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Chapter 2
Investments in Equity Securities
2 Modern Advanced Accounting in Canada, Seventh Edition
A brief description of the major points covered in each case and problem.
CASES
Case 2-1
A company increases its equity investment from 10% to 25%. Management wants to compare
the equity method and fair value method in order to understand the affect on the accounting and
wants to know which method better reflects management‟s performance.
Case 2-2
A company has acquired an investment in shares of another company and members of its
accounting department have differing views about how to account for it.
Case 2-3
This case focuses on the accounting for a long-term investment when the investee is hostile and
refuses to co-operate with the investor.
Case 2-4
This case, adapted from a past UFE, involves a parent company that is in financial difficulty. An
investment in an associate has been written off and a subsidiary has been sued. The student
must assess whether the company can continue to report on a going concern basis and
determine what should be disclosed in the notes to the financial statements.
Case 2-5
This case, adapted from a past UFE, gives an illustration of a company that has raised money
for its operations in several ways (i.e. other than raising common equity) and asks the student to
analyze the accounting issues for the various types of investments.
Case 2-6
This case, adapted from a past UFE, involves a company that is considering the purchase of a
46.7% interest in another company in the scrap metal business. The student must write a memo
to discuss 1) all relevant business considerations pertaining to the purchase and 2) how the
purchaser should report its investment if it were to proceed with the purchase.
Solutions Manual, Chapter 2 3
PROBLEMS
Problem 2-1 (20 min.)
This problem involves the calculation of the balance in the investment account for an investment
carried under the equity method over a two-year period. Then, journal entries are required to
reclassify and account for the investment as FVTPL for the third year.
Problem 2-2 (20 min.)
This problem involves the preparation of journal entries for a FVTPL investment for one year. In
year 2, journal entries are required to reclassify and account for the investment as a held-forsignificant-influence investment.
Problem 2-3 (30 min.)
This problem involves the preparation of journal entries over a two-year period for an investment
under two assumptions: (a) that it is a significant influence investment and (b) that it is
accounted for using the cost method.
Problem 2-4 (40 min)
This problem requires journal entries, the calculation of the balance in the investment account
and the preparation of the investor‟s income statement under both the equity method and cost
method. The investee reports a loss from discontinued operations for the year.
Problem 2-5 (40 min)
This problem compares the investment account balance, the income per year, and the
cumulative income for a three-year period for a 20% investment if it was classified as FVTPL,
investment in associate and FVTOCI.
Problem 2-6 (30 min)
This problem requires the preparation of slides for a presentation to describe GAAP for publicly
accountable enterprises for financial instruments as they relate to FVTPL, FVTOCI, held-forsignificant-influence and held-for-control investments.
Problem 2-7 (30 min)
4 Modern Advanced Accounting in Canada, Seventh Edition
This problem requires the preparation of slides for a presentation to describe GAAP for private
enterprises for financial instruments as they relate to FVTPL, FVTOCI, held-for-significantinfluence and held-for-control investments.
WEB-BASED PROBLEMS
Web Problem 2-1
The student answers a series of questions based on the 2011 financial statements of Rogers
Communications Inc., a Canadian company. The questions deal with ratio analysis and
investments reported using cost method, equity method and fair-value method.
Web Problem 2-2
The student answers a series of questions based on the 2011 financial statements of Goldcorp
Inc., a Canadian company. The questions deal with ratio analysis and investments reported
using cost method, equity method and fair-value method.
SOLUTIONS TO REVIEW QUESTIONS
1. A business combination is a transaction or other event in which an acquirer obtains control
of one or more businesses. Transactions sometimes referred to as „true mergers‟ or
„mergers of equals‟ are also business combinations as that term is used in this IFRS. A
parent–subsidiary relationship exists when, through an investment in shares or other means,
the parent company has control over the subsidiary company. The key common element is
the concept of control.
2. A FVTPL investment is reported at fair value with the fair value adjustment reported in net
income whereas an investment in an associate is reported using the equity method.
3. A control investment exists if one entity has the power to determine another entity‟s key
strategic policies and activities. Joint control exists when two or more companies have an
agreement that establishes joint control such that no one of them can unilaterally determine
the other entity‟s key strategic policies and activities.
Solutions Manual, Chapter 2 5
4. The purpose of the IFRS 8: Operating Segments is to improve the information available to
shareholders and investors about the lines of business and geographic areas in which the
company does business. Some of this information is lost in the aggregation process of
consolidation, and the disaggregation of segment reporting is valuable for detailed analysis.
5. The equity method should normally be used to report an investment when the investor has
significant influence over or has joint control of the investee. The ability to exercise
significant influence or joint control may be indicated by, for example, representation on the
board of directors, participation in policy-making processes, material intercompany
transactions, interchange of managerial personnel or provision of technical information.
6. The equity method records the investor‟s share of changes in the investee‟s equity . The
investee‟s equity is increased by income and decreased by dividends. Therefore the
investor records an increase in its equity account balance when the investee earns income,
and records a decrease when the investee pays dividends.
7. The Ralston Company could determine that it was inappropriate to use the equity method to
report a 35% investment in Purina in two separate types of circumstances. For example, if
another shareholder group owned up to 65% of Purina‟s voting shares, Ralston could argue
that its ownership did not provide significant influence over Purina. In this case, Ralston
would likely classify the investment as a FVTPL investment and report it at fair value.
Alternatively, Ralston might argue that its 35% ownership established control over Purina.
This would occur if, for example, Ralston also owned convertible preferred shares that, if
converted, would increase its voting share ownership to greater than 50%. In this case,
Ralston would argue that it should consolidate Purina.
8. The FVTPL would have been reported at fair value. The previous investment should be
adjusted to fair value on the date of the change. The cost of the new shares is added to the
fair value of the previously held shares. The sum of the two values becomes the total cost
of shares when calculating the acquisition differential.
9. An investor should report its share of an investee‟s other comprehensive income in the
same manner that it would report its own other comprehensive income. Thus, the investor‟s
6 Modern Advanced Accounting in Canada, Seventh Edition
percentage of the investee‟s OCI should be reported on a separate line below operating
profit, net of tax, and full disclosure should be provided. However, the investor‟s measure of
materiality should be used to determine whether or not the item is sufficiently material to
warrant separate presentation.
10. In this case, Ashton‟s share of the loss of Villa ($280,000) exceeds the cost of its investment
in Villa ($200,000). The extent of loss recognized by Ashton depends on whether it has
legal or constructive obligations or made payments on behalf of Villa.
a) Assume that Ashton has constructive obligations on behalf of Villa because it may have
guaranteed the liabilities of Villa such that if not paid by Villa Ashton would have to pay on
their behalf. In this case, Ashton would record 40% x $700,000 or $280,000 as a reduction
of the investment account and as a recognized loss on the statement of operations. The
investment account will now have an $80,000 credit balance, and should be reported as a
liability.
b) However, if Ashton does not have constructive obligations with respect to the liabilities of
Villa, losses would only be recognized to the extent of the investment account balance. That
is, a $200,000 loss would be recognized and the investment account balance would be
reduced to zero. Ashton would resume recognizing its share of the profits of Villa only after
its share of the profits equal the share of losses not recognized ($80,000 in this case).
11. Able would reduce its investment account by the percentage that was sold, and record a
gain or loss on disposition. It would then reevaluate its reporting method for the investment.
If significant influence still exists, it should report using the equity method. If it no longer
exists, Able should report using the fair value method and would measure any remaining
interest in the investee at fair value.
12. The disclosure requirements for an investment in an associate are stated in IFRS 12. An
entity shall disclose:
(a) for each associate that is material to the reporting entity:
(i) the name of the associate.
(ii) the nature of the entity’s relationship with the associate (by, for example, describing
the nature of the activities of the associate and whether they are strategic to the
entity’s activities).
Solutions Manual, Chapter 2 7
(iii) the principal place of business (and country of incorporation, if applicable and
different from the principal place of business) of the associate.
(iv) the proportion of ownership interest or participating share held by the entity and, if
different, the proportion of voting rights held (if applicable).
(b) for each associate that is material to the reporting entity:
(i) whether the investment in the associate is measured using the equity method or
at fair value.
(ii) summarised financial information about the associate.
(iii) if the associate is accounted for using the equity method, the fair value of its
investment in the associate, if there is a quoted market price for the investment.
(c) financial information about the entity’s investments in associates that are not individually
material
(d) the nature and extent of any significant restrictions (eg resulting from borrowing
arrangements, regulatory requirements or contractual arrangements between investors with
significant influence over an associate) on the ability of associates to transfer funds to the
entity in the form of cash dividends, or to repay loans or advances made by the entity.
(e) when the financial statements of an associate used in applying the equity method are as
of a date or for a period that is different from that of the entity:
(i) the date of the end of the reporting period of the financial statements of that
associate; and
(ii) the reason for using a different date or period.
(c) the unrecognised share of losses of an associate, both for the reporting period and
cumulatively, if the entity has stopped recognising its share of losses of the associate when
applying the equity method.
13. The FVTPL reporting method would typically show the highest current ratio because a
FVTPL investment is a short term trading investment, which must be shown as a current
asset. For the other reporting methods, the investment could be classified as a non-current
asset depending on management‟s intention for the investment.
14. Private enterprises may elect to account for investments in associates using either the
equity method or the cost method. The method chosen must be applied consistently to all
similar investments. When the shares of the associate are traded in an active market, the
investor cannot use the cost method; it must use either the equity method or the fair value
method.
15. IFRS 9 requires that all nonstrategic equity investments be measured at fair value including
investments in private companies. However, an entity can elect on initial recognition to
8 Modern Advanced Accounting in Canada, Seventh Edition
present the fair value changes on an equity investment that is not held for short-term trading
in other comprehensive income (OCI). The gains or losses are cleared out of accumulated
OCI and transferred directly to retained earnings and are never recycled through net
income. Under IAS 39, investments that did not have a quoted market price in an active
market and whose fair value could not be reliably measured were reported at cost. This
provision no longer exists under IFRS 9.
SOLUTIONS TO CASES
Case 2-1
The investment in Ton was appropriately classified as FVTPL in Year 4 on the assumption that
Hil did not have significant influence with a 10% interest.
The reporting of the investment at the end of Year 5 depends on whether Hil has significant
influence. IAS 28 states that the ability to exercise significant influence may be indicated by, for
example, representation on the board of directors, participation in policy-making processes,
material intercompany transactions, interchange of managerial personnel or provision of
technical information. If the investor holds less than 20 percent of the voting interest in the
investee, it is presumed that the investor does not have the ability to exercise significant
influence, unless such influence is clearly demonstrated. On the other hand, the holding of 20
percent or more of the voting interest in the investee does not in itself confirm the ability to
exercise significant influence. A substantial or majority ownership by another investor may, but
would not automatically, preclude an investor from exercising significant influence.
If Hil does have significant influence as a result of owning greater than 20% of the voting
shares, it would adopt the equity method as of January 1, Year 5. The change from the fair
value method to the equity method would be accounted for prospectively due to the change in
circumstance. The fair value method was appropriate in Year 4 when Hil did not have
significant influence. The equity method is appropriate starting at the time of the additional
investment.
Solutions Manual, Chapter 2 9
The additional cost of the 15,000 shares will be added to the carrying amount of the investment
as at January 1, Year 5 to arrive at the total cost of the investment under the equity method.
The following summarizes the financial presentation of the investment-related information in the
financial statements for Year 5. In the first scenario, the fair value method is used assuming that
the investment is classified as FVTPL. In the second scenario, the equity method is used
assuming that the investment is classified as significant influence (SI):
FVTPL SI
On balance sheet
Investment in Ton $925,0001
$885,0002
On comprehensive income statement
In net income
Dividend income $120,0003
Equity income $130,0004
Unrealized gains 50,0005
Total $170,000 $130,000
Notes:
1) 25,000shares x 37 = 925,000
2) 10,000shares x 35 + 525,000 + equity income for Year 5 of 130,0004
– dividends
received in Year 5 of 120,0003 = 885,000
3) 25% x 480,000 = 120,000
4) 25% x 520,000 = 130,000
5) 25,000shares x (37 – 35) = 50,000
Cost of investment (10,000shares x 35 + 525,000) $875,000
Hil‟s share of net carrying amount of Ton‟s shareholders‟ equity
(25% x [2,600,000+500,000-480,000]) 655,000
Land $220,000
No amortization of acquisition differential pertaining to land
The fair value method probably provides the best means of evaluating the return on the
investment. The dividend income and the unrealized gains are reported in net income. The
present bonus scheme considers net income. As such, the unrealized gains are considered
10 Modern Advanced Accounting in Canada, Seventh Edition
when evaluating management‟s performance. This is appropriate since they represent part
of the return earned by Hil during the year. Under the equity method, equity income would
be reported in net income and would be considered when evaluating management. The
unrealized gains are not reported in net income and would obviously not be considered in
evaluating management‟s performance under the equity method.
Case 2-2
In this case, students are asked to, in effect, assume the role of a consultant and advise
Cornwall Autobody Inc. (CAI) how it should report its investment representing 33% of the
common shares of Floyd’s Specialty Foods Inc. (FSFI).
Accountant #1 suggests that the cost method is appropriate because it is really just a loan. This
might have some validity because Floyd‟s friend Connelly certainly seems to have come to his
rescue. However Connelly‟s company did buy shares, and there is no evidence that they can or
will be redeemed by FSFI at some future date. An investment in shares is not a loan, which
would have to be reported as some sort of receivable. While knowledge of the business or the
ability to manage it such as might be seen in the exchange of management personnel or
technology, might be indicators that significant influence exists and can be asserted, the
absence of knowledge of the business and ability to manage do not necessarily mean that there
cannot be significant influence. They are not requirements for the use of an alternative such as
the cost method.
Accountant #2 feels that the equity method is the one to use simply because the ownership
percentage is over 20%. This number is a quantitative guideline only and whether an investment
provides the investee with significant influence over the investee or not depends on facts other
than the ownership percentage. For significant influence, the ability to influence the strategic
operating and investing policies has to be present. Representation on the board of directors
would be evidence of such ability. There is no evidence of board membership.
Accountant # 3 also suggests the equity method saying that 33% ownership gives them the
ability to exert significant influence. Whether they exert it or not doesn‟t matter. This part is
correct; you do not have to actually exert it. However, owning 33% does not necessarily mean
that you possess this ability. Mr. Floyd was the sole shareholder of FSFI before CAI‟s
Solutions Manual, Chapter 2 11
investment, and we have no knowledge that he has relinquished some of this control to
Connelly in return for his bail out.
The circumstances would seem to rule out the three possibilities presented by the accountants.
The investment should be reported at fair value. The only choice (and it is a choice) is whether
to report the unrealized gains in net income or other comprehensive income. More information
is needed to determine whether CAI has other similar investments and what its preference is
with respect to the reporting of this type of investment.
Case 2-3
(a) This 28% investment has the possibility of being only a significant influence investment
under IAS 28 (to be accounted for using the equity method) or a fair-value investment under
IFRS 9. While the ownership is greater than 20%, the ability to influence the strategic
operating and investing policies does not seem to be present. There is no board
membership or significant intercompany transactions between the two companies. In fact
Magno cannot even receive information other than that which is available to the market as a
whole. Therefore it seems evident that this investment should be reported at fair value.
(b) Management would like to use the equity method because it would result in Magno reporting
28% of Grille -To – Bumper‟s yearly earnings. Under the fair-value method, Magno would
report its investment at fair value at each reporting date with unrealized gains reported either
in net income or other comprehensive income. The fair-value method would be very
expensive to apply because Grille -To – Bumper‟s shares are not traded in an active market.
Some sort of business valuation would have to be performed every year to estimate the fair
value of Grille -To – Bumper‟s shares. The cost involved may not justify the effort.
(c) If Magno had representation on the board of directors, the investment would be considered
to be a significant influence investment. With such membership Magno might be able to
influence dividend policy. On the date that it became a significant influence investment,
Magno would change to using the equity method on a prospective basis.
Case 2-4
Memo to: Partner
12 Modern Advanced Accounting in Canada, Seventh Edition
From: CA
Subject: Going concern status of Canadian Computer Systems Limited (CCS)
There are several factors that suggest that CCS may not be a going concern. However, many
are limited to the impact of the investment in Sandra Investments Limited (SIL) on the cash
flows and financial statements of CCS. Subsequent events regarding SIL suggest that CCS may
be able to continue operations. Our conclusion on the going concern status of CCS will have
implications with regard to disclosure and the content of our audit report.
Analysis of going concern status
General considerations
Among other things, it will be important to consider the current environmental factors when
assessing the future of CCS. These include inflation projections, fluctuations in interest rates,
US currency rates, economic recessions, competition in the industry, and inventory
obsolescence. These factors may affect the prospects of CCS.
Impact of SIL on the financial results of CCS
The poor financial results of CCS are for the most part a direct result of its accounting treatment
for its investment in SIL. SIL was de-listed by a US stock exchange, because of perceived
financial difficulties. As a result of SIL’s continued losses, CCS decided to write off its
investment in SIL. In addition, SIL liabilities that were guaranteed by CCS were also recorded in
the accounts of CCS. The write-off and assumption of SIL’s liabilities adversely affected CCS’s
income statement, while the increase in liabilities adversely affected CCS’s working capital
position.
However, after CCS’s year-end, SIL was able to raise US$40 million through a preferred share
issue. SIL used the US$40 million to pay off the liabilities guaranteed by CCS. In addition, SIL
was relisted by the stock exchange. These events do much to allay any concerns that CCS may
not be a going concern.
The cash flows of CCS
Over the past two years, CCS has incurred substantial operating losses. In Year 11, losses
totaled $3.58 million (Year 10 – $5.88 million). However, net income after discontinued
Solutions Manual, Chapter 2 13
operations was $1.94 million in Year 11 and, more importantly, net cash outflows from
operations were $1.18 million. Therefore, net cash outflows from operations are substantially
less than reported operating losses. Cash flows from operations are an important consideration
in deciding whether CCS is a going concern.
The new equity issue being considered for the Year 12 fiscal year would help improve cash
flows in the coming year, especially if any of the loans are called.
The management of CCS has partially lost control over the company’s cash flows. Currently, the
bank has full control over the cash flows of CCS, as it collects cash receipts and releases funds
based on operating budgets. This practice is an indication that CCS is having difficulty in
obtaining financing for its operations. On the other hand, interest rates charged are at 1% over
prime, suggesting that the bank believes the security for the loan (accounts receivable and the
floating charge debenture on all assets) is adequate. In any case, the bank’s control over cash
flows does ensure that adequate cash flows for operations will be maintained through these
demand loans.
Assessment of the balance sheet of CCS
For the year ended September 30, Year 11, CCS has a negative shareholders’ equity balance of
$74.6 million (Year 10 – $76.7 million). However, this deficit was created largely by the write-off
of the SIL loan guarantee of $55.42 million in Year 10. In Year 11, a further $2.83 million in
interest charges was expensed. Without these expenses, shareholders’ equity would have a
deficit balance of only $16.35 million.
In hindsight, the write-offs were not required. The success of SIL’s preferred share issue does
suggest that investors have confidence in the company and, more importantly, CCS no longer
has any obligation for the loan, since it has now been paid off.
IAS 36 requires that an entity shall assess at the end of each reporting period whether there is
any indication that an impairment loss recognized in prior periods for an asset other than
goodwill may no longer exist or may have decreased. If any such indication exists, the entity
shall estimate the recoverable amount of that asset. An impairment loss recognized in prior
periods for an investment in an associate shall be reversed if, and only if, there has been a
change in the estimates used to determine the asset’s recoverable amount since the last
14 Modern Advanced Accounting in Canada, Seventh Edition
impairment loss was recognized. If this is the case, the carrying amount of the asset shall be
increased to its recoverable amount. That increase is a reversal of an impairment loss.
The increased carrying amount of the investment attributable to a reversal of an impairment loss
shall not exceed the carrying amount that would have been determined had no impairment loss
been recognized for the asset in prior years. The reversal of the impairment loss for the
investment is recognized immediately in net income.
CCS’s working capital deficiency of $83.71 million (Year 10 – $92.27 million) also points to a
going concern problem. However, after the liabilities are reduced by the SIL loan and related
interest accrued, the deficiency shrinks to $22.2 million (Year 10 – $26.37 million). A comparison
of Year 10 to Year 11 results suggests that the working capital position of CCS is improving.
The mortgages payable balance of $21.6 million could also reduce the working capital
deficiency. This balance had been reclassified as a current liability because of the failure of CCS
to comply with debt service requirements and operating covenants. If the mortgage holder
agrees to not demand payment of the mortgage and to put the mortgage loan back in good
standing, then the amount should be classified as a long-term liability. The violation of the
covenants could be the result of the method that was used to account for losses in SIL.
After all these deductions are made, the working capital deficiency in Year 11 would then be just
$600,000 (Year 10 – $4.77 million).
The growing accounts payable of CCS ($400,000) may indicate an inability on CCS’s part to pay
its creditors on time. The $160,000 proceeds from the common shares issued during the year
were used to satisfy liabilities owing to the company’s directors and officers.
Management intends to sell property that is carried on the balance sheet at $1.85 million. The
proceeds from this sale could help improve cash flows and may also indicate that management
is trying to rid CCS of unprofitable and inefficient assets.
In addition, no dividends have been paid on the common shares or the preferred shares in the
last two years. The non-payment of dividends is probably due to the fact that CCS is not
permitted to pay dividends without the bank’s approval.
Solutions Manual, Chapter 2 15
Another factor that should be considered in the going concern analysis is CCS’s long-term loan
of $15 million, which has been in default since September 30, Year 11. This loan should be
classified as a current liability unless the lender formally agrees to forgive the violation and not
call the loan. In addition, any long-term debt that is payable on demand should be classified as a
current liability since it can be called at any time. To avoid the classification as current liabilities,
the lenders must formally agree to change the terms of the loans so that the loans are not
callable on demand. The reclassification of any loans from long term to current will make the
working capital situation worse and could negatively affect the CCS‟s ability to continue as a
going concern.
Assessment of income statement
There are signs that the company is controlling its costs. Operating expenses have decreased
by 32% in Year 11 from the Year 10 amounts. In addition, it appears that CCS is discontinuing
certain operations that had been contributing to its losses in prior years; these operations may
also have adversely affected cash flows.
Sales fell 35% in Year 11 compared to Year 10. In addition, there is a large increase in CCS’s
accounts receivable balance from Year 10, which may indicate a problem with collections.
CCS has completed a new software development program that may help sales in the future. The
actual impact of this new product on cash flows should be determined.
CCS may be able to borrow funds using its plant assets as collateral. These assets may have a
much higher market value than those reflected on the balance sheet. There are also other bases
of measurement that could be used to value the assets, such as replacement cost or fair value.
These measurements provide a better reflection of the underlying value of the assets.
The pending lawsuit may result in judgments or cash awards. However, management believes
that this claim is without merit, an opinion that needs to be confirmed by CCS’s lawyers. Further,
any amount that may be awarded pursuant to an action is recoverable under the company’s
insurance policies.
Other steps CCS could take
16 Modern Advanced Accounting in Canada, Seventh Edition
My analysis of the financial position of CCS uncovered a number of cash planning opportunities
that may enable CCS to improve its profitability. Currently, CCS has a large amount of debt
outstanding, with interest payable at high interest rates. Management should discuss with the
bank opportunities that may be available to restructure the debt. By providing cash flow
statements and budgets, management may be able to convince the bank that the risk of lending
CCS funds is lower than originally perceived. Further, a greater effort could be made to sell the
property held for resale. Selling SIL would also generate cash flows. In addition, CCS could
increase its efforts to collect the outstanding receivables; one alternative is to sell the
receivables to a credit agency.
Implications of disclosing a going concern problem in the financial statements
If it is concluded that a going concern problem exists, then we must determine the appropriate
type of disclosure. The most conservative treatment that could be adopted is to use an
alternative basis of measurement (e.g., liquidation value). In this case, not only will balance
sheet values be changed, but the classification of assets and liabilities in the financial
statements may also need to be adjusted.
We must consider whether there is adequate disclosure in the financial statements and whether
disclosure explicitly draws attention to the going concern problem. In evaluating the adequacy of
disclosure, we would consider the content of financial statements, including the terminology
used, the amount of detail given, the location of the disclosure, and its prominence in the
financial statements.
If it is decided that the going concern problem is to be disclosed in a note, and the figures used
in the financial statements will not be adjusted, then certain information should be included in
the note. First, the note should state that there are adverse conditions and events, which
indicate that the accounting principles used, are not applicable. The note should also provide
details of management’s plans, if any, for dealing with the adverse conditions and events and
management’s evaluation of their significance for operations, as well as any mitigating factors
that may be present. The possible effects on operations should be explained if the problem is
not resolved. Finally, the note should state the anticipated timing of the resolution of surrounding
uncertainties.
Solutions Manual, Chapter 2 17
Disclosure does not have to be limited to the financial statements. Going concern problems
could be communicated in media announcements or in the management discussion and
analysis in the annual report, or could be included with documents filed with the provincial
securities commissions.
At a minimum, going concern matters should be disclosed in notes to the financial statements.
There are legal implications if a going concern problem is not disclosed properly to auditors,
directors, officers, and any company administrators.
Case 2-5
(a)
Memorandum
To: Partner
From: CA
Subject: Penguins in Paradise (PIP)
Many users will be relying on the financial statements. Most significantly, equity investors will
be relying on the financial statements to calculate their participation payment. They will want
accounting policies that maximize profit. In addition, they will want to ensure that PIP‟s
operations, particularly its costs, are being efficiently controlled. The bank will also be relying
on the financial statements to ensure that the operations are under control. They will likely want
to see statements that maximize income (minimize losses) and show positive cash flows. The
promoter will be relying on the financial statements in calculating his participation payment.
Like all the other investors, he will want profit to be high in order to maximize his own income.
In setting the accounting policies, the client must bear in mind that in this situation they will have
a direct impact on PIP‟s cash flows. Cash flows will be very important in the first stages of the
life of the play, a period in which expenses will exceed revenues. Early recognition of expenses
will decrease profit, and the participation payments that are based on operating profits. I
recommend that the accounting policies be set in accordance with accounting standards for
private enterprises (ASPE). Future profits are uncertain. To be conservative, items should be
expensed now and revenues should be recognized once production of the play commences.
Limited partners
18 Modern Advanced Accounting in Canada, Seventh Edition
The investor contributions to the limited partnership should be shown as “partners‟ capital” in the
shareholders‟ equity section of the balance sheet. The investors are entitled to the residual
interest of the entity after all debt holders have received the interest.
Royalty rights
Accounting for the royalty right payments to PIP is very important because of the impact this
amount will have on the participation payments to investors.
First, it must be determined whether the amount paid to PIP for the royalty rights is an income
item or a capital item. A royalty payment is very similar to a dividend. The investors will receive
a royalty (or participation) payment that is based on their initial contribution. The payment that
they receive could also be considered a return of their investment. Both of these facts imply
that the payments to PIP by the investors are on account of capital.
On the other hand, in order for the investors to earn a royalty, the critical event that must take
place is the production of the play. The cost of producing the play is the cost of earning the
income. In addition, the original contributions will not be refunded to the investor.
If the amount paid to PIP by the investors is considered to be on account of income, it is
important to determine the period in which the amount should be recognized. The critical event
here is the signing of the contract. Also, no future services have to be provided. These facts
suggest that the amount should be recognized as income immediately.
However, if profit is earned and a royalty payment is made by PIP, it will be based on future
profit. Expenses will be incurred in the future and therefore, the amount paid to PIP by investors
should be matched to the period in which the expense is incurred. In addition, by recognizing
the investors‟ payments to PIP as income in future periods, we would obtain a better matching
of expenses since the production is in a future period. I recommend that the investor payments
to PIP be treated as income and recognized in future years.
To help avoid interpretation problems in the future, “true operating expenses” must be defined.
The definition will help clarify what types of expenses are deductible and what types of revenues
must be included in income.
Solutions Manual, Chapter 2 19
Sale of reservation rights
The timing of recognition of the fees earned from selling reservation rights must be determined.
The amount relates to the future performance of the play, that being in Year 2. If the play is
cancelled, the theatregoers will ask for a refund of their reservation fee. Therefore, there is a
case for future recognition. Arguments favoring recognition in Year 1 include the fact that the
critical event is selling the reservation rights, and that the amount is non-refundable. In addition,
the amount paid cannot be applied against future ticket prices and no future services are to be
rendered.
Since the play must run in a future year to avoid having to repay the reservation fee, the
reservation fee should be recognized as revenue in Year 2. Doing so will reduce income for the
current year and reduce the participation payment in the current year.
Sales of movie rights
The payment received for the sale of the movie rights can be taken into income in the current
year because there is no direct tie to future expenses or events. Alternatively, the amount that
was paid is based on the success of the play, and should be taken into income in future periods.
Government grant
We must determine whether the government grant is attributable to income or capital. The
treatment of this amount will affect the royalty payment. If the amount is taken into income
immediately, the participation payments will increase. If the amount is offset against an asset
that is depreciated, then the participation payments derived from the grant will be paid over
time. If the grant is tied to hiring Canadians to perform in the play, then the amount should be
credited against the related expense.
If the grant has to be spent on costumes and sets made in Canada, then the amount should be
netted against the related assets. The grant should be recognized when it becomes payable,
not when it is collected.
In order to decide how this amount should be recognized, we must determine what the 50%
content rule pertains to – against what purchase should it be offset? We must also determine
the length of time that the rules apply in case the amount has to be repaid at a later date.
20 Modern Advanced Accounting in Canada, Seventh Edition
Bank Loan
We must determine how to record the payment to the bank that is based on the play‟s success.
The 5% that is payable as well as an accrual based on expected future profits could be
expensed. Alternatively, just the 5% amount could be expensed because the remaining
balance that would have to be paid is uncertain and difficult to determine.
Salaries and miscellaneous costs
Given that these costs are incurred in the start-up of the operations, the amounts can be
expensed in either the current year or future years. Arguments can be made for either
treatment. There is no certainty of the play succeeding and so, to be conservative, the amount
should be expensed in the current period. On the other hand, the amounts do relate to
production in future years, and in order to match expenses with revenues, the amounts should
be expensed in future periods.
Costumes and sets
The costumes and sets can be expensed either in Year 1 or in future periods. Prudence would
dictate that the amount should be expensed immediately because there is no certainty the play
will succeed. However, the costumes and sets do relate to production in future years.
Capitalizing the amount and recording depreciation in future years will provide a better matching
of revenues and expenses.
Insurance
The insurance premiums that are currently being paid can be either capitalized or expensed.
The term insurance has no future value or any impact on revenues, and it should be expensed
in the period incurred. An argument for capitalizing the costs is that the cost was incurred to
secure financing which will benefit future production. Given the investors‟ objective of
maximizing their initial losses, and maximizing future years‟ income, the amount should be
expensed in the current period.
Promoter’s fees
We must determine what amount, if any, should be accrued for the promoter‟s fees. At present,
Solutions Manual, Chapter 2 21
the payment is too uncertain; thus, the amount should be accounted for in the year that an
amount becomes payable.
(b)
(i) investor in Limited Partnership units
The limited partnership units represent an equity interest in the business. In order to determine
the appropriate accounting for the units, it is necessary to determine how the investment would
be classified. The potential classifications are FVTPL, FVTOCI , significant influence, joint
control, or control. In order to further determine the appropriate classification, it is necessary to
determine the extent to which control or significant influence might exist over the strategic
operating and financing policies of the partnership.
In a limited partnership, the general partner usually makes the key operating and financing
decision; the other investors usually have has very little say in the operating and financing
policies of the entity. As such, the limited partners would not likely have control, joint control or
significant influence. Since the units are not actively traded, determining the fair value will be
difficult. The investor may prefer to report the investment as fair-value-through OCI so that profit
is not affected by the subjective assessment of the fair value.
(ii) investor in royalties
The investments in royalties give the investors the right to participate in the operating profits of
the plays. They would not enable the investor to have any influence or control over the
operating and investing policies of the partnership and generally do not have any characteristics
of equity. On this basis, they would NOT be classified as held for trading, available for sale or
significant influence, control, or joint control investments. The investment has the
characteristics of an intangible asset. It is a right that enables participation in future profits.
Further, the plays likely have a definite timeline over which they will be offered. Assuming that
the amount paid for these royalties can reasonably recovered, they would be capitalized as
finite life intangible assets and amortized over the life of the play. They would also be analyzed
for impairment on an annual basis.
(iii) investor in movie rights
The investments in movie rights give the investors the right to receive profits from the creation of
motion pictures from the content of the plays. They would not enable the investor to have any
22 Modern Advanced Accounting in Canada, Seventh Edition
influence or control over the operating and investing policies of the partnership and generally do
not have any characteristics of equity. On this basis, they would NOT be classified as held for
trading, available for sale or significant influence, control, or joint control investments. The
investment has the characteristics of an intangible asset. It is a right that enables the holder to
earn profit from the content of the plays at a future date. Further, the timeline over which the
profits will be earned is not known since the movie must be produced and released before profit
can be earned. On this basis the movie rights would generally be accounted for as an indefinite
life intangible. It is important also to consider that the investment must be analyzed for
impairment on an annual basis. This would be complicated by the difficulty in determining the
extent and likelihood of potential future profits from the rights.
