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Ch 7 Answer Key

Advanced Accounting (University of Toronto)

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Chapter 7

(A) Intercompany Profits in
Depreciable Assets
(B) Intercompany Bondholdings

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A brief description of the major points covered in each case and problem.

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 CPA 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 CPA exam, students are asked to discuss accounting issues involving
revenue recognition related to multiple deliverables, intercompany transactions involving
depreciable assets, inventory valuation and asset retirement obligation.

Case 7-6
In this case taken from a CPA 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.

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PROBLEMS
Problem 7-1 (15 min.)
This is a relatively short problem requiring the reconstruction of the investment account when
the parent used the equity method. Unrealized profit transactions in depreciable assets made by
both companies are involved.

Problem 7-2 (20 min.)

This question requires the preparation of a consolidated income statement when the parent has
used the cost method and where the realization of an unrealized profit in depreciable assets is
involved.

Problem 7-3 (30 min.)

This problem consists of two-year consolidated income statements that have been incorrectly
prepared and require correcting. Intercompany transactions and unrealized intercompany profits
in depreciable assets have been overlooked.

Problem 7-4 (30 min.)

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

Problem 7-5 (40 min.)

This problem focuses on a single transaction involving the intercompany sale of equipment. It
contrasts the differences between an upstream and downstream transaction. It also compares
the results when reporting under cost, equity, and consolidated bases.

Problem 7-6 (80 min.)

The preparation of a consolidated balance sheet and consolidated retained earnings statement
when the parent has used the cost method is required. There are unrealized profits in
inventories and land involved as well as intercompany bondholdings, which are accounted for
using the effective-interest method. The question also requires the preparation of the year’s
equity method journal entries, an explanation of why deferred income taxes arise with the

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elimination of intercompany bondholdings and an explanation as to how the parent company

extension theory would affect the debt to equity ratio.

Problem 7-7 (30 min.)

This problem involves intercompany sales of equipment. It requires the preparation of a
consolidated income. Then, students are asked to explain the impact on the separate entity and
consolidated financial statements when the parent changes to the equity method from the cost
method and from a wholly-owned to partially-owned subsidiary.

Problem 7-8 (35 min.)

The preparation of a consolidated income statement is required when the parent has used the
equity method of accounting. Unrealized profits in depreciable and nondepreciable assets as
well as inventories are involved. Every line on the income statement requires adjustment in the
consolidation process. The preparation of the parent’s income statement under the cost method
is also required.

Problem 7-9 (35 min.)

The preparation of a consolidated statement of financial position is required when the parent
has used the equity method and there are intercompany bondholdings and intercompany profits
in a depreciable asset. NCI is measured at the date of acquisition using the fair value as
determined by an independent business valuator.

Problem 7-10 (70 min.)

A comprehensive problem that involves all of the consolidation adjustments taken to the end of
Part A of Chapter 7.

Problem 7-11 (35 min.)

This problem involves equity method journal entries and the calculation of selected accounts
when there are intercompany bondholdings, which are accounted for using the effective-interest
method.

Problem 7-12 (35 min.)

This problem requires the preparation of a consolidated income statement when the parent has
used the cost method and there are intercompany bondholdings.

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Problem 7-13. (30 min.)

This problem involves equity method journal entries and the calculation of selected accounts
when there are intercompany bondholdings.

Problem 7-14 (75 min.)

This is a problem from a CGA exam that involves unrealized profits in inventories and building
when the parent has used the equity method. It involves the preparation of a consolidated
income statement and consolidation worksheet, the calculation of selected items from the
consolidated balance sheet, and an explanation of the difference if the parent had used the cost
method.

Problem 7-15 (50 min.)

In this fairly difficult problem, selected trial balance accounts from the records of a parent and its
90%–owned subsidiary are given. The parent has used the equity method and there are
intercompany bonds and unrealized gains on land. The preparation of a consolidated income
statement and a consolidated retained earnings statement is required.

Problem 7-16 (85 min.)

In this comprehensive problem, the parent has used the cost method and there are unrealized
profits in land, depreciable assets, and inventory. The preparation of the three consolidated
financial statements and a consolidation worksheet are required along with an explanation of
how the historical cost principle supports the elimination of unrealized profits. It also involves
the calculation of goodwill, NCI (using the market price of the subsidiary’s shares at the date of
acquisition) and return on equity under the parent company extension theory.

Problem 7-17 (80 min.)

This problem appeared on a CGA national examination. It involves unrealized profits in
inventory and equipment. The preparation of a consolidated income statement, retained
earnings statement and consolidation worksheet are required along with an explanation of how
the historical cost principle supports consolidation adjustments. It also involves the calculation
of goodwill impairment loss and NCI under the parent company extension theory.

Problem 7-18 (40 min.)

This problem involves an intercompany sale of equipment when both the parent and subsidiary
use the revaluation model to account for equipment. The student must calculate account
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balance for selected account for the separate entity statements of the parent and subsidiary and
for the consolidated statements.

SOLUTIONS TO REVIEW QUESTIONS

1. A $2,700 intercompany gain recorded by a constituent company is held back in the

preparation of the consolidated income statement by showing no gain on the statement.
Income tax expense is reduced by the amount of income tax that the selling company
recorded on this gain in the year of sale. In subsequent years, the intercompany gain is
realized in the preparation of consolidated income statements by reducing depreciation
expense. This reduction in expense increases consolidated net income and thus realizes a
portion of the gain in before-tax dollars. Income tax expense is increased each year by the
depreciation expense reduction multiplied by the tax rate used on the original gain
transaction. This results in a portion of the gain being realized in after-tax dollars. Over the
life of the asset, the reduction in depreciation exactly offsets the gain that had been
eliminated.

2. The realization of an intercompany inventory profit is accomplished by decreasing

consolidated cost of goods sold by the amount of the profit. The resultant cost of goods
sold is stated at historical cost to the entity. The realization of an intercompany depreciable
asset profit is accomplished by decreasing consolidated depreciation expense. The
resultant depreciation expense is stated at historical cost to the entity.

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

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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.

*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.

10. The four approaches are as follows:

(a) The purchasing affiliate acted as an agent for the issuing affiliate; gains or losses are
allocated to the issuer.

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(b) Gains or losses are allocated to the purchasing affiliate because it made the open
market purchase of the bonds.
(c) Gains or losses are allocated to the parent company because it controls the actions
of the affiliates.
(d) Gains or losses are allocated to both the purchasing and the issuing affiliates.

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.

11. An "interest elimination loss" is created in the preparation of a consolidated income

statement as a result of the unequal elimination of interest revenue and expense. When
the elimination of interest revenue is greater than the elimination of interest expense, a
reduction of the entity's before-tax net income results. This "loss" does not appear as a
separate item in the consolidated income statement.

12. The holdback of a gain from an intercompany sale of an asset 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 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
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.

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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 bond holdings 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
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
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eliminated from equity method 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
subsidiary? The case attempts to illustrate that no clear-cut solution to this question can be found.
This lack of an absolute answer makes financial accounting both intriguing and frustrating.
Interesting class discussion can be generated from this issue.

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.

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(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.

Case 7-3
(a) The following amounts would be reported on the separate-entity financial statements:

Slum’s books Plum’s books

Years 4 + 5 Years 6 through 9
Amortization per year 168,000 / 6 = 28,000 200,000 / 4 = 50,000
Tax Rate 30% 40%
Tax savings per year 8,400 20,000

Gain on Sale at end of Year 5

Proceeds on sale 200,000
Carrying amount (168,000 x 4/6) 112,000
Gain on sale 88,000

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Income tax (@30%) 26,400

The consolidated entity paid taxes of $26,400 at the end of Year 5 and gained a tax saving of
$20,000 - $8,400 = $11,600 per year in Years 6 through 9. In nominal terms, it gained $11,600
x 4 - $26,400 = $20,000. 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., ($88,000 - $26,400) x 40% = $24,640. Since this amount is
greater than the overall tax saving of $20,000, Plum would realize an overall loss of
$4,640 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
$28,000 to $50,000 per year. The extra $22,000 must be eliminated on consolidation so
that only $28,000 of amortization expense is reported on the consolidated income
statement. Income tax on the $22,000 must also be eliminated. Three alternatives are
presented below for the elimination of tax on the excess amortization for each of Years 6
to 9:

Controller Manager Other

Excess amortization $22,000 $22,000 $22,000
Proposed tax rate 30% 40% 52.727%
Tax saving eliminated 6,600 8,800 11,600
Tax saving before adjustment 20,000 20,000 20,000
Tax saving after adjustment 13,400 11,600 8,400

The controller’s suggestion of 30% can be supported on the basis that the total tax eliminated
over 4 years will be $26,400 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 $13,400 on amortization expense of
$28,000 on the consolidated income statement. This is $5,000 per year more than Slum’s tax
saving of $8,400 per year before it sold the machine to Plum. This fairly presents the actual
situation because Plum is achieving an incremental tax benefit of $5,000 per year (i.e. $20,000
overall gain spread over 4 years) as a result of the intercompany transaction.

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The other option can initially be supported on the basis that it would report a tax saving of
$8,400 on amortization expense of $28,000 on the consolidated income statement which is
consistent with what was reported before the intercompany transaction occurred. However, it
would eliminate a total of $46,400 of tax over 4 years, which is $20,000 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, CPA
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.

Changes in capital structure

If the convertible debentures are, in substance, permanent equity of CDL, then their classification
as shareholders' equity is appropriate and gives the proper presentation of the economic
substance of the transaction. Therefore, it is necessary to determine whether these debentures
are, in substance, equity or debt.

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

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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.

Future financial solvency

Although it is impossible to assess the company's solvency 20 years from now with accuracy, it is
important to assess the financial stability and trends. This will provide insight into whether the
company will be able to meet the solvency tests required to force conversion. Financial solvency is
unlikely to be a concern in 20 years’ time in light of the following: the size of the company (lots of
equity); publicly held debt (major financial institutions will have debt covenants aimed at solvency);
and diversification that should insulate the company from shocks to one sector of the economy.

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.
 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
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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.

Redeemable preferred shares

Two issues need to be considered with respect to the redeemable preferred shares: their
classification on the balance sheet (same issue as the convertible debentures), and their
measurement on the balance sheet.

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.

Measurement of the conversion

There are three alternatives for recording the conversion:
1) Record at $20 million
This alternative is supported by the historic cost concept. The cost to CDL of the preferred
shares is $20 million. This approach would be reinforced if the $20 million were the legal,
stated amount (i.e., the paid-in amount). CDL could then appropriate retained earnings for the
future payment of $20 million.
2) Record at $40 million
The $40 million represents the effective "stake" of the shareholder in CDL. The excess $20
million should first be charged against contributed surplus, and then the balance charged
against retained earnings.
3) Amortize $20 million over 5 years
This alternative would gradually reflect the increase in the effective stake of the shareholder
over the five-year term. Since the shares are classified as debt, the charge would be to income.

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.
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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.

Disposal of residential real estate segment

In substance, all that has happened to CDL is that it sold the residential real estate operations.
However, control over the assets of the commercial division did not change since CDL
controlled these assets both before and after this series of transactions. Therefore, under the
historic cost concept, the assets of the commercial division should remain at carrying amounts.
In RPI's case, the assets should be recorded at historical cost for the following reasons:
 There is not a new economic entity.
 The fair values were not determined at arm's length, as the buyer had nothing to lose if an
inflated price was chosen.
 Appraisal increments (which we could obtain) would be accepted if there had been a
reorganization of capital.
RPI for its separate entity financial statements and CDL for it consolidated financial statements
could use the revaluation model in IAS 16 to value the assets of the commercial division at fair
value. However, it would have to do so on an ongoing basis and not on a one-shot deal.

Case 7-5

Memo to: File

Subject: Accounting Issues for BSL group of companies

Given the changes at BSL during the year, new accounting treatments will be applied. It
appears that Jack has incorrectly handled some of the new situations from an accounting
perspective. Because the changes typically affect more than one of the companies, they have
been discussed from a transactional level rather than an entity level.

Fuel Tank Installation Sales

Revenue — Multiple deliverables

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The revenue generated from selling the installation and maintenance package possibly has
three distinct streams of revenue: the revenue related to the fuel tank sale, the delivery and
installation service of the fuel tank at the client’s site, and the five-year ongoing maintenance
contract for the fuel tank. The total revenue that will be derived from the sale of the entire fuel
tank package is $40,000.

If there is objective and reliable evidence of fair value for all units of accounting in an
arrangement, the arrangement consideration should be allocated to the separate units of
accounting based on their relative fair values. In this case, we need to determine if the tank
itself, the delivery and installation costs, and the maintenance package represent separate units
of accounting. The items are considered as separate units of accounting if:
1) The item has value to the customer on a stand-alone basis; the item has value on a stand-
alone basis if it is sold separately by any vendor or the customer could resell the delivered
item on a stand-alone basis. In the context of a customer's ability to resell the delivered item,
this criterion does not require the existence of an observable market for that deliverable.
2) There is objective and reliable evidence of the fair value of the item; and
3) The items include arrangements with respect to general rights of return (if applicable).

Fair value of delivery and installation

Based on the information provided by Jack, Tanks doesn’t sell the tank without installing it.
However, other vendors sell the installation separately from the tank, for the same tanks.
Therefore, a fair value can be established for the delivery and installation component.

Fair value of maintenance contract

The value of the maintenance package can be calculated as follows: 5 years × $5,000 per year
(fair market value), which totals $25,000. Therefore, if the total revenue generated from the sale
of one tank is $40,000, $15,000 should be allocated to the sale and installation of the unit and
$25,000 should be allocated to the maintenance package.

The maintenance contract therefore appears to meet the criteria to be considered a separate
unit of accounting and should be accounted for as such. The value allocated to the maintenance
package should be accounted for as deferred revenue. The amounts will be brought into income
as the maintenance services are rendered over time.

Revenue-Recognition — Delivery and Installation Delays

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We also need to consider the fact that delivery and installation are delayed and only happen two
to three weeks after the agreement is signed. Revenue recognition says performance should be
regarded as having been achieved when all of the following criteria are met: a) persuasive
evidence of an arrangement exists; b) delivery has occurred or services have been rendered;
and c) the seller’s price to the buyer is fixed or determinable. In this case, there is a signed
agreement, but delivery and installation are delayed (two to three weeks later), so Tanks cannot
recognize the revenue at the point of signing the contract. It must wait until terms of the contract
are fulfilled — in other words, the point of customer acceptance, which in this case is when the
tank is installed and working — to recognize the revenue.

Related Party Transactions

There are many related party transactions taking place this year due to the creation of the two
new subsidiaries. Upon consolidation, complete elimination of unrealized intercompany gains or
losses and adjustments of applicable income. At an individual company level, related party
transactions will have to be properly accounted for.

The sale of the trucks and trailers to Transport appears to have been handled incorrectly. BSL
and Transport have both recorded this transfer, which took place after the subsidiary was set
up, at the exchange amount, shown by the $84,000 gain appearing on BSL’s income statement
and the $400,000 of property, plant and equipment appearing on Transport’s balance sheet
($431,000 purchase price less approximately $31,000 of amortization for the period).

The sale of trucks and trailers by BSL to Transport represents a related party transaction that is
not in the normal course of operations for either of these businesses, since a sale of a capital
asset is not considered to be in the course of normal operations. Secondly, because Transport
is a 100%-owned subsidiary, the ownership has not significantly changed. For these two
reasons, the carrying amount must be used to value this transaction. There is no impact at the
consolidated level because the transaction would be eliminated.

For Transport, the assets (trucks and trailers) must be recorded at their carrying amount of
$347,000, and the difference between the assets and the note payable of $431,000 ($84,000)
would be a reduction to equity.

The other related party transactions between BSL and its subsidiaries (Transport and Tanks),
the interest payments and the rent for the property (which are both at fair market value), are in
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the normal course of business and should be recorded at the exchange amount (3840.18). Jack
appears to be handling these transactions correctly. There should be disclosure of the fact that
the subsidiaries received free rent from the parent company for the first two months of the year
(in other words, the rent agreement for new location started in March, and based on the rental
income in the financial statements, rent was free prior to that date).

Management may wish to disclose the guarantee made to the environmental authority by BSL
related to Tanks’ operating license in the notes to the consolidated audited financial statements
because it increases the overall risk of BSL on a consolidated basis. In Tanks’ stand-alone
statement, management needs to consider whether it should disclose the fact that Tanks
benefits from a guarantee from BSL of Tanks’ obligations since it is being provided for free. It is
likely that this related party transaction should be disclosed.

Capitalization of Training Costs and License

Assets are economic resources controlled by an entity as a result of past transactions or events
and from which future economic benefits may be obtained. An intangible asset must be
identifiable, the entity must have control over the resource, and there must be future economic
benefits. If an item does not meet the definition of an intangible asset, it is recognized as an
expense when it is incurred.

Tanks has capitalized the $20,000 of training costs incurred to have Sean Piper certified as a
fuel tank installer. While it might be argued that there are future benefits to Sean Piper being
certified in order to operate the business and legally earn revenue, training costs are generally
not capitalized under Canadian GAAP. It is too difficult to ascertain a) whether there will actually
be any benefits (future revenue), and b) if there are, the appropriate period over which to
amortize the benefits. In this particular case, the main reason for the uncertainty is that there is
no way of guaranteeing that Sean will stay. Even though he owns 25% of the company, he
could decide tomorrow to leave or to stop being an installer. Therefore, there is no way of
controlling the use of the asset. Tanks should therefore expense the training costs in the year
incurred. The Handbook provides examples of expenditures that are not part of the cost of an
intangible, and training costs are included on that list, making the recommended treatment
option even clearer.

However, we have noted that the value of the license itself does not appear to have been
recorded as an intangible asset in Tanks. There is no indication of the cost of the license or how
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long it is good for, but if the amount is large enough and has future benefit to Tanks,
management may want to capitalize the cost as an intangible asset.

Inventory Valuation
The owners have decided to stockpile scrap metal inventory this year. In the past, scrap metal
was not a material amount ($10,000 on the balance sheet of BSL). BSL is stockpiling the
inventory because management expects the price at which they can sell the metal to increase
above normal conditions.

In addition to establishing the inventory quantity, BSL needs to ensure it has properly valued its
large inventory of scrap metal in order to ensure that the inventory has been accounted for in
accordance with GAAP; in other words, at the lower of cost or net realizable value (NRV). The
challenge in establishing the NVR of the entire inventory amount is coming up with the quantity.
The metal prices should be fairly easy for management to obtain since there is a market for
scrap metal.

The Non-Controlling Interest (In Consolidated Financial Statements)

The non-controlling interest is the equity in a subsidiary not attributable, directly or indirectly, to
a parent. In this case, there is a non-controlling interest of 25% in Tanks, the portion owned by
Sean Piper. BSL will have to properly account for the non-controlling interest when it prepares
its consolidated financial statements.

Non-controlling interest should be presented in the consolidated statement of financial position

within equity, separately from the equity of the owners of the parent. The consolidated income
statement should present separately the net income attributable to owners of the parent and to
non-controlling interest.

Warranty Provision
There may be a need for a warranty provision related to the tank installations. Additional
information is required to ascertain if this is the appropriate accounting treatment.

Asset Retirement Obligation

There may be a need to establish a liability related to the stockpile of scrap metal. The large
amounts of metal, if exposed to the elements, will likely rust, potentially creating a chemical
runoff. BSL would be responsible for either preventing the runoff or cleaning it up. Depending on
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the legislative requirements related to the license held, there may be a contingent liability
relating to Tanks’ license with the environmental authority. An environmental liability may
actually need to be accrued. More information is required.

Case 7-6
To: Partner
From: CPA
Subject: Enviro Facilities Inc. Engagement

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.

No single one of these circumstances provides compelling evidence of questionable

management integrity. Changing accounting estimates is commonplace and often justifiable.
There has been no conviction on the patent infringement suit and nuisance lawsuits are not
unusual. An aggressive approach to tax can be in the interests of the shareholders, and the
rumour regarding the affiliated company is just that: a rumour. Collectively however, these
events give a hint that management may lack integrity, thus increasing the risk associated with
the engagement.

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

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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
available for the shares. Furthermore, EFI operates in an industry where the valuation of assets
is very subjective and requires estimates.

Provincial sales tax audit

The amount under investigation by the provincial auditors is $6,314,000 ($451,000,000 x 7% x
20%), which is greater than the materiality threshold. The result of the sales tax audit must
therefore be carefully considered to determine whether and how it should be reported in the
statements. The situation is difficult to assess because the audit is continuing and there has not
yet been an assessment or even an indication by the provincial auditors of what they have
determined. If they rule against EFI, both the balance sheet and the income statement will be
affected. A negative ruling will increase the cost of the items purchased. Long-lived assets on
the balance sheet will increase by the amount of the tax reassessment. That amount will be
amortized to the income statement over the lives of the assets. Thus the income statement will
reflect the portion of the tax that relates to the amortized portion of the assets. Similarly, the
income statement will be affected by tax pertaining only to supplies that have been expensed.
The effect on income is important because prospective purchasers in deciding what price to pay
for EFI’s shares may rely on the statement. Once we receive the notice of assessment from the
government, we will be able to evaluate whether the interpretation by the auditor is correct.

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 $6,314,000 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 $7,459,168 ($9,000,000 –
$10,000,000 / 6.49), 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
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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 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.

Patent infringement award

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 a $20 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 $20
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 $20 million, they must be worth $20 million. If the market value is less than
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$20 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
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.

Waste-disposal sites

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.

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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.

Locating and negotiating costs

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
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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
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 $3.4 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 $3.4 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.

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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.

Affiliated company dumping/purchases of disposal sites

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.

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.

New cost-accounting system

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
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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
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

Asset profit – X Company selling

April 30, Year 3 – sale 60,000 24,000 36,000
Depreciation Year 3 (12,000  8/12) 8,000 3,200 4,800
Balance December 31, Year 3 52,000 20,800 31,200 (c)
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Investment in Y Company

Balance January 1, Year 2 $ 86,900)

Year 2 transactions:
Increase in Y Company retained earnings
([125,000 – 70,000]  80%) 44,000)
X’s share of acquisition differential amortization * (1,150)
Holdback of Year 2 asset profit (net) ((a) 21,600  80%) (17,280)
Year 3 transactions:
Increase in Y Company retained earnings
([104,000 – 70,000])  80%) 27,200)
Acquisition differential amortization (*) (1,150)
Realization of Year 2 asset profit ((b) 5,400  80%) 4,320)
Holdback of Year 3 asset profit (net) (c) (31,200)
Balance December 31, Year 3 $111,640)

* (86,900 / 80% – 100,000) x 80% / 6 =1,150

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 3,600 (b)

(a) Calculation of consolidated profit attributable to Peggy’s shareholders for Year 4

Profit of Peggy 185,000

Profit of Sally 53,000
Add: Equipment gain realized (a) 1,800
Adjusted profit 54,800 (c)

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Consolidated profit 239,800

Attributable to:
Shareholders of Peggy 226,100
NCI (25% x 54,800) 13,700
239,800

(b) Peggy Company

Consolidated Income Statement
Year 4

Revenues (580,000 + 270,000) $850,000

Miscellaneous expense (110,000 + 85,000) 195,000
Depreciation expense (162,000 + 97,000 - (a) 3,000) 256,000
Income tax expense (123,000 + 35,000 + (a) 1,200) 159,200
Total expenses 610,200
Consolidated profit 239,800
Attributable to:
Shareholders of Peggy 226,100
NCI (25% x 54,800) 13,700
239,800

(c) Deferred income taxes - December 31, Year 4 (b) 2,400

Problem 7-3
Intercompany profits – subsidiary selling

Before tax 40% tax After tax

Equipment
Gain on sale, Sept. 30, Year 5 $28,000 $11,200 $16,800
Depreciation Year 5
(28,000 / 5  3/12) 1,400 560 840 (a)
Balance, Dec. 31, Year 5 26,600 10,640 15,960 (b)
Depreciation Year 6 (28,000 / 5) 5,600 2,240 3,360 (c)
Balance, Dec. 31, Year 6 $21,000 $8,400 $12,600
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Building
Gain on sale, Jan. 1, Year 6 $59,500 $23,800 $35,700
Depreciation Year 6 (59,500 / 7) 8,500 3,400 5,100 (d)
Balance, Dec. 31, Year 6 $51,000 $20,400 $30,600 (e)

Intercompany Rent
Year 5 (42,000  3/12) $10,500 (f)

Year 6 $42,000 (g)

Calculation of consolidated net income

Year 5 Year 6
Incorrectly reported income $185,000 $269,000
Add: incorrect amount for NCI 45,000 8,160
Incorrect amount for consolidated net income 230,000 277,160
Less: Net unrealized profits
Equipment (b) (15,960) (h)
Building (e) (30,600) (i)
Add: equipment profit realized (c) 3,360 (i)
Corrected consolidated net income $214,040 $249,920
Attributable to:
Shareholders of Parent $173,030 $248,570
NCI ((45,000 – (25% × (h) 15,960)) 41,010
NCI ((8,160 – (25% × (i) 27,240)) 1,350
$214,040 $249,920

Parent Company
Corrected Consolidated Income Statements
Years 5 and 6
Year 5 Year 6
Miscellaneous revenues $875,000 $950,000
Miscellaneous expense 419,800 497,340
Rent expense (70,200 – (f) 10,500) 59,700
(71,800 – (g) 42,000) 29,800
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Depreciation expense (100,000 – (a) 1,400) 98,600

(98,200 – (c) 5,600 – (d) 8,500) 84,100
Income tax expense (93,500 – (b) 10,640) 82,860
(107,000 + (c) 2,240 – (e) 20,400) 88,840
Consolidated net income $214,040 $249,920
Attributable to:
Shareholders of Parent $173,030 $248,570
NCI (45,000 – (25% x (h) 15,960)) 41,010
NCI (8,160 – (25% x (i) 27,240)) 1,350
$214,040 $249,920

Problem 7-4
(a) Before tax 40% tax After tax
Equipment (Parent selling)
Gain on sale, Dec. 31, Year 2 $500,000 $200,000 $300,000 (a)
Depreciation Year 3
(500,000 / 5) 100,000 40,000 60,000 (b)
Balance, Dec. 31, Year 3 400,000 160,000 240,000 (c)
Depreciation Year 4 100,000 40,000 60,000 (d)
Balance, Dec. 31, Year 4 $300,000 $120,000 $180,000 (e)
Dividends received by Hanna from Fellow (200,000 x 80%) 160,000 (f)

Equipment (7,000,000 + 4,000,000 – (a) 500,000) $10,500,000

Accumulated depreciation (2,700,000 + 1,450,000 – (b + d) 200,000) 3,950,000
Retained earnings, beginning of year, for Hanna $5,000,000
Unrealized gain, beginning of year (c) 240,000
4,760,000
Retained earnings, beginning of year, for Fellow 3,000,000
Retained earnings, date of acquisition 2,100,000
Change since acquisition 900,000
Hanna’s share x 80%
720,000
Consolidated retained earnings, beginning of year $5,480,000
Depreciation expense (800,000 + 610,000 – (d) 100,000) 1,310,000
Net income for Hanna 1,500,000
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Dividends from Fellow (f) (160,000)

Realized gain on sale of equipment (d) 60,000
1,400,000
Net income for Fellow 550,000
Hanna’s share x 80%
440,000
Consolidated net income 1,840,000
Dividends declared (only Hanna’s dividends declared) 500,000

(b)
Equipment (same as above) $10,500,000
Accumulated depreciation (same as above) 3,950,000

Retained earnings, beginning of year, for Hanna $5,000,000

Retained earnings, beginning of year, for Fellow 3,000,000
Retained earnings, date of acquisition 2,100,000
Change since acquisition 900,000
Unrealized gain, beginning of year (c) 240,000
660,000
Hanna’s share x 80%
528,000
Consolidated retained earnings, beginning of year 5,528,000

Depreciation expense (same as above) 1,310,000

Net income for Hanna 1,500,000
Dividends from Fellow (f) (160,000)
1,340,000
Net income for Fellow 550,000
Realized gain during Year 4 (d) 60,000
610,000
Hanna’s share x 80%
488,000
Consolidated net income 1,828,000
Dividends declared (same as above) 500,000
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Problem 7-5
(a) (in 000s) i) ii) iii) iv)
NORD’s own income 200 200 200 200
HABS’s own income 500 500
Less: unrealized profit (500) (500)
HABS’s adjusted income 0 0
Consolidated net income 200
NORD’s ownership 75%
NORD’s share of HABS’s income 0
Dividend income from HABS (75% x 100) 75
NORD’s total income 200 200 275
Consolidated net income attributable to:
NORD’s shareholders 200
NCI (75% x 0) 0
200

(b) (in 000s) i) ii) iii) iv)

HABS’s own income 500 500 500 500
Less: unrealized profit - 500 - 500
HABS’s adjusted income 0 0
Dividend income from NORD (75% x 100) 75
NORD’s own income 200 200
Consolidated net income 200
HABS’s ownership 75%
HABS’s share of NORD’s income . 150 .
HABS’s total income 500 150 575
Consolidated net income attributable to:
HAB’s shareholders 150
NCI (25% x 200) 50
200
(c)
We can make the following observations about the income reported under the different reporting
methods:

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1. Net income under the equity method is equal to consolidated net income attributable to
parent’s shareholders because the unrealized profit is eliminated in both situations.
2. The full amount of unrealized profit is eliminated regardless of whether the transaction is
upstream as per part (a) or downstream as per part (b).
3. Unrealized profit is not eliminated under the cost method.
4. Income under cost method will be higher than income under the equity method and
consolidated net income attributable to parent’s shareholders when dividends received
from the investee exceed the investor’s share of the investee’s adjusted net income.

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 7-6

Calculation, allocation, and amortization of the acquisition differential

Cost of investment, July 1, Year 1 207,900

Implied value of 100% (207,900 / .9) 231,000
Total shareholders' equity of Garden 175,000
Acquisition differential 56,000
Allocation: FV – CA
Inventory 12,000
Buildings 10,000
Patents 16,000 38,000
Balance – goodwill 18,000

Amortization
Balance Balance
July 1/1 Years 1 to 7 Year 8 Dec. 31/8

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Inventory 12,000 12,000

Buildings (10 years) 10,000 6,500 1,000 2,500 (a)
Patents (8 years) 16,000 13,000 2,000 1,000 (b)
Goodwill 18,000 1,950 7,150 8,900
56,000 33,450 10,150 12,400 (c)

Intercompany receivables and payables

On open account 22,000 (d)
Dividends (30,000  90%) 27,000 (e)

Intercompany profits and losses

Before tax 40% tax After tax
Opening inventory - Forest selling
(18,000  30%) 5,400 2,160 3,240 (f)
Ending inventory - Forest selling
(22,000  30%) 6,600 2,640 3,960 (g)

Land profit - Garden selling

August 1, Year 6 18,000 7,200 10,800 (h)
Sale of ¼ of land, Year 8 4,500 1,800 2,700 (i)
Balance, Dec. 31, Year 8 13,500 5,400 8,100 (j)

Intercompany bond transactions

Cost to retire bonds 57,968
Carrying amount on bonds retired (93,376  60/100)56,026
Loss to the entity Jan. 1, Year 8 1,942 777 1,165
Interest elimination gain [(k) 882 – (m) 458] 424 170 254
Balance loss, Dec. 31, Year 8 1,518 607 911

Par value (100,000  60%) 60,000

Carrying amount (93,376  60%) 56,026
Loss to Forest 3,974 1,590 2,384)
Interest elimination gain (56,026 x 8% - 60,000 x 6%) 882 353 529)
Balance loss Dec. 31, Year 8 3,092 1,237 1,855) (l)

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Par value 60,000

Cost to Garden 57,968
Gain to Garden 2,032 813 1,219)
Interest elimination loss (57,968 x 7% - 60,000 x 6%) 458 183 275)
Balance gain Dec. 31, Year 8 1,574 630 944) (n)

Deferred income taxes, Dec. 31, Year 8

Ending inventory (g) 2,640
Land (j) 5,400
Bond loss [(l) 1237 – (n) 630] 607 8,647) (o)

Garden’s accumulated depreciation, date of acquisition 95,000 (p)

Calculation of consolidated net income Year 8

Income of Forest 41,000)
Less: Dividends from Garden (50,000  90%) 45,000
Unrealized profit in ending inventory (g) 3,960
Realized loss on bonds (net) (l) 1,855 50,815)
(9,815)
Add: realized profit in opening inventory (f) 3,240)
Adjusted net income (loss) (6,575)
Income of Garden 63,000
Add: Realized bond gain (net) (n) 944
Realized gain on land (i) 2,700 3,644
66,644
Less: Amortization of the acquisition differential (c) 10,150
Adjusted income 56,494
Consolidated net income, Year 8 49,919
Attributable to:
Shareholders of Forest 44,270
NCI (10% x 56,494) 5,649
49,919

Calculation on consolidated retained earnings – Jan. 1, Year 8

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Retained earnings of Forest, Jan. 1, Year 8 64,000

Less: Unrealized profit in opening inventory (f) 3,240
Adjusted retained earnings 60,760
Retained earnings of Garden, Jan. 1, Year 8 126,000
Retained earnings of Garden at acquisition (175,000 – 150,000) 25,000
Increase 101,000
Less: Amortization of acquisition differential (c) 33,450
Unrealized profit on land (h) 10,800
Adjusted increase 56,750
Forest's ownership % 90% 51,075
Consolidated retained earnings, Jan. 1, Year 8 111,835

Calculation of non-controlling interest – Dec. 31, Year 8

Common shares 150,000

Retained earnings 139,000
Total shareholders' equity 289,000
Add: Unamortized acquisition differential (c) 12,400
Realized bond gain (net) (n) 944
302,344
Less: unrealized profit on sale of land (j) 8,100
Adjusted shareholders' equity 294,244
Non-controlling interest’s share 10%
Non-controlling interest, Dec. 31, Year 8 29,424

(a) (i) Forest Company

Consolidated Balance Sheet
December 31, Year 8

Cash (13,000 + 48,800) 61,800

Receivables (25,000 + 86,674 – (d) 22,000 – (e) 27,000) 62,674
Inventories (80,000 + 62,000 – (g) 6,600) 135,400
Plant and equipment (740,000 + 460,000 + (a) 10,000 – (j) 13,500 – 95,000 1,101,500
Accumulated depreciation (625,900 + 348,400 + (a) 7,500 – 95,000)) (886,800)
Patents (0 + 4,500 + (b) 1,000) 5,500
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Goodwill 8,900
Deferred income taxes (o) 8,647
Total assets 497,621

Current liabilities (59,154 + 53,000 – (d) 22,000) 90,154

Dividends payable (6,000 + 30,000 – (e) 27,000) 9,000
6% bonds payable (94,846  40%) 37,938
Common shares 200,000
Retained earnings (see part (a) (ii)) 131,105
Non-controlling interest 29,424
Total liabilities and shareholders' equity 497,621

(a) (ii) Forest Company

Consolidated Retained Earnings Statement
Year 8
Retained earnings, Jan. 1 111,835)
Add: net income 44,270)
156,105)
Less: dividends 25,000)
Retained earnings, Dec. 31 131,105)

(b)
Dec. 31 Investment in Garden Company 50,845
Equity method income 50,845
To record 90% of adjusted subsidiary income
(56,494*  90%)

Dec. 31 Cash 45,000

Investment in Garden Company 45,000
To record 90% of Garden's dividend of 50,000

Equity method income 2,575

Investment in Garden Company 2,575
To record the adjustments to parent’s net income
(3,960 + 1,855 – 3,240)
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* see the calculation of consolidated net income.

(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 7-7
(a) Before tax 40% tax After tax
Equipment (Subsidiary selling)
Gain on sale, Jan. 1, Year 5 $240,000 $96,000 $144,000 (a)
Depreciation for January, Year 6
($240,000 / 4 / 12) 5,000 2,000 3,000 (b)
Balance, Jan. 31, Year 6 $235,000 $94,000 $141,000 (c)
Dividends received by Goodkey from Jingya (600,000 x 100%) 600,000 (d)

Goodkey Co.
Consolidated Income Statement
For month ended January 31, Year 5
Sales (10,000,000 + 6,000,000) $16,000,000
Gain on sale of equipment (0 + 240,000 – (a) 240,000) 0
Other income (800,000 + 50,000 – (d) 600,000) 250,000
16,250,000
Depreciation expense (450,000 + 180,000 – (b) 5,000) 625,000
Other expenses (6,600,000 + 4,300,000) 10,900,000
Income tax expense (1,220,000 + 719,000 – (a) 96,000 + (b) 2,000) 1,845,000

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13,370,000
Net income $2,880,000
Attributable to:
Shareholders of parent $2,880,000
Non-controlling interest 0

(b)
Everything would be the same except for other income on Goodkey’s separate entity income
statement. Under the equity method, it should exclude the dividends received from Jingya and
should include Goodkey’s share of Jingya’s net income from a consolidated viewpoint, which is
$190,000 calculated as follows:

Jingya’ net income $1,091,000

Unrealized gain from sale of equipment (c) 141,000
950,000
Goodkey's share x 100%
Equity method income $950,000 (e)
Goodkey’s other income should be (800 – (d) 600 + (e) 950) 1,150,000
Goodkey’s net income will now be $2,880,000 ($2,530,000 – $800,000 + $1,150,000), which is
equal to consolidated net income attributable to Goodkey’s shareholders.

(c)
Everything would remain the same as in part (a) except for the following:
Goodkey’s other income (800 – (d) 600 + 80% x (d) 600) 680,000
Consolidated net income would remain the same at $2,880,000 but it would be attributable
as follows:
Attributable to:
Shareholders of parent (2,880 – 190) $2,690,000
Non-controlling interest ([1,091 – (c) 141] x 20%) 190,000

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Problem 7-8
(a)
Acquisition differential – buildings 1,250 (a)
Yearly amortization (25,000 / 20)

Intercompany revenues and expenses

Interest revenue and expense (12,000  ½) 6,000 (b)

Rental revenue and administrative expense 50,000 (c)

Sales and purchases 90,000 (d)

Intercompany profits
Before tax 40% tax After tax
Land gain – M selling
realized in Year 9 10,000 4,000 6,000 (e)

Opening inventory – K selling 12,000 4,800 7,200 (f)

Ending inventory – K selling 5,000 2,000 3,000 (g)

Machinery gain – M selling

realized by depreciation in Year 9
(13,000  5) 2,600 1,040 1,560 (h)

Calculation of non-controlling interest in profit of K Company – Year 9

Income of K 25,500
Add: realized profit in opening inventory (f) 7,200
32,700
Less: Amortization of acquisition differential (a) 1,250
Unrealized profit in ending inventory (g) 3,000
Adjusted profit 28,450

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Non-controlling interest’s share 20%

Non-controlling interest, Year 9 5,690 (i)

M Co.
Consolidated Income Statement
Year 9
Sales (600,000 + 350,000 – (d) 90,000) $860,000
Interest revenue (6,700 – (b) 6,000) 700
Gain on land sale (8,000 + (e) 10,000) 18,000
Total revenues 878,700
Cost of goods sold
(334,000 + 225,000 – (d) 90,000 – (f) 12,000 + (g) 5,000) 462,000
Distribution expense (80,000 + 70,000 – (h) 2,600 + (a) 1,250) 148,650
Administrative expense (147,000 + 74,000 – (c) 50,000) 171,000
Interest expense (1,700 + 6,000 – (b) 6,000) 1,700
Income tax expense
(20,700 + 7,500 + (e) 4,000 + (f) 4,800 – (g) 2,000 + (h) 1,040) 36,040
Total expenses 819,390
Profit 59,310
Attributable to:
Shareholders of M 53,620
Non-controlling interest (i) 5,690
$ 59,310

(b)
M Co.
Income Statement
December 31, Year 9
Sales $600,000
Interest revenue 6,700
Dividend income from subsidiary (20,000 x 80%) 16,000
622,700
Cost of goods sold 334,000
Distribution expense 80,000
Administrative expense 147,000
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Interest expense 1,700

Income tax expense 20,700
583,400
Profit $ 39,300

Problem 7-9
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
Inventory (12,000)
Land 50,000
Plant and equipment 70,000 108,000 75,600 32,400
Balance – goodwill 30,000 29,400 600

Balance Amortization Balance

Jan. 1/6 Years 6 to 11 Dec. 31/11
Inventory (12,000) (12,000) –
Land 50,000 – 50,000 (a)
Plant and equipment 70,000 21,000 49,000 (b)
108,000 9,000 99,000
Goodwill – parent’s portion 29,400 17,640 11,760
- NCI’s portion 600 360 240
30,000 18,000 12,000 (c)
Total 138,000 27,000 111,000

Intercompany profits and losses

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Before tax 40% tax After tax

Intercompany bonds – Dec. 31, Year 11

Investment in Gold Co. bonds
(230,000 – [30,000/10]) 227,000
Bonds payable
(477,500  [200,000 / 500,000]) 191,000
Realized loss – entity 36,000 14,400 21,600 (d)

Investment 227,000
Par value 200,000
Realized loss to Pure 27,000 10,800 16,200

Par value 200,000

Carrying amount 191,000
Realized loss to Gold 9,000 3,600 5,400 (e)

Patent – Gold selling

Selling price, July 1, Year 8 63,000
Carrying amount 42,000
Gain on sale 21,000 8,400 12,600
Amort. to Dec. 31, Year 11
([21,000/7]  3½) 10,500 4,200 6,300
Balance, Dec. 31, Year 11 10,500 4,200 6,300 (f)

Deferred income taxes, Dec. 31, Year 11

Gain on patent (f) 4,200
Loss on bonds (d) 14,400 18,600 (g)
Gold’s accumulated depreciation, date of acquisition 75,000 (h)

Calculation of non-controlling interest – Dec. 31, Year 11

Ordinary shares 500,000

Retained earnings 200,000
Total shareholders' equity – Gold 700,000
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Less: Unrealized gain on sale of patent (f) 6,300

Realized loss on sale of bond (e) 5,400 11,700)
Adjusted shareholders' equity 688,300)
Non-controlling interest’s share 30%
206,490
Share of acquisition differential
- other than goodwill (30% x 99,000) 29,700
- goodwill 240 29,940
236,430
Pure Company
Consolidated Statement of Financial Position
December 31, Year 11

Land (100,000 + 150,000 + (a) 50,000) 300,000)

Plant and equipment (625,000 + 940,000 + (b) 70,000 – (h) 75,000) 1,560,000)
Less: accumulated depreciation
(183,000 + 220,000 + (b) 21,000 – (h) 75,000) (349,000)
Patent (net) (31,500 – (f) 10,500) 21,000)
Goodwill (c) 12,000)
Deferred income taxes (g) 18,600)
Inventory (225,000 + 180,000) 405,000)
Accounts receivable (212,150 + 170,000) 382,150)
Cash (41,670 + 57,500) 99,170)
Total assets 2,448,920)

Ordinary shares 750,000)

Retained earnings 1,019,960)
Non-controlling interest 236,430)
Bonds payable (477,500  [300,000 / 500,000]) 286,500)
Accounts payable (56,030 + 100,000) 156,030)
Total liabilities and shareholders' equity 2,448,920)

Problem 7-10
Calculation, allocation, and amortization of acquisition differential

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Cost of 80% investment in Spruce Ltd., Jan. 2, Year 4 2,000,000

Implied value of 100% 2,500,000
Carrying amounts of Spruce's net assets:
Common shares 500,000
Retained earnings 1,250,000
Total shareholders' equity 1,750,000
Acquisition differential 750,000
Allocation: FV – CA
Mineral rights 750,000
Balance 0

Balance Amortization Balance

Jan. 1/4 Years 4 to 6 Year 7 Dec. 31/7

Mineral rights 750,000 (a) 0 (b) 0 750,000 (c)

Intercompany sales and purchases 1,000,000 (d)

Intercompany profits

Before tax 40% tax After tax

Equipment Jan. 2/5 – Spruce selling
(500,000 – 400,000) 100,000 (e)
Depreciation Years 5 and 6 40,000
Balance, Dec. 31, Year 6 60,000 24,000 36,000 (f)
Depreciation, Year 7 20,000 8,000 12,000 (g)
Balance, Dec. 31, Year 7 40,000 16,000 24,000 (h)

Inventory Jan. 1, Year 7 – Spruce selling 200,000 80,000 120,000 (i)

Inventory Dec. 31, Year 7 – Spruce selling 120,000 48,000 72,000 (j)

Spruce’s accumulated depreciation, date of acquisition 600,000 (k)

Deferred income tax – Dec. 31, Year 7

Equipment (h) 16,000

Inventory (j) 48,000
Deferred income tax asset 64,000 (l)

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Calculation of consolidated net income – Year 7

Income of Poplar 1,100,000

Less: Dividend from Spruce (250,000  80%) 200,000
Adjusted net income 900,000
Income of Spruce 521,500
Less: Amortization of acquisition differential (b) 0
Unrealized profit in closing inventory (j) 72,000
449,500
Add: Realized profit in opening inventory (i) 120,000
Equipment profit realized (g) 12,000 132,000
Adjusted net income 581,500 (m)
Consolidated net income 1,481,500
Attributable to:
Shareholders of Poplar 1,365,200
NCI (20% x 581,500) 116,300
1,481,500

(a) (i) Poplar Ltd.

Consolidated Income Statement
Year 7

Sales (4,900,000 + 2,000,000 – 1,000,000 (d)) 5,900,000

Interest revenue (0 + 21,500) 21,500
Total revenues 5,921,500
Cost of goods sold
(2,400,000 + 850,000 – (d) 1,000,000 – (i) 200,000 + (j) 120,000) 2,170,000
Other expenses (962,000 + 300,000 – (g) 20,000) 1,242,000
Interest expense (38,000 + 0) 38,000
Income tax expense
(600,000 + 350,000 + (i) 80,000 – (j) 48,000 + (g) 8,000) 990,000
Total expenses 4,440,000
Net income 1,481,500
Attributable to:
Shareholders of Poplar 1,365,200
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NCI (20% x 581,500) 116,300

1,481,500

Calculation of consolidated retained earnings – Jan. 1, Year 7

Retained earnings of Poplar, Jan. 1, Year 7 10,000,000
Retained earnings of Spruce, Jan. 1, Year 7 2,000,000
At acquisition 1,250,000
Increase 750,000
Less:
Unrealized profit in opening inventory (i) 120,000
Unrealized profit in equipment (f) 36,000
Adjusted increase 594,000 (n)
Poplar's ownership % 80% 475,200
Consolidated retained earnings, Jan. 1 Year 7 10,475,200

(ii) Poplar Ltd.

Consolidated Statement of Retained Earnings
Year 7

Retained earnings, Jan. 1, Year 7 $10,475,200

Add: net income 1,365,200
11,840,400
Less: dividends 600,000
Retained earnings, Dec. 31, Year 7 $11,240,400

Calculation of non-controlling interest – Dec. 31, Year 7

Common shares of Spruce 500,000)

Retained earnings of Spruce, Jan. 1, Year 7 2,000,000)
Net income, Year 7 521,500)
Dividends, Year 7 (250,000)
Total shareholders' equity, Dec. 31, Year 7 2,771,500)
Less: Unrealized equipment profit (h) 24,000
Unrealized profit in ending inventory (j) 72,000 96,000)
2,675,500)
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Add: Unamortized acquisition differential (c) 750,000

Adjusted shareholders' equity, Spruce 3,425,500)
Non-controlling interest’s share 20%
Non-controlling interest, Dec. 31, Year 7 685,100)

(iii) Poplar Ltd.

Consolidated Balance Sheet
Dec. 31, Year 7
Cash (1,000,000 + 500,000) 1,500,000)
Accounts receivable (2,000,000 + 356,000) 2,356,000)
Inventory (3,000,000 + 2,006,000 – (j) 120,000) 4,886,000)
Plant and equipment (14,000,000 + 2,900,000 – (e) 100,000 – (k) 600,000) 16,200,000)
Accumulated depreciation (4,000,000 + 1,000,000 – (f) 60,000 – (k) 600,000) (4,340,000)
Investment in bonds 488,000
Mineral rights (c) 750,000)
Deferred income taxes (l) 64,000)
Total assets 21,904,000)

Accounts payable (2,492,000 + 2,478,500) 4,970,500

Bonds payable (500,000 + 0) 500,000
Premium on bonds payable (8,000 + 0) 8,000
Common shares 4,500,000
Retained earnings 11,240,400
Non-controlling interest 685,100
Total liabilities and shareholders' equity 21,904,000

(b) Investment Account, Dec. 31, Year 7 - Equity Method

Balance, Dec. 31, Year 7 – cost method 2,000,000

Add: Adjusted increase in Spruce's retained earnings to
Jan. 1, Year 7 (n) 594,000
Poplar's ownership % 80% 475,200
2,475,200
Add: Adjusted income of Spruce, Year 7 (m) 581,500
Poplar's ownership % 80% 465,200
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2,940,400
Less: Dividend from Spruce (250,000  80%) 200,000
Balance, Dec. 31, Year 7 2,740,400

Alternative calculation:
Consolidated retained earnings, Dec. 31, Year 7 11,240,400
Retained earnings – Poplar Dec. 31, Year 7 – cost
method (10,000,000 + 1,100,000 – 600,000) 10,500,000
Difference 740,400
Investment in Spruce – cost method 2,000,000
Investment in Spruce – equity method, Dec. 31, Year 7 2,740,400

(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 7-11
Cost of bonds 150,064
Par value of bonds 800,000 (a)
Less: unamortized discount 73,065 (b)
Carrying amount of bonds 726,935
Intercompany portion (160,000 / 800,000) 20% 145,387
Loss to the entity 4,677 (c)
Tax at 40% 1,871 (d)
Realized loss after tax 2,806 (e)

Cost 150,064 Par 160,000

Par 160,000 Carrying amount 145,387
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Gain to Alpha 9,936 (f) Loss to Beta 14,613 (i)

Tax at 40% 3,974 (g) Tax at 40% 5,845 (j)
Realized gain after tax 5,962 (h) Realized loss after tax 8,768 (k)

Bond Amortization Table for Alpha

Date Effective Interest (6%) Interest Paid (5%) Amortization Balance

Jan 1, Yr 4 150,064
June 30, Yr 4 9,004 8,000 1,004 151,068
Dec 31, Yr 4 9,064 8,000 1,064 152,132
Total 18,068 16,000 2,068 (l)

Bond Amortization Table for Beta

Date Effective Interest (6.5%) Interest Paid (5%) Amortization Balance

Jan 1, Yr 4 726,935
June 30, Yr 4 47,251 40,000 7,251 734,186
Dec 31, Yr 4 47,722 40,000 7,722 741,908
Total 94,973 80,000 14,973
Intercompany (20%) 18,995 16,000 2,995 (m)

Before tax 40% tax After tax

Alpha
Realized gain on bonds (f) 9,936 (g) 3,974 (h) 5,962
Interest elimination loss* (l) 2,068 827 1,241
Balance December 31, Year 4 gain 7,868 3,147 4,721 (n)

Beta
Realized 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

(a) Realized loss on bonds, Year 4 (c) 4,677

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(b) December 31, Year 4

Investment in Beta Corporation 102,600
Equity method income 102,600
90%  114,000 share of Beta's profit

Cash 27,000
Investment in Beta Corporation 27,000
90%  30,000 dividends from Beta

Equity method income 6,274

Investment in Beta Corporation 6,274
Net bond loss allocated to Beta (90%  (o) 6,971)

Investment in Beta Corporation (n) 4,721

Equity method income 4,721
Net bond gain allocated to Alpha

(c) Carrying amount of bonds 741,908

Intercompany portion (20%) 148,382
Consolidated bonds payable December 31, Year 4 593,526

Problem 7-12

Cost of bonds July 1, Year 7 381,250

Par value of bonds 400,000
Less: unamortized discount 20,000
Carrying amount 380,000
Realized loss to entity July 1, Year 7 (before tax) 1,250 (a)

Par value 400,000

Cost of bonds 381,250
Realized gain to Parent Co. (before tax) 18,750 (b)
Par value 400,000
Carrying amount (400,000 – 20,000) 380,000

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Realized loss to Sub. Co. (before tax) 20,000 (c)

Before tax 40% tax After tax

Entity
Realized loss (gain) July 1, Year 7 (a) 1,250 500 750 (d)
Interest elimination gain (loss) Year 7* 125 50 75 (e)
Balance loss (gain) Dec. 31, Year 7 1,125 450 675

Parent Co.
Realized loss (gain) July 1, Year 7 (b) (18,750) (7,500) (11,250)
Interest elimination gain (loss)
Year 7* (1,875) (750) (1,125)
Balance loss (gain) Dec. 31, Year 7 (16,875) (6,750) (10,125) (f)

Sub. Co.
Realized loss (gain) July 1, Year 7 (c) 20,000 8,000 12,000
Interest elimination gain (loss)
Year 7* 2,000 800 1,200
Balance loss (gain) Dec. 31, Year 7 18,000 7,200 10,800 (g)

* 10 interest periods to maturity

Intercompany interest revenue

(400,000  10%  ½ + [(b) 18,750 / 5  ½]) =
21,875 (h)
Intercompany interest expense
Interest expense (400,000  10%) 40,000
Discount amortization ([20,000 / 10 periods]  2) 4,000
Total interest expense for the year 44,000

Interest expense July 1 to Dec. 31, Year 7 22,000 (i)

Gain on elimination of intercompany revenues and expenses 125

Calculation of consolidated net income, Year 7

Income of Parent Co. 197,875
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Add: Realized net bond gain (f) 10,125

Adjusted net income 208,000
Income of Sub. Co. 64,000
Less: Realized net bond loss (g) 10,800
Adjusted net income 53,200 (j)
Consolidated net income, Year 7 261,200
Attributable to:
Shareholders of Parent 247,900
NCI (25% x (j) 53,200) 13,300
261,200

Parent Co.
Consolidated Income Statement
Year 7

Interest revenue (21,875 + 0 – (h) 21,875) 0

Miscellaneous revenue (900,000 + 500,000) 1,400,000
Loss on retirement of intercompany bonds (a) 1,250
Interest expense (44,000 – (i) 22,000) 22,000
Other expense (600,000 + 350,000) 950,000
Income tax expense (124,000 + 42,000 – (d) 500 + (e) 50) 165,550
Total expenses 1,138,800
Net income 261,200
Attributable to:
Shareholders of Parent 247,900
NCI (25% x 59,680) 13,300
261,200

Problem 7-13
Intercompany bond purchase – Oct. 1, Year 5
Par value of 20% (80,000 / 400,000) of Palmer's bonds 80,000
Cost of 20% purchased 72,000
Realized gain to Scott Corporation (before tax) 8,000 (a)

Par value of 20% of Palmer's bonds 80,000

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Carrying amount ([400,000 – 16,000]  20%) 76,800

Realized loss to Palmer Corporation (before tax) 3,200 (b)

Realized gain to entity ((a) 8,000 – (b) 3,200) (before tax) 4,800 (c)

Yearly interest elimination loss (4,800 / 4) 1,200 (d)

Interest elimination loss Year 5 ((d) 1,200  3/12) 300

60% 60%
Before tax After tax Before tax After tax
Entity Palmer
Realized gain (loss) Oct. 1,
Year 5 (c) 4,800 2,880 (b) (3,200) (1,920)
Interest elimination
loss (gain)* 300 180 (200) (120)
Balance gain (loss)
Dec. 31, Year 5 4,500 2,700 (3,000) (1,800) (e)

Scott
Realized gain (loss) Oct. 1,
Year 5 (a) 8,000 4,800
Interest elimination
loss (gain)* 500 300
Balance gain (loss)
Dec. 31, Year 5 7,500 4,500 (f)

* ¼ x 3/12

a) December 31, Year 5

Investment in Scott Corporation 42,000
Equity method income 42,000
70%  $60,000 Share of Scott's profit

Cash 9,100
Investment in Scott Corporation 9,100
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70%  $13,000 Share of Scott's dividends

Equity method income (e) 1,800

Investment in Scott Corporation 1,800
Net bond loss allocated to Palmer

Investment in Scott Corporation (f) 3,150

Equity method income 3,150
Net bond gain allocated to Scott ($4,500  70%)

b) Carrying amount of bonds Oct. 1, Year 5 (400,000 – 16,000) 384,000

Discount amortization Oct. to Dec. Year 5 (16,000 / 4 x 3/12) 1,000
Carrying amount of bonds, Dec. 31, Year 5 385,000
Intercompany portion (20%  385,000) 77,000
Consolidated bonds payable Dec. 31, Year 5 308,000

Problem 7-14 (in 000s)

Calculation and allocation of acquisition differential

Cost of 60% investment in ENS $ 780

Implied value of 100% investment in ENS 1,300
Carrying amount of ENS:
Common shares $500
Retained earnings 130
Total shareholders’ equity 630
Acquisition differential $1,470
Allocated: (FV – CA)
Equipment (24)
Internet domain names 100
Land 150 226
Balance — goodwill $1,244

Acquisition differential amortization and goodwill impairment schedule

Balance Amortization/Impairment Balance

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Dec. 31, Yr4 Yr5- Yr7 Yr8 Dec. 31, Yr8

Equipment (6 years) $ (24) $ (12) $ (4) $ (8) (a)

Internet domain names 100 - - 100
Land 150 - - 150 (b)
Goodwill 1,244 1,144 25 75 (c)
Total $ 1,470 $ 1,132 $ 21 $ 317 (d)

Intercompany sales and cost of sales $650 (e)

Intercompany other revenues and other expenses (6 x 12) 72 (f)
Intercompany inventory profits – ENS selling
ENS’s gross margin % = (3,330 – 2,331) / 3,330 = 30%

Before tax 40% tax After tax

Closing inventory (30% x 450) $ 135 $ 54 $ 81 (g)
Beginning inventory (30% x 350) 105 42 63 (h)

Intercompany receivables and payables $182 (i)

Intercompany depreciable assets profits – RAV selling

Before tax 40% tax After tax

Proceeds on sale $782
Carrying amount 632
Unrealized gain on sale of building, July 1, Year 5 150 $60 $90
Realized gain per year (15 years remaining) 10 4 6 (j)
Realized gains to December 31, Year 8 (3.5 years) 35 14 21 (k)
Unrealized gains, December 31, Year 8 $ 115 $46 $69 (l)

ENS’s income (3,330 – 2,331 – 104 – 448) = $447 (m)

(a)
Sales (5,020 + 3,330 – (e) 650) $7,700
Other revenues (109 + 0 – (f) 72) 37
Total revenues 7,737
Cost of goods purchased (2,388 + 2,377 – (e) 650) 4,115
Change in inventory (92 – 46 + (g) 135 – (h) 105) 76
Amortization expense (208 + 104 – (a) 4 – (j) 10) 298
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Goodwill impairment (0 + 0 + (c) 25) 25

Income tax and other expenses (912 + 448 – (g) 54 + (h) 42 +
(j) 4 – (f) 72) 1,280
Total expenses 5,794
Consolidated net income $1,943
Attributable to:
Shareholders of RAV 1,779.8
Non-controlling interest (40% x [(m) 447 – (g) 81 + (h) 63 – (d) 21]) 163.2
$1,943

(b)
Current assets
Cash (175 + 91) $266
Accounts receivable (261 + 242 – (i) 182) 321
Inventory (26 + 305 – (g) 135) 796

Property, plant & equipment

Land (700 + 330 + (b) 150) $1,180
Building – net (870 + 665 – (l) 115) 1,420
Equipment – net (722 + 397 – (a) 8) 1,111

Intangible assets
Internet domain names $100
Goodwill 75

(c)
Subsidiary’s retained earnings, beginning of year $279
Unrealized profit in beginning inventory (h) (63)
216
Subsidiary’s common shares 500
716
Unamortized acquisition differential (d) (317 + 21) 338
$1,054
NCI’s share (40%) $421.6

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(d)
i) RAV’s separate entity income would decrease because it would report dividend income from
ENS of $153.6 (60% x $256) instead of equity method income of $250.8.
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.
(e)
See journal entries below.

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CONSOLIDATED FINANCIAL STATEMENT WORKING PAPER

RAV COMPANY
CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, YEAR 8
Eliminations
RAV ENS Dr. Cr. Consolidated
Income Statements - Year 8
Sales $ 5,020,000 $ 3,330,000 5 $ 650,000 $ - $ 7,700,000
Other revenues 109,000 0 11 72,000 37,000
Equity method income from ENS 250,800 1 250,800 0
Total income 5,379,800 3,330,000 7,737,000

Cost of goods purchased 2,388,000 2,377,000 5 650,000 4,115,000

Change in inventory 92,000 (46,000) 7 135,000 6 105,000 76,000
Amortization Expense 208,000 104,000 4 4,000 298,000
10 10,000
Goodwill impairment 0 0 4 25,000 25,000

Income tax and other expenses 912,000 448,000 6 42,000 7 54,000 1,280,000
10 4,000 11 72,000
Total expenses 3,600,000 2,883,000 5,794,000
Profit $ 1,779,800 $ 447,000 $ 1,943,000
Attributable to
Non-controlling interest 12 163,200 0 163,200
Shareholders of RAV 1,779,800
Total $ 1,342,000 $ 895,000

RETAINED EARNINGS STATEMENTS — for Year 8

Balance, January 1 $ 615,000 $ 279,000 3 $ 279,000 $ - $ 615,000
Profit 1,779,800 447,000 Above 1,342,000 895,000 1,779,800
2,394,800 726,000 2,394,800
Dividends 416,400 256,000 1 153,600 416,400
12 102,400
Balance, December 31 $ 1,978,400 $ 470,000 $ 1,978,400

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Total $ 1,621,000 $1,151,000

Statement of Financial Position - December 31, Year 8

Cash $ 175,000 $ 91,000 $ - $ - $ 266,000
Accounts receivable 261,000 242,000 8 182,000 321,000
Inventory 626,000 305,000 7 135,000 796,000
Land 700,000 330,000 3 150,000 1,180,000
Building – net 870,000 665,000 10 10,000 9 125,000 1,420,000
Equipment – net 722,000 397,000 4 4,000 3 12,000 1,111,000
Investment in ENS 654,600 0 2 421,600 1 97,200 0
6 63,000 3 1,117,000
9 75,000
Deferred income tax asset 7 54,000 10 4,000 100,000
9 50,000
Internet domain names 0 0 3 100,000 100,000
Goodwill 0 0 3 100,000 4 25,000 75,000
$ 4,008,600 $ 2,030,000 $ 5,369,000

Accounts payable $ 481,000 $ 328,000 8 182,000 $ 627,000

Long-term debt 349,200 732,000 0 0 1,081,200
Common shares 1,200,000 500,000 3 500,000 1,200,000
Retained earnings 1,978,400 470,000 Above 1,621,000 1,151,000 1,978,400
Non-controlling interest 13 102,400 2 421,600 482,400
12 163,200
$ 4,008,600 $ 2,030,000 $ 5,369,000
$ 3,433,000 $3,433,000

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JOURNAL ENTRIES

1 Equity method income $ 250,800

Investment in ENS $ 97,200
Dividends paid (60% x 256,000) 153,600
To adjust investment account under equity method to balance at beginning of year

2 Investment in ENS 421,600

Non-controlling interest (part d) in solutions
manual) 421,600
To establish non-controlling interest at beginning of year

3 Common shares 500,000

Retained earnings 279,000
Internet domain names 100,000
Land 150,000
Goodwill 100,000
Equipment 12,000
Investment in ENS 1,117,000
Non-controlling interest
To eliminate subsidiary's shareholders' equity and
establish acquisition differential at beginning of Year 8

4 Goodwill impairment 25,000

Goodwill 25,000
Equipment - net 4,000
Amortization expense 4,000
To amortize the acquisition differential for Year 8

5 Sales 650,000
Cost of sales 650,000
To eliminate intercompany sales

6 Investment in ENS 63,000

Change in inventory 105,000
Income tax expense 42,000
To eliminate unrealized profits in beginning inventory

7 Change in inventory 135,000

Inventory 135,000
Deferred income tax asset 54,000
Income tax and other expenses 54,000
To eliminate unrealized profits in ending inventory

8 Accounts payable 182,000

Accounts receivable 182,000
To eliminate intercompany receivables and payables

9 Investment in ENS 75,000

Deferred income tax asset 50,000
Building - net 125,000
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To eliminate intercompany gain on sale of equipment at beginning of Year 8

1
0 Building - net 10,000
Amortization expense 10,000
Income tax expense 4,000
Deferred income tax asset 4,000
To eliminate excess depreciation from intercompany gain on sale of equipment

1
1 Other revenues 72,000
Other expenses 72,000
To eliminate intercompany rent revenue and rent expense

1
2 Non-controlling interest-P&L 163,200
Non-controlling interest-SFP 163,200
To record NCI's share of income for the year

1
3 Non-controlling interest-SFP 102,400
Dividends paid (40% x 256,000) 102,400
To record NCI's share of dividends paid

Total of debits and credits $ 3,433,000 $ 3,433,000

(adapted from CGA Canada)

Problem 7-15
Year 10 income statements
P Company S Company
Sales $687,000 $416,000
Interest income 2,000
Equity method income 125,763
Gain on sale of land 7,000
Total revenues 819,763 418,000
Cost of sales 412,200 249,600
Interest expense 16,500
Selling and admin. expense 48,000 24,000
Income tax expense 15,000 9,690
Total expenses 491,700 283,290
Net income $328,063 $134,710

Bonds payable – P Company

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Issued Jan. 1, Year 3 $200,000 (a)

Discount Jan. 1, Year 3 $5,000)
Amortized – Years 3 to 9 (5,000/ 10  7) (3,500)
– to July 1, Year 10 (500 ½) (250) 1,250
Balance, July 1, Year 10 198,750 (b)
Discount amortization July to Dec., Year 10 250
Balance, Dec. 31, Year 10 $199,000

Investment in bonds – S Company

Par value July 1, Year 10 $40,000
Purchase discount, July 1, Year 10 (40,000 – 38,000) $2,000)
Amortized, Year 10 (2,000 / 2½  ½) (400) (c) 1,600
Balance, Dec. 31, Year 10 $38,400
Cost of intercompany bonds July 1, Year 10 38,000
Par value 40,000
Realized gain on bond – S Company (before tax) $2,000 (d)

Par value, July 1, Year 10 40,000

Carrying amount ((b) 198,750  20%) 39,750
Realized loss on bonds – P Company (before tax) $250 (e)

Realized gain to entity, July 1, Year 10 ((d) 2,000 – (e) 250) $1,750 (f)

Before tax 40% tax After tax

Entity
Realized gain July 1, Year 10 (f)$1,750 $700 $1,050
Interest elimination gain Year 10* 350 140 210 (g)
Balance gain Dec. 31, Year 10 $1,400 $560 $840 (h)

P Company
Realized gain (loss) July 1, Year 10 (e)$(250) $(100) $(150)
Interest elimination gain (loss) Year 10* (50) (20) (30)
Balance gain (loss), Dec. 31, Year 10 $(200) $(80) $(120) (i)

S Company
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Realized gain July 1, Year 10 (d) 2,000 800 1,200

Interest elimination gain Year 10* 400 160 240
Balance gain Dec. 31, Year 10 $1,600 $640 $960 (j)

* ½ year amortization, 2½ years to maturity

Intercompany revenues and expenses

Sales $76,000 (k)
Interest expense – P Company
8%  200,000 (a) $16,000
Discount amortization, Year 9 (250 + 250) 500
Total Year 10 $16,500

½ year 8,250
Intercompany portion (40,000/ 200,000) 20% $1,650
Interest revenue – S Company
8%  (c) 40,000  ½ 1,600
Purchase discount amortized (c) 400 2,000
Interest elimination loss – Year 10 (g) $350

Intercompany profits
Before tax 40% tax After tax
Land – S selling – realized in Year 10
(28,000 – 21,000) $7,000 $2,800 $4,200 (l)

Calculation of equity method income

S Company net income $134,710
Add: Realized bond gain net (j) 960
Realized land gain (l) 4,200
Adjusted net income 139,870 (m)
P Company's ownership % 90%
125,883
Less: Realized bond loss (net) – P Company (i) 120
$125,763
(a) P Co.

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Consolidated Income Statement

Year 10

Sales (687,000 + 416,000 – (k) 76,000) $1,027,000

Gain on bond retirement (f) 1,750
Gain on sale of land (7,000 + (l) 7,000) 14,000
Total revenues 1,042,750
Cost of sales (412,200 + 249,600 – (k) 76,000) 585,800
Interest expense (16,500 – 1,650) 14,850
Selling and admin. expense (48,000 + 24,000) 72,000
Income tax expense (15,000 + 9,690 + (h) 560 + (l) 2,800) 28,050
Total expenses 700,700
Net income $342,050
Attributable to:
Shareholders of P Co. $328,063
Non-controlling interest ((m) 139,870 × 10%) 13,987
Consolidated net income $ 342,050

(b) P Co.
Consolidated Retained Earnings Statement
Year 10

Retained earnings, Jan. 1, Year 10 $ 78,000

Add: net income 328,063
406,063
Less: dividends 10,000
Retained earnings, Dec. 31, Year 10 $396,063

Problem 7-16

Calculation, allocation, and amortization of acquisition differential

Champlain NCI
(80%) (20%)

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Cost of 80% investment in Samuel 129,200

Fair value of NCI’s Interest in Samuel (14 x 2,000) 28,000

Carrying amounts of Samuel's net assets:

Ordinary shares 50,000
Retained earnings 12,000
Total shareholders' equity 62,000 49,600 12,400
Acquisition differential, Jan. 1, Year 4 79,600 15,600
Allocation: FV – CA
Inventories (18,000) (14,400) (3,600)
Patent 14,000 11,200 2,800
Balance – Goodwill 82,800 16,400

Balance Amortization Balance

Jan. 1/4 Years 4 to 7 Year 8 Dec. 31/8

Inventories (18,000) (18,000) - -

Patent 14,000 7,000 1,750 5,250 (a)
Subtotal (4,000) (11,000) 1,750 5,250
Goodwill – Champlain’s purchase 82,800 34,800 19,200 28,800 (b)
- NCI’s share 16,400 6,600 3,600 6,200 (c)
95,200 30,400 24,550 40,250

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

Opening inventory – Samuel selling 1,900 760 1,140 (f)

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Closing inventory – Samuel selling 3,300 1,320 1,980 (g)

Gain on equipment Jan. 1/6 – Samuel selling 21,000 (h)

Depreciation to Dec. 31, Year 7 ([21,000 / 6]  2) 7,000
Balance, Dec. 31, Year 7 14,000 5,600 8,400 (i)
Depreciation Year 8 (21,000  6) 3,500 1,400 2,100 (j)
Balance, Dec. 31, Year 8 10,500 4,200 6,300 (k)

Gain on land – Champlain selling 7,000 2,800 4,200 (l)

Intercompany revenues and expenses, receivables and payables

Sales and purchases 92,000 (m)
Receivables and payables 21,000 (n)
Dividends receivable and payable (5,500  80%) 4,400 (o)
Samuel’s accumulated depreciation, date of acquisition 17,000 (p)

Deferred income taxes (Dec. 31, Year 8)

Inventory (g) 1,320
Equipment (k) 4,200
Land (l) 2,800 8,320 (q)

Calculation of consolidated profit – Year 8

Profit of Champlain 42,800
Less: Dividends from Samuel (11,000  80%) 8,800 (r)
Adjusted profit 34,000
Profit of Samuel 13,000
Add: Realized profit in opening inventory (f) 1,140
Equipment gain realized (j) 2,100 3,240
16,240
Less: Unrealized profit in closing inventory (g) 1,980
14,260 (s)
Less: Amortization of acquisition differential
- Champlain’s share (d) 20,600
- NCI’s share (e) 3,950 24,550
Adjusted profit (10,290)
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Profit 23,710
Attributable to:
Shareholders of Champlain 24,808
NCI (20% x (s) 14,260 – (e) 3,950) - 1,098
23,710

(a) (i) Champlain Ltd.

Consolidated Income Statement
Year 8

Sales (535,400 + 270,000 – (m) 92,000) 713,400

Miscellaneous revenue (9,900 – (r) 8,800) 1,100
Total revenues 714,500
Cost of sales
(364,000 + 206,000 – (m) 92,000 + (g) 3,300 – (f) 1,900) 479,400
Selling expense (78,400 + 24,100) 102,500
Admin. exp. (including depreciation & goodwill impairment loss)
(46,300 + 20,700 + (a) 1,750 + (b) 19,200 + (c) 3,600 – (j) 3,500) 88,050
Income taxes (13,800 + 6,200 + (f) 760 – (g) 1,320 + (j) 1,400) 20,840
Total expenses 690,790
Profit 23,710
Attributable to:
Shareholders of Champlain 24,808
NCI (20% x (s) 14,260 – (e) 3,950) (1,098)
23,710

Calculation of consolidated retained earnings – Jan. 1, Year 8

Retained earnings of Champlain, Jan. 1/8 45,500

Less: Unrealized profit in land (l) 4,200
Adjusted retained earnings 41,300
Retained earnings of Samuel, Jan. 1/8 68,000
At acquisition 12,000
Increase 56,000
Less: Unrealized profit in opening inventory (f) 1,140
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Unrealized equipment gain (net) (i) 8,400 9,540

Adjusted increase 46,460
Champlain's ownership % 80% 37,168
Less: Champlain’s share of amort. of acquisition differential. (d) (26,000)
Consolidated retained earnings, Jan. 1, Year 8 52,468

(a) (ii) Champlain Ltd.

Consolidated Retained Earnings Statement
Year 8
Retained earnings, Jan. 1, Year 8 52,468
Add: profit 24,808
77,276
Less: dividends 20,000
Retained earnings, Dec. 31, Year 8 57,276

Calculation of non-controlling interest – Dec. 31, Year 8

Ordinary shares 50,000
Retained earnings (68,000 + 13,000 – 11,000) 70,000
Total shareholders' equity, Dec. 31, Year 8 120,000
Less: Unrealized profit in ending inventory (g) 1,980
Unrealized equipment gain (k) 6,300 8,280
Adjusted shareholders' equity 117,720
Non-controlling interest’s share 20%
22,344
Add: NCI’s share of unamortized acquisition differential (e) 7,250
Non-controlling interest, Dec. 31, Year 8 29,594

(a) (iii) Champlain Ltd.

Consolidated Statement of Financial Position
December 31, Year 8

Property, plant, and equipment

(198,000 + 104,000 – (l) 7,000 – (h) 21,000 – (p) 17,000) 257,000)
Accumulated depreciation (86,000 + 30,000 – 10,500* – (p) 17,000) (88,500)
Patent (a) 5,250)
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Goodwill (b & c) 35,000)

Deferred income taxes (q) 8,320)
Inventories (35,000 + 46,000 – (g) 3,300) 77,700)
Accounts receivable (60,000 + 55,000 – (n) 21,000 – (o) 4,400) 89,600)
Cash (18,100 + 20,600) 38,700)
Total assets 423,070)

Ordinary shares 225,000)

Retained earnings 57,276)
Non-controlling interest 29,594)
Dividends payable (5,000 + 5,500 – (o) 4,400) 6,100)
Accounts payable (56,000 + 70,100 – (n) 21,000) 105,100)
Total liabilities and shareholders’ equity 423,070)
* 7,000 + (j) 3,500 = 10,500

(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) Goodwill under entity theory 35,000

Less: NCI’s share 6,200
Goodwill under parent company extension theory 28,800

NCI on statement of financial position under entity theory 29,594

Less: NCI’s share of goodwill (20%) 6,200
NCI on statement of financial position under parent company extension theory 23,394
(d) 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 interest.

(e)
See below for summary of journal entries.

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CONSOLIDATED FINANCIAL STATEMENT WORKING PAPER

CHAMPLAIN LTD.
CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, YEAR 8
Eliminations
Champlain Samuel Dr. Cr. Consolidated
Income Statements - Year 8
Sales $ 535,400 $ 270,000 7 92,000 $ 713,400

Dividend and miscellaneous income 9,900 0 6 8,800 1,100

Total income 545,300 270,000 714,500

Cost of sales 364,000 206,000 9 3,300 7 92,000 479,400

8 1,900
Selling expense 78,400 24,100 102,500

Administrative expense (incl.

amortization and goodwill impairment) 46,300 20,700 5 22,800 13 3,500 88,050
5 1,750
Income taxes 13,800 6,200 8 760 9 1,320 20,840
13 1,400
Total expenses 502,500 257,000 690,790
Profit $ 42,800 $ 13,000 $ 23,710
Attributable to:
Non-controlling interest 15 1,098 (1,098)
Shareholders of Champlain 24,808

Total $130,810 $99,818

Retained Earnings Statements - Year 8

68,0
Balance, January 1 $ 45,500 $ 68,000 3 00 1 6,968 $ 52,468
9
Profit 42,800 13,000 Above 130,810 9,818 24,808
88,300 81,000 77,276

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Dividends 20,000 11,000 6 8,800 20,000

16 2,200
Balance, December 31 $ 68,300 $ 70,000 $ 57,276

Total $198,810 $117,786

Statement of financial position, December 31, Year 8

Property, plant, and equipment
$ 198,000 $ 104,000 0 4 17,000 $ 257,000
12 21,000
14 7,000
Accumulated depreciation (86,000) (30,000) 4 17,000 (88,500)
12 7,000
13 3,500
Patent 3 7,000 5 1,750 5,250
Goodwill 3 57,800 5 22,800 35,000
Deferred income taxes 9 1,320 13 1,400 8,320
12 5,600
14 2,800
Investment in Samuel-at cost 129,200 0 1 6,968 3 182,800 0
2 32,892
8 1,140
12 8,400
14 4,200
Inventories 35,000 46,000 9 3,300 77,700
Accounts receivable 60,000 55,000 10 21,000 89,600
11 4,400
Cash 18,100 20,600 38,700
Total assets $ 354,300 $ 195,600 $ 423,070

Ordinary shares 225,000 50,000 3 50,000 $ 225,000

Retained earnings 68,300 70,000 Above 198,810 117,786 57,276
5,5
Dividends payable 5,000 00 11 4,400 6,100
Accounts payable 56,000 70,100 10 21,000 105,100

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Non-controlling interest 15 1,098 2 32,892 29,594

16 2,200
$ 354,300 $ 195,600 $ 423,070

$433,128 $433,128

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JOURNAL ENTRIES

1 Investment in Samuel 6,968

Retained earnings (note a) 6,968
To adjust retained earnings to equity method at beginning of year

2 Investment in Samuel 32,892

Non-controlling interest (note b) 32,892
To establish non-controlling interest at beginning of year

3 Ordinary shares 50,000

Retained earnings 68,000
Patent 7,000
Goodwill 57,800
Investment in Samuel 182,800
To eliminate subsidiary's shareholders' equity and
establish acquisition differential at beginning of Year 8

4 Accumulated depreciation 17,000

Property, plant and equipment 17,000
To eliminate Samuel's accumulated depreciation at date of acquisition

5 Goodwill impairment 22,800

Goodwill 22,800
Amortization expense 1,750
Patent - net 1,750
To amortize the acquisition differential for Year 8

6 Dividend income 8,800

Dividends paid 8,800
To eliminate dividends from subsidiary

7 Sales 92,000
Cost of sales 92,000
To eliminate intercompany sales

8 Investment in ENS 1,140

Cost of sales 1,900
Income tax expense 760
To eliminate unrealized profits in beginning inventory

9 Cost of sales 3,300

Inventory 3,300
Deferred income tax asset 1,320
Income tax and other expenses 1,320
To eliminate unrealized profits in ending inventory

1
0 Accounts payable 21,000
Accounts receivable 21,000

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To eliminate intercompany receivables and payables

1
1 Dividend payable 4,400
Dividend receivable 4,400
To eliminate intercompany dividend receivable and payable

1
2 Investment in Samuel 8,400
Deferred income tax asset 5,600
Accumulated depreciation 7,000
Equipment 21,000
To eliminate intercompany gain on sale of equipment at beginning of Year 8

1
3 Accumulated depreciation 3,500
Depreciation expense 3,500
Income tax expense 1,400
Deferred income tax asset 1,400
To eliminate excess depreciation from intercompany gain on sale of equipment

1
4 Investment in Samuel 4,200
Deferred income tax asset 2,800
Land 7,000
To eliminate intercompany gain on sale of land at beginning of Year
8

1
5 Non-controlling interest-SFP 1,098
Non-controlling interest-P&L 1,098
To record NCI's share of income for the year

1
6 Non-controlling interest-SFP 2,200
Dividends paid (20% x 11,000) 2,200
To record NCI's share of dividends paid

Total of debits and credits $ 433,128 $ 433,128

Notes
a Consolidated retained earnings, beginning of Year 8
(= Champlain's retained earnings, beginning of Year 8 under equity method) $ 52,468
Champlain's retained earnings, beginning of Year 8 under cost method 45,500
$
Difference between cost and equity method, beginning of Year 8 6,968

b NCI, end of Year 8 $ 29,594

Less: NCI's share of consolidated net income for Year 8 1,098
Add: NCI's share of Samuel's dividends for Year 8 (20% x 11,000) 2,200
$
NCI, beginning of Year 8 32,892

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Problem 7-17
Calculation, allocation, and amortization of acquisition differential

Cost of 70% investment in Dandy $13,300

Implied value of 100% $19,000
Carrying amounts of Dandy’s net assets:
Common shares $1,250
Retained earnings 6,500
Total shareholders' equity 7,750
Acquisition differential, Jan. 1, Year 4 11,250
Allocation: FV – CA
Inventory $100
Equipment 500 600
Balance – Goodwill $10,650

Amortization
Balance Balance
Jan. 1/4 Years 4 to 8 Year 9 Dec. 31/9
Inventory $100 $100 - -
Equipment (10-year life) 500 250 $50 $200
(a)
Goodwill 10,650 9,350 190 1,110
(b)
$11,250 $9,700 $240 $1,310
(c)

Intercompany profits
Before tax 40% tax After tax

Opening inventory – Dandy selling (3,400 x 50%) $1,700 $680 $1,020 (d)

Closing inventory – Dandy selling (4,500 x 50%) $2,250 $900 $1,350(e)

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Gain on equipment Jan. 1/5 – Handy selling $360 (f)

Depreciation to Dec. 31, Year 8 ([360 / 8]  4) 180
Balance, Dec. 31, Year 8 $180 $72 $108 (g)
Depreciation Year 9 (360  8) 45 18 27 (h)
Balance, Dec. 31, Year 9 $135 $54 $81 (i)

Intercompany revenues and expenses, receivables and payables

Sales and purchases $5,900 (j)
Consulting revenues and expenses (50 x 12) $600 (k)

Deferred income taxes (Dec. 31, Year 9)

Inventory (e) $900
Equipment (i) 54 $954 (l)

Calculation of consolidated net income – Year 9

Income of Handy $1,960
Less: Dividends from Dandy (980  70%) (m) 686
1,274
Add: Realized gain on equipment (h) 27
Adjusted net income 1,301
Income of Dandy $1,060
Add: Realized profit in opening inventory (d) 1,020
Less: Amortization of acquisition differential (c) (240)
Unrealized profit in closing inventory (e) (1,350)
Adjusted net income 490
Consolidated net income $1,791
Attributable to:
Shareholders of Handy $1,644
NCI (30% x 490) 147
$1,791

(a) Handy Company

Consolidated Income Statement
Year 9

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Sales (22,900 + 8,440 – (j) 5,900) $25,440

Cost of sales (15,200 + 3,680 – (j) 5,900 + (e) 2,250 – (d) 1,700) 13,530
Gross profit 11,910
Other revenue (1,820 + 0 – (m) 686 – (k) 600) 534
Selling & admin expense (1,040 + 620 + (a) 50 – (h) 45) (1,665)
Other expenses (5,520 + 2,240 + (b) 190 – (k) 600) (7,350)
Income before income taxes 3,429
Income tax expense (1,000 + 840 + (d) 680 – (e) 900 + (h) 18) 1,638
Net income $1,791
Attributable to:
Shareholders of Handy 1,644
NCI (30% x 490) 147
$1,791

(b)
Calculation of consolidated retained earnings – Jan. 1, Year 9
Handy’s retained earnings $10,620
Unrealized gain on sale of equipment (g) (108)
Subtotal 10,512
Dandy’s retained earnings, beginning of Year 9 $7,050
Dandy’s retained earnings, at acquisition 6,500
Change in retained earnings since acquisition 550
Cumulative differential amortization and impairment (c)(9,700)
Unrealized profit in beginning inventory (d) (1,020)
(10,170)
Handy’s share @ 70% (7,119)
Consolidated retained earnings $3,393

Handy Company
Consolidated Statement of Retained Earnings
For the year ended December 31, Year 9

Retained earnings, beginning of year $3,393

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Add: Net income 1,644

5,037
Less: Dividends paid (1,960)
Retained earnings, end of year $3,077

(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.

(d) Goodwill impairment loss under entity theory $190

Less: NCI’s share (30%) 57
Goodwill impairment loss under parent company extension theory $133

NCI on income statement under entity theory $147

Add: NCI’s share of goodwill impairment (30%) 57
NCI on income statement under parent company extension theory $204

(e) See below for summary of journal entries.

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CONSOLIDATED FINANCIAL STATEMENT WORKING PAPER

HANDY LTD.
CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, YEAR 9
Eliminations
Handy Dandy Dr. Cr. Consolidated
Year 9 income statements
Sales $ 22,900 $8,440 7 $ 5,900 $ - $ 25,440
Cost of sales 15,200 3,680 9 2,250 7 5,900 13,530
8 1,700
Gross profit 7,700 4,760 11,910

Other revenue 1,820 0 5 686 534

6 600

Selling and administrative expense 1,040 620 4 50 11 45 1,665

Other expenses 5,520 2,240 4 190 6 600 7,350
Income before income taxes 2,960 1,900 3,429
Income tax expense 1,000 840 8 680 9 900 1,638
11 18
Profit $ 1,960 $1,060 $ 1,791
Attributable to
Non-controlling interest 12 147 $ 147
Shareholders of Handy 1,644
Total $ 10,521 $ 9,145
Year 9 retained earnings statements
$
Balance, January 1 $ 10,620 $ 7,050 1 $ 7,227 - $ 3,393
3 7,050
Profit 1,960 1,060 Above 10,521 9,145 1,644
12,580 8,110 5,037

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Dividends 1,960 980 5 686 1,960

13 294
Balance, December 31 $ 10,620 $ 7,130 $ 3,077
Total $ 24,798 $ 10,125

Balance Sheet, December 31, Year 9

Cash $ 1,540 $ 980 $ - $ - $ 2,520
Accounts receivable 3,000 1,250 4,250
Inventory 3,600 4,250 9 2,250 5,600

Property, plant, and equipment—net 4,540 3,210 3 250 4 50 7,815

11 45 10 180
Goodwill 3 1,300 4 190 1,110
Deferred income tax asset 9 900 11 18 954
10 72
Investment in Dandy 13,300 0 2 2,649 1 7,227 (0)
8 1,020 3 9,850
10 108
Total $ 25,980 $ 9,690 $ 22,249
Current liabilities $ 4,560 $ 680 0 0 $ 5,240
Long-term liabilities 3,300 630 3,930
Common shares 7,500 1,250 3 1,250 7,500
Retained earnings 10,620 7,130 Above 24,798 10,125 3077
Non-controlling interest 13 294 2 2,649 2502
12 147
Total $ 25,980 $ 9,690 $ 22,249
$ 32,686 $ 32,686

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Journal Entries
1 Retained earnings (note a) 7,227
Investment in Dandy 7,227
To adjust retained earnings to equity method at beginning of year

2 Investment in Dandy 2,649

Non-controlling interest (note b) 2,649
To establish non-controlling interest at beginning of year

3 Common shares 41,250

Retained earnings 7,050
Equipment 250
Goodwill 1,300
Investment in Dandy 9,850
To eliminate subsidiary's shareholders' equity and
establish acquisition differential at beginning of Year 9

4 Goodwill impairment 190

Goodwill 190
Amortization expense 50
Property, plant & equipment – net 50
To amortize the acquisition differential for Year 9

5 Dividend income 686

Dividends paid 686
To eliminate dividends from subsidiary

6 Other revenue 600

Other expenses 600
To eliminate consulting revenue and expenses

7 Sales 5,900
Cost of sales 5,900
To eliminate intercompany sales

8 Investment in Handy 1,020

Cost of sales 1,700
Income tax expense 680
To eliminate unrealized profits in beginning inventory

9 Cost of sales 2,250

Inventory 2,250
Deferred income tax asset 900
Income tax expenses 900
To eliminate unrealized profits in ending inventory

1
0 Investment in Handy 108
Deferred income tax asset 72
Equipment - net 180

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To eliminate intercompany gain on sale of equipment at beginning of Year 8

1
1 Equipment - net 45
Depreciation expense 45
Income tax expense 18
Deferred income tax asset 18
To eliminate excess depreciation from intercompany gain on sale of equipment

1
2 Non-controlling interest-P&L 147
Non-controlling interest-SFP 147
To record NCI's share of income for the year

1
3 Non-controlling interest-SFP 294
Dividends paid (30% x 980) 294
To record NCI's share of dividends paid

Total of debits and credits $ 32,686 $ 32,686

Notes
a Consolidated retained earnings, beginning of Year 9
(= Handy's retained earnings, beginning of Year 9 under equity
method) $ 3,393
Handy's retained earnings, beginning of Year 9 under cost method 10,620
Difference between cost and equity method, beginning of Year 9 $ (7,227)

b Dandy's common shares $ 1,250

Dandy's retained earnings 7,130
Unamortized acquisition differential 1,310
Ending inventory (1,350)
Dandy's adjusted shareholders' equity 7,540
NCI's share 30%
NCI, end of Year 9 2,502
Less: NCI's share of consolidated net income for Year 9 -147
Add: NCI's share of Dandy's dividends for Year 9 294
NCI, beginning of Year 9 $ 2,649

(CGA-Canada adapted)

Problem 7-18
Under historical cost accounting and ignoring the intercompany sale, depreciation
expense would be $500,000 / 10 years = $50,000 per year. The equipment would be
reported as follows on the balance sheet:
Year 1 Year 2 Year 3

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Cost 500,000 500,000 500,000

Accumulated depreciation 50,000 100,000 150,000
Carrying amount 450,000 400,000 350,000

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:

Year 1 Year 2 Year 3

Fair value under revaluation model 460,000 416,000 370,000
Carrying amount under historical cost model450,000 400,000 350,000
AOCI 10,000 16,000 20,000

Using the above figures, the financial statement presentation would be as follows for the
separate entity and consolidated financial statements:

Year 1 MEL SENS CONS

(a) Equipment 511,111 511,111

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(b) Accumulated depreciation 51,111 51,111

Net carrying value of equipment 460,000 460,000
(c) AOCI 10,000 10,000
(d) Gain on sale
(e) Depreciation expense 50,000 50,000

Year 2 MEL SENS CONS

(a) Equipment 520,000 520,000
(b) Accumulated depreciation 104,000 104,000
Net carrying value of equipment 416,000 416,000
(c) AOCI 16,000 16,000
(d) Gain on sale
(e) Depreciation expense 51,111 51,111

Year 3 MEL SENS CONS

(a) Equipment 422,857 528,571
(b) Accumulated depreciation 52,857 158,571
Net carrying value of equipment 370,000 370,000
(c) AOCI (370,000 – (420,000 x 7/8) 2,500 20,000
(d) Gain on sale of equipment (420,000 – 416,000) 4,000
(e) Depreciation expense (420,000 / 8) 52,500 52,000

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