FINANCIAL ACCOUNTING: CONSOLIDATION & ADVANCED ISSUES [FA4] PRACTICE EXAMINATION #1 (Updated to the 2012/13 Module Notes)

FA4 Before starting to write the examination, make sure that it is complete and that there are no printing defects. This examination consists of 11 pages. There are 7 questions for a total of 100 marks.

READ THE QUESTIONS CAREFULLY AND ANSWER WHAT IS ASKED.

To assist you in answering the examination questions, CGA-Canada includes the following glossary of terms. Glossary of Assessment Terms Adapted from David Palmer, Study Guide: Developing Effective Study Methods (Vancouver: CGA-Canada, 1996). Copyright David Palmer. Calculate

Compare

Contrast

Criticize

Define

Describe Design

Determine

Diagram

Discuss

Evaluate

Mathematically determine the amount or number, showing formulas used and steps taken. (Also Compute). Examine qualities or characteristics that resemble each other. Emphasize similarities, although differences may be mentioned. Compare by observing differences. Stress the dissimilarities of qualities or characteristics. (Also Distinguish between) Express your own judgment concerning the topic or viewpoint in question. Discuss both pros and cons. Clearly state the meaning of the word or term. Relate the meaning specifically to the way it is used in the subject area under discussion. Perhaps also show how the item defined differs from items in other classes. Provide detail on the relevant characteristics, qualities, or events. Create an outcome (e.g., a plan or program) that incorporates the relevant issues and information. Calculate or formulate a response that considers the relevant qualitative and quantitative factors. Give a drawing, chart, plan or graphic answer. Usually you should label a diagram. In some cases, add a brief explanation or description. (Also Draw) This calls for the most complete and detailed answer. Examine and analyze carefully and present both pros and cons. To discuss briefly requires you to state in a few sentences the critical factors. This requires making an informed judgment. Your judgment must be shown to be based on knowledge and information about the subject. (Just stating your own ideas is not sufficient.) Cite authorities. Cite advantages and limitations.

Explain

In explanatory answers you must clarify the cause(s), or reasons(s). State the “how” and “why” of the subject. Give reasons for differences of opinions or of results. Identify Distinguish and specify the important issues, factors, or items, usually based on an evaluation or analysis of a scenario. Illustrate Make clear by giving an example, e.g., a figure, diagram or concrete example. Interpret Translate, give examples of, solve, or comment on a subject, usually making a judgment on it. Justify Prove or give reasons for decisions or conclusions. List Present an itemized series or tabulation. Be concise. Point form is often acceptable. Outline This is an organized description. Give a general overview, stating main and supporting ideas. Use headings and sub-headings, usually in point form. Omit minor details. Prove Establish that something is true by citing evidence or giving clear logical reasons. Recommend Propose an appropriate solution or course of action based on an evaluation or analysis of a scenario. Relate Show how things are connected with each other or how one causes another, correlates with another, or is like another. Review Examine a subject critically, analyzing and commenting on the important statements to be made about it. State Clearly provide a position based on an evaluation, e.g., Agree/Disagree, Correct/Incorrect, Yes/No. (Also Indicate) Summarize Give the main points or facts in condensed form, like the summary of a chapter, omitting details and illustrations. Trace In narrative form, describe progress, development, or historical events from some point of origin

CGA-CANADA FINANCIAL ACCOUNTING: CONSOLIDATIONS AND ADVANCED ISSUES [FA4] PRACTICE EXAMINATION #1 (Updated to the 2012/2013 Module Notes) Marks

Time: 4 Hours

Notes: 1. 2. 3. 4. 5. 6. 7.

30

All calculations must be shown in an orderly manner to obtain part marks. Round all calculations to the nearest dollar. Narratives for journal entries are not required unless specifically requested. Assume a December 31 fiscal year end unless specifically stated otherwise. Assume all amounts are material unless directed otherwise. Assume all companies are public companies unless otherwise noted. Assume no companies use differential reporting unless otherwise noted.

Question 1 Select the best answer for each of the following unrelated items. Answer each of these items in your examination booklet by giving the number of your choice. For example, if the best answer for item (a) is (1), write (a)(1) in your examination booklet. If more than one answer is given for an item, that item will not be marked. Incorrect answers will be marked as zero. Marks will not be awarded for explanations. Note: 2 marks each

a.

PLT owns 60% of the ordinary shares of SOC and 80% of the cumulative preferred shares of SOC. SOC reported income of $1,000,000 and paid dividends of $800,000, of which $200,000 went to the ordinary shareholders and $600,000 went to the preferred shareholders. The dividend to the preferred shareholders included $150,000 for the current year and $450,000 for 3 years in arrears. How much income should PLT recognize for its investment in preferred shares of SOC under the equity method? 1) 2) 3) 4)

$120,000 $150,000 $360,000 $480,000

b. PEL owns 60% of the voting shares of SAK, a public company, and 15% of the voting shares of TUN, a private company. SAK owns 70% of the voting shares of TUN. Which of the following represents the appropriate accounting treatment for PEL’s investments in SAK and TUN? Investment in:

1) 2) 3) 4)

SAK

TUN

Equity Consolidation Consolidation Consolidation

Cost Cost Equity Consolidation

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c.

BEL Ltd. was incorporated on January 1, 20X8, and earned income before taxes of $200,000 for the year ended December 31, 20X8. BEL used the straight-line method for accounting purposes and recorded depreciation expense of $30,000. For tax purposes, BEL claimed the maximum capital cost allowance of $50,000. During the year, the federal government announced that tax rates would be reduced from the current rate of 44% to 42%, effective January 1, 20X9.

What is current income tax payable at December 31, 20X8? Assume that no income tax was paid during the year. 1) 2) 3) 4)

$75,600 $79,200 $92,400 $96,800

d. BEL Ltd. was incorporated on January 1, 20X8, and earned income before taxes of $200,000 for the year ended December 31, 20X8. BEL used the straight-line method for accounting purposes and recorded depreciation expense of $30,000. For tax purposes, BEL claimed the maximum capital cost allowance of $50,000. During the year, the federal government announced that tax rates would be reduced from the current rate of 44% to 42%, effective January 1, 20X9. What is the deferred income tax asset or liability at December 31, 20X8? 1) 2) 3) 4) e.

$8,400 deferred income tax asset $8,400 deferred income tax liability $8,800 deferred income tax asset $8,800 deferred income tax liability

PENN College, a not-for-profit organization, received $100,000 cash from an alumnus. The donor specified that the money be used to buy some land on which the organization plans to build a new campus. How should the $100,000 contribution be reported, assuming that PENN College uses the deferral method of accounting for contributions? 1) 2) 3) 4)

As revenue of the operating fund As deferred revenue of the operating fund As a credit to net assets of the operating fund As a credit to the land account in the operating fund

f. Which of the following statements best describes the Accounting Standards Board’s requirements for financial reporting? 1) 2) 3) 4)

Private enterprises must report their financial results in accordance with Part II of the CICA Handbook — Accounting, Accounting Standards for Private Enterprises. Private enterprises must report their financial results in accordance with Part I of the CICA Handbook — International Financial Reporting Standards. Public companies must report their financial results in accordance with Part I of the CICA Handbook — International Financial Reporting Standards. Local governments must report their financial results in accordance with Part III of the CICA Handbook — Accounting Standards for Not-for-Profit Organizations.

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g. On October 1, 20X9, GER issued a purchase order to purchase a piece of equipment from a foreign company for 100,000 foreign currency units (FC). The equipment will be delivered on November 1, 20X9, and payment in full is required on December 31, 20X9. On October 2, 20X9, GER entered into a forward exchange contract to purchase FC100,000 on December 31, 20X9, at a rate of FC1 = C$2.10. The exchange rates were as follows during this period of time:

October 1 and 2 November 1 December 31

Spot Rate

Forward Rate

FC1 = C$2.05 FC1 = C$2.15 FC1 = C$2.20

FC1 = C$2.10 FC1 = C$2.18 FC1 = C$2.20

Assume that the forward contract was designated as a cash-flow hedge and any exchange adjustments pertaining to the hedge were cleared out of other comprehensive income when the equipment was delivered. At what amount should the equipment be reported at December 31, 20X9? Ignore accumulated depreciation. 1) 2) 3) 4)

$207,000 $210,000 $215,000 $220,000

h. On October 1, 20X9, GER issued a purchase order to purchase a piece of equipment from a foreign company for 100,000 foreign currency units (FC). The equipment will be delivered on November 1, 20X9, and payment in full is required on December 31, 20X9. On October 2, 20X9, GER entered into a forward exchange contract to purchase FC100,000 on December 31, 20X9, at a rate of FC1 = C$2.10. The exchange rates were as follows during this period of time:

October 1 and 2 November 1 December 31

Spot Rate

Forward Rate

FC1 = C$2.05 FC1 = C$2.15 FC1 = C$2.20

FC1 = C$2.10 FC1 = C$2.18 FC1 = C$2.20

Assume that the contract was not designated as a hedge. What is the exchange gain or loss on the forward contract for 20X9? 1) 2) 3) 4) i.

$ 2,000 loss $ 2,000 gain $ 10,000 loss $ 10,000 gain

How are deferred tax (DIT) assets and deferred tax liabilities classified on the balance sheet? 1) Current and long-term DIT assets and DIT liabilities are each reported separately on the balance sheet with the classification being determined by the expected reversal date. 2) DIT assets and DIT liabilities are classified as non-current. Assets and liabilities are not netted. 3) DIT assets and DIT liabilities are classified according to the balance sheet item that caused the temporary difference. Current assets and liabilities and long-term assets and liabilities are netted. 4) DIT assets and DIT liabilities are classified as non-current. Assets and liabilities are netted.

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j.

Which of the following treatments is not in accordance with GAAP for a not-for-profit organization (NFPO) that has been operating for 2 years? 1) An NFPO with revenue of $440,000 in the current year and $520,000 in the preceding year reported the purchase of capital assets as an expense in the current year. 2) An NFPO with revenue in excess of $1 million reported the donation of a collection of artwork at fair value but does not intend to amortize the artwork. 3) An NFPO reported the donation of prizes for a raffle at fair value. 4) An NFPO received a collection of historical treasures but did not report the contribution because a fair value of the treasures could not be reasonably estimated.

k. On September 30, 20X8, TAC acquired shares in a foreign company at a cost of FC100,000 and classified the investment as held for trading. At December 31, 20X8, the shares had a market value of FC80,000. Management of TAC believes that the market price of the shares will recover in 20X9. The exchange rate was FC1 = C$1.20 on September 30, 20X8 and FC1 = C$1.15 on December 31, 20X8. At what amount should the investment be reported on TAC’s balance sheet at December 31, 20X8? 1) 2) 3) 4) l.

$ 92,000 $ 96,000 $115,000 $120,000

JAN has a wholly owned subsidiary in China. This subsidiary is dependent on JAN for financing and sales. How should foreign exchange gains on translation of the acquisition differential related to equipment be reported on JAN’s consolidated financial statements? 1) 2) 3) 4)

Gains should be reported in other comprehensive income. Gains should be reported as an adjustment to the equipment account. Gains should be deferred and amortized into income over the remaining life of the equipment. Gains should be reported in net income.

m. Which of the following statements best describes why the Certified General Accountants Association has deemed it essential to create a Code of Ethical Principles and Rules of Conduct (CEPROC) and to establish a mechanism for enforcing observance of CEPROC? 1) In return for the legal right to control entrance into the profession, the association must ensure that its members act in the interest of society and its members. 2) A prerequisite to success is the establishment of an ethical code that stresses primarily the professional’s responsibility to clients and colleagues. 3) A requirement of most provincial laws calls for the profession to establish a code of ethics. 4) An essential means of self-protection for the profession is the establishment of flexible ethical standards. n. When will consolidated statements include the investee’s identifiable assets at 100% of their fair value? 1) Immediately after the investor purchases enough shares to obtain significant influence over the investee 2) Immediately after the investor increases its ownership from having significant influence to obtaining control over the investee 3) Immediately after the parent increases its percentage ownership from 80% to 100% 4) Immediately after the investor decreases its ownership from having control to having significant influence over the investee

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o. On January 1, 20X6, HML purchased 60% of TAP for $1,000,000. HML uses the cost method to account for its investment in TAP on its separate entity financial statements. HML reported the following net income and retained earnings on its financial statements for 20X9:

Net income Retained earnings

Separate Entity

Consolidated

$100,000 $980,000

$130,000 $890,000

If HML had been using the equity method on its separate entity financial statements, would the investment in TAP and net income be higher or lower than what is presently reported on HML’s separate entity financial statements? Investment Account 1) 2) 3) 4)

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Lower Lower Higher Higher

Net Income Lower Higher Lower Higher

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25

Question 2 On December 31, 20X5, PAD purchased 90% of the ordinary shares of SBC for $5,049,000. On that date, SBC had ordinary shares of $1,250,000 and retained earnings of $3,000,000, and fair values were equal to carrying values for all its net assets except inventory (fair value was $60,000 greater than book value) and capital assets (book value was $100,000 greater than fair value). The financial statements for PAD and SBC for the year ended December 31, 20X8, were as follows: Balance Sheets December 31, 20X8 PAD

SBC

Cash Accounts receivable Inventory Capital assets — net Investment in SBC Total assets

$

680,000 1,555,000 2,800,000 3,676,000 5,049,000 $ 13,760,000

$ 435,000 1,025,000 1,790,000 3,000,000 — $ 6,250,000

Current liabilities Notes payable Ordinary shares Retained earnings Total

$

$ 255,000 1,185,000 1,250,000 3,560,000 $ 6,250,000

400,000 5,800,000 2,000,000 5,560,000 $ 13,760,000

Statements of Income and Retained Earnings year ended December 31, 20X8

Sales Cost of sales Gross profit Other income Depreciation Income tax and other expenses Net income Retained earnings, beginning Dividends paid Retained earnings, end

PAD

SBC

$ 3,800,000 1,600,000 2,200,000 240,000 (480,000) (500,000) 1,460,000 4,200,000 (100,000) $ 5,560,000

$ 2,710,000 1,140,000 1,570,000 0 (310,000) (210,000) 1,050,000 2,580,000 (70,000) $ 3,560,000

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Additional information 1. Capital assets are to be depreciated over an average remaining useful life of 10 years as at December 31, 20X5. Each year, the cash-generating unit is evaluated to determine if there has been an impairment in value. Goodwill was found to be impaired by $200,000 in 20X7 and $50,000 in 20X8. 2. On July 2, 20X7, PAD sold a machine to SBC for $215,000. PAD had paid $250,000 for this machine on July 2, 20X2, and had been depreciating the machine on a straight-line basis over 10 years. There was no change in the estimated useful life of this machine or in the residual value of $20,000. Both companies calculate depreciation on a monthly basis. 3. During December 20X8, PAD purchased merchandise from SBC for $500,000. Of this merchandise, 30% was resold by PAD and the other 70% remains in its December 31, 20X8, inventory. On December 31, 20X7, the inventories of PAD contained $100,000 of merchandise purchased from SBC. SBC earns a gross margin of 25% on its sales to PAD. 4. PAD accounts for its investment in SBC using the cost method and also uses the cost method when reporting its investment in SBC for its separate entity financial statements. 5. Both companies pay income taxes at the rate of 40%. Ignore deferred income taxes when allocating and amortizing the acquisition differential. 6. Consolidated retained earnings at the end of 20X7 were $3,549,300. 7. For 20X6 and 20X7, the return on average shareholders’ equity (ROE) attributable to PAD’s shareholders was in excess of 25%. Accordingly, PAD’s shareholders have set a target ROE of at least 25% for 20X8. 8. ROE for PAD’s shareholders is calculated as follows:  

Net income attributable to PAD’s shareholders Average shareholders’ equity attributable to PAD’s shareholders

Required 5

12 4

a.

Prepare an acquisition differential allocation schedule and an acquisition differential amortization/impairment schedule from the date of acquisition to December 31, 20X8.

b. Prepare a consolidated income statement for the year ended December 31, 20X8. c.

Calculate ROE for 20X8 for PAD’s shareholders based on PAD’s i) Separate entity financial statements ii) Consolidated financial statements

4

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d. Indicate whether the target ROE of 25% has been met. Briefly explain the possible causes of the difference in returns in part (c) and give your opinion as to which return is the most relevant to PAD’s shareholders.

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14

Question 3 On December 31, 20X5, PLT Inc. acquired 90% of the voting shares of SPE Limited for 690,000 foreign currency units (FC). On the acquisition date, the fair values of all of the identifiable assets and liabilities for SPE equalled their carrying values. Selected account balances from SPE’s general ledger on December 31, 20X5, were as follows: Equipment Building Accumulated depreciation Ordinary shares Retained earnings

FC

250,000 1,350,000 195,000 600,000 96,000

SPE purchased the building and equipment on January 1, 20X4. The condensed trial balance of SPE for the year ended December 31, 20X8, was as follows: Accounts receivable Inventory Building Equipment Cost of goods sold Depreciation expense Other expenses Dividends paid Total debits

FC

197,000 255,000 1,350,000 350,000 1,200,000 130,000 470,000 300,000 FC 4,252,000

Liabilities Ordinary shares Retained earnings, beginning Sales Accumulated depreciation Total credits

FC

682,000 600,000 300,000 2,250,000 420,000 FC 4,252,000

Additional information 1. Sales, inventory purchases, and other expenses occurred uniformly over the year. 2. The inventory on hand at the end of each year was purchased uniformly over the last quarter of the year. On December 31, 20X7, the inventories totalled FC375,000 and on December 31, 20X8, they totalled FC255,000. 3. On January 1, 20X8, equipment was purchased by SPE for FC100,000. It has an estimated useful life of 8 years and a salvage value of FC5,000. SPE uses the double-declining-balance method to calculate depreciation expense. There were no other purchases of capital assets between 20X4 and 20X8. 4. The dividends were declared and paid on January 1, 20X8. 5. The exchange rates were as follows: January 1, 20X4 December 31, 20X5 December 31, 20X7 Average, 4th quarter 20X7 December 31, 20X8 Average for 20X8 Average, 4th quarter 20X8

C$1 = FC0.50 C$1 = FC0.60 C$1 = FC0.70 C$1 = FC0.68 C$1 = FC0.80 C$1 = FC0.76 C$1 = FC0.79 Continued...

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Required

14

4

a.

Determine the Canadian dollar amounts for all assets and liabilities as at December 31, 20X8, assuming that SPE is a self-sustaining foreign operation.

6

b. Determine the Canadian dollar amounts for total assets and total liabilities on SPE’s financial statements at December 31, 20X8, assuming that SPE is accounted for using the foreign currency transactions approach.

4

c.

Using the translated amounts from parts (a) and (b), calculate the debt-to-asset ratio for SPE at December 31, 20X8, under the two different classifications for the foreign subsidiary. Assume that you are a creditor of SPE. Based on the debt-to-asset ratio, briefly explain whether you would be more favourably inclined to do business with SPE if it was classified as a self-sustaining foreign operation or accounted for using the foreign currency transactions approach.

Question 4 Lanark Housing Corporation (LHC) is a not-for-profit housing organization that was incorporated on January 1, 20X9. Its purpose is to provide residential accommodation for physically disabled adults in the town of Lanark. The nature of LHC’s operations is described in Exhibit 4-1. Its sources of funding are described in Exhibit 4-2. The executive director of LHC has asked for your assistance in establishing accounting policies for LHC for its general-purpose year-end financial statements. The accounting policies should be consistent with generally accepted accounting principles. Required Identify 10 accounting issues and provide recommendations on the treatment of these issues in LHC’s financial statements for the year ended August 31, 20X9. Assume that:   

LHC would want to set up two funds for reporting purposes, a general fund and a capital fund. Average annual revenues exceed $700,000. The restricted fund method is used to account for restricted contributions.

EXHIBIT 4-1 Nature of Operations In March 20X9, LHC purchased a 15-unit apartment building in downtown Lanark for $750,000. It then spent $250,000 in renovations to upgrade the building to make it accessible for its residents. LHC offers 24-hour non-medical attendant care. Support care services are provided through a combination of staff members and volunteers. The staff members receive a monthly salary. As an inducement to recruit and retain qualified support care workers, each staff member is allowed 15 sick days per year. The employee can bank the sick days not used in any one year. Upon termination or retirement, the employee is paid for banked sick days at the wage rate in effect at that time. Rental payments are due the first day of each month and are based on each tenant’s income. Most of the tenants are very good about making their rental payments on time. Some rental payments are received late. On August 31, 20X2, there was $13,000 of unpaid rent. LHC plans to install central air conditioning in the building in April 20X10 at an expected cost of $50,000. This expenditure is being financed by a special fundraising event. By December 31, 20X9, this event raised $20,000 in cash and $15,000 in pledges from citizens in the local community. Continued... PEFA4#1

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EXHIBIT 4-2 Sources of Funding The cost of acquiring and renovating the apartment building was financed by a $1,000,000 cash donation received from a donor’s estate. The provincial government funds approximately 70% of non-medical care and support costs. Claims are made monthly for the previous month’s eligible costs. LHC depends on outside fundraising efforts, primarily door-to-door canvassing and sponsored bingos, to cover the remaining non-medical care and support costs.

6

Question 5 On January 1, 20X9, MAR Limited acquired bonds of DEC Corporation for $536,798 and classified the bonds as available for sale. The bonds have a face value of $500,000, pay interest annually at a coupon rate of 7%, and mature on December 31, 20X18. The market rate of interest for similar bonds was 6% on January 1, 20X9, and 5% on December 31, 20X9. Required 2

a.

Prepare the calculation to prove that the market value of the bonds at December 31, 20X9, is approximately $571,079.

4

b. Indicate the account names and account balances to be reported on the balance sheet at the end of 20X9, and in net income and other comprehensive income for 20X9 under two scenarios: i) MAR designates the bonds as a held-for-trading (HFT) investment ii) MAR designates the bonds as an available-for-sale (AFS) investment

6

Question 6 On November 1, 20X9, MAL signs a contract with HOP to purchase 100,000 barrels of oil at $50 per barrel for delivery on January 31, 20X10. Payment is due on delivery. At December 31, 20X9, oil with a delivery date of January 31, 20X10, is trading on the futures market at $52 per barrel. Required

5

3

a.

Briefly explain why the contract signed by MAL is a derivative.

1

b. Calculate the gain or loss to be recognized in income by MAL for 20X9 if this contract must be valued at fair value under IAS 39, Financial Instruments — Recognition and Measurement.

2

c.

Briefly explain under what circumstances MAL would not have to value this contract at fair value.

Question 7 Public Practice — Association with Tax Returns You are the tax partner on the audit of Marshall Corp., a Canadian public company. Marshall Corp. has been an audit client of your firm for a number of years and you have enjoyed good relations with Marshall. Joan McCutcheon, CEO, has generally enjoyed very cordial relations both with the audit partner in charge of her audit and with you as the tax partner managing the tax affairs of Marshall Corp. Continued...

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As part of your service for Marshall Corp. over the last 15 years, you have prepared Joan McCutcheon’s personal tax return. In the course of preparing the tax return this year, you are reviewing her calculations of capital gains on certain stocks that she sold during the year. You come to the conclusion that she has incorrectly calculated the cost basis for several of the stocks that have been sold. You notice that she has used specific identification in calculating the gain. You point out to her that the Income Tax Act requires that she use average cost for securities acquired over a series of transactions rather than the specific identification method she has used. You raise the issue with Joan and she indicates that she wants to prepare the tax return using the information she has provided to you. She will not accept your opinion that the cost basis that she has used is incorrect. What are the issues facing you in this particular situation? How would you determine what to do? Source: Morley Lemon, “Public Practice — Association with Tax Returns,” Centre for Accounting Ethics, University of Waterloo, http://accounting.uwaterloo.ca/ethics/pubpractice/association.htm, Accessed March 4, 2011. Required Outline your professional obligations, assuming that you are a CGA, and recommend how you should respond to Joan’s request. You answer should be between 600 and 1,000 words.

END OF EXAMINATION 100

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CGA-CANADA FINANCIAL ACCOUNTING: CONSOLIDATIONS & ADVANCED ISSUES [FA4] SUGGESTED SOLUTIONS #1 (Updated to the 2012/13 Module Notes) Marks 30

Time: 4 Hours Question 1 Note: 2 marks each

Sources/calculations: a.

1) Topic 6.5 (Level 2) $150,000 × 80% = $120,000

b. 4) Topic 3.1 (Level 1); Topic 6.6 (Level 2) c.

2) Topic 6.9 (Level 2) ($200,000 + $30,000 – $50,000) × 44% = $79,200

d. 2) Topic 6.9 (Level 2) ($50,000 – $30,000) × 42% = $8,400 e.

3) Topic 9.3 (Level 1)

f.

3) Topic 1.1 (Level 1)

g. 1) Topic 7.5 (Level 1) FC100,000 × $2.15 – FC100,000 × ($2.18 – $2.10) = $207,000 h. 4) Topic 7.1 (Level 1) FC100,000 × ($2.20 – $2.10) = $10,000 i.

4) Topic 6.9 (Level 2)

j.

3) Topic 9.2 (Level 1)

k. 1) Topic 7.1 (Level 1) FC80,000 × $1.15 = $92,000 l.

4) Topic 8.2 (Level 1)

m. 1) Topic10.5 (Level 1) n. 2) Topic 6.1 (Level 2) o. 2) Topic 3.2 (Level 1)

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Question 2 Source: Topics 4.2, 4.4, 5.1, 5.4, 5.5, and 5.7 (Level 1) 5

a.

Calculation of acquisition differential Cost of 90% of SBC Implied value of 100% of SBC Book value of SBC: Ordinary shares Retained earnings

(1)

$ 5,049,000 $ 5,610,00 $ 1,250,000 3,000,000

(1)

4,250,000 1,360,000

Acquisition differential Allocated as follows: Inventory Capital assets — net Goodwill

$

60,000 (100,000)

(40,000) $ 1,400,00

Acquisition differential amortization/impairment schedule Balance at Amortization/ Amortization/ Acquisition Impairment Impairment Balance at December 31, 20X5 20X6-20X7 20X8 December 31, 20X8

(1) (1) (1)

12

(1) (3) (1) (2) (1) (2)

(2)

Inventory Capital assets — net (10 yrs) Goodwill Total b.

$

60,000 (100,000) 1,400,000 $ 1,360,000

$ 60,000 (20,000) 200,000 $ 240,000

$ $ (10,000) 50,000 $ 40,000

0 (70,000) 1,150,000 $ 1,080,000

(a) (b)

PAD Consolidated Income Statement year ended December 31, 20X8 Sales [3,800,000 + 2,710,000 – (d) 500,000] Cost of sales [1,600,000 + 1,140,000 – (d) 500,000 + (e) 87,500 – (f) 25,000] Gross profit Other income [240,000 + 0 – (g) 63,000] Depreciation [480,000 + 310,000 – (a) 10,000 – (c) 16,000] Goodwill impairment (b) Income tax and other expenses [500,000 + 210,000 + (c) 6,400 – (e) 35,000 + (f) 10,000] Net income Attributable to: Equity holders of the company Non-controlling interests (h) Consolidated net income

$ 6,010,000 2,302,500 3,707,500 177,000 (764,000) (50,000) (691,400) $ 2,379,100 $ 2,281,850 97,250 $ 2,379,100

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Notes: Intercompany profits Before Tax Sale of machine — PAD selling Proceeds from sale Net book value [$250,000 – ($250,000 – $20,000) ÷ 10 × 5] Gain on sale of machine Gain on machine realized per year (over 5 years) Cumulative gain on machine realized (for 1.5 years) Intercompany sales Ending inventory — SBC selling ($500,000 × 70% × 0.25) Beginning inventory — SBC selling ($100,000 × 0.25) Intercompany dividend ($70,000 × 90%) Non-controlling interests SBC’s net income Unrealized profit in ending inventory Unrealized profit in beginning inventory Amortization of acquisition differential NIC’s share (10%) 4

c.

After Tax

$ 32,000

$ 48,000

16,000 24,000 500,000

$ 6,400 9,600

$ 9,600 14,400

87,500

35,000

52,500

(e)

25,000 63,000

10,000

15,000

(f) (g)

$ 215,000 135,000 80,000

$ $

(c) (d)

$ 1,050,000 (52,500) 15,000 (40,000) $ 972,500 $ 97,250

(h)

Separate Entity

Consolidated

Net income attributable to PAD’s shareholders

$ 1,460,000

$ 2,281,850

Shareholders’ equity, beginning of year Shareholders’ equity, end of year Average shareholders’ equity

$ 6,200,000 7,560,000 6,880,000

$ 5,549,300 7,731,150 1 6,640,225

ROE 1

4

Tax

21.2%

34.4%

2,000,000 + 3,549,300 + 2,281,850 – 100,000 = 7,731,150

d. The target rate of return of 25% has been met according to consolidated financial statements but not according to the separate entity financial statements. The main reason for the difference in returns is due to the difference between income earned by SBC compared to dividends paid by SBC for 20X8. In the separate entity financial statements, the cost method was used to account for the investment in SBC. Accordingly, dividend income of $63,000 (90% × $70,000) was included in PAD’s income. The consolidated income statement incorporates SBC’s net income on a line-by-line basis and makes other adjustments for amortization of the acquisition differential and unrealized profits. Since SBC’s net income was $1,050,000, consolidated net income will be much greater than income under the cost method. The net income on the consolidated income statement is a more relevant measure to PAD’s shareholders because it better reflects the performance of the companies controlled by PAD; net income is a better measure of SBC’s performance than dividends income.

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14

Question 3 Source: Topics 7.2, 8.2, and 8.3 (Level 1) 4

a.

(2) (2)

6 (1/2) (1/2) (1/2) (1/2) (1) (1) (1) (1)

Total assets Total liabilities

b. Accounts receivable Inventory Equipment Building Accumulated depreciation (100,000 ÷ 8 × 2) (420,000 – 25,000) Total assets Liabilities 1

4

FC

Rate

$

1,732,000 682,000

0.80 0.80

2,165,000 852,500

FC

Rate

197,000 255,000 250,000 100,000 1,350,000

0.80 0.79 0.60 0.70 0.60

(25,000) (395,000) 1,732,000

0.70 0.60

682,000

0.80

$1

$

246,250 322,785 416,667 142,857

(35,714) (658,333)

559,524 2,250,000

(694,047) 2,684,512 852,500

The Canadian dollar amount is determined by taking the amount in FC and dividing by the exchange rate.

c.

Foreign Currency Transactions Approach

Total debt Total assets Debt-to-asset ratio

$ 852,500 $ 2,684,512 0.32:1

Self-sustaining Foreign Operation

$ 852,500 $ 2,165,000 0.39:1

As a creditor, I would normally prefer to do business with a company with a low debt-to-asset ratio because the risk of default on its debt would appear to be lower. Since the debt-to-asset ratio is lower when SPE is classified based on the foreign currency transaction approach, I would react more favourably if I received financial information with SPE classified based on the foreign currency transaction approach. However, if I knew that the financial results would change significantly depending on the classification of the subsidiary, I would want to receive the information that most fairly presents the true financial position of the company. Neither of these methods presents the fair value of all assets and liabilities at December 31, 20X8.

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14

Question 4 Source: Topics 9.2, 9.3, 9.4, and 10.4 (Level 1) LHC should adopt the following recommendations for the related accounting issues for its year-end financial statements:       

 

  

The accrual basis of accounting should be used to properly match revenues to expenses. The cost of acquiring and renovating the apartment building should be capitalized as an asset in the capital fund. The building should be amortized over its useful life. Depreciation expense should be reported as an expense of the capital fund. The $1,000,000 cash donation from the donor’s estate should be recorded as revenue of the capital fund. The salary costs should be expensed as incurred in the operating fund. The estimated costs of unpaid sick leave should be set up as a liability and as an expense of the operating fund on an annual basis. The value of the volunteers’ time provided for support care services should be set up as revenue and an expense of the operating fund if the amount is measurable and such services would be purchased had they not been provided by the volunteers. The contributions from the provincial government should be accrued as a receivable and revenue of the operating fund at the end of each month based on actual costs incurred during the month. The rent from the tenants should be recognized as revenue of the operating fund in the month in which it is due. At the end of the year, an allowance for doubtful accounts should be set up for any doubtful accounts. Donations from door-to-door canvassing and proceeds received from bingos should be recognized as revenue of the operating fund as the cash is received. The cash received for the planned expenditure on air conditioning equipment should be recorded as revenue of the capital fund. The pledges received for the planned expenditure on air conditioning equipment should be recorded as pledges receivable and revenue of the capital fund to the extent that the amount to be received can be reasonably estimated and the ultimate collection is reasonably assured.

Note: 11/2 marks for each recommendation to a maximum of 14 marks.

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6

Question 5 Source: Topics 1.3, 1.5, and 1.7 (Level 1) 2

a.

4

b.

Present value of principal ($500,000, 5%, 9 years) Present value of annual interest ($35,000, 5%, 9 years) Market value of bonds on December 31, 20X8 (i) HFT Balance sheet Investment in DEC bonds Net income Interest income Unrealized gain Other comprehensive income Unrealized gain

(1) (1) (1) (1)

$ 322,305 248,774 $ 571,079 (ii) AFS

$ 571,079

$ 571,079

$ 32,208 1 37,073 2

$ 32,208 37,073 2

Notes:

6

1

$536,798 × 6% = $32,208

2

$571,079 – [$536,798 – ($35,000 – $32,208)] = $37,073

Question 6 Source: Topics 2.1 and 2.3 (Level 1) 3

a.

The contract is a derivative because:   

5

Its value changes in response to changes in the price of oil It will be settled at a future date: January 31, 20X10 It requires nominal or no initial investment

1

b. Gain of 100,000 barrels ($52 – $50) = $200,000

2

c.

MAL would not have to value the contract at fair value if MAL entered into a contract with the intention of actually purchasing and taking delivery of the oil. It is not speculating in the price of oil and has no intention of selling the contract for a profit. It intends to take delivery of the oil because the oil is needed for its own operations.

Question 7 As a CGA, you must abide by CGA Canada’s Code of Ethical Principles and Rules of Conduct (CEPROC). Statutes that need to be considered in this scenario include the following: 

Responsibilities to Society



Trust and Duties



Due Care and Professional Judgment



Deceptive Information



Responsibilities to the Profession Continued...

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Specific comments about how each statute relates to this situation follow. Responsibilities to Society As a CGA, you have a fundamental responsibility to safeguard and advance the interests of society. Facilitating tax evasion clearly breaches this obligation. It appears that Joan McCutcheon is trying to improperly defer the payment of income taxes by using the specific identification method to determine the adjusted cost base of securities sold. You have already advised Joan that the average cost method must be used; however, it appears that she has decided to ignore your expert advice. Joan may be more amenable to preparing her return in accordance with the Income Tax Act if you are able to quantify the additional amount of tax that she would be liable for and point out that the prohibited specific identification method only serves to defer1 this amount, rather than avoiding it completely. If Joan insists on following through with her current plan, you must consider and abide by R101, Discredit, and R102, Unlawful Activity, of CEPROC. Specifically, you cannot knowingly act in a manner that would discredit the profession and cannot participate in activities believed to be unlawful. Trust and Duties You must also consider the requirement to act in the interest of interested third parties, which in this case are the Canada Revenue Agency and the citizens of Canada. Both interested parties have a legitimate expectation that all taxpayers will pay their fair (legal) share of taxes as determined by the Income Tax Act. R201.2b, Discretionary Disclosure, exempts you from the duty of confidentiality and permits you to disclose information of suspected criminal activity, providing that you are acting in accordance with advice received from your provincial law society. Due Care and Professional Judgment You are also governed by R303, Adherence to Acknowledged Principles and Standards, which requires you to adhere to the requirements of any governing act or regulation, including the Income Tax Act. The Income Tax Act requires that taxable income be determined in accordance with the governing statute — which it appears Joan is trying to circumvent. Deceptive Information R402, Association with Financial Information, prohibits members from being associated with any tax filing that they know or should know is false or misleading. Responsibilities to the Profession You must also carry on work in a manner which will enhance the image of the profession and the association. Accordingly, you must remain cognizant of R602, Disciplinary Action, which provides that you are subject to disciplinary action by the association if you breach professional conduct and R606, Detrimental Actions, which prohibits you from participating in any actions that are detrimental to the profession or association. Continued...

1

Assuming that Joan correctly reports the total sales proceeds and total cost over time, then total sales proceeds – total cost = total capital gain. If Joan reduces her initial gain now by using the specific identification method, then, when the remaining securities are sold, her gain will be higher than it would have been had the average cost method been properly applied throughout.

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Course of action As suggested above, it may be beneficial to outline the facts to Joan and hope that she listens to your counsel. If she does not, you must revisit the matter with Joan and advise her of your professional obligations. If Joan agrees to file a tax return that complies with the governing statutes, nothing more need be done. If she does not agree, however, you must withdraw from the engagement, seek legal advice, and act on your legal counsel’s recommendations. This will likely require you to report Joan’s suspected tax evasion to the Canada Revenue Agency. Your actions may well result in the loss of the audit engagement of Marshall Corp. While consequences like this may be regrettable, the Trust and Duties section of the Code of Ethical Principles anticipates them; it requires members to sacrifice their self-interests in favour of other interested parties. Clearly the potential loss of a long-standing audit client due to acting ethically is sacrificing your self-interest. Assume for the moment that Marshall Corp. indicates that it wishes to retain you as auditors even though Joan has ignored your counsel and refuses to use the average cost method. If this happens, you and the other partners will likely wish to meet and discuss whether you wish to retain Marshall as a client. McCutcheon is the CEO of Marshall and presumably has considerable influence over the manner in which the company conducts its affairs. McCutcheon has demonstrated her willingness to act illegally: specifically, to knowingly evade income taxes. Does your firm want to be associated with a company whose CEO cannot be trusted to act in accordance with the law? Ultimately, the firm’s decision would be a matter of considerable professional judgment that would take into account a number of factors that are not detailed in the limited facts provided in the case.

END OF SOLUTIONS 100

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