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Chapter 7
CASES
Case 7-1
In this case, students are asked to compare the accounting for an intercompany transaction
depending on whether the investee company was a controlled entity, a significantly influenced
entity, or a related party.
Case 7-2
In this case, students are asked to discuss how a loss on intercompany bondholdings should be
allocated to the parent and/or to the subsidiary.
Case 7-3
In this real life case, students are asked to determine the economic benefits of transferring a
machine from the subsidiary to the parent in order to increase the tax savings from depreciation
expense. The case also requires a discussion of various alternatives for reporting the tax savings
on the consolidated income statement.
Case 7-4
In this case taken from a CA exam, students are asked to prepare a memo for the partner to
address the accounting implications and disclosure requirements for transactions involving
convertible debentures and spin off of a division from a subsidiary to the parent and then to a newly
created subsidiary.
Case 7-5
In this case taken from a CA exam, students are asked to prepare a statement of loss to support an
insurance claim and to prepare an analysis of accounting issues involving nonmonetary
transactions, asset impairments and lease termination payments.
Case 7-6
In this case taken from a CA exam, students are asked to prepare a memo for the partner to
address the accounting issues for a new client in the waste management business. The accounting
issues include intercompany transactions in capital assets, revenue recognition, contingencies and
capitalization of expenditures.
WEB-BASED PROBLEMS
Web Problem 7-1
The student answers a series of questions based on the 2011 financial statements of Barrick Gold
Corporation, a Canadian company. The questions deal with accounting policies for tangible and
intangible long-term assets and the impact of changes in accounting policies on certain financial
ratios.
3. Yes. The realization of the intercompany profit through the adjustment to consolidated
depreciation is considered to be in effect an indirect sale of a portion of the equipment to
customers outside the consolidated entity. Further, if a depreciable asset is sold to a third
party, the remaining intercompany profit is then realized.
4. No. The only time an adjustment of this kind affects the non-controlling interest calculation
is when the subsidiary was the selling company in the transaction that created the original
intercompany gain.
5. As long as the purchaser continues to depreciate the depreciable asset an adjustment will
be required on consolidation to change depreciation expense to what it would have been
had the intercompany sale not taken place.
6. As the purchaser uses the depreciable asset and earns a profit by selling its own goods
and services to outsiders, a portion of the previously unrecognized gain is considered to be
realized from a consolidation viewpoint. As each year passes, the amount of unrealized
gain is reduced and, in turn, the adjustment of beginning retained earnings is reduced.
7. Rather than simply eliminating the unrealized gain from the purchaser’s cost of the asset,
both the cost of the asset and accumulated depreciation are adjusted to the amounts that
would have been reported by the seller had the intercompany transaction not occurred.
This usually means that the cost and accumulated amortization are both increased i.e.
grossed up to get to the target amount.
*8. The consolidated financial statements should report account balances as if the
intercompany transaction has not occurred. The transfer from cumulative other
comprehensive income to retained earnings should be reversed on consolidation. In turn,
the equipment should be remeasured to fair value with the adjustment to fair value being
added to/subtracted from cumulative other comprehensive income.
Copyright © 2013 McGraw-Hill Ryerson Limited. All rights reserved.
Solutions Manual, Chapter 7 7
*9. This statement is true. There should never be a gain on the consolidated income statement
from an intercompany sale of equipment regardless of whether the companies are using
the historical cost model or the fair value model to value the equipment because there has
not been a transaction with outsiders. However, there could be a gain or loss on the
separate entity income statement for the selling entity because the transaction may occur
at a point in time when the financial statements have not been updated to the most recent
fair value for the equipment. For example, the equipment may have been updated to fair
value at the end of the previous period but the sale took place late in the current year when
the fair value was higher than previously reported.
Approach (d) is conceptually superior because each affiliate will actually record the gain
(loss) so allocated when it amortizes the premiums or discounts that caused the
consolidated gains (losses) in the first place. As a result, the eliminations in consolidated
statements mirror the entries made by both the purchaser and the issuer.
12. The holdback of an intercompany asset gain results in the creation of a deferred tax asset
in the preparation of the consolidated balance sheet because, although the selling affiliate
has recorded the tax in its income statement, it will not be an expense of the entity until the
asset is sold to outsiders. The adjustment in the preparation of a consolidated income
Copyright © 2013 McGraw-Hill Ryerson Limited. All rights reserved.
8 Modern Advanced Accounting in Canada, Seventh Edition
statement creating a gain on bond retirement results in a deferred tax liability in the
consolidated balance sheet because none of the constituent affiliates has paid (or recorded)
the tax on the gain, but will do so in future periods when they amortize the premiums or
discounts that caused the gain.
13. Gains (losses) on the intercompany sales of assets are realized for consolidated purposes
when the assets have been used up or sold outside the entity. This event occurs in periods
that are subsequent to the period in which the selling affiliate recorded the gain.
Gains (losses) resulting from the elimination of intercompany bondholdings are realized for
consolidation purposes in the period in which the intercompany acquisition takes place.
The affiliates' share of the gain (loss) is recorded in subsequent periods when the
discounts or premiums that caused the gain (loss) are amortized by each affiliate.
14. Gains should be recognized when they are realized i.e., when there has been a transaction
with outsiders and consideration has been given/received. When the parent acquires the
subsidiary’s bonds for cash in the open market, it is transacting with an outsider and giving
cash as consideration. From the separate entity perspective, the parent is investing in
bonds. However, from a consolidated point of view, the parent is retiring the bonds of the
subsidiary when it purchases the bonds from the outside entity. Therefore, when the
investment in bonds is offset against the bonds payable on consolidation, any difference in
the carrying amounts is recorded as a gain or loss on the deemed retirement of the bonds.
15. The matching principle requires that expenses be matched to revenues. When
intercompany bondholdings are eliminated, a gain or loss on the deemed retirement of the
bonds is recognized on the consolidated financial statements. In turn, the income tax on
the gain or loss must be recognized to match to the gain or loss. Since the income tax is
not currently payable or receivable but deferred until the temporary differences reverse, it
is set up as deferred income tax.
SOLUTIONS TO CASES
Case 7-1
1. If Enron controlled LIM2, Enron did overstate its earnings by reporting a profit of $67 million
Copyright © 2013 McGraw-Hill Ryerson Limited. All rights reserved.
Solutions Manual, Chapter 7 9
on a transaction with LIM2. When consolidated financial statements are prepared, the
intercompany transaction between Enron and LIM2 would be eliminated and the fibre optic
cable would be remeasured to the carrying value of this asset prior to the sale. The profit on
the fibre optic cable would only be recognized on the consolidated income statement when
LIM2 sells this cable to outsiders or through reduced depreciation expense over the useful
life of this asset.
2. If Enron only had significant influence over LIM2, it would use the equity method to report its
investment. Since Enron does not control LIM2, it would not be able to dictate the selling
price of the cable. Since Enron only has significant influence, the interests’ of the other
shareholders would have to be considered in setting the price. It would be similar to Enron
selling to outsiders. IAS 28 states that profit pertaining to the other shareholders’ interest
would be considered realized and need not be eliminated; only the investor’s percentage
interest in the investee times the profit must be eliminated. The unrealized profit would be
eliminated from investment income.
3. IAS 24 does not deal with the measurement of related party transactions. It only deals with
the disclosure requirements for related party transactions.
If the transaction were to be reported at carrying amount, Enron would not report the gain. If
the transaction were to be reported at exchange amount under IAS 24, Enron would be able
to report the gain.
In most of the situations considered in this question, Enron should not have reported the gain.
Gains from intercompany transactions are typically eliminated and not reported on the seller’s
financial statement. Gains are typically not reported until they are realized in a transaction with
a non-related party. This requirement applies to consolidated financial statements and
investments reported under the equity method but does not necessarily apply under related
party transactions.
Case 7-2
(a)
This case is designed to give life to a theoretical accounting issue discussed within the chapter: If a
subsidiary's debt is retired, should the resulting gain or loss be assigned to the parent or to the
Students should note that the decision as to assignment only becomes necessary because of the
presence of the non-controlling interest. Regardless of the level of ownership all intercompany
balances are eliminated on consolidation. Not until the time that the non-controlling interest
computations are made does the identity of the specific party become important.
All financial and operating decisions are assumed to be made in the best interest of the business
entity as a whole. This debt would not have been retired unless corporate officials believed that
Penston/Swansan would benefit from the decision. Thus, a strong argument can be made against any
assignment to either separate party.
(b)
Students should be required to pick one method and justify its use. Discussion usually centers on the
following issues:
• Parent company officials made the actual choice that created the loss. Therefore, assigning the
$300,000 to the subsidiary directs the impact of their reasoned decision to the wrong party. In
effect, the subsidiary had nothing to do with this transaction (as indicated in the case) so that its
financial records should not be affected by the $300,000 loss.
• The debt was that of the subsidiary. Because the subsidiary's debt is being retired, all of the
$300,000 should be attributed to that party. Financial records measure the results of
transactions and the retirement simply culminates an earlier transaction made by the subsidiary.
The parent is doing no more than acting as an agent for the subsidiary (as indicated in the
case). If the subsidiary had acquired its own debt, for example, no question as to the
assignment would have existed. Thus, changing that assignment simply because the parent
chose to be the acquirer is not justified.
• Both parties were involved in the transaction so that some allocation of the loss is required. If, at
the time of repurchase, a discount existed within the subsidiary's accounts, this figure would
have been amortized to interest expense (if the debt had not been retired). Thus, the $300,000
loss was accepted now in place of the later amortization. This reasoning then assigns this
portion of the loss to the subsidiary. Because the parent was forced to pay more than face
value, that remaining portion is assigned to the buyer.
The consolidated entity paid taxes of $13,200 at the end of year 2 and gained a tax saving of
$10,000 - $4,200 = $5,800 per year in years 3 through 6. In nominal terms, it gained $5,800 x 4
- $13,200 = $10,000. In present value terms, it realized a return of nearly 30%. Therefore, the
intercompany sale was a good financial decision.
(b) 40% of Slum’s after-tax gain on the sale of the machine would now be credited to the non-
controlling interest i.e., ($44,000 - $13,200) x 40% = $12,320. Since this amount is
greater than the overall tax saving of $10,000, Plum would realize an overall loss of
$2,320 on the intercompany transaction. From Plum’s perspective, it is not a good
financial decision.
(c) As a result of the intercompany transaction, amortization expense has increased from
$14,000 to $25,000 per year. The extra $11,000 must be eliminated on consolidation so
that only $14,000 of amortization expense is reported on the consolidated income
statement. Income tax on the $11,000 must also be eliminated. Three alternatives are
presented below for the elimination of tax on the excess amortization for each of Years 3
to 6:
The controller’s suggestion of 30% can be supported on the basis that the total tax eliminated
over 4 years will be $13,200 which is equal to the tax paid by Slum when the gain was reported
for tax purposes. This results in reporting a tax saving of $6,700 on amortization expense of
$14,000 on the consolidated income statement. This is $2,500 per year more than Slum’s tax
saving of $4,200 per year before it sold the machine to Plum. This fairly presents the actual
situation because Plum is achieving an incremental tax benefit of $2,500 per year (i.e. $10,000
overall gain spread over 4 years) as a result of the intercompany transaction.
The other option can initially be supported on the basis that it would report a tax saving of
$4,200 on amortization expense of $14,000 on the consolidated income statement which is
consistent with what was reported before the intercompany transaction occurred. However, it
would eliminate a total of $23,200 of tax over 4 years, which is $10,000 more than the tax paid
on the original sale of the machine. Therefore, this alternative does not fairly present the true
tax situation for the consolidated entity or the non-controlling interest. The manager’s
suggestion would produce similar results as the other option.
Case 7-4
Memo to: Partner
From: Stephanie Baker, CA
Subject: Canadian Developments Limited (CDL) Engagement
As requested, I have analyzed the accounting implications, financial statement disclosure, and other
matters of importance relating to several transactions that CDL entered into during the Year 8 fiscal
year.
Overall, the policies suggested by CDL management lead me to conclude that there is a bias towards
adopting policies that maximize earnings and provide a strong balance sheet in order to attract new
investors.
Likelihood of conversion
The classification of the debenture will depend on the likelihood of the debenture being converted
to common shares. In this instance, the holders of the debentures are a relatively small group
(major shareholder (53%) and large institutions), and CDL may be able to find out from them what
their intentions are. If the majority of the holders confirm their intention to convert, the question of
uncertainty will be largely resolved.
CDL has the option to trigger (force) conversion by repaying the debt at maturity by issuing common
shares. The existence of the option, however, is not sufficient to permit accounting for the debenture on
the unsupported assumption that the conversion will occur. CDL must intend to force conversion if it
wishes to account for the debentures as permanent equity.
Unusual features
The lower interest rate on the debenture indicates that a large portion of the security's value lies in
the conversion feature, thus increasing the likelihood of conversion.
Other factors
There are other, less critical, factors that can be considered in determining whether the debenture
should be classified as debt or equity:
• In common with other forms of debt the debenture pays interest and therefore the return is not
dependent on earnings.
Copyright © 2013 McGraw-Hill Ryerson Limited. All rights reserved.
14 Modern Advanced Accounting in Canada, Seventh Edition
• The legal form of the instrument is debt; if CDL were liquidated, this debenture would take
precedence over equity.
• The debentures can be redeemed by the holder at the purchase price.
The most important consideration in this decision is the intention of CDL and the debt holders
regarding conversion. If we can establish that conversion is likely, then I would support the client's
classification of this debenture as equity.
There should be full disclosure in the notes to the financial statements regarding the classification of
this transaction. We must ensure that the income statement treatment of the interest payments is
consistent with the balance sheet presentation. That is, if this debenture is classified as equity, then
the interest payments should be disclosed as dividends. If Revenue Canada requires debt
treatment, then the dividends should be disclosed net of tax.
There will be no effect on CDL's basic earnings per share figure regardless of the balance sheet
treatment given to this transaction because the amount available to the common shareholders will
be the same under both presentations. However, if the conversion proved dilutive, then the effects
of the conversion would have to be incorporated in the calculation of the fully diluted earnings per
share. If CDL does not already disclose fully diluted earnings per share and the conversion is
dilutive, then fully diluted earnings per share will have to be disclosed.
Classification
Since the preferred shares are mandatorily redeemable in five years' time, they do not constitute a
part of CDL's permanent capital. CDL should classify share capital according to the substance i.e.
debt, which would result in the preferred shares being excluded from the permanent equity section
of the balance sheet.
Investors contribute cash to enterprises so that they can earn a return on their investment. Whether
a payment is made each year or not, an investor expects ultimately to receive the return earned
annually. In the case of a preferred share issue that is mandatorily redeemable, the return will be
provided either annually or at maturity, usually in a fixed form.
In this instance, the return has been fixed at $40 million payable in five years' time. The $40 million
represents both a return of capital and income over the five-year period until maturity. In substance,
the earnings on the invested capital are accruing over the five years and will be paid out in one
lump sum. Accounting for the substance of the transaction suggests discounting the $40 million
payment and accruing the annual dividend each year as a form of interest expense.
The conversion will need to be disclosed in the notes to the financial statements.
Case 7-5
Memo to: Engagement Partner
From: CA
Re: Accounting Issues for Bakersfield Ball Boys Limited (BBB)
Below I have outlined the major accounting concerns facing the BBB engagement for the June
30, Year 11 financial statements. Before proceeding to the specific issues, I want to bring
several broader issues to your attention.
BBB is a private company. Accordingly, it can use IFRS or ASPE. BBB’s majority shareholder,
Tall Bottle, is a public company. Since Tall Bottle must use IFRS, it will likely insist that BBB
also uses IFRS to facilitate the preparation of consolidated financial statements. My comments
below are made on the assumption that BBB is using IFRS.
In analyzing and recommending accounting policies for the new issues facing BBB in Year 11,
we must be sensitive to the fact that the objectives of the minority shareholders, Mr. Bill Griffin
and Excavating Inc., conflict with those of the management of BBB and, probably, the majority
shareholder of BBB, Tall Bottle Ltd. (Tall Bottle). Commencing with the current year,
management's remuneration contract includes a bonus based on annual pre-tax income.
Accordingly, management is likely to want to maximize income. It appears that Tall Bottle
supported the new bonus arrangement, possibly hoping to maximize income and net assets for
consolidation. However, Mr. Bill Griffin and Excavating Inc. were opposed to the bonus
arrangement. Therefore, these minority shareholders will want to ensure that income is not
unjustifiably overstated. A factor that could mitigate this conflict is that BBB may want to
decrease revenues, where possible, in order to minimize any payments (or maximize receipts)
under the new equalization program.
As a result of these conflicting objectives, our overall exposure on this engagement has
increased. This exposure risk will be further increased if we recommend accounting policies,
since they might ultimately cause financial harm to one of the users of the financial statements.
(Candidates failed to identify the conflicting objectives of the users of the financial statements
and the corresponding risks.)
Sportsplus contract
Exclusive rights
Since the minority shareholders may have concerns that the management of BBB and the
majority shareholder are benefiting from BBB at their expense, we must be careful in dealing
with the Sportsplus contract arrangement. During the year, Sportsplus granted valuable
advertising rights to Tall Bottle at no cost, in exchange for BBB's local television rights. It
appears that Tall Bottle may have benefited from this deal at the expense of the other
shareholders. We will need to determine whether BBB gave up any revenues in its deal with
Sportsplus so that Tall Bottle could become BBB's official sponsor. Specifically, was the sale of
television rights to Sportsplus at fair market value? This will be difficult for us to determine. If we
establish that the sale was not at fair market value, we could suggest that a receivable from Tall
Bottle be established for the difference between the contract price and fair value. Tall Bottle may
suggest that the free advertising they received was compensation for management services
provided to BBB. If so, BBB should recognize a management fee expense and revenue from
sale of TV rights. If Tall Bottle opposes this accounting treatment, as a minimum this related
party transaction should be disclosed in the notes to the financial statements so that other
shareholders can assess its implications.
Signing bonus
The $250,000 signing bonus received by BBB for renewing its contract with Sportsplus can be
accounted for in several ways. One approach is to take the full amount into income in the
current year. Management may argue, for example, that the critical event in earning the
An alternative approach is to consider the payment as part of the total revenue for the contract.
The amount of the signing bonus would then be taken into income over the contract term.
Management will obviously favour recognizing all the income in Year 11. However, given the
magnitude of the payment, the substance of the transaction is probably better portrayed by
treating the payment as part of the total revenue for the contract. In light of the stronger
theoretical support for amortizing this revenue over the contract term and the strong concerns
that the minority shareholders may raise, it is my recommendation that the signing bonus be
amortized over the three-year contract term.
(Although candidates identified the alternative methods of recognizing revenue for the signing
bonus, they did not analyze the merits of each alternative in adequate depth.)
(Candidates did not identify the accounting implications of the payments for high ratings. Most
candidates tried to analyze the signing bonus issue and the high ratings payment issue together,
even though they were based on different facts and therefore required separate analysis.)
Player contracts
Player contracts probably represent one of the most significant costs of BBB. Accordingly, these
commitments should be disclosed in the notes to the financial statements, as required by
generally accepted accounting principles (GAAP).
Frank Ferter
It is uncertain at this time whether Frank Ferter will be selected to play for the All Star Team,
which would oblige BBB to pay him a $50,000 bonus. Since Ferter is favoured to capture this
honour, it is likely that the amount will be paid by BBB and, therefore, the amount should be
accrued in the financial statements. If investigation reveals that his inclusion in the team is
unpredictable, then this contingent liability should be disclosed in the notes to the financial
statements. In any event, this amount is probably immaterial to the financial statements.
Management's proposal to amortize the cost of Ferter's three-year contract over ten years
seems overly aggressive. Their position is probably based on an attempt to increase their
bonus. It is very difficult to estimate the future benefit of this player to the future of the team-the
uncertainty of the future benefit is analogous to that of advertising expenditures. Given the
uncertainty, it is recommended that the contract be expensed over the three-year period.
(Overall, candidates were able to identify and appropriately discuss the accounting implications
of the player contracts.)
Termination payment
As a result of the move to its new premises, BBB was required to make a final payment of $3.6
million to NoWay Park to terminate its lease. This payment can be accounted for in several ways.
One approach is to expense the payment in the current year since no future benefit will be obtained
by BBB from this site.
An alternative approach is to amortize the payment over the ten-year term of the new lease with Big
Top stadium. This approach is supported by the fact that the termination payment was a cost that
had to be incurred in order to rent the new premises. This cost should therefore be matched to the
period during which the benefit is to be derived from the new stadium.
A final option is to amortize the cost over the remaining three-year period of the previous lease with
NoWay. However, this approach has little theoretical support, except perhaps the argument that it is
the first three years of the new lease that carry the highest cost.
(Candidates were able to identify the alternative accounting methods for the lease termination
payment, and they discussed these alternatives in adequate depth.)
Equalization costs
As a result of the new equalization program, BBB may receive from, or be required to pay to,
the league a portion of its revenues. However, the final amount cannot be determined until the
season ends, since it depends on many variables, such as BBB's revenues and the revenues
of all other teams in the league. These amounts in turn depend on how each team is doing in
the league, which teams are in the playoffs, etc. Furthermore, it is difficult to estimate BBB's
revenues in the new stadium because there is no basis for comparison. An accounting problem
arises, however, because BBB's year-end is mid-way through the season.
One approach is to postpone recording any amount in the accounts until the net cost/revenue
is known in October. One can argue that it is simply too difficult to make any reasonable
estimate, given all the unknown variables discussed above. Under this approach, however,
BBB would disclose the possible contingent liability.
The alternative is to accrue for an amount that will likely be paid by BBB (contingent gains
cannot be accrued). However, this accrual will be very difficult to measure, for the reasons
discussed above.
In light of the fact that the statements will be used to determine management bonuses and the
difficulty associated with estimating the net revenue/cost, I recommend that no amount be
accrued in the financial statements and only the contingent liability be disclosed. Although this
treatment will cause an inconsistency between the period of management "effort" and the
period in which the net amount is included, an estimate of the amount is simply too difficult at
present. This approach will not require any adjustment to the prior year's financial statements.
(Candidates understood that the June 30 year-end caused an accounting problem with regard to
these equalization payments. However, they did not identify or analyze the accounting
implications.)
Roof collapse
Copyright © 2013 McGraw-Hill Ryerson Limited. All rights reserved.
Solutions Manual, Chapter 7 21
We must determine the net cost to BBB of the roof collapse, after considering recoveries from
the insurance company. If there is a material net cost to BBB, then this cost should be disclosed
separately.
Ticket refunds
The ticket refunds should be reported as a reduction of net sales. The unused tickets should be
recorded as unearned revenue.
Gift certificates
The gift certificates can be recorded as a liability. However, it seems more appropriate to give no
accounting recognition to these certificates because the certificates are really only an executory
contract at present and a portion of them may never be reimbursed.
(Candidates failed to identify and discuss the accounting and audit implications of the roof
collapse.)
Insurance claim
Attached to this memo is my draft report to BBB, which includes the statement of loss.
Attached in Appendix I is the statement of loss you requested to support your claim for
damages in accordance with your business-interruption insurance policy. Our underlying
premise in preparing this statement is that BBB should be put into the same position as if the
roof collapse had not occurred. Our calculations show that your total claim amounts to
$1,980,696.
We must review the insurance policy to ensure that all items included in our statement of loss
are appropriate and that no items to which BBB is entitled are missing from the statement. After
reviewing the policy, we will make any changes needed.
At present, the statement does not include several items that should be considered and
perhaps added. For example, the insurance company should reimburse you for any legal,
Please call us once you have had an opportunity to review the enclosed information so that we
can discuss any comments you may have.
Yours truly,
CA
(Generally, candidates understood the concepts to be applied in preparing the statement of loss
(i.e. a differential revenue/cost analysis) and prepared an appropriate statement.
APPENDIX I
Bakersfield Ball Boys Ltd.
Statement of Loss
Re: Roof Collapse at Big Top
Lost revenue
Ticket sales (Note 1) $1,400,000
Confection gross profit (Note 2) 79,896
1,479,896
Additional costs (costs saved)
Gift certificates (Note 3) 480,000
Stadium rental 132,500
Groundskeeper costs (Note 4) (7,500)
Cleaning crew (Note 5) (10,500)
Food vendors (Note 6) (13,700)
580,800
Net loss to BBB $2,060,696
Note 1:
Number of Big Top cancelled tickets 40,000
Ticket price x $35
Lost ticket sale revenues $1,400,000
Note 3:
Note that this amount may be reduced by the portion that is not likely to be redeemed. The
insurance company may refuse to reimburse these costs, arguing that they were not a
necessary cost as a result of the roof collapse.
Note 4:
NoWay actual costs $9,000
Big Top projected costs 16,500
Costs saved $7,500
Note 5:
NoWay actual costs $15,250
Big Top projected costs 25,750*
Costs saved $10,500
* Assumes that BBB did not have to pay for clean-up crews at Big Top.
Note 6:
No Way actual costs $19,200
Big Top projected costs 32,900
Costs saved $13,700
Overview
The Enviro Facilities Inc. (EFI) engagement has considerable risk associated with it. In
reviewing the file, I noted a number of events that raise concerns about the integrity of EFI’s
management. These events include:
(1) management’s refusal to notify the bank of its error in converting foreign funds and the
inclusion of the amount of the error in income;
(2) the change in the accounting estimate of the useful lives of assets, which has the effect of
increasing income;
(3) the ongoing dispute with the provincial tax auditors;
(4) the patent infringement suit; and
(5) the rumour that an affiliated company may not comply with environmental legislation.
Moody’s has put EFI’s credit rating on alert for downgrading due to a toughening of
environmental legislation. EFI therefore has an incentive to improve the appearance of its
financial statements so as to influence Moody’s decision. A downgrade in the credit rating
would be costly to EFI as it would increase the cost of borrowing.
EFI’s managers and owners probably have an incentive to report higher income because of the
pending sale of the company. EFI’s accounting policies and the estimates used suggest that
this is the case. The prospective purchasers will likely use the financial statements to determine
the price of the shares, particularly because the company is private and no market price is
If the issue is not resolved by the time we sign the financial statements, we must decide whether
this issue should be disclosed as a contingent liability or whether the amount should be accrued
in the financial statements. If we determine that the liability is likely and the $7.22 million is a
reasonable estimate, then it should be accrued. We should consult our tax department to help
us in this regard. The risk to us is that there could be inadequate disclosure of a material event,
which is especially crucial because of the possible sale of the shares. Conversely, disclosure
when the likelihood of the liability being realized is small may reduce the proceeds that the
current owners of the company could receive.
Bank error
The treatment of the bank error results in income being increased by $6,128,258, an amount
that is material. This misstatement of income could influence the decisions of potential buyers
and bond-rating agencies. Clearly, including the amount in income is not correct accounting.
The money does not belong to EFI, and the bank could ask for repayment once they discover
the error. The amount of the error should be set up as a liability, not included as revenue. Of
course, the liability may never be paid if the bank does not notice the error. If EFI refuses to
Copyright © 2013 McGraw-Hill Ryerson Limited. All rights reserved.
26 Modern Advanced Accounting in Canada, Seventh Edition
change its method of accounting for the error, we should point out that the amount is taxable.
The company may then agree to change its accounting approach since it imposes real
economic costs. Our firm should also question whether we should remain associated with EFI
given their unwillingness to return money that clearly does not belong to them.
The award against EFI made by the court in the patent infringement case is unusual. Aggrieved
parties normally receive a straightforward payment as compensation. The payment is usually
treated as an expense for accounting purposes. In this case, however, EFI is receiving
something that could have value, so the accounting is more complex. Various accounting
approaches could reasonably be used. First, since the purchase is a court-imposed penalty, the
$18 million share purchase could be considered to be an $18 million fine and shares to have
been acquired at zero cost. This approach would be unattractive to EFI since it would have a
significant effect on the income statement at a time when it is very concerned about the bottom
line (because of the potential sale of the shares and the alert placed on EFI’s credit rating). An
alternative approach would be to record the shares as an asset on the balance sheet at $18
million. This approach would be attractive to EFI’s management because the income statement
would be unaffected.
It is clear that EFI may be receiving an asset because of the court decision. The first step would
be to determine whether the shares would meet the definition of an asset. According to the
IFRS Framework, paragraph 49, “An asset is a resource controlled by the entity as a result of
past events and from which future economic benefits are expected to flow to the entity”. The
shares will be controlled by EFI and are the result of a past event (the court ruling), however
whether or not there will be any future benefits depends on the performance of Waste Systems.
If EFI is likely to derive a future benefit from the shares, then the definition of an asset has been
met.
The next question to be resolved is what the asset is worth. If the shares are to be recorded on
the balance sheet at $18 million, they must be worth $18 million. If the market value is less than
$18 million, then the amount in excess of the fair market value should be expensed since that
amount represents a penalty. Since Waste Systems Integrated Limited is a private company, it
could be difficult to arrive at a reasonable estimate of its fair market value. I strongly suggest
that we have a valuation done of the company so that we have authoritative support for the
Copyright © 2013 McGraw-Hill Ryerson Limited. All rights reserved.
Solutions Manual, Chapter 7 27
value. Such support is especially important in view of EFI management’s concern about the
income-statement figures at the present time. That Waste Systems had been in financial
difficulty is an indication that its market value is low.
If we determine that Waste Systems has a value greater than zero and should be recorded as
an asset, a number of accounting issues will need to be resolved. We must determine whether
the shares should be considered a long- or short-term asset and whether we should
consolidate, or use the equity method. We cannot make these accounting decisions until we
have found out, for example, whether there are restrictions on EFI’s ability to sell the shares. (If
there are, accounting as a financial asset would be appropriate; otherwise, we must determine
what management’s intentions are.) Similarly, we need to find out what proportion of Waste
Systems EFI owns, to help determine the method of accounting for the investment.
EFI has significantly lengthened the estimated lives of its waste disposal sites and decreased
the estimated cost of sealing and cleaning up the sites. The change has a significant effect on
income, which is important because the owners are considering selling their shares. Waste-
disposal sites represent 64% of EFI’s assets and 41% of operating expenses. The disposal
sites will be an important consideration for prospective purchasers, and they may rely on the
financial statements. Thus we must exercise great care in this highly risky part of the audit.
Compounding the problem is the fact that EFI changed consulting engineers this year and the
new engineers, Cajanza Consulting Engineers (Cajanza), recommended the changes.
However, there may be an independence problem. EFI owes Cajanza $2.9 million, and the
amounts owing date back to Year 4. It is not clear why this amount has been outstanding for so
long, but EFI may be using the debt to influence Cajanza’s judgment or Cajanza may feel
pressure to provide results favorable to EFI to secure its money. It is difficult to understand how
the costs of sealing and cleaning up sites can decrease at a time when environmental regulation
is increasing, so the reduction in estimated costs requires some attention.
EFI uses three different methods for amortizing the cost of the sites. We must decide whether
using three methods is justifiable. The IFRS Framework requires that consistent accounting
policies be applied across the entity, so it is likely that using these different methods is not
acceptable. “The measurement and display of the financial effect of like transactions and other
events must be carried out in a consistent way throughout an entity and over time for that entity
and in a consistent way for different entities.”[IFRS Framework, par.39] Therefore, the company
should determine which accounting policy is the most appropriate and apply this accounting
policy consistently. The same methodology should be used to calculate amortization expense
across for an asset class.
Given the circumstances and the incentives for management to increase earnings, additional
audit steps should be taken to satisfy us that the estimated lives and clean-up costs are
reasonable. One approach would be for us to engage an engineering firm to assess the lives
and clean-up costs of the sites.
In any case, it will be necessary for the changes in estimates to be disclosed in the notes.
EFI amortizes the costs of locating new waste-disposal sites and negotiating agreements with
municipalities. This approach is debatable and requires professional judgment to resolve.
IAS 16 states that the cost of an item of property, plant and equipment includes any costs
directly attributable to bringing the asset to the location and condition necessary for it to be
capable of operating in the manner intended by management. One could argue that locating
new waste-disposal sites and negotiating agreements with municipalities is a cost of bringing
the asset to the location and condition necessary for it to be capable of operating in the manner
intended by management.
On the other hand, one could argue that the cost associated with negotiating a contract would
be considered an administrative cost and would be expensed as incurred. According to IAS
16.19 “Examples of costs that are not costs of an item of property, plant and equipment
are…administration and other general overhead costs.”
We will have to discuss this matter with management to determine their rational for capitalizing
the cost. If we deem that it is not a cost of bringing the asset to the location and condition
necessary for use, the cost will need to be expensed.
Onkon-Lakerton contract
EFI has recognized the guaranteed portion of the contract with the Onkon-Lakerton municipality
as revenue. The revenue recognition criteria [IAS 18.20] states that “when the outcome of a
transaction involving the rendering of services can be estimated reliably, revenue associated
with the transaction shall be recognized by reference to the stage of completion of the
transaction at the balance sheet date. The outcome of a transaction can be estimated reliably
when all the following conditions are satisfied:
(a) the amount of revenue can be measured reliably;
(b) it is probable that the economic benefits associated with the transaction will flow to the
entity;
(c) the stage of completion of the transaction at the balance sheet date can be measured
reliably; and
(d) the costs incurred for the transaction and the costs to complete the transaction can be
Copyright © 2013 McGraw-Hill Ryerson Limited. All rights reserved.
30 Modern Advanced Accounting in Canada, Seventh Edition
measured reliably.
EFI may be able to support their position that the outcome of the contract with Onkon-Lakerton
can be estimated reliably, due to the guaranteed minimum revenue of $3.2 million per year.
However, IFRS still requires that revenue recognition be based on the stage of completion of
the transaction. EFI has not performed any of the work in relation to the contract. Indeed, the
contract period has not yet even begun. Therefore, EFI cannot recognize the $3.2 million of
revenue related to this contract.
US subsidiary lawsuits
Two US subsidiaries of the company are being sued for improper disposal of hazardous waste.
The alleged activities took place before EFI acquired the subsidiaries, and the sale-purchase
agreement provides for a price adjustment in the event of this type of liability. Provided that the
agreement covers the situation in question, including costs of litigation, and the previous owner
is able and willing to meet the obligation, then no additional audit work is necessary and it is not
necessary to make any disclosure in the financial statements.
However, before we can come to that conclusion, we must assure ourselves that EFI is fully
protected. We must be certain that the price-adjustment clauses cover legal claims of this type
and that the clauses are still in force—for example, there may be limits on how long the seller
remains responsible for actions of this type. We must determine whether the previous owner is
ready, willing, and able to meet the terms of the contract. The previous owner could have gone
out of business, could lack the resources to satisfy the claim, or could deny responsibility for
some or all of the damages.
If we conclude that there is some probability that EFI will be responsible for some or all of the
claims, we will have to consider a provision should be recorded in accordance with IAS 37.
In anticipation of the sale of shares by the owners, EFI plans to dispose of waste sites whose
clean-up costs exceed their carrying amount. This transaction would be a related party
transaction and must be disclosed in the notes of the financial statements [per IAS 24], which
would draw attention to the users that the company was transferring the assets.
Copyright © 2013 McGraw-Hill Ryerson Limited. All rights reserved.
Solutions Manual, Chapter 7 31
We must determine whether EFI will be free of liabilities after selling the sites. EFI may be liable
contractually or legally for any future clean-up costs that result from past ownership. If potential
liabilities exist they must be reported in the financial statements.
With regard to the rumour that Enviro (Bermuda) does not plan to comply with environmental
legislation, it is not necessary for us to do anything at this point because the information is only
a rumour and nothing illegal has been done yet. We should, however, be alert for information
that substantiates the rumours.
The new cost-accounting system will have an effect on the financial statements, so we need to
consider the effect of the changes carefully. Compost is a by-product of the waste-collection
process. Cost allocation to by-products is arbitrary. Costs can be allocated according to the
amount of revenue generated by the sale of compost or on the basis of direct costs, or by
allocating just the incremental costs. What management needs to know is the incremental cost
of producing compost so that management can determine whether it is profitable to make and
sell compost.
An effect of the new cost accounting system will be to increase income in the first year because
some of the costs of the waste-disposal business that would previously have been expensed
will now be included in inventory as part of the cost of the compost. Only actual costs can be
capitalized. We need to determine if the standard cost approximates actual cost. If not, an
adjustment must be made to reflect actual costs. Depending upon the magnitude of the
allocated costs and inventory, we should consider retroactive treatment.
Overall conclusion
The effects of the bank error, the sales-tax audit, and the treatment of the waste disposal sites,
etc., raise the possibility that the financial statements may be materially misstated.
Management seems to have taken steps that have had the effect of increasing the net income
and the assets on the balance sheet. We must consider whether we should resign from the
engagement altogether because of the questionable integrity of management. Among other
integrity concerns, the company’s handling of the bank error and changes in accounting
Copyright © 2013 McGraw-Hill Ryerson Limited. All rights reserved.
32 Modern Advanced Accounting in Canada, Seventh Edition
estimates, apparently to window-dress the statements, should make us question whether we
want to be associated with this client.
SOLUTIONS TO PROBLEMS
Problem 7-1
Before tax 40% tax After tax
Asset profit – Y Company selling
January 1, Year 2 – sale 45,000 18,000 27,000
Depreciation Year 2 9,000 3,600 5,400
Balance December 31, Year 2 36,000 14,400 21,600 (a)
Depreciation Year 3 9,000 3,600 5,400 (b)
Balance December 31, Year 3 27,000 10,800 16,200
Investment in Y Company
Problem 7-2
Equipment gain
Before Tax 40% tax After tax
Year 2 sale – Sally selling 15,000
* Depreciation Years 2 and 3 (3,000 2) 6,000
Balance December 31, Year 3 9,000 3,600 5,400
Depreciation Year 4 3,000 1,200 1,800 (a)
Balance December 31, Year 4 6,000 2,400 (b) 3,600
Problem 7-3
Intercompany profits – subsidiary selling
Building
Sale, Jan. 1, Year 6 42,000 16,800 25,200
Depreciation Year 6 (42,000 / 7) 6,000 2,400 3,600 (d)
Balance, Dec. 31, Year 6 36,000 14,400 21,600 (e)
Intercompany Rent
Year 5 (12,000 3/12) 3,000 (f)
Parent Company
Corrected Consolidated Income Statements
Years 5 and 6
Year 5 Year 6
Miscellaneous revenues $750,000 $825,000
Miscellaneous expense 399,800 492,340
Rent expense (52,700 – (f) 3,000) 49,700
(64,300 – (g) 12,000) 52,300
Depreciation expense (75,000 – (a) 400) 74,600
(80,700 – (c) 1,600 – (d) 6,000) 73,100
Income tax expense (81,000 – (b) 3,040) 77,960
(94,500 + (c) 640 – (e) 14,400) 80,740
Consolidated net income 147,940 126,520
Attributable to:
Shareholders of Parent 116,580 126,520
NCI (32,500 - 25% x (h) 4,560) 31,360
NCI (5,160 - 25% x (i) 20,640) 00,000
147,940 126,520
When the parent controls the subsidiary, the consolidated financial statements best reflect the
financial position and results of operations of the combined entities. At the date of acquisition,
the net assets of the subsidiary including goodwill are reported at fair values. The net assets of
the parent are reported at their carrying values. Therefore, the consolidated financial
statements do not reflect the fair value of all assets and liabilities. However, the assets and
liabilities are reported at the values required by generally accepted accounting principles.
Problem 7-5
Calculation, allocation, and amortization of the acquisition differential
Amortization
Balance Balance
July 1/1 Years 1 to 7 Year 8 Dec. 31/8
(b)
Dec. 31 Investment in Garden Company 50,845
Investment income 50,845
To record 90% of adjusted subsidiary income
(56,494* 90%)
(c) A loss is recognized on the consolidated books when the subsidiary purchased the
parent’s bonds in the open market because the bonds are deemed to be retired from a
consolidated point of view. However, the bonds have not been retired from a separate–
company perspective. On the separate–entity books, the discount on the bonds will
continue to be amortized and income tax will be determined based on the amortization of
the premium or discount. The total loss recognized over the remaining term of the bonds
through the amortization of the discount will equal the loss on the deemed retirement –
only the timing is different. Therefore, these differences are considered to be timing
differences and would give rise to a deferred income tax asset.
(d) The debt-to-equity ratio would increase. Debt would stay the same while equity would
decrease due to the reduction in NCI under the parent company extension theory.
Problem 7-6
(a)
Acquisition differential – buildings 1,250 (a)
Yearly amortization (25,000 / 20)
Intercompany profits
Before tax 40% tax After tax
Land gain – M selling
realized in Year 6 10,000 4,000 6,000 (e)
Income of K 25,500
Add: profit in opening inventory (f) 7,200
32,700
Less: Amortization of acquisition differential (a) 1,250
Profit in ending inventory (g) 3,000
Adjusted profit 28,450
Non-controlling interest’s share 20%
Non-controlling interest, Year 6 5,690 (i)
M Co.
Consolidated Income Statement
Year 6
Problem 7-7
Calculation, allocation, and amortization of acquisition differential
Total 70% 30%
Cost of investment, Jan. 1, Year 6 483,000 483,000
Fair value of NCI 195,000 195,000
678,000
Carrying amounts of Gold's net assets:
Ordinary shares 500,000
Retained earnings 40,000
Total shareholders' equity 540,000 378,000 162,000
Acquisition differential 138,000 105,000 33,000
Allocation: FV - CA
Investment 227,000
Par value 200,000
Loss to Pure 27,000 10,800 16,200
Problem 7-8
Calculation, allocation, and amortization of acquisition differential
Intercompany bonds
Before tax 40% tax After tax
Cost of bonds Jan. 2, Year 4 242,500
Carrying value of bonds purchased
Par 500,000
Issue premium
(14,000 – [14,000 / 7 2]) 10,000
510,000
Intercompany portion 50%
255,000
Gain to entity, Jan. 1, Year 4 12,500 5,000 7,500 (k)
Interest elimination loss, Year 4* 2,500 1,000 1,500
Net gain to entity, Dec. 31, Year 4 10,000 4,000 6,000 (l)
Allocation:
Cost 242,500
Par value (500,000 50%) 250,000
Gain to Spruce, Jan. 1, Year 4 7,500 3,000 4,500
Interest elimination loss, Year 4* 1,500 600 900
Net gain to Spruce, Dec. 31, Year 4 6,000 2,400 3,600 (m)
Par value 250,000
Carrying value 255,000
Alternative calculation:
Consolidated retained earnings, Dec. 31, Year 4 11,245,680
Retained earnings – Poplar Dec. 31, Year 4 – cost
method (10,000,000 + 1,100,000 – 600,000) 10,500,000
Difference 745,680
Investment in Spruce – cost method 2,000,000
Investment in Spruce – equity method, Dec. 31, Year 4 2,745,680
(c)
Gains should be recognized when they are realized i.e., when there has been a transaction with
outsiders and consideration has been given/received. When the parent acquires the subsidiary’s
bonds for cash in the open market, it is transacting with an outsider and giving cash as
consideration. From the separate entity perspective, the parent is investing in bonds. However,
from a consolidated point of view, the parent is retiring the bonds of the subsidiary when it
purchases the bonds from the outside entity. Therefore, when the investment in bonds is offset
against the bonds payable on consolidation, any difference in the carrying amounts is recorded as a
gain or loss on the deemed retirement of the bonds.
Problem 7-9
Calculation, allocation, and amortization of acquisition differential
Cost of 85% investment in Sloan Ltd. 3,026,000
Implied value of 100% 3,560,000
Carrying amounts of Sloan's net assets:
Common shares 2,200,000 Dr
Retained earnings 1,100,000 Dr
Total shareholders' equity 3,300,000
Acquisition differential 260,000
Allocation:
FV – CA
Plant and equipment 200,000
Accounts receivable - 75,000
Amortization
Balance Balance
Jan. 1/1 Years 1 to 3 Year 4 Dec. 31/4
Inventories
Beginning – Porter selling 14,000) 5,600) 8,400) (i)
– Sloan selling 1,500) 600) 900) (j)
Totals 15,500) 6,200) 9,300)
Date Effective Interest (1) Interest Paid (2) Amortization (3) Balance
Jan 1, Yr 1 (750,000 – 52,680 = ) 697,320
Dec 31, Yr 1 48,812 45,000 3,812 701,132
Dec 31, Yr 2 49,079 45,000 4,079 705,211
Dec 31, Yr 3 49,365 45,000 4,365 709,576
Dec 31, Yr 4 49,670 45,000 4,670 714,246
Notes:
1) Balance x 7%
2) 750,000 x 6%
3) Effective interest – interest paid
Beta
Gain (loss) on bonds (i)(14,613) (j) (5,845) (k) (8,768)
Interest elimination loss (gain) (m) (2,995) (1,198) (1,797)
Balance December 31, Year 4 gain (loss) (11,618) (4,647) (6,971) (o)
* from bond amortization
Cash 27,000
Investment in Beta Corporation 27,000
90% 30,000 dividends from Beta
Problem 7-11
Parent Co.
Loss (gain) July 1, Year 7 (c) (7,500) (3,000) (4,500)
Interest elimination gain (loss)
Year 7* (750) (300) (450)
Balance loss (gain) Dec. 31, Year 7 (6,750) (2,700) (4,050) (e)
Sub. Co.
Loss (gain) July 1, Year 7 (d) 8,000 3,200 4,800
Interest elimination gain (loss)
Year 7* 800 320 480
Balance loss (gain) Dec. 31, Year 7 7,200 2,880 4,320 (f)
Parent Co.
Consolidated Income Statement
Year 7
Gain to entity ((a) 4,000 – (b) 1,600) (before tax) 2,400 (c)
60% 60%
Before tax After tax Before tax After tax
Entity Palmer
Gain (loss) Oct. 1,
Year 5 (c) 2,400 1,440 (b) (1,600) (960)
Interest elimination
loss (gain)* 150 90 (100) (60)
Balance gain (loss)
Dec. 31, Year 5 2,250 1,350 (1,500) (900) (e)
Scott
Gain (loss) Oct. 1,
Year 5 (a) 4,000 2,400
Interest elimination
loss (gain)* 250 150
Balance gain (loss)
Dec. 31, Year 5 3,750 2,250 (f)
* ¼ x 3/12
a) December 31, Year 5
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Solutions Manual, Chapter 7 63
Investment in Scott Corporation 49,000
Investment income 49,000
70% $70,000 Share of Scott's profit
Cash 10,500
Investment in Scott Corporation 10,500
70% $15,000 Share of Scott's dividends
(b)
Current assets
Cash (150 + 75) 225
Accounts receivable (275 + 226 – (i) 150) 351
Inventory (594 + 257 – (g) 60) 791
(c)
Subsidiary’s retained earnings, beginning of year $279
Unrealized after-tax profit in beginning inventory (h) (45)
234
(d)
i) RAV’s separate entity income would decrease because it would report dividend income from
ENS of $182.4 (60% x $304) instead of investment income of $210.
ii) Consolidated net income would remain the same because intercompany dividends and
other intercompany transactions are eliminated and only income from outsiders is reported.
Income from outsiders remains the same.
(adapted from CGA Canada)
Problem 7-14
Year 9 income statements
P Company S Company
Sales 630,000 340,000
Interest income 1,850
Investment income 15,339
Gain on sale of land 7,000
Total revenues 652,339 341,850
Cost of sales 485,000 300,000
Interest expense 17,000
Selling and admin. expense 50,000 20,000
Income tax expense 34,000 8,740
Total expenses 586,000 328,740
Net income 66,339 13,110
Gain to entity, July 1, Year 9 ((d) 1,250 – (e) 500) 750 (f)
P Company
Gain (loss) July 1, Year 9 (e) (500) (200) (300)
Interest elimination gain (loss) Year 9* (100) (40) (60)
Balance gain (loss), Dec. 31, Year 9 (400) (160) (240) (i)
S Company
Gain July 1, Year 9 (d) 1,250 500 750
Interest elimination gain Year 9* 250 100 150
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68 Modern Advanced Accounting in Canada, Seventh Edition
Balance gain Dec. 31, Year 9 1,000 400 600 (j)
½ year 8,500
Intercompany portion (40,000 / 200,000) 20% 1,700
Interest revenue – S Company
8% (c) 40,000 ½ 1,600
Purchase discount amortized (c) 250 1,850
Interest elimination loss – Year 9 (g) 150
Intercompany profits
Before tax 40% tax After tax
Land – S selling – realized in Year 9
(21,000 – 15,000) 6,000 2,400 3,600 (l)
(a) P Co.
Consolidated Income Statement
Year 9
(b) P Co.
Consolidated Retained Earnings Statement
Year 9
Problem 7-15
Champlain NCI
(80%) (20%)
Cost of 80% investment in Samuel 129,200
Fair value of NCI’s Interest in Samuel (14 x 2,000) 28,000
Champlain’s share
(80% x subtotal + Goodwill) 79,600 26,000 20,600 33,000 (d)
NCI’s share
(20% x subtotal + Goodwill) 15,600 4,400 3,950 7,250 (e)
Intercompany profits
Before tax 40% tax After tax
(b) When the gain on the sale of the equipment is eliminated on consolidation, the equipment
is restated to its carrying value on Champlain’s books prior to the intercompany sale. The
carrying value represents Champlain’s original cost less accumulated amortization based
on the historical cost. After the consolidation adjustment, the equipment is reported at the
historical cost to the consolidated entity net of accumulated amortization.
(c) The return on equity attributable to the shareholders of Samuel would not change because
the parent company extension theory only affects values used for non-controlling interests.
Problem 7-16
(c) Assets should never be reported on the balance sheet at an amount higher than the
future economic benefits. If an asset is sold at a loss, this may indicate that the asset is
impaired and the loss should be recognized even if the sale did not occur. If the selling
price in the intercompany transaction is not a true reflection of the economic value, the
loss would also not be realistic; if so, the loss would be eliminated on consolidation so
that the asset is reflected at the amount it was reported at prior to the intercompany sale.
Problem 7-17
Intercompany profits
Before tax 40% tax After tax
Opening inventory – Dandy selling (2,000 x 40%) 800 320 480 (d)
Handy Company
Consolidated Statement of Retained Earnings
For the year ended December 31, Year 6
(c) When unrealized profit is eliminated from the carrying value of the equipment, the
equipment ends up being reported at the original cost of the equipment less
accumulated amortization based on the original cost, as if the intercompany
transaction had never taken place. So, in effect, the equipment is reported at its
historical cost.
(CGA-Canada adapted)
Under the revaluation model and ignoring the intercompany sale, the equipment would
be reported as follows on the balance sheet:
Year 1 Year 2 Year 3
Grossed up cost 511,111 520,000 528,571
Grossed up accumulated depreciation 51,111 104,000 158,571
Carrying amount = fair value 460,000 416,000 370,000
The amounts are grossed up using the ratio of fair value / carrying amount under
historical cost model.
Under the revaluation model and ignoring the intercompany sale, the depreciation
expense would be reported as follows on the income statement:
Year 1 Year 2 Year 3
Carrying amount beginning of year 500,000 460,000 416,000
Remaining useful life 10 9 8
Depreciation expense for the year 50,000 51,111 52,000
Under the revaluation model and ignoring the intercompany sale, accumulated other
comprehensive income (AOCI) would be reported as follows on the balance sheet:
WEB-BASED PROBLEMS
Web Problem 7-1
The following answers were determined using the 2011 consolidated financial
statements for Barrick Gold Corporation.