Chapter 4 Consolidation of Non-Wholly Owned Subsidiaries A brief description of the major points covered in each case and problem.CASES
Management of the parent company wants to compare goodwill and non-controlling interests sheet under four theories of reporting a 60%-owned subsidiary and wants to know whether the subsidiary must be remeasured to fair value annually and which theory best reflects the economic reality of the business combination.Case 4-2This case, adapted from a past UFE, questions the allocation of the acquisition cost and involves loss carryforwards and unrecognized intangible assets. Case 4-3 (prepared by J. C. (Jan) Thatcher, Lakehead University, and Margaret Forbes, formerly University of Saskatchewan).This case requires students to analyze the clauses of a franchise agreement to determine whether or not control exists because of the agreement.
Six separate scenarios describe variations about one company’s investment in shares of another company. In each scenario, the major question focuses on whether or not control is present.
The merger of two professional services firms is described and the student is asked to prepare a memo discussing the accounting implications of various aspects of the merger including the valuation of work in progress and the transfer of assets to a separate management company.
This case, adapted from a past UFE, involves a company operating an amusement park and golf course. It buys a sport franchise, builds a new arena and acquires the net assets of another amusement park. The student must assess a variety of capitalize versus expense issues, revenue recognition issues and how to account for the business combinations. PROBLEMSProblem 4-1 (35 min)This problem requires the preparation of a consolidated statement of financial position under the entity theory subsequent to the acquisition of a 70% interest in a subsidiary, and the calculation of goodwill and NCI under the parent company extension theory. Problem 4-2 (90 min.)Five separate cases are presented requiring the preparation of a consolidated balance sheet involving the same parent and subsidiary company. The cases vary as to the percentage of voting shares acquired and the price paid. Cases 1 and 2 are proportional and can be used as a classroom illustration to show that if the goodwill for a 100% owned subsidiary is $15,000, then the goodwill for an 80% owned subsidiary should be $12,000. The remaining cases involve goodwill of zero amount and negative goodwill. Problem 4-3 (50 min.)This problem requires the preparation of the parent’s separate entity balance sheet and a consolidated balance sheet of a parent and its 90%-owned subsidiary in which the allocation of the acquisition differential results in negative goodwill. Part of the acquisition cost needs to be allocated to an unrecorded customer supply contract. Problem 4-4 (30 min.)In this problem, a parent purchases 80% of the common shares of a subsidiary whose balance sheet contains the asset goodwill. The student is required to prepare a consolidated balance sheet. Problem 4-5 (20 min.)The parent’s and subsidiary’s statements of financial position are presented along with the consolidated statement of financial position. The ownership percentage has to be determined along with particular fair values of the subsidiary’s assets and liabilities. Problem 4-6 (80 min.)The preparation of a consolidated balance sheet under four theories of consolidation immediately after a parent company issues shares for a 70% interest in a subsidiary. Other acquisition costs and share issue costs are involved as well as negative goodwill. The student must also calculate and interpret the current ratio and debt-to-equity ratio. Problem 4-7 (80 min.)This problem involves preparing a consolidated statement of financial position using each of the four theories of consolidation. The student must also calculate and interpret the current ratio and debt-to-equity ratio. Problem 4-8 (40 min.)A parent has a 90% owned subsidiary. Unconsolidated and consolidated balance sheets are presented and the problem requires the preparation of the subsidiary’s balance sheet. Problem 4-9 (35 min.)A parent acquires 70% of the common shares of a subsidiary. The preparation of a consolidated balance sheet is required using the trading price of the subsidiary’s shares to value the non-controlling interests. Part of the acquisition cost needs to be allocated to an unrecorded taxi license. Problem 4-10 (45 min.)A consolidated balance sheet and the parent’s separate entity balance sheet are to be prepared after a 90%-owned subsidiary has been acquired. Part of the acquisition cost needs to be allocated to unrecorded Internet domain names. Problem 4-11 (65 min.)This problem involves preparing a consolidated statement of financial position using each of the four theories of consolidation and stating which theory is required under IFRS. Problem 4-12 (30 min.)Selected account balances for the consolidated balance sheet are required to be calculated for an 80%-owned subsidiary. Problem 4-13 (45 min.)Journal entries are to be prepared for the acquisition of an 80%-owned subsidiary and other direct costs involved with the acquisition. A consolidated balance sheet is to be prepared. Part of the acquisition cost needs to be allocated to unrecorded in-process research and development.
Web Problem 4-1The student answers a series of questions based on the 2011 financial statements of BCE Inc., a Canadian company. The questions deal with different theories of consolidation, the significance of non-controlling interests and the impact of consolidation theory on certain ratios. Web Problem 4-2The student answers a series of questions based on the 2011 financial statements of Barrick Gold Corporation, a Canadian company. The questions deal with different theories of consolidation, the significance of non-controlling interests and the impact of consolidation theory on certain ratios. SOLUTIONS TO REVIEW QUESTIONS
- No, it is not the same. A negative acquisition differential exists if the implied value for a 100% acquisition is less than the carrying amount of the subsidiary’s net assets. Negative goodwill exists if the implied acquisition cost is less than the fair value of the subsidiary’s identifiable net assets. It is possible to have a negative acquisition differential and end up with positive goodwill.
- Proprietary theory requires consolidation of the parent’s share of the subsidiary’s net assets, therefore giving no recognition to the non-controlling interest at all. Parent company theory views the purchase transaction as having occurred between the parent and the subsidiary only and therefore requires the non-controlling interest to be recorded at its share of the carrying amount of the subsidiary at the date the parent acquired its controlling interest. Entity theory views the consolidated entity as being owned by two groups of shareholders, the parent and the non-controlling interest, and views the purchase transaction to have revalued both parties’ ownership. Thus, the entity theory requires the non-controlling interest to be recorded at its percentage share of the fair value of the subsidiary’s net assets (including goodwill) at the date that the parent acquired its controlling interest.
- Under the proprietary theory, non-controlling interest is not reported on the consolidated balance sheet. Under the parent company theory, non-controlling interest is reported as a liability. Under the parent company extension theory and the entity theory, non-controlling interest is reported as a separate component of shareholders’ equity.
- Goodwill of this nature is treated as if it does not exist at the date of acquisition. Then, a new goodwill figure is calculated based on the acquisition cost at the date of acquisition. When preparing the schedule to allocate the acquisition differential, we assume that the goodwill had been written off by the subsidiary just before the parent acquired its controlling interest in the subsidiary. When calculating goodwill and goodwill impairment in subsequent years, we must make adjustments on consolidation based on the goodwill calculated at the date of acquisition
- If 80% of a subsidiary cost $80,000, it is inferred that 100% would have cost $100,000. The fair value of 100% of the subsidiary’s net assets is subtracted from this implied acquisition cost and the difference is goodwill. The amount of the non-controlling interest is determined based on the subsidiary’s fair values and goodwill arising from the purchase. With a small ownership percentage (e.g., 52%), or when majority ownership is reached through a series of small step acquisitions, this inference as to what 100% would cost is significantly less reliable than at higher ownership percentages.
- Non-controlling interest represents the equity interest of the non-controlling shareholders in the fair value of the subsidiary. IFRS 10 requires that it be shown in shareholders’ equity in the consolidated balance sheet.
- Goodwill and non-controlling interest differ under the two consolidation theories. Under the parent company extension theory, only the parent’s share of the subsidiary’s goodwill is reported because it is too difficult or subjective to measure the total goodwill of the subsidiary. Since the non-controlling interest’s share of the subsidiary’s goodwill is not included on the consolidated balance sheet, the value for non-controlling does not include a share of the subsidiary’s goodwill. Therefore, both goodwill and non-controlling interest are smaller amounts under the parent company extension theory in comparison to the entity theory.
- Contingent consideration is the additional consideration that may be payable for the acquisition of a business. The additional consideration is dependent upon whether certain future events occur (or do not occur). For example, a further payment may be required if future net income reaches (or fails to reach) a certain level. The contingent consideration should be measured at fair value at the date of acquisition. To do so, the parent should assess the amount expected to be paid in the future under different scenarios, assign probabilities as to the likelihood of the scenarios occurring, derive an expected value of the likely amount to be paid, and use a discount rate to derive the value of the expected payment in today’s dollars.
- Changes in the fair value of contingent consideration that will be payable in cash should be recognized in net income at each reporting date with a corresponding adjustment to the contingent liability.
- A private company may choose not to consolidate its subsidiaries and instead can report its investment in subsidiaries using the equity method or the cost method. All subsidiaries should be reported using the same method. However, if the entity would otherwise choose to use the cost method and if the security is traded in an active market, it must report the investment at fair value.
- Negative goodwill exists if the implied acquisition cost for a 100% investment is less than the fair value of the subsidiary’s identifiable net assets. Negative goodwill is reported on the consolidated income statement as a gain on purchase.
- No, the historical cost principle is not applied when accounting for negative goodwill. In fact, it is violated. The subsidiary’s identifiable net assets are reported at fair value on the consolidated balance sheet at the date of acquisition regardless of the amount paid by the parent. The negative goodwill is reported as a gain on purchase, which is not consistent with the historical cost principle.
- Any income earned by the subsidiary subsequent to the date of acquisition is incorporated in the consolidated income statement on a line-by-line basis. Any income earned by the subsidiary prior to the date of acquisition is not incorporated in the consolidated income statement because the subsidiary was not part of the consolidated group prior to the date of acquisition.
- The consolidation elimination entries are not recorded in the accounting records of either the parent or subsidiary unless the subsidiary applies push down accounting. The elimination entries are recorded on a consolidated working paper or consolidated worksheet, which is used to facilitate the consolidation process.
- Deferred charges do not meet the definition of an asset. Therefore, the deferred charge should not be reported on the consolidation balance sheet. In other words, the deferred charge should be measured at zero and would appear as a fair value deficiency on the schedule of acquisition differential.
- A parent-founded subsidiary would not have any acquisition differential i.e., there would not be any difference between the fair value and book value of assets and liabilities on the date of acquisition.
SOLUTIONS TO CASES Case 4-1 Under all theories of consolidation except for the entity theory, only the portion of Leafs’ goodwill purchased by Maple is reported on the consolidated balance sheet. Given an acquisition cost of $600,000, Maple paid $264,000 for its share of Leafs’ goodwill as shown in the first column of Exhibit I. Putting a value on 100% of Leafs’ goodwill is not an easy matter as there are different ways of determining this value. First, one could assume a linear relationship between the amount paid for 60% and the value of 100% of the subsidiary. In this case, if 60% of the shares were worth $600,000, then 100% of the shares should have been worth $1,000,000. In turn, 100% of goodwill would be measured at $440,000 as indicated in the second column of Exhibit I. (See below.) Secondly, one could listen to the argument made by the management of Maple and assume that there was not a linear relationship between the amount paid for 60% and the value of 100% of the subsidiary. Management stated that it was willing to pay a premium of $120,000 over and above the market price of the shares in order to gain control over Maple and the premium would be $120,000 regardless of the percentage of shares acquired. If this were the case, the total value of Leafs would be $920,000 of which $360,000 would be allocated to goodwill as indicated in the third column of Exhibit I. The value assigned to goodwill will affect the value reported for non-controlling interest under the entity theory. When goodwill is measured at $440,000, non-controlling interest is reported at $400,000 as indicated in the fourth column in Exhibit II. When goodwill is measured at $360,000, non-controlling interest is reported at $320,000 as indicated in the fifth column in Exhibit II. The subsidiary’s assets and liabilities are brought on to the consolidated balance sheet at fair values only at the date of acquisition. These fair values become the historical values for reporting purposes subsequent to the date of acquisition. That is, the subsidiary’s assets and liabilities are not remeasured to fair value on each reporting date subsequent to the date of acquisition. The entity theory presents the fair value of the net assets of the subsidiary including goodwill at the date of acquisition. The entity theory probably best reflects the economic reality of the business combination since fair value is often a better reflection of economic reality.. Since the entity theory presents the highest values for assets, it will produce the lowest percentage return on assets in subsequent periods because these assets need to be depreciated, expensed or written off at some point. For this reason, the management of Maple may probably prefer to not use the entity theory when preparing the consolidated financial statements.
ALLOCATION OF ACQUISITION COST
60% 100% 100%Cost of 60% of Leafs $600Implied value of 100% of Leafs (Note 1) $1,000Implied value of 100% of Leafs (Note 2) $920Carrying amount of Leafs’ net assets 200 200(60% x [1,000 –800]) 120 . .Acquisition differential 480 800 720AllocatedFair value excess for identifiable assets 240 400 400Fair value excess for liabilities (24) (40) (40)Goodwill $264 $440 $360 Notes:
- The implied value is calculated assuming a linear relationship between the value for 60% and the value of 100% i.e. if 60% is worth $600,000 then 100% is worth $600,000 / .6 = $1,000,000
- The implied value is calculated assuming a non-linear relationship and assuming that each share is worth $40 and that a control premium of $120,000 is paid regardless of the number of shares purchased. Given that the total shares outstanding is 12,000 / .6 = 20,000, the total value of Leafs would be 20,000 shares x $40 + $120,000 = $920,000
Consolidated Balance SheetAt December 31, Year 7(In 000s) (See notes) Proprietary Parent Co. Parent Ex Entity Entity(a) (b) (c) (d1) (d2)
Identifiable assets $2,840 $3,240 $3,400 $3,400 $3,400
Goodwill 264 264 264 440 360$3,104 $3,504 $3,664 $3,840 $3,760 Liabilities $ 2,004 $2,324 $2,340 $2,340 $2,340Non-controlling interest 80Shareholders’ equityControlling interest 1,100 1,100 1,100 1,100 1,100Non-controlling interest . . 224 400 320$3,104 $3,504 $3,664 $3,840 $3,760 Notes:
- The assets and liabilities are calculated as follows:
(a) Carrying amounts for Maple and 60% of fair values for Leafs(b) Carrying amounts for Maple and carrying amounts for Leafs plus 60% of fair value excess for Leafs’ identifiable assets and liabilities plus 60% of the value of Leafs’ goodwill(c) Carrying amounts for Maple and carrying amounts for Leafs plus 100% of fair value excess for Leafs’ identifiable assets and liabilities plus 60% of the value of Leafs’ goodwill(d1) Carrying amounts for Maple and carrying amounts for Leafs plus 100% of fair value excess for Leafs’ identifiable assets and liabilities plus 100% of the value of Leafs’ goodwill assuming a linear relationship between the value of 60% and the value of 100%(d2) Carrying amounts for Maple and carrying amounts for Leafs plus 100% of fair value excess for Leafs’ identifiable assets and liabilities plus 100% of the value of Leafs’ goodwill assuming a non-linear relationship and a control premium of $120,000
- The non-controlling interest is calculated as follows:
(b) 40% x carrying amount of Leafs’ shareholders’ equity(c) 40% x fair value of Leafs’ identifiable assets and liabilities(d1) 40% x fair value of Leafs’ identifiable assets, liabilities, and goodwill(d2) 40% x fair value of Leafs’ identifiable assets and liabilities and Leafs’ goodwill in totalless goodwill purchased by Maple i.e., 40% x ((1,400,000 –840,000) + (,360,000 –264,000)) Case 4-2 Memo To: PartnerFrom: CASubject: Eternal Rest Engagement As requested, I have reviewed the files and notes prepared for the Eternal Rest Limited (ERL) engagement. Below is my analysis and disposition of outstanding accounting issues. Overview Management has an income-based bonus plan which creates incentives for them to increase ERL’s income.Tranquil acquisition The value of the shares issued in the Tranquil acquisition was set as the closing market price on the day before the signing of the sale agreement. However, the shares must be held in escrow and cannot be sold for a year. This restriction reduces the market value of the shares. Therefore, a discount from the market price should be applied when calculating the cost of the investment in Tranquil. Similarly, the first mortgage bonds that were issued are non-interest-bearing, and recording them at face value ignores implicit interest. Using the face value of the bonds to determine the acquisition cost of Tranquil overstates the price and therefore overstates the amount of goodwill recorded on acquisition.The information provided indicates that Tranquil likely receives funds in advance for services to be provided (such as prepaid funerals). However, no unearned revenue is reported on the balance sheet. It is unclear what revenue recognition policy Tranquil uses for prepaid services, and the policy needs to be identified so that the reason for the absence of unearned revenue can be evaluated.The use of historical cost as an estimate of fair value does not seem very realistic since it is unlikely that values for land, buildings and equipment will remain unchanged over time. By reporting the assets at historical cost, any fair value excess related to these assets would end up in goodwill. Since goodwill is not amortized whereas the fair value excess related to buildings and equipment would be amortized, net income would be overstated in the current year. Also, understating the value of land permits immediate recognition of the increase in the value if some of it was sold (as was done) thereby increasing income. Since ERL’s management has a bonus plan based on income before taxes, historical cost may have been used as an estimate of fair value to increase their bonuses.I have concerns about the reliance that was placed on management’s estimates of the fair value of Tranquil’s land, buildings and equipment. It is not clear from the files that other evidence supporting the fair value estimates (such as appraisals) were obtained. Indeed, the fact that ERL sold some of the land acquired in the purchase of Tranquil at a gain supports the contention that historical cost is a poor basis for estimating the fair value of the acquired assets.(The key issue was the apparent misvaluation of the acquired assets and the resulting effect on income and ERL management’s bonus. Candidates were expected to identify the issue in their evaluation of the situation. Some candidates recognized that using historical costs to estimate fair value might not be realistic, but few followed through by discussing the accounting effects of the treatment and its implications. It is the follow-through from identification to analysis that demonstrates depth of understanding of an issue. Most candidates, however, did not tackle the issue from an accounting perspective.) The $820,000 included in working capital and held in trust for cemetery maintenance should be segregated on the balance sheet, classified as a long-term asset on the balance sheet or disclosed in the notes to the financial statements since its use is restricted.No indication is given that the $3 million paid for the non-competition agreements signed as part of the Tranquil acquisition is being amortized. Since the agreements are for five years it is appropriate to amortize the amount over that period. This treatment also applies to the non-competition agreement signed in the Peaceful acquisition.Peaceful acquisition As with Tranquil, the goodwill recorded in regard to Peaceful may be overstated. The loss carry-forwards have not been recorded, so their value is included in goodwill, thereby overstating goodwill. IFRSs require that the tax benefit be set up if there is reasonable assurance that the benefits will be realized during the carryforward period. It appears that there is reasonable assurance since use of the carryforwards was one of the reasons for the purchase by ERL and since some of the carryforward benefits have already been used. ERL has incorrectly treated the benefit from utilization of the carryforwards as a gain in Year 5.If the loss carryforward benefit is recognized as an asset at the date of acquisition, it should be drawn down as the benefit of the loss carryforwards are utilized. If no benefit was recognized at the date of acquisition, then a credit to income tax expense should be recognized when the benefit of the loss carryforwards are utilized. Also, since the allocation of the acquisition cost for Peaceful to the acquired assets and liabilities was done in the same manner as for the Tranquil acquisition, I am also concerned about the amount reported for goodwill.Environmental issue The Sunset Hill land is subject to a government order related to environmental concerns. An employee estimates that clearing up the concerns would cost about $500,000. No accrual has been made. The potential cost should be recognized in the statements as a liability if the amount is measurable. If the cost increases the value of the land that it should be capitalized. Otherwise, the cost would be expensed. If the uncertainty regarding the amount cannot genuinely be estimated, then the contingent liability should be disclosed in the notes.(The environmental issue was handled well by most candidates.) Case 4-3 Factory Optical Distributors, Teaching Note*Purpose of the caseThe purpose of this case is to provide students with an opportunity to work with IFRS 10: Consolidated Financial Statements. The requirement is very directive, asking students to examine the specific clauses of a franchise agreement to determine if control exists. The answer is not immediately obvious, since ownership by the parent is much less than 50%, and there are no convertible preferred shares outstanding or signed shareholder agreements in place. Students must look further to decide whether the details of the franchise agreement give FOD (Burnaby) control over the franchisee. Control has the following three elements:(a) the investor has power over the investee to direct the relevant activities.(b) the investor has exposure, or rights, to variable returns from its involvement with the investee and(c) the investor has the ability to use its power over the investee to affect the amount of the investor’s returns.All three elements must be met for the investor to have control. Objectives and constraintsSince FOD is a public company, audited financial statements are required. Thus, IFRSs must be used in reporting the franchise investments. DiscussionFactory Optical Distributors (FOD) (Burnaby) owns 35% of the franchise operation’s outstanding common shares. No other equity instruments can be issued. Thus control does not exist based on share ownership or ownership of convertible rights, options, or warrants. As well, there is no evidence of an irrevocable shareholder agreement conferring control to either party. IFRS 10 requires consolidation of all subsidiaries. A subsidiary is defined as an entity that is controlled by another entity. The following specifics of the franchise agreement between FOD (Burnaby) and its franchise operations suggest that the franchisee may be controlled by FOD (Burnaby):
- FOD is the only supplier of the lenses to the franchisees and approves the suppliers of frames. Thus, FOD has control over the supply of the primary products offered by the franchise (while the franchisee controls the services offered).
- FOD maintains control over advertising, requires a minimum amount to be spent on advertising and promotion, and dictates special sales and promotions. These points, coupled with FOD’s control over the supply of frames and lenses, indicate that FOD is highly involved in many of the day-to-day decisions that must be made for the franchises to succeed.
- The franchise agreement sets a maximum on the salary of the franchisee, limiting the rights of the franchisee to withdraw funds from the corporation without involving the other shareholders.
- The franchise fee is not a flat fee, but is variable based on revenue. Thus, FOD from the returns earned by the franchises.
- FOD guarantees the financing for new franchise locations or for renovations to existing locations and, thus, is exposed to the same financial risk as the franchises.
The following specifics of the franchise agreement suggest that the franchisee may not control the franchisees:
- The franchisee has clear voting control based on common share ownership. The franchisee is in charge of day-to-day operations and thereby determines the following:
- quality of services provided to the customer
- other products and services to be offered to the public
- selling price of products and services
The decision as to whether or not the franchisees are controlled by FOD is one of professional judgment. Some students may feel that given FOD’s control of financing and operating policies, and exposure to similar business risks, a subsidiary does exist. Others may feel that the factors discussed in the case do not provide sufficient evidence, and a subsidiary does not exist. In the opinion of the authors, a subsidiary does exist and consolidation would be appropriate. There is no right or wrong answer to this case. A good classroom discussion will raise all of the issues, and will allow students to formulate their own opinions based on professional judgment.
- Although A Ltd. appears to control B Co., it can only do so if more than 5 percent of the shareholders do not attend or vote at annual meetings. Since approximately 30 percent of the outstanding shares are typically not voted at the meeting, this is substantially more than minimum amount required to control the vote. Therefore, it does appear that A has control. Accordingly, it should report its investment in B Co. on a consolidated basis.
- A Ltd.’s holding of convertible bonds would provide control of B Co. if converted. If A Ltd. has the ability to convert these bonds at any time, it should report its investment in B Co. on a consolidated basis. The details of the conversion privileges should be examined carefully in this case.
- A Ltd. owns a controlling block of shares of B Co. in this case. The fact that a receiver has seized a portion of B Co.’s inventory does not necessarily indicate a loss of control for A. We must investigate the financial condition of B Co. and the involvement of a receivor in the future. If the receiver has instructions to liquidate the company, then A Ltd. may no longer have control over B and may not even have significant influence. if the receiver is simply taking possession of some inventory to satisfy a condition of the loan and has no intention of taking further action, then A Co. continues to have power over B. If A has control, it should report its investment in B Co. on a consolidated basis. If it has significant influence, it should use the equity method to report its investment and ensure that the investment is not valued at an amount in excess of the recoverable amount. If A has neither control nor significant influence, it should report its investment at fair value.
- A Ltd. should not report its investment in B Co. on a consolidated basis this year. Next year, however, assuming the company makes the required payments to C Inc., it should consolidate B Co. A Ltd. holds the right to all of the outstanding voting shares this year; however, C Inc. has the right to acquire 150,000 voting shares due to its ownership of convertible bonds. The acquisition agreement seems to have been structured to ensure that C Inc. maintains control until A Ltd. has paid 70% of the share purchase price. Next year, A Ltd. will own all of B Co.’s shares plus half of the convertible bonds, and thus will clearly have control.C Inc. will be required to consolidate B Co. this year based on its ownership of convertible bonds, as long as it is able to convert these bonds at any time. It is possible that A Ltd. has a significant influence investment this year. If further examination of the agreement indicates that this is the case, the investment should be reported using the equity method. If A Ltd. does not have significant influence, the investment should be reported at fair value. The unrealized gain should be reported in net income unless A Ltd. irrevocably designates that the unrealised gains will be reported in other comprehensive income and will never be reported in net income.
- Since the trustee has seized all of B Co.’s assets, A Ltd. has lost control and probably does not have significant influence. It should discontinue consolidating B Co. Instead, the investment should be reported at fair value. Any gain or loss resulting from the adjustment to fair value should be reported in net income.
- While A Ltd. only owns 2% of equity, it does hold irrevocable agreements from the other partners that allow it to determine the strategic operating, investing, and financing activities of B Co. Therefore, this is a control investment and A Ltd. should consolidate B
Case 4-5 Smith & StewartManagement Committee Dear Sir/Madam: We enclose our report, which advises your firm on financial accounting issues. For purposes of analysis, several assumptions were made and are stated in the report. If these assumptions are inappropriate, please advise us, as changes in assumptions may change our recommendations. Yours truly, CA DRAFT REPORT ON FINANCIAL ACCOUNTING ISSUES
Financial accounting matters
In providing advice to the Smith & Stewart partnership (Stewart) on financial accounting matters, we must first answer two key, related questions:
- What basis is to be used to value assets and liabilities in the partnership’s financial statements: historical cost or fair value?
- What are the needs of the users of the financial statements?
These questions must be answered first because they affect the most important, if not all, information in the financial statements. You are probably aware that there is no single right way to prepare financial statements. It is the needs of the users that determine the methods used and hence the choice of valuation method.
Basis of Valuation
The partnership agreement requires an annual valuation of the firm’s assets and liabilities. The annual valuation is to be used in determining payments to be made by the firm to retiring or withdrawing partners and contributions to be made to the firm by new partners. It is not clear what form the partnership intends the annual valuation to take. You may be envisaging financial statements prepared using fair values instead of historical cost. Or you may be envisaging financial statements prepared using historical cost values and a separate, annual valuation report. Although the use of fair values for all assets and liabilities is not in accordance with generally accepted accounting principles (GAAP), Stewart’s financial statements do not have to conform to GAAP. What matters is whether the historical cost values prescribed by GAAP or some other basis of valuation will be the most useful to the users of Stewart’s financial statements.
Users and their needs
We have made the following assumptions about the major users of the financial statements and their needs:
- The bank. The bank will use the financial statements in assessing Stewart’s future cash flows to determine whether these amounts are likely to be sufficient to repay interest and principal amounts to the bank. In addition, the bank will look to the balance sheet to confirm that any loans advanced to Stewart are within the agreed limits, namely, 75% of the carrying value of receivables and 40% of the carrying value of work in progress.
- Partners will use the financial statements primarily to assess the firm’s performance. The partnership may also intend the financial statements to serve as the “annual valuation”. In addition, the partnership will want the financial statements to be prepared in such a way that it will be able to maximize its loans from the bank. Finally, partners will use the statements to determine the income amounts to be included in their individual tax returns.
Which valuation method to use
We recommend that the financial statements – especially the receivables and work in progress – be prepared on the basis of fair, rather than historical cost, values for two main reasons. First, the receivables and work in progress are two of the most significant assets on the balance sheet. Stating them at their fair values will increase the limits of the bank loan compared to the limits that would apply if these assets were stated at their historical cost.
Second, by reflecting fair values, the financial statements can be used to help determine the contributions to be made by new partners or the payments to retiring or withdrawing partners. Thus, the statements will serve the purpose of the annual valuation. A separate valuation report will not be needed, which will reduce the cost to Stewart of preparing the information requested.
Specific accounting policies
Accounting policies need to be chosen for:
- The value at which work in progress (WIP) will be recorded in the accounts;
- The timing of recognizing the revenue associated with WIP, and
- The value at which property, plant and equipment will be recorded.
The admission/retirement of partners and other matters with accounting policy implications are also discussed. The final part of this section deals with the valuation of the WIP at the merger date.
Work in progress (WIP)
The partnership can adopt one of the following two approaches to recording the WIP in the accounts:
- Record WIP at the regular billing rates, as time is accumulated for each client
Since the full amount is not always recoverable, the value of the WIP will be lowered to fair value (i.e., the best estimate of the likely recoverable amount) when the financial statements are to be prepared. The time spent can be recorded on a daily, weekly, or monthly basis, depending on how current the information needs to be. Your new computer system can track this information and provide up-to-date information promptly. This approach is consistent with our recommendation to use fair values.
- Record WIP at the cost incurred by the firm
Under this approach the accounts will show only the costs incurred by the firm for a given account; that is, no profit component will be included in WIP. For example, for each client, it will be necessary to determine the cost of the employee time spent on the client’s work to date, the cost of administrative services used for this client, etc. This approach entails numerous allocations of cost, which are crude estimates at best. For example, it is difficult to estimate the per-hour cost for each employee. Although employee salaries are fixed, the total hours that the employee will work during a given period are difficult to determine in advance. This approach would comply with GAAP, since WIP is stated at cost. The first approach would provide a higher WIP value, an advantage with regard to the bank loan. In addition, it would provide information that would be useful to the partners in determining admission/withdrawal payments. The second approach, although in accordance with GAAP, would not serve these purposes. Therefore, we recommend the first approach. Note that it has no adverse tax consequences. The increased value would not be added to taxable income until it is recognized as revenue.
Assuming that the recommendation above is accepted, WIP will be stated at the amount considered likely to be recovered. Another question remains: when should the WIP be recorded as a receivable and the corresponding amount included in the income statement as revenues? The timing affects the limits on the bank loan. As noted earlier, the loan maximum is set at 75% of receivables, as opposed to only 40% of WIP. Thus, the earlier that WIP can be recorded as receivable, the sooner the partnership will be able to borrow more money. Stewart has three options for timing the recognition of revenue:
- Record revenue as work proceeds
Under this option, all WIP will be recorded as accounts receivable. The accounts receivable balance will increase as early as possible, thereby maximizing the limits established on the bank loan as early as possible. However, the actual amount billed to the client may be more or less than the total hours spent on the client’s work. If the discrepancies are material, then the usefulness and credibility of the financial statements will be very limited, since revenues for prior periods will constantly have to be adjusted to reflect actual revenues. To the extent that the likely realizable value can be accurately estimated, based on past experiences perhaps, then these adjustments may not be material.
- Record the revenue when the amount has been invoiced
Under this option, the revenue will be recorded when the actual billable amount has been determined. Therefore, there will be no subsequent adjustments to the financial statements, as may occur under option 1.
- Record the revenue when the cash is eventually received
Under this option, revenue would be recorded only when the cash is eventually received. However, this option unduly delays the recognition of revenue. It is too conservative, unless you do in fact have doubts about the collectability of your accounts. I assume that cash collections are not a problem since, for example, risky accounts usually involve a retainer fee. Based on the objectives stated for the financial statements, option 1 would best serve your needs. However, it is probably very difficult for the partners to estimate, within a reasonable margin of error, the billable amount since the amount may depend on many factors such as the outcome of a case, etc. Therefore we recommend option 2, recognizing revenue when the billable amount has been determined. Note that the assets value will be increased as a result of our earlier recommendation to record WIP at the likely recoverable amount as each case is worked on. In order to postpone recognizing revenue until the billable amount has been determined, an offsetting liability, such as “unearned revenue,” would be recorded in the accounts. This unearned revenue would become “earned revenue” when the receivable is recorded in the accounts.
Other contributed assets
It is necessary to determine the value to be ascribed to the other assets contributed to the new partnership, namely, the property, plant and equipment. These assets can be recorded at their carrying amounts from the predecessor firms or at their fair value as of the transfer date. We recommend that the property, plant and equipment be recorded at fair value, to assist in the annual valuation of the firm. If fair values are difficult to determine, then we suggest that the carrying amounts be used. Future yearly valuations will report the property, plant and equipment at fair value, anyway, regardless of the amounts recorded in the accounts at this stage.
Admission of partners
Although the question of how to account for retiring and newly admitted partners may not arise until Stewart’s first year-end, the matter is addressed here since it can affect the value of all assets, liabilities and partners’ capital accounts. Generally, the question is whether the financial statements should reflect fair values, established by the contributions made by newly admitted partners or by payments made to withdrawing partners. These fair values can include goodwill. The alternative is to leave the assets and liabilities at their historical values. Both alternatives are acceptable under GAAP. As previously recommended the financial statements should be prepared using fair values, on an annual basis. Under this policy, partners’ accounts would reflect their share of the value of the firm. This policy would eliminate the need for a separate valuation report to determine withdrawal payments and admission contributions.
If the partnership decides to establish a management company to hold some of its assets and liabilities, these amounts would be included in the partnership’s financial statements since the assets and liabilities are owned and controlled by the partnership. Payments made to partners are generally not recorded in the accounts as an expense. Being members of a partnership, the partners are not paid a salary. Instead, they are entitled to the residual income of the partnership, after it has paid for all other expenses. Therefore, payments to partners are recorded as “drawings” which are deducted directly from their respective capital accounts.
WIP at the merger date
The new partnership agreement requires WIP to be valued at the merger date and the amount to be recorded as goodwill. The WIP outstanding at the merger date is an actual asset that will be received in the future, assuming that it is recoverable. Goodwill, on the other hand, is an intangible asset that arises from anticipated earning power, synergies and a variety of factors that cannot be identified separately.. Thus, the amount assigned to goodwill must reflect these other unidentifiable factors.. The goodwill amount cannot be arbitrarily determined to be the amount of the opening WIP balance. It is possible to record goodwill in the accounts if the partnership wishes to do so, but whatever amount is assigned to the goodwill account will be in addition to the WIP balance, not instead of it. The WIP balance must be presented in the financial statements as WIP or as a receivable. To do otherwise would result in double counting – first, the amount would be recorded as goodwill (which stays on the balance sheet) and then it would be recorded again, as revenue, when the cash is actually received or when the final bill is known. If the partnership decides that it does want to establish a goodwill account, then, as noted earlier, the amount assigned to it must reflect the anticipated earning power of the firm. This amount will be offset by an increase in each partner’s capital account. Case 4-6 REPORT TO PARTNER Fabio & Fox, Chartered AccountantsFor The Year Ending September 30, Year 8 As requested, I have prepared a report that can be used for your next meeting with Leo Titan, Chief Executive Officer of Lauder Adventuress Limited (“LAL”). The report deals with the accounting implications of the matters discussed with Leo. Over the past year, the business of LAL has changed: it now owns a sports franchise and is currently building a sports arena. A number of transactions have taken place in connection with the construction of the arena. You have asked me to comment on the various issues related to these transactions. There are multiple users of LAL’s financial statements, and they may have differing objectives. Before selecting the accounting policy for each transaction, we must consider the different users and decide who the primary user of the financial statements is. Users of LAL’s financial statements There are many users of LAL’s financial statements and, as noted, the objectives of each user may conflict. The users include LAL’s: Creditors. LAL’s creditors look to the financial statements to predict future cash flows and determine whether their loans will be repaid. Further, they look to the financial statements to ensure that the loan covenants are not violated and assist in determining the value of their security. The financial statements may not be appropriate for this use. Non-controlling shareholders. The non-controlling shareholders are not active in the business and need the financial statements to assess and monitor their investment and to assess Leo’s performance. They are also interested in being able to predict cash flow and in minimizing cash outflows in the form of taxes and unwarranted bonus payments. Management. Management bases its bonus on the financial statements and uses them to report the financial results of the company to shareholders. As a result, management may have a bias towards selecting accounting policies that tend to increase income and delay recognition of expenses, thus maximizing bonuses. Other users of the financial statements include Revenue Canada for income tax purposes. However, our engagement is with the directors of LAL and its management, and they must be our primary concern. As a result, the recommendations presented below must be consistent with their objectives, must fairly disclose the financial results of LAL, and must enable all users to monitor their investment. As noted, the company uses International Financial Reporting Standards (“IFRSs”). Some flexibility may exist in the choice of accounting policies. New policies can be selected to reflect the changing business. Overall, the accounting policies recommended must balance management’s objective of maximizing its bonus and the shareholders’ and creditors’ need to predict future cash flows using financial statements they can rely on. The accounting implications for each issue identified are discussed below. The alternative accounting treatments available are explained and an accounting policy is recommended where possible. The policies recommended ensure that the financial statements are not materially misleading and enable the users of the financial statements to predict the future cash flows of the company. Land revaluation ($100 million) The land currently owned and recorded in the financial statements is worth considerably more than $5.4 million if the sale of the excess land is used as a basis for calculating its value. Management would like to recognize a fair value increment in order to increase the value of the land to $100 million. The alternative is disclosing the potential increased value of the land in a note to the financial statements. However, neither approach is reasonable nor justifiable based on the information provided. All land is not identical or of equal value and, as a result, reporting an increment in the Year 8 financial statements based on the selling price of the excess land sold to developers would be misleading. It would be possible, however, for the company to choose to move to a revaluation model to account for its investment in land. IAS 16 provides an option with regards to accounting for property, plant and equipment – either a cost or revaluation model may be used. This would permit the company to revalue land to its fair value. However, it would be required to apply such a revaluation policy to all land held by LAL as the revaluation model is applied to an entire class of property, plant and equipment. Further this policy must be applied on an ongoing basis. Revaluation increases are credited to equity (as opposed to the income statement) except to the extent that they reverse a revaluation decrease of the same asset previously recognized in the income statement. Therefore, if the company expects that the value of the land has increased, such revaluation increase would impact equity and not the operating results for the current period, so changing to a revaluation model would not achieve the company’s objective of maximizing its earnings. It should also be noted that adopting a revaluation policy may be more onerous than using the cost method and may involve more complex record keeping. For example, values need to be tracked at the asset level as revaluation increases and decreases are only offset at the asset level and not the asset class level. Revaluations would need to be made with sufficient regularity that the carrying amount of the asset does not differ materially from that which would be determined using fair value at the balance sheet date. Given the objectives of the users of the financial statements as noted previously, and the fact that moving to a revaluation model would not increase earnings or be reflective of current cash flows, as well as the increased complexity associated with applying the revaluation model, I would initially recommend that the company maintain its accounting policy for land at historical cost. As noted above, recognizing fair value increments in the income statement for this type of asset is not in accordance with IFRSs. Sale of land ($24 million) Management intends to report the sale of the excess land in fiscal Year 8. We must decide whether it should be reported in the Year 8 or the Year 9 fiscal period. The sale has been agreed to, the sales contract has been signed, and a 25% deposit has been received. These facts support recognition in fiscal Year 8. However, the sale does not close until the Year 9 fiscal period and, although the deposit has been paid, the collectibility of the balance may not be assured. The sale has not closed and therefore the gain on sale should be reported in Year 9. The gain on sale could be presented as a separate line item on the income statement if such presentation is relevant to an understanding of the company’s financial performance. Note disclosure of the sale will help provide all users of the financial statements with the relevant information. One possibility to be considered is whether this excess land could have been classified as investment property up to and including the date of the sale. We do not have sufficient information to make that assessment. Paragraph 5 of IAS 40 provides the definition of investment property. “It is property (land or a building—or part of a building—or both) held (by the owner or by the lessee under a finance lease) to earn rentals or for capital appreciation or both, rather than for:(a) use in the production or supply of goods or services or for administrative purposes; or(b) sale in the ordinary course of business.” If it were possible to consider the excess land as investment property, LAL would have the option of using either the cost model or the fair value option. If the fair value option were chosen, in effect the sale price would be recognized in Year 8 regardless of conditions surrounding the sale, as fair value changes are recognized in income statement. Note that the use of the fair value option may in effect recognize a portion of the contingent profit element of the sale if this type of compensation would generally be offered on comparable transactions (i.e. – fair value determined based on a market model not using entity specific values). More information is needed. NSL start-up costs ($20 million) We must determine whether the start-up costs related to NSL should be capitalized or should be expensed as an operating cost. Their treatment will become an important issue to management if NSL is consolidated with LAL. Generally, start-up costs should be expensed as incurred under IFRSs unless such costs can be considered a tangible or intangible asset. If a future benefit results from having incurred them, they qualify as an asset and can be capitalized. It is therefore necessary to consider the nature of the particular start-up costs incurred. According to IAS 38 (paragraph 69) “In some cases, expenditure is incurred to provide future economic benefits to an entity, but no intangible asset or other asset is acquired or created that can be recognized. In these cases, the expenditure is recognized as an expense when it is incurred…Other examples of expenditure that are recognized as an expense when they are incurred include: expenditure on start-up activities (i.e. start-up costs), unless this expenditure is included in the cost of an item of property, plant and equipment in accordance with IAS 16. Start-up costs may consist of establishment costs such as legal and secretarial costs incurred in establishing a legal entity, expenditure to open a new facility or business (i.e., pre-opening costs) or expenditures for starting new operations or launching new products or processes (i.e. pre-operating costs).” Therefore, the equipment costs ($3.2 million) would likely qualify for capitalization as property, plant and equipment. However, advertising and promotion costs ($1.5 million), wages, benefits and bonuses ($6.8 million), and other operating costs ($3.3 million) are period costs and should be expensed as incurred. We would need further information to determine whether or not the costs related to the acquisition of the player contracts ($12 million) can be capitalized as costs of acquiring an intangible asset (IAS 38). If they do not qualify for recognition as intangible assets, the costs should be expensed as incurred. The amount of control and whether there are future economic benefits would have to be assessed to determine if the costs meet the criteria for capitalization as an intangible asset (IAS 38.15) Note that if capitalizing – impairment should be reviewed upon indicators of impairment. Due to the nature of this asset, impairment reviews are likely required on a regular basis and may introduce more volatility to reported earnings. Purchase of amusement park ($4.25 million) Since the asset is acquired as part of a business combination, IFRS 3 applies. This means that the assets acquired are recorded at their fair values at the date of acquisition. Any other costs incurred to acquire those assets are expensed. While the specific costs in question here are not addressed in IFRS 3, the Basis for Conclusions to IFRS 3 at BC365 and BC 369 seems to support that the assets should be recorded at their fair values and should not include other costs. If the acquirer has to move the assets or prepare a site etc. those are not costs related to the business combination itself but to separate activities of the acquirer. As such, given that the assets are already recorded at their fair value on acquisition, it would seem that any other costs to relocate, install, prepare site etc. should be expensed. Therefore, under IFRS, the costs incurred to set up, or move, the amusement park assets to the new location must be expensed for accounting purposes. This would include the $350,000 incurred to transport the amusement park assets to their new location, the $400,000 spent to get the assets in operating order, and the $500,000 spent to install the assets in their new location (i.e. the amount spent on site preparation and foundations). In addition, there is a negative acquisition differential equal to $1.3 million. This differential is net of the present value of a loss carry forward recorded as an asset in the acquisition cost. In order to recognize a deferred tax asset, its realization must be probable. If a deferred tax asset qualifies for recognition, it should be recognized at its undiscounted amount as IFRS prohibits discounting of deferred tax assets (IAS 12, paragraph 53). This would increase the negative acquisition cost differential, thereby increasing the credit to the income statement (refer below). The negative acquisition cost differential (or “excess”) reflects a bargain purchase. In accordance with IFRS 3, before recognizing a gain on a bargain purchase, the company would first need to reassess whether it has correctly identified all of the assets acquired and all of the liabilities assumed and recognize any additional assets or liabilities that are identified in that review. To the extent that excess still remains after such review, the company would recognize a gain in the income statement reflecting the bargain purchase. Insurance on construction ($1.4 million) Management wants to capitalize the cost of insurance related to the construction activity in the current period. One argument is that this amount relates to the cost of constructing the building and would not otherwise have been incurred. According to IAS 16, paragraph 16, the cost of the building should include any costs directly attributable to bringing it to the location and condition necessary for the building to be capable of operating in the manner intended. The issue is whether the cost is “directly attributable” to the asset being constructed. Given that it could be argued that this insurance cost is a necessary cost of the construction activity, this amount could be capitalized, which would maximize income. On the other hand, one might argue that insurance is an overhead cost and is generally incurred every year and should therefore be expensed as incurred (IAS 16, paragraph 19 (d)). I recommend that the amount be capitalized to the asset under construction and that the asset value be monitored to ensure there is no impairment to the value. Ride relocation ($540,000) Again, we must decide whether the costs should be capitalized or expensed for accounting purposes. Does the expenditure represent a “betterment” to the rides and increase their useful life, or is the amount strictly a moving cost or repair-type expenditure? In order to capitalize this amount, we must argue that the cost improves the useful life of the rides or increases the amount of future income that can be earned from the rides. The support for expensing these costs in the current period includes the fact that it is a moving cost and does not improve or lengthen the useful life of the rides relocated. Another possibility might potentially be to say that the dismantling is a preparation costs for the new arena to be built- i.e. part of capital cost related to arena. However, although IAS 16, para. 16(c) refers to dismantling costs, these dismantling costs must relate to the item acquired, i.e. if a machine was acquired, and the machine had to be dismantled in order to relocate to the acquirer’s place of business, then such dismantling costs would be included in the cost of the asset. It does not appear that costs to dismantle a different asset (i.e. rides) could be included in the cost of the arena. IAS 16, para. 20 in fact suggests that costs to redeploy an item (i.e. in this case, to move the rides from one location to another) should not be included in the carrying amount of that item. Based on the above discussion, the amount should be expensed in the current period. It is difficult to argue that the useful life of the rides has been increased. Without strong support for this position, capitalizing the cost is not reasonable. This treatment allows for better predictability of cash flows given that the amount was incurred in the current period. Arranging fees ($500,000) A $500,000 fee was paid to a mortgage broker to arrange financing for LAL. This amount has been recorded as “Other assets.” No financing has been arranged to date. The accounting for the fee paid to the mortgage broker depends on the nature of the fee and the classification of the resulting financial liability (IAS 39). We don’t have a lot of information as to the nature of the fees. If the fee is similar to a commission it could be considered a transaction cost. However, if the fee is payment for services of researching alternatives and then another fee would be levied upon the actual transaction, then the first fee would not be a transaction cost and should be expensed when incurred. If the arranging fee is not refundable if financing isn’t arranged, then the fee should be expensed as incurred since it would not be considered to be a transaction cost related to a financial liability (Transaction costs are defined in AG13 as “fees and commissions paid to agents (including employees acting as selling agents), advisers, brokers and dealers, levies by regulatory agencies and securities exchanges, and transfer taxes and duties. Transaction costs do not include debt premiums or discounts, financing costs or internal administrative or holding costs.”). In this sense, transaction costs are incremental costs that are directly attributable to the acquisition of a financial liability. If the arranging fee meets the definition of a transaction cost, then the classification of the related financial liability must be considered as described below. Until such time as the related financing was drawn down, transaction costs would be deferred on the balance sheet. Upon drawdown of the related financing:Transaction costs would be expensed if they relate to financial liabilities that are accounted for at fair value through the profit and loss.Transaction costs related to financial liabilities not at fair value through the profit and loss would be netted against the financial liability. Consolidation of NSL ($500,000) NSL must be consolidated for accounting purposes because LAL controls the company. Golf membership fees We must determine whether the revenue from the non-refundable golf membership fees can be recognized in income immediately or deferred and recognized in income over time—as members use the course. The accounting depends on the nature of the services provided. The justification for recognizing the amount in income is that the fee is non-refundable and there is no future service that must be provided. In fact, members are required to pay a separate monthly fee of $100 to maintain their membership. IAS 18, Paragraph 17 states: “Initiation, entrance and membership fees. Revenue recognition depends on the nature of the services provided. If the fee permits only membership, and all other services or products are paid for separately, or if there is a separate annual subscription, the fee is recognized as revenue when no significant uncertainty as to its collectibility exists. If the fee entitles the member to services or publications to be provided during the membership period, or to purchase goods or services at prices lower than those charged to non-members, it is recognized on a basis that reflects the timing, nature and value of the benefits provided.” Conversely, the support available for deferring the income is that the amount has not yet been earned, that is, the member would not have paid the $2,000 entrance fee in absence of the right it provides for membership over the subsequent membership period. If deferred, the income should be recognized over a 5-year period —the length of the contract. My preliminary recommendation is that the amount be taken into income immediately. The amount is non-refundable, there is a separate, monthly membership fee over and above the entrance fee, and immediate recognition better reflects the actual cash flows. All users of the financial statements are served well by this policy. The $350,000 in upgrade costs to the facilities should not be recorded in the financial statements until incurred. Contingent profit on the sale of excess land Management wants to disclose the probability that a contingent gain will be earned on the sale of the excess land in a note to the financial statements. Disclosure is possible. However, it is important that disclosures for contingent assets avoid giving misleading indications of the likelihood of income arising. According to IAS 37, if the likelihood that a future benefit will be received is probable, then disclosure should be made in a note to the financial statements, including a brief description of the nature of the contingent asset and, where practicable, an estimate of its financial effect. (Note: consider the earlier discussion around investment property and impact on financial statements if treated as investment property using the fair value option.) If and when the payment is received, management should consider whether it should be disclosed separately on the face of the income statement or in the notes when such presentation is relevant to an understanding of LAL’s financial performance. Golf course relocation costs ($168,000) We must decide whether the golf-course relocation costs should be capitalized as part of the golf course lands or whether they should be expensed for accounting purposes. Generally, the decision depends on whether the expenditure represents a betterment or improvement to the course or a repair to the current property. The argument that the relocation cost improves the course and potentially increases the future revenue that LAL could earn suggests that the amount should be capitalized. On the other hand, one could argue that the cost does not increase the value of the course or the potential for increased revenues in the future in that these costs serve only to relocate an existing asset. Note that IAS 16, paragraph 19 c) specifically prohibits capitalization of costs associated with relocating an asset. Another argument might be that the golf course relocation costs are actually costs of getting the road into its intended state and therefore that these costs should be capitalized as part of the road costs. The relocation costs are arguably directly attributable to the cost of the road. I recommend that the golf course relocation costs be capitalized as part of the road costs for accounting purposes. Management maximizes its bonus, and the other users of the financial statements will be able to predict future cash flows. Private boxes ($36,000 vs. $180,000) We must determine whether the revenue from leasing private boxes should be recognized for accounting purposes or deferred. In order to recognize the deposits received as income, the deposits received would have to be non-refundable with no requirement of providing service in the future. However, each deposit is a prepayment on a five-year lease of a box. Therefore, the support for deferring recognition of the income is that future revenue will be earned from use of the boxes, i.e. that revenue has not yet been earned and therefore should not be recorded in the financial statements. Therefore, since there is an element of future service involved by virtue of the lease arrangement, the deposit should be recognized as income over the period of the lease.Bonus accrual Overall, the bonus system appears to be determining the accounting policies selected, and poor decisions may be made as a result. The bonuses must be accrued for in the year in which they are earned, based on net income, and not when they are paid. Conclusion The recommendations made above are based on the analysis provided and the users and their objectives. Overall, management’s selected policies are misleading, given the significant expenses and short-term cash requirements of LAL. The accounting treatments selected must be fairly disclosed so that the various users with their differing objectives can properly interpret the financial statements. SOLUTIONS TO PROBLEMS Problem 4-1(a)Cost of 70% of Barrel $329,000Implied value of 100% of Barrel 470,000 (a)Carrying amount of Barrel’s net assets (480,000 – 180,000) 300,000Acquisition differential 170,000Allocated:Plant and equipment (320,000 –270,000) 50,000 (b)Goodwill $120,000 (c) Pork Co. Consolidated Statement of Financial Position December 31, Year 2 Plant and equipment (400,000 + 270,000 + (b) 50,000) $720,000Goodwill (c) 120,000Inventory (120,000 + 102,000) 222,000Accounts receivable (45,000 + 48,000) 93,000Cash (22,000+ 60,000) 82,000$1,237,000 Ordinary shares $260,000Retained earnings 200,000Non-controlling interest (30% ´ (a) 470,000) 141,000Long-term debt (240,000 + 108,000) 348,000Current liabilities (216,000 + 72,000) 288,000$1,237,000 (b) Goodwill under entity theory $120,000Less: NCI’s share (30%) 36,000Goodwill under parent company extension theory $84,000 NCI under entity theory $141,000Less: NCI’s share of goodwill (30%) 36,000NCI under parent company extension theory $105,000 Problem 4-2 Case 1 Cost of investment $95,000Carrying amount of Sub Ltd.’s net assetsAssets $88,000Liabilities 30,00058,000Acquisition differential 37,000 Allocated: FV – CAInventory (26,000 –21,000) $5,000Plant (60,000 –51,000) 9,000Trademarks (14,000 –7,000) 7,00021,000Long-term debt (19,000 –20,000) 1,000 22,000 Balance: goodwill $15,000 Par Ltd. Consolidated Balance Sheet January 1, Year 2 Cash (100,000 –95,000 + 2,000) $7,000Accounts receivable (25,000 + 7,000) 32,000Inventory (30,000 + 21,000 + 5,000) 56,000Plant (175,000 + 51,000 + 9,000) 235,000Trademarks (0 + 7,000 + 7,000) 14,000Goodwill (0 + 0 + 15,000) 15,000$359,000 Current liabilities (50,000 + 10,000) $60,000Long-term debt (80,000 + 20,000 –1,000) 99,000Common shares 110,000Retained earnings 90,000$359,000 Case 2 Cost of 80% investment $76,000Implied value of 100% $95,000Carrying amount of Sub Ltd.’s net assetsAssets $88,000Liabilities 30,00058,000Acquisition differential 37,000 Allocated: FV – CAInventory $5,000Plant 9,000Trademarks 7,00021,000Long-term debt 1,000 22,000Goodwill $15,000 Non-controlling interest (20% ´ 95,000) $19,000 Par Ltd. Consolidated Balance Sheet January 1, Year 2 Cash (100,000 –76,000 + 2,000) $26,000Accounts receivable (25,000 + 7,000) 32,000Inventory (30,000 + 21,000 + 5,000) 56,000Plant (175,000 + 51,000 + 9,000) 235,000Trademarks (0 + 7,000 + 7,000) 14,000Goodwill (0 + 0 + 15,000) 15,000$378,000 Current liabilities (50,000 + 10,000) $60,000Long-term debt (80,000 + 20,000 –1,000) 99,000Common shares 110,000Retained earnings 90,000Non-controlling interest 19,000$378,000 Case 3 Cost of investment $80,000Carrying amount of Sub Ltd.’s net assetsAssets $88,000Liabilities 30,00058,000Acquisition differential 22,000 Allocated: FV – CAInventory $5,000Plant 9,000Trademarks 7,00021,000Long-term debt 1,000 22,000Goodwill $ –0– Par Ltd. Consolidated Balance Sheet January 1, Year 2 Cash (100,000 –80,000 + 2,000) $22,000Accounts receivable (25,000 + 7,000) 32,000Inventory (30,000 + 21,000 + 5,000) 56,000Plant (175,000 + 51,000 + 9,000) 235,000Trademarks (0 + 7,000 + 7,000) 14,000$359,000 Current liabilities (50,000 + 10,000) $60,000Long-term debt (80,000 + 20,000 –1,000) 99,000Common shares 110,000Retained earnings 90,000$359,000 Case 4 Cost of investment $70,000Carrying amount of Sub Ltd.’s net assetsAssets $88,000Liabilities 30,00058,000Acquisition differential 12,000 Allocated: FV – CAInventory $5,000Plant 9,000Trademarks 7,00021,000Long-term debt 1,000 22,000Negative goodwill (10,000)Recognized in income 10,000Goodwill $–0– Par Ltd. Consolidated Balance Sheet January 1, Year 2Cash (100,000 –70,000 + 2,000) $32,000Accounts receivable (25,000 + 7,000) 32,000Inventory (30,000 + 21,000 + 5,000) 56,000Plant (175,000 + 51,000 + 9,000) 235,000Trademarks (0 + 7,000 + 7,000) 14,000$369,000 Current liabilities (50,000 + 10,000) $60,000Long-term debt (80,000 + 20,000 –1,000) 99,000Common shares 110,000Retained earnings (90,000 + 10,000) 100,000$369,000 Case 5 Cost of 90% investment $63,000Implied value of 100% investment $70,000Carrying amount of Sub Ltd.’s net assetsAssets $88,000Liabilities 30,00058,000Acquisition differential 12,000Allocated: FV – CAInventory $5,000Plant 9,000Trademarks 7,00021,000Long-term debt 1,000 22,000Negative goodwill (10,000)Recognized in income 10,000Goodwill $ –0– Non-controlling interest (10% ´ 70,000) $7,000 Par Ltd. Consolidated Balance Sheet January 1, Year 2 Cash (100,000 –63,000 + 2,000) $39,000Accounts receivable (25,000 + 7,000) 32,000Inventory (30,000 + 21,000 + 5,000) 56,000Plant (175,000 + 51,000 + 9,000) 235,000Trademarks (0 + 7,000 + 7,000) 14,000$376,000 Current liabilities (50,000 + 10,000) $60,000Long-term debt (80,000 + 20,000 –1,000) 99,000Common shares 110,000Retained earnings (90,000 + 10,000) 100,000Non-controlling interest 7,000$376,000 Problem 4-3(a)Cost of 90% investment $40,500Implied value of 100% investment 45,750Carrying amount of Seeview Co.’s net assetsAssets $87,500Liabilities 62,50025,000Acquisition differential 20,000 Allocated: FV – CAInventory $1,250Plant assets 8,750Intangible assets 2,500Contract with Customer 10,00022,500Long-term debt 5,000 27,500Negative goodwill (7,500)Recognized in Petron’s income 7,500Goodwill $–0– Non-controlling interest (10% x 45,000) $4,500 Petron Co. Consolidated Balance Sheet June 30, Year 2 Cash and receivables (80,000 –40,500 –1,000 + 16,250) $54,750Inventory (47,500 + 7,500 + 1,250) 56,250Plant assets (190,000 + 58,750 + 8,750) 257,500Intangible assets (20,000 + 5,000 + 2,500) 27,500Contract with Bardier 10,000$406,000 Current liabilities (52,500 + 25,000) $77,500Long-term debt (81,250 + 37,500 –5,000) 113,750Common shares 127,500Retained earnings (76,250 + 7,500 –1,000) 82,750Non-controlling interest 4,500$406,000(b) Petron Co.Balance SheetJune 30, Year 2 Cash and receivables (80,000 –40,500 –1,000) $ 38,500Inventory 47,500Investment in Seeview (40,500 + 7,500) 48,000Plant assets (net) 190,000Intangible assets 20,000$344,000 Current liabilities $ 52,500Long-term debt 81,250Common shares 127,500Retained earnings (deficit) (76,250 + 7,500 –1,000) 82,750$344,000 Problem 4-4 Cost of investment (288,000 + 40,000 for contingent consideration) $328,000Implied value of 100% investment $410,000Carrying amount of McGraw Ltd.’s net assetsAssets $728,000Liabilities 390,000338,000Less: goodwill 39,000299,000Acquisition differential 111,000Allocated: FV – CAInventory $6,500Land 39,000Plant and equipment (13,000) 32,500Goodwill $78,500 Hill Corp. Consolidated Balance Sheet December 31, Year 4Cash (13,000 + 6,500) $19,500Accounts receivable (181,300 + 45,500) 226,800Inventory (117,000 + 208,000 + 6,500) 331,500Land (91,000 + 52,000 + 39,000) 182,000Plant and equipment (468,000 + 377,000 – 13,000) 832,000Goodwill (117,000 + 0 + 78,500) 195,500$1,787,300 Current liabilities (156,000 + 104,000) $260,000Contingent consideration payable 40,000Long-term debt (416,000 + 286,000) 702,000Common shares 520,000Retained earnings 183,300Non-controlling interest (20% x $410,000) 82,000$1,787,300
Purchase for Continue…..