Advanced Financial Accounting in Canada, 1st edition Nathalie Johnstone Solution Manual

Type:

Solution Manual

Resource:

Advanced Financial Accounting in Canada

Edition:

1st Edition

Author(s):

Nathalie Johnstone Kristie Dewald Cheryl Wilson

Chapter 1 Introduction to Advanced Financial Accounting Review Questions 1-1. Arguments for classification as a passive investment: Delta only owns 15% of the voting shares of Epsilon. The remaining shares are held by one company, indicating that Delta may not have influence.

Arguments for classification as an associate: Typically, a shareholding of 20% or more is indicative of significant influence. However, this factor is not definitive. Other factors should also be considered to determine whether or not significant influence exists. In this case, Delta Corporation can elect one member of the board of directors, indicating that there is some influence over the policies of Epsilon. Delta also possesses a patent that Epsilon needs in its operations, which it allows Epsilon to use. This patent further indicates that there is significant influence.

Conclusion: Based on the information provided, the investment in Epsilon should be classified as an associate and Delta Corporation should use the equity method to account for its investment.

1-2. IFRS 10 outlines the three criteria that must be present for control to exist. They are the power criterion, return criterion, and the link between the two. The power criterion refers to the ability of an investor to direct the relevant activities of the investee. The return criterion refers to the risks and rewards associated with the earnings of the investee. The link between the first two criteria is the ability to use its power to affect the earnings of the investee.

1-3. Factors that should be considered in determining control include: 1. Voting rights along with convertible rights.

2. Right to choose key personnel, such as the board of directors or key management.

3. The right to veto key decision of the investee or right to force the investee to enter into a specific transaction.

4. Material transactions with the investee.

5. Exchange of management or technology.

1-4. Factors used to determine if an investor has significant influence are presented in IAS 28: 1. Voting rights of 20% to less than 50% is usually considered enough to give the investor significant influence.

2. Other factors to consider are: - representation on the board of directors, but not enough to control the board - ability to share in determining the policies of the investee .

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- material intercompany transactions - exchange of management or technical information 1-5. IFRS 10 refers to the parent as an entity that controls another company, which is referred to as the subsidiary. The parent-subsidiary relationship exists when one company controls another entity.

1-6. Strategic investments are investments that are closely linked to the strategic goal of the investor. Traditionally, these types of investments help the investor improve or meet its organizational goals. There are three classifications for strategic investments: associates, subsidiaries, and joint arrangements.

1-7. A joint arrangement is defined in IFRS 11 as an agreement between two or more investors where they share control over an operation. There are two types of joint arrangements: joint ventures and joint operations.

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Chapter 1: Introduction to Advanced Financial Accounting

Case 1-3 Heavenly Hakka Inc., Nature’s Harvest, and Premier Inc. Situation A – Heavenly Hakka Inc. Objectives of Financial Reporting Heavenly Hakka Inc. (HH) is a private company given that Vincent is its sole owner. Therefore, with Vincent’s consent, HH can choose to use Accounting Standards for Private Enterprises (ASPE) to report its investment in Szechwan Samosas Inc. (SSI).

Analysis of the Case Scenario and Appropriate Accounting Alternative(s) HH, Ibrahim, and Venkat each own 1/3 of the shares of SSI. However, HH is entitled to 40% of the profits of SS, given Vincent’s involvement. Lately, however, because of differences among Vincent and the other two owners relating to expansion of the operations of SSI beyond Ontario, Vincent has not been visiting the premises of SSI. The case is not clear on how this is going to affect the profit-sharing agreement. Further, the case is also not clear on why HH is being compensated for Vincent’s time spent on the operations of SSI via a larger share of the profits of SSI instead of via a management fee. Any management fees paid by SSI to HH for Vincent’s time would, for tax purposes, constitute an expense to SSI. Further, paying for Vincent’s time via a management fee is a more accurate reflection of the underlying economic reality.

It is not clear from the facts of the case whether the three owners have joint control over SSI. The incorporation documents and any other agreements that may exist between the three owners of SSI have to be reviewed to obtain further details on this point. Nevertheless, the facts in the case clearly indicate that HH does not possess sole control of SSI. While HH is the sole supplier of the fillings that go into the samosas of SSI, that fact by itself is not indicative of control of SSI

by HH. At most, it indicates that HH has significant influence over SSI. Further, HH does not have the power to direct the activities of SSI without the cooperation of the other two shareholders. Thus, the facts in the case suggest that HH either has joint control over or can significantly influence SSI. Recently, however, differences have arisen among Vincent and the other two shareholders of SSI. If incorporation documents or other agreements among the shareholders of SSI exist evidencing joint control, such control will not be affected by the recent differences between the shareholders. On the other hand, if such documents or agreements do not exist, the other two shareholders could, based on their combined 2/3 ownership of SSI, theoretically join together to prevent HH from having any influence over SSI. However, that seems unlikely given that HH is the sole supplier of the fillings that go into the samosas of SSI. Thus, the recent differences between the shareholders most probably will not affect any significant influence that HH has over SSI. Thus, HH should account for its investment in SSI either as a joint venture or as an investment over which it has significant influence. If HH decides not to use International Financial Reporting Standards (IFRS), then it should use the equity basis to report its investment in SSI. Alternatively, if HH opts to use ASPE, it can use the cost basis to report its investment in SSI. .

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In case of a joint venture, proportionate consolidation is also available as another reporting alternative under ASPE. Irrespective of the method chosen, SSI and HH should account for Vincent’s time devoted to SSI as a management fee.

An investor is also required by IFRS 12 to provide the following disclosures relating to its material associates and joint ventures: -

Significant judgements and assumptions made while determining that the investor has significant influence over the associate or joint control over the joint venture

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Name of, nature of relationship with, and principal place of business of, joint arrangement or associate

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Proportion of ownership interest held, and if different the proportion of voting shares held

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Whether investment in the joint venture or associate measured using fair value or equity method

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Summarized financial information including amounts in aggregate for assets, liabilities, revenues and profits, and losses

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If the joint venture associate has a different year-end than that of the investor, the fact of that difference and the reason for it

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The nature and extent of significant restrictions on the ability of the associate or joint venture to pay dividends or loans and advances

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Any unrecognized portion of the losses of the joint venture or associate under the equity method of accounting

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Contingent liabilities relating to associate or joint venture in accordance with IAS 37, Provisions, Contingent Liabilities and Contingent Assets

Situation B – Nature’s Harvest Objectives of Financial Reporting Mid-West is a publicly incorporated company in Canada. Therefore, Mid-West has to follow all the reporting requirements that publicly accountable enterprises are required to follow in Canada.

Analysis of the Case Scenario and Appropriate Accounting Alternative(s) Mid-West owns 60% of the voting shares of Nature’s Harvest (NH). Assuming that Benezuela’s laws relating to corporations are similar to those of Canada’s, such ownership would normally provide Mid-West control over NH. Thus, in normal circumstances, it would be appropriate for Mid-West to consolidate the financial statements of NH with its own financial statements while reporting its consolidated financial statements.

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However, lately, the nationalistic government of Benezuela appears to have changed its statutes relating to corporations to encourage Benezuelan management of Benezuelan companies and to prohibit repatriation of profits by Benezuelan companies to their foreign parents. Thus, the ability of Mid-West to direct the operations of NH appears to have been lost. Therefore, MidWest no longer controls NH. Consequently, Mid-West has to revalue its investment in NH at fair market value on the date on which it lost control, recognizing a gain or loss for the difference between such fair market value and the carrying value of its investment in NH in its consolidated financial statements.

Under international accounting standards, any retained interest in the investee has to be recorded initially at fair market value. However, how Mid-West reports its retained interest in NH will depend on the present nature of the investment. Mid-West still has two of its appointees as members of the board of directors of NH. Further, Mid-West continues to provide technical expertise to NH. Therefore, it appears that Mid-West has significant influence over the operations of NH. Mid-West should thus report its investment in NH using the equity basis.

Further, when an investor determines that it does not control an entity despite being the dominant shareholder of that entity, the basis for such determination, and any related significant assumptions and judgments, have to be disclosed. The investor is also required to disclose sufficient information needed for investors to assess the accounting consequences of such determination.

The disclosures required by an investor relating to its associates as discussed in situation A above relating to Heavenly Hakka’s investment in Szechwan Samosas also apply to the case of Mid-West’s investment in Nature’s Harvest.

Situation C – Premier Inc. Objectives of Financial Reporting Premier is a Canadian public limited company. Therefore, it has to report its investment in Crystal Inc. using international accounting standards (IFRS).

Analysis of the Case Scenario and Appropriate Accounting Alternative(s) Premier has a 19% shareholding in Crystal Inc. Based on quantitative factors alone, the investment of Premier in Crystal would be classified as a passive investment. However, the nature of an investment cannot be classified solely based on quantitative factors; qualitative factors should also be considered. Premier is represented on Crystal’s board of directors. There is no information to suggest that the other shareholders are inimical of Premier’s influence on Crystal. Thus, it appears that Premier has significant influence over Crystal. More importantly, Premier also has veto and blocking rights as set forth in the partnership agreement between itself and Crystal. The case has not provided details about the nature of the veto and blocking rights possessed by Premier. Nevertheless, these additional rights are strongly indicative of significant influence. In conclusion, since it appears that Premier has significant influence over Crystal, it should report its investment in Crystal Inc. using the equity basis. .

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The disclosures required by an investor relating to its associates as discussed in situation A above relating to Heavenly Hakka’s investment in Szechwan Samosas also apply to the case of Premier’s investment in Crystal. Further, Premier has to disclose the significant assumptions and judgements made by it in determining that it has significant influence over Crystal despite owning less than 20 percent of the voting rights of Crystal.

Case 1-5 Abundance Chemicals and Engineering Ltd. (ACE) Abundance Chemicals and Engineering Ltd. (ACE) has been a public company since 2007; therefore, it must follow IFRS for its financial reporting. Based on the facts presented in the case, joint arrangements are not an option for the two new investments. Our focus will be on classification of a control or an associate investment. If neither of these options is appropriate, the default position would be to classify these investments as passive investments.

Titanium Carbide (TC) Control is the ability to direct the strategic operating, investing, and financing decisions of TC. In 2023, ACE agreed to purchase 45% of the 250,000 outstanding voting common shares. The agreement calls for an immediate cash payment of 50% with equal payments at the end of 2024 and 2025. This by itself does not give ACE control of TC since ChemTech still owns 55% of the remaining shares.

The ability to elect three members of the seven-person board of directors and the veto power of the chairman of the board does provide ACE with a strong ability to control the direction of TC’s operations.

TC has some preferred shares outstanding that give the holder the ability to convert to common voting shares. Currently, ChemTech owns 60% of the convertible preferred shares, which is equal to 150,000 votes.

The breakdown of voting shares in 2023 would be: ACE

112,500 (30.4%)

Chem Tech

137,500 (common) 120,000 (preferred convertible to common) 257,500 (69.6%)

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Chapter 1: Introduction to Advanced Financial Accounting

Assuming ACE purchases the converted shares from ChemTech in 2024, the breakdown of voting shares in 2024 would be: ACE

112,500 (common) 60,000 (preferred convertible to common) 172,500 (46.6%)

ChemTech

137,500 (common) 60,000 (preferred convertible to common) 197,500 (53.4%)

Assuming ACE purchases the converted shares from ChemTech in 2025, the breakdown of voting shares in 2025 would be: ACE

112,500 (common) 120,000 (preferred convertible to common) 232,500 (62.8%)

ChemTech

137,500 (37.1%)

As a general rule, ownership of 20% or more but less than 50% is an indication of significant influence. In 2023, ACE owns 30.4%, which would likely give it significant influence over the strategic operating, investing, and financing decisions. In addition to the voting rights, ACE has the ability to elect three members of the seven-person board. Given the board directs the direction of the company, this further indicates that ACE has significant influence.

In 2024, assuming ACE purchases the converted shares from ChemTech, ACE would hold 46.6% of the common shares, which does not give ACE control. If ACE does not purchase the first group of shares, ACE would continue to hold 30.4%.

Conclusion Based on the information in the case, ACE does not have control of TC in 2023 and 2024. As such, ACE should classify its investment in TC as an associate.

In 2025, assuming ACE purchases all of the converted preferred shares, ACE would control TC and would reclassify TC as a control investment.

Planet Engineering Technology Inc. (PET) In 2023, ACE holds 19% of the voting common shares and is the largest shareholder, given the other shares are widely held. However, 19% is well below the majority votes. ACE is able to elect two members of the six-member board of directors, which gives ACE the ability to .

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influence the direction of the company. The fact that the balance of the shares are widely held make it more likely that ACE has influence over PET. There are other factors that need to be considered.

There are significant intercompany transactions between ACE and PET, with ACE purchasing 70% of PET’s annual sales. This would indicate that PET is reliant on ACE for these sales, indicating significant influence. ACE has now allowed PET the ability to use its patented purification process, which has reduced PET costs by 2%. Both facts indicate that ACE has the ability to influence PET. ACE holds convertible bonds that would convert to an additional 36% voting right; however, the bonds can only be converted after July 1, 2025, and only at the option of the issuer. ACE does not have the ability to force that conversion; therefore, it cannot convert the voting rights without the approval of PET. ACE holds convertible preferred shares that if converted would give ACE 52% of the PET voting rights. However, these preferred shares cannot be converted until December 31, 2026.

Conclusion Given the facts, it is clear that ACE has significant influence over PET until 2026. PET should be classified as an associate. Assuming ACE converts the preferred shares after December 31, 2026, ACE would control PET and should classify the investment as a control investment after the conversion takes place.

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Case 1-1 Quantum Structures Corporation Objectives of the Case The purpose of this case is to provide two situations where the student must determine the appropriate method of accounting for intercorporate investments. In both situations, there are qualitative factors that must be considered.

Objectives of Financial Reporting Quantum Structures Corporation (QSC) is currently a private corporation and, therefore, could follow ASPE. However, there is mention that it is going to issue shares to the public in the next few years. Therefore, even if QSC was not constrained to follow International Financial Reporting Standards (IFRS) now, it will be required to do so when going public. We should also consider the users of the financial information; the bankers and other investors are likely interested in cash flow prediction to evaluate if the company can pay off its loans. Since QSC is planning on going public in the near future, we will assume it is following IFRS as this would meet the needs of the current users as well as simplifying the ability to go public in the future.

Accounting for the Investments Growth Limited

QSC has 100,000 out of 180,000 votes or 56%. This would indicate that QSC has control and should consolidate Growth Limited under IFRS. However, there are factors that indicate that QSC does not have the power to direct the activities of Growth Limited. QSC’s ability to direct the activities of and thus control Growth Limited appears impaired because Keara can restrict day-to-day decision making and long-term plans through her ability to refuse the appointment of management and to approve significant transactions. On the other hand, QSC may be able to exert significant influence over Growth Limited. The terms of the sale agreement, including the length of time these terms are in effect, and other relevant factors should be reviewed. If such a review indicates that control is absent but nevertheless QSC can exert significant influence over Growth Limited, then QSC should report its investment in Growth Limited using the equity method of accounting.

Donna Ltd.

QSC owns 37% of the voting shares that, based on the guidelines provided under IFRS, would indicate significant influence and thus require the use of the equity method. However, there are factors that indicate that QSC has no influence over Donna Ltd. The family has elected all members of the Board, QSC has not been able to obtain a seat on the Board, and all shares are closely held by family members. Thus, the investment in Donna Ltd. appears to be passive. Therefore, it has to be accounted at fair value, with a choice to record the changes in value to the profit and loss statement or into other comprehensive income. As a passive investment, dividends received (if any) would be recorded as revenue in the net income section of the statement of income.

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Case 1-2 DeSantis Inc. To determine the reporting method, we must determine the level of control that exists for each acquisition made by DeSantis Inc. There are three possibilities of categories: control (subsidiary), significant influence (associate), or a passive investment (FVOCI, FVTPL, or cost). The factors to determine whether control or significant influence exists are the same. It is the degree of influence that differentiates control from significant influence. If the investment is neither a subsidiary nor an associate, then the investment must be classified as a passive (non-strategic) investment.

1. DeSantis paid cash for 40% of the common shares of Miller, which is less than a controlling interest in the votes. Since it does not control the votes, we need to look to see if anything else gives DeSantis effective control. Items that might indicate control would be:

a. Significant intercompany purchases: In this case, DeSantis purchases an estimated 45%55% of Miller’s total production. This might indicate control; however since there is excess demand for Miller’s production, this would indicate that if DeSantis does not purchase the raw materials, Miller would have no problems finding another buyer.

Therefore, Miller is not dependent on DeSantis, indicating no control or influence. b. Control of the day-to-day operations: In this case, the current owner (Zach) owns the remaining 60% of the shares and runs the operations of the company, which indicates DeSantis has no influence or control over Miller. However, Zach has asked for DeSantis to review the operation in the hopes of increasing efficiencies. This would indicate some influence.

Conclusion: The facts indicate that this investment would be an associate. An associate is accounted for using the equity method of accounting. DeSantis would include equity income in its statement of income (SI) based on 40% of the adjusted net income of Miller.

Any dividends received or receivable would decrease the Investment in Miller account balance on the statement of financial position (SFP).

2. DeSantis acquired 55% of the common shares of Watson, which typically indicates control. However, the founder (Hallie) still holds 45%, which will be sold to DeSantis over the next three years. The sales agreement allows Hallie the ability to veto significant decisions regarding the operations of Watson, and she will continue to run the day-to-day operations of Watson. These two factors indicate that Hallie controls Watson, rather than DeSantis. Given the agreement to purchase the remaining shares over the next three years, it is likely that DeSantis has influence over the operations.

Conclusion: It is likely that DeSantis has influence over Watson for the next three years; therefore, this investment would be an associate. An associate is recorded using the equity method of accounting. DeSantis would include equity income in its statement of income (SI) based on 40% of the adjusted net income of Watson. Any dividends received or receivable would decrease the Investment in Watson account balance on the statement of financial position (SFP). Once DeSantis purchases all the remaining shares and Hallie no longer has the power to veto decisions, DeSantis would have a control investment that would then require the consolidation of Watson.

3. DeSantis purchased 15% of the common shares of Harper, a publicly traded company.

Of the remaining shares, 75% are held by three brothers. In this case, there is a related group of individuals with a large ownership block, which would indicate the group has control, not DeSantis. Further, it is unlikely that DeSantis has any influence over the operating activities of Harper. Therefore, this investment should be recorded as a passive investment. Since DeSantis does not plan to hold this investment for a long period of time, it should record the investment as an FVTPL investment. This requires that the value of the investment is adjusted at each reporting period, with the market gain or loss recorded in the SI. Any dividends received would be recorded as revenue. .

Case 1-4 Hernik Inc. and Gonari Ltd. Hernik Inc. is a public company and must, therefore, follow IFRS. At first glance, we would assume that Hernik controls Gonari with 65% of the common shares. Even with the voting rights attached to the preferred shares held by Mr. Gonari, we can see that Hernik Inc. controls 59.1% of the votes.

Hernik Inc. Michael Gonari Total votes

Type of Shares Common Common Preferred

Shares 65,000 35,000 5,000

Votes 65,000 35,000 10,000 110,000

59.1% 31.8% 9.1% 100%

We must consider the sales agreement, which affords Mr. Gonari the right to veto any significant management appointment as well as approve any significant transactions. These two provisions would indicate that Mr. Gonari still has the ability to control the strategic operating, investing, and financing policies of Gonari Ltd. While Mr. Gonari has indicated he has no intention of exercising his right under the sales agreement, it is the ability to control or direct that is important in determining control or influence. It would appear that Mr. Gonari will have control of Gonari Ltd. until the remaining shares are sold to Hernik Inc. While it appears that Hernik has control over Gonari with 59.1% of the votes, we can see that Mr. Gonari can take over control at any point. The fact that Mr. Gonari has not intention of exercising his option is not relevant, it is the fact that he could at any point that would give him control. Given that Mr. Gonari can gain control at any time, Hernik Inc. would likely not have significant influence and should classify their investment as a passive investment, either as a FVTPL or FVOCI investment.

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