Ch03 beechy ism

CHAPTER 3
Business Combinations
This chapter contains the central discussion of business combinations in the text. We
address the nature of a business combination and the general approach to accounting for a
business combination that arises from one company’s purchasing control of another.
The chapter provides a conceptual discussion of the alternative approaches to reporting
business combinations, but focuses mainly on the acquisition method and provides an
illustrative example. The general approach to accounting for a business combination under
the acquisition method is a five-step process:
1. Identify the acquirer.
2. Determine the acquisition date.
3. Calculate the fair value of the purchase consideration transferred (i.e., the cost of
the purchase).
4. Recognize and measure, at fair value, the identifiable assets and liabilities of the
acquired business.
5. Recognize and measure either goodwill or a gain from a bargain purchase, if
either exists in the transaction.
Each step in the process is explained from a conceptual perspective, identifying the
potential difficulties. The difficulties of estimating fair values are discussed. Professional
judgement must be exercised while determining the purchase price when a business
combination is not a cash transaction and when allocating the fair value of the acquisition
to the underlying assets and liabilities. It is important for students to recognize these
crucial but often overlooked aspects of business combinations.
In this chapter, we present an illustration of the direct method of preparing consolidated
financial statements. We discuss the advantages and disadvantages of purchasing shares
(as well as share exchanges) as compared to a purchase of net assets. We include a
conceptual discussion of the recognition of goodwill and negative goodwill (i.e., a gain
from bargain purchase), as a result of the business combination. The chapter also briefly
describe push-down accounting. In this chapter, we do not discuss the issue of non-
controlling interest chapter in order to avoid confusion between (1) alternative basic
approaches to consolidation on the one hand and (2) alternative treatments of non-
controlling interest on the other. Non-controlling interest is discussed fully in Chapter 5.
Accounting for deferred income taxes is discussed as an appendix to this chapter.
It is wise to be certain that students fully understand the concepts discussed in this chapter
before proceeding to the following chapters. Cases 3-1 through to 3-5 are one- and two-
issue cases intended to highlight specific points—least some of them should be assigned.
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Copyright © 2014 Pearson Canada Inc.

Chapter 3 – Business Combinations
Case 3-6 is a multi-subject case for which you may assign the whole case or only a part
thereof. In Case 3-7 students are asked to review a claim of damages based on a
disagreement over accounting policies.
SUMMARY OF ASSIGNMENT MATERIAL
Case 3-1: Ames Brothers Ltd.
Reviewing the material in the previous chapter on the reporting of intercorporate
investments, this case also raises the issue of acquisition of control through indirect
holdings.
Case 3-2: Sudair Ltd. and Albertair Ltd.
This case is an example of a situation for which it is difficult to identify the acquirer. It is
likely a reverse take-over.
Case 3-3: Pool Inc. and Spartin Ltd.
This case is effective for pointing out how the legal form of a business combination can
vary without affecting the economic substance. The alternative combination methods
suggested are a straight take-over, a reverse take-over, and the creation of a new holding
company.
Case 3-4: Boatsman Baots Limited and Stickney Skate Corporation
In this case, two private companies combine. The ownership interests are 60/40, but a
shareholders' agreement calls for equal representation on the Board of Directors. An
additional complication arises from the existence of a significant non-controlling interest in
one of the companies. The case asks the student to consider the different consolidation
approaches.
Case 3-5: Growth Inc. and Minor Ltd.
This is the only case in the book that focuses on the issue of fair valuation and illustrates
that the determination of fair values in a business combination is not as simple or as
precise as it might seem at first glance.
Case 3-6: Wonder Amusements
This is a multi-competency case that incorporates accounting, assurance and tax issues.
The students must consider the users’ objectives in analyzing the proposed accounting
treatment and making recommendations. The recommended accounting policies need to
comply with international standards.
Case 3-7: Major Developments Corporation
In this case, students are asked to review a claim of damages based on a disagreement
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over accounting policies. The issues in dispute include consolidation (does control exist?),
revenue recognition, the valuation of an investment and the capitalization of costs. You
could change the required for the case in a class discussion and have half the class
preparing arguments for Major and half of the class preparing arguments for John
Gossling.
P3-1 (30 minutes, easy)
A straight-forward problem that illustrates the similarity of reported results regardless of
the combination method used. It helps to demonstrate why the acquisition method of
consolidation is used.
The problem provides six independent cases with different permutations of the values of
the purchase price, fair value of net identifiable assets, and carrying value of net
identifiable assets. The problem requires students to calculate the 1) net fair value
adjustment, 2) fair value adjustment allocated to net identifiable assets, and 3)
goodwill/gain from bargain purchase for each of these six independent cases.
This problem requires consolidation at the date of acquisition under the acquisition
method. One aspect that may give students trouble is the existence of preferred shares in
the acquired company.
P3-4 (20 minutes, medium)
This is a problem on the acquisition method that requires an SFP at the date of acquisition.
The problem illustrates what the statement of financial position of the acquired company
as a separate entity looks like when the acquirer purchases the net assets directly by an
issuance of shares to the acquiree (rather than to the acquiree’s shareholders).
This is a relatively straight-forward problem requiring the preparation of a pro-forma
statement of financial position upon the purchase of net assets for cash.
Preparation of eliminations and adjustments at date of acquisition. Fair value decrements
predominate.
Preparation of a consolidated statement of financial position at the date of acquisition; a
straight-forward problem.
The first of a series of three related problems, this is a simple start that requires only a
statement of financial position at the date of acquisition of a purchased subsidiary. The
succeeding problems are P4-6 (for one year after acquisition) and P4-7 (for the second
year after acquisition).
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P3-9 (35 minutes, difficult)
The problem requires students to derive the separate entity SFP of the parent under the
cost method on the date of acquisition of its subsidiary using the provided separate entity
SFP of the subsidiary and the consolidated SFP on that date.
P3A-1 (30 minutes, easy)
The problem requires calculation of the deferred taxes relating to the fair value adjustment
allocated to the net identifiable assets in six independent cases.
P3A-2 (40 minutes, medium)
This problem requires students to cope with negative goodwill. The problem also requires
assigning fair values to two off-balance sheet assets: (1) production rights and (2) tax loss
carryforward. It is an exercise in assigning fair values to the net assets; no consolidation is
required.
P3A-3 (20 minutes, easy)
Eliminations and adjustments, including the adjustment relating to deferred taxes on the
date of acquisition are related.
ANSWERS TO REVIEW QUESTIONS
Q3-1: A business combination can result from either (1) a purchase of the assets of a
business entity as a going concern or (2) a purchase of a majority of the voting shares of
another corporation that constitutes a going concern.
Q3-2: The acquiring company can pay for another business by cash, by other assets, by
issuing its own shares, or by a combination of these.
Q3-3: A purchase of assets or net assets is recorded in total at the fair values of the assets
or net assets on the acquisition date, i.e. the date on which control is obtained over the net
assets. Any surplus of the total purchase price over the fair values of the net assets is
recorded as goodwill.
Q3-4: Under IFRS, the fair value of an asset is the amount at which it can be exchanged
between knowledgeable, willing parties in an arm’s length transaction. Usually the fair
value is arrived at based on market-based evidence determined by appraisal. If market-
based measures are not available, fair values may need to be estimated using income or a
depreciated replacement cost approach.
Q3-5: Fair values should reflect the transaction price that would have ensued in an arm’s
length transaction. Therefore, the valuation technique used to obtain such fair values
should reflect all the factors that would be considered by market participants to set the
price. In general, therefore, liabilities are measured at their discounted present values using
current market rates of interest.
Q3-6: Negative goodwill or a gain from bargain purchase exists when the price paid is less
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than the fair value of the net identifiable assets acquired. Negative goodwill or a gain from
bargain purchase is recognized as a gain in the consolidated SCI issued by the acquirer in
the period in which the business combination occurs.
Q3-7: After the issuance of shares, the acquirer owns the assets that previously belonged
to the other company and the other company is a new shareholder in the acquirer.
Q3-8: A purchase of shares has the advantages that (1) not all of the shares need be
purchased (thereby reducing the cost of the investment); (2) the shares may be selling for a
market price that is less than fair value; (3) the shares are easier to sell than the assets; (4)
the business entity purchased remains as a separate legal entity; and (5) the purchase price
may be less because the selling shareholders may not be taxed on their gains from selling
the shares.
Q3-9: The disadvantages of executing a business combination via a purchase of shares is
that non-controlling shareholders (if any) may limit the exercise of control by the acquirer
and that the purchase may be more expensive than a direct purchase of the assets. In
addition, the acquirer will not be able to deduct for income tax purposes either the costs of
the assets in excess of their carrying values or any of the goodwill.
Q3-10: An acquirer can negotiate directly with the shareholders or can issue a public
tender offer to acquire the target company’s shares, regardless of whether the
management of the target company approves of the attempted acquisition or not.
Q3-11: An acquirer of shares does not gain tax deductibility for the values of the net
assets acquired. The assets continue to have their same pre-combination tax values to the
acquired company, which still exists as a separate taxpaying entity. When the assets are
acquired directly, however, a new tax basis is established for the assets on the books of the
acquirer.
Q3-12: An acquirer can limit the number or proportion of shares that it is willing to buy in
a tender offer. If more shares are tendered than the acquirer is willing to buy, the acquirer
will buy only the proportionate part of each block of shares tendered.
Q3-13: The newly issued shares of P will be owned by the former shareholders of S.
Q3-14: The acquirer is the company whose pre-combination shareholders have voting
control of the combined economic entity.
Q3-15: A reverse take-over is most likely to be used when the in-substance acquirer wants
a stock exchange listing and the in-substance acquiree (but legal acquirer) has one.
Q3-16: The legal acquirer’s net assets will be reported at fair values because it is actually
the acquiree, in substance.
Q3-17: A name change often occurs to reflect the economic reality that the legal acquiree
has control of the combined enterprise, and because the legal acquiree wants its name to
appear on the financial statements and on the stock exchange listing, if any. Also, a name
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change clarifies the accounting requirement to restate the legal acquirer’s net assets to fair
value.
Q3-18: The only form of business combination in which the combining companies cease
to exist as separate legal entities is a statutory amalgamation.
Q3-19: When a parent company (or its owners) rearrange the intercorporate ownerships
among the parent and its subsidiaries, the rearrangement is called a corporate
restructuring. Because the transactions that are entered into for the restructuring are not
arms-length transactions, there is no substantive change in ownership of the corporate
group as a whole and no basis for revaluing the assets. Therefore, the restructuring is
accounted for as though it were a pooling of interests.
Q3-20: Push-down accounting is most likely to be used when the purchaser acquires
100% of the acquiree’s voting shares and there are no outstanding public issues of
bonds, preferred shares or other non-voting securities.
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CASE NOTES
Case 3-1: Ames Brothers Ltd.
Objectives of the Case
This case is intended to focus students’ attention on (1) whether control has been obtained
through indirect holdings and (2) whether equity reporting is appropriate for each of the
investor companies. There is only one investee corporation with three investors making
competing investments.
Objectives of Financial Reporting
As these are all public companies, minimum disclosure and compliance with securities acts
would be appropriate and an IFRS constraint is assumed.
a. Has a business combination occurred?
No investor has gained direct ownership of a majority of Ames Brothers’ (ABL) voting
shares. Indirect holdings exist, however; Patterson Power Corporation has control of one
ABL investor (Silverman) and probably has significant influence over another of the
investors (Hislop). As a result, Patterson controls 32% (Silverman’s share) of ABL and
can influence voting of another 24% (Hislop’s share). Effectively, Patterson would appear
to be able to control ABL. The fact is, however, that Patterson’s beneficial interest in
ABL is only 32%; Patterson does not have control of Hislop and therefore cannot be
assured of controlling that portion of ABL. A business combination has not occurred.
Note that the 58% holding of ABL preferred shares is irrelevant to this question because
the preferred shares are non-voting.
b. How should the ABL shares be reported?
Silverman Mines: Silverman Mines has the largest single block of ABL’s shares. Silverman
is also a conduit for Patterson’s clear significant influence over ABL. Since Patterson
could arrange the financial affairs of ABL and Silverman to manipulate reported income of
Silverman and Patterson if the cost method of reporting was used, Silverman should
report its investment in ABL on the equity basis. Note that it does not matter whether the
significant influence over ABL originates with Patterson or with Silverman; Silverman is
clearly involved in the exercise of significant influence.
Hislop Industries: As was the case for Silverman, Hislop should report its investment in
ABL on the equity basis, assuming that Patterson has significant influence over Hislop.
This demonstrates that more than one investor can report the same company on the equity
basis.
Render Resources: Render’s investment is in non-voting preferred shares. The cost basis is
appropriate.
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Patterson Power Corporation: Patterson has no direct investment in ABL. However,
Patterson controls Silverman and therefore normally will consolidate Silverman. As a
result of the consolidation, Silverman’s investment in ABL will appear as an investment on
Patterson’s consolidated statements. In addition, Patterson will report its equity in the
earnings of Hislop. Hislop will report its share of the earnings of ABL. By picking up its
38% of Hislop’s earnings, Patterson will be reporting its 38% of Hislop’s 24% of ABL’s
earnings available to common shares. In other words, 9.12% (38% × 24%) of ABL’s
earnings will find their way into the Patterson statements as a result of Hislop’s holdings,
and another 23.04% (72% × 32%) will show up as a result of the consolidation of
Silverman.
Case 3-2: Sudair Ltd. and Albertair Ltd.
This case involves a situation that is an example of a reverse take-over or a situation
where it is difficult to identify the acquirer. It is a single issue case that focuses on the
identification of an acquirer.
Objectives of Financial Reporting
There is little to indicate objectives except for the fact that both combining companies are
public companies and that compliance with security acts is a relevant objective.
Discussion
Sudair is the issuing company, issuing two new shares for each outstanding share of
Albertair. Sudair is legally the acquirer. The substance of the transaction may be different,
however.
The effect of the exchange of shares is that the former shareholders of Albertair will hold
1,200,000 shares of Sudair, or 54.5% of the outstanding shares, while the original
shareholders of Sudair end up holding only 45.5% of the Sudair shares. Since the former
shareholders of Albertair will have a majority of the shares in the combined company, the
combination could be considered to be a reverse take-over wherein the legal acquiree is in
substance the acquirer.
Before concluding that the combination is a purchase, other factors should be considered.
While it is true that the former Albertair shareholders end up with a majority of the votes,
the majority is not a large one. There is no indication in the case that there are large blocks
of stock being held on either side. If the shares of both companies are widely distributed,
then the “dominant position” of the Albertair shareholders is more apparent than real.
Another fact is that while ex-Albertair shareholders have more votes, Sudair seems to be
bringing more assets to the combination. More assets might be extended to indicate more
employees and/or managers, in which case the former management of Sudair may actually
have a larger impact on the combined company, regardless of the distribution of shares.
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Therefore, while it is clear that Sudair is not the acquirer in substance, it is not clear that
Albertair is the acquirer either.
Case 3-3: Pool Inc. and Spartin Ltd.
This case is intended to illustrate some of the different ways in which a business
combination can be effected, and the fact that the form of the combination does not affect
the substance of the transaction. The financial reporting for the transaction should follow
the substance rather than the form.
Analysis of Alternatives
Prior to the combination, Pool has 1,600,000 common shares outstanding at a market
price of $33 per share. Spartin has 1,200,000 common shares outstanding with a market
price of $20 per share. In the combination, whatever the form, new shares will be issued in
the ratio of two Spartin shares to one Pool share. The alternative exchanges would have
the following results:
Alternative 1: Pool will issue 600,000 new shares in exchange for Spartin’s shares. Pool
will then have 2,200,000 shares outstanding, of which 1,600,000 (73%) will be held by the
original shareholders of Pool and 600,000 (27%) will be held by the former shareholders
of Spartin. Spartin will still have 1,200,000 shares outstanding, all of which will be owned
by Pool Inc. Pool is the legal acquirer, and also is the acquirer in substance.
Alternative 2: Spartin will issue 3,200,000 new common shares in exchange for Pool’s
shares. After the exchange, Spartin will have 4,400,000 common shares outstanding, of
which 3,200,000 (73%) will be held by the former shareholders of Pool and 1,200,000
(27%) will be held by the original shareholders of Spartin. Pool will still have 1,600,000
shares outstanding, all owned by Spartin Ltd. In this alternative Spartin is the legal
acquirer because it is the issuer of the shares and ends up owning the shares of Pool. In
substance, however, Pool is the acquirer because Pool’s former shareholders clearly have
voting control over the combined enterprise. This is an example of a reverse take-over.
Alternative 3: PS Enterprises will issue 4,400,000 new shares in exchange for the shares
of both Pool and Spartin. After the exchange 3,200,000 (73%) of the PSE shares will be
held by the former shareholders of Pool and 1,200,000 will be held by the former
shareholders of Spartin. The shares of Pool and of Spartin will both be owned by PSE.
PSE is the legal acquirer, but Pool remains the acquirer in substance because the former
Pool shareholders have voting control over PSE.
Instructors should make sure that their students clearly understand who owns what shares
under each of the preceding alternatives. Some students develop the impression that each
combining corporation owns the shares of the other, or that the shareholders of the two
combining corporations swap shares.
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Under each alternative, Pool is the acquirer in substance. Therefore, the price of the
exchange will be based on the value of the Pool's shares. Using a value of $33 times the
number of Pool shares (or Pool share-equivalents in the case of the second and third
alternatives), the purchase price is 600,000 shares @ $33 = $19,800,000. Given that the
fair value of the net assets approximates the carrying values and that the carrying value of
Spartin’s net assets is $20,000,000, it would appear that there is a negative goodwill of
$200,000.
Negative goodwill has to be reported as a gain in the consolidated SCI by the acquirer.
Under all three combination alternatives, the consolidated assets and liabilities of the
reporting enterprise should be shown at the same values, since there is no difference in
substance among the alternatives. The actual book entries for recording the shares issued
would, of course, be different due to the fact that the issuing entity is different in each
alternative. Further, in the case of a reverse-takeover even though the consolidated
financial statements are issued by the legal parent, the issued financial statements should
reflect the substance of the financial statements as if the legal subsidiary (but in substance
the real parent) had instead issued them. We would suggest that instructors avoid getting
tangled up in the recording technicalities and focus on the substantive issues instead.
Case 3-4: Boatsman Boats Limited and Stickney Skate Corporation
1. To illustrate and evaluate the alternative methods of accounting for business
combinations.
2. To require a decision on the presentation of the financial statements considering the
objectives of financial reporting. In addition, the measurement of fair values is
considered.
The investment has been recorded by Boatsman at $1,300,000 which is a little over 65%
of the fair value of Stickney’s net assets. This is viewed as the purchase price because
Boatsman is a private corporation with no market value for its shares. Since the Ontario
Business Corporations Act specifies that shares issued must be recorded at their
equivalent cash value, the fair value of the assets acquired is taken as the best available
approximation of the shares’ current cash equivalent.
Some students may suggest that the appropriate measure of the value of the transaction is
40% of the fair value of the total net assets of the combined entity (Boatsman plus
Stickney), since that is the net asset value underlying the shares being received by Clyde
Stickney. However, the transaction must be viewed from the point of view of Boatsman,
the reporting entity, and not from Clyde’s point of view.
Discussion
Legal environment
In responding to this question, students should recognize that BBL is a private
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corporation with only two shareholders, both of whom are actively involved in
management. It must be determined if IFRS is a constraint for this company. An
assumption will need to be made by the student.
Users and objectives
Since BBL is a private corporation, public investors are not users of BBL’s statements.
BBL is financed 28.27% by debt, of which about half is long-term. It is likely, therefore,
that creditors (including banks) will be using BBL’s statements to test credit-worthiness.
If the statements are consolidated, SSC’s substantially larger debt will appear on BBL’s
statement of financial position. Unless BBL guarantees SSC’s debt, creditors may prefer
for BBL not to consolidate SSC.
Boatsman and Stickney may be users of the statements, in order to evaluate their own
performance and to see how the businesses are doing, relative to past performance.
BBL and SSC remain separate legal entities. Each will be taxed individually, and thus
consolidation policy will have no effect on taxes payable by the companies.
The immediate objectives of the BBL financial statements seem to be as follows:
1. To aid creditors in making decisions to lend money or extend credit.
2. To enable the shareholders/managers to evaluate the overall performance of the
business.
Evaluation of Alternatives
Students should be encouraged to look beyond a narrow interpretation of the Handbook
in evaluating the alternatives. Two approaches should be used:
1. Evaluate the alternatives in light of the substance of the combination and the practical
impact on the management and functioning of the two companies.
2. Evaluate the alternatives in terms of the usefulness of the resultant financial statements
to the users.
Hopefully, both avenues of approach will bring students to the same conclusions. Since
IFRS is not a binding constraint in this case, the specific answer is not as important as is
the process of analysis used to get there. Along the way, students should evaluate not only
the alternative consolidation approaches, but also the usefulness of consolidated
statements in general.
There are good grounds for arguing that the combination is, in substance, a pooling-of-
interests. The two companies are continuing business in parallel and neither is taking over
the other operationally. In addition, the two shareholders have agreed to a 50-50 division
on the board of directors, even though Boatsman has 60% of the voting shares. If the
combination is treated as a pooling, then the financial results of the prior years will be
combined as though the companies had always been combined. This retroactive
application will facilitate evaluation by both user groups.
The legal requirement to record issued shares at their cash equivalent results in a
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substantial deficit under pooling. This deficit will not inhibit dividend payments, because
dividends are paid by individual legal entities. Boatsman does not have a deficit on its
separate-entity statement of financial position; it is the process of consolidation that gives
rise to the deficit. Nevertheless, such a large deficit does make it appear as though the
companies have been unprofitable, which is untrue. Note disclosure would have to be used
to explain how the deficit arose.
Another fly in the pooling ointment is the substantial non-controlling interest. Since the
non-controlling shareholder holds 35% of SSC, he or she can easily block any special
resolutions, such as changes in the letters patent or corporate by-laws, including corporate
restructuring or amalgamation. Therefore, it can be argued that the two companies are not
equally controlled. Control of BBL is absolute, but control of SSC is conditional upon the
cooperation (or lack of opposition) of the non-controlling shareholder.
The new entity method could be applied whether the combination is a purchase or a
pooling. The method of execution will differ, but the substance under both purchase and
pooling is that the assets of both companies will be revalued. If the fair values are not too
subjective, one can argue that the new basis of accountability will enable the creditors to
get a better picture of the financial structure of the combined company.
Under book-value-pooling, consolidated liabilities amount to 47.24% of assets; under the
new entity method (or fair-value-pooling), liabilities are only 42.00% of assets. On the
other hand, the revalued assets under fair-value-pooling will cause larger depreciation and
lower net income in future years. Comparison with prior years will be difficult, if not
impossible. And although a change in ownership structure has occurred, no real change in
the operation of the two companies has occurred.
Both the purchase and acquisition approaches view the combination as though BBL had
made an investment in the net assets of SSC. As a result, part (65%) or all of SSC’s net
assets are consolidated at fair values, while BBL’s net assets remain at carrying value. The
substance of the combination does not suggest that BBL should be viewed as an acquirer
of SSC, however.
Many people object to the “split valuation” of SSC’s net assets when the purchase method
is used, as suggested by CA. The purchase method does yield the same results as would
have been obtained had BBL directly purchased 65% of the net assets of SSC, rather than
65% of the shares.
The acquisition method allowed under IFRS, in contrast, uses a consistent valuation of
100% of the SSC assets which are under the control of BBL. BBL controls all of the SSC
assets, not just 65%.
[ICAO]
Case 3-5: Growth Inc. and Minor Ltd.
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This case demonstrates the variability that can be present in the estimation of fair values in
a business combination. A substantial range of feasible fair values is possible, such that
goodwill could be anything from a large positive number to a negative amount. A lesser
objective is to have students address the disposition of negative goodwill.
Users and Objectives
The range of values selected will have a large impact on two potential users and their
objectives. The company has two covenants that need to be maintained or the bank loan
will be due. Therefore, the impact on the current ratio and the debt-to-equity ratio must be
considered in selecting the values. In addition, management will want to maximize net
income to maximize the amount of bonus they will receive.
Analysis
Using the information in the case, the following ranges of fair values can be derived. The
following table is set up so that the fair value that results in the maximum total net asset
fair value is shown in the second column and the value that results in the minimum total is
shown in the third column.
The first column contains the carrying values as presented in the case (a future tax rate of
20% has been assumed to calculate the additional deferred income tax liability, answer will
change depending on the tax rate assumed:
Book
value
Fair value range Difference excluding
deferred income tax
liabilityMaximum Minimum
(1) (2) (3) (4)=(2)–(1)
(5)=(3)–
(1)
Cash $200,000 $200,000 $200,000 0 0
Accounts receivable 770,000 770,000 770,000 0 0
Inventories (a) 1,000,000 1,000,000 900,000 0 (100,000)
Capital assets (b) 5,000,000 7,800,000 7,100,000 2,800,000 2,100,000
Leased building
(receivable) (c) 4,030,000 4,030,000 3,070,000 0 (960,000)
Accounts payable (300,000) (300,000) (300,000) 0 0
Debentures payable (d) (7,000,000) (4,800,000) (7,000,000) 2,200,000 0
Deferred income taxes (e) (700,000) (1,700,000) (908,000)
Net asset values $3,000,000 $7,000,000 $3,832,000 5,000,000*
1,040,000
*
Incremental deferred income tax assuming a tax rate @ 20% 1,000,000 208,000
Total deferred income tax liability (1,700,000) (908,000)
Fair value of consideration 6,500,000 6,500,000
(Gain on bargain purchase)/goodwill (500,000) 2,668,000
* The difference in the net asset values is calculated before considering the additional
deferred income taxes on the FVAs.
a. Inventories may be reduced by the 10% decline in estimated net realizable value.
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b. The fair values are the two appraisals. Note that the two values are $700,000 apart,
which is a variance of about 9 - 10%. Normally, appraised values are considered to be
in substantial agreement if they are only 10% apart.
c. Under IFRS, finance leases are valued at the present value of the minimum lease
payments discounted using the interest rate implicit in the lease. If this is not
practicable to determine, the lessee’s incremental borrowing rate can be used instead.
In the present example, the lessee’s incremental borrowing rate will be the 14%
current yield on its bond. Therefore, the lower value is the result of recalculating the
amount due by using the current bond yield of 14% as the borrowing opportunity rate.
The building is leased to Growth and therefore the lease receivable on Minor’s books
and the lease payable on Growth’s books will be eliminated on consolidation.
However, use of the lower value in consolidation would imply that the payable on
Growth’s books should be written down, resulting in a gain in the year of acquisition
of Minor.
d. The lower figure for the debentures is the present value of the future cash flow using
the current yield of 14% as the discount rate (a more exact calculation is $4,776,000).
e. Under IFRS, a deferred tax liability arises to the extent of the difference between the
tax base and the fair values of the net identifiable assets of the acquiree. The carrying
value of the deferred tax liability of $700,000 represents the deferred tax impact of the
difference between the tax basis and the carrying values in the books of Minor of its
assets and liability. Therefore, all we need to do now is to find out the deferred tax
impact of the difference between the carrying values and fair values of the net assets
and liabilities, excluding of course the carrying value of the deferred tax liability of
Minor. The difference is $5,000,000 between the maximum fair values and the
carrying values of the net assets of Minor.
Therefore, the incremental deferred tax liability is $1,000,000. In contrast, the
difference drops to $1,040,000 when the minimum of the fair value range of the net
assets of Minor is used. The incremental deferred tax liability assuming a tax rate of
20% is $208,000. The total deferred tax liability is $1,700,000 and $908,000
respectively. The goodwill recognized in connection with the business combination is
suitably adjusted to the extent of the deferred tax liability recognized. Consequently,
when the maximum values are used there is a gain on bargain purchase of $500,000,
while when the minimum values are used the goodwill is $2,668,000.
All of the above values can be justified within the guidelines offered by IFRS. It is perhaps
unlikely that the extreme values would be used in all cases; the impact of the options on
the current ratio and debt-to-equity ratio should be considered. Then the impact on net
income and the bonus plan should be considered.
If high values are used that result in negative goodwill, such negative goodwill should be
recognized as a gain in the consolidated SCI issued by the acquirer. Under the acquisition
method the net identifiable assets are always valued at their fair values irrespective of the
purchase price.
One attempt at an outcome would be as follows:
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Book value
Possible fair
value Difference
Cash 200,000 200,000 0
Accounts receivable 770,000 770,000 0
Inventories 1,000,000 1,000,000 0
Capital assets 5,000,000 7,800,000 2,800,000
Leased building (receivable) 4,030,000 4,030,000 0
Accounts payable (300,000) (300,000) 0
Debentures payable (7,000,000) (7,000,000) 0
Deferred income taxes (700,000) (1,260,000)
Net asset values 3,000,000 5,240,000 2,800,000
Incremental deferred income tax @ 20% tax
rate 560,000
Total deferred income tax liability (1,260,000)
Fair value of consideration 6,500,000
(Bargain purchase)/goodwill 1,260,000
Under this scenario, the inventory would be left at carrying value because the inventory
appears to be in excess, but not unsalable. Capital assets would be assigned a value in their
present state. The leased building (receivable) would be assigned a value equal to the
value of the payable on Growth’s books, thereby permitting a direct offset on
consolidation. The debentures would be maintained at their carrying value because the
market in these bonds is thin and they probably could not be retired without paying the full
maturity value. The calculated total deferred tax liability will therefore be $1,260,000. The
remaining $1,260,000 of the purchase price would be assigned to goodwill. Note that
there is no deferred tax liability on goodwill since goodwill is not deductible for tax
purposes and thus gives rise to a permanent difference.
Case 3-6: Wonder Amusements
This is a multi-competency case which incorporates accounting, assurance and tax issues.
The appropriateness of the accounting treatments proposed by the chief executive officer
need to be considered. This case should be written as a report.
Report to Partner
Overview
As requested, I have prepared a report that can be used for your next meeting with Leo
Titan, Chief Executive Officer of Wonder Amusements Limited (WAL). The report deals
with the accounting, audit, and tax implications of the matters discussed with Leo. Over
the past year, the business of WAL has changed: it now owns a sports franchise and is
currently building a sports arena. A number of transactions have taken place in connection
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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 WAL’s financial statements, and they may have differing
objectives. Before recommending an accounting policy for each transaction, we must
consider the different users and decide who the primary user of the financial statements is.
Our audit risk is higher this year given the acquisitions that have taken place during the
year and the additional users of the financial statements.
Users
There are many users of WAL’s financial statements and, as noted, the objectives of each
user may conflict. The users include WAL’s:
- Creditors. WAL’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 the Canada Revenue Agency for income tax
purposes. However, our engagement is with the directors of WAL and its management,
and they must be our primary concern. As a result, the recommendations presented below
are consistent with their objectives, fairly disclose the financial results of WAL, and enable
all users to monitor their investment.
International Financial Reporting Standards (IFRS) must be followed because we are to
issue an audit opinion on the financial statements; however, some flexibility exists 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, audit and tax 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
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statements are not materially misleading and enable the users of the financial statements to
predict the future cash flows of the company.
Land revaluation
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
or justifiable. All land is not identical or of equal value and, as a result, reporting the
increment in the 20X6 financial statements would be misleading. Furthermore, recognizing
fair value increments on the net income section of the statement of comprehensive income
is not in accordance with IFRS.
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 WAL 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 SCI) except to the extent that they reverse a revaluation decrease of the
same asset previously recognized in the SCI. Therefore, if the company expects that the
value of the land has increased, such revaluation increase would impact equity and not the
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 statement of financial position 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, it appears that the company will be better off maintaining its
accounting policy for land at historical cost.
If this amount is recorded in the SCI, we will have to issue a qualified audit opinion.
Management will not want our firm to do this. For tax purposes, the increase in value is
not taxable until the land is ultimately sold.
Sale of land
Management intends to report the sale of the excess land in fiscal 20X6. We must decide
whether it should be reported in the 20X6 or the 20X7 fiscal period. The sale has been
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agreed to, the sale contract has been signed, and a 25% deposit has been received. These
facts support recognition in fiscal 20X6. However, the sale does not close until the 20X7
fiscal period and, although the deposit has been paid, the collectability of the balance may
not be assured.
The sale has not closed and the land has not been turned over to the developers.
Therefore, the income should be reported in 20X7 as a non-operating or an unusual item.
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 is possible to consider the excess land as investment property, WAL would have the
option of using either the cost model or the fair value option. If the fair value option is
chosen, in effect the sale price would be recognized in 20X6 regardless of conditions
surrounding the sale, as fair value changes are recognized in SCI. 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.
During our audit, we will have to review the sale agreement to see if the sale is final and if
the deposit is non-refundable. If the agreement is final, and there are no contingencies, my
recommendation may change and we may then be able to agree with management’s
proposed treatment. Otherwise, recognizing the sale in 20X6 would cause us to qualify
our audit opinion. When the sale is ultimately recognized, we will need to determine the
appropriate cost allocation of the land to this transaction.
We would need to review the contingencies on sale and impact to fair value reported in
the 20X6 financial statements if the fair value option is selected. Note – use of cost model
would require disclosure of fair value.
The tax treatment will also depend on when the sale is completed. If the sale is reported in
the current year, than a reserve on the proceeds not yet due may be claimed. Alternatively,
if the sale is reported in 20X7, a reserve on the deposit paid can be claimed. In addition,
we must ensure that this transaction is capital in nature. Given WAL’s primary intention
was not to earn income from the sale of land, it would appear that this amount would be
considered capital in nature and 25% of the capital gain can be distributed to shareholders
on a tax free basis as a capital dividend.
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NSL start-up costs
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 WAL. Generally, start-up costs should be
expensed as incurred under IFRS 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.
Based on IAS 38 (paragraph 69) 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.
For tax purposes, we must determine if the players’ contracts can be deducted in the year
or treated as an eligible capital expenditure. It would appear that these costs relate to
annual operating expenses and can be deducted for tax purposes. We should also consider
using a partnership structure so any losses incurred can be applied against WAL’s income
in the short term. WAL will have to share the small business deduction and other related
credits/allowances with its associated corporations.
Purchase of amusement park
Since the asset is acquired as part of a business combination, IFRS 3 (Revised) 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(Revised), the Basis for
Conclusions to IFRS 3(Revised) at BC 365 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. Additional support for this
conclusion is provided by IAS 16, para 20 which states that the costs of relocating or
reorganizing part or all of an entity’s operations should not be included in the carrying
amount of an item of property, plant and equipment.
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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 purchase price discrepancy equal to $1.3 million. This
discrepancy is net of the present value of a loss carry forward recorded as an asset in the
purchase price. In order to recognize a deferred tax asset, its realization must be probable.
We would need to assess this as part of our audit. 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 purchase price discrepancy, thereby increasing the credit to the statement of
comprehensive income (refer below).
The negative purchase price discrepancy (or “excess”) reflects a bargain purchase. In
accordance with IFRS 3 (revised), 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 an excess still remains after such
review, the company would recognize a gain in the SCI reflecting the bargain purchase.
For audit purposes, we must determine how the fair market values of the assets purchased
were determined keeping in mind that management may be motivated to inflate the values
recorded in order to record a higher bargain purchase in the SCI and thereby maximize
any bonus.
For tax purposes, the cost of acquiring the assets has to be added to the relevant capital
cost allowance classes and depreciated using prescribed rates. The prior years’ losses will
be available to offset income generated from the amusement park business. However, the
losses will “age” by a year due to the change in control/wind up. The tax cost of the assets
will transfer to WAL.
Insurance on construction
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)).
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Given the users and their objectives, this amount should be capitalized to the asset under
construction and the asset value should be monitored to ensure there is no impairment to
the value. For tax purposes, the amount would also have to be capitalized as a building
cost and added to the prescribed capital cost allowance class for the building.
Ride relocation
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 cost
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 expense is not reasonable. This treatment allows
for better predictability of cash flows given that the amount was incurred in the current
period.
The tax treatment will follow the accounting treatment unless the amount is determined to
be a capital expenditure. The proposed accounting treatment suggests otherwise.
Arranging fees
A $500,000 fee was paid to a mortgage broker to arrange financing for WAL. 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
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liability (Transaction costs are defined in AG13 of IAS 39 as including “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 statement
of financial position. 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.
During our audit, we must find out whether the amount is refundable if financing is not
found. For tax purposes, the amount is likely a type of financing charge and should be
deducted over a five-year period.
Consolidation of NSL
NSL must be consolidated for accounting purposes because WAL controls the company.
If this subsidiary is not consolidated with WAL’s results, we will have to qualify our audit
opinion. For tax purposes, the tax returns are filed on an entity-by-entity basis, so
consolidated reporting is not required.
While use of private enterprise reporting would be an option for the subsidiary, it is likely
that the users (creditors) would want consolidated financial statements upon which to base
their decisions.
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 whether performance has been
completed and if the deposits are non-refundable.
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 or future cost that must be incurred.
Conversely, the support available for deferring the income is that the amount has not yet
been earned. If deferred, the income should be included over a five-year period – the
length of the contract.
The non-refundable fee can be taken into income immediately. The amount is non-
refundable, there is a separate, monthly membership fee over and above the entrance fee,
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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.
During our audit, we must review the membership agreement and confirm the
refundability (or non-refundability) of amounts. For tax purposes, a reserve can be claimed
for services not yet provided. The upgrade to the facility will likely be capital in nature and
will have to be capitalized for tax purposes in the year 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.
If and when the payment is received it should be disclosed separately on the face of the
statement of comprehensive income or in the notes when such presentation is relevant to
an understanding of WAL’s financial performance.
For tax purposes, when the additional amount is determinable, it must be included as
proceeds from the disposition of the land. It can be included in the year of receipt.
Amending a prior year’s tax return will not be necessary.
Golf course relocation costs
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 WAL 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 20 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. Therefore, the golf course relocation costs should be capitalized as part of the
road costs for accounting purposes. This allows management to maximize its bonus, and
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the other users of the financial statements to predict future cash flows.
For tax purposes, the interest and property taxes incurred during the year can be
deducted. As well, the cost of $140,000 to move two golf course holes could be
considered a landscaping cost and can also be deducted in the year incurred. The tax
deductibility of these costs is important, given that the accounting treatment will not affect
the tax treatment.
Private boxes
We must determine whether the revenue from leasing private boxes should be recognized
for accounting purposes or deferred. The support for recognizing the income is that the
deposit received appears non-refundable (since the case does not mention otherwise and it
appears fair to assume that a deposit in relation to a five-year lease would be non-
refundable rather being refundable) and there are nightly charges to cover operating
expenses. The support for deferring recognition of the income is that the service of
providing the box is being performed over a five-year period, and future revenue will be
earned from use of the boxes. For the reasons cited, this amount should be deferred and
recognized on a straight line basis over the five-year period. This is inconsistent with the
objectives but required to comply with IFRS.
During our audit, we must review the sale agreement to determine the refundability of the
deposit. For tax purposes, a reserve can be claimed for services not yet provided.
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 they
are earned, based on net income, and not when they are paid.
Depending on the materiality of the bonus payments, we may have to qualify our audit
opinion if these amounts are not accrued. For tax purposes, the bonus payments must be
paid within 180 days of year-end to be deductible. The 20X6 bonus is not deductible until
paid, while the 20X7 bonus is deductible in the year accrued.
Other tax issues
Other tax issues that need to be pursued:
- The interest costs incurred during the construction period may have to be capitalized.
- CCA cannot be taken on rides that are not available for use.
- Deferred income taxes will arise because accounting policies differ from tax
regulations.
These issues need to be analyzed further.
Conclusion
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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 WAL. The accounting
treatments selected must be fairly disclosed so that the various users with their differing
objectives can properly interpret the financial statements.
[CICA; adapted]
Case 3-7: Major Developments Corporation
Students are asked to consider both sides of specific accounting treatments as part of a
legal claim. The accounting issues in this case include the determination of when control
exists, revenue recognition, valuation of an investment and the capitalization of costs.
The following solution is adapted from the suggested approach included in the CICA 1999
UFE Report, Question 1, Paper II, suitably modified to comply with IFRS requirements.
DRAFT REPORT TO LEGAL COUNSEL
Overview
Terms of Reference
This report provides our assessment of the validity of the positions put forward by Mr.
John Gossling, an employee of Bouchard Wiener Securities Inc. (BWS), and Major
Developments Corporation (Major) on the accounting practices followed by Major. The
objective of this report is to make legal counsel fully aware of the strengths and
weaknesses of Major’s positions so that counsel can provide the best defence for BWS in
legal actions taken by Major. We explain accounting policies so that counsel will be able
not only to defend Mr. Gossling’s statements but also to counter the arguments made by
Major. We should note that in our view Mr. Gossling has made comments that
demonstrate that he has less than a full understanding of accounting and accounting
principles. While we have done our best to put forward positions that will help you defend
BWS, it must be recognized that defence in some cases will be difficult.
Our report does not evaluate the portfolio recommendations made by Mr. Gossling. It
comments on the accounting issues only.
We have used the information provided by Major in defence of its accounting choices.
However, it is important to recognize that Major may be selective in the information it
provides. Major could be withholding information so that it can make the strongest
arguments in its defence.
It should also be recognized that Mr. Gossling might not have been unbiased in his
assessment of Major because of BWS’s short position in Major’s stock. It is possible that
Gossling was pressured or felt compelled to help his employer profit from its investment
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decisions.
IFRS
Before getting into the specifics of the case, it is important to explain how IFRS functions
and is applied. IFRS is misunderstood by many users of accounting information, who
believe that it offers far more definitive guidance about how companies should account for
their activities than it really does. In fact, IFRS is principles based and therefore is often
very flexible and ambiguous, permitting preparers of accounting information considerable
leeway. Companies often use the flexibility in IFRS to advance their own reporting
objectives. As Major is a public company, its management has incentives to try to keep its
share price high. Therefore it is not unusual to see public companies make aggressive
accounting choices. That said, simply because an accounting policy is consistent with
IFRS does not mean that it results in fair presentation of an entity’s financial situation.
Mr. Gossling’s analysis was based on the assumption that the only accounting principles
that Major can follow are the ones present exclusively in the IFRS included as part of
Canadian GAAP in the CICA Handbook. IAS 8, Accounting Policies, Changes in
Accounting Estimates and Errors, provides guidance on selection and application of
suitable accounting policies. According to IAS 8, whenever a particular IFRS is applicable
to a particular situation, the accounting policy applied to that situation should be
determined as per that IFRS. IFRSs are also accompanied by guidance (both mandatory
and not-mandatory) for applying such IFRSs. Further, the interpretations of IASs and
IFRS, which are issued by the International Financial Reporting Interpretations Committee
(IFRIC), are part of the IASB’s authoritative literature.
However, in the absence of an IFRS which applies specifically to the situation under
question, the management of an entity is required under IFRS to use its judgement for
developing and applying suitable accounting policies which are relevant, reliable, achieve
representational faithfulness; are neutral, prudent and complete in all respects. For the
purpose of developing suitable accounting policies management should refer to and
consider the applicability of the following authoritative sources in descending order:
- Requirements in other IFRSs dealing with similar and related issues;
- Definitions, recognition criteria and measurement concepts of assets, liabilities,
income and expenses in the framework;
- Most recent pronouncements of other standard-setting bodies that make use of a
similar conceptual framework while developing their accounting standards, and
other accounting literature and accepted industry practices.
However, when another source is used, the policy must be consistent with the conceptual
framework of IFRS. Mr. Gossling should have considered these sources as well as the
Handbook.
IFRS must always be evaluated in the context of materiality or overall impact on user
decisions, which is a judgement call. Audit standards say that an auditor must determine
108

what level of error or misstatement would not impact users’ decisions. Mr. Gossling does
not appear to have considered materiality. For a public company with an after-tax income
of $118 million, income before income tax would be about $200 million and materiality
would be in the region of $10 million. Therefore it is possible that Major did not follow
IFRS in a particular area but, if the amount in question was not considered material a
deviation from IFRS is allowed as long as such immaterial departures from IFRSs are not
made to achieve a particular presentation of an entity’s financial position, financial
performance or cash flows.
While a clean audit opinion increases the credibility and reliability of financial statements,
it does not conclusively prove that the financial statements are in accordance with IFRS
and free of material misstatement.
Consolidation
Major consolidated the assets and results of two corporations in which it has no equity
interest. Major has loans to these companies that are in default, and has a legal opinion
stating that the properties can be repossessed to recover the loans. IFRS requires control
for consolidation to be used. Generally voting control means 50%+ of the votes.
However, control can be exercised without voting control and even without an equity
interest (IAS 27, Consolidated and Separate Financial Statements). IFRS considers a
company to be in control even in the absence of an equity investment if the facts support
that control exists. In this situation it appears that Major has control of the properties
since it can repossess them.
Mr. Gossling appears to have used a strict definition of control, using as evidence the
requirements of having more than 50% of the voting shares. He should have considered
the terms of the loans that were disclosed in the notes of the financial statements when
evaluating whether Major should have consolidated. However, in defence of Mr. Gossling,
Major did not appear to have the ability to exercise control as of the financial statement
date. The note does not make it clear whether under the terms of the loans Major is able
to exercise control in the event of default. In other words, it is not clear whether the mere
act of default gives control to Major. If default does not automatically give control, then
consolidation may not be appropriate since Major has not exercised its right to repossess
the properties and it might never take the steps to do so. In fact, if Major did not have
control in some form on the financial statement date, then consolidating could make the
financial statements misleading, as Mr. Gossling states.
IFRS requires that the acquirer has the financial ability to obtain actual control. In the
present case, Major appears to have such ability. Under IFRS, control exists when an
entity has the ability to exercise that power, regardless of whether control is actively
demonstrated or is passive in nature. Therefore, Major could argue that the circumstances
implied for all intent and purposes that it actually controlled the company at the financial
statement date even though actual control did not exist at that date and therefore fair
presentation requires consolidation.
Are either or both of these investees special purpose entities? If they are and Major is, in
substance, the entity which controls the SPE, IFRS would require consolidation. Major
109

would be in control of the SPEs if 1) they conduct their activities to meet Major’s needs,
2) Major has the decision-making powers to obtain the majority of the benefits from the
activities of the SPEs, 3) Major obtains the majority of the benefits from the SPEs using
an “auto pilot” mechanism, 4) Major is exposed to the business risks of the SPEs
consequent to having the right to the majority of the SPEs benefits, and lastly 5) Major
has the majority of residual interest in the SPEs. It would appear that the investees are not
variable interest entities as both are limited companies with shareholders. Thus, the
shareholders would be the parties at risk. This would have to be confirmed.
Our interpretation, based on the assumption that Major has not taken measures to
repossess the properties of the two companies acting as collateral is that Major should
have accounted for these defaulted loans according to the provisions of IFRS 9, Financial
Instruments. IFRS 9 requires financial assets to be classified either at amortized cost or
fair value on the basis of 1) the entity’s business model for managing the financial asset,
and 2) the contractual cash flow characteristics of the financial asset.
According to IFRS 9 a financial asset should be measured at amortized cost if both of the
following conditions are satisfied:
- The objective of the business model under which the asset is owned is to collect
contractual cash flows, and
- Under the contractual terms relating to the financial asset, the entity has the rights
only to cash flows on specified dates which are solely payments of the principal
and interest on the principal amount outstanding.
Further, under IFRS 9 a financial asset measured at amortized cost has to be tested for
impairment subsequent to the time of its initial measurement.
Since it appears that the main intent of Major is to collect the contractual cash flows from
its loans, and the right of repossession is solely for the purposes of realization of the cash
flows relating to the loans (subject to restrictions), the loans should be valued at amortized
cost. This interpretation is supported by the application guidance relating to IFRS 9,
which states that the fact that a full recourse loan is collateralised does not by itself affect
the analysis of whether the contractual cash flows are solely payments of principal and
interest on the principal amount outstanding.
The impairment loss on the loans should be measured as the difference between the asset’s
carrying value and the present value of the discounted estimated future cash flows using
the original effective interest rate. The loss has to be recognized in the profit and loss of
Major.
On the other hand, if Major has taken steps to repossess the properties, the defaulted
loans should be written down to the value of the repossessed property. Further, Major
should record those assets that it has a right to repossess in its books. Finally, since, the
loan by Major is to the two companies, Skyscraper Inc. and Wenon Corporation, and not
to the shareholders of these two companies, Major can only repossess the properties of
these two companies, but not their shares. Therefore, Major cannot consolidate these two
companies since it cannot take possession of their shares but only their properties.
110

One final point on this issue is that Major should have recorded the assets of the two
companies retroactively because the losses were known previously, Major accounted for
this event prospectively. This treatment is a deviation from IFRS.
Bill and Hold
Major sells merchandise using a bill and hold arrangement whereby revenue is recognized
but the goods are held by Major for the customer. The fact that the goods are held by
Major does not automatically mean that a sale has not taken place. However, it is unusual
to recognize revenue before shipment, so there would have to be good evidence that
recognition before shipment was appropriate. Under IAS 18 in a bill and hold type sale
revenue can be recognized only when delivery is delayed at the request of the buyer, who
nevertheless takes title and accepts the billing, provided:
- It is probable that delivery will be made,
- The item sold is on hand, is identifiable and is ready for delivery to the buyer at the
time the sale is recognized,
- The buyer explicitly acknowledges having made instructions to defer the delivery,
and
- Usual payment terms are applicable.
No revenue should however be recognized if there is only a mere intention to acquire or
manufacture the goods in time for delivery.
In the present case, revenue is recognized when the goods are placed in the company’s
designated storage area. However, from the facts provided it is not clear whether the
other requirements for recognizing revenues from a bill and hold type sale are satisfied.
Therefore, our preliminary opinion is that this type of transaction would more likely not be
considered a sale. More information is required before we can conclude whether the
timing of revenue recognition is appropriate.
Further, the key criterion to consider in this situation is whether the risks and rewards of
ownership have been transferred to the buyer. Sometimes even when there is transfer of
title, such transfer does not correspond with the transfer of risks and rewards of
ownership. Major, of course will argue that the risks and rewards have been transferred
and that it was merely providing storage space to the customer. Ultimately, whether the
risks and rewards have been transferred is a question of fact. For example, do customers
who buy on a buy and hold basis usually pick up the goods? Are these sales easily and
commonly cancelled? In other words are they bona fide orders or merely informal
agreements that allow the seller to pad its sales? Even if these transactions are legitimate,
are the risks and rewards actually transferred? For example, if the goods are stolen or
destroyed, who is responsible for the loss?
If the risks and rewards have not been transferred, then revenue should not be recognized.
Mr. Gossling’s opinion is valid, and IFRS has been violated by Major. It is our opinion
that the risks and rewards of ownership has not been transferred when Major recognized
the revenue and therefore the accounting used by Major is in violation of IFRS.
111

Rely Holdings
Major has a long-term investment in a company called Rely Holdings that it accounts for
on the equity basis. This suggests that Major most probably has significant influence over
Rely Holdings. During 20X5, Major increased its ownership interest in Rely by purchasing
an additional 25% of the shares for $5 million. Major’s original 23% interest in Rely was
recorded at $25 million. According to IAS 28, Investments in Associates, investments in
associates must be tested for impairment using the provisions under IAS 39 and written
down to their recoverable value if such value is less than costs. Specifically, the entire
carrying amount of the investment is tested for impairment in accordance with IAS 36 as a
single asset, by comparing its recoverable amount (higher of the value in use and fair value
less costs to sell) with its carrying amount, when the application of the requirements in
IAS 39 indicates that the investment is impaired. According to IAS 39 a significant or
prolonged decline in the fair value of an investment in an equity instrument below its cost
is also objective evidence of impairment.
Therefore, in our view, the fact that Major could more than double its interest in Rely for
20% of the cost of the original investment is highly suggestive of impairment in the value
of the investment. The fact that Major recorded a loss of $750,000 from the company
provides additional support for this view. However, the low price is only suggestive of
impairment. It does not definitively imply impairment. Major will argue that the decline in
value is not prolonged and therefore Rely should not be written down to market. Major
will contend that the decline in value was just part of the usual cycle that real estate
companies follow or that the additional interest in Rely was acquired on a distress basis
and Major was taking advantage of a market opportunity to increase its holdings of an
attractive investment.
Additional information will have to be obtained to argue for impairment. If general market
conditions were very poor at the time of acquisition, then Major’s point of view has more
justification. If there were problems with particular properties owned by Rely or with
areas in which they are located, then an argument of impairment has more strength. In our
opinion, the question of whether the investment is impaired and therefore overstated can
be argued.
Asian Property Income and Valuation
Major accrues revenue from rental properties in countries with unstable economies even
though the rents are not being paid. Given the economic conditions in these countries, it is
not certain if or when the rents will be collected. The question is whether the revenue
should be accrued given the uncertainty. Major clearly explains the situation in the notes
to the financial statements, so one cannot argue that readers are unaware of how the
economic crisis affected the financial statements. The note does say that Major expects
rents to be collected in full. It is in Major’s interest to take this position because, under
IFRS, if collection is not reasonably assured then recognition of revenue is not
appropriate. Reasonable expectation of collection is required because economic conditions
may force the tenants of these buildings out of business and then rents would never be
collected.
112

Major will likely argue that recognition of revenue is a judgement by management based
on its assessment of the risks of the situation. Since Major will have detailed information
about its tenants, its decision to recognize revenue may be reasonable and supportable. In
addition, Major may have provided an adequate allowance for potential bad debts, which
means income and assets would not have been overstated. If Major did take an adequate
allowance for bad debts, supporting Mr. Gossling’s position is more difficult because this
is an appropriate treatment for uncertainty about collections if the impact of the
uncertainty is measurable. However, we need more information about the amount allowed
for bad debts, if any. It is also possible that Major made no allowance for bad debts.
Gossling’s position on this issue is supportable. He does not argue that accruing the
revenue is not in accordance with IFRS in general, but it is not in accordance with IFRS in
this situation. He is correct if the collection of rents is uncertain and not measurable, and
this is the point he makes. He contends that collection is unlikely given the economic
conditions. If nothing else, Gossling and Major disagree on their interpretations of the
economic facts. While Major’s management may have better information about its tenants,
Gossling is likely more objective in his assessment of the facts. Ultimately, more
information is required to assess the collectability of the rents.
In addition, the problems with collection may imply that the Asian properties are impaired.
The value of the real estate property is tied to the present value of its future cash flows. If
those cash flows are more uncertain or not collectable at all, then the present value of the
property declines. The value of the properties could also be affected by foreign exchange
currency risk, particularly if the value of the Asian currency falls significantly.
Capitalization of Acquisition Costs
The provisions of IAS 40, Investment Property are applicable here. As per IAS 40, an
investment property should be measured initially at cost. Transactions costs should be
included in such initial measurement. However, under IAS 40, the cost of a purchased
investment property is made up of its purchase price and any directly attributable
expenditure. Therefore, Major’s practice of classifying all expenditures made to
investigate new properties as assets regardless of whether the properties are purchased
appears indefensible.
Conclusion
Mr. Gossling has left BWS in a vulnerable position regarding at least some of the
controversies. His emphasis on IFRS in evaluating Major’s financial statements
demonstrated a poor understanding of accounting rules. He could have easily focused on
the quality of Major’s earnings without specifically stating that IFRS had been violated. At
the same time, Mr. Gossling has demonstrated a sound understanding of the relevance of
accounting information, and the concerns he has raised in his report, by and large, have
merit. However, because of his focus on IFRS, he has left BWS exposed.
SOLUTIONS TO PROBLEMS
113

P3-1
a. Statement of financial position:
Alternatives:
1 2 3 4
Current assets $6,650,000 $5,700,000 $8,550,000 $8,550,000
Capital assets 13,450,000 13,450,000 13,450,000 13,450,000
Investments 350,000 350,000 350,000 350,000
Goodwill 500,000 500,000 500,000 500,000
Total Assets $20,950,000 $20,000,000 $22,850,000 $22,850,000
Current liabilities $4,150,000 $4,000,000 $4,150,000 $4,150,000
Long-term liabilities 6,800,000 6,000,000 6,800,000 6,800,000
Deferred income taxes 2,000,000 2,000,000 2,000,000 2,000,000
Common shares 1,500,000 1,500,000 3,400,000 3,400,000
Retained earnings 6,500,000 6,500,000 6,500,000 6,500,000
Total Equities $20,950,000 $20,000,000 $22,850,000 $22,850,000
Only in the fourth alternative is Prairie’s statement of financial position really a
consolidated statement. In the first three alternatives, Prairie is buying the assets (or net
assets) of Savannah, and those assets will be recorded directly on Prairie’s books.
b. Share ownership and intercompany relationship:
Alternativ
e
Company Shares owned by Intercompany
relationship
1 Prairie Prairie’s prior shareholders none
Savannah
2 Prairie Prairie’s prior shareholders none
Savannah
3 Prairie 80% by Prairie’s prior shareholders;
20% by Savannah Inc.
Prairie partially owned
by Savannah Inc.
Savannah Savannah’s prior shareholders
4 Prairie 80% by Prairie’s prior shareholders;
20% by Savannah Inc.
Savannah wholly
owned by Prairie Ltd.
Savannah Prairie Ltd.
P3-2
Measure Step:
Case
A B C D E F
114

Purchase price (a) $120 $120 $100 $80 $100 $80
Carrying value of net identifiable assets (b) 80 100 80 100 120 120
Fair value of net identifiable assets (c) 100 80 120 120 80 100
Net fair value adjustment (a – b) 40 20 20 (20) (20) (40)
Fair value adjustment allocated to net identifiable assets
(c–b) (20) 20 (40) (20) 40 20
Balance = goodwill/(gain on bargin purchase) (a – c) 20 40 (20) (40) 20 (20)
115

P3-3
Measure Step:
100% Purchase of West Company Ltd., December 31, 20X6
Purchase price* $600,000
Fair value of preferred shares* 250,000
Less carrying value of West’s net identifiable assets (100%) (660,000)
= Fair Value Adjustment, allocated below 190,000
Carrying value Fair Fair value
FVA Allocated
(a) Value Adjustment
(b) (c)=(b)–(a)
Current assets $200,000 $250,000 $50,000
Capital assets, net 750,000 850,000 100,000
Current liabilities (140,000) (175,000) (35,000)
Long-term liabilities (150,000) (220,000) (70,000)
Preferred shares (250,000) (250,000) 0 45,000
Total fair value adjustment allocated to net identifiable
assets and preferred shares (45,000)
Net asset carrying value $660,000
Fair value of net identifiable assets acquired $705,000
Balance of FVA allocated to goodwill $145,000
The total fair value of West Company, including the value of the preferred shares is
$850,000. Under IFRS, the full fair value of the acquiree can also be calculated as the
purchase price paid by the acquirer for its shares plus the fair value of the non-controlling
interest. Under IFRS the fair value of preferred shares is treated as a non-controlling
interest.
Acquisition
Current assets $450,000
Capital assets, net 1,750,000
Goodwill 245,000
Total assets $2,445,000
Current liabilities $265,000
Long-term liabilities 420,000
Total liabilities 685,000
Common shares 1,300,000
Retained earnings 210,000
Total share equity of East Ltd. 1,760,000
Preferred shares in West Ltd.* 270,000
116

Total liabilities and shareholders' equity $2,445,000
*Non-controlling interest
Consolidation Worksheet (not required):
East West Con. Adj. Con. Adj. Con. SFP
Current assets $200,000 $200,000 $50,000 $450,000
Capital assets, net 900,000 750,000 100,000 1,750,000
Goodwill 100,000 145,000 245,000
Total assets $1,200,000 $950,000 $150,000 $145,000
$2,445,00
0
Current liabilities 90,000 140,000 35,000 265,000
Long-term liabilities 200,000 150,000 70,000 420,000
Total liabilities 290,000 290,000 685,000
Common shares 700,000 115,000 (115,000) 600,000 1,300,000
Retained earnings 210,000 295,000 (295,000) 210,000
Total share equity of East LTd. $910,000 $410,000
$1,510,00
0
Non-controlling interest (preferred shares of
West) 250,000 250,000
Total liabilities and
shareholders’ equity $1,200,000 $950,000 ($10,000) $305,000
$2,445,00
0
117

P3-4
1. Analysis of the purchase transaction:
100% Purchase of the net assets of Succeed Corp., January 1, 20X7
Purchase price (90,000 shares x $100) $9,000,000
Less carrying value of Succeed’s net identifiable assets (100%)
(7,480,000
)
= Fair Value Adjustment, allocated below 1,520,000
Carrying
value Fair Fair value
FVA
Allocated
(a) Value
Adjustmen
t
(b) (c)=(b)–(a)
Cash $780,000 $780,000 —
Accounts receivable 2,000,000 2,000,000 —
Inventories 520,000 520,000 —
Plant and equipment (net) 5,100,000 5,450,000 $350,000 $350,000
Patent 110,000 110,000 110,000
Current liabilities (310,000) (310,000) —
Long-term liabilities (610,000) (510,000) 100,000 100,000
Total fair value
adjustment allocated to
net identifiable assets (560,000)
Net asset carrying value $7,480,000
Fair value of net
identifiable assets
acquired
$8,040,00
0
Balance of FVA allocated
to goodwill $960,000
2. In addition to the patent, other intangible assets that could potentially exist are a
customer list, trade name, trademark, or copyright. (Note: this list is not all-inclusive.)
118

3.
Prosper Ltd.
Statement of Financial Position
January 1, 20X7
Current assets:
Cash $1,180,000
Accounts receivable 3,600,000
Inventories 1,520,000 $6,300,000
Plant and equipment (net) 8,950,000
Patent 110,000
Goodwill 960,000
Current liabilities $ 910,000
Long-term liabilities 1,410,000
2,320,000
Common shares (190,000 outstanding) 11,500,000
Retained earnings 2,500,000
14,000,000
Total liabilities and share equity $16,320,000
Prosper Succeed Adjustments Adjustments Consolidated
Cash $400,000 $780,000 $1,180,000
Accounts receivable 1,600,000 2,000,000 3,600,000
Inventory 1,000,000 520,000 1,520,000
Plant and equipment (net) 3,500,000 5,100,000 350,000 8,950,000
Patent 110,000 110,000
Goodwill 960,000 960,000
Total assets $6,500,000 $8,400,000 $1,420,000 $0 $16,320,000
Current liabilities $600,000 $310,000 $910,000
Long-term liabilities 900,000 610,000 (100,000) 1,410,000
Common shares (190,000
outstanding) 2,500,000 1,000,000 9,000,000 (1,000,000) 11,500,000
Retained earnings 2,500,000 6,480,000 (6,480,000) 2,500,000
Total liabilities and share equity $6,500,000 $8,400,000 $8,900,000 ($7,480,000) $16,320,000
P3-5
119

1. Measure goodwill:
100% Purchase of the net assets of Beryl Corp., January 1, 20X7
Purchase price $582,000
Less carrying value of Beryl’s net identifiable assets (100%) (385,000)
= Fair Value Adjustment, allocated below $197,000
FVA Allocated
(a) Value
Adjustmen
t
(b) (c)=(b)–(a)
Cash $100,000 $100,000 —
Accounts receivable 250,000 250,000 —
Inventories 200,000 250,000 $50,000 $50,000
Machinery and equipment (net) 250,000 370,000 120,000 120,000
Patent 55,000 77,000 22,000 22,000
Current liabilities (120,000) (120,000) —
Long-term liabilities (350,000) (350,000) 0 0
Total fair value adjustment allocated to net
identifiable assets (192,000)
Net asset carrying value $385,000
Fair value of net identifiable assets acquired $577,000
2.
Amber Corporation
Pro-forma Statement of Financial Position
January 1, 20X7
Cash ($800,000 – $582,000) $318,000
Accounts receivable ($275,000 + $250,000) 525,000
Inventories ($250,000 + $250,000) 500,000
Total current assets 1,343,000
Machinery and equipment (net) ($450,000 + $370,000) 820,000
Patent 77,000
Goodwill 5,000
120

Current liabilities ($75,000 + $120,000) $195,000
Long-term liabilities ($555,000 + $350,000) 905,000
Total liabilities 1,100,000
Common shares 200,000
Retained earnings 945,000
Total shareholders’ equity 1,145,000
Total liabilities and shareholders' equities $2,245,000
Note: this pro-forma statement of financial position is not a consolidated statement; Amber
is buying Beryl’s assets, not its shares.
Amber
Corp.
Beryl Assets Purchase
Price
Amber
Corp. SFP
Cash $800,000 $100,000 ($582,000
)
$318,000
Accounts receivable 275,000 250,000 525,000
Inventories at cost 250,000 250,000 500,000
Machinery and equipment—net 450,000 370,000 820,000
Patent — 77,000 77,000
Goodwill 5,000 5,000
Total assets $1,775,000 $1,052,000 $2,245,000
Current liabilities 75,000 120,000 195,000
Long-term liabilities 555,000 350,000 905,000
Capital–common shares 200,000 200,000
Retained earnings 945,000 945,000
Total liabilities and shareholders’ equity $1,775,000 $470,000 $2,245,000
121

P3-6
Measure (not required):
100% Purchase of the net assets of Serene Ltd., October 1, 20X6
Purchase price $1,500,000
Less carrying value of Serene’s net identifiable assets (100%) (1,460,000)
= Fair Value Adjustment, allocated below $40,000
FVA
Allocated
(a) Value
Adjustmen
t
(b) (c)=(b)–(a)
Cash $330,000 $330,000 —
Receivables 390,000 350,000 ($40,000) ($40,000)
Inventories 580,000 770,000 190,000 190,000
Capital assets, net 1,200,000 900,000 (300,000) (300,000)
Current liabilities (350,000) (380,000) (30,000) (30,000)
Long-term liabilities (690,000) (690,000) — —
Total fair value adjustment allocated to net
identifiable assets 180,000
Net asset carrying value $1,460,000
Fair value of net identifiable assets
acquired
$1,280,00
0
Eliminations and Adjustments
Eliminations Adjustments
Increase Decrease
Common shares $360,000
Retained earnings 1,100,000
Inventory $190,000
Goodwill 220,000
Investment in Serene Ltd. 1,500,000
Receivables $40,000
Capital assets 300,000
Current liabilities 30,000
Eliminating entry (not required):
122

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