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.

83Copyright © 2014 Pearson Canada Inc.

Chapter 3 – Business Combinations

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. 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 CorporationIn 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 AmusementsThis 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.

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Case 3-7: Major Developments CorporationIn this case, students are asked to review a claim of damages based on a disagreement 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.

P3-2 (20 minutes, easy) 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.

P3-3 (20 minutes, easy)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).

P3-5 (20 minutes, easy) 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.

P3-6 (15 minutes, easy)



Preparation of eliminations and adjustments at date of acquisition. Fair value decrements predominate.

P3-7 (20 minutes, easy)Preparation of a consolidated statement of financial position at the date of acquisition; a straight-forward problem.

P3-8 (30 minutes, easy) 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).

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 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 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.



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.

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.

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.

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 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 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.


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:

Bookvalue

Fair value range Difference excluding deferred income tax

liability Maximum 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.

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:

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 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 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 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.

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.

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)).

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 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, 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 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

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 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 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 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. 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.

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.

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

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:



Alternative Company Shares owned by Intercompanyrelationship

1 Prairie Prairie’s prior shareholders noneSavannah

2 Prairie Prairie’s prior shareholders noneSavannah

3 Prairie 80% by Prairie’s prior shareholders; 20% by Savannah Inc.

Prairie partially owned by Savannah

Inc.Savannah Savannah’s prior shareholders4 Prairie 80% by Prairie’s prior shareholders;

20% by Savannah Inc.Savannah wholly

owned by Prairie Ltd.Savannah Prairie Ltd.

P3-2Measure Step:

Case

A B C D E F

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)



P3-3Measure 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.

AcquisitionCurrent assets $450,000 Capital assets, net 1,750,000Goodwill 245,000Total assets $2,445,000

Current liabilities $265,000Long-term liabilities 420,000Total liabilities 685,000

Common shares 1,300,000Retained earnings 210,000Total share equity of East Ltd. 1,760,000Preferred shares in West Ltd.* 270,000



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



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


FVA Allocated

(a) ValueAdjustmen

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 110,000 110,000 110,000Current liabilities (310,000) (310,000) —Long-term liabilities (610,000) (510,000) 100,000 100,000Total fair value adjustment allocated to net identifiable assets (560,000)Net asset carrying value $7,480,000 Fair value of net identifiable assets acquired

$8,040,000


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.)



3.Prosper Ltd.

Statement of Financial PositionJanuary 1, 20X7

Current assets: Cash $1,180,000Accounts receivable 3,600,000Inventories 1,520,000 $6,300,000

Plant and equipment (net) 8,950,000Patent 110,000Goodwill 960,000Total assets $16,320,000

Current liabilities $ 910,000Long-term liabilities 1,410,000

2,320,000Common shares (190,000 outstanding) 11,500,000Retained earnings 2,500,000

14,000,000Total liabilities and share equity $16,320,000

Consolidation Worksheet (not required):

Prosper SucceedAdjustment

sAdjustment

sConsolidated

Cash $400,000 $780,000 $1,180,000Accounts 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 $910,000Long-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

1. Measure goodwill:

100% Purchase of the net assets of Beryl Corp., January 1, 20X7Purchase 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

Adjustment

(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) 250,000 370,000 120,000 120,000Patent 55,000 77,000 22,000 22,000Current liabilities (120,000) (120,000) —Long-term liabilities (350,000) (350,000) 0 0Total 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 CorporationPro-forma Statement of Financial Position

January 1, 20X7Cash ($800,000 – $582,000) $318,000 Accounts receivable ($275,000 + $250,000) 525,000Inventories ($250,000 + $250,000) 500,000Total current assets 1,343,000Machinery and equipment (net) ($450,000 + $370,000) 820,000Patent 77,000



Goodwill 5,000Total assets $2,245,000

Current liabilities ($75,000 + $120,000) $195,000 Long-term liabilities ($555,000 + $350,000) 905,000Total liabilities 1,100,000Common shares 200,000Retained earnings 945,000Total shareholders’ equity 1,145,000Total 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



P3-6

Measure (not required):

100% Purchase of the net assets of Serene Ltd., October 1, 20X6Purchase 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) ValueAdjustmen

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

$1,280,000


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 300,000Current liabilities 30,000

Eliminating entry (not required):



Common shares $360,000 Retained earnings 1,100,000Inventory 190,000Goodwill 220,000 Investment in Serene Ltd. $1,500,000 Receivables 40,000 Capital assets 300,000 Current liabilities 30,000

P3-7Measure:

100% Purchase of the net assets of Subtle., December 31, 20X6Purchase price $2,100,000 Less carrying value of Subtle’s net identifiable assets (100%) (1,600,000)= Fair Value Adjustment, allocated below $500,000

Carrying value Fair Fair value Fair value

FVA Allocated

(a) ValueAdjustmen

t Adjustment (b) (c)=(b)–(a) (c)=(b)–(a)

Cash $110,000 $110,000 — — —Accounts receivables 350,000 350,000 — — —Inventories 580,000 650,000 70,000 70,000 Land 820,000 950,000 130,000 130,000 Buildings and equipment 1,350,000 1,150,000 (380,000) 180,000 (200,000)Accumulated depreciation (380,000) 0 380,000 380,000 Patents 210,000 160,000 (50,000) (50,000)Current liabilities (460,000) (460,000) — — —

Long-term liabilities (980,000) (850,000) 130,000 130,000 Total fair value adjustment allocated to net identifiable assets (460,000)Net asset carrying value $1,600,000 Fair value of net identifiable assets acquired $2,060,000 Balance of FVA allocated to goodwill $40,000



Profound LimitedConsolidated Statement of Financial Position

December 31, 20X6Current assets:

Cash (2,300,000 – 2,100,000 + 110,000) $310,000 Accounts receivable (600,000 + 350,000) 950,000Inventory (500,000 + 580,000 + 70,000) 1,150,000

2,410,000Property, plant and equipment:

Land (1,000,000 + 820,000 + 130,000) 1,950,000Buildings and equipment (6,200,000 + 1,350,000 – 380,000 + 180,000) 7,350,000Accumulated depreciation ( – 3,000,000 – 380,000 + 380,000) –3,000,000

6,300,000Patents (210,000 – 50,000) 160,000Goodwill 40,000

200,000Total assets $8,910,000

Accounts payable (1,100,000 + 460,000) $1,560,000 Long-term debt (2,100,000 + 980,000 – 130,000) 2,950,000

4,510,000Shareholders’ equity:

Common shares 1,550,000Retained earnings 2,850,000

4,400,000Total liabilities and shareholders’ equity $8,910,000


Subtle Limited

Consolidation Consolidation Profound

Profound Limited

Carrying value

Adjustments Adjustments Consolidated SFP

Assets:

Cash $2,300,000 $110,000 ($2,100,000) $310,000

Accounts receivable 600,000 350,000 950,000

Inventory 500,000 580,000 70,000 1,150,000

Land 1,000,000 820,000 130,000 1,950,000



Buildings and equipment 6,200,000 1,350,000 (380,000) 180,000 7,350,000

Accumulated depreciation (3,000,000) (380,000) 380,000 (3,000,000)

Patents — 210,000 (50,000) 160,000

Goodwill 40,000 40,000

$7,600,000 $3,040,000 $8,910,000

Liabilities and shareholders’ equity:

Accounts payable $1,100,000 $460,000 1,560,000

Long-term debt 2,100,000 980,000 (130,000) 2,950,000

Common shares 1,550,000 1,000,000 (1,000,000) 1,550,000

Retained earnings 2,850,000 600,000 (600,000) 2,850,000

$7,600,000 $3,040,000 $8,910,000

Eliminations (not required):Common shares $1,000,000 Retained earnings 600,000 Inventory 70,000 Land 130,000 Buildings and equipment 180,000 Accumulated depreciation 380,000 Goodwill 40,000 Long-term liabilities 130,000 Investment in Subtle Ltd. $2,100,000 Buildings and equipment 380,000 Patents 50,000

P3-8

Analysis of purchase transaction

100% Purchase of the net assets of Serena., February 4, 20X7

Purchase price$1,200,00

0 Less carrying value of Serena’s net identifiable assets (100%) (400,000)= Fair Value Adjustment, allocated below $800,000

Carrying value Fair Fair value Fair value

FVA Allocated

(a) ValueAdjustmen

t Adjustment (b) (c)=(b)–(a) (c)=(b)–(a)

Cash $95,000 $95,000 — — —



Accounts and other receivables 85,000 85,000 — — —Inventories 60,000 60,000 — — —Buildings and equipment 750,000 650,000 (350,000) 250,000 (100,000)Accumulated depreciation (350,000) 0 350,000 — 350,000 Patents 250,000 250,000 — 250,000 Deferred charges 100,000 $0 (100,000) — (100,000)Accounts and other payables (120,000) (120,000) — — —

Bonds payable (180,000) (180,000) — — —Deferred income taxes (40,000) (40,000) — — —

Total fair value adjustment allocated to net identifiable assets (400,000)Net asset carrying value $400,000 Fair value of net identifiable assets acquired $800,000 Balance of FVA allocated to goodwill $400,000

Pradeesh Corp.Consolidated Statement of Financial Position

January 4, 20X7ASSETSCurrent assets:

Cash $215,000 Accounts and other receivables 235,000 Inventories 150,000 $600,000

Buildings and equipment 2,150,000 Accumulated depreciation (700,000) 1,450,000

Patents 250,000 Goodwill 400,000

$2,700,000

LIABILITIES AND EQUITIESLiabilities:

Accounts and other payables $300,000 Bonds payable 180,000



Deferred income taxes 120,000 $600,000

Shareholders' equity:Common shares 1,800,000 Retained earnings 300,000 2,100,000

$2,700,000

Eliminations (not required):a. Common shares $150,000

Retained earnings 250,000 Investment in Serena $400,000

b. Buildings and equipment 250,000 Patents 250,000 Goodwill 400,000

Investment in Serena 800,000 Deferred charges 100,000

c. Accumulated depreciation 350,000 Buildings and equipment 350,000

Consolidation worksheet (not required):Pradeesh Corp.

Statements of Financial PositionJanuary 4, 20X7

Consolidation WorksheetPradeesh Serena Adjustments Consolidated

Assets: Dr (Cr)Cash 120,000 95,000 215,000 Accounts and other rec. 150,000 85,000 235,000 Inventories 90,000 60,000 150,000

Buildings and equip. 1,500,000 750,000 250,000b 2,150,000

(350,000)c

Accumulated dep. (700,000) (350,000) 350,000c (700,000)

Patents — — 250,000b 250,000

Deferred charges — 100,000 (100,000)b 0



Goodwill — — 400,000b 400,000

Investment in Serena 1,200,000 — (400,000)a 0

(800,000)b

Total assets 2,360,000 740,000 (400,000) 2,700,000

Liabilities and equities: (Dr) CrAccounts and other pay. 180,000 120,000 300,000

Bonds payable — 180,000 180,000Deferred income taxes 80,000 40,000 120,000

Common shares 1,800,000 150,000 (150,000)a 1,800,000

Retained earnings 300,000 250,000 (250,000)a 300,000Total Equities 2,360,000 740,000 (400,000) 2,700,000

P3-9Purchase price paid by Rodriguez for 100% of Teresa $325,000 Gain on bargain purchase 25,000 Fair-value of 100% of net identifiable assets of Teresa 350,000

Measure step (not required):

Fair-value of 100% of net identifiable assets of Teresa 350,000 Carrying value of net identifiable assets of Teresa 450,000 Fair value adjustment (100,000)Less FVA allocated to net identifiable assets

Land($75,000

)Buildings 35,000 Equipment (45,000)Notes payable (15,000) (100,000)Goodwill $0

Separate entity SFP of Rodriguez:Teresa Consolidated Difference Con. Adj. Rodriguez

Cash $25,000 $70,000 $45,000 $45,000 Accounts receivable 72,500 197,500 125,000 125,000



Inventory 129,000 234,000 105,000 105,000 Investment in Teresa 0 0 0 (325,000) 325,000 Land 125,000 280,000 155,000 (75,000) 230,000 Buildings (net) 60,000 720,000 660,000 35,000 625,000 Equipment (net) 48,000 338,000 290,000 (45,000) 335,000 Goodwill 0 50,000 50,000 0 50,000

Total Assets $459,500 $1,889,500 $1,430,00

0 ($410,000

) $1,840,000

Accounts payable $6,000 $131,000 $125,000 $125,000 Notes payable 3,500 572,500 569,000 15,000 554,000 Common stock 310,000 380,000 70,000 (310,000) 380,000

Retained earnings 140,000 806,000 666,000 (115,000)

* 781,000

Total Liabilities & OE $459,500 $1,889,500 $1,430,00

0 ($410,000

) $1,840,000 * $140,000 – $25,000 = $115,000.P3A-1Measure step:

Case

A B C D E F

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 (d) = (a – b) 40 20 20 (20) (20) (40)

Fair value adjustment allocated to net identifiable assets (e) = (c–b) (20) 20 (40) (20) 40 20

Deferred tax liability/(asset) relating to the FVA allocated to the net identifiable assets (f) = [(e) × 30%] 6 (6) 12 6 (12) (6)Balance = goodwill/(gain on bargin purchase) [(d) + (e) + (f)] 26 34 (8) (34) 8 (26)

P3A-2

When the fair values of Supply Corporation’s net assets (as shown in the problem) are totalled, the fair value of the recorded net assets acquired amounts to $860,000. To this should be added the fair value of the production process rights acquired of $196,000 and the fair value of the tax benefit from the unrecognized tax loss carryforwards of $64,000 ($140,000 × 40%). Since Retail believes that it is highly probable that Supply will have sufficient taxable income in the future to utilize its tax loss carryforwards, the tax benefit of $64,000 on the tax loss carryforward of $160,000 can be recognized as an asset.

When the two unrecorded assets are added, the total fair value of the net assets acquired is $1,120,000. This total is in excess of the purchase price of $980,000. Therefore, there is a gain from a bargain purchase amounting to $140,000:



Consideration given $980,000 Carrying value of net assets acquired:

Assets 1,275,000 Liabilities (785,000)

Net Assets at carrying value 490,000FVA:

Inventories 10,000 Buildings (100,000)Machinery and equipment 270,000 Land 150,000 Investment 10,000 Unearned revenue 10,000 Bonds Payable 20,000 Benefit of tax loss carryforwards 64,000 Production process rights 196,000 Total FVA 630,000 Fair value of net assets acquired 1,120,000 Goodwill ($140,000)

Alternative approach:Fair value of net assets recorded on Supply's books $860,000

Fair value of rights to production processes 196,000

Benefit of tax loss carryforwards ($160,000 × 40%) 64,000

Fair value of net identifiable assets acquired: 1,120,000

Purchase price paid to acquire 100% of Supply 980,000

Gain from bargain purchase ($140,000)

Under the acquisition method negative goodwill is recognized as a gain on bargain purchase in the consolidated SCI issued by Retail Ltd. The acquisition method also requires all assets and liabilities of a subsidiary acquired in a business combination to be reported at their fair values on the date of acquisition, irrespective of the purchase consideration paid. Such assets and liabilities also include assets and liabilities not present on the acquiree’s books, such as the production process rights and the benefit of tax loss carryforwards in the present example. Therefore, the net assets of Supply Corporation will be valued in total at $1,120,000 in the consolidated SCI despite the fact that Retail Ltd. paid only $980,000 for them. Since the difference of $140,000 is recognized as a gain on bargain purchase, naturally goodwill relating to the acquisition will be valued at zero on the consolidated SFP.



P3A-3

Measure step (not required);

100% Purchase of the net assets of Serene Ltd., October 1, 20X6Purchase 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) ValueAdjustmen

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 (350,000) (380,000) — —Deferred tax asset (690,000) (690,000) 45,000 45,000

Total fair value adjustment allocated to net identifiable assets 135,000 Net asset carrying value $1,110,000

Fair value of net identifiable assets acquired $900,000


Eliminations and adjustments: Eliminations Adjustments

Increase Decrease

Common shares $360,000

Retained earnings 1,100,000

Deferred tax asset 45,000

Inventory $190,000

Goodwill 175,000

Investment in Serene Ltd. 1,500,000



Receivables $40,000 Capital assets 300,000Current liabilities 30,000

Eliminating entry (not required):Common shares $360,000 Retained earnings 1,100,000Inventory 190,000Deferred tax asset 45,000Goodwill 175,000 Investment in Serene Ltd. $1,500,000 Receivables 40,000 Capital assets 300,000 Current liabilities 30,000



SSP 3-1a.

Statement of Financial PositionAugust 31, 20X6

Cash and cash equivalents (2,350,000 + 1,200,000 – 2,000,000) $1,550,000Accounts receivable (2,000,000 + 1,800,000) 3,800,000Land 5,000,000Machinery and equipment (net) (13,500,000 + 11,000,000) 24,500,000Deferred development costs (600,000 + 4,000,000) 4,600,000Goodwill 4,000,000

$43,450,000

Accounts payable (650,000 + 1,100,000) $ 1,750,000Notes payable, long-term (2,000,000 + 18,000,000 + 900,000) 20,900,000Common shares 15,000,000Retained earnings 5,800,000

$43,450,000

b.


Cash and cash equivalents (2,350,000 + 1,200,000) $3,550,000Accounts receivable (2,000,000 + 1,800,000) 3,800,000Land 5,000,000Machinery and equipment (net) (13,500,000 + 11,000,000) 24,500,000Deferred development costs (600,000 + 4,000,000) 4,600,000Goodwill 4,000,000

$45,450,000

Accounts payable (650,000 + 1,100,000) $ 1,750,000Notes payable, long-term (2,000,000 + 900,000) 2,900,000Common shares 35,000,000Retained earnings 5,800,000

$45,450,000




Cash and cash equivalents (2,350,000 + 1,200,000 – 1,000,000) $2,550,000Accounts receivable (2,000,000 + 1,800,000) 3,800,000Land 5,000,000Machinery and equipment (net) (13,500,000 + 11,000,000) 24,500,000Deferred development costs (600,000 + 4,000,000) 4,600,000

$40,450,000

Accounts payable (650,000 + 1,100,000) $ 1,750,000Notes payable, long-term (2,000,000 + 900,000) 2,900,000Common shares 28,500,000Retained earnings 1,800,000

$40,450,000



SSP 3-2

100% Purchase of Shelley Inc., January 1, 20X6Purchase price $850,000 Less carrying value of Target’s net identifiable assets (100%) (450,000)= Fair Value Adjustment, allocated below 400,000


FVA Allocated

(a) Value Adjustment (b) (c)=(b)–(a)

Cash $55,000 $55,000 —Accounts receivable 135,000 135,000 —Inventories 90,000 90,000 —Land 180,000 300,000 $120,000 $120,000

Buildings (net) 430,000 450,000 20,000 20,000Equipment 120,000 180,000 60,000 60,000

Accounts payable (140,000)(140,000) —

Long-term debt payable (420,000)(420,000) —

Deferred tax liability (50,000) (50,000) (50,000)Fair value adjustment allocated to net identifiable assets

($150,000)

Net asset carrying value $450,000

Fair value of assets acquired $600,000 Balance of FVA allocated to goodwill $250,000



Patricia Ltd.Consolidated SFPJanuary 1, 20X6

ASSETS Cash (80,000 + 55,000) $135,000 Accounts receivable (220,000 + 135,000) 355,000

Inventories (100,000 + 90,000) 190,000 Total current assets 680,000 Land (800,000 + 180,000 + 120,000) 1,100,000 Buildings (net) (1,100,000 + 430,000 + 20,000) 1,550,000

Equipment (net) (720,000 + 120,000 + 60,000) 900,000

Investment in Shelly Inc. (850,000 + 0 - 850,000) —

Goodwill (+250,000) 250,000TOTAL ASSETS $4,480,000 LIABILITIES AND SHAREHOLDERS’ EQUITY

Accounts payable (120,000 + 140,000) $260,000 Long-term debt payable (400,000 + 420,000) 820,000

Deferred tax liability (+ 250,000) 50,000 Total liabilities 1,130,000 Common shares (1,000,000 + 850,000 + 200,000 - 200,000) 1,850,000

Retained earnings (1,500,000 + 250,000 - 250,000) 1,500,000

Total shareholders’ equity 3,350,000TOTAL LIABILITIES AND SHAREHOLDERS’ EQUITY $4,480,000

Note: The bolded amounts are adjustments that must be made to: • recognize fair value increments; • recognize goodwill; • eliminate Patricia’s investment account; • recognize the deferred tax liability arising from the acquisition; and • eliminate Shelley’s date-of-acquisition shareholders’ equity.
