent revenue or expense,
or profit or loss, to the combined entity.
2. The types of intercompany revenue and expenses eliminated in the preparation of the
consolidated income statement include sales and purchases, rentals, interest, and
management fees. These eliminations have no effect on the amount of consolidated net
income or the net income attributable to non-controlling interest.
3. Intercompany sales when collected and paid, intercompany cash sales, and intercompany
borrowings do not alter the total cash of the consolidated entity. It is the same concept as
an individual transferring cash among his/her bank accounts, or from one pocket to
another.
4. The intercompany profit recorded in Period one is considered to be realized when the
particular asset is sold outside the consolidated entity by the purchasing affiliate.
5. Revenue should be recognized when it is earned with a transaction outside of the reporting
entity. The reporting entity for consolidated financial statements encompasses the parent
and all of its subsidiaries. Since intercompany transactions are transactions within the
reporting entity (not outside of the reporting entity), they must be eliminated when
preparing consolidated financial statements.
6. This statement is true if the selling affiliate has an income tax rate of 40%. The $1,000
reduction from ending inventory reduces the consolidated entity's net income. A
corresponding reduction of $400 in income tax expense transfers the tax from an expense
to an asset on the consolidated balance sheet. When the $1,000 profit is subsequently
realized, the $400 is transferred from the consolidated balance sheet to the consolidated
income statement in order to achieve a proper matching of expense to revenue.
7. The matching principle requires that expenses be matched to revenues. When

intercompany profits are eliminated from the consolidated financial statements, the income

tax expense related to those profits must also be eliminated. When the previously
unrecognized intercompany profits are recognized in a later period, the income tax on
these profits must be expensed.
8. There is no adjustment to income tax expense corresponding to the elimination of

intercompany revenue and expenses because there is no change to the income before tax
for the consolidated entity; therefore, there should be no change to the tax expense for the
consolidated entity. Whatever tax was paid or saved for the two entities will not change for
the consolidated entity since the income before tax did not change. Income tax expense is
adjusted on consolidation when consolidated profits are changed due to adjustments for
unrealized profits.
9. Ideally, intercompany losses should be eliminated in the same manner as intercompany

gains. In turn, an impairment test would be carried out. If the recoverable amount were less
than the carrying amount, an impairment loss would be reported. When the impairment
loss is greater than the intercompany loss, one can get to the same result by not reversing
the intercompany loss and simply reporting an impairment loss to bring the carrying
amount down to the recoverable amount.
10. The elimination of intercompany sales and purchases reduces sales revenue and cost of
goods sold on the consolidated income statement. No other items on the consolidated
statements are affected. The elimination of intercompany profits in ending inventory affects
the following elements of the consolidated statements: cost of goods sold is increased;
income tax expense is decreased; net income is decreased; net income attributable to the
parent is decreased; net income attributable to the non-controlling interest is decreased (if
the subsidiary was the seller); the asset inventory is decreased; deferred income tax
assets are increased; non-controlling interest in net assets is decreased (if the subsidiary
was the seller); and consolidated retained earnings is decreased.
11. For a downstream transaction, the adjustment for unrealized profits is applied to the
parent’s income and is fully charged or credited to the parent. For an upstream
transaction, the adjustment for unrealized profits is applied to the subsidiary’s income
which is shared between the parent and non-controlling interest. In other words, the non-
controlling interest is affected by elimination of profit on upstream transactions but is not

affected by the elimination of profit on downstream transactions.
12. At the end of Year 1, the unrealized profit is removed from ending inventory and added to
cost of goods sold which decreases income. In Year 2, the unrealized profit is removed
from beginning inventory, which decreases cost of goods sold for Year 2 and increases
income for Year 2. Although Year 1 and Year 2 income both must be adjusted, the
adjustments are offsetting. Therefore, the combined income for the two years does not
change as a result of the adjustments.
13. It will not be eliminated again on the consolidated income statement for subsequent years.
However, if the land remains within the consolidated entity, the unrealized gain will be
eliminated in the preparation of all subsequent consolidated balance sheets and
statements of retained earnings until such time as the land is sold to outside parties.
14. Adjustments are required on consolidation to bring the consolidated balances to the
amounts that would have been on the subsidiary’s books had it not sold the land to the
parent. Therefore, any gain reported on sale would have to be eliminated. The revaluation
surplus account would have to reflect the increase in fair value over the original cost of the
land when it was purchased by the subsidiary.
15. The journal entry would be as follows:

Investment income xxx
Investment in subsidiary xxx
where xxx is equal to the parent’s share of the unrealized profits.
16. Under IFRSs, only the investor’s percentage ownership in the associate times the profit in
ending inventory is considered to be unrealized; since the investor cannot control the
associate or the other shareholders of the associate, the profit in ending inventory times
the percentage ownership of the other shareholders is considered to be a transaction with
outsiders. Under ASPE, the entire profit in ending inventory is considered to be unrealized.
ASPE states that the unrealized profit is same amount that would be considered to be
unrealized for consolidated financial statements. For downstream transactions between a
parent and subsidiary, the entire amount of unrealized profit is eliminated and charged to
the parent’s shareholders.

SOLUTIONS TO CASES
Case 6-1
Using the data provided in the question, the financial statements for the parent, subsidiary and
consolidated entity would appear as follows for the 3 months:
Parent Subsidiary Consolidated

Aug Sept July Aug July Aug Sept
BALANCE SHEET
Inventory 240 200 200 200
Prepaid tax 16
INCOME STATEMENT
Sales 300 240
300
Cost of goods sold 240 200
200
Gross margin 60 40
100
Income tax expense 24 16 40
Net income 36 24 60
The following comments outline how all of the above financial statements present fairly the
financial position and financial performance of the company in accordance with GAAP:
1. The parent and subsidiary are separate legal entities. Each entity will pay income tax
based on the income earned by the separate legal entity. Therefore, the subsidiary will
pay income tax based on the profit it earned in August and the parent will pay income
tax based on the profit it earned in September.
2. The consolidated statements combine the statements of the parent and subsidiary as if
they were one entity i.e., one set of statements for the family.
3. Accounting principles should be and have been properly applied for all of the individual
financial statements. The main principles involved with these statements are the
historical cost principle, the revenue recognition principle, and the matching principle.
4. The historical cost principle requires that certain items such as inventory be reported at

historical cost. This has been done for all 3 financial statements. Note that the historical
cost for the inventory from a consolidated perspective was $200 which is the cost paid
by the subsidiary when it purchased the goods from outsiders.
5. The revenue recognition principle requires that revenue be reported when it is earned
i.e., when the benefits and risks of ownership are transferred to the buyer. When the
subsidiary sold to the parent, the benefits and risks were transferred to the parent.
Accordingly, the subsidiary reported revenue. However, from the consolidated
perspective, the family retained the benefits and risks; they were not transferred to an
outside entity. Therefore, no revenue is reported on the consolidated income statement
for August.
6. When the parent sells to an outside entity in September, it reports revenue on its
separate entity income statement. Since the family has sold the inventory to an outside
entity, the family has earned the revenue. Accordingly, the revenue is reported in
September on the consolidated income statement.
7. The matching principle requires that costs be expensed in the same period as the
revenue to which it relates. This provides the best measure of performance. Since the
subsidiary reported revenue in August, it reported cost of goods sold in August in order
to match expenses to revenue in August. Similarly, the parent reported cost of goods
sold in September to match expenses to revenue in September. Since revenue was
reported in September from a consolidated viewpoint, the cost of goods sold is reported
as an expense in September as well. The cost from a consolidated viewpoint was the
amount paid by the subsidiary when it bought the inventory from outsiders.
8. Income tax must also be matched to the income to which it relates. In August, the
subsidiary reported income tax expense of $16 to match against the pre-tax income of
$40. Since no income was reported in the consolidated income statement for August, no
tax expense should be reported in income. Given that the subsidiary probably paid the
tax to the government, the tax is considered to have been prepaid from a consolidated
viewpoint because the tax was not yet due from a consolidated viewpoint.
Case 6-2
Overview
The managers of King Limited (King) are planning a share issue and do not want King's
earnings impaired by the poor performance of Queen Limited (Queen). The financial
statements of King will be widely distributed due to the share issue planned for Year 18. The
auditor must be aware of management's bias and must ensure that earnings and assets are not
overstated.
The drug industry is highly competitive. The principal assets in this industry are intangible due
to the large expenditures on research and development. The nature of these assets creates
problems. Note disclosure will be very important.
The relationship between King and Queen is uncooperative. It will, therefore, be difficult to
obtain sufficient and appropriate audit evidence to support the accounting method and values
used to record the Queen investment.
Accounting for the investment
The choice of the appropriate method to account for the Queen investment depends primarily
on whether King has significant influence over Queen. The following factors indicate that King
does have significant influence:
• King's ownership meets the 20% guideline;
• King had membership on the board of directors, and voluntarily gave it up;
The following factors indicate that King does not have significant influence:
• inter-company transactions have declined and are no longer material;
• dividends have not been paid recently, and perhaps earnings of Queen will not accrue to
King; and
• given the uncooperative nature of Queen and King's relationship, it does not appear that
King has significant influence over Queen.
(Students could have discussed other valid factors in determining whether King exerts
significant influence over Queen)
If King is able to exert significant influence over Queen, then it will continue to use the equity
method of accounting for the investment. If King no longer has significant influence, the
investment in Queen would be reported at fair value. It is difficult to determine whether
management of King manipulated the change in influence by ceasing to trade with Queen and
removing the King representative from Queen's board of directors. In any case, the change in
method would be accounted for prospectively since the change was made due to a change in
circumstance. Therefore, the prior period adjustment reported in the draft financial statements

would not be appropriate and should be reversed.
(Students should have reached a conclusion on the issue of significant influence and proceeded
with their analysis of either the fair value method or the equity method. This response discusses
both methods. However, students were not expected to provide an analysis of both the equity
and the fair value methods.)
Equity method
King must reflect its share of Queen's current loss. As shown in Appendix I, the investment
would be written down from $27.4 million to zero because King’s share of Queen’s losses
exceed the balance in the investment account. However, the investment would not be valued
as a negative amount because King is not legally obligated to pay any of Queen’s liabilities.
Fair value method
If King no longer has significant influence, it would adopt the fair value method starting on the
date it lost significant influence. The balance in the investment account under the equity
method would be retained as the initial balance under the fair value method. If the change in
significant influence occurred before Queen suffered the huge loss in Year 17, the balance in
the investment account would be $27.4 million. If the change in significant influence occurred
after King accrued its share of Queen’s loss for Year 17, the balance in the investment account
would be zero. King will likely argue that it had lost significant influence before Queen incurred
the loss and would thereby avoid the write down.
On the date that King lost its significant influence, it would make an irrevocable decision to
report dividend income and the fair value adjustments in net earnings or other comprehensive
income. At the end of each reporting period, the investment would be revalued to fair value.
At August 31, Year 17, Queen’s shares were trading at $13 per share. If this is a fair reflection
of the fair value of the company, then King’s investment would be revalued to $26 million and
the revaluation adjustment would be reported in net earnings. The adjustment would be a loss
of $1.4 million if the investment account had not been written down to zero or a gain of $26
million if the change in accounting method had occurred after King accrued its share of Queen’s
loss.
Given that Queen suffered huge losses and given that Queen’s shares were trading as low as
$5 per share during the year, one could argue that $13 is not a true reflection of the fair value of

Queen. The following factors should be considered in evaluating whether the market price is an
appropriate reflection of the fair value of the Queen shares:
• The fact that Queen refuses to disclose information may indicate a liquidity problem that the
company is reluctant to publicize. On the other hand, Queen may be trying to maintain
confidentiality about its new drug breakthrough.
• Stock prices have been volatile, so the stock price cannot be relied on as an indication of
value unless the volatility can be explained by specific economic events (e.g., generic drug
competition, new viral drug).
• Queen has experienced severe losses this year; this situation may be considered unusual.
• There is no evidence to suggest that Queen will continue to incur losses unless economic
circumstances have changed. If, for example, competition has increased, recurring write-
offs of research and development expenditures can be expected.
• There is no evidence that the market value of King's share of Queen has been less than the
carrying value for a prolonged period.
These factors suggest that the decline in future cash flows is not permanent and that the market
price of $13 may be a reasonable reflection of the fair value of Queen. However, the market
price of Queen's shares after year-end may provide additional evidence supporting this
conclusion.
(Students should have reached a conclusion on the reasonability of the trading price as a
reflection of the fair value of the Queen’s shares.)
The current situation is unusual and will require detailed note disclosure to describe the change
in reporting method and the impact on the financial statements.
APPENDIX I
Valuation of Investment Account
(in thousands of dollars)
Carrying amount per draft financial statements $25,000

Reverse adjustment for prior period adjustment 2,400
Restated balance under equity method, beginning of year 27,400
Entries for year under equity method:
Realized profit in beginning inventory (22% x 5,000) 1,100
Unrealized profit in ending inventory (22% x 1,000) (220)
Share of Queen’s loss (22% x 140,000 = 30,800) (Note 1) (28,280)
Balance under equity method, end of year $ -o–
Note 1: The adjustment should be the amount required to bring the investment account
to zero.
Case 6-3
Memo to: Linda Presner, Partner
From: CA
Subject: Accounting issues regarding Metal Caissons Limited (MCL)
Overview of the engagement
The financial statements of MCL will be used by the two shareholders, the bank and the
Department of National Defence (DND). Their needs must be considered when assessing
appropriate accounting policies and disclosures. John Ladd and Paul Finch wish to present
financial statements conveying a picture of profitability and a strong financial position to the
bank and the DND. However, it would be in their best interests to adopt policies that will also
minimize corporate taxes. The bank and the DND would likely expect generally accepted
accounting principles for private enterprises (ASPE) to be used in all instances.
(Most candidates devoted too much time to the definition of the users of MCL’s financial statements
and their needs. These candidates failed to incorporate this analysis in their analysis of the
accounting issues.)
Going concern
This issue must be assessed to determine whether the financial statements should be stated on
the basis of historical costs or liquidation values. A potential going concern problem is
suggested by the following:
• By excluding the government grants from revenues, MCL would be in a loss position. If
the year-to-date results are typical, the long-term profitability of MCL may be marginal.
However, such losses may, however, be normal in a start-up situation.
• DND is the sole client and can cancel the contract if the terms of the contract are not
met. Delivery dates have been missed; however, recent deliveries have been made on
time.
• MCL's working-capital position indicates potential insolvency if government grants are
not received. MCL has not met the terms of the job-creation grant, and this may explain
why the grant has not yet been received.
• The working-capital position has deteriorated further because DND has not paid for the
caissons received to date. The metal caissons must meet high standards of quality, and
DND's inspection process may have slowed down approvals. Alternatively, the fact that
DND has not paid may mean that there are problems that have not yet been disclosed to
us.
• There is nothing to indicate that the contract with DND will be renewed at the end of five
years or that the manufacturing process can be changed to another product at that time.
• The lawsuit pending against MCL, if successful, could drive the company into
bankruptcy.
• Although there are many factors that raise a concern about the ability of MCL to continue
as a going concern, MCL continues to operate as a going concern. DND has not yet
cancelled the contract and the bank has not called the loan. Therefore, MCL should
continue to report on a going-concern basis. However, they should disclose their
reliance on the DND contract and the significant risks that may bear on their ability to
continue as a going concern.
(Candidates were expected to address the going-concern issue. The better responses presented
some quantitative analysis. Most candidates failed to address this major issue in adequate depth.)
Government grants
At present, 79% of MCL's total workforce is employed in the plant, which is below the 85%
specified in the job-creation grant. If the conditions cannot be met by their due date, the grant
receivable will need to be written off.
The recording of the grants as revenue is inappropriate under GAAP since the grants pertain to
the cost of the plant and cost of employees. The grants do not pertain to the sale of goods or
provision of services. The building grant should be netted against the capitalized cost of the
plant, or recorded as a deferred credit and amortized to income over the life of the plant. The

job-creation grant should be deferred and amortized to income over the three-year period of the
agreement. It will be necessary to disclose the terms of the grants.
(Most candidates discussed the accounting implications of government grants in adequate depth.)
Late delivery penalties
Further review of the contract with DND is required. It is apparent that the late delivery penalties
($110,000 for 55 days at $2,000 per day) for the first three caissons have not been accrued, and
this issue must be discussed with management. DND should be contacted to find out whether
the penalties will be enforced or waived and whether specifications have been met on all the
caissons delivered to date. If the penalty is not waived, an accrual for the amount of the penalty
will be required.
Clarification is needed on the procedures to be followed if a caisson proves unacceptable. To

date no caissons have been returned; however, the amount of the penalties may increase with
each day that the specifications continue not to be met. Related disclosures for the contracts,
including the penalties, will be required.
(Most candidates did not quantify the amount of the possible penalty payment.)
Investment in MSI
With a 60% ownership interest, MCL likely has control over MSI. Under ASPE, the investment in
MSI can be reported on a consolidated basis or using the cost method or equity method. Since
MSI is reporting profit in excess of dividends paid, the consolidated statements or the equity
method would increase profits for MCL. Since consolidated statements are generally viewed as
more useful, I will assume that MCL will choose to report its investment on a consolidated basis.
Since MSI reported a profit of $40,000, the consolidated net income attributable to MCL’s
shareholders would normally increase by $24,000 (60% x 40,000). However, some of MSI’s
profit was made from intercompany transactions. The intercompany transactions should be
eliminated when preparing the consolidated statements since they did not involve an outside
entity. The unrealized profits in ending inventory should also be eliminated. This will reduce
inventory by $30,000 i.e. 30% x 100,000 and increase cost of goods sold by $30,000. Since the
profit of $30,000 was initially reported by MSI, both the shareholders of MCL and the non-
controlling interests in MSI will be affected when the profit is eliminated. The portion attributable
to the shareholders of MCL is $18,000 (60% x 30,000). Therefore, the consolidated net income

attributable to MCL’s shareholders will only increase by $6,000 (24,000 – 18,000).
Capitalized expenditures
Capitalizing costs is appropriate only if a likely future benefit is associated with the expenditure.
The capitalized expenditures will likely be reclassified as follows:
Expenditure Accounting Treatment

Office furniture Amounts spent on the purchase of office equipment should be
added to the capital asset account and depreciated over the life of
these assets.
Travel costs Costs related to the search of the plant site should be included in
the cost of land.
Calls for tender The cost of calls for tender should be included in the cost of the
plant and depreciated over the life of the plant.
Product development costs These costs should be capitalized as development costs if the
costs can be recovered through future sales of products or
services. The costs should be amortized over the life of the related
product.
Grant negotiations These costs should be netted against the amount of the grants
received and amortized on the same basis as the grants.
Contract negotiations These costs should be capitalized as a cost of the DND contract
and amortized over the life of the contract.
Admin & legal costs These costs and the incorporation costs should be expensed as
incurred since they do not provide any measurable future benefit
(Most candidates addressed capitalized expenditures in adequate depth.)
Miscellaneous issues
The following issues must also be considered:
1. We must discuss with management whether there are plans to manufacture products for
customers other than the DND. MCL is economically dependent on the DND contract, and
this relationship must be disclosed.
2. After reviewing the government contract and after discussions with management and the
DND, we should consider whether the present method of recording revenue at the time the
product is shipped is appropriate. Perhaps, revenue should not be recognized until the client
confirms that the detailed specifications have been met.
3. MCL's lawyers will be contacted to assess the progress of the Deutsch Production lawsuit.
Either the amount of the potential damages must be accrued or the appropriate disclosure
made about the contingent liability depending on the certainty with respect to the outcome of
the lawsuit. This is a critical issue considering the materiality of the amount and its impact on
MCL as a going concern.
4. We must find out why no principal payments of long-term debt have been recorded on the
financial statements. If required payments have not been made, MCL could be in default,
and this would be yet another consideration in the assessment of whether MCL is a going
concern. Principal payments may also have been erroneously charged as interest expense.
5. The current portion of the long-term debt should be classified separately and disclosure
made of the debt agreement and the principal payments to be made over the next five years.
6. Interest can be capitalized during the construction period only until production commences.
It appears that interest has been capitalized beyond this period and an adjustment should be
made. Once properly calculated, the amount should be disclosed in the notes to the financial
statements.
7. Depreciation has been calculated on plant equipment at what appears to be a low rate. The
appropriateness of the rate will have to be assessed giving regard to the useful life of the
related assets being depreciated.
Case 6-4

Memo to: Audit Partner
From: Audit Senior
Re: D Ltd. – Consolidated Financial Statements
As requested, I have prepared the following memorandum, which outlines the important
financial accounting issues of D and N, its subsidiary, and K, its investee company.
1. The shares issued by D to purchase N and K should be measured at their fair value at the
date of acquisition. For now, I will assume that the fair value of 160,000 common shares
was $2,000,000 when D purchased its investments in N and K.
2. It appears that there has been no allocation of the $640,000 acquisition cost excess for N in
the consolidated financial statements. The excess should be first be allocated to identifiable
assets. Any remaining excess should be allocated to goodwill. The goodwill should be
checked for impairment at the end of each year and written down if there is an impairment
loss.
3. Given that N had capitalized some research and development expenditures, there may be
some value in what they were developing. The projects that met the conditions for
capitalization should be measured at fair value at the date of acquisition assuming that the
assets can be separately identified and reliably measured. In turn, these assets should be
amortized over their useful lives. Amortization should commence once the assets are being
used in operations and are generating revenue for the company.
4. D can use either the entity theory or parent company extension theory in preparing the
consolidated financial statements. Under these theories, N’s assets and liabilities would be
measured at fair value at the date of acquisition. It appears that the consolidated financial
statements were prepared using the parent company theory because non-controlling interest is
measured at $590,000, which is 20% of the carrying amount of N’s net assets at the end of Year 2
(i.e. common shares of $1,000,000 plus retained earnings of $1,950,000). I will assume that D will
use the entity theory. Non-controlling interest at the date of acquisition should have been
$1,000,000 calculated as follows:
Acquisition cost for 80% interest in N $4,000,000

Implied value for 100% interest in N (4,000,000 / .8) 5,000,000
NCI’s share (20%) 1,000,000
This assumes that there is a linear relationship between the value of 80% and the value of 100% of
N.
5. Intercompany transactions and balances between D and K must be eliminated. Sales and
cost of sales should be reduced by the intercompany sales of $1,200,000. The unrealized
profit of $200,000 (1,200,000 – 1,000,000) should be taken out of ending inventory and
added to cost of goods sold. Since this was an upstream sale, non-controlling interest will
be affected by this adjustment.
6. The investment in K has been accounted for using the cost method. This method is not
acceptable under IFRSs. With a 40% interest in K, D would normally have significant
influence. If so, the equity method would be appropriate. For the purpose of this discussion,
I will assume that D does have significant influence and the equity method should be used.
7. Under the equity method, the acquisition cost would have to be allocated in a manner similar
to what is done for consolidation purposes. The acquisition differential would be allocated to
identifiable net assets where the fair value is different than carrying amount. This fair value
difference would have to be amortized and an adjustment made to the investment account
on an annual basis. We do not have sufficient information at this point to determine the
adjustment for Year 1.
8. Since D paid less than the fair value of K’s identifiable net assets, there is negative goodwill
in this acquisition cost. Negative goodwill is calculated to be $233,333 ($2,100,000 / .9 –
$2,100,000). If we used the same principles applied for consolidation purposes, this negative
goodwill would be reported as a gain on purchase.
9. Under the equity method, D’s share of the unrealized profit from intercompany transactions
would have to be eliminated. Since K made an after-tax profit of $120,000 ([1,200,000 –
1,000,000] x [1 – 0.4]) on sales to D, $48,000 (40% x 120,000) would have to be eliminated
from the investment account. Since D and K are related parties, the details of intercompany
transactions would need to be disclosed in the notes to the consolidated financial
statements.
10.Based on the discussion above, I have recalculated the following account balances for the
consolidated financial statements in the schedules below:
Goodwill
Investment in K (under equity method)
Non-controlling interest on balance sheet
Profit
Allocation and amortization of acquisition cost for investment in N
Cost of 80% investment, September, Year 1 4,000,000
Implied value of 100% investment (4,000,000 / .8) 5,000,000
Carrying amounts of N’s net assets:
Common shares 1,000,000
Retained earnings 1,850,000
Total shareholders' equity 2,850,000
Acquisition differential 2,150,000
Allocation: FV – CA
Land 800,000
Plant and equipment 700,000
Research and development expenditures - 90,000
Existing goodwill - 60,000 1,350,000
Balance – newly calculated goodwill 800,000
Balance Amortization Balance

Sept 1 Aug. 31
Year 1 Year 2 Year 2
Land 800,000 800,000

Plant and equipment 700,000 70,000 630,000
Research and development - 90,000 - 90,000
Old goodwill - 60,000 - 60,000
New goodwill 800,000 800,000
2,150,000 70,000 2,080,000
Investment in K
Investment in K, at date of acquisition 2,100,000
Retained earnings of K, Aug. 31, Year 2 1,710,000
Retained earnings of K, at acquisition 1,760,000
Change - 50,000
Less: profit in ending inventory (200,000 x [1 - .4]) - 120,000
Adjusted increase - 170,000
D’s ownership % 40% - 68,000
Investment in K, Aug. 31, Year 2 2,032,000
Non-controlling interest on balance sheet
Common shares of N 1,000,000
Retained earnings of N 1,950,000
Less: unrealized profit in ending inventory
([850,000 – 630,000] x .6) - 132,000 1,818,000
Unamortized acquisition differential 2,080,000
4,898,000
20%
Non-controlling interest, Aug. 31, Year 2 979,600
Calculation of consolidated profit – Year 2

Profit of D 600,000
Less: Dividends from N (200,000 x 80%) 160,000
Dividends from K (150,000 x 40%) 60,000 220,000
380,000
Profit of N 300,000
Less: profit in closing inventory (220,000 x .6) - 132,000
amortization of acquisition differential - 70,000
Adjusted profit 98,000
Profit of K 100,000
Less: profit in closing inventory (200,000 x .6) - 120,000
Adjusted profit - 20,000
D’s ownership % 40% - 8,000
Consolidated profit, Year 2 470,000
Attributable to:
Shareholders of D 450,400
Non-controlling interests (20% x 98,000) 19,600
470,000
Case 6-5
REPORT ON ACCOUNTING POLICIES USED IN THE FINANCIAL STATEMENTS OF GOOD

QUALITY AUTO PARTS LIMITED FOR THE YEAR ENDED FEBRUARY 28, Year 11.
To the members of the union, Good Quality Auto Parts Limited:
I have been engaged to analyze the financial statements of Good Quality Auto Parts Limited
(GQ) for the year ended February 28, Year 11 and determine whether there are any
controversial accounting issues. For the purposes of this report, "controversial accounting
issues" will be defined as accounting policies that have the effect of reducing payments under
the profit-sharing plan to the union members.
The existence of the profit-sharing contract creates incentives for the management of GQ to
make accounting choices that reduce net income and thereby reduce the payments that must
be made to the union members. Accounting standards for private enterprises (ASPE) allow
considerable flexibility and judgment by the preparers of financial statements in selecting
accounting policies. Since the company is privately owned, the costs (real or perceived) of
reporting lower income may be small relative to the savings generated. For example, the effect
of lower income on new or existing lenders may be considered less important than the savings
derived from reduced profit sharing. In addition since the term of the contract is only three
years, some of the income deferral may yield permanent savings if the profit-sharing
component is not renewed in subsequent contracts.
In analyzing the accounting policies, I will be taking as strong a position as can be justified to
support the union's objective of making net income as large as possible. This is in conflict with
the objective of management, which is to reduce net income.
Inventory write-down
Accounting practice requires that inventory be measured at the lower of cost and net realizable
value. Thus, if the inventory cannot be sold, management can justify its write-off. However,
since much of the inventory has been on hand for several years, the decision to write it off this
year raises a question as to the motivation for the write-off. Management could be writing off the
inventory solely to reduce income, thereby reducing the payments required under the profit-
sharing plan. The problem must be considered from two points of view. First, is the inventory
genuinely unsaleable? If not, then the entry to write down the inventory must be reversed,
resulting in a higher net income figure. Assuming that the inventory is unsaleable, the next
question is whether the write-off legitimately belongs in the current period. If the inventory

became unsaleable in the current year, then the write belongs in the current period. If the
inventory was unsaleable in prior years, it should have been written down in prior years. In that
case, the financial statements should be retroactively restated to correct the error in the
appropriate period.
Allowance for returns

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

There is no requirement that all assets owned by a firm be depreciated in the same way. Thus,
GQ can argue that the use of an accelerated method on the new equipment better reflects the
pattern in which the asset’s future economic benefits are expected to be consumed by GC. We
can argue that the portfolio of manufacturing equipment acquired to produce similar products
should be accounted for similarly. If there is no difference between the new and old equipment
with respect to the effect of technological obsolescence, then either the new asset should be
depreciated on a straight-line basis or similar assets acquired previously should be
depreciated on the accelerated method. The financial impact of using the same depreciation
method for both cannot be determined at this point.
Write-off of goodwill
Goodwill should be written down or written off if there has been a permanent impairment of its
value i.e. if the recoverable amount of the cash generating unit in which the goodwill is located
is less than the carrying amount of the net assets, including goodwill, of the cash generating
unit. The fact that the auto parts industry is suffering through poor economic times does not
necessarily imply that what was purchased (the company name, its customers, etc.) no longer
has any value. The auto industry is very sensitive to economic cycles, and it is expected that
such downturns will occur. (Indeed, their occurrence should have been factored into the
acquisition cost paid by GQ).
Unless GQ can come up with strong evidence that the intangibles purchased have been
impaired, there is no justification for the write-off even though GQ's auditors supported it. It is
important to emphasize that their support may rest in conservatism: auditors are willing to
accept accounting treatments that are conservative. However, conservatism is inconsistent with
the union's objectives. The value of the asset acquired in Year 5 must still exist unless there is
specific evidence of its impairment. GQ should provide evidence of impairment.
Unrealized profits from intercompany sales

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

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

Under ASPE, CG has the choice to use either the taxes-payable method or the liability method
of accounting for income taxes. Accordingly, the new method is acceptable under ASPE. We
could argue that the change is in violation of the contract, as the contract was signed on the
understanding that major accounting policies would remain the same. The arbitrator may accept
this argument. The arbitrator, however, would likely demand consistent treatment of accounting
changes.
Case 6-6
REPORT TO PARTNER ON PLEX-FAME CORPORATION
Overview
PFC is a public corporation. Therefore, the financial statements will be used by stakeholders for
a variety of purposes, including the evaluation of the company and its management. As a result,
the managers have incentives to increase or smooth earnings to influence the share price or
present a favourable impression of themselves to the stakeholders. In addition, the company is
expanding rapidly and, therefore, may need to raise capital. By using accounting choices to
increase earnings or otherwise improve the appearance of the financial statements, management
may be attempting to reduce the cost of capital by lowering the cost of debt or increasing the
selling price of the shares. The company may have a competing objective of minimizing tax by
choosing accounting policies that reduce income in cases where Revenue Canada requires for
tax purposes the same accounting policies that are used in the general-purpose financial
statements. PFC also wants to ensure it does not violate the debt covenant and wants to keep
the debt to equity ratio below 2:1.
Given that PFC is a public company and that it may raise capital, it is likely that management
would choose accounting policies that increase income. Its financial statements must be in
compliance with International Financial Reporting Standards (“IFRSs”).
The issues are discussed below. The impact of the accounting and reporting on the key metrics
(income, debt and equity) are shown in the appendices. Appendix I shows the accounting impact
for the issues where the accounting was not specified in the case. Appendix II shows the impact
when the company’s policies must be changed to be in accordance with GAAP.
Penalty payment
PFC received a $2 million payment from a contractor who built a theatre complex for PFC in
Montreal. The payment was for completing the project late. In its attempt to increase income,
management will want to record the penalty as revenue.
Arguments could be made for treating the penalty payment either as income (revenue or reduction
of expenses) or as a reduction in the capital cost of the complex (balance sheet).
If PFC incurred additional costs because of the delay in opening the new complex, and the penalty
was compensation for those additional costs incurred, then the penalty should be used to offset
those costs incurred. If the additional costs incurred related to the capital cost of the complex,
then the penalty should be used to reduce the capital cost of the complex. Analogies might be
drawn with the IFRS standard on government grants (IAS 20). This section recommends that
payments such as grants should be treated as cost reductions. The parallel here is that the
penalty payment is like a grant and therefore should be treated as a reduction in the capital cost
of the complex or in costs expensed as incurred.
On the other hand, if the penalty payment was compensation for lost revenue, then an argument
might be made for treating the penalty as revenue. If the penalty is treated as revenue, then we
must consider whether it should be disclosed separately. Since the penalty payment is non-
recurring, financial statement users would find separate disclosure informative because the
portion of revenue and income that is non-recurring can be valued differently by the market and
by individual investors and influence the evaluation of management. Therefore, if material, the
penalty should be disclosed as a separate revenue item either on the face of the income statement
or in the notes.
“Rue St. Jacques”
Ticket proceeds
PFC would prefer to recognize revenue as early as possible with the earliest date being the sale
of the tickets. However, the most appropriate treatment for recognizing revenue for “Rue St.
Jacques” is when the show is performed.
IAS 18, paragraph 15- Admission fees, requires “revenue from artistic performances, banquets
and other special events is recognized when the event takes place. When a subscription to a
number of events is sold, the fee is allocated to each event on a basis which reflects the extent
to which services are performed at each event.”
Performance is the critical event in the earnings process, and therefore revenue is not earned
until the show is put on. There is no assurance that the production will be completed, or that any
performance for which tickets are sold will take place (for example, the show could be closed
down before it begins its run or even after it begins its run). In that case, it will be necessary to
refund the acquisition cost of tickets to buyers.
Interest on ticket proceeds
PFC earns a significant amount of interest by holding the money paid in advance by ticket
purchasers. The interest revenue could be treated as either income or deferred revenue
depending on the facts and circumstances. Management’s preference will be to include the
interest in income since it will serve to improve the bottom line. Immediate recognition of interest
revenue is justifiable. If the show is cancelled, PFC will be able to keep the interest revenue—
only the amount paid for the tickets will be refunded. In addition, by buying their seats in advance,
purchasers guarantee their seats but pay a premium for the guarantee (the interest earned by
PFC and forgone by the purchasers).
On the other hand, interest may be factored into the price and constitute a discount from future
higher prices. That is, PFC may be providing a discount to people who purchase their tickets in
advance. Prices may rise in the future. If this is the case, then treating the interest as deferred
revenue may make sense.
Pre-production costs
PFC has incurred significant costs in advance of the opening of “Rue St. Jacques.” We must
determine whether these costs should be capitalized and amortized, or expensed as incurred.
PFC would likely prefer to capitalize costs since this treatment would minimize the current effect
on income at a time when it is considering going to the capital markets. In principle, capitalization
and amortization of the costs over the life of the show appears reasonable. The issue is whether
the show will generate adequate revenues (in excess of the capitalized costs) to justify including
them on the balance sheet as assets. It is very difficult, however, to determine whether a theatre
production will be successful. Indications are that the show will be a success, given its long run
in Paris and the extent of advance ticket sales. These facts support capitalization; expensing
would likely be too conservative in light of these facts. However, despite these indicators of
success, the show could still bomb if costs are excessive or it does not suit the tastes of Canadian
theatre goers. As long as the definition of as asset can be met, setting it up as an asset is
acceptable.
If PFC chooses to capitalize the pre-production costs, they must be amortized over a reasonable
period of time. One method is to expense costs against net revenues dollar for dollar until the pre-
production costs are covered (i.e. cost recovery first method). With this method the show will
generate no income until the pre-production costs have been recovered. A second alternative is
to amortize over the estimated life of the show.

Of course, once the show opens, ongoing production costs should be expensed as incurred.
Advertising and promotion
PFC paid $12 million for advertising and promotion costs a large part of which related to the “Rue
St. Jacques” show.These costs should be expensed as incurred because it is difficult to assess
the effectiveness of advertising costs i.e. to determine whether they provide future benefit.
Debt defeasance
PFC has structured the debt-retirement transaction as an in-substance defeasance of debt. The
effect of the transaction is to remove debt from the balance sheet and thereby reduce the amount
of debt reported (thus, for example, decreasing the debt-to-equity ratio). Unfortunately, IFRSs do
not allow the use of this type of arrangement.
IAS 1, paragraph 32 states “An entity shall not offset assets and liabilities or income and
expenses, unless required or permitted by an IFRS.” Paragraph 33 states “An entity reports
separately both assets and liabilities, and income and expenses.” Offsetting in the statements of
comprehensive income or financial position or in the separate income statement (if presented),
except when offsetting reflects the substance of the transaction or other event, detracts from the
ability of users both to understand the transactions, other events and conditions that have
occurred and to assess the entity’s future cash flows.
IAS 32 (para. 42) includes the following requirement:
A financial asset and a financial liability shall be offset and the net amount presented in the
balance sheet when, and only when, an entity:
a. currently has a legally enforceable right to set off the recognized amounts; and
b. intends either to settle on a net basis, or to realize the asset and settle the liability
simultaneously.
Both of these conditions must be met in order to offset a financial asset and a financial liability.
However, the facts indicate that the holders of the company’s syndicated loan are not even aware
of PFC’s intended method of settling its debt. Therefore, the first condition for offsetting has not
been met, i.e. PFC has no legally enforceable right to set off the amounts recognized for its
syndicated loan, its investment in treasury bills and its forward contract. Therefore, this
arrangement would not allow the removal of these items from PFC’s balance sheet. The treasury
bonds and the debt must be reinstated on the financial statements and reported separately as an
asset and a liability. The $5 million difference between the value of the asset and the liability must
be reversed. This will increase income if the difference was previously recorded as a loss or will
reduce a non-current asset if it was previously recorded as a deferred charge.
From the information obtained to date, it is not currently clear how PFC is accounting for its
forward contract. PFC may want to consider whether the forward contract to buy US dollars
qualifies as a hedge of its debt obligation. If hedge accounting is not applied, then PFC will be
required to account for the forward contract as a derivative instrument measured at fair value
through the profit and loss.
Sale of theatres
PFC began selling theatres recently where economic conditions justified the sale of a particular
theatre. This year, a significant part of net income was generated through the sale of theatres.
PFC has included the proceeds from these sales as revenue on the income statement (as
opposed to treating them as gains or losses on disposition) because it considers such sales as
an ongoing part of its operations. However, the sales could also be considered incidental to
ongoing operations, with only gains or losses on disposition being reported in the income
statement. In the latter case, the gains and losses would not be included in revenues. Including
the proceeds from the sale of theatres is consistent with management’s objective of making the
financial statements more attractive for going to the capital markets.
Based on the information available, it is not possible to conclude whether these sales do represent
part of ongoing operations. We should review the sale agreements and board minutes to confirm
that these sales are indeed “ongoing.” If the sales are ongoing, the theatres would have to be
reported as a current asset similar to inventory. If the theatres continue to be reported as part of
property, plant and equipment, then it would be inappropriate to report the sales through revenue;
the sales should be reported as gains on sale.
If the sales can be considered part of ongoing operations, consideration should be given to
whether there should be separate disclosure of the revenue from theatre sales. Burying the
revenues from theatre sales will make it more difficult for users and the capital markets to value
the company because revenue from sales of theatres may not be as regular or predictable as
revenues from other sources. If such sales are material, separate disclosure of revenue should
be made either on the face of the income statement or in the notes.
Selling off a significant number of theatres raises the question of whether the number being sold
is large enough to be considered a discontinued operation, requiring separate disclosure of
information. For the theatre sales to qualify as a discontinued operation, they must represent a
separate major line of business or geographical area of operations. My assessment is that the
sale of theatres should not be considered a discontinued operation because PFC is continuing in
the theatre business. If, for example, PFC were ceasing to operate all of its movie theatres to
focus on live theatre, an argument for discontinued operations might be made. In this case, the
sale of theatres appears to be part of a continuing reassessment of its portfolio of theatres.
The sales for profit are consistent with management’s apparent objective of income maximization.
Management could manipulate the situation by selling only theatres that would generate a profit
(instead of selling ones that have more economic value in some other use).
PFC will need to consider the balance sheet classification of the theatres it intends to sell, i.e.,
whether they should be classified as non-current assets held for sale. A non-current asset should
be classified as held for sale if its carrying amount will be recovered principally through a sale
transaction rather than through continued use, which seems to be the case here. However,
certain additional criteria must be met to classify an asset as held for sale, which would also need
to be considered. If these criteria are met, then the theatre held for sale should be measured at
the lower of its carrying amount and fair value less costs of disposal. Non-current assets held for
sale (or assets and liabilities of a disposal group classified as held for sale) are presented
separately on the balance sheet.
Partnership agreement
PFC formed a partnership with an unrelated company whereby the other company contributed
cash and PFC contributed television production equipment. As part of the deal, PFC withdrew
the cash contributed by the other company for its own use. The substance of the transaction
appears to be the sale (rather than contribution) of assets to the partnership and the recording of
the gain on sale. By using this approach, management may be attempting to increase income
artificially by recognizing the full gain.
The facts suggest that this transaction is a partial sale of assets. If this is the case, the full gain
should not be recognized. The facts supporting this assertion are as follows. First, cash can be
withdrawn immediately; thus the partnership acted as a conduit for selling of the assets. Second,
the deal is based on future profits; that is, the value of PFC’s contribution appears to be dependent
on the future performance of the partnership. Third, Odyssey appears to be offering little expertise
to the partnership and thus cash is simply being funneled to PFC via the partnership. If this
transaction is just a partial sale of assets, the gain should only be $10.75 million ($40 million -0.45
(portion of assets sold) x $65 million (carrying amount of assets sold)) rather than $25 million.
The method preferred by PFC (recording full sale of the assets) might be supported by the fact
that future profits will be shared, suggesting that this is a legitimate partnership arrangement.
However, more information is required to understand how the value of PFC’s contribution may be
adjusted if the net income of Phantom earned between July 1, Year 7 and June 30, Year 8 does
not meet expectations, since this adjustment would appear to impact the calculation of each
partners’ respective interests.
In assessing the substance of this transaction, we must consider management’s intentions. We

will have to discuss the transaction with management and review pertinent documents to
determine its substance. We can then form an opinion on the appropriate method of accounting.
The accounting for the investment in the partnership depends on PFC’s level of influence over
the operating and financing policies for the partnership. With a 55% interest, PFC may be able to
determine these policies and would have control over the partnership. If so, they would
consolidate the partnership financial statements with their own financial statements.
If both parties to the partnership have equal say over the policies of the partnership, then the
partnership would be deemed to be a joint venture. Under IFRS 11, PFC could report its
investment using the equity method.
Conclusion
As indicated in Appendix I, income would decrease if the pre-production costs and/or
advertising costs have been capitalized and should have been expensed. As indicated in
Appendix II, income should be reduced for the unrealized gain on the transfer of assets to the
partnership and debt should be increased to reverse the debt defeasance transaction. After
adjustment, the return on equity on an annualized basis is only 18.8%, which is below the
company’s target return on equity. The debt to equity ratio is 1.98, which is slightly below the
maximum amount set in the debt covenant. We will need to review major transactions in the last
month of the year to ensure they are accounted for correctly. Otherwise, the company could be
in violation of their debt covenant. This would raise concerns of the company’s ability to
continue as a going concern.
APPENDIX I
IMPACT OF ACCOUNTING ENTRIES ON KEY METRICS
(in millions)
Transaction Income Debt Equity ROE Debt:Equity
Penalty Payment
- report as income 2 2 I* D*
- report as reduction of capital cost
Rue St. Jacques ticket

- report as unearned revenue
Interest on ticket proceeds

- report as income 1.7 1.7 I D
- report as deferred revenue
Pre-production costs
- capitalize and later expense
- expense as incurred (15) (15) D I
Advertising & promotion costs

- capitalize and later expense
- expense as incurred (12) (12) D I
Debt defeasance
- if loss was previously recorded 5 5 I D
- if deferred charge was recorded
Sale of theatres as revenue
Investment in partnership

- if full consolidation I I
- if proportionate consolidation I I
* Notations:
I = increase
D = decrease
NOTHING NOTED = no change

APPENDIX II
IMPACT OF ACCOUNTING CHANGES ON KEY METRICS
(in millions)
Adjustment Income Debt Equity ROE Debt:Equity
Unadjusted position 147 1,490 780 18.8% 1.91
Interest on tickets deferred (1.7) (1.7)
Debt defeasance 25
Investment in partnership
- reduce gain to 10.75 (14.25) (14.25)
Adjusted position 131.05 1,515 764.05 17.2% 1.98
Annualized to 12 months (times 12/11) 18.8%
Target ROE 20.0%

Maximum debt to equity ratio 2.00
SOLUTIONS TO PROBLEMS
Problem 6-1
(a)
Intercompany balances
Sales and purchases for Year 3 180,000 (a)
Accounts receivable and payable at end of Year 3 40,000 (b)
Intercompany inventory profits Before 40% After

tax tax tax
Opening inventory – Sub selling (60,000 x .3) 18,000 7,200 10,800 (c)
Closing inventory – Sub selling (70,000 x .3) 21,000 8,400 12,600 (d)

Consolidated account balances
Inventory (500,000 + 300,000 – (d) 21,000) 779,000
Accounts payable (600,000 + 320,000 – (b) 40,000) 880,000
Retained earnings, beginning of year
PAT 2,400,000
SAT R/E, beginning of year 1,100,000
SAT R/E, date of acquisition 900,000
Change since acquisition 200,000
Less: unrealized profit in beginning inventory (c) - 10,800
189,200
PAT’s share x 90% 170,280
Consolidated retained earnings 2,570,280
Sales (4,000,000 + 2,500,000 – (a) 180,000) 6,320,000
Cost of sales (3,100,000+1,700,000–(a)180,000+(d) 21,000–(c)18,000) 4,623,000
Income tax expense (80,000 + 50,000 – (d)8,400 + (c)7,200) 128,800
(b) Since the subsidiary was the seller of the intercompany sales, these transactions are
upstream transactions and the non-controlling interest (NCI) will absorb their share of the
adjustments to eliminate the unrealized profits. NCI on the income statement will decrease
by $1,260 (10% x 12,600) for its share of unrealized after-tax profits in ending inventory and
increase by $1,080 (10% x 10,800) for its share of after-tax profits in beginning inventory.
NCI on the balance sheet will decrease by $1,260 (10% x 12,600) for its share of unrealized
after-tax profits in ending inventory.
Problem 6-2
(a)
Intercompany revenues and expenses
Sales and purchases (100,000 + 80,000) 180,000 (a)
Rent revenue and expense 24,000 (b)
Interest revenue and expense (70% x 50,000) 35,000 (c)
Intercompany inventory profits Before 40% After

tax tax tax
Opening inventory – Sub selling 5,000 2,000 3,000 (d)
Closing inventory – Parent selling
(100,000 x .50 x .30) 15,000 6,000 9,000 (e)
Calculation of non-controlling interest:

Income of subsidiary (9,000 / 10%) 90,000
Add: opening inventory profit (d) 3,000
Adjusted 93,000
10%
9,300 (f)
Parent Company
Consolidated Income Statement
for the Current Year
Sales (500,000 – (a) 180,000) 320,000

Rental revenue (24,000 – (b) 24,000)
Interest revenue (50,000 – (c) 35,000) 15,000
Total revenue 335,000
Cost of goods sold
(350,000 – (a) 180,000 – (d) 5,000 + (e) 15,000) 180,000
Rent expense (24,000 – (b) 24,000)
Interest expense (35,000 – (c) 35,000)
Administration expenses 45,000
Income tax expense (42,000 + (d) 2,000 – (e) 6,000) 38,000
Total expense 263,000
Profit 72,000
Attributable to:
Shareholders of parent 62,700
Non-controlling interests (f) 9,300
72,000
Proof:
Profit previously reported 69,000
Add: opening inventory profit (3,000 x 90%) 2,700
71,700
Less: closing inventory profit 9,000
Consolidated profit attributable to shareholders of parent 62,700
(b)
The matching principle requires that expenses be matched to revenues. When intercompany
revenues are eliminated from the consolidated financial statements, the related cost of goods
sold should also be eliminated. When profits are eliminated, income tax expense related to
those profits should also be eliminated. When the previously unrecognized intercompany profits
are recognized in a later period, the income tax on these profits should be expensed.
Problem 6-3
Pike Spike Consolidated
December 31, Year 1
Land 100,000 115,000*
Gain on Sale
Income Tax on Gain
December 31, Year 2
Land 128,000 115,000*
Gain on Sale 28,000
Income Tax on Gain 11,200***
December 31, Year 3
Land
Gain on Sale 12,000 25,000**
Income Tax on Gain 4,800*** 10,000***
* = fair value of land at date of acquisition
** = selling price to outsiders less amount paid at acquisition = 140,000 – 115,000
*** = 40% x gain on sale of land
Problem 6-4
(a)
Acquisition differential amortization
Plant – Waste
Years 1– 5 ([15,000 / 8 years] x 5 years) 9,375 (a)
Year 6 (15,000 / 8 years) 1,875 (b)
Goodwill – Baste

Years 4 – 5 19,000 (c)
Year 6 –0–
Intercompany Revenues and Expenses
Sales (90,000 + 170,000 + 150,000) 410,000 (d)
Rent (25,000 + 14,000) 39,000 (e)
Interest 10,000 (f)
Dividend income: All intercompany from Waste & Baste 43,750 (g)
Intercompany Profits
Before tax 40% tax After tax

Opening inventory – Waste selling
(15,000 x .30) 4,500 1,800 2,700 (h)
Ending inventory – Baste selling
(60,000 x .30) 18,000 7,200 10,800 (i)
– Paste selling
(22,000 x .30) 6,600 2,640 3,960 (j)
– Waste selling
(60,000 x .30) 18,000 7,200 10,800 (k)
42,600 17,040 25,560) (l)
Paste Company
for the Year Ended December 31, Year 6
Sales (450,000 + 270,000 + 190,000 – (d)410,000) 500,000

Dividends (43,750 – (g) 43,750)
Interest (10,000 – (f) 10,000)
Rent (130,000 – (e) 39,000) 91,000
Total income 591,000
Cost of sales (300,000 + 163,000 + 145,000 – (d) 410,000
– (h) 4,500 + (l) 42,600 + (b) 1,875) 237,975
General & administrative (93,000 + 48,000 + 29,000 – (e) 39,000) 131,000
Interest (10,000 – (f) 10,000)
Income tax (27,000 + 75,000 + 7,000 + (h) 1,800 – (l) 17,040) 93,760
Total expenses 462,735
Profit 128,265
Attributable to:
Shareholders of Paste 109,910
Non-controlling interests (20% x 94,025* + 25% x -1,800*) 18,355
128,265
* see part (c) for calculation of 94,025 and –1,800
(b)
Calculation of consolidated retained earnings – December 31, Year 6
Retained earnings of Paste December 31, Year 6 703,750

Profit in ending inventory (j) (3,960)
Retained earnings of Waste December 31, Year 6 146,000
Retained earnings of Waste – acquisition 40,000
Increase 106,000
Less: profit in ending inventory (k) 10,800
amortization of acquisition differential (a) 9,375 + (b) 1,875 11,250
Adjusted increase 83,950
Paste's ownership % 80% 67,160
Retained earnings of Baste December 31, Year 6 79,000

Retained earnings of Baste – acquisition 80,000
Decrease (1,000)
Less: amortization of acquisition differential for Baste (c) 19,000
profit in ending inventory (i) 10,800
(30,800)
Paste's ownership % 75% (23,100)

Consolidated retained earnings December 31, Year 6 743,850
(c)
Profit of Waste 104,000

Add: profit in opening inventory (h) 2,700
106,700
amortization of acquisition differential (b) 1,875
94,025
Paste’s share x 80% 75,220
Profit of Baste 9,000

Less: profit in ending inventory (i) 10,800
(1,800)
Paste’s share x 75% - 1,350
Profit in ending inventory – Paste selling (j) - 3,960
Investment income from subsidiaries 69,910
(d)
Revenue should be recognized when it is earned i.e., when the benefits and risks have been
transferred to an entity outside of the reporting entity. The reporting entity for consolidated
financial statements encompasses the parent and all of its subsidiaries. Since intercompany
transactions are transactions within the reporting entity (not outside of the reporting entity), they
must be eliminated when preparing consolidated financial statements. When the inventory is
sold outside of the consolidated entity, the difference between the selling price and the original
cost to the consolidated entity would be reported as profit of the consolidated entity.
Problem 6-5
(a) X's equity method journal entries
Year 1

Cash 18,750
Investment in Y Co. 18,750
75% x $25,000 dividends.

Investment income 97,500
75% x $130,000 net income.

To hold back 75% of the $18,000 after-tax
inventory profit – Y selling
(60% x $30,000 = $18,000).

To hold back the after-tax land profit –
X selling (60% x $37,000 = $22,200).

Acquisition differential amortization – Year 1
Inventory 60,000
Equipment $45,000/15 = 3,000
63,000
x Co.’s share (@ 75%) 47,250
Note: Year 1 investment income is $14,550 (97,500 – 13,500 – 22,200 – 47,250)
Year 2
Cash 3,750
75% x 5,000 dividends.

75% x 16,000 net loss.

Acquisition differential (equipment) amortization. (3,000 x 75%)

To realize opening inventory profit – Y selling.

To realize land profit – X Selling

To hold back after-tax inventory profit – X selling
(60% x $12,000)
Note: Year 2 investment income is $14,250 (–12,000 – 2,250 + 13,500 + 22,200 – 7,200)
(b) Calculation of consolidated net income – Year 1
Net income of X 400,000

Less: Land profit 22,200
Adjusted 377,800
Net income of Y 130,000

Less: closing inventory profit (18,000)
acquisition differential amortization (63,000)
Adjusted 49,000
Consolidated net income 426,800
Attributable to:

Shareholders of X 414,550
426,800
Calculation of Consolidated Net income – Year 2
Net income of X 72,000

Less: closing inventory profit 7,200
64,800
Add: land profit realized 22,200
Adjusted net income 87,000
Net income (loss) of Y (16,000)
Add: opening inventory profit realized 18,000
Less: acquisition differential amortization (3,000)
Adjusted net income (1,000)
Attributable to:
Shareholders of X 86,250
Non-controlling interests (25% x -1,000) (250)
86,000
(c)
Changes in Non-controlling Interest
Years 1 and 2
Balance Jan. 1 Year 1 [25% x (170,000 + 105,000)] 68,750

Allocation of Y Co.’s adjusted net income Year 1
(25% x 49,000) 12,250
81,000
Less: dividends (25% x 25,000) 6,250
Balance Dec. 31, Year 1 74,750
Allocation of Y Co.’s adjusted net income Year 2
(25% x - 1,000) (250)
74,500
Less: dividends (25% x 5,000) 1,250

Balance Dec. 31, Year 2 73,250
Proof:
Y - Common shares 100,000

- Retained earnings (70,000 + 130,000 − 25,000 − 16,000 − 5,000) 154,000
- Shareholders' equity Dec. 31, Year 2 254,000
- Unamortized acquisition differential 39,000
293,000
25%
73,250

(d) Calculation of Investment in Y Co. (Equity Method)
As at December 31, Year 2
Shareholders' equity of Y Jan. 1, Year 1 170,000

Acquisition differential 105,000
275,000
X's ownership 75%
Cost of 75% investment in Y Jan. 1, Year 1 206,250
Investment income – Year 1 14,550
Year 2 14,250 28,800
235,050
Less: Dividends received
Year 1 (75% x 25,000) 18,750
Year 2 (75% x 5,000) 3,750 22,500
Investment in Y Dec. 31, Year 2 212,550
Proof:
Shareholders' equity of Y 254,000

Balance, unamortized equipment (45,000 − 6,000) 39,000
293,000
X's ownership 75%
219,750
Less: Holdback of inventory profit – X selling 7,200
Investment in Y, December 31, Year 2 212,550
Problem 6-6
Intercompany profits
Opening inventory Q selling 80,000 32,000 48,000 (a)

L selling 52,000 20,800 31,200 (b)

Ending inventory Q selling 35,000 14,000 21,000 (c)
L selling 118,000 47,200 70,800 (d)
(a) Calculation of consolidated profit
Profit of L 580,000
Less: Dividends
From M (80% x 200,000) 160,000
From Q (70% x 150,000) 105,000
Ending inventory profit (d) 70,800 335,800
244,200
Add: opening inventory profit (b) 31,200
Profit of M 360,000
Profit of Q 240,000
Less: ending inventory profit (c) 21,000
219,000
Add: opening inventory profit (a) 48,000
267,000
Consolidated profit 902,400
Attributable to:
Shareholders of L 750,300
Non-controlling interests (20% x 360,000 + 30% x 267,000) 152,100
902,400
(b)
Calculation of consolidated retained earnings – beginning of current year
Retained earnings of L 976,000

Less: opening inventory profit (b) 31,200
Adjusted 944,800
Retained earnings of M 843,000

Acquisition retained earnings 500,000
Increase 343,000
L's ownership 80% 274,400
Retained earnings of Q 682,000

Acquisition retained earnings 50,000
Increase 632,000
Less: opening inventory profit (a) 48,000
Adjusted increase 584,000
L's ownership 70% 408,800
Consolidated retained earnings – beginning of year 1,628,000
Problem 6-7
Calculation, allocation, and amortization of acquisition differential
Cost of 80% investment, Jan. 1, Year 3 1,600,000

Implied value of 100% investment 2,000,000
Carrying amounts of Least's net assets:
Assets 3,000,000
Liabilities 1,500,000
Allocation: FV - CA
Accounts receivable - 20,000
Inventories - 50,000
Plant and equipment (net) 35,000
Long-term liabilities 100,000 65,000
Balance – goodwill 435,000

Jan. 1 Dec. 31
Year 3 Years 3 to 8 Year 9 Year 9
Accounts receivable - 20,000 - 20,000
Inventories - 50,000 - 50,000

Plant and equipment (net) 35,000 26,250 4,375 4,375 (a)
Long-term liabilities 100,000 100,000
Goodwill 435,000 52,200 8,700 374,100 (b)
500,000 108,450 (c) 13,075 (d) 378,475
Sales and purchases (2,000,000 + 1,500,000) 3,500,000 (e)
Loss on land, July 1, Year 7

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

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

(500,000 x 0.20) 100,000 40,000 60,000 (j)
– Least selling
(714,280 x 0.30) 214,284 85,714 128,570 (k)
314,284 (l) 125,714 188,570
Intercompany dividends declared but not paid (80% x 100,000) 80,000 (m)
Deferred income taxes – ending inventory (40,000 + 85,714) 125,714 (n)
Calculation of consolidated retained earnings – Jan. 1 Year 9
Retained earnings of Most, Jan. 1, Year 9

(10,400,000 – 1,000,000 + 350,000) 9,750,000
Less: Profit in opening inventory (g) 37,500

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

Net income of Most 1,000,000
Less: Dividends from Least (100,000 x 80%) 80,000
Profit in closing inventory (j) 60,000
Land loss (f) 30,000 170,000
830,000
Add: profit in opening inventory (g) 37,500
Net income of Least 400,000
Add: profit in opening inventory (h) 154,285
554,285
Less: profit in closing inventory (k) 128,570
amortization of acquisition differential (d) 13,075
Consolidated net income 1,280,140
Attributable to:
Shareholders of Most 1,197,612
1,280,140
Calculation of consolidated non-controlling interests – Jan. 1 Year 9 (Method 1)
Least’s common shares, Jan. 1, Year 9 500,000
Retained earnings of Least, Jan. 1, Year 9 2,000,000
Less: profit in opening inventory (h) 154,285
Unamortized acquisition differential (500,000 – 108,450) 391,550
2,737,265
NCI’s ownership % 20%
NCI, Jan. 1, Year 9 547,453

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

Consolidated Statement of Changes in Equity
For Year Ended December 31, Year 9
Common Retained
Stock Earnings Total NCI Total
Balance, beginning of year 1,000,000 10,332,312 11,332,312 547,453 11,879,765
Add: net income 1,197,612 1,197,612 82,528 1,280,140
Less: dividends (350,000) (350,000) (20,000) (370,000)
Balance, end of year 1,000,000 11,179,924 12,179,924 609,981 12,789,905
Proof of consolidated retained earnings, end of Year 9
Retained earnings of Most, Dec. 31, Year 9 10,400,000

Less: profit in ending inventory (j) 60,000
Retained earnings of Least, Dec. 31, Year 9 2,300,000
Retained earnings of Least at acquisition 1,000,000

Increase 1,300,000
amortization of acquisition differential
((c) 108,450 + (d) 13,075) 121,525
Adjusted increase 1,049,905 (p)
Most's ownership % 80% 839,924
Consolidated retained earnings, Dec. 31, Year 9 11,179,924
Proof of non-controlling interest, end of Year 9 (Method 1)

Retained earnings of Least 2,300,000
Common shares of Least 500,000
Adjusted shareholders' equity 2,671,430
Add: unamortized acquisition differential 378,475
3,049,905
20%
Non-controlling interest, Dec. 31, Year 9 609,981
Calculation of consolidated non-controlling interests – end of Year 9 (Method 2)

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

Consolidated Balance Sheet
December 31, Year 9
Cash (500,000 + 40,000) 540,000

Accounts receivable (1,700,000 + 500,000 – (m) 80,000) 2,120,000
Inventories (2,300,000 + 1,200,000 – (l) 314,284) 3,185,716
Plant and equipment (net) (8,200,000 + 4,000,000 + (a) 4,375) 12,204,375
Land (700,000 + 260,000) 960,000

Goodwill (b) 374,100
Deferred income taxes (n) 125,714
Total assets 19,509,905
Current liabilities (600,000 + 200,000 – (m) 80,000) 720,000

Long-term liabilities (3,000,000 + 3,000,000) 6,000,000
Common shares 1,000,000
Retained earnings 11,179,924
Non-controlling interest 609,981
Total liabilities & shareholders' equity 19,509,905
(c) The cost principle requires that certain assets such as inventory be reported at cost. When
a profit is made on an intercompany sale, the inventory cost to the purchaser is higher than
the cost incurred by the seller. An adjustment is made on consolidation to remove the profit
from the inventory of the purchaser to bring the value of the inventory down to the original
cost to the consolidated entity.
(d) The debt to equity ratio would increase because debt remains the same but the non-
controlling interest within shareholders’ equity decreases. Non-controlling interests
decreases because it does not contain the incorporate the non-controlling interests’ share
of the value of the subsidiary’s goodwill.
Problem 6-8
Opening inventory – L selling 5,000 2,000 3,000 (a)
Ending inventory – K selling 8,000 3,200 4,800 (b)
(a)
December 31
Cash 20,200
Investment in L Co. ($5,000 x 95%) 4,750
Investment in J Co. ($3,000 x 90%) 2,700
Investment in K Co. ($15,000 x 85%) 12,750

To record dividends received from subsidiary companies.
Investment in L Co. (20,000 x 95%) 19,000

Investment in K Co. (30,000 x 85%) 25,500
Investment in J Co. (5,000 x 90%) 4,500
To record share of subsidiaries' profit
Investment Income 1,230

Investment in L Co. (3,000 x .95) 2,850
Investment in K Co. (4,800 x .85) 4,080
To hold back after-tax inventory profit in ending inventory (K Co.) and add back after-tax inventory
profit in beginning inventory (L. Co.)
Investment Income is $40,000 − $1,230 = $38,770.
(b) Calculation of consolidated profit attributable to shareholders of H Co. – Year 5
Profit of L 20,000
Add: profit in opening inventory (a) 3,000
H Co.'s ownership % 95% 21,850
Profit of J (5,000)
H Co.'s ownership % 90% (4,500)
Profit of K 30,000
Less: profit in ending inventory (b) 4,800
H Co.'s ownership % 85% 21,420
Consolidated profit attributable to shareholders of H Co. – Year 5 38,770
(c) H Company
Consolidated Retained Earnings Statement

Retained earnings, January 1 12,000

Add: profit 38,770
50,770
Less: dividends 10,000
Retained earnings, December 31 40,770
Problem 6-9
Intercompany profits Before 40% After

tax tax tax
Opening inventory* – Purple selling 95,538 38,215 57,323
Ending inventory – Purple selling 194,000 77,600 116,400
Land – Purple selling

(260,000 – 203,500) 56,500 22,600 33,900
* Inventory at selling price (690,000 x 60%) 414,000

Inventory at cost (414,000 / 1.30) 318,462
Profit 95,538
Calculation of consolidated net income attributable to Purple’s shareholders – current year
Net income of Purple 568,100

Add: opening inventory profit 57,323
625,423
Less: Ending inventory profit 116,400
Land profit 33,900 150,300
Net income of Sand 248,670
Purple’s ownership 70% 174,069

Consolidated net income attributable to Purple’s shareholders – current year 649,192
Note:
The intercompany rentals and interest revenue/expense cancel each other out when Sand's net
income is added to Purple's.

Problem 6-10
Sales and purchases (90,000 + 177,000) 267,000 (a)
Rental revenue and expense (2,800 x 12) 33,600 (b)
Interest revenue and expense (360,000 x 0.05) 18,000 (c)
Opening inventory – Evans selling
(21,250 – [21,250 / 1.25]) 4,250 1,700 2,550 (d)
– Falcon selling
(11,000 x 0.3) 3,300 1,320 1,980 (e)
7,550 3,020 4,530 (f)
Ending inventory – Evans selling
(28,750 – [28,750 / 1.25]) 5,750 2,300 3,450 (g)
– Falcon selling
(3,000 x 0.3) 900 360 540 (h)
6,650 2,660 3,990 (i)
Calculation of consolidated profit – current year
Profit of Evans 61,900

Less: Intercompany dividends (40,000 x 80%) 32,000
Profit in ending inventory (g) 3,450 35,450
26,450
Add: profit in opening inventory (d) 2,550
Profit of Falcon 75,500
Less: profit in ending inventory (h) 540
74,960
Add: profit in opening inventory (e) 1,980
76,940
Consolidated profit 105,940

Attributable to:
Shareholders of Evans 90,552
105,940
(a) Evans Company

for the Current Year
Sales (450,000 + 600,000 – (a)267,000) 783,000

Raw materials & finished goods purchased
(268,000 + 328,000 – (a)267,000) 329,000
Changes in inventory
(20,000 + 25,000 – (f)7,550 + (i)6,650) 44,100
Other expenses (104,000 + 146,000 – (b)33,600) 216,400
Interest expense (30,000 – (c)18,000) 12,000
Income taxes (31,700 + 43,500 + (f)3,020 – (I)2,660) 75,560
Profit 105,940
Attributable to:
Shareholders of Evans 90,552
105,940
(b)
Calculation of consolidated retained earnings – beginning of year
Retained earnings of Evans, beginning of year 632,000

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

Consolidated retained earnings, beginning of year 906,266
Consolidated dividends declared 30,000
Problem 6-11
Calculation, allocation, and amortization of the acquisition differential
Cost of 90% investment, Jan. 2, Year 1 90,000

Implied value of 100% investment 100,000
Carrying amounts of S's net assets:
Common shares 60,000
Retained earnings 20,000
Total shareholders' equity 80,000
Acquisition differential – patents 20,000
Amortization:
Years 1 – 4 (a) 16,000
Year 5 (b) 4,000 20,000
Balance, Dec. 31, Year 5 –0–

Opening inventory – S selling
(7,000 x 0.40) 2,800 1,120 1,680 (c)
– P selling
(3,000 x 0.40) 1,200 480 720 (d)
4,000 1,600 2,400 (e)
Ending inventory – S selling
(20,000 x 0.40) 8,000 3,200 4,800 (f)
– P selling
(5,000 x 0.40) 2,000 800 1,200 (g)
10,000 4,000 6,000 (h)
Sale of land – Year 3 S selling (50,000 – 40,000) 10,000 4,000 6,000 (i)

Calculation of consolidated net income – Year 5
Net income of P Company 60,000

Less: Dividends from S (10,000 x 90%) 9,000
Profit in ending inventory (g) 1,200 10,200
49,800
Add: profit in opening inventory (d) 720
Net income of S Company 48,000
Less: profit in ending inventory (f) 4,800
patent amortization (b) 4,000
39,200
Add: profit in opening inventory (c) 1,680
40,880
Attributable to:
Shareholders of P Co. 87,312
91,400
Calculation of consolidated retained earnings – Jan. 1, Year 5
Retained earnings of P, Jan. 1, Year 5

(101,000 + 12,000) 113,000
Less: profit in opening inventory (d) 720
Retained earnings of S (34,000 + 10,000) 44,000
Retained earnings of S at acquisition 20,000
Increase since acquisition 24,000
Less: Amortization of patents (a) 16,000
Land gain (i) 6,000
Profit in opening inventory (c) 1,680 23,680
Adjusted increase 320 (j)
P's ownership % 90% 288
Consolidated retained earnings, Jan. 1, Year 5 112,568
Calculation of consolidated non-controlling interests, beginning of Year 5 (Method 1)
Company S shareholders' equity
104,000
Less: Land gain (i) 6,000
Profit in beginning inventory (c) 1,680 7,680
Adjusted shareholders' equity 96,320
Unamortized acquisition differential 4,000
100,320
10%
Non-controlling interest, Jan 1, Year 5 10,032

Non-controlling interests at date of acquisition (10% x [90,000 / .9) 10,000
S Co.’s adjusted increase in retained earnings (j) 320
NCI’s share @ 10% 32
P Co.
Consolidated Statement of Changes in Equity
For Year Ended December 31, Year 5
Common Retained
Shares Earnings Total NCI Total
Balance, beginning of year 150,000 112,568 262,568 10,032 272,600
Add: net income 87,312 87,312 4,088 91,400
Less: dividends (12,000) (12,000) (1,000) (13,000)
Retained earnings, Dec. 31 150,000 187,880 387,880 13,120 351,000
Proof:
Retained earnings of P, Dec. 31, Year 5
(101,000 + 60,000) 161,000
Less: Profit in ending inventory (g) 1,200
Retained earnings of S, Dec. 31, Year 5
(34,000 + 48,000) 82,000
Retained earnings of S at acquisition 20,000
Increase since acquisition 62,000
Less: Amortization of the patents
((a)16,000 + (b)4,000) 20,000
Land gain (i) 6,000
Profit in ending inventory (f) 4,800 30,800
Adjusted increase 31,200 (k)
P's ownership % 90% 28,080
Consolidated retained earnings, Dec., 31, Year 5 187,880
Calculation of consolidated non-controlling interests – Dec. 31 Year 5 (Method 1)

Company S shareholders' equity
142,000
Less: Land gain (i) 6,000
Profit in ending inventory (f) 4,800 10,800
Unamortized acquisition differential 0
131,200
10%
Non-controlling interests, Dec. 31, Year 5 13,120
Calculation of consolidated non-controlling interests – Dec. 31 Year 5 (Method 2)

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

64 Modern Advanced Accounting in Canada, Fifth Edition
Problem 6-12
Acquisition differential amortization – Year 5
Plant and equipment depreciation (60,000 / 5) 12,000 (a)

Patent amortization (40,000 / 8) 5,000 (b)
Goodwill impairment loss 3,000 (c)
20,000 (d)
Sales – Runner to Road 420,000 (e)

Rental – Runner to Road 35,000 (f)
Opening inventory – Runner selling 75,000 30,000 45,000 (g)
Ending inventory – Runner selling 40,000 16,000 24,000 (h)
(a) Road Ltd.

Sales (4,000,000 + 2,100,000 - (e)420,000) 5,680,000

Rental revenue (70,000 - (f)35,000) 35,000
Total income 5,715,000
Materials used in manufacturing
(2,000,000 + 800,000 - (e)420,000) 2,380,000
Change in work-in-progress & finished goods inventory
(45,000 - 20,000 - (g)75,000 + (h)40,000) (10,000)
Employee benefits (550,000 + 480,000) 1,030,000
Interest expense (250,000 + 140,000) 390,000
Depreciation (405,000 + 245,000 + (a)12,000) 662,000
Patent amortization (25,000 + (b)5,000) 30,000
Goodwill impairment loss (c) 3,000
Income tax (300,000 + 200,000 + (g)30,000 - (h)16,000) 514,000
Total expenses 4,999,000
Profit 716,000
Attributable to:
Shareholders of Road 625,700
Non-controlling interests
(30% x [300,000 – (d)20,000 + (g)45,000 - (h)24,000]) 90,300
716,000
(b)
Since Road uses the equity method of accounting for its investment in Runner, consolidated
retained earnings at December 31, Year 5 would be $2,525,700, which is equal to Road’s retained
earnings on its separate entity financial statements.
(c)
The return on equity attributable to shareholders of Road for Year 5 would not change. Only the
NCI’s share of consolidated profit would change under the parent company extension theory.
The NCI’s share of consolidated profit would increase because the NCI’s share of Runner’s
goodwill and goodwill impairment is not reported under this theory.
Problem 6-13
Calculation, allocation, and amortization of acquisition differential
Cost of 70% investment, January 1, Year 1 63,000

Carrying amounts of Sage's net assets:
Ordinary shares 50,000
Inventory -12,000
Unfavourable lease agreement -18,000 -30,000
Balance – goodwill 55,000

January 1 December 31
Year 1 Years 1 & 2 Year 3 Year 3
Inventory - 12,000 - 12,000

Lease agreement -18,000 -7,200 -3,600 -7,200 (a)
Goodwill 55,000 3,060 1,530 50,410 (b)
25,000 - 16,140 (c) -2,070 (d) 43,210
Intercompany receivables and payables – notes 55,000 (e)
Management fee 26,500 (f)

Sales and purchases
Post selling 125,000
Sage selling 90,000 215,000 (g)
Interest (12% x 1/2 x 55,000) 3,300 (h)
Land – Sage selling 30,000 12,000 18,000 (i)
Opening inventory – Sage selling
(14,000 x 0.25) 3,500 1,400 2,100 (j)
Ending inventory – Sage selling
(28,000 x 0.25) 7,000 2,800 4,200 (k)
– Post selling
(18,000 x 0.25) 4,500 1,800 2,700 (l)
11,500 4,600 6,900 (m)
Deferred income taxes – December 31, Year 3

Inventory 4,600
Land 12,000
16,600 (n)
Accumulated depreciation at date of acquisition for Sage 10,000 (o)
Calculation of consolidated profit
Profit of Post 107,979
Less: Investment income from Sage1,479
Profit in ending inventory (l) 2,700 4,179
Profit of Sage 24,000
Add: profit in opening inventory (j) 2,100
26,100
Add: Amortization of acquisition differential (d) 2,070
Less: Profit in ending inventory (k) 4,200
Land gain (i) 18,000 -22,200
Profit 109,770
Attributable to:
Shareholders of Post 107,979
109,770
(a) (i) Post Corporation

Consolidated Statement of Profit
For the Year Ended, December 31, Year 3
Sales (900,000 + 240,000 – (g)215,000) 925,000
Interest revenue (6,800 – (h)3,300) 3,500
Cost of goods sold
(540,000 + 162,000 – (g)215,000 - (j)3,500 + (m)11,500) 495,000
Interest expense (20,000 – (h)3,300) 16,700
Other expense
(180,000 + 74,800 – (f)26,500 - (a)3,600) 224,700
Goodwill impairment loss (b) 1,530
Income tax expense
(80,000 + 16,000 +(j) 1,400 – (m) 4,600 – (i) 12,000) 80,800
Profit 109,770
Attributable to:
Shareholders of Post 107,979
109,770
Calculation of non-controlling interests – December 31, Year 3

Less: Profit in ending inventory (k) 4,200
Land gain (i) 18,000 - 22,200
Add: unamortized acquisition differential 43,210
Non-controlling interest’s share 30%
Non-controlling interest, December 31, Year 3 45,603
(a) (ii) Post Corporation

Consolidated Statement of Financial Position
December 31, Year 3
Land (175,000 + 19,000 – (i)30,000) 164,000
Plant and equipment (520,000 + 65,000 – (o) 10,000) 575,000

Accumulated depreciation ([229,400] + [17,000] – (o) 10,000)
(236,400)
Goodwill (b) 50,410
Deferred income taxes (n) 16,600
Inventory (34,000 + 27,000 – (m)11,500) 49,500
Accounts receivable (17,200 + 9,100) 26,300
Cash (12,200 + 12,900) 25,100
Total assets 670,510

Non-controlling interests 45,603
411,310
Unfavourable lease agreement 7,200
Accounts payable (212,000 + 40,000) 252,000
Total shareholders’ equity & liabilities 670,510
(b)
Goodwill impairment loss – entity theory 1,530
Less: NCI’s share @30% 459
Goodwill impairment loss – parent company extension theory 1,071
NCI – entity theory 1,791

NCI’s share of goodwill impairment loss 459
NCI – parent company extension theory 1,332
(c)
Goodwill – entity theory 50,410
Less: NCI’s share @30% 15,123
Goodwill – parent company extension theory 35,287
NCI – entity theory 45,603

NCI’s share of goodwill impairment loss 15,123

NCI – parent company extension theory 30,480

Problem 6-14
(a) Acquisition cost Allocation Acquisition January 1, Year 1
Cost
(60,000 x $80)
4,800,000
Implied value of 100% investment (80,000 shares x $80)
6,400,000
CA: Ordinary Shares 3,500,000
Retained Earnings 2,100,000
5,600,000
Acquisition differential
800,000
Allocati
on:
Life

Inventory
100,00
0 Cr
1
Land
200,00
0 Dr
Equipment
200,00
0 Cr
10

Patents
400,00
0 Dr
5
L.T. Liability
100,00
0 Cr
4
Subtotal
200,000 Dr
Balance: Goodwill
600,000 Dr
800,000 Dr
Non-controlling interest (20,000 shares @ $80) 1,600,000
Amortization Table:
Allocation Life
Amortization
Balance
YR 1 – YR 4 YR 5 Dec. 3, YR 5

Inventory 100,000 Cr 1
100,000Cr 0
0
Land 200,000 Dr
200,000 Dr
Equipment 200,000 Cr 10
80,000Cr
20,000 Cr
100,000 Cr
Patents 400,000 Dr 5
320,000Dr
80,000Dr
0
L.T. Liability 100,000 Cr 4
100,000Cr
0
Goodwill 600,000 Dr
600,000 Dr
800,000 Dr 40,000 Dr
60,000 Dr
700,000 Dr
Devine’s accumulated depreciation at date of acquisition 500,000
Intercompany Amounts:
Dividends: 500,000 x 75%

375,000
Sales: Vine (YR 5) 2 M + Devine (YR

5) 1.2M
3,200,000
Advances from Vine to Devine:

200,000
BT Tax AT
Land: Upstream Gain Sept 1, YR 5 400,000
160,000
240,000
Unrealized Profits:
BT
Tax
AT
Opening
Upstream 100 K
@ 40%
40,000 16,000
24,000
Downs
tream 300 K
@ 33 1/3%
100,000
40,000
60,000
Ending Upstream
500 K
@ 40%
200,000
80,000
120,00
0
Downstream 600 K @ 33
1/3%
200,000
80,000
120,00
0
(b) Consolidated Income Statement for the year ending December 31, Year 5
Sales (11.6 M + 3 M – 3.2 M)

11,400,000
Dividend, Investment Income, and Gains
(400 K + 1,000 K – 375K – 400K)
625,000
12,025,000
Cost of Goods Sold

(8M + 1.5 M – 3.2 M - 40K – 100K + 200K + 200K) 6,560,000
Other Expenses (500K + 300K – 20K (Equip) + 80 K (Patent) 860,000
Taxes (500K + 200K – 160K + 16K + 40K –80K – 80K) 436,000
Total expenses 7,856,000
Profit 4,169,000
Attributable to:
Shareholders of Vine 3,768,000
Non-controlling interests (2M – 240K –120K + 24K – 60K) x .25 401,000
4,169,000
Reconciliation:
Vine Profit:
3,000,000
Dividends from Devine Included

(375,000)
Equity in Earnings of Devine

1,143,000
Consolidated Profit Attributable to Vine’s Shareholders 3,768,000
(c) Consolidated Retained Earnings: Proof
Parent retained earnings at December 31, Year 5

12,000,000
Sub retained earnings at December 31, Year 5 7,000,000
Retained earnings at acquisition 2,100,000
Increase since acquisition 4,900,000
Less: unrealized profits, ending inventory (120,000)
Land (240,000)
Less: cumulative amortization of acquisition differential (100,000)
Realized retained earnings since acquisition 4,440,000
(a)
Parent %
75%
3,330,000
Less: unrealized profits, ending inventory (120,000)
Consolidated retained earnings
15,210,000
(d)
Consolidated Statement of Financial Position
December 31, Year 5
Assets
Land (6M + 2.5 M + 200K – 400K) 8,300,000
Plant and Equipment (18.8M + 11.8M – 200K – 500K) 29,900,000
Accumulated depreciation (5.8M + 5.0M – 100K – 500K) (10,200,000)
Goodwill
600,000
Deferred Income Tax (160K + 80K + 80K)

320,000
Inventories (4.6 M + 2.4 M – 200K – 200K

6,600,000
Cash and Current Receivables (900K + 300K)

1,200,000
36,720,000

Equities and Liabilities
Ordinary shares
10,000,000
Retained Earnings (See part c)

15,210,000
Non-controlling interests (See Below) 2,710,000
Long Term Liabilities (6.6 M + 1.1 M)

7,700,000
Deferred Income Taxes (200K+100K) 300,000
Current Liabilities (700K + 300K – 200K advances) 800,000
36,720,000
Non-controlling Interests: (Method 1)
Devine – Carrying amount December 31, Year 5 10,500,000

Unrealized Profits – Upstream:
Land (240,000)
Inventory (120,000)
Unamortized acquisition differential 700,000
10,840,000
25%
Non-controlling interest 2,710,000
Calculation of non-controlling interests – December 31, Year 5 (Method 2)

Non-controlling interests at date of acquisition (25% x [4,800,000 / .75) 1,600,000
Devine’s adjusted increase in retained earnings (a) 4,440,000
NCI’s share @ 25% 1,110,000
Non-controlling interest, December 31, Year 5 2,710,000
(e)
Non-controlling interest – at date of acquisition
- under implied value approach (25% x 6,400,000) 1,600,000
- using market value of Devine’s shares (20,000 shares x $75) 1,500,000

Decrease in non-controlling interest 100,000
Non-controlling interest, December 31, Year 3
- as previously calculated 2,710,000
- as per new calculation 2,610,000
Goodwill at December 31, Year 3

- as previously calculated 600,000
- decrease due to change in non-controlling interest 100,000
- as per new calculation 500,000
Problem 6-15
(a)
Cost of 70% investment, January 1, Year 2 $ 84,000

Carrying amount of Sand’s net assets:
Total shareholders’ equity 80,000
Inventory - 9,000
Equipment 24,000 15,000
Goodwill as at January 1, Year 2 $ 25,000
Balance Amortization/Impairment Balance

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

for the year ended December 31, Year 5
Sales ($798,000 + $300,000 – $100,0002) $ 998,000

Investment and interest income ($1,500 + $3,600 – $1500 – $2,400 )4 3
1,200
80 Modern Advanced Accounting in Canada, Seventh Edition
Cost of goods sold ($480,000 + $200,000 – $100,0002 + $10,5006) 590,500

Interest expense ($10,000 – $2,400 ) 3
7,600
Research & development expenses ($40,000 + $12,000 + (a) $4,000) 56,000
Miscellaneous expense ($106,000 + $31,600 + (b) 21,500 – $24,0001) 135,100
Income taxes ($80,000 + $32,000 – $4,2006 – $8,0005) 99,800
Net income 110,200
Attributable to:
Shareholders of Paper 107,050
Non-controlling interest ($48,000 – $12,000 – $25,500) (30%) 3,150
110,200
Notes:
1
Management fee ($2,000 × 12) $ 24,000
2
Downstream sales 100,000
3
Interest ($40,000 × 8% × 9/12) 2,400
4
Investment income from Sand 1500
5
Land — upstream $ 20,000 $ 8,000 $ 12,000
6
Ending inventory — downstream($30,000 × 35%) $ 10,500 $ 4,200 $ 6,300
(c)
i) Inventory ($66,000 + $44,000 – $10,5006) $ 99,500
ii) Land ($150,000 + $30,000 – $20,0005) $ 160,000
iii) Notes payable: The notes payable would not be shown on the consolidated balance sheet.
iv) Non-controlling interest ($50,000+$120,000–$12,000+(c)$11,500) (30%) $ 50,850
v) Common shares $ 150,000
(d)
Non-controlling interest – at date of acquisition
- under implied value approach (30% x 120,000) 36,000
- using independent appraisal 30,000
Decrease in non-controlling interest and goodwill 6,000
Goodwill impairment loss for the year ended December 31, Year 5
- decrease due to change in goodwill at acquisition 6,000
Allocation of goodwill and goodwill impairment

Paper’s NCI’s
share share Total
Total value of subsidiary at date of acquisition 84,000 30,000 114,000
Fair value of identifiable net assets 66,500 28,500 95,000
Goodwill at date of acquisition 17,500 1,500 19,000
Goodwill impairment in Year 5 14,276 1,224 15,500
Goodwill at December 31, Year 5 3,224 276 3,500
Profit attributable to non-controlling interest for the year ended December 31, Year 3
- increase due to reduced goodwill impairment loss
(30% x 21,500 – 1,224) 5,226
SOLUTIONS TO WEB-BASED PROBLEMS

Web Problem 6-1
The following answers are based on the 2011 consolidated financial statements for RONA Inc.:
(a) RONA uses the weighted average cost method to cost its inventory. This is
disclosed in the inventory valuation accounting policy as described in note 3(d) to the
consolidated financial statements.
(b) At the end of 2011, inventory represented 30.2% (840,287 / 2,780,378) of RONA’s
total assets. This was a slight decrease from 31.0% (905,467 / 2,921,620) in 2010.
This was determined using the consolidated statements of financial position.
(c) RONA does eliminate intercompany transactions and unrealized profits when
preparing its consolidated financial statements as per note 3(a)(iii) to the
(d) The numerator, cost of goods sold, will increase by the sales amount of the
intercompany sale and decrease by the unrealized profit in ending inventory. The
denominator, average inventory, will decrease by one-half of the unrealized profit in
ending inventory because of the use of average inventory rather than year-end
inventory. By using one-half of the unrealized profit in the denominator and the full

unrealized profit in the numerator, the inventory turnover after the eliminating entries
will be lower than the original inventory turnover. Earnings per share will decrease
due to the elimination of the unrealized profit in ending inventory.
(e) Land is valued at cost as per the accounting policy for property, plant and equipment
described in note 3(g) to the consolidated financial statements.
(f) The debt- to- equity ratio would decrease because debt would not change but equity
would increase. The return on average equity would also decrease because net
income would stay the same and equity would increase.
Web Problem 6-2

The following answers are based on the September 30, 2011 consolidated financial statements
for Cenovus Energy Inc. which are available on the company’s website under the “Invest in us”
section.
(a) Cenovus uses the first-in, first-out or weighted average cost methods to cost its
product inventory as per the accounting policy for inventories in note 3(l) to the
(b) At the end of 2011, inventories represented 5.8% (1,291 / 622,194) of Cenovus’ total
assets, which is higher than the 2010 portion, which was 4.4% (880 / 19,840).
(c) As per the principles of consolidation accounting policy as described in note 3(a) to
the consolidated financial statements, Cenovus does eliminate intercompany
transactions and unrealized profits when preparing its consolidated financial
statements.
(d) The numerator, cost of goods sold, will increase by the sales amount of the
intercompany sale and decrease by the unrealized profit in ending inventory. The
denominator, average inventory, will decrease by one-half of the unrealized profit in
ending inventory because of the use of average inventory rather than year-end
inventory. By using one-half of the unrealized profit in the denominator and the full
unrealized profit in the numerator, the inventory turnover after the eliminating entries
will be lower than the original inventory turnover. Earnings per share will decrease
due to the elimination of the unrealized profit in ending inventory.
(e) Land is valued at per the accounting policy for property, plant and equipment
described in note 3(o) to the consolidated financial statements.
(f) The debt- to- equity ratio would decrease because debt would not change but equity
would increase. The return on average equity would also decrease because net
income would stay the same and equity would increase.


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Intercompany Inventory and Land

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Problem 6-2 (20 min.)

Problem 6-3 (20 min.)

Problem 6-4 (40 min.)

Problem 6-5 (40 min.)

Problem 6-6 (30 min.)

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Problem 6-8 (30 min.)

Problem 6-9 (25 min.)

Problem 6-10 (40 min.)

Problem 6-11 (40 min.)

Problem 6-12 (25 min.)

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Problem 6-15 (50 min.)

Web Problem 6-2

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

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

9. Ideally, intercompany losses should be eliminated in the same manner as intercompany

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15. The journal entry would be as follows:

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Parent Subsidiary Consolidated

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Accounting for the investment

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Fair value method

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Carrying amount per draft financial statements $25,000

Subject: Accounting issues regarding Metal Caissons Limited (MCL)

Overview of the engagement

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Late delivery penalties

Clarification is needed on the procedures to be followed if a caisson proves unacceptable. To

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Expenditure Accounting Treatment

(Most candidates addressed capitalized expenditures in adequate depth.)

The following issues must also be considered:

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

Balance Amortization Balance

Land 800,000 800,000

Calculation of consolidated profit – Year 2

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

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Allowance for returns

Use of accelerated depreciation

Unrealized profits from intercompany sales

Bonus to president and chairman

Change to tax allocation

REPORT TO PARTNER ON PLEX-FAME CORPORATION

“Rue St. Jacques”

Interest on ticket proceeds

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Advertising and promotion

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

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