CMA Accelerated Program
CORPORATE TAXATION &
FINANCIAL ACCOUNTING
MODULE 2
Corporate Taxation and Financial Accounting – Module 2
Table of Contents
Corporate Taxation
1.
Federal Taxation in Canada
2.
Net Income for Tax Purposes and Taxable Income
14
3.
Computation of Taxes Payable
44
4.
Integration & Refundable Taxes
52
5.
Problems with Solutions
58
6.
Current Corporate Tax Rates
86
3
Financial Accounting – Module 2
1.
Accounting for Income Taxes
2.
Accounting Policies, Changes in Accounting Estimates and Errors
129
3.
Investments
161
4.
Operating Segments
241
5.
Interim Financial Reporting
245
6.
Foreign Currency Transactions
249
7.
Foreign Currency Translation
260
8.
Financial Instruments
292
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Corporate Taxation
1.
FEDERAL TAXATION IN CANADA
1.1
The Canadian Tax System and Legislation
 Federal Income Tax Act
Canadian federal income tax is imposed by the Income Tax Act (the “Act”). The Act
was first introduced in 1917 as the Income War Tax Act, whose primary purpose was to
generate revenues to fund World War I. Since its first introduction in 1917, the Act has
undergone significant changes. The Act contains the rules and regulations for
determining who is liable to pay tax, what types of income attract tax, how much tax
must be paid, and when the tax must be paid.
The current Act is lengthy in detail (approaching 2,500 pages), and its form is complex.
It is organized into 17 parts, I through XVII, which are subdivided into Divisions and
Subdivisions. The Act is amended frequently and keeping abreast of changes to the law
is difficult. For these reasons, it is important to understand basic principles that can be
applied to any income tax issue.
 Other Sources of Income Tax Information
In addition to the Income Tax Act and Federal Excise Tax Act, there are other sources of
income tax information including interpretation bulletins, information circulars, and court
cases.
Interpretation Bulletins and Information Circulars
The Canada Revenue Agency (“CRA”) issues Interpretation Bulletins and Information
Circulars that provide extensive and valuable commentary on the law. As the name
implies, Interpretation Bulletins explain CRA’s interpretation of many provisions of the
Act.
Information Circulars are designed to provide the general public non-technical
information on tax matters, such as CRA’s organization and procedures. An example is
IC 88-2 “General Anti-Avoidance Rules”, which differentiates tax avoidance from tax
evasion and explains the importance of each.
Interpretation Bulletins and Information Circulars do not actually have the force of law,
however, they are a very reliable source of information.
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Court Cases
The Canadian court system settles disputes regarding the application and interpretation of
various sections of the Act. These cases usually deal with a specific situation and a
narrow set of facts; applying court judgments to different situations is therefore difficult.
Regardless, over the years sufficient jurisprudence in tax law has been developed that it is
now a key source of definitions and interpretations. As an example, many court cases
have developed guidelines for distinguishing between business income and capital gains.
These terms are not defined in the Act, leaving taxpayers (and the Canada Revenue
Agency) to interpret the Act themselves. For such gray areas of tax law, court decisions
are an invaluable guide.
International Tax Treaties
Canada has negotiated tax treaties with many countries. The main purpose of the treaties
is to reduce the incidence of double taxation where tax provisions between countries
overlap.
1.2
Tax Principles and Concepts
To be an effective decision-maker, a management accountant must possess a sound
understanding of income tax principles and concepts. The Income Tax Act is the main
source for tax principles and concepts. While the Act is written and presented in a
complex manner, the fundamental principles and concepts are logical. Furthermore, only
a small part of the Act is relevant to management. The rest of the Act deals with very
specific rules that do not concern typical business transactions.
Within the fundamental tax principles and concepts, a number of variables influence the
business decision process.
Taxpayers
Who is liable to pay tax in Canada? Individuals, corporations, and trusts are the
three entities subject to tax in Canada. They file T1, T2 and T3 tax returns
respectively. For the purposes of the Act, these three entities are referred to as
“persons”. Individuals and trusts are not covered in this lesson.
Types of Income
The types of income that a taxpayer may earn are employment, business,
property, capital gains, and other. The taxable entities mentioned above may earn
any or all types of income, however, only individuals can earn employment
income. The basic tax issues for each of these types of income that are relevant to
a corporation are reviewed in this lesson.
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Alternative forms of business
A taxpayer can conduct business in one of four basic forms of organization proprietorship, corporation, partnership, and joint venture. Business conducted in
the incorporated form will be subject to taxation within the corporation. Business
conducted in any other form will flow through to the owners. Proprietorships,
partnerships and joint ventures are not taxable entities on their own. For example,
if an individual operates a sole proprietorship or partnership the earnings
therefrom will be included in their individual tax return. Correspondingly, if a
corporation is a member of a partnership, their share of the partnership earnings
will be included in their corporate tax return.
Tax Jurisdiction
The jurisdiction(s) in which a taxpayer is subject to tax is determined by the place
where it conducts business. In Canada, most taxpayers are subject to tax in two
jurisdictions: federal and provincial. With globalization of the marketplace, many
taxpayers now conduct business in foreign jurisdictions, which may subject them
to foreign taxes.
Taken together, the variables outlined above affect management’s decision-making
process. For example, the decision to raise financing is influenced by the variables of
taxpayers and their type of business. Financing raised with equity capital is maintained
by dividend distributions. Dividends are considered property income and are taxable if
received by individuals, but generally free of tax if received by corporations. However,
dividends are not deductible by the corporations who pay them, and therefore must be
serviced with after-tax dollars. This compares to debt financing, where the resulting
interest is deductible by the corporation and taxable as property income to the recipient.
The ultimate rate of return to the investor and the cost of financing are thus influenced by
tax variables.
1.2.1
The Concept of Residency
In Canada, income taxes are levied “on the taxable income for each taxation year of
every person resident in Canada at any time in the year”. “Person” and “taxpayer” in
this context refer to the taxable entities – individuals, corporations and trusts. The term
“resident” has a crucial meaning for income tax purposes; it determines the basis for
taxation in Canada.
 Residence of Individuals
Although the term “resident” is not actually defined in the Act, many court cases have
established the fundamental concept of residency for tax purposes. The Courts have held
that an individual is resident in Canada for tax purposes if the person normally or
customarily lives in Canada in the settled routine of his or her life. In making this
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determination, all the relevant facts must be considered. Factors such as number of days
physically present in Canada and maintenance of significant personal and economic ties
(e.g. family members, dwelling, bank accounts, investment properties, membership in
social organizations) are important in the determination of residency in Canada. The
degrees of residency for individuals are examined next.
Full-time Resident
A full-time resident is taxed on his/her worldwide income for the entire year. Therefore,
all income (whether from a source inside or outside Canada) of a full-time resident is
taxable in Canada. To determine whether an individual is a full-time “factual” resident,
Interpretation Bulletin 221R3 indicates that the CRA will consider significant “primary”
ties. Significant ties include maintaining a dwelling, the presence of a spouse (legal or
common-law), and the presence of dependents. Secondary ties to consider include
personal property, social memberships, employment etc. In general, unless an individual
severs all significant ties upon leaving Canada, the individual will continue to be a factual
resident of Canada and will be subject to taxation on his/her worldwide income.
Where a full-time resident earns income from a foreign source (which may have been
taxed in another country), he or she may be eligible for a credit (called foreign tax credit)
against Canadian tax payable for tax paid to another country. Treaties between Canada
and many other foreign countries also minimize the problem of double taxation that
arises with the “worldwide income rule” for full-time residents.
Part-time resident
If an individual clearly establishes or severs the ties outlined above during the year, they
are generally considered a part-time resident. A part-time resident is treated as full-time
resident for part of the year that the individual resides in Canada, and as non-resident for
the remainder. Consequently, they are taxed on their worldwide income for the part of
the year they are considered resident in Canada. For example, if an individual establishes
full-time residency on May 15, then the individual is considered to be a non-resident of
Canada from January 1 to May 14, and a full-time resident thereafter. The individual
would be taxable in Canada on worldwide income earned after May 14. Prior to this
date, the individual would be considered a non-resident. The application of Canadian
taxation to non-residents is outlined below.
Non-resident
A person who is not resident in Canada may still be liable to pay Canadian income tax.
A non-resident who was employed in Canada, who carried on a business in Canada, or
who disposed of taxable Canadian property during the year is liable to pay tax in Canada
on the income derived from these transactions. The common items included in Taxable
Canadian property are real estate located in Canada, capital property used in business in
Canada and shares of Canadian private corporations. Note that a non-resident is not
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subject to Canadian tax on worldwide income, only income from employment, business,
and dispositions of certain property.
Deemed Full-time Resident
In addition to “factual” residency outlined above in relation to full and part-time
residents, the Act provides that a non-resident individual who “sojourns” in Canada in the
year for a period of 183 days or more is deemed to be a full-time resident of Canada
throughout the year. This deeming rule can be harsh; the implication is that an individual
would be subject to Canadian taxation on his/her worldwide income for the entire year
(i.e., as if s/he were a full-time resident of Canada).
The term “sojourn” basically means physically present, but on a more transient basis than
a resident. A sojourner lacks a settled home in Canada which would make him or her a
resident. The rationale is that a non-resident who spends so much time in Canada has a
stake in the country not unlike a full-time resident, and should therefore be taxed the
same way. American visitors or businesspersons that travel extensively to Canada would
be caught by this deeming rule.
 Residence of Corporations
A corporation is also a “person” or “taxpayer”, and therefore must also determine its
residency status to determine its liability for Canadian taxation. A corporation resident in
Canada is liable for tax on its worldwide income. The rules for determining residency are
clearer for corporations than for individuals.
In general, all corporations incorporated in Canada are considered residents of Canada for
tax purposes. Therefore, any corporation incorporated under the federal or a provincial
jurisdiction is a Canadian resident, regardless of where the shareholders reside.
In addition, corporations incorporated outside of Canada (foreign incorporated) may also
be liable for Canadian taxation. If the “mind and management” of the corporation is
exercised from within Canada, then the corporation is deemed to be resident in Canada.
A significant amount of judgement is required to establish where the mind and
management of a corporation resides. The CRA considers factors such as the place
where the board of directors meets and where the books and records are located in
determining if the central management and control over the major policy affairs of a
corporation is located in Canada. Also note that if the mind and management ceases to
be exercised from Canada, then Canadian residency and taxation cease.
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The following table summarizes the residency tests.
INDIVIDUALS
Degree of Residency
Test
Taxation
Full-time resident
Place where person normally
or customarily lives; place of
significant social and
economic ties
Taxed on worldwide income for entire
calendar year;
Non-resident
No significant social or economic ties in
Canada
Taxed only on income from
employment or business earned in
Canada, or from disposition of certain
Canadian property;
Part-time resident
Individual establishes (or ceases)
residency in Canada at some point during
the year
Taxed on worldwide income for period
of year that individual is full-time
resident; taxed as non-resident for
remainder of year;
Deemed resident
Non-resident who sojourns (i.e., resides
temporarily) in Canada for 183 days or
more
Taxed on worldwide income for entire
calendar year;
Deemed resident
If incorporated in Canada
Deemed resident
Place where central management and
control actually abides (applies to
corporations not incorporated in Canada)
Taxed on worldwide income for entire
fiscal year of corporation;
Taxed on worldwide income for entire
fiscal year of corporation;
CORPORATIONS
1.2.2
Filing Obligations
 Taxation Year
As mentioned above, a taxpayer that is a resident of Canada is liable to pay tax on the
taxable income for each taxation year. The taxation year for an individual is the
calendar year (i.e., January 1 to December 31). The taxation year of a corporation is the
same as its fiscal year, which may or may not coincide with the calendar year. A
corporation is free to select its own fiscal period, and therefore its own taxation year, as
long as it is not longer than 53 weeks. The 53-week period allows the business year to
end on, for example, the last Friday in March each year.
 Filing of Tax Returns
The Act sets out the time limit for filing income tax returns for a taxation year. In the
case of individuals, returns must be filed by April 30th of the year following the taxation
year, which is the calendar year. Therefore, the deadline for filing your 2010 tax return is
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April 30, 2011. The deadline is extended to June 15th for self employed individuals
reporting business income, for example a partner of law firm. Corporations must file
their income tax returns within six months of the end of the taxation year (i.e., fiscal
year). Failure to file an income tax return will result in penalties if there are taxes owing.
 Payment of Tax
For individuals, the Canada Revenue Agency collects income tax through a system of
withholdings at source, installments, and payment on filing of tax returns. Individuals
receiving income from employment have their tax withheld at source - the employer
deducts the tax from each pay and remits the tax to the CRA. Individuals who earn
income from sources not subject to withholding i.e., business income or capital gains,
may be liable to pay quarterly installments throughout the calendar year. Any remaining
unpaid taxes (after consideration of withholding and installments) must be paid on the
filing of his/her income tax return on or before April 30th of the following year. Selfemployed individuals taking advantage of the extended deadline outlined above should
note that their unpaid tax continues to be due on April 30th.
As noted above, an individual may be liable for installments if they receive income that is
not subject to withholding at source. In general, if the amount owing on filing exceeds
$3,000 for more than one year, installments will be required.
Most corporations must pay income tax through monthly or quarterly installments, with
the balance due two or three months after the end of their fiscal year. The deadline for
final tax payment is extended for most Canadian controlled private corporations to three
months after the end of the taxation year. Corporate installments are not required if taxes
payable do not exceed $3,000 for the current or preceding year.
 Interest and Penalties
A taxpayer that does not file an income tax return on time, or does not make a payment of
tax as required by the Act, is liable for interest or penalties on the unpaid tax liability.
Penalties for late filing of a resident corporate tax return start at 5% of the unpaid tax plus
1% per month the tax remains unpaid up to a maximum of 12 months. In addition,
interest will be charged on the amount of tax outstanding and the penalties outstanding.
If a return is filed on time, but unpaid taxes not remitted, the taxpayer will be liable for
interest on the amount outstanding. Taxpayers will also be assessed interest on late
installments. The obvious intent is to force taxpayers to remit the correct amount of tax,
in the manner required by the Income Tax Act, and within the time specified by the Act.
Interest is charged at the prescribed rate plus 4%. The prescribed rate is found in the
Income Tax Regulations. It is established quarterly based on the average treasury-bill
rate. Interest accrues daily until the tax liability is paid. Both interest and penalties are
non-deductible expenses for tax purposes, which means that after-tax cash flows must
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finance the interest and penalties. The effective cost of not complying with the rules in
the Income Tax Act is thus very high.
1.3
Principles of Tax Planning
Management’s objective is to understand and apply tax planning fundamentals and
concepts. In this regard, it is important for the management accountant to know what
constitutes legitimate tax planning, and to be aware of the limitations imposed by the Act.
 General Anti-avoidance Rules (GAAR)
The Act contains a broad set of rules to prevent abusive transactions that avoid taxes.
These rules, collectively known as General Anti-Avoidance Rules (GAAR), seek to
deny the tax benefit that results from avoidance transactions. While the intent is to
prevent tax avoidance, it is important that the rules do not also interfere with legitimate
transactions. In this regard, GAAR distinguishes between legitimate tax planning and
abusive tax avoidance.
An “avoidance” transaction is basically any transaction (or set of transactions) that
results in a tax benefit, unless the transaction can be considered to have a legitimate
purpose other than to obtain a tax benefit. Tax avoidance occurs where taxpayers arrange
their affairs in an artificial way to avoid taxes. For example, a person may give incomeproducing property to a spouse for no other reason than to reduce his or her tax liability.
Another example is a person taking advantage of a tax loophole for no business reason
other than to reduce his or her tax liability. GAAR would seek to deny any tax benefit
realized with these types of transactions.
By contrast legitimate “tax planning” involves transactions that, while undertaken to
achieve a tax benefit, comply with the object and spirit of the Act. An example of
legitimate tax planning is the sale of property to a related corporation for fair market
value consideration. Another example is investing in RRSPs or Tax Free Savings
Accounts to reduce taxable income. These types of transactions are not tax avoidance
because they are undertaken for motives other than to achieve a tax benefit and because
they are within the spirit of the Act. For these reasons, taxpayers are free to conduct
legitimate tax planning without being challenged by the General Anti-Avoidance Rules.
A further distinction must be made between tax avoidance and tax “evasion”. Tax
“evasion” involves a deliberate breach of the Income Tax Act, for example by failing to
file a return or failing to report income. Tax evasion is illegal, and is subject to both civil
and criminal penalties. Tax avoidance transactions, while contrary to the spirit of the
income tax legislation, are not illegal because they do not involve fraud or any other
illegal measures. The process of audit, investigation, search, seizure and prosecution is
used to attack tax evasion, while GAAR is aimed at reducing tax avoidance.
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The concept of tax avoidance, evasion and planning is very subjective. Thus, taxpayers
must assess their risk tolerance and investigate the circumstances in which abuse of tax
law may occur.
 Types of Tax Planning
When engaging in tax planning, a management accountant seeks to preserve financial
resources. This objective can be achieved in three broad ways.
1) Shifting income from one time period to another (tax deferral);
2) Splitting income with another taxpayer;
3) Converting the nature of income from one type to another.
Recall that tax principles and concepts revolve around a limited number of variables,
namely taxpayer, type of income, alternative forms of business, and tax jurisdiction. Tax
planning basically involves changing one of these variables in an effort to reduce or defer
the tax cost of financial transactions.
When reviewing the planning concepts below, keep in mind that tax issues should never
be the primary motive for arranging one’s business affairs to create wealth. Ultimately,
management must evaluate all tax planning strategies in terms of risk and economic
soundness.
Shifting income from one time period to another
This strategy is desirable because tax is paid later rather than sooner (i.e., tax is
deferred). Wealth is enhanced because the time value of money reduces the cost of the
tax liability. A real tax saving (versus deferral) can also be realized if the future tax rate
is lower than it is presently. To illustrate these concepts, consider investments in RRSPs.
A contribution to an RRSP reduces current income tax because it is deductible from net
income for tax purposes. Tax on the income earned within the RRSP is deferred until the
individual withdraws cash from the RRSP. If the individual is in a lower tax bracket
when the withdrawals are made, then a tax savings is realized because the tax saved on
the deduction of the original contribution exceeds the tax cost on the withdrawal. This is
usually the case when an individual contributes to an RRSP during his or her working
years, and withdraws only during the retirement years.
Deferring taxes can also be achieved by the use of corporations and by “rollovers” of
property.
Use of Corporations
Individuals with significant income producing investments can hold them directly or
indirectly through a corporation (i.e., a holding company). A holding company may
provide tax deferral advantages under certain conditions. A tax deferral is enjoyed if the
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current tax payable by the corporation is less than the current tax that would be payable if
the individual earned the income directly. The same principles apply to business income
earned by a corporation compared to an unincorporated enterprise. Because of a system
of refundable taxes (see section 4.2), the advantage of using corporations to earn passive
investment income is limited.
Rollovers of Property
The disposition of capital property (see section 2.4) can trigger the realization of accrued
capital gains and therefore tax payable. In this regard, the Act contains numerous rules
that provide for the non-realization of such gains. When the rules apply, the nonrealization of capital gains is commonly referred to as a “rollover”. The term implies that
the taxation of the accrued gains is deferred (i.e., “rolled over”) to a future time when it
will be taxed in one of the following situations:
•
•
•
in the hands of the person to whom the property is transferred, when that
person disposes of the property;
when the “new” property that is substituted for the “old” property is sold, or;
when the property is sold to a person who does not qualify for a similar
subsequent rollover.
Taxpayers who wish to use the rollover rules must comply with specific administrative
procedures, including filing a form electing to treat the transaction on a tax-deferred
basis.
The most common rollover is the tax free transfer of property to a taxable Canadian
corporation in return for a combination of share and non-share (boot) consideration. The
rollover requires the election of a “transfer price” (ETP). The ETP can be set to defer all
or any portion of tax gains and income. The ETP becomes the proceeds of disposition for
the transferor and the cost base to the transferee.
The ETP must be set between:
• Maximum – Fair market value of asset
• Minimum – Greater of:
o Fair market of boot, and
o Tax cost base
Splitting income with another taxpayer
Because of the graduated tax rates in Canada, individuals can reduce overall taxes by
splitting income with another related person. For example, an individual earning
$100,000 has a marginal tax rate of approximately 44%. Therefore, every incremental
dollar earned will attract 44 cents of tax. If the individual’s spouse earned little or no
income, then every dollar of income transferred to him or her will create little or no
incremental tax. The tax savings can be substantial.
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Property income can be shifted to a related person by selling it for fair value
consideration. Future capital gains and business income can be transferred to a related
minor by gifting capital property to the minor. While such strategies trigger a disposition
(and therefore capital gain) upon transfer, overall tax savings can be realized if the future
income from the property is expected to be significant.
To be successful, income-splitting strategies must adhere to the rules for non-arm’s
length transactions and the General Anti-Avoidance Rules (GAAR) outlined above.
Converting the nature of income
A taxpayer can earn five basic types of income (employment, business, property, capital
gains and other). Each type is taxed differently, and in some cases more favorably than
another. For example, dividends attract lower tax than interest income due to the
dividend tax credit (see section 4.0). As well, because capital gains are only one-half
taxable, a taxpayer benefits by converting business or property income into capital gains.
Changing the nature of income for tax purposes is not always easy, and usually requires
shifting income from one entity to another (such as the use of a corporation).
The foregoing discussion on tax planning strategies is by no means an exhaustive list. It
is intended to give a flavour for the tax ideas relevant to the management accountant.
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2.
NET INCOME FOR TAX PURPOSES AND TAXABLE INCOME
A taxpayer (individual or corporation) derives income from five basic sources. These are
employment income, business income, property income, capital gains and losses, and
other specific sources. The sum of the five sources of income comprises a taxpayer’s net
income for tax purposes. From this figure, a narrow list of specific deductions is
applied to arrive at taxable income. Taxable income is the base upon which the tax
liability is computed (see section 2.5). The calculation of net income for tax purposes
can be illustrated with a formula commonly referred to as the “ordering rules”.
Net Income for Tax Purposes = A + B − C − D
where:
A =
Sum of income for the year from employment, business, property, and other
B =
taxable capital gains in excess of allowable capital losses for the year
C =
other deductions (RRSP, moving expenses, etc…)
D =
losses for the year from employment, business, property, allowable business
investment losses
All sources of income (i.e., worldwide) would be included in the above formula.
Net income for tax purposes cannot be negative. If the sum of C and D exceeds the sum
of A and B in the above formula, then the excess is added to non-capital losses and can
be applied against other years’ net income for tax purposes (see section 2.5).
For the corporate taxpayer the relevant sources of income are: business, property, and net
taxable capital gains. The basic principles for each of these sources of income in the
formula above are covered in the sections below.
2.1
Business Income
Income (or loss) from business is the profit (or loss) from a taxpayer’s business
activities. Business income is determined in the same way for all three types of taxable
entities: individuals, corporations, and trusts. A “business” is broadly defined in the
Income Tax Act (ITA) to include a profession, trade, manufacture, or undertaking of any
kind, and adventure or concern in the nature of a trade. Enterprises usually, though not
necessarily, have identifiable evidence of their existence through a name, location, etc.
The business may be operated as a corporation, sole proprietorship, or partnership.
The latter part of the definition would need to be considered as well, “adventure or
concern in the nature of a trade”. This refers to the occasions when a taxpayer acquires
property with the full intent of reselling it later at a profit. For example: a taxpayer
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purchases an undervalued used car with the intent of reselling it later for a profit. The
transaction is similar to that of a used car dealer. Any profits made on this transaction
would be considered business income and treated as such for tax purposes.
It is important to distinguish business income from capital gains and property income.
Although all of these types of income are included in the determination of Net Income,
the rules for the how the amounts are included differ, as well as the tax rate applied.
 Business Income Versus Capital Gain
In most cases, a business is readily identifiable by the nature of its activities. For
example, the manufacturing and development of computer chips for resale would
constitute a business. Sometimes, however, it is difficult to distinguish whether income
from a transaction is business in nature or capital gain. The sale of land may be either a
capital transaction or a business income transaction depending on the facts of the
circumstances.
The distinction is important because business income is fully taxed whereas only one-half
of capital gains are taxed. Moreover, business losses can be applied against all other
sources of income (e.g. capital gains or employment income), whereas capital losses are
only available for offsetting against capital gains. Business income is taxed less
favorably while business losses are treated more preferentially. The full amount of
business income is taxed in the year that it is earned while only one half of capital gains
are taxable in the year in which the gain is realized. Business losses, unlike that of
capital losses, can be used to offset income from all other sources.
The chief factor in distinguishing a business activity from a capital gain transaction is the
intended use of the property on acquisition. The principal reason for the purchase and
the subsequent use of the property will determine the type of income of the profit (loss)
generated upon sale. If the property was acquired for the purpose of resale, then its
disposition is likely business income i.e., if the property purchased is considered
inventory, then all profits triggered upon sale would be considered business income.
Conversely, property acquired for the purpose of providing the owner a long-term benefit
is likely capital property and its disposition would create a capital gain or loss, i.e., any
gains generated upon the sale of capital assets used in the course of running a business
are deemed to be capital gains.
Other factors in distinguishing business income or loss from capital gain or loss are
identified in the discussion of capital gains taxation section 2.4.
 Business Income Versus Property Income
Business income differs from property income in that the former is the result of an
organized activity, whereas the latter is passive in nature. Both business income and
property income are computed as the profit therefrom; that is, expenses incurred to earn
the income are generally deducted to arrive at taxable income. However, the tax rates
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applied to business income and property income may differ. These topics will be
discussed in the calculation of tax payable in section 3.
 Computation of Income From Business
For income tax purposes, income from a business is basically the net profit (or loss) for
the taxation year. “Profit” is determined in accordance with accountins standards for
private enterprises (ASPE) or International Financial Reporting Standards (IFRS) for
publicly accountable entities or any other entity that has elected to adopt IFRS. In this
document the use of IFRS also implies the use of ASPE if it applies to a private
enterprise.
Note that for fiscal years beginning on or after January 1, 2011, IFRS financial statements
are required for all publicly accountable enterprises. On May 31, 2010, CRA released
guidance in Income Tax Technical News Bulletin 42 acknowledging that IFRS is an
acceptable starting point for determining taxable income. The CRA has not however,
provided any other significant guidance on the broader effects of using IFRS as a starting
point for calculating income tax. There could be income tax implications for CanadianControlled Private Corporations electing to use IFRS because they must use balance sheet
amounts, which are different under IFRS, in calculation of certain corporate tax credits.
Once IFRS profit (or loss) is determined, it is then subjected to a number of limitations
and specific adjustments to arrive at income from business for tax purposes. As IFRS
permits considerable flexibility in the selection of accounting policies, it is possible to
manipulate accounting income in an attempt to reduce taxable income. For this reason,
the Income Tax Act prescribes limitations and adjustments to accounting income to arrive
at income from business for tax purposes. These limitations and adjustments mostly
relate to the deductibility of expenses.
 General limitations to business profit determination
Income Earning Purpose Test
The Act contains two general limitations that govern whether an item is deductible for
income tax purposes. The general limitation states that, in computing income from a
business or property, no deduction may be made for an outlay or expense “except to the
extent that it was made or incurred by the taxpayer for the purpose of gaining or
producing income from a business or property”. Put another way, an expenditure must
have been incurred to earn income from a business for it to be deductible for tax
purposes. For example, the cost of sending the owner’s children to summer camp would
not be deductible by the corporation because the income-earning test is not met. Note
that profit does not have to actually result from the expenditure; rather, there must be a
reasonable expectation of profit when the expenditure was made for it to be deductible.
Expenditures of a personal nature are not allowed, as they are not incurred to earn income
from a business.
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Corporate Taxation and Financial Accounting – Module 2
Reasonableness Test
The reasonableness test is the second limitation on the deductibility of expenses for tax
purposes. It states that a deduction may be made for an outlay or expenditure only to the
extent that it is “reasonable in the circumstances”. Thus, an otherwise deductible
expense may be denied if it is not reasonable given the nature of the business activities.
It could also be denied if the amount of the expense was not reasonable (i.e., significantly
in excess of what taxpayers in similar situations would normally incur.)
 Specific Limitations to Business Profit Determination
Capital Test
The Act dictates that no item is deductible in arriving at business income if it was
incurred “on account of capital”, or is an allowance in respect of “depreciation
obsolescence or depletion,” unless it is specifically permitted within the ITA. Capital
Cost Allowance (CCA) is permitted within the confines of the Act. It allows for the
gradual and uniform expensing of fixed tangible assets and intangible capital property
over time. Such an allowance ensures that all organizations expense similar assets at a
comparable rate. The CCA system is discussed in section 2.2.
Exempt Income Test
This limitation deems an expense as nondeductible if it is incurred to generate income
that will be tax exempt.
Reserve Test
Unless explicitly stated, all business allowances, reserves and contingent accounts are not
tax deductible. Reserves which are specifically allowed are reserves for doubtful
accounts, reserves for undelivered goods and services and reserves for unpaid amounts.
Personal Expense Test
This limitation prohibits any deductions for a taxpayer’s personal or living expenses. The
only exception to this rule is traveling expenses incurred during the course of conducting
business away from home.
Adjustments to accounting income to determine income from business for tax
purposes
The ITA also lists specific expenses that are not deductible from income, even if they
otherwise qualify under the general limitation and the reasonableness test. A list of
permitted expenses is also written in the ITA. These exceptions ensure consistency
among taxpayers in the calculation of taxable income. If an expense passes the income
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Corporate Taxation and Financial Accounting – Module 2
earning and reasonableness test, and is not one of the exceptions (or is one of the
permitted deductions) listed in the ITA, then the expense is deductible.
The following is a list of common business expenses that are not deductible under the
ITA.
•
•
•
•
•
•
•
•
•
•
•
•
•
amortization of bond discount or premium (discount may be deductible upon
redemption of bond under allowable expenses below)
fines or penalties imposed by statute or law
meals and entertainment (50% of the actual costs incurred is deductible)
recreational facilities and club dues, including amounts for the use and/or
maintenance of a yacht, camp, lodge or golf course
income taxes, interest and penalties thereon
automobile mileage payments – limited to 54 cents per km for 2009, the rates
are published the year following.
interest and property taxes on vacant land (in excess of income generated from
the land)
appraisal costs – unless for the purpose of earning business income i.e., to
obtain insurance
charitable donations (not a deduction in determining business income – for
corporations donations are deductible in determining taxable income subject
to certain limits)
political contributions (although not deductible, these generate tax credits that
are deductible from taxes payable)
advertising expense – for advertisements in periodicals, only 50% of the
advertising costs are deductible if the original Canadian editorial content (i.e.,
Canadian author) is less than 80% of the total advertising content. This would
limit the deductible amount for advertising in a Canadian edition of a
primarily foreign written magazine
bonuses not paid within 180 days of year end
accounting losses/gains on asset sales.
Some of the common deductible expenses are:
•
•
•
•
•
•
•
•
Page 18
capital cost allowance (see section 2.2)
cumulative eligible capital amount
interest incurred on funds borrowed to earn income (limited when funds are
borrowed for a passenger vehicle)
actual warranty costs incurred
warranty reserve paid to third party
actual write off of bad debt
inventory write-downs by virtue of the tax requirement to carry inventory at
the lower of acquisition cost or fair market value
expenses of borrowing money or issuing shares (can deduct evenly over 5
years)
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Corporate Taxation and Financial Accounting – Module 2
•
•
•
•
•
•
discount on bonds at maturity provided the bonds are issued for not less than
97% of their maturity amount and the effective yield is not more than 4/3 of
the coupon rate (if not within these guidelines the discount at maturity is only
half deductible)
landscaping
premiums on life insurance required as the collateral for a loan
employer contributions to RPP or DPSP made within 120 days of year end
expenses of representation for license, permit, franchise or trademark paid to a
government body or agency
scientific research and experimental development costs – to the extent that
such costs were incurred within Canada, such costs can be fully deducted in
the year in which they are paid out, including costs incurred to procure capital
assets.
Finally, note that LIFO is not permitted for inventory valuation. Valuation at lower of
cost and fair market value for each item or class OR valuation of the entire inventory at
fair market value is permitted.
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Example Problem:
Bat Co. gives you the following accounting information for its June 30, 20x9 taxation year.
Compute net income for tax purposes.
Revenues
Direct expenses
Gross margin
Depreciation expense
Club dues
Meals and entertainment
Write-down of investments
$3,000,000
(1,770,000)
1,230,000
850,000
20,000
60,000
Net Loss for Accounting Purposes
(930,000)
(500,000)
($200,000)
Other information:
• Capital cost allowance (i.e., depreciation for tax purposes) is $800,000 for the year.
• Management decided to write-down the value of investments in subsidiaries. There was no
actual disposition of the investments.
Analysis:
Net loss for accounting purposes
Add back: expenses not deductible for tax purposes
Depreciation expense
Club dues
Meals and entertainment (50% of $60,000)
Write-down of investments
Less: expenses permitted for tax purposes
Capital cost allowance
Net Income for Tax Purposes
($200,000)
850,000
20,000
30,000
500,000
1,400,000
(800,000)
$400,000
Comments:
• The write-down of investment will be recognized as a capital loss for tax purposes only when the
investments are actually disposed of.
• The above shows that net income for tax purposes can be positive even though there is a loss for
accounting purposes. If management decided not to write-down the investment, then accounting
income would be $300,000, and net income for tax would remain unchanged at $400,000. In
other words, the arbitrary accounting entries (such as depreciation and write-down of
investment) have no effect on net income for tax purposes.
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2.2 CAPITAL COST ALLOWANCE (CCA) AND CUMULATIVE
ELIGIBLE CAPITAL AMOUNT (CECA)
2.2.1
Depreciable Property and CCA
The rules governing the write-off for tax purposes of depreciable capital property are
outlined in this section. These rules determine the amount of depreciation expense,
known as capital cost allowance (CCA), which may be claimed as a deduction for tax.
This is important because of the significance of capital investments that most businesses
make in long-term assets such as buildings and equipment. The amount and timing of
deductions for these capital expenditures can significantly impact cash flows by reducing
the amount of tax paid in a particular year.
The CCA system consists of over 44 classes or pools of assets, with each class having a
specific write-off rate. The Act specifies which CCA class assets should be included in.
. The declining balance method, with some minor adjustments, is used to determine the
annual CCA claim for most classes.
 Basic Rules of the CCA System
The calculation of capital cost allowance (CCA) consists of a few basic steps. In general
the balance in each CCA class to be used as the base for the CCA calculation is
determined by taking the opening balance in the class, adding purchases and subtracting
disposals. The appropriate CCA rate is then applied to the class to obtain the deduction
for tax purposes for the year. The balance of costs for each CCA class is referred to as
the Undepreciated Capital Cost, or UCC.
The detailed rules to calculate CCA are outlined below.
Calculation of CCA
Undepreciated capital cost (UCC) of the class – beginning of
the year
Add: purchases in the year
Deduct: dispositions in the year at the lesser of:
(a) capital cost
(b) proceeds of disposition
UCC before adjustment
Deduct: ½ net amount *
UCC before CCA
Deduct: CCA in the class for the year (CCA rate % x A)
Add: 1/2 net amount *
UCC of the class - end of the year
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$xxx
xxx
$ xxx
$ xxx
A
(xxx)
$ xxx
(xxx)
$ xxx
(xxx)
xxx
$ xxx
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Corporate Taxation and Financial Accounting – Module 2
*
“half-year rule”
purchases in the year
$xxx
deduct: lesser of capital cost and proceeds of disposition above
(xxx)
Net amount (positive amounts only)
$xxx
 General Notes
− CCA may be claimed on all tangible capital property other than land.
− To be eligible for CCA, the taxpayer must own the property, and the property
must be available for use. Therefore, assets under construction or assembly do
not qualify for CCA until they are completed.
− The capital cost of purchases gets added to a CCA class. The cost includes
shipping, sales tax, installations, and legal fees. Any government assistance, such
as grants, reduces the cost that is added to the CCA class.
 Rates of Capital Cost Allowance
The CCA system groups similar types of depreciable property into specific classes. The
Income Tax Act assigns a CCA rate to each class.
Determining which class a particular asset belongs to can sometimes be difficult. Some
of the more common classes of assets follow:
Page 22
Class
CCA
rate
Description of CCA Class
1
4%
Buildings and other structures acquired after 1987, including
component parts such as air-conditioning/heating equipment
and elevators
1MB
10%
1NRB
6%
3
5%
Non-residential buildings and other structures acquired after
March 18, 2007, including component parts which are used
90% or more for manufacturing and processing in Canada,
provided the building is allocated to a separate Class 1
Buildings and other structures acquired after March 18, 2007,
including component parts which are not used 90% or more for
manufacturing and processing, but are used 90% or more for
non-residential purposes, provided the building is allocated to a
separate Class 1
Buildings, as above, acquired before 1988
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Corporate Taxation and Financial Accounting – Module 2
8
20%
Equipment and machinery, such as photocopiers, fax machines,
and general-purpose signs. Tools costing more than $500.
10
30%
Automotive equipment, general-purpose electronic data
processing equipment, and systems software purchased before
March 23, 2004.
10.1
30%
Passenger vehicles with a cost exceeding $30,000 +taxes –
addition to class is limited to $30,000 plus tax (net of any GST
recovered)
Separate class for each vehicle
12
100%
Small tools and kitchen utensils costing less than $500 acquired on or after
May 2, 2006, computer software other than systems software, and
videotapes
13
See
below
Improvements made to leased premises (leasehold
improvements)
14
See
below
Patents, franchises, concessions, and licenses having a limited
legal life, and is the lower of
Total capital cost divided by the remaining life of the
asset or
The total capital cost.
29
Manufacturing and processing machinery and equipment acquired after
March 18, 2007 and up to the end of 2014, after which assets will be placed
in Class 43
43
44
50%
Straight
Line
30%
25%
45
45%
50
55%
52
100%
Manufacturing and processing assets acquired before March 19, 2007
Patents acquired after April 26, 1993 (may elect not to use Class 44 and use
Class 14 instead)
General-purpose electronic data processing equipment, and
systems software purchased after March 22, 2004, but before
March 19, 2007
General-purpose electronic data processing equipment, and
systems software purchased after March 18, 2007
General-purpose electronic data processing equipment (new
only), and systems software acquired after January 27, 2009
and before February 2011
No half-year rule
CCA for classes 13 and 14 is calculated on the straight-line basis. For class 13, the
period of amortization is the term of the lease plus one renewal period with a minimum
write-off period of 5 years. For class 14, the basis for write-off is the limited legal life on
an exact days basis.
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Corporate Taxation and Financial Accounting – Module 2
 Half-year Rule
The ITA restricts the amount of CCA that can be claimed in the first year of an asset’s
acquisition to one-half of the normal amount. The mechanics of this rule (known as the
“half-year rule”) are illustrated above. The half-year rule applies to net additions, which
is equal to asset purchases less disposals in the year. Another way of looking at this
approach is that the assets included in the opening UCC are entitled to the full CCA rate
and net additions in the year qualify for one-half of the normal rate.
The half-year rule is intended to compensate for the fact that depreciable property is
purchased throughout the year. Additions are often not used for the full year in the year
of purchase; available CCA on these additions is arbitrarily reduced by 50%.
 Short Taxation Years
When a taxpayer has a taxation year of less than 12 months, the CCA claim for the year
must be prorated for the number of days in the taxation year divided by 365. The halfyear rules still applies to net purchases in the year. For example, if the first taxation year
of a business runs from June 30 to December 31, and the business acquires $10,000 of
computer equipment (class 10 – 30%), then the CCA for the period is $760 ($10,000 *
30% * 185/365 days * 1/2 year rule). The half-year rule does not apply to either class 14
or eligible capital property.
 Dispositions of Depreciable Property in the Year
The CCA system allows taxpayers to write-off the cost of depreciable property for tax
purposes over time. At some point, a taxpayer may dispose of depreciable property and
receive proceeds of disposition different from the tax value of the depreciable property
(i.e., Undepreciated Capital Cost, or UCC). The disposition of depreciable property can
give rise to three types of income: recapture, terminal loss, and/or capital gains.
Recapture of CCA
On the disposition of depreciable capital property in the year, the lesser of the cost or
proceeds is subtracted from the relevant CCA class. If the UCC balance of a class
becomes negative as a result of applying the proceeds, then the taxpayer must add the
negative amount to taxable income as business income. In effect, a negative UCC pool
means that excess CCA deductions were taken for tax purposes; the taxpayer must
recapture the tax deductions taken by including the negative UCC pool in income.
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Corporate Taxation and Financial Accounting – Module 2
Example Problem:
Tofu Inc. purchased a Class 1 (4%) building in 20x7 for $100,000. Tofu Inc. intended to use the
building to house one of its divisions. In 20x9, the building is sold for $100,000 after Tofu Inc.
decided to discontinue the division. Tofu Inc. did not own any other building. Maximum CCA
was claimed each year. Determine the impact of the disposition to Tofu Inc.
Analysis:
The building is depreciable property, and qualifies as a Class 1 (4%) asset. The half-year rule
applies in 20x7, the year of acquisition.
Class 1
20x7
UCC – beginning of year
Purchases during the year
CCA (4% x $100,000 x 1/2)
UCC – end of year
$0
100,000
$100,000
($2,000)
$98,000
20x8
UCC – beginning of year
CCA (4% x $98,000)
UCC – end of year
$98,000
(3,920)
$94,080
20x9
UCC – beginning of year
Disposal
$94,080
(100,000)
(5,920)
5,920
$0
Recapture
UCC – end of year
The recapture of $5,920 in 20x9 is a logical result because Tofu Inc. fully recovered the $100,000
cost from the proceeds of disposition. Therefore, the deductions taken in 20x7 and 20x8 (total
$5,920) were, in hindsight, excessive.
If Tofu Inc. were to purchase another building before the end of its 20x9 taxation year, the
recapture of $5,920 would be deferred because the UCC balance would not be negative at the end
of the year. In that case, the recapture would effectively reduce the UCC (and hence the future
CCA deductions) on the newly acquired building.
Terminal Loss
If all of the assets in a particular CCA class are disposed of, but a balance remains in the
class, then a taxpayer is entitled to claim the remaining balance as a deduction from
income. This deduction is known as a terminal loss. Conceptually, a terminal loss
recognizes that insufficient CCA deductions were claimed in the past (in hindsight).
Example Problem:
Continuing with the example above, if the proceeds of disposition were $80,000 instead of
$100,000, then the UCC balance at the end of 20x9 would be $14,080 (i.e., $94,080 UCC less
$80,000 proceeds). Since no other assets remain in Class 1, Tofu Inc. would be entitled to deduct
the $14,080 as a terminal loss. The net cost to Tofu Inc. of the building of $20,000 ($100,000
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Corporate Taxation and Financial Accounting – Module 2
original cost less $80,000 proceeds from sale) is recovered in the tax system as follows: $5,920
total CCA in 20x7 and 20x8 and $14,080 in terminal loss.
Capital Gain
If the proceeds of disposition of depreciable property exceed the adjusted cost base, a
capital gain arises. If the proceeds are less than the adjusted cost bases, no capital loss
arises. The CCA system will ensure that the capital loss component of the transaction is
deductible as either terminal loss or increased CCA deductions in the future.
 Class 13 Assets
An exception to the declining balance method of depreciation used for most CCA classes
applies for class 13 (leasehold improvements). A leasehold improvement is a capital
improvement or alteration to a property leased by the taxpayer; for example, a substantial
renovation of store premises by adding walls and fixtures. If the taxpayer owned the
store, the renovations would be added to the same class as the original cost of the
building (i.e., class 1). It would then be depreciated under the CCA system along with
the building. If instead the taxpayer had a six-year lease on the building, class 13 allows
the taxpayer to claim CCA on a straight-line basis over the six years.
Note that:
• the minimum period for depreciating a class 13 asset is 5 years;
• the maximum period is the term of the lease plus the first renewal period, not to
exceed 40 years;
• the write-off in the first year is 50% of that otherwise allowed (effectively the half
year rule);
• CCA is calculated for each leasehold improvement separately (i.e., the pool concept
does not apply);
• Class 13 CCA must be prorated as discussed above for short taxation years.
 Class 14 Assets
This class includes limited-life intangible assets such as patents, franchises, and licenses.
As with class 13, the straight-line method of depreciation applies to class 14, and CCA is
determined separately for each asset. However, class 14 differs from the other classes in
that the date of purchase of the asset is used to determine CCA in the year of acquisition.
CCA for class 14 is calculated using the formula below:
CCA
=
Page 26
Original cost
*
number of days property was owned in the
taxation year
total number of days in life of the asset
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Corporate Taxation and Financial Accounting – Module 2
Because of this calculation method, class 14 is not subject to either the half-year rule or
the proration of CCA for short taxation years.
 Class 10.1 Assets
Class 10 contains automobiles. In order to limit the deductibility of CCA for luxury
autos, each passenger vehicle costing more than $30,000 plus taxes must be placed in a
separate class 10.1. The amount added to the class is limited to $30,000 plus taxes (net of
GST/HST recovered). Further, the regular rules for terminal loss and recapture do not
apply to Class 10.1. Instead, CCA is deductible in the year of disposition of the auto.
The final year CCA is equal to half the CCA that would have been deductible if the
disposition had not occurred.
2.2.2
Eligible Capital Property and Cumulative Eligible Capital Amount
An Eligible Capital Expenditure (ECE) can generally be defined as a capital property of
an intangible nature that has an unlimited life (intangible capital properties with a limited
life belong in Class 14 discussed above). Some of the common types of eligible capital
property are listed below:
•
•
•
•
goodwill;
patents, franchises, licenses that do not have a specific legal limited life;
trademarks;
customer lists;
The system for writing off Eligible Capital Expenditures is similar to the CCA system for
depreciable property. A pool basis is used, and the write-off (known as the deduction for
Cumulative Eligible Capital) is also determined on the declining balance basis. All ECE
are included in one pool for tax purposes. The general framework of the system is as
follows:
Page 27
•
75% of the cost of all ECE is added to a common pool referred to as the
Cumulative Eligible Capital (CEC) account;
•
75% of the proceeds of disposition of any ECE item is subtracted from the
CEC pool;
•
If the pool is negative at the end of the year, the negative amount is added to
business income (this is similar to recapture for depreciable property).
Similarly, if the pool is positive and the business has discontinued, the full
balance is deducted from income as a terminal loss;
•
the CEC pool is depreciated on a declining balance basis at the maximum rate
of 7% per year;
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Corporate Taxation and Financial Accounting – Module 2
•
the one-half year rule does not apply in the year of acquisition;
An inequity in the taxation results from the 75% inclusion rate used for the CEC pool on
the disposition of eligible capital property. This inequity will be illustrated below.
Example Problem:
In 20x7, Sprout Corp. purchased an existing business and acquired, among other assets, a
customer list for $20,000 and goodwill for $60,000. In 20x9, the business is sold. Sprout Corp.
receives $40,000 for the customer list and $100,000 for the goodwill. Track the Cumulative
Eligible Capital Account (CEC) for the relevant years.
Analysis:
CEC
20x7
Additions
Customer List (75% of $20,000)
Goodwill (75% of $60,000)
20x8
Amortization (7%)
$15,000
45,000
60,000
(4,200)
CEC balance – end of 20x7
$55,800
Amortization (7%)
20x9
Disposal
(3,906)
CEC balance – end of 20x8
$51,894
Sale of customer list (75% of $40,000)
Sale of goodwill (75% of $100,000)
(30,000)
(75,000)
Business income inclusion
CEC balance – end of 20x9
($53,106)
$ 53,106
$0
Comments:
The sale of the customer list and goodwill results in a negative CEC pool fully taxable as business
income in 20x9.
Note that the $53,106 is comprised of two components –
1.
2.
recapture of previous ECE claims $8,106
capital gain on disposition of property $45,000 = 75% of $140,000 proceeds less
$80,000 cost.
The capital gain component on the sale of property is taxed at 75% because of the rates used for
the ECE pool. However, all other capital gains are taxed at a rate of 50%. This inequitable
treatment caused CRA to put rules in place to allow taxpayers to adjust the inclusion rate on the
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Corporate Taxation and Financial Accounting – Module 2
capital gain component to 50%. For the above taxpayer, the adjusted amount of capital gain is
50% of $60,000 = $30,000. The $30,000 is combined with the true recapture component of
$8,106 to total a business income inclusion of $38,106. This is preferable to a business income
inclusion of $53,106. Further, if the taxpayer prefers the capital gain component be reflected on
the tax return as a capital gain, an election may be made. This would be preferable if the taxpayer
had unused capital losses.
2.2.3
Accounting Rules versus Tax Rules
The discussion above examined the tax rules for depreciable property. To solidify our
understanding of these rules, it is important to highlight how they differ from the
accounting treatment of similar property.
 Cost Allocation
Generally accepted accounting principles (GAAP) attempt to allocate the capital cost of
an asset over its useful life, thereby matching cost with revenues. The useful life and
salvage value of an asset is estimated and the cost is allocated over each accounting
period. This process requires judgment; hence, similar businesses acquiring similar
assets may reach different estimates and therefore different accounting incomes from
year to year.
For tax purposes, however, a standardized system for depreciable property is imposed.
The CCA system assigns depreciable property into classes, with each class having a
specific amortization rate. Judgment is removed and any depreciation expense recorded
for accounting is removed in the computation of taxable income. The obvious intent of
the uniform CCA system is to eliminate the ability of taxpayers to abuse the tax system
by deciding on the depreciation for tax. Therefore, equality for all taxpayers is preserved.
Another difference is that depreciation for accounting is mandatory whereas depreciation
for tax is discretionary. GAAP requires the proper matching of expenses with revenues.
However, a taxpayer can choose not to claim CCA on a particular class for a particular
year. This may be the case because it has operating losses and claiming additional CCA
deductions will compound the tax losses. The fact that CCA is discretionary opens up
significant opportunity for tax planning.
 Gains and Losses on Depreciable Property
As explained earlier, the disposition of depreciable property can result in recapture,
terminal loss, or capital gain for tax purposes. Because of the pool concept with the CCA
system, recapture and terminal loss are only recognized when the pool becomes negative
or when all of the assets in the class are disposed (respectively). For tax purposes, a
capital gain only results if the proceeds exceed the original cost of the particular asset.
There are no capital losses on depreciable property, only terminal losses.
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Corporate Taxation and Financial Accounting – Module 2
The accounting rules differ significantly from the tax rules for depreciable property. In
the year of sale, the accounting rules state that a gain or loss arises from the difference
between the proceeds and the net book value of the depreciable property. Because the
pool concept does not exist for accounting, it is possible for a gain or loss to be
recognized for accounting and not for tax. As with accounting depreciation, any gain or
loss recorded in accounting net income is removed for tax purposes.
 CCA and Management Decision-Making
A thorough understanding of the capital cost allowance system is crucial for effective
management decision-making. In the lesson on Financial Management, you will learn
the importance of identifying relevant cash flows for the net present value approach to
capital budgeting. The relevant cash flows include the tax shield generated by the capital
investment over time. In other words, CCA affects cash flows by reducing taxes paid.
Therefore, management is responsible for understanding how the cost of a capital
investment will be recovered for tax so that a quantitative evaluation of the investment
can be made.
CCA can also affect management’s pricing decisions. Depreciation is often a significant
portion of a company’s general and administrative expense, which must be allocated to
products and services as overhead. The amount of accounting depreciation used in the
overhead allocation must approximate the capital cost allowance for tax; otherwise,
relevant pricing decisions cannot be made.
 CCA and Tax Planning
The capital cost allowance system gives rise to several tax planning opportunities.
•
Because CCA deductions are discretionary, a taxpayer can shift income (or preserve
losses) for tax purposes from year to year by delaying the CCA deduction. This is
particularly useful where non-capital losses for tax purposes risk expiring (see section
2.5).
•
Some assets are written off for tax purposes more rapidly than others, depending on
the CCA class. Whenever a company purchases a group of assets, management
should carefully consider how to allocate the purchase price. Allocating the purchase
price to faster write-off tax classes will enhance the cash flows of the investment and
therefore increase the rate of return to shareholders.
•
The disposition of depreciable property can sometimes create recapture of CCA,
which is considered business income. Recall that recapture arises when a CCA class
becomes negative at the end of the year. A taxpayer can mitigate the effect of
recapture by speeding up the purchase of new assets, thereby reinstating the CCA
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class to a positive balance. Similarly, deferring the purchase of new assets to the next
taxation year can accelerate a terminal loss (and therefore business loss).
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2.3
PROPERTY INCOME
Property income is generally defined as the return on invested capital where little or no
effort1 has been expended by the investor in producing the return. Property income can
be distinguished from business income, which requires relatively high effort to earn. The
role of the taxpayer in earning property income is considered passive while with business
income, it is considered to be active. The following are the main types of property
income:
•
•
•
•
interest income (return on investments in bonds, mortgages, loans and bank deposits);
dividend income (return on the investment in shares of the capital stock of a
corporation);
rental income (return from the ownership of real estate or other tangible property);
royalty income (return on the ownership of property such as patents or copyrights);
Note that property income is the annual or regular return realized from allowing another
to use one’s property. It does not include the gain or loss that may result from the actual
sale of the property. This latter source of income is considered capital gain or loss (see
section 2.4). Note that with regards to the sale of depreciable property, should the sale
price be in excess of the original cost of the property, any gain from sale is considered to
be a capital gain. However, should any recapture (from the previously deducted capital
cost allowance) or terminal loss be triggered upon sale, such recapture/loss is deemed to
be property income/loss (and not capital gain/loss) and treated as such for tax purposes
(see section 2.2).
The types of property income discussed above may also be considered business income if
significant effort is expended to earn the income. For example, banks obviously conduct
a business even though the interest income they earn on loans is considered property
income to an individual who casually lends his friend money. Professional judgement
must be applied in each case where the distinction between property and business income
is blurred.
The Income Tax Act states that a taxpayer’s income from property for the year is the
“profit therefrom”. Property income is thus computed on a net basis; that is, it takes into
account revenues and related expenses incurred to earn those revenues. Examples of
expenses commonly incurred to earn property revenues are investment counseling fees
(for interest or dividend income) and property taxes (for rental income). Similar to the
determination of business income, expenses can be deducted provided they are:
1)
2)
3)
4)
1
incurred to earn such revenues
not an expenditure that is capital in nature
not a reserve
not personal or living expenses
Effort is defined in terms of time, labour and attention.
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5) considered reasonable under the circumstances
The deduction of interest expense is allowed, despite such an expense being capital in
nature, if the loan was used to generate property income. The taxpayer must maintain
thorough documentation which directly links the interest expense to the revenues
generated from the loan for the expense to be deducted.
2.3.1 Interest Income
Interest income is the compensation received for the use of borrowed funds. The
calculation of interest earned is usually easy to determine based on the terms of the loan
agreement. For tax purposes, corporate taxpayers must recognize income on the accrual
basis. This means that interest must be computed daily even though the interest may only
be received monthly or quarterly. The timing of income recognition for tax purposes is
important as it will affect investment decisions.
Some common deductible expenses from interest income are:
• Interest expense on loans used to finance the investment
• Investment counseling fees
• Accounting fees for record keeping and tax purposes
2.3.2 Dividend Income
Taxpayers receive dividends as a return on investment in corporate shares. These
dividends reflect the distribution of a portion of the corporation’s after-tax profits to
the shareholders.
Dividends received by corporations are generally not subject to income taxes (see section
4.2 for exceptions). Because dividends are paid out of after-tax earnings and dividends
are not a deductible expense, this general rule ensures that multiple taxation of after-tax
profits is eliminated at the corporate level. The dividend is included in the determination
of net income for tax purposes, and then deducted in determining taxable net income.
The rules for inter-corporate dividends raise important tax planning implications. These
issues are examined separately in section 4.
2.3.3 Rental Income
Rental income is the compensation received for allowing another person to use one’s real
property, usually land or building. The profit from rental activities must be included in
taxable income when earned (i.e., on accrual basis). Deductions permitted against rental
revenue are determined under the normal rules for profit determination. For example,
interest on loans used to acquire rental property is a deductible expense.
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Other common deductions from rental income include:
• Property taxes
• Insurance expense
• Maintenance and Repair (non-capital in nature)
• Utilities
When total expenses exceed the total amount of revenues generated, such a loss is
deemed to be property loss and can be used to offset other sources of income.
Special rules apply in the determination of capital cost allowance deductible against
rental income. A taxpayer cannot create or increase a rental loss with CCA and all
buildings with a cost of $50,000 or more must be placed into a separate class (section
2.2).
 CCA Rules For Rental Properties
Special rules apply in the determination of CCA for rental properties. These rules limit
the amount of capital cost allowance that can be claimed as a deduction against rental
income.
The first rule is that CCA cannot be claimed to create or increase a rental loss from all
rental properties combined. The second rule states that each rental building costing
$50,000 or more must be held in a separate CCA class. Therefore, the general rule for
pooling similar assets does not apply to rental buildings costing $50,000 or more. Both
rules are illustrated in the example below.
Example Problem:
Beta Corp. purchased two rental properties in 2006. Building X cost $40,000; building Y cost
$200,000. The buildings earned the following income or loss during fiscal 2006. Compute the
maximum capital cost allowance that can be claimed for Beta Corp. in fiscal 2006.
Gross rental revenue
Less: Expenses (excluding CCA)
Income (loss) before CCA
Building X
Building Y
$35,000
(50,000)
($15,000)
$88,000
(70,000)
$18,000
Total
$3,000
Analysis:
Both buildings qualify as Class 1 properties with a maximum CCA rate of 4%. Because building
Y has an original cost greater than $50,000, it must be placed in a separate CCA Class 1. Any
additions to Class 1 less than $50,000 would be pooled with the class containing building X.
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MAXIMUM CCA
Building X
Building Y
$40,000
$1,600
$800
$200,000
$8,000
$4,000
Original cost
CCA at 4%
Half-year rule for year of acquisition
Total
$4,800
The maximum CCA that could normally be claimed from rental income in fiscal 2006 is $4,800.
However, CCA cannot be claimed to create or increase a rental loss. Therefore, CCA is limited to
$3,000. The $3,000 CCA may be claimed from either the class containing building X or Y, or a
combination of the two. Allocating the CCA between the two buildings should consider any
future sale prospects.
TAXABLE INCOME FROM RENTAL PROPERTY
Total
Income (loss) before CCA
Less: CCA on building Y
Income (loss) before CCA
$ 3,000
(3,000)
$0
The benefit from $1,800 of CCA that could not be claimed is not lost. The UCC of the class is
only reduced by the actual CCA claimed. Therefore, the unclaimed amount of $1,800 remains in
the UCC of the class and will be considered in the calculation of maximum CCA allowable in
future years. The benefit of the unclaimed CCA is therefore not lost - it is merely deferred.
2.4
CAPITAL GAINS AND LOSSES
Capital property is property that provides a long-term or enduring benefit to its owners.
Corporations hold capital property (such as land, buildings, and intangibles) to generate
cash flows over many years. The disposition of capital property gives rise to capital
gains or capital losses.
2.4.1
Calculation of capital gain or loss for tax purposes
The capital gain or loss on the disposition of a capital property is calculated using the
following formula. Each of the terms of the formula is defined below.
Proceeds of disposition
$xxx
A
$xxx
B
Capital Gain or Loss
$xxx
C=A-B
Taxable Capital Gain
or Allowable Capital Loss (1/2)
$xxx
(1/2* C)
Less:
Adjusted Cost Base (ACB)
Expenses of disposition
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Capital Gains or Losses are treated significantly different than other sources of income in
terms of timing of revenue recognition, the amount subjected to tax and the utilization of
the losses incurred. Taxable capital gains are included in net income for tax purposes in
the year of disposition. Only one half of the gains are taxable (“taxable capital gain”),
and only one half losses are deductible (“allowable capital loss”). Allowable capital
losses are only deductible against taxable capital gains incurred in the year. Any unused
amount becomes a net capital loss carry over, and may be carried back 3 years or forward
indefinitely and only be applied against taxable capital gains in the relevant year(s).
 Proceeds of Disposition
Proceeds of disposition (“POD”) is the selling price received or receivable on the
disposition of property. In this regard, it does not matter whether the POD is received in
cash or is payable in the future. Where property is sold in exchange for other property,
the POD is equal to the fair market value of the property received in exchange.
As explained above, there must be a disposition for a capital gain (or loss) to materialize.
Property can be treated as having been disposed even though no proceeds of disposition
are actually received. For example, a disposition of property is deemed to have occurred
in the following circumstances: upon the death of an individual, when property is
changed from personal use to business use, or vice-versa, or when a person ceases to be
resident of Canada for tax purposes. In all these circumstances, the proceeds of
disposition are generally deemed to be the fair market value of the property at the time of
(deemed) disposition. Because deemed dispositions can result in the premature
recognition of taxes on capital gains, it is important to understand the situations when
they occur.
 Adjusted Cost Base (ACB)
The ACB is the tax cost of the capital property. This is generally the same as the original
purchase price (i.e., historical cost), however there are exceptions. The cost of property
acquired before 1972 (i.e., before capital gains were taxed) is adjusted to reflect the value
of the capital property on December 31, 1971. As well, certain non-deductible expenses,
such as interest and property tax on vacant land, are added to the cost of land.
Consequently, instead of incurring an operating loss on the land in the year, the cost of
the land is increased and the eventual gain on the disposal will be lower. Conversely, the
recipient of a subsidy and a governmental grant will be used to reduce the cost of the
asset, and subsequently create a greater capital gain on sale of the asset.
A taxpayer often holds a group of identical properties that have been acquired over a
period of time for different costs. The adjusted cost base of identical properties must be
averaged when calculating the capital gain or loss. Identical properties are capital
property with the same attributes
A superficial loss occurs when a taxpayer disposes of a property and triggers an
allowable capital loss and shortly thereafter re-acquires the same or similar property. If
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the re-acquisition occurs within 30 days of the sale, the loss is disallowed and added to
the capital cost of the asset re-acquired. In effect, the denied loss will be realized when
the re-acquired asset is eventually sold permanently. The intent of the rule is to prevent
taxpayers from claiming capital losses when, in substance, the property never leaves the
taxpayers hands.
 Expenses of Disposition
Due to the complexity in the transactions, owners tend to need assistance in the disposal
of capital property. All costs associated with the disposition are deductible in calculating
capital gains or losses. Such costs could include: legal fees, commission or brokerage
fees, advertising etc.
Example Problem:
In 20x9, Magma Corp. disposed of two investments. Stock A was sold for
$500,000 and cost $345,000. Stock B was purchased for $195,000 and was sold
for $150,000. The investments were held as capital property. Magma Corp. paid
$5,000 to a broker to dispose of each investment. Calculate the capital gain or
loss for 20x9.
Analysis:
Proceeds of disposition
Stock A
Stock B
A
$500,000
$150,000
B
$345,000
5,000
(350,000)
$195,000
5,000
(200,000)
A-B
$150,000
($50,000)
$75,000
($25,000)
Cost
Expenses of disposition
Capital Gain (Capital Loss)
Taxable Capital Gain (1/2)
(Allowable Capital Loss)
The net taxable capital gain for 20x9 is $50,000 ($75,000 - $25,000). If Magma
Corp’s marginal tax rate is 40%, then the capital gain will attract $20,000 in taxes.
Therefore, the effective tax rate on the capital gain is 20% (i.e., 1/2 * 40%, or
$20,000 taxes / $100,000 economic gain).
Capital losses are only deductible against capital gains. If Magma Corp. did not
sell stock A, then the allowable capital loss in stock B could not be used in 20x9.
Instead, the allowable capital loss could only be carried back 3 years or forward
indefinitely and claimed against taxable capital gains.
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2.4.2
Depreciable Versus Non-depreciable Capital Property
In section 2.2, the CCA system for write off of depreciable property was introduced.
Examples of depreciable capital property are buildings, equipment, leasehold
improvements, etc. used by the taxpayer for the purpose of earning income from a
business or property. Land is not considered depreciable capital property.
Because these assets are depreciated under the CCA system, it is not possible to generate
a capital loss on sale of these assets. Instead, the cost of the property is recovered over
time through CCA deductions or terminal losses.
Capital gains arise on the disposition of depreciable property if the proceeds on sale
exceed the original cost of the property.
Either capital gains or capital losses may arise on the disposition of non-depreciable
capital property. Examples of non-depreciable capital property are land and
investments in shares, or bonds.
2.4.3
Capital Gain or Loss versus Business Income or Loss
As discussed in section 2.1, it is important to distinguish capital gains or losses from
business income or losses. One-half of capital gains are taxed only when realized.
Business income is fully taxed when earned. Because the ITA does not provide specific
guidelines, establishing whether a transaction is a capital one is complex. This area is the
most highly litigated area of taxation.
The key to distinguishing capital gains versus business income treatment is the intended
purpose of acquiring the property. If the property was acquired for the purpose of
providing the owner a long-term benefit, then it is classified as capital property.
Conversely, if the property was acquired for the purpose of resale at a profit, similar to
inventory, then the disposition results in business income. As previously stated, the
nature of the asset disposed of is irrelevant to the classification of the income source;
disposition of the same assets could result in different classification of income, depending
on the intended purpose of the acquisition.
As original intent cannot be documented, four other relevant factors used by the courts to
distinguish capital from income are outlined below. All of the factors need to be
considered together to provide compelling evidence to support one or the other.
1. the relationship of the transaction to the taxpayer's business: if the property is
similar to those purchased and sold in the normal course of business, then the
transaction is likely business income.
2. the nature of the property: if the property was used to generate income, then its
disposition is likely one of a capital nature. The entity’s course of conduct with
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the property over the time of ownership, starting with the point of purchase, use
over the ownership, and the reason and nature of its disposal will all be factored
in.
3. number and frequency of transactions: if the taxpayer has entered into many
similar transactions in the past then the disposition of property may be of a
business income nature. For example, a taxpayer who builds a house, lives in it
for a short period of time, sells the property and then repeats the cycle is likely to
have the income on sale of the houses treated as business income and not as
capital gain;
4. period of ownership: was the property held for a long period? If so, it is an
indicator of a capital transaction.
All of the above factors would be considered in determining whether a particular
transaction is business income or capital gain.
Canadian market securities usually serve the dual purpose of generating annual returns
and to realize a profit upon resale. The ITA has created a provision which allows for all
sales of Canadian securities to be treated as capital transactions, if the taxpayer elects to
do so.
2.4.4
Special Rules
 Allowable Business Investment Loss (ABIL)
Normally, an allowable capital loss can only be deducted against a taxable capital gain.
However, a special type of allowable capital loss called an Allowable Business
Investment Loss (ABIL) may be deducted against any type of income sources.
Therefore, ABILs can offset business income or employment income earned in a
particular year. An ABIL is equal to 50% of the business investment loss arising on the
disposition of shares or debt of a Canadian-Controlled Private Corporation (“CCPC”)
carrying on an active business primarily in Canada. The intent of the rule is to encourage
investment in small businesses in Canada by offering a more attractive deduction if the
investment fails. If an ABIL cannot be deducted in the year it is incurred (i.e., because of
insufficient other sources of income), then it is added to the taxpayers non-capital loss
pool, and may be carried forward 10 years and back 3 years against any type of income.
If unused after the tenth year, it becomes a net-capital loss that can be carried forward
indefinitely against taxable capital gains.
 Capital Gains Reserve
A taxpayer that does not receive the full proceeds of disposition in cash at the time of sale
is entitled to claim a reserve against a capital gain on disposition. The gain is gradually
brought into taxable income as the proceeds are received in cash. The intent of the rule is
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to match the taxation of the capital gain with the cash received, and not immediately upon
sale. As the proceeds of disposition may be relatively large at times, such a provision is
not uncommon. Were it not for the reserve, a taxpayer who does not immediately receive
all the proceeds of disposition would have to finance the tax on the capital gain with
his/her own funds. The capital gain reserve is optional for each property sold; that is a
taxpayer can choose to have the capital gain fully included in income instead of over
time. For example, a taxpayer may not wish to claim a capital reserve if it had losses
available to offset the capital gain in the year of disposition.
The Act restricts the deferred recognition of capital gains to a maximum of five years. A
minimum of 20% of the capital gain must be recognized in each of the five years.
Example Problem:
In 2006, SeaTech sold excess land that it owned for $1,000,000. SeaTech
purchased the land 15 years ago for $380,000. Expenses of disposition amounted
to $20,000. Because the purchaser of the land, ApexCorp, does not have the cash
to pay the full $1M sale price, it offers to pay the sale price in equal payments
over 10 years. Determine the amount and timing of the taxable capital gain to
SeaTech assuming the offer is accepted.
Analysis:
If SeaTech held the land as capital property, then the disposition will result in a
capital gain of $600,000 in 2006. One-half of this amount, or $300,000, is taxable
to SeaTech; the issue is the timing of the taxation of the capital gain.
Since the full proceeds of disposition are not received in full in 2006, SeaTech
can elect to claim a reserve against the capital gain. However, the deferral is
restricted to a maximum of 5 years, with a minimum of 20% of the taxable capital
gain required to be included in income each year.
Calculation of capital gain
Proceeds of disposition
Cost
Expenses of disposition
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$380,000
20,000
$400,000
$1,000,000
A
($400,000)
B
Capital Gain
$600,000
Taxable Capital Gain
(1/2)
$300,000
A–B
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Taxation of capital gain
2006
Total Taxable capital gain
$300,000
Reserve – lesser of A or B
A) Deferred proceeds $900,000 X $300,000
Total proceeds
$1,000,000xxxxxxxxxx
= $270,000
B) Maximum reserve 80% of $300,000
= $240,000
Taxable Capital Gain for 2006
$60,000
Comment:
At least 20% of the capital gain must be recognized each year for a maximum of 5
years. In other words, the maximum reserve that can be claimed in the first year
is 80% of the capital gain, 60% in year 2, and so on.
The taxable capital gain that must be recognized in each of the years 2007 through
2010 is also $60,000, as calculated above. If SeaTech’s effective tax rate were
40%, then the capital gain will attract $24,000 of taxes each year from 2007 to
2010 inclusive. The proceeds would continue to be received at $100,000 per year
through 2015.
In practice, the vendor would charge interest on a promissory note taken back as
proceeds of disposition. The interest earned would be taxable as investment
income.
 Tax Planning for Capital Gains and Losses
As the realization of capital gains or losses is largely at the discretion of the taxpayer,
there is some opportunity for effective tax planning with dispositions of capital property.
A taxpayer who wishes to "trigger" a capital gain or loss (i.e. by selling an investment) in
a particular year can normally do so by deferring the disposition until that year. Tax can
be saved if an individual defers the recognition of a capital gain until he or she is in a
lower tax bracket for a particular year. In addition, taxpayers can create accrued capital
losses to offset capital gains and therefore shelter the gains from tax.
Achieving a return via a capital gain delays tax until the property is sold, and even then
only one-half of the gain is taxable. This compares with interest-bearing investments that
offer annual returns, but also attract tax earlier than investments earning a return from
capital gain. Any evaluation of investments must be done on an after-tax basis, and with
due regard to the timing of the cash flows.
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2.5
COMPUTATION OF TAXABLE INCOME
After computing Net Income for Tax Purposes, a taxpayer may deduct items to arrive at
Taxable Income. Taxpayers compute their tax liability using taxable income as the base.
Taxable income = Net Income for Tax Purposes less Division C Deductions
Division C Deductions for
Corporations
Net-capital loss carryovers
Non-capital loss carryovers
Donations to charities
Dividends from Canadian
corporations
2.5.1 Loss Carryovers
The most common deduction in determining Taxable Income is losses carried over. A
taxpayer’s losses are classified as either non-capital losses or net capital losses. A noncapital loss arises when the calculation of Net Income is negative. This type of loss is
usually a loss from employment, business, property or an ABIL (within certain
limitations). Non-capital losses may be carried back 3 years and forward 20 years against
all types of income.
As outlined in Section 2.4, a net capital loss is equal to 50% of a capital loss that arises
on the disposition of a non-depreciable capital property. Net capital losses may be
carried back 3 years and forward indefinitely against taxable capital gains. The carryback and carry-forward rules for these losses are summarized as follows:
Type of loss
Non-capital loss
Net-capital loss
Carry-back period
Carry-forward period
3 years
3 years
20 years
Indefinitely
Where taxes are paid in one year, and losses incurred in another, a taxpayer can recover
taxes by applying the carry-forward or carry-back rules (subject to the time limits). This
strategy can be a significant source of cash flow to an enterprise, particularly where a
high amount of tax is paid in a year. For this reason, loss utilization is an important tax
planning area. A management accountant must be aware of the time limits for applying
losses, and take steps to preserve losses that risk expiring. These steps include creating
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income by forgoing discretionary deductions (such as CCA), selling assets with accrued
gains, or reorganizing a group of related companies so that income-producing entities are
offset by entities that have accumulated tax losses.
It should be noted that losses that are incurred in a given year must be used to the full
extent they can be in the year incurred. Only the unused losses can be carried over to be
used in other years at the taxpayer’s discretion.
Further, on the change in control of a corporation, significant restrictions are placed on
the use of loss carry-forwards to prevent tax loss trading. The restrictions are
summarized as follows:
•
•
•
•
•
Deemed taxation year end immediately prior to change in control
Realization of accrued losses on most property with fair market value less
than tax cost
Expiration of net capital losses, unused charitable contributions and
ABIL’s
Restriction on use of non-capital loss carry overs to income generated
from a same or similar business carried on with a reasonable expectation
of profit.
Available election of deemed dispositions for most property with fair
market value greater than tax cost.
2.5.2 Charitable donations
Donations to charities are usually not considered a deductible expense because they are
not incurred for the purpose of earning income. However, a deduction is permitted in
computing Taxable Income for donations made to registered charities. Tax treatment for
corporations and individuals differ. For corporations, the deduction is made in arriving at
Taxable Income, and is limited to 75% of Net Income, whereas individuals are entitled to
a tax credit. Undeducted charitable donations may be carried forward five years.
2.5.3 Dividends
Corporations may deduct dividends received from taxable Canadian corporations,
Canadian resident, affiliate corporations and non-resident corporations (excluding foreign
affiliates) that carried on business in Canada continuously since June 18, 1971. This
deduction is intended to eliminate double-taxation in multi-level corporate structures.
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3.
COMPUTATION OF TAXES PAYABLE
A corporation is a separate legal entity that is owned, directly or indirectly, by
individuals. As defined in the ITA, a taxpayer includes a corporation. Therefore,
corporations must compute first Net Income and then Taxable Income in order to
determine their liability for tax. The formula introduced in section 2 is used for this
purpose, with the exception that corporations do not earn employment income. In
general, the same rules for computing Net Income apply to both corporations and
individuals.
There are three types of corporations for income tax purposes: public corporations,
private corporations and Canadian-controlled private corporations (“CCPC”). A
public corporation is a company resident in Canada whose shares are traded on a
designated Canadian stock exchange. A private corporation is a company resident in
Canada which is not a public corporation and is not controlled by a public corporation. A
CCPC is a private corporation that is not controlled by non-residents, public corporations,
or any combination of the two. Furthermore, CCPC’s must be considered a Canadian
resident for tax purposes. Each type of corporation has special rules for the computation
of tax payable, with the rules favoring CCPCs.
The basic scheme for calculating Federal taxes payable of a corporation is as follows:
Less:
Less:
Less:
Add:
Federal Tax ( Taxable income x Basic
Federal tax rate)
Federal tax abatement
Net Federal Tax
Small Business Deduction
Manufacturing & Processing Deduction
General Rate Reduction
Subtotal
Other Federal tax credits
Federal Tax Payable
Provincial tax (Taxable income x Provincial
tax rate)
Total Tax Payable
xxx
(xxx)
XXX
xxx
xxx
xxx
(xxx)
XXX
xxx
XXX
xxx
XXX
Taxable income, which is the base for determining the tax liability, was discussed above.
Each of the other components of the above scheme is examined below.
3.1 Basic Federal Tax Rate and Federal Abatement
The ITA imposes a basic federal tax rate of 38%. This rate is applied to taxable income
and is the starting point in the computation of tax payable for corporations resident in
Canada. The Federal tax abatement is 10% of taxable income. The abatement is a
deduction in computing Part I tax and is intended to compensate for the imposition of
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Provincial income taxes. It is available on income that is taxed in a province. Any
income that is not taxed in a province or is earned outside of Canada is not eligible for the
abatement. Therefore, the basic rate of federal tax is actually 28% for all corporations.
3.2
Small Business Deduction
The Small Business Deduction (SBD) is a deduction against federal tax and is available
only to small Canadian controlled private corporations (CCPC). Recall that a CCPC is a
private corporation that is not controlled by non-residents, public corporations, or any
combination of the two. The SBD is equal to 17% of the first $500,000 of active
business income earned in Canada of a CCPC (must be a CCPC throughout the taxation
year). Note that the amount eligible for the SBD cannot exceed taxable income. Active
business income is business income other than specified investment business or personal
service business and includes an adventure in the nature of trade.
The combined tax rate applicable to taxable income eligible for the Small Business
Deduction is 16.00%, calculated as follows:
Federal tax rate
Less: Federal tax abatement
Net Federal tax
Less: Small Business Deduction
Federal Part I tax
Provincial tax on income eligible for SDB
Add:
(assumed average)
TOTAL TAX PAYABLE
38.00%
(10.00)
28.00%
(17.00)
11.00%
5.00%
16.00%
In essence, the first $500,000 of active business income earned by a CCPC is subject to
an effective tax rate of 16.00%.
 Specified investment business (SIB)
Active business income excludes income from a specified investment business (SIB). A
SIB is a business whose principal purpose is to earn property income unless it employs
more than 5 full time employees through the year. The intent of excluding SIB income
from eligibility from the small business deduction is to prevent a taxpayer from setting up
a corporation to earn investment income (otherwise taxed as property income) and benefit
from the reduced tax rate applied to business income.
 Personal services business (PSB)
A personal services business (PSB) is a business of providing services where the
individual who provides the services owns 10% or more of the corporation and would
reasonably be regarded as an employee of the entity to which the services are provided,
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Corporate Taxation and Financial Accounting – Module 2
unless the corporation employs more than 5 full time employees through the year. The
intent of excluding PSB income from eligibility from the small business deduction is to
prevent a taxpayer from setting up a corporation to earn what would otherwise be taxed
as employment income.
 Associated Corporations
Special rules in the ITA ensure that corporations that are part of an associated group do
not claim multiple Small Business Deductions. A group of associated corporations must
share the $500,000 limit for claiming the SBD. This rule makes sense because otherwise
it would be possible for taxpayers to benefit from the low 16.00% tax rate by simply
creating a new corporation every time income exceeds $500,000.
Basically, two corporations are associated if one of the following conditions is met:
• one of the corporations controls the other,
• the same person or group of persons controls both corporations,
• each of the corporations are controlled by a person, the persons are related and
there is minimum of 25% cross ownership
• one of the corporations was controlled by a person, and that person is related to
each member of a group of persons controlling the other corporation, and that
person has a minimum 25% cross ownership
• each of the corporations was controlled by a related group and each of the
members of one related group was related to each of the members of the other
related group, and there is a minimum of 25% cross ownership by one or more
members of each group.
• the corporations are not associated but share a common associated corporation.
For purposes of cross ownership, shares of a specified class are excluded. In general
these are preferred shares or other non-voting shares.
 Calculation
The SBD is 17% of the least of:
a. Net Canadian active business income
b. Taxable income less 10/3 x Foreign non-business tax credit less 3 x Foreign business
tax credit
c. Business limit
 Large CCPCs
The SBD was intended to provide a tax incentive to small business. As such, the SBD is
subject to a phase out when the Taxable Capital (debt and equity capital) reaches $10
million. At a Taxable Capital of $15 million, the SBD limit will be reduced to nil.
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Corporate Taxation and Financial Accounting – Module 2
3.3 Manufacturing & Processing Deduction
This deduction from tax is an incentive to all Canadian corporations engaged in
manufacturing and processing (M&P) activities in Canada. Profits that result from M&P
activities are subject to a tax reduction of 11.5% in 2011 and 13.0% in 2012.
Currently this deduction is calculated at the same 11.5% as for the General Rate
Reduction (see 3.4 below). Therefore there is no difference in the net federal tax rate
applied to M&P profits versus other types of profits.
The deduction is available on all Canadian M&P profits. For CCPC’s which have
claimed the small business deduction, the M&P deduction is available only on taxable
Canadian manufacturing and processing income in excess of the amount claimed for
purposes of the small business deduction. Further, as with the SBD, the M&P deduction
amount cannot exceed taxable income. The effect of the M&P deduction is to reduce the
effective total tax rate to approximately 27.5%.
Less:
Less:
Add:
Federal tax rate
Federal tax abatement
Net Federal tax
M & P Deduction
Federal Part I tax
Provincial tax for M&P income (assumed
average)
TOTAL TAX PAYABLE
38.00%
(10.00)
28.00%
(11.50)
16.50%
11.00%
27.50%
A formula is used to determine Canadian manufacturing and processing profits subject to
the low rate of tax:
Manufacturing Profits
=
Total Business
Profits
X
(MC + ML)
(C + L)
where
MC
C
ML
L
=
=
=
=
cost of manufacturing and processing capital
total cost of capital
cost of manufacturing labor
total cost of labour
Based on the formula, the higher the concentration of manufacturing labour and capital in
a business, the greater the entitlement to the M&P tax credit. Due to this arbitrary
formula, there is a slight opportunity for tax planning in designing an organizational
structure that will maximize this potential deduction. Taxpayers can opt to set up the
M&P division as a separate entity or as part of core organization to maximize the amount
of profit to which this deduction is applicable.
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Corporate Taxation and Financial Accounting – Module 2
 Calculation
The M&P deduction is 11.5% of the lessor of:
a.
b.
M&P processing profits (as calculated above) less income eligible for the small
business deduction
Taxable income less income eligible for the small business deduction less 3 times
the foreign business tax credit less aggregate investment income for a CCPC,
where Aggregate Investment Income (“AII”) includes taxable capital gains,
interest, rents, royalties less net capital losses (AII excludes dividends that are
deductible in calculating taxable income)
3.4 General Rate Reduction
The general rate reduction (GRR) is an 11.5% (13.0% in 2012) deduction against federal
tax. The general rate reduction is applied to “full rate taxable income”. Therefore, the
general rate reduction is only available on income that does not benefit from either the
small business deduction or manufacturing and processing profits deduction discussed
above. The general rate reduction is also not available on any income benefiting from
refundable taxes (see 4.2 below).
Therefore, the effective total tax rate on full-rate taxable income is similar to that
determined for M&P profits.
3.5
Other Federal Tax Credits
3.5.1
Foreign Tax Credit
The Foreign Tax Credit is a credit against taxes payable for tax paid on income to
countries other than Canada. As Canada includes worldwide income to determine taxes
payable, any foreign tax paid on the same income in other countries becomes a credit
against Canadian taxes payable. Note that the foreign tax credit cannot exceed the
equivalent Canadian tax payable on the foreign income.
3.5.2
Investment Tax Credits (ITC)
The ITC is a tax incentive to businesses and is aimed at stimulating new investment in
Canada in scientific research, manufacturing and processing, transportation, and natural
resources development (e.g. mining, farming, fishing). ITC’s are available at both the
federal and provincial level.
Currently a 10% ITC is available for investment in qualified property (building, grain
elevator or machinery and equipment) in the Atlantic Provinces only.
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Corporate Taxation and Financial Accounting – Module 2
ITC’s available in all of Canada are:
•
•
•
a 20% ITC for scientific research and experimental development (SR&ED)
expenditures, and
a 10% ITC for apprenticeship expenditures (maximum $2,000 credit per eligible
apprentice)
a 25% ITC for child care spaces (maximum $10,000 credit per eligible space).
The investment tax credit can be applied against taxes payable, thus reducing cash taxes.
In addition, where a corporation is a CCPC throughout the taxation year, an additional
ITC of 15% is available on SR&ED expenditures subject to certain expenditure and
income level restrictions. The SR&ED ITCs for CCPC’s may also be refundable.
Refundable ITCs are desirable where a corporation has losses for tax purposes and thus
cannot apply the ITCs against tax payable. The cash received from the refundable ITCs
is an additional source of financing for operating expenditures.
Any unutilized ITC’s which were not eligible for refund may be carried back 3 years and
forward 20 years against tax otherwise payable.
Any ITC received for capital expenditures must reduce the cost base of the asset available
for CCA. Any ITC received for current expenditures must reduce the amount of the
deductible expenditure.
3.5.3
Political Contributions Tax Credit
The Federal Accountability Act, which became effective on January 1, 2007, included a
ban on contributions from corporations to federal political parties and candidates.
Corporations can still make provincial, political contributions and receive a provincial tax
credit.
Comprehensive Example
ABC Corporation is a CCPC, and is in the business of manufacturing children's toys. Mr.
and Mrs. ABC are the shareholders and actively manage the business. Over the course of
the fiscal year, the following transactions occurred.
1)
During the fiscal period, there was active business income of $300,000. All of the
profits are attributed to the M&P operations of the business.
2)
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ABC corporation also owns a building on the other side of town, which they rent
out. Net rent for prior periods were normally much higher, however, this year due
to the deteriorating condition of the building, much more was invested in
maintenance and repairs. Net rental income before CCA was $23,500. The
maximum CCA available for this building for deduction is $60,000.
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Corporate Taxation and Financial Accounting – Module 2
3)
During the course of the year, ABC made a donation of $10,000 to the children's
hospital.
4)
Depreciation expense of $34,000 was deducted.
5)
In June, ABC disposed of a piece of equipment from Class 12. The net book
value of this asset was $25,000; the asset was sold for proceeds of $15,000. There
are four other assets remaining in this asset class.
6)
During the course of the year, ABC received dividends from non-connected,
Canadian Corporations of $32,000.
7)
In August, ABC disposed of a piece of land that they have owned since
incorporation. The original cost of the land was $12,000 and it sold for $150,000,
and had associated selling costs of $7,500.
8)
Losses Carried Over: (Expiration in Brackets)
Net Capital Losses (N/A)
Non-Capital Losses (1)
ABIL (2)
100,000
30,000
1,500
9)
ABC reported Meal and Entertainment expense of $35,000 for the year. ABC
paid Mr. ABC’s annual golf club membership dues of $15,000.
10)
The company has a maximum of $55,000 CCA available for deduction (excluding
the CCA for the building)
11)
ABC reported Income for Accounting Purposes of $256,000. The provincial tax
rate on income eligible for small business deduction is 5%.
Required:
Calculate the net income, taxable income, and the taxes payable (excluding refundable
taxes and before tax credits) for ABC corporation’s fiscal year.
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Corporate Taxation and Financial Accounting – Module 2
Solution
Accounting Income
Add Back:
$256,000
Depreciation
Capital Gain 1
Meals and entertainment (50%)
Accounting Loss on disposal of assets (25,000 –
15,000)
Charitable donations
Club dues
$34,000
65,250
17,500
10,000
Accounting Gain on disposal of land
CCA – Rental Building (limited to net income)
CCA
Net Income for Tax Purposes
Charitable donations
Dividends
Net Capital loss carry over (limited to the taxable capital gain)
Non-Capital loss carry over
ABIL
Taxable Income
130,500
23,500
55,000
Deduct:
10,000
15,000
151,750
-209,000
198,750
-10,000
-32,000
-65,250
-30,000
-1,500
$60,000
Taxes Payable
Federal Tax (38%)
Federal abatement (10%)
Net federal tax
Small business deduction ($60,000 x 17%)
Provincial sales tax (5% of taxable income)
Total taxes payable
1
Proceeds
Selling costs
Adjusted cost base
Capital gain
Taxable capital gain (50%)
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$22,800
-6,000
16,800
-10,200
3,000
$9,600
$150,000
-7,500
-12,000
$130,500
$65,250
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Corporate Taxation and Financial Accounting – Module 2
4. INTEGRATION & REFUNDABLE TAXES
A corporation is a separate legal entity taxed separately from its shareholders.
Double taxation could result when the income earned by the corporation is taxed once at
the corporate level and then a second time at the shareholder level.
The Act contains a set of tools to achieve integration of the corporate and personal
taxation to minimize the incidence of double taxation. The primary tool is the dividend
gross up and tax credit procedure introduced below. Further tools for integration are
introduced under the heading of refundable taxes.
In theory the dividend gross up and tax credit procedure operates as follows:
When a corporation pays dividends from after-tax income to an individual shareholder,
the shareholder includes a grossed-up amount in income. The addition of the gross up is
intended to place the shareholder in the same pre-tax position as the corporation.
The shareholder calculates tax at their marginal rate and reduces the tax payable by a
dividend tax credit. The dividend tax credit is theoretically equal to the tax paid by the
corporation on the income.
4.1
Tax Treatment of Dividend Received by Individuals
4.1.1
Tax Treatment of Dividend Received by Individuals – Non-eligible dividends
For dividends received from the active business income of CCPC’s that was subject to a
reduced rate of tax or from the investment income of a CCPC which was eligible for
refundable taxes (“non-eligible dividends”), the gross up is 125% of the dividend
received. Although 125% of the dividend is included in income, a Federal dividend tax
credit against tax payable equal to 13 1/3% of the grossed-up dividend is available to
individuals. The gross-up and dividend tax credit are parts of an overall scheme to
reduce the impact of double taxation. This scheme is known as “integration”. Because
dividends represent the distribution of after-tax profits, they are taxed twice: once to the
corporation and then again to the individual when the dividends are received.
Integration (theoretical model) of Individual and Corporate Taxes
Non-Eligible
Dividends
CORPORATION:
Income
Less: Tax (20%)
Net earnings available for dividends
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$1,000
(200)
$800
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Corporate Taxation and Financial Accounting – Module 2
INDIVIDUAL SHAREHOLDER:
Dividend from corporation (from above)
Taxable dividend (125% x $800 actual dividend)
Tax to individual (45%)
Less: dividend tax credit ($200 corporate tax)
$800
$1,000
$450
(200)
(theoretically $1,000 x 13.33% = $133 + 6 2/3%
for provincial tax)
Net tax to individual
TOTAL TAX ON $1,000 CORPORATE INCOME
Paid by corporation
Paid by individual
$250
$200
$250
$450
Perfect integration arises when the corporate tax rate is 20%. However the corporate rate
of 20% is only realizable when the corporation is eligible for certain tax rate reductions
i.e., small business deduction. Therefore, an element of double taxation may exist for
dividends received from corporations, as the tax credit provided is insufficient to offset
the taxes paid at the corporate level. In order to alleviate an element of this doubletaxation, the 2006 budget introduced the concept of “eligible dividends”
4.1.2
Tax Treatment of Dividend Received by Individuals – Eligible dividends
For dividends received from the income of a Canadian public corporation or a CCPC
(other than investment income) which was not subject to a reduced tax rate, the gross up
is 145% of the dividend received. Although 145% of the dividend is included in income,
a dividend tax credit against tax payable equal to approximately 19% of the grossed-up
dividend is available to individuals.
Integration (theoretical model) of Individual and Corporate Taxes
Eligible
Dividends
CORPORATION:
Income
Less: Tax (31%)
Net earnings available for dividends
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$1,000
(310)
$690
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Corporate Taxation and Financial Accounting – Module 2
INDIVIDUAL SHAREHOLDER:
Dividend from corporation (from above)
Taxable dividend (theoretically 145% x $690 actual
dividend)
Tax to individual (45%)
Less: dividend tax credit ($310 corporate tax)
$690
$1,000
$450
(310)
(theoretically $1,000 x 19% = $190 + 12% for
provincial tax)
Net tax to individual
TOTAL TAX ON $1,000 CORPORATE INCOME
Paid by corporation
Paid by individual
$140
$310
$140
$450
4.2 Refundable Taxes
As discussed above, the Income Tax Act attempts to integrate the taxation of corporations
and individuals. In general, the overriding goals of integration are:
Reduce the incidence of double taxation through the dividend gross-up and tax credit
procedure. The procedure is intended to make an individual indifferent
between earning business income directly versus through a corporation.
Reduce the corporate tax rate on investment income earned by a CCPC which is
distributed to shareholders – Refundable Part I tax.
Reduce the tax savings/deferral afforded by using a corporation to earn property
income – Refundable Part I tax.
Reduce the use of multiple corporations to defer tax on intercorporate dividends –
Part IV tax.
In order to achieve these goals, the Act imposes a system of special taxes and refundable
taxes, namely the Refundable Part I tax and Part IV tax. This process of paying a special
tax and then subsequently refunding them if certain conditions are met effectively
prevents individuals from deferring taxes on passive income earned in a corporation.
Were it not for the rules, an individual could simply transfer investments into a
corporation (which is usually taxed at a lower rate than for individuals) and defer
personal tax until such time the individual withdraws the money from the corporation. It
prevents individuals from having access to tax-free money for re-investment. In effect,
the special refundable taxes render an individual indifferent to earning passive income in
a corporation or earning it personally.
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Corporate Taxation and Financial Accounting – Module 2
4.2.1 Refundable Part I Tax on Investment Income
The Refundable Part I Tax on Investment income is comprised of 2 components:
•
•
20% of the tax paid by a CCPC on investment income, and
6 2/3% Additional Refundable Tax (ART) paid by a CCPC on investment income
Recall that the small business deduction reduces the tax rate on active business income
earned by a CCPC to a theoretical rate of 20%. Investment income (property, rents, net
capital gains) earned by a CCPC is not eligible for the small business deduction, nor the
general rate reduction. Accordingly, investment income earned by a CCPC will bear a
significantly higher tax rate, theoretically 40%. To eliminate this bias, 20% of the tax
paid by a CCPC on investment income is eligible for refund on payment of dividends to
shareholders (see RDTOH below).
Further, investment income earned by a CCPC is also subject to a special refundable tax
of 6-2/3 %. This tax is called “Additional Refundable Part I Tax” (ART), with Part I
referring to the section in the ITA that contains the provisions. The special tax is on top
of the usual tax applicable to income earned by a CCPC. If a CCPC is in a province with
a 14.5% tax rate, then the combined corporate tax on the investment income is almost
50%, as follows:
Less:
Add:
Add:
Federal tax rate
Federal tax abatement
Net Federal tax
Refundable Part 1 Tax
Federal Part I tax
Provincial tax (assumed)
INITIAL TAX PAYABLE
38.00%
(10.00)
28.00%
6.67%
34.67%
14.50%
49.17%
At close to 50% taxation rate, there is little incentive to incorporating investment income
as the highest personal marginal tax rate would be lower if the investment income was
earned directly. The 6-2/3% special tax is eligible for refund when the CCPC eventually
pays dividends to its shareholders (see discussion of RDTOH below).
The dividend is then taxed in the shareholders’ hands under the normal rules. The
refund rate is $1 for every $3 dollars of dividends paid. The objective is to make it
unattractive to shelter investment income within a corporate structure in order to defer the
second level of taxation to the amounts earned. After the refundable taxes, the effective
tax on investment income in the corporation is 22.50% (i.e., 49.17% calculated above less
26.67% total refunded taxes). Double taxation is reduced but not eliminated.
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The additional refundable tax is calculated as 6 2/3% of the lessor of:
a. Aggregate Investment Income
b. Taxable income less income eligible for the small business deduction
4.2.2 Refundable Part IV Tax on Dividends Received
Part IV tax is assessed on certain dividends received by a private corporation (not just
CCPC’s) from certain other corporations. Part IV tax is payable on “portfolio”
dividends, which are basically dividends from other companies in which the shareholder
holds only a minor interest (i.e., non-connected as defined by less than 10% ownership).
Upon receipt of a dividend from a non-connected company, the corporation pays the Part
IV tax of 33.3%, leaving 66.7% for reinvestment. The tax is 33 1/3% of dividends
received, and is also refunded at a rate of 1:3 when dividends are passed on to
shareholders of the recipient corporation. Since dividends are normally tax-free when
received by corporations, the effect of the Part IV tax is to prevent taxpayers from
deferring tax indefinitely on passive income.
Refundable Part IV tax also applies to dividends received from “connected” corporations,
where the corporation paying the dividend itself receives a dividend refund. This halts
any attempt to set up a series of related corporations in an attempt to defer the incidence
of the special refundable taxes. A “connected” corporation is basically one in which a
shareholder corporation owns 10% or more of the voting shares of another corporation.
4.2.3 Refundable Dividend Tax on Hand (RDTOH)
Private corporations use an account, called the RDTOH, to track the Refundable Part I
and Part IV refundable taxes that are paid and refunded over time. RDTOH is calculated
as follows:
Opening balance (previous year’s RDTOH)
Add:
Less
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$ XXX
Refundable Part I Tax paid (26-2/3% of investment
income)
XXX
Refundable Part IV Tax paid (33-1/3% of portfolio
dividends, plus share of dividend refund received by
the connected corp. paying the dividend)
XXX
Dividend refund of preceding year
(XXX)
RDTOH
$ XXX
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Corporate Taxation and Financial Accounting – Module 2
Although the special taxes discussed above are refundable, they are significant because of
the impact on the timing of cash flows. Management must understand the rules and be
cognizant of the impact of the special taxes on cash flow and on the rate of return realized
on different investments. The RDTOH balance is particularly important to management
as it represents a future source of cash flow. The amount of the RDTOH balance would,
for example, be relevant in valuing a company that is about to be sold.
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Corporate Taxation and Financial Accounting – Module 2
5.
PROBLEMS WITH SOLUTIONS
Dates & Tax Rates: For all Problems with Solutions, use the current effective tax rates
found in Section 6 of the Taxation Notes. Dates are expressed as 20XX, where 20x1
represents year 1, 20x2 represents year 2 and so on.
Multiple Choice Questions
1.
Peter, an Australian Citizen, typically spends the months of Sep-Mar in Canada
where he earns a living as an Alpine Ski Coach. He then spends the months of
April-July working as a coach in New Zealand and spends the month of August
resting on the beaches of Bali. Peter would be normally considered a
for
Canadian tax purposes.
a) Full-time resident
b) Part-time resident
c) Non-resident
d) Deemed resident
e) Australian resident
2.
The Austin Corporation has the following opening UCC balances at the beginning
of its fiscal 20x1 year:
Class 1 – 4%
Class 8 – 20%
$175,000
120,000
During the year, the following transactions occurred:
Class 8 Additions
Proceeds on disposal on capital asset
originally costing $78,000.
$50,000
30,000
What is the maximum amount of CCA that can be claimed for the year 20x1?
a) $31,000
b) $33,000
c) $35,000
d) $37,000
e) $41,000
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Corporate Taxation and Financial Accounting – Module 2
3.
The Bent Corporation has a December 31 year end. They moved into leased
premises on March 1, 20x1 and incurred $30,000 in leasehold improvements. In
June 20x2, they incurred another $20,000. The lease term is 5 years with two
renewal options of 3 years. How much CCA can be taken on these leasehold
improvements for the year ended December 31, 20x2?
a) $5,000
b) $5,179
c) $6,250
d) $6,607
e) $6,709
4.
The Davis Company purchased the assets of another corporation at the beginning of
20x1 and in so doing acquired goodwill in the amount of $500,000. The Davis
Company estimates that the useful life of the goodwill is 20 years. How much
eligible capital amount can be taken in 20x1 on this purchase?
a) $12,500
b) $13,125
c) $25,000
d) $26,250
e) $35,000
5.
The Choueiry Corporation sold land for proceeds of $420,000 in 20x1 generating a
taxable capital gain of $200,000. The proceeds are due from the buyer of the
property as follows:
20x1
20x2
20x3
20x4
20x5
20x6
$20,000
40,000
200,000
60,000
60,000
40,000
How much of the taxable capital gain will be taken into income in 20x3?
a) $38,810
b) $40,000
c) $43,810
d) $76,190
e) $95,239
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Corporate Taxation and Financial Accounting – Module 2
6.
Samco Inc. owns an apartment building and incurred the following revenues and
expenditures for the year ended December 31, 20x2:
Revenues
Expenditures Mortgage interest
Property taxes
Maintenance
Utilities
Purchase of new appliances (Class 8)
UCC Balances, Jan 1, 20x1 Class 1 – 4%
Class 8 – 20%
$206,000
75,000
12,000
35,000
45,000
20,000
$350,000
120,000
How much CCA will Samco claim for the year 20x2 assuming the income is
property income?
a) $19,000
b) $38,000
c) $39,000
d) $40,000
e) $42,000
7.
Which one of the following statements is true with respect to the reporting by an
individual of dividends received from a taxable corporation resident in Canada?
a)
b)
c)
d)
e)
Page 60
The amount received is grossed up and then the individual may claim a tax
credit.
An individual who receives dividends need not report them for personal tax
purposes because the corporation has already paid tax.
The individual includes the amount received in the computation of income
from a business because the amount was expensed by the corporation in
calculating its business profits.
The amount received is grossed up and, as a result, the individual bears the
burden of double taxation on corporate profits.
The amount received is grossed up and included as income from property in
the computation of net income for tax purposes, but then the entire grossed-up
amount is taken as a deduction in the computation of taxable income.
© CMA Ontario, 2011
Corporate Taxation and Financial Accounting – Module 2
8.
A profitable company buys a depreciable class 8 asset (i.e. 20% CCA rate) for
$500,000 at the beginning of Year 1. The company uses straight-line amortization
for capital assets for accounting purposes. This asset has an expected useful life of
8 years and has an estimated residual value of $50,000 at the end of 8 years. At the
beginning of Year 3, the company sells this asset, which is the last asset in this class
held by the company, for $350,000. What is the effect of this sale on the company’s
Year 3 taxable income?
a)
b)
c)
d)
e)
9.
Which of the following statements about the small business deduction is FALSE?
a)
b)
c)
d)
e)
10.
$10,000 terminal loss
$30,000 recapture
$37,500 terminal loss
$26,000 recapture
$100,000 terminal loss
A corporation must be a CCPC throughout the year to qualify for the small
business deduction.
The small business deduction is a deduction used in determining income for
tax purposes.
Foreign income is removed from the base on which the small business
deduction is calculated.
The benefits of the small business deduction are also available for large
CCPCs.
The business limit must be allocated among associated companies for the
purpose of determining the small business deduction for each company.
When calculating net income for tax purposes, which of the following would NOT
be added back to accounting net income?
a)
b)
c)
d)
e)
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Depreciation, amortization and depletion.
Charitable contributions.
Loss on disposal of assets.
Income tax provision.
None of the above (i.e., all of the above would be added back to accounting
net income).
© CMA Ontario, 2011
Corporate Taxation and Financial Accounting – Module 2
Use the following information for questions 11-12:
Sandra Company has the following transactions in capital assets in the years 20x1
through to 20x2:
Class 8 (20%) - Undepreciated Capital Cost, January 1, 20x1
$450,000
Purchases
20x1
20x2
$200,000
150,000
Disposals:
20x1
20x2
Proceeds
$50,000
$40,000
Original
Cost
$100,000
30,000
11.
What is the maximum CCA that can be claimed in 20x2? Assume that the
maximum CCA was claimed in 20x1.
a) $99,000
b) $105,000
c) $110,000
d) $111,000
12.
Sandra Company would report of taxable capital gain of how much in 20x2?
a) $0
b) $5,000
c) $10,000
d) $20,000
13.
During the current year, Audrey Corporation incurred costs of $45,000 for
leasehold improvements to its newly rented building. The lease was signed in the
current year for an initial term of three years plus four successive options to renew
the lease, each for an additional one year term. Which one of the following amounts
represents the maximum capital cost allowance claim in the current year?
a) $4,500
b) $5,625
c) $7,500
d) $11,250
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Corporate Taxation and Financial Accounting – Module 2
Problem 1
For each of the following independent cases, determine the residency status and Canadian
taxation of the taxpayer for 20x1. Include in your analysis the basis for your conclusions.
a.
b.
c.
d.
e.
Global Ltd. was incorporated in Ontario in 1972 and, until 2002, carried on
business in the province. In 2000, the operations were relocated to Texas.
Armstrong Inc. was incorporated in Arkansas in 2000. The head office is located in
Huntsville Ontario, where the board of directors resides.
Twisted Inc. was incorporated in Florida in 1987. For the years 1987 through 1997,
all board of director’s meetings were held in Whistler, B.C. In 1997, all the
directors moved to Sarasota, Florida and all meetings held in Florida.
Jack Reed is a German citizen who moved to Canada on September 1, 20x1. Prior
to departing Germany he earned employment income in Germany. As of
September 20x1, he earns employment income in Canada. He also has a savings
account in Germany which earns Canadian equivalent interest of $2,000 per month.
Louise Volka is a Canadian citizen who has lived and worked in New Jersey since
2000. She maintains a savings account in Canada, earning $200 per month.
Problem 2
The following represents the December 31, 20x1, income schedule for Sweet Stuff Ltd,
an incorporated candy manufacturer in Canada:
Revenues
Sales
Interest income
Other
Expenses
Cost of goods sold
Depreciation (incl. $124,000 for capital lease)
Advertising
Meals and entertainment
Charitable donations
Interest expense – capital lease
Miscellaneous
Income before taxes
$ 1,500,000
200,000
10,000
1,710,000
$
985,000
264,000
80,000
30,000
20,000
26,000
5,000
1,410,000
$
300,000
Income tax provision
Net income
(120,000)
$
180,000
Other information:
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Corporate Taxation and Financial Accounting – Module 2
1. Sweet Stuff Ltd. leases machinery. The annual lease payment is $125,000.
For tax purposes, the lease is treated as an operating lease.
2. Undepreciated Capital Cost (UCC) at the beginning of the year:
Class 8 (20% CCA rate)
Class 10 (30% CCA rate)
$720,000
$250,000
There were no additions or dispositions of capital assets during the year.
Required:
Calculate 20x1 net income for tax purposes for Sweet Stuff Ltd.
Problem 3
The December 31, 20x1 income statement for Margo Ltd. is as follows:
Sales Revenue
Cost of Goods Sold (Note 1)
Gross Profit
Operating Expenses:
Salaries and Wages
Rents
Property Taxes (Note 2)
Depreciation (Note 3)
Amortization of Goodwill (Note 4)
Charitable Contributions
Legal Fees (Note 5)
Bad Debt Expense
Warranty Provision
Social Club Membership Fees
Other Operating Expenses
Operating Income
Other Revenues (Expenses):
Gain on Sale of Investments (Note 6)
Interest Revenue
Interest on Late Income Tax Installments
Investment Counselor Fees
Foreign Interest Income (Note 7)
Dividends From Canadian Corporations
Premium on Redemption of Preferred Shares
Income Before Taxes
Page 64
$ 925,000
(717,000)
$ 208,000
$40,200
22,200
8,800
35,600
1,700
19,800
2,220
7,100
5,500
7,210
39,870
$9,500
2,110
(1,020)
(500)
1,530
3,000
(480)
(190,200)
$ 17,800
14,140
$ 31,940
© CMA Ontario, 2011
Corporate Taxation and Financial Accounting – Module 2
Notes and Other Information:
1. The calculation of cost of goods sold was based on an opening inventory of $225,000
and a closing inventory of $198,600. In addition, the closing inventory was reduced
$15,000 by a reserve for future declines in value. This is the first year the Company
has used an inventory reserve.
2. Property taxes included $1,200 for taxes paid on vacant land. The company has held
this land since 19x3 in anticipation of relocating its head office.
3. The maximum capital cost allowance for the current year is $58,000.
4. As the result of a business combination during the year, Margo Ltd. acquired $34,000
in goodwill. For accounting purposes, this balance is being amortized on a straightline basis over 20 years. The goodwill qualifies as an eligible capital expenditure for
tax purposes. At the beginning of the year, there is no balance in the cumulative
eligible capital account.
5. For legal fees, $1,200 was paid to appeal an income tax assessment; $1,020 was paid
for general corporate matters.
6. The gain on sale of investments is for marketable securities that were sold for
$30,500. Their cost was $21,000.
7. The gross foreign interest of $1,800 was received net of $270 in foreign withholding
taxes.
Required:
Determine the minimum Net Income for Tax Purposes and Taxable Income of Margo
Ltd. for the year ending December 31, 20x1.
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Corporate Taxation and Financial Accounting – Module 2
Problem 4
Linden Industries Inc. began operations in 20x1 and has a December 31 fiscal year end.
While it was fairly successful in its first year of operation, excessive production of an
unmarketable product resulted in a large operating loss for 20x2. Profits have come back
in 20x3 and 20x4 and the Company anticipates this trend will continue.
The relevant income and loss figures are as follows:
20x1
Business income (loss)*
Capital gains
Capital losses
Dividends received
Charitable donations
$95,000
0
(10,000)
12,000
23,000
20x2
($205,000)
0
(14,000)
42,000
3,000
20x3
20x4
$69,500
9,000
0
28,000
8,000
$90,000
11,250
0
32,000
22,000
All of the dividends were received from taxable Canadian corporations.
* note that this amount excludes dividends received and charitable donations
Required:
Compute the net income for tax purposes and taxable income for Linden Industries in
each of the four years. Indicate the amended figures for any year in which losses are
carried back. Analyze the amount and type of carry-overs that would be available at the
end of each of the four years.
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Corporate Taxation and Financial Accounting – Module 2
Problem 5
Mr. Class has carried on a rug manufacturing business since January 1, 20x1. In January
20x1, he acquired the following assets:
Cost
Machinery and equipment (class 43)
Land
Building (class 1)
Franchise (unlimited period)
Rate
$40,000
15,000
80,000
20,000
30%
4%
Mr. Class claimed the maximum capital cost allowance in computing his income for the
calendar year 20x1.
Because of an unforeseen fall in the stock market, Mr. Class had to sell his business in
December 20x2.
Proceeds of disposition
Machinery and equipment
Land
Building
Franchise
$22,000
15,000
70,000
20,000
Required:
Based on the information provided above, what are the deductions and inclusions in
computing Mr. Class’s business income for tax purposes for the years 20x1 and 20x2?
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Corporate Taxation and Financial Accounting – Module 2
Problem 6
Intangibles Ltd. has a December 31 year end and reports net income of $100,000 for
20x4. The following 20x4 transactions have not been included in arriving at the reported
net income.
1. On October 1, 20x4, the company acquired a five-year concession, at a cost of
$8,000, to operate snack counters at a local country fair.
2. As at January 1, 20x4, the company owned a franchise having no definite life. The
franchise, which cost $10,000 in 20x3, is to sell a brand name of packaged snacks at
amusement parks.
3. During the year, the company made a leasehold improvement costing $60,000 on
Leasehold A, one of its leased properties. The lease is for a ten-year period beginning
on January 2, 20x1, with two renewal options of five years each.
4. On January 1, 20x4, the company obtained a patent on a new coin-operated
dispensing machine, at a cost of $25,500. The legal life of the patent is 17 years.
Required:
Assuming that Intangibles Ltd. always claims the maximum amount of amortization for
tax purposes, prepare a schedule showing the maximum amounts that can be claimed for
20x4.
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© CMA Ontario, 2011
Corporate Taxation and Financial Accounting – Module 2
Problem 7
Mercantile Ltd. carries on a wholesale and retail business in one province only.
The corporation’s income for accounting purposes, before income tax, was $192,000 for
the fiscal year ending December 31, 20x1. The corporation’s accounting records provide
the following additional information:
a) During the period, the corporation received $20,000 in taxable dividends on various
investments made in Canadian public corporations. Interest on Canadian treasury
bills was $22,000.
b) Maximum capital cost allowance for the year was $4,000 less than the amount of
depreciation claimed for accounting purposes.
c) The corporation realized a gain of $1,000 on the sale of public shares in January
20x1. The corporation paid $2,000 for these shares in 19x2. Proceeds of disposition
were $3,100 and the broker’s fees were $100. This was the only transaction made on
account of capital.
d) Charitable donations of $10,000 were made in the year. All donations were made to
registered charitable organizations.
e) Interest expense includes $1,000 charged on an income tax reassessment of a prior
year.
f) A net capital loss of $5,000 and a non-capital loss of $10,000, which were never
claimed in preceding years by Mercantile Ltd., remain available in the taxation year
20x1.
Required:
Compute Mercantile Ltd.’s minimum net income for tax purposes and taxable income
for the 20x1 fiscal year.
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Corporate Taxation and Financial Accounting – Module 2
Problem 8
A Ltd., a Canadian-Controlled Private Corporation, has the following net income for tax
purposes for the taxation year ending December 31, 20x2:
Active business income in Canada
Rental income (net)
Taxable capital gain
Taxable dividends received from Canadian taxable
corporations (non-controlled)
$125,000
9,000
5,000
6,000
A Ltd. incurred a business loss during the taxation year 20x1. A non-capital loss of
$20,000 remains available for 20x2 and subsequent taxation years. The corporation
wants to claim the maximum amount of losses. Due to this loss, charitable donations of
$30,000 made to registered organizations in 20x1 could not be claimed.
Required:
Compute A Ltd.’s taxable income and small business deduction for the 20x2 taxation
year (Show your calculations in detail).
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© CMA Ontario, 2011
Corporate Taxation and Financial Accounting – Module 2
Problem 9
Barry Palermo incorporated a business on January 1, 20x1 with initial capital of
$380,000. He immediately purchased a business from a sole proprietor. The opening
balance sheet of the new corporation immediately following the purchase was as follows:
PALERMO MANUFACTURING LTD.
BALANCE SHEET,
As at January 1, 20x1
ASSETS
Current
Inventory
Fixed
Land - at cost
Building - at cost
Equipment - at cost
$ 30,000
$100,000
150,000
40,000
290,000
Other
Goodwill - at cost
60,000
$380,000
LIABILITIES AND SHAREHOLDERS’ EQUITY
Shareholders’ equity
Authorized, issued and fully paid –
1,000 common shares
$380,000
Additional information with respect to Palermo Manufacturing Ltd. is as follows:
1. The company is a Canadian-Controlled Private Corporation having December 31st as
its fiscal year-end;
2. The company commenced operations effective January 1, 20x1;
3. The building houses the company's manufacturing facilities; all of the company's
equipment is used in its manufacturing operations;
4. Mr. Palermo owns all of the outstanding shares of the company.
The company's net income for tax purposes for the year ended December 31, 20x1,
consisted of the following:
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Corporate Taxation and Financial Accounting – Module 2
Active Business Income Earned in Canada
Canadian investment income
Dividend income
Net income
$ 250,000
72,000
20,000
$ 342,000
The following information is also available:
1. active business income includes $200,000 in manufacturing and processing profits,
2. all of the dividend income was from taxable Canadian corporations,
3. Taxable dividends paid during 20x1 amounted to $200,000.
Required:
Calculate the total 20x1 Part I and IV federal tax payable by Palermo Manufacturing Ltd.
Assume provincial income tax of 5%.
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© CMA Ontario, 2011
Corporate Taxation and Financial Accounting – Module 2
SOLUTIONS
Multiple Choice Questions
1.
d
Deemed full-time resident because Peter sojourned in Canada for more than
183 days.
2.
b
Class 1 - $175,000 x 4%
Class 8 - $120,000 x 20% + [(50,000 – 30,000) x 20% x ½]
3.
b
20x1 LI: $30,000 / 8 = $3,750
20x2 LI: $20,000 / 7 x ½ = $1,428
Total = $5,179
4.
d
$500,000 x 75% x 7% = $26,250
5.
c
20x2 Reserve – lesser of:
(i) $200,000 x 360,000 / 420,000 = $171,429
(ii) $200,000 x 20% x (4-1) = $120,000 *
$7,000
26,000
$33,000
20x3 Reserve – lesser of:
(i) $200,000 x 160,000 / 420,000 = $76,190 *
(ii) $200,000 x 20% x (4-2) = $80,000
Inclusion in income =
20x3 Reserve – 20x2 Reserve = $120,000 - $76,190 = $43,810
6.
c
Maximum CCA = lesser of…
(i) net income of rental property = $206,000 – 75,000 – 12,000 – 35,000 –
45,000 = $39,000
(ii) ($350,000 x 4%) + (120,000 x 20%) + ($20,000 x 20% x ½) = $40,000
7.
a
This is how the system attempts to integrate the taxation of individuals and
corporations to avoid double taxation of corporate profits.
Choices b) and c) are incorrect because dividends received by an individual
must be included in income from property under subsection 12(1) of the ITA.
Choice d) is incorrect because it omits the dividend tax credit which relieves
the double taxation. Choice e) is incorrect because the relief comes in the
form of a tax credit (section 121 of Division E of the ITA), not a deduction.
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Corporate Taxation and Financial Accounting – Module 2
8.
a
UCC at the end of Year 1 = $500,000 - ($500,000 x 20% x 50%)
= $450,000
UCC at the end of Year 2 = $450,000 x 80% = $360,000
Proceeds of $350,000 - UCC of $360,000 = $10,000 terminal loss
9.
b
The small business deduction represents a credit against the tax otherwise
payable on income from an active business carried on in Canada, and is
designed for only small CCPCs. However, a corporation does not have to be
'small' in order to qualify for the credit. The benefits of the small business
deduction are phased out for very large CCPCs in accordance with a
prescribed formula (choice d). To be eligible, the company must have been a
CCPC throughout the year (choice a). Because the small business deduction is
a credit against the tax otherwise payable, it has nothing to do with the
determination of income for tax purposes (choice b). In calculating the small
business deduction, income from foreign sources is removed from the base
(choice c) and the business limit is reduced by any portion allocated to
associated corporations (choice e).
10.
e
For choice a), CCA is deducted from net income instead of depreciation,
amortization and depletion. For choice b), charitable contributions are
calculated as a separate tax deduction in arriving at taxable income. For
choice c), losses on disposal of assets are calculated differently for tax
purposes and are applied against capital gains. For choice d), income tax
expenses are not deductible for tax purposes.
11.
d
20x1 CCA: ($450,000 x 20%) + [(200,000 - 50,000) x 20% x 1/2]
= $90,000 + 15,000 = $105,000
UCC, end of 20x6 = $450,000 + 200,000 - 50,000 - 105,000 = $495,000
20x2 CCA: (495,000 x 20%) + [(150,000 - 30,000) x 20% x 1/2] = $111,000
12.
b
$40,000 Proceeds - $30,000 Original Cost = $10,000 Capital Gain
Taxable Capital Gain = $10,000 x 1/2 = $5,000
13.
a
Lesser of :
(i) Cost / initial lease term + 1 renewal = $45,000 / (3 + 1) = $11,250
(ii) Cost / 5 years = $45,000 / 5 = $9,000
CCA = $9,000 x 1/2 = $4,500
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Corporate Taxation and Financial Accounting – Module 2
Problem 1
a.
Global Ltd. would be considered resident in Canada for the full year and would be
taxed on its worldwide income for the year. It was incorporated in Canada. The
fact that the corporation had ceased doing business in Canada after 2002 does not
alter this conclusion.
b.
Armstrong Inc. would be considered resident in Canada for the full year and
would be taxed on its worldwide income for the year. Although the Company
was not incorporated in Canada, the mind and management of the Company
appears to be resident in Canada.
c.
Twisted Inc. would be considered non-resident as it is not incorporated in Canada
and the mind and management is no longer in Canada.
d.
Jack would be considered a part-year resident and subject to Canadian tax on his
worldwide income from September 1, 20x1. Any German tax paid on German
interest earned after September 1, 20x1 would be eligible for credit against
Canadian taxes payable.
e.
Louise would be considered non-resident as she has no significant ties to Canada.
The Canadian interest earned would be subject to Canadian withholding tax.
Problem 2
Accounting net income
$ 180,000
Additions:
Income tax provision
Charitable donations
Depreciation
Interest expense - capital lease
50% of meals & entertainment
$ 120,000
20,000
264,000
26,000
15,000
445,000
Deductions:
Lease payment
CCA ($720,000 x .2 + $250,000 x .3)
$ 125,000
219,000
(344,000)
$ 281,000
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Corporate Taxation and Financial Accounting – Module 2
Problem 3
The minimum Net Income for Tax Purposes and Taxable Income of Margo Ltd. is
calculated as follows:
Pre-Tax Accounting Income
Additions:
Inventory Reserve
Property Taxes On Vacant Land
Depreciation Expense
Goodwill Amortization
Charitable Contributions
Taxable Capital Gain ([50%][$30,500 - $21,000])
Warranty Provision
Social Club Membership Fees
Interest On Late Income Tax Installments
Foreign Taxes Withheld
Premium On Share Redemption
Deductions:
Capital Cost Allowance
Amortization Of Cumulative Eligible Capital (Note 1)
Accounting Gain On Sale of Investments
Net Income for Tax Purposes
Deductions:
Charitable contributions (Note 2)
Dividends
Taxable Income
$ 31,940
$15,000
1,200
35,600
1,700
19,800
4,750
5,500
7,210
1,020
270
480
(58,000)
(1,785)
(9,500)
92,530
(69,285)
$ 55,185
(19,800)
(3,000)
$ 32,385
Note 1:
The cumulative eligible capital account has an addition of $25,500 ([3/4][$34,000]) for
the goodwill acquired. Amortization for the year is $1,785 ([7%][$25,500]).
Note 2:
The $19,800 contributions to registered charities are fully deductible because the amount
is less than the threshold of 75% of net income for tax, or $41,389.
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Corporate Taxation and Financial Accounting – Module 2
Problem 4
Net Income and Taxable Income before Carryovers
20x1
20x2
20x3
20x4
Business Income (Loss)
Taxable Capital Gain
Dividends**
Net Income (Loss) for tax*
Dividends
Charitable Contributions**
$ 95,000
0
12,000
$ 107,000
(12,000)
(23,000)
($205,000)
0
42,000
($163,000)
(42,000)
0
$ 69,500
4,500
28,000
$ 102,000
(28,000)
(8,000)
$ 90,000
5,625
32,000
$ 127,625
(32,000)
(22,000)
Taxable Income (Loss)* before Carryovers
$ 72,000
($205,000)
$ 66,000
$ 73,625
*Net income for tax or taxable income cannot be negative. The 20x2 loss would be
added to loss carry-overs.
**Note that, for corporations, dividends are deducted in the determination of taxable
income. In addition, charitable contributions are a deduction rather than the basis for a
tax credit.
20x1 Analysis
Because there are no capital gains in 20x6 to offset the capital loss, there would be a netcapital loss carry forward of $5,000 ($10,000 * 1/2) at the end of 20x1.
20x2 Analysis
Net income for tax and taxable income for 20x2 are nil. A non-capital loss of $205,000
arises, a portion of which could be carried back to 20x1. Amended taxable income for
20x1 is $0:
20x1 Taxable Income As Reported In 20x1
Non Capital Loss Carry Back From 20x2
Amended 20x1 Taxable Income
$ 72,000
(72,000)
$ 0
The charitable donations in 20x2 are not deductible since they exceed 75% of the net
income for the year. The $3,000 not deducted can be carried forward 5 years.
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Corporate Taxation and Financial Accounting – Module 2
The summary of carry-over balances at the end of 20x2 is:
Non Capital Loss ($205,000 - $72,000)
Charitable Donations from 20x2
$ 133,000
$
3,000
Net Capital Loss From 20x1 ($10,000 * 1/2)
Addition from 20x2 ($14,000 * 1/2)
Net Capital Loss Carry-forward
$
5,000
7,000
$ 12,000
20x3 Analysis
Taxable income in 20x3 before the application of carry-overs is $66,000. The various
balances carried forward from 20x2 could be used in any order that the taxpayer chooses.
The following calculation uses the losses in inverse order to their time limits. As
charitable contributions expire after five years, we have deducted those first. This is
followed by non-capital losses, which expire after 20 years. As shown in the following
calculations, this leaves no room for the deduction of capital loss carry-overs:
•
•
•
•
20x3 Taxable Income Before Carryovers
Carry Over Of Charitable Contributions (All)
Carry Over Of 20x1 Non Capital Loss (Maximum)
20x3 Taxable Income After Carryovers
$66,000
(3,000)
(63,000)
$
0
The order used above in deducting losses is generally preferable as long as the taxpayer
anticipates future taxable capital gains. Note, however, that while capital loss carry-overs
have an unlimited life, they can only be deducted against capital gains. If Linden does
not anticipate future capital gains, it would probably deduct the maximum $4,500 of net
capital loss and reduce the non-capital loss deduction accordingly.
After the preceding allocation of losses, the following balances remain:
•
•
•
Page 78
Charitable contributions ($3,000 - $3,000)
Non Capital Loss ($133,000 - $63,000)
Net Capital Loss (Unchanged)
Nil
$70,000
$12,000
© CMA Ontario, 2011
Corporate Taxation and Financial Accounting – Module 2
20x4 Analysis
The 20x4 taxable income after the application of carry forward provisions would be as
follows:
20x4 Taxable Income Before Carryovers
Remaining 20x2 Non Capital Loss Carryover
Balance Available
Allowable Capital Loss Carryover (Maximum)
Taxable Income After Carryovers
$73,625
(70,000)
$ 3,625
(3,625)
$0
The allowable capital loss carry forward used in this period is limited to the balance of
income available after deducting the 20x3 non-capital loss carryover. Note, however, if
20x4 taxable capital gains had been less than $3,625, they would have been the limiting
factor for recognition of the allowable capital losses.
At the end of 20x4, the only remaining carry-forward is the balance of the Net Capital
Loss:
•
Net Capital Loss ($12,000 - $3,625)
$8,375
This loss will reduce taxes by about $3,350 (i.e., $8,375 * 40% tax rate). Since net
capital losses can only reduce capital gains, the time value of money may significantly
reduce the true value of this loss carry-forward.
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Corporate Taxation and Financial Accounting – Module 2
Problem 5
Machinery Building
Class 43
Class 1
20x1 Beginning UCC
(A)
-
Land
-
Franchise
CEC
Total
Allowable
Deductions
-
Additions
40,000
80,000
20,000
15,000
Less: Disposals
Net Purchases
40,000
80,000
20,000
15,000
Application of 1/2 yr. rule
CCA Base
CCA Rate
2006 CCA
Ending 20x1 UCC Balance
(B)
(A)+(B)
20,000
20,000
30%
6,000
34,000
40,000
40,000
4%
1,600
78,400
15,000
15,000
7%
1,050
13,950
*
8,650
15,000
20x2 Sale (lower of cost or
proceeds)
22,000
20x2 - Terminal
Loss/(Recapture)
12,000
70,000
15,000
**
15,000
8,400
(1,050)
-
* Acquisitions added to the CEC pool at 75%
** 75% of proceeds subtracted from the CEC pool on disposition
Therefore, the allowable deduction for 20x1 is $8,650 and 20x2 is $20,400.
From the above, we can see how Mr. Class recovers the cost of his investments in capital
property. For example, Mr. Class purchased the machinery in January 1, 20x1 for
$40,000. The asset was recovered as follows:
CCA in 20x1
Proceeds from purchaser
Terminal loss (deduction for tax)
Total recovery through tax system
$ 6,000
22,000
12,000
$ 40,000
Similar analysis can be performed for the other capital investments.
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© CMA Ontario, 2011
20,400
Corporate Taxation and Financial Accounting – Module 2
Problem 6
1.
$8,000 / 5 years = $1,600 x 3/12
$ 400
2.
20x3: $10,000 x 75% x 7% = $525
20x4: $7,500 - 525 = 6,975 x 7%
$ 488
3.
$60,000 / (7 yrs. left + 5 yrs) x 1/2 rule
4. Maximum Amortization = Greater of:
a) Class 14: $25,500 / 17 years
b) Class 44: $25,500 x ½ rule x 25%
Page 81
$2,500
$1,500
$3,187.50
© CMA Ontario, 2011
Corporate Taxation and Financial Accounting – Module 2
Problem 7
MERCANTILE LTD.
Dec 31, 20x1
Accounting income
$192,000
Adjustment for depreciation vs. CCA
4,000
Charitable donations
10,000
Non-deductible interest on tax reassessment
1,000
Capital gain for accounting purposes
(1,000)
Taxable Gain on Sale of Securities:
Proceeds
$ 3,100
Cost
(2,000)
Selling costs
(100)
1,000
Taxable portion
1/2
500
Net income For Tax Purposes
206,500
Charitable donations
(10,000)
Dividends from Cdn. public corporations
(20,000)
Net capital loss carryover
Non-capital loss carryover
Taxable Income
(500)
(10,000)
$ 166,000
Notes:
Deduction for net capital loss is limited to taxable capital gains earned in the year.
Page 82
© CMA Ontario, 2011
Corporate Taxation and Financial Accounting – Module 2
Problem 8
Year End December 31, 20x1
A. LTD.
Active business income
$125,000
Rental income
9,000
Taxable capital gain
5,000
Taxable dividends received
6,000
Net Income for Tax Purposes
145,000
Taxable Dividends Received
(6,000)
Non-capital loss
(20,000)
Charitable Donations
(30,000)
Taxable income
$89,000
Small Business Deduction:
Limited to 17% of lesser of A, B, and C:
Small Business Deduction Limit
A
$500,000
Active Business Income Earned in Canada
B
$125,000
Taxable income
C
$89,000
Therefore, the Small Business Deduction that can
be claimed in 20x1 is:
Page 83
$15,130
© CMA Ontario, 2011
Corporate Taxation and Financial Accounting – Module 2
Problem 9
31-Dec-x1
Active business income Earned in Canada
$250,000
Investment income
72,000
Taxable dividends received
20,000
Net Income for Tax Purposes
342,000
Taxable dividends received
(20,000)
Taxable income
322,000
Small Business Deduction:
Limited to 17% of lesser of A, B, and C:
Small Business Deduction Limit
A
$500,000
Active Business Income
B
$250,000
Taxable income
C
$322,000
Therefore, Small Business Deduction that can
be claimed in 20x1 is:
$42,500
Tax Payable – Part I
Federal tax (38% of taxable income)
$122,360
Federal tax abatement (10%)
($32,200)
Net Federal Tax
Refundable Part I Tax (6.67% x Investment Income)
Small Business Deduction (17% of $250,000)
M&P credit (11.5% of M&P profits - see below for limit)
Subtotal
Provincial Tax Payable (5% of taxable income)
Total Part I Tax Payable
Part IV Tax Payable - $20,000 x 33 1/3 %
Page 84
$90,160
$4,800
($42,500)
$0
$52,460
16,100
$68,560
$6,667
© CMA Ontario, 2011
Corporate Taxation and Financial Accounting – Module 2
Refundable Dividend Tax On Hand (RDTOH)
Opening balance (previous year’s RDTOH)
$0
Refundable Part 1 Tax paid (26-2/3% of investment inc.)
$19,200
Refundable Part IV Tax paid (33-1/3% of portfolio div.)
$6,667
Dividend refund of preceding year
$0
RDTOH end of year balance
$25,867
Dividend Refund
Limited to lesser of A and B:
1/3 x Taxable Dividends Paid
A
$66,666
RDTOH Balance
B
$25,867
Therefore, dividend refund is :
$25,867
M&P Deduction
Canadian M&P profits
$200,000
less: Small Business deduction limit
($250,000)
Amount eligible for M&P Deduction
$0
Page 85
© CMA Ontario, 2011
CMA Accelerated Program – Corporate Taxation and Financial Accounting 2
6.
CURRENT CORPORATE TAX RATES
Rate Description
Capital Gains Inclusion Rate
CEC Pool Inclusion Rate
Federal Tax Rate
Federal Tax Abatement
Small Business Deduction
M&P Deduction
General Rate Reduction
Page 86
2011
50%
75%
38%
10%
17%
11.5%
11.5%
2012
50%
75%
38%
10%
17%
13%
13%
© CMA Ontario - 2011
CMA Accelerated Program – Corporate Taxation and Financial Accounting 2
1.
Accounting for Income Taxes
Introduction to Income Tax Allocation - no tax rate changes
Income tax allocation addresses two major questions:
1) What amount should be reported as income tax expense in the financial statements?
2) How should the amount of income tax expense be presented in the financial
statements?
Interperiod tax allocation provides the answer to the first question. The income tax
expense reported in the financial statements is the income tax that would be paid if the
revenues and expenses in the financial statements were used to calculate taxable income.
Thus, income tax expense is matched to the company's accounting net income rather than
calculated on the basis of taxable income (i.e. on the amount currently payable).
Intraperiod tax allocation answers the second question. The income tax expense related
to regular operations is shown separately from the income tax resulting from discontinued
operations, prior period adjustments and other comprehensive income.
The following illustration outlines the presentation of income tax expense in the income
statement and statement of retained earnings:
XYZ Limited
Income Statement
For the Year Ended December 31, 20x4
Sales
Cost of Goods Sold
XXX
XXX
Gross Profit
Selling and Administrative Expenses
XXX
XXX
Operating Income
Other Income and Expenses
Net Income Before Income Taxes and
Discontinued Operations
Income Tax Expense - Current
- Deferred
XXX
XXX
XXX
XXX
XXX
XXX
Net Income Before Discontinued Operations
Discontinued operations - net of tax
XXX
XXX
Net Income
XXX
Page 87
interperiod
tax allocation
intraperiod
tax allocation
© CMA Ontario - 2011
CMA Accelerated Program – Corporate Taxation and Financial Accounting 2
XYZ Limited
Statement of Retained Earnings
For the Year Ended December 31, 20x4
Retained Earnings, Jan. 1, 20x4 as previously reported
Adjustment for prior period adjustment error, correction,
change in accounting policy - net of tax effect
Retained Earnings, Jan 1, 20x4 as restated
Add: Net Income
Less: Dividends
Retained Earnings, December 31, 20x4
XXX
XXX
XXX
XXX
XXX
XXX
XXX
intraperiod
tax allocation
A few definitions
A permanent difference2 relates to an expense item that is not deductible or a revenue
item that is not taxable. Example of the most common permanent differences are:
•
dividends received from taxable Canadian corporations are not taxable,
•
private club dues are not deductible,
•
one-half of entertainment expenses are not deductible,
•
life insurance premiums on key executives are not deductible,
•
fines, penalties and interest on taxes are not deductible,
•
the portion of non-taxable capital gains.
A timing difference are those components of accounting income that enter into the
computation of taxable income, but do so in a different period than they are recognized
for financial reporting. Examples of timing differences are:
•
financial accounting depreciation (non deductible) vs. capital cost allowance
(deductible),
•
warranty expense (non deductible) vs. warranty costs incurred (deductible),
•
pension expense (non deductible) vs. payment to pension trustee (deductible),
•
deferred development costs - development costs are deductible as costs are
incurred, but will often flow through the income statements with the related
revenues,
•
when bonds are issued at a discount, the amount of the discount will be deductible
for tax purposes when the bonds are refunded. The amortization of the bond
discount becomes a timing difference.
A temporary difference refers to the accumulation of timing differences. The Deferred
Income Tax Account balance at year end is calculated based on temporary differences.
2
the terms 'permanent difference' and 'timing difference' are not explicitly recognized by IAS 12. These
terms however, will be used in this course.
Page 88
© CMA Ontario - 2011
CMA Accelerated Program – Corporate Taxation and Financial Accounting 2
IAS 12 defines a temporary difference as differences between the carrying amount if an
asset or liability in the statement of financial position and its tax base. Temporary
differences may be either:
•
taxable temporary differences which will result in taxable amounts in determining
taxable income of future periods when the carrying amount of the asset or liability
is recovered or settled, or
•
deductible temporary differences which will result in amounts that are deductible
in determining taxable income of future periods when the carrying amount os the
asset or liability is recovered or settled. (IAS 12.5)
The relationship between timing differences and temporary differences are summarized
in the following table:
Timing Difference
Temporary Difference
CCA vs. Depreciation
Net Book Value Less Undepreciated
Capital Cost Allowance
Warranty Expense vs. Warranty Costs
Warranty Liability
Pension expense vs. Payments to pension
plan trustee
The balance in the pension account on the
Statement of Financial Position.
Development costs incurred
Deferred development costs on Statement
of Financial Position.
Amortization of Bond Discount or
Premium
Accumulated amortization of the bond
discount or premium.
Example 1: Gravelines Company Limited was formed on January 2, 20x5. The general
ledger accounts of Gravelines Company, before consideration of income tax expense, for
the year ended December 31, 20x5, included the following:
Debit
Sales
Dividend Revenue from ABC Ltd. (Note 1)
Cost of Goods Sold
Depreciation Expense (Note 2)
Administration Expenses
Warranty Expense (Note 3)
Life Insurance Expense (Note 4)
Uninsured Fire Loss (Note 5)
Other Expenses
Page 89
Credit
$1,000,000
20,000
$500,000
100,000
52,000
40,000
10,000
40,000
8,000
$750,000
$1,020,000
© CMA Ontario - 2011
CMA Accelerated Program – Corporate Taxation and Financial Accounting 2
Note 1 - Intercorporate dividends are not taxable.
Note 2 - The company has adopted straight-line depreciation for reporting purposes, but
is claiming the maximum capital cost allowance for tax purposes. The 20x5
capital cost allowance claim is $150,000. Purchases of capital assets during
20x5 amounted to $1,000,000.
Note 3 - The company provides a twelve month warranty on its sales. Actual
expenditures made in 20x5 under its warranty were $20,000. These
expenditures are deductible for income tax purposes.
Note 4 - Premiums paid on life insurance policies are usually not deductible for income
tax purposes. Assume that the premiums paid on this policy are not deductible.
Note 5 - This loss is fully deductible for tax purposes.
Assume the income tax rate is 40%.
The reconciliation between accounting income and taxable income for the Gravelines
Company is as follows:
Net income before taxes ($1,020,000 - 750,000)
$270,000
Permanent difference Dividend revenue not taxable
Life insurance expense not deductible
(20,000)
10,000
Timing difference CCA
Depreciation
(150,000)
100,000
Warranty expense not deductible
Actual warranty expenditures
40,000
(20,000)
Taxable Income
Tax rate
230,000
40%
Current portion of Income Tax Expense
$92,000
The journal entry to record the income tax expense is:
Income tax expense (260,0001 x 40%)
Income tax payable (230,000 x 40%)
Deferred income tax account (30,0002 x 40%)
1
2
Page 90
104,000
92,000
12,000
Accounting income a of $270,000 adjusted for permanent differences of
$10,000
sum of the timing differences
© CMA Ontario - 2011
CMA Accelerated Program – Corporate Taxation and Financial Accounting 2
Note that the deferred income tax account calculation above is simplified because the tax
rate in the future is assumed to remain stable at 40%. An alternative calculation of the
deferred income tax account is as follows:
Temporary difference3 relating to:
• Difference between NBV/UCC
Ending NBV = $1,000,000 Additions - 100,000 Depreciation
Ending UCC = $1,000,000 Additions - 150,000 CCA
$900,000
850,000
$50,000
x 40%
• Warranty liability: $20,000 x 40%
$20,000 cr.
8,000 dr.
$12,000 cr.
The notation 'cr.' and 'dr.' are used to denote a liability and asset respectively. For
example, the fact that the undepreciated capital cost is lower than the net book value
implies that we have deducted the assets faster for tax purposes than we have for
accounting purposes. This implies that we have lost future deductibility of the assets
thereby creating a liability. Similarly, the warranty liability will be deductible as costs are
incurred in the future thereby creating an asset.
The income statement for the Gravelines Company would be as follows:
Gravelines Company Limited
Income Statement
For the Year Ended December 31, 20x5
Sales
Cost of Goods Sold
Gross Profit
Selling and Administrative Expenses:
Depreciation
Administrative
Warranty
Life Insurance
Fire Loss
Other
$1,000,000
500,000
500,000
$100,000
52,000
40,000
10,000
40,000
8,000
250,000
20,000
Dividend Revenue
Net Income before Taxes
Provision for income taxes
Current
Deferred
3
250,000
270,000
92,000
12,000
104,000
This term refers to the accumulation of timing differences and will be defined in the next section.
Page 91
© CMA Ontario - 2011
CMA Accelerated Program – Corporate Taxation and Financial Accounting 2
Net Income
$166,000
The Statement of Financial Position accounts are as follows:
Income Tax Payable - Current Liability
Deferred income taxes - Long-Term Assets
Deferred income taxes - Long-Term Liabilities
$92,000
8,000
20,000
Interperiod tax allocation - changing tax rates
When a change in the tax rate is enacted into law, its effect on the existing deferred
income tax asset or liability account should be recorded immediately as an adjustment to
income tax expense in the period of the change. (IAS 12.46 and 12.47) This change
results in the asset or liability being stated at the effective tax rate that relates to the
realization of the benefits or the discharge of the liability.
When dealing with situations where the tax rate changes, the approach for calculating
deferred income tax expense is different than the approach used in the above example
where no changes in tax rates occurred.
Example 2: Assume the following information for the Gravelines Company limited for
the year 20x6:
Net income before taxes
$450,000
The following items are included in net income before taxes:
Depreciation expense
Warranty expense
Dividend Revenue from ABC Ltd.
Life insurance expense not deductible for income tax purposes
Pension expense
120,000
50,000
25,000
12,000
20,000
Other Information:
Capital cost allowance claimed
Warranty costs incurred
Pension payments paid to pension plan trustee
Purchase of capital assets
170,000
35,000
16,000
150,000
Tax rate in effect for 20x6 and future years (enacted in 20x6)
Page 92
38%
© CMA Ontario - 2011
CMA Accelerated Program – Corporate Taxation and Financial Accounting 2
If you recall, the deferred income tax liability (net) at the end of 20x5 was $12,000 and
consisted of the following:
On fixed assets: difference between net book value and undepreciated
capital cost: $900,000 - 850,000 = $50,000 x 40%
On warranty liability: $20,000 x 40%
$20,000 cr.
8,000 dr.
$12,000 cr.
The current portion of income tax expense can be calculated as follows:
Net income before taxes
Permanent Differences:
Dividend revenue from ABC Ltd.
Life insurance expense not deductible for income tax purposes
Timing Differences:
Depreciation
CCA
Warranty expense
Warranty costs incurred
Pension expense
Pension payments paid to plan trustee
Net income for tax purposes
$450,000
(25,000)
12,000
120,000
(170,000)
50,000
(35,000)
20,000
(16,000)
$406,000
x 38%
Current portion of income tax expense
$154,280
In order to calculate the deferred portion of income tax expense, we must first calculate
the deferred income tax asset or liability:
On fixed assets: difference between net book value and undepreciated
capital cost*: $930,000 - 830,000 = $100,000 x 38%
On warranty liability**: $35,000 x 38%
On pension liability***: $4,000 x 38%
$38,000 cr.
13,300 dr.
1,520 dr.
$23,180 cr.
*Net Capital assets, end of 20x6: $900,000 Opening Balance + 150,000 Purchases
- $120,000 Depreciation
Undepreciated capital cost: $850,000 Opening Balance + $150,000 Purchases
- $170,000 CCA
$930,000
830,000
** Warranty Liability at end of 20x6: $20,000 Opening Balance
+ 50,000 Warranty expense - 35,000 Warranty Costs Incurred
$35,000
*** Pension Liability at end of 20x6: $20,000 Pension Expense
- 16,000 Pension Payments paid to pension plan trustee
$4,000
Page 93
© CMA Ontario - 2011
CMA Accelerated Program – Corporate Taxation and Financial Accounting 2
The deferred income tax expense will be equal to the amount that adjusts the beginning
deferred income tax liability to the ending balance of the deferred income tax liability:
$23,180 - 12,000 = $11,180.
The journal entry to record income tax expense would be as follows:
Income tax expense - current
Income taxes payable
$154,280
Income tax expense - deferred
DIT Account
$11,180
$154,280
$11,180
Note that the deferred income tax asset or liability account is usually carried as a net
balance on the books of the company. However, for purposes of disclosure on the
Statement of Financial Position, deferred tax assets are shown separately from deferred
tax liabilities. Statement of Financial Position disclosure of deferred income tax balances
would be as follows:
Long-term assets
Deferred income taxes
$14,820
Long-term liabilities
Deferred income tax liabilities
$38,000
Example 3: Assume that the following company's only difference between accounting
and taxable income is due to differences between CCA and depreciation:
Year
Net income
before taxes
Excess of CCA
over depreciation
Tax Rate
20x2
20x3
20x4
20x5
$70,000
70,000
70,000
70,000
$30,000
30,000
(30,000)
(30,000)
45%
35%
30%
30%
The current portion of income taxes payable is calculated as follows:
Net income before taxes
Excess of CCA over depreciation
Net income for tax purposes
Page 94
20x2
$70,000
(30,000)
$40,000
20x3
$70,000
(30,000)
$40,000
20x4
$70,000
30,000
$100,000
20x5
$70,000
30,000
$100,000
x 45%
x 35%
x 30%
x 30%
$18,000
$14,000
$30,000
$30,000
© CMA Ontario - 2011
CMA Accelerated Program – Corporate Taxation and Financial Accounting 2
The deferred income tax liability and deferred portion of income tax expense are
calculated as follows:
Deferred
Income Tax
Liability
$13,500
21,000
9,000
0
20x2: $30,000 x 45%
20x3: $60,000 x 35%
20x4: $30,000 x 30%
20x5: $0 x 30%
Deferred Income
Tax Expense
$13,500 dr.
7,500 dr.
12,000 cr.
9,000 cr.
The deferred income tax expense in any given year is calculated as the increase (dr) or
the drawdown (cr.) of the deferred income tax liability.
The following table calculates net income:
20x2
20x3
20x4
20x5
Net income before taxes
Provision for income taxes
Current
Deferred
$70,000
$70,000
$70,000
$70,000
18,000
13,500
31,500
14,000
7,500
21,500
30,000
(12,000)
18,000
30,000
(9,000)
21,000
Net income
$38,500
$48,500
$52,000
$49,000
Note that the effective tax rate (provision for income taxes / net income before taxes) in
20x2 is equal to 45%, the tax rate in effect in that year. However, for 20x3 it is equal to
30.7% which is less than the tax rate in 20x3. This is because the deferred portion of the
income tax expense captures the impact on the rate change on total accumulated
temporary differences at the beginning of 20x3.
The income tax expense for 20x3 can be calculated in an alternative way as follows:
Net income before taxes
Less impact of tax rate reduction on opening temporary differences:
$30,000 x (.45 - .35)
$70,000
x 35%
$24,500
(3,000)
$21,500
A similar calculation could be made for the year 20x4.
Page 95
© CMA Ontario - 2011
CMA Accelerated Program – Corporate Taxation and Financial Accounting 2
Accounting for net operating losses
Recognition of a deferred income tax asset is permitted on net operating losses if it is
probable that sufficient taxable income will be generated in the future to liquidate the tax
asset created by the net operating losses. (IAS 12.34) Recall that net operating losses can
be carried back three years and forward twenty years.
IAS 12 states that the existence of unused tax losses is strong evidence that future taxable
income may not be available. It provides the following criteria in assessing whether the
probability that taxable income will be available against which the unused tax losses or
unused tax credits can be utilized before they expire:
•
whether the entity has sufficient taxable temporary differences relating to the
same taxation authority and the same taxable entity, which will result in taxable
amounts against which the unused tax losses or unused tax credits can be utilized
before they expire;
•
whether it is probable that the entity will have taxable profits before the unused
tax losses of unused tax credits expire;
•
whether the unused tax losses result from identifiable causes which are unlikely to
recur; and
•
whether tax planning opportunities are available to the entity that will create
taxable profits in the period in which the unused tax losses or unused tax credits
can be utilized.
To the extent that it is not probable that taxable profit will be available against which the
unused tax losses or unused tax credits can be utilized, the deferred tax asset is not
recognized. (IAS 12.36)
For example, assume a company incurs a loss for tax purposes of $100,000 and the tax
rate is 40%. If it is probable that the company will generate enough taxable income in
future years to completely use up this loss, then it may set up an asset of $40,000
($100,000 x 40%) on its Statement of Financial Position. Note that this $100,000
becomes a temporary difference.
Any losses carried back will result in a debit to income taxes receivable and a credit to
income tax benefit.
Page 96
© CMA Ontario - 2011
CMA Accelerated Program – Corporate Taxation and Financial Accounting 2
Example - assume that the entity has no temporary or permanent differences. The entity's
accounting and taxable incomes for the years 20x1 through to 20x8 are as follows:
Year
20x1
20x2
20x3
20x4
20x5
20x6
20x7
20x8
Accounting and Taxable
Income (Loss)
$160,000
60,000
100,000
120,000
(600,000)
(150,000)
300,000
1,200,000
Tax
Rate
36%
36%
34%
33%
30%
28%
26%
25%
In the years 20x1 to 20x4 the income tax expense will be equal to the current portion:
Year
20x1
20x2
20x3
20x4
Income Tax
Expense
$160,000 x 36%
60,000 x 36%
100,000 x 34%
120,000 x 33%
Tax
Rate
$57,600
21,600
34,000
39,600
20x5: the entity will carry back and claim any taxes paid in the years 20x2, 20x3 and
20x4:
Net loss for tax purposes
Less carried back
to 20x2
to 20x3
to 20x4
Carried forward
($600,000)
60,000
100,000
120,000
($320,000)
If the entity's management believes that it is probable that this loss carryforward will be
used up to offset future taxable income, then this will cause a deferred tax asset in the
amount of $320,000 x 30% = $96,000. The journal entries for 20x5 will be as follows:
Income taxes receivable
Income tax benefit - current
$95,200
DIT Account
Income tax benefit - deferred
96,000
Page 97
$95,200
96,000
© CMA Ontario - 2011
CMA Accelerated Program – Corporate Taxation and Financial Accounting 2
The bottom portion of the income statement will be as follows:
Net loss before income taxes
Income tax benefit
Current
Deferred
Net loss
($600,000)
95,200
96,000
191,200
($408,800)
20x6: again, if the entity's management believes that it is probable that this loss
carryforward will be used up to offset future taxable income, this loss will cause the
deferred tax asset to increase:
Total loss carryforward amount to the end of 20x6:
$320,000 + 150,000
$470,000
Times the tax rate in effect at the end of 20x6
28%
Balance in DIT Account, December 31, 20x6
Less balance in DIT Account, December 31, 20x5
DIT benefit, year ended December 31, 20x6
131,600 dr.
96,000 dr.
$35,600 cr.
The journal entry for 20x6 will be as follows:
DIT Account
Income tax benefit - deferred
35,600
35,600
The bottom portion of the income statement will be as follows:
Net loss before income taxes
Income tax benefit - deferred
Net loss
($150,000)
35,600
($114,400)
20x7: in 20x7 we are generating taxable income and will be able to use up $300,000 of
the loss carryforward, leaving $170,000 to be carried forward to 20x8 and beyond.
Total loss carryforward amount to the end of 20x7:
$470,000 - 300,000
Times the tax rate in effect at the end of 20x7
Balance in DIT Account, December 31, 20x7
Less balance in DIT Account, December 31, 20x6
DIT expense, year ended December 31, 20x7
Page 98
$170,000
26%
44,200 dr.
131,600 dr.
$87,400 dr.
© CMA Ontario - 2011
CMA Accelerated Program – Corporate Taxation and Financial Accounting 2
The journal entry for 20x7 will be as follows:
Income tax expense - deferred
DIT Account
87,400
87,400
The bottom portion of the income statement will be as follows:
Net income before income taxes
Income tax expense - deferred
Net income
$300,000
87,400
$212,600
20x8: in 20x8 we are generating more taxable income than we have losses carryforward:
Taxable income before application of loss carry-forward
Less loss carry forward
Taxable income
$1,200,000
170,000
1,030,000
x 25%
Current portion
$257,500
The deferred tax account will be drawn down to zero - the balance of $44,200 will
become the deferred tax expense for the year. The journal entries for 20x8 will be as
follows:
Income tax expense - current
Income taxes payable
Income tax expense - deferred
DIT Account
The bottom portion of the income statement will be as follows:
Net income before income taxes
Income tax expense
Current
Deferred
Net income
Page 99
$257,500
$257,500
44,200
44,200
$1,200,000
257,500
44,200
301,700
$898,300
© CMA Ontario - 2011
CMA Accelerated Program – Corporate Taxation and Financial Accounting 2
Classification of DIT Balances on the Statement of Financial Position
The classification of DIT balances on the Statement of Financial Position are based on
the whether or not the temporary difference result in an asset or a liability. All temporary
differences causing a deferred income tax asset are aggregated and classified a long-term
asset. Similarly, all temporary differences causing a deferred income tax liability are
aggregated and classified as a long-term liability.
IAS 12 allows an entity to offset deferred tax assets against deferred tax liabilities but
only in very restrictive and rare circumstances:
Current balances can be offset if, and only if, the entity:
•
has a legally enforceable right to set off the recognized amounts; and
•
intends either to settle on a net basis, or to realize the asset and settle the liability
simultaneously. (IAS 12.71)
Deferred tax balances can be offset if, and only if:
•
the entity has a legally enforceable right to set off current tax assets against
current tax liabilities; and
•
the deferred tax assets and the deferred tax liabilities relate to income taxes levied
by the same taxation authority on either:
the same taxable entity; or
different taxable entities which intend either to settle current tax liabilities
and assets on a net basis, or to realize the assets and settle the liabilities
simultaneously in each future period in which significant amounts of
deferred tax liabilities or assets are expected to be settled or recovered.
(IAS 12.74)
The bottom line is that the circumstances under which an entity can offset deferred
(current) income tax assets against deferred (current) income tax liabilities is rare.
Limitation on the Deferred Income Tax Asset Account
Deferred tax assets are recognized for all deductible temporary differences, but only to
the extent that these are recoverable. The carrying amount of deferred tax assets must be
reviewed each year.
Deferred Taxes on items flowing through OCI
To the extent that there is a deferred tax element on an item flowing through other
comprehensive income, then the deferred tax portion also flows to other comprehensive
income. For example, assume an investment classified as FCTOCI increases in value by
$10,000 during the year. The deferred tax liability associated with this investment is
$3,000. This will be credited to the DIT account and debited to OCI.
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Comprehensive Example
Assume that the Clarke Company has the following information available as at December
31, 20x2:
Net book value of fixed assets
$1,706,240
Undepreciated Capital Cost
Class 1 (4%)
Class 8 (20%)
Class 10 (30%)
629,450
340,000
175,210
$1,144,660
Warranty liability
Accrued pension liability
Non-capital loss carryforwards (incurred in 20x2)
$60,000
$200,000
$280,000
Tax Rate
35%
You are given the following information for the year ended December 31, 20x3:
Net income before taxes
Depreciation expense
Warranty expense
Warranty costs incurred
Pension expense
Amount paid to pension plan trustee
Club dues
Entertainment expenses
Equity income
$1,200,000
180,000
140,000
125,000
75,000
100,000
6,000
20,000
80,000
Capital Asset Additions:
Class 8
Class 10
$40,000
20,000
Capital Asset Disposals
Class 8:
Proceeds
Net book value of assets sold
Class 10: Proceeds
Net book value of assets sold
Original cost of asset sold
20,000
25,000
15,000
6,000
30,000
Tax rate (enacted at the end of 20x3)
33%
Calculate the income tax expense as it would appear on the income statement.
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Deferred income taxes (net) @ December 31,20x2:
NBV/UCC difference: ($1,706,240 - 1,144,660) x 35%
Warranty liability: 60,000 x 35%
Accrued Pension liability: 200,000 x 35%
Loss carryforward: $280,000 x 35%
$196,553
21,000
70,000
98,000
$ 7,553
cr.
dr.
dr.
dr.
cr.
Calculation of allowable CCA for the year:
Class
1
8
10
1
2
UCC - Beg
$629,450
340,000
175,210
$1,144,660
Additions
Disposals
$40,000
20,000
$60,000
$20,000
15,000
$35,000
Rate
4%
20%
30%
CCA Claim
$ 25,178
70,000
53,313
$148,491
1
2
UCC - End
$ 604,272
290,000
126,897
$1,021,169
$340,000 x 20% + [(40,000 - 20,000) x 20% x 1/2]
$175,210 x 30% + [(20,000 - 15,000) x 30% x 1/2]
Current portion of income taxes expense Net income before taxes
Permanent differences:
Club dues
Non-taxable portion of entertainment
expenses
Equity income
Temporary differences:
Depreciation
CCA
Loss on sale of equipment (20,000 - 25,000)
Gain on sale of equipment (15,000 - 6,000)
Pension expense
Amount paid to pension trustee
Warranty expense
Warranty costs
Taxable income
Application of loss carryforward
Current portion of income tax expense
Page 102
$1,200,000
6,000
10,000
(80,000)
180,000
(148,491)
5,000
(9,000)
75,000
(100,000)
140,000
(125,000)
$1,153,509
(280,000)
873,509
x 33%
$ 288,258
© CMA Ontario - 2011
CMA Accelerated Program – Corporate Taxation and Financial Accounting 2
Deferred income taxes (net) @ December 31,20x3:
NBV/UCC difference:
NBV: $1,706,240 - 180,000 Dep+ 60,000 Add -25,000 Disp - 6,000 Disp
= (1,555,240 - 1,021,169) = 534,071 x 33%
Warranty liability: (60,000 + 140,000 - 125,000) x 33%
Accrued Pension liability: (200,000 + 75,000 - 100,000) x 33%
$176,243
24,750
57,750
93,743
7,553
$86,190
DIT @ December 31, 20x2
Increase = Deferred Income Tax Portion of Income Tax Expense
cr.
dr.
dr.
cr.
cr.
Income Statement Presentation Net income before taxes
Provision for income taxes
Current
Deferred
Net income
$1,200,000
$288,258
86,190
374,448
$ 825,552
The Statement of Financial Position presentation of the deferred tax assets and liabilities
are as follows:
Long-term assets
Deferred tax assets ($24,750 + 57,750)
Long-term liabilities
Deferred tax liabilities
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$82,500
$176,243
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CMA Accelerated Program – Corporate Taxation and Financial Accounting 2
ASPE Differences
•
private entities can opt to use the taxes payable method or future income taxes
method. The future income taxes method is as described in this chapter with a few
differences outlined below.
•
the taxes payable method reports only the current portion of income tax expense
and related income taxes payable/receivable. If this method is used, then the entity
must disclose significant temporary differences in the notes to the financial
statements.
•
if the income tax allocation method is used, the differences between ASPE and
IFRS are as follows:
a difference in terminology: deferred income taxes are called future income
taxes (FIT),
the classification of future income taxes is based on the nature of the asset or
liability that caused the temporary difference: if the asset causing the
temporary difference is classified as a current asset, then the resulting future
income tax liability is classified as a current liability.
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Problems with Solutions
Multiple Choice Questions
1.
Trevino Corporation's taxable income differed from its accounting income
computed for this past year. An item that would create a permanent difference in
accounting and taxable incomes for Trevino would be
a) a balance in the Unearned Rent account at year end
b) using accelerated depreciation for tax purposes and straight-line depreciation
for book purposes
c) the payment of the golf club dues for the president's membership
d) making installment sales during the year
2.
A company uses the accrual method to account for the provision of warranties. This
would typically result in what type of difference and in what type of deferred
income tax?
a)
b)
c)
d)
3.
Type of Difference
Permanent
Permanent
Temporary
Temporary
Deferred Tax
Asset
Liability
Asset
Liability
Romero Corporation purchased a computer on January 2, 20x2, for $400,000. The
computer has an estimated 5-year life with no residual value. The straight-line
method of depreciation is being used for financial statement purposes and the
following CCA amounts will be deducted for tax purposes:
20x2
20x3
20x4
20x5
20x6
20x7
$ 80,000
128,000
76,800
46,000
46,000
23,200
Assuming an income tax rate of 30% for all years, the net deferred tax liability that
should be reflected on Romero's Statement of Financial Position as at December 31,
20x3 should be
a)
b)
c)
d)
Page 105
Current
$0
$960
$13,440
$14,400
NonCurrent
$14,400
$13,440
$960
$0
© CMA Ontario - 2011
CMA Accelerated Program – Corporate Taxation and Financial Accounting 2
4.
Price Corporation's partial income statement after its first year of operations is as
follows:
Income before income taxes
$1,000,000
Income tax expense
Current
$376,000
Deferred
24,000
400,000
Net income
$ 600,000
Price uses the straight-line method of depreciation for financial reporting purposes
and CCA for tax purposes. The amount charged to depreciation expense on its
books this year was $400,000. No other differences existed between book income
and taxable income except for the amount of depreciation.
Assuming a 40% tax rate, what amount was deducted for CCA on the corporation's
tax return for the current year?
a)
b)
c)
d)
$320,000
$380,000
$400,000
$460,000
Use the following information for questions 5 - 7:
Bean Co., at the end of 20x8, its first year of operations, prepared a reconciliation
between pretax financial income and taxable income as follows:
Pretax financial income
Estimated litigation expense
Instalment sales
Taxable income
$300,000
800,000
-600,000
$500,000
The estimated litigation expense of $800,000 will be deductible in 20x0 when it is
expected to be paid. The gross profit from the installment sales will be realized in the
amount of $300,000 in each of the next two years. The estimated liability for litigation is
classified as noncurrent and the installment accounts receivable are classified as $300,000
current and $300,000 noncurrent. The income tax rate is 30% for all years.
5.
The income tax expense is
a) $90,000
b) $120,000
c) $150,000
d) $300,000
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6.
The deferred tax asset to be recognized is
a) $90,000 current
b) $90,000 noncurrent
c) $240,000 current
d) $240,000 noncurrent
7.
The deferred tax liability to be recognized is
a) $30,000
b) $60,000
c) $90,000
d) $180,000
8.
On January 1, 20x8, Edge, Inc. purchased a machine for $90,000which will be
depreciated $9,000 per year for financial statement reporting purposes. For income
tax reporting, the asset is a Class 8 asset with a CCA rate of 20%. Assume a present
and future enacted income tax rate of 30%. What amount should be added to Edge's
deferred income tax liability for this timing difference at December 31, 20x8?
a) $5,400
b) $3,000
c) $2,700
d) $0
9.
Goll Company reported the following results for the year ended December 31,
20x2, its first year of operation:
20x2
Income (per books before income taxes)
$250,000
Taxable income
400,000
The disparity between book income and taxable income is attributable to a timing
difference, which will reverse in 20x3. What should Goll record as a net deferred
tax asset or liability for the year ended December 31, 20x2, assuming that the
enacted tax rates in effect are 40% in 20x2 and 35% in 20x3? The 20x3 tax rate was
known at the end of 20x2.
a) $60,000 deferred tax liability
b) $52,500 deferred tax asset
c) $60,000 deferred tax asset
d) $52,500 deferred tax liability
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CMA Accelerated Program – Corporate Taxation and Financial Accounting 2
10.
Which of the following would result in a deferred tax liability?
a) When the estimated warranty liability for accounting purposes is greater than
the warranty obligation for income tax purposes
b) When the company pays membership dues for one of its employees and the
amount is expensed for accounting purposes, but is never deductible for tax
purposes
c) When the company records a gain for accounting purposes but the amount is
never taxable for tax purposes
d) When the net book value of equipment is greater than the undepreciated
capital cost of this equipment
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CMA Accelerated Program – Corporate Taxation and Financial Accounting 2
Problem 1
The controller of Carstwell Manufacturing Ltd. was finalizing the company's financial
statements for the year ended December 31, 20x1. He had determined that financial
statement income before income taxes was $235,000, a dramatic improvement over the
prior year when the company had suffered a loss. For fiscal 20x0, the company had
recorded a net loss of $80,000 for both accounting and tax purposes. No refund of
previous years' taxes paid has been claimed by Carstwell. The company felt that it was
probable that the loss would be used within the allowable period, so they recognized the
deferred benefit of the tax loss for accounting purposes.
The controller reviewed some of the notes he had made to himself in preparing the
financial statements up to this point. The notes were as follows:
1) The company had deducted $200,000 of depreciation for 20x1. For tax purposes, the
company had recorded $300,000 in capital cost allowance.
2) For the first time in its history, the company had recorded warranty expense for
products sold. At the end of fiscal 20x1, the liabilities included an accrual of $40,000
for warranties.
3) The company sold a depreciable asset for proceeds of $25,000. The net book value of
the asset was $30,000.
4) The company pays tax at the rate of 45%. This rate was in effect last year and is not
expected to change.
5) The balance in the deferred income tax account amounted to a credit of $121,500 and
was classified as follows on the Statement of Financial Position as at December 31,
20x0:
Long-term Assets
Deferred Income Taxes
$36,000
Long-term Liabilities
Deferred Income Taxes
$157,500
Required:
Prepare the lower portion of the company's income statement beginning with "Income
before taxes." Show current and deferred tax expense separately.
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CMA Accelerated Program – Corporate Taxation and Financial Accounting 2
Problem 2
Chive Ltd.'s income of $700,000 before income taxes for the year ended March 31, 20x1,
includes the following items:
•
Some equipment was disposed of during the year for $192,500. The net book value of
these items at the time of the sale was $70,000 and the original cost was $225,000.
•
Dividends received from a taxable Canadian corporation during the year totaled
$35,000.
•
Capital cost allowance claimed amounted to $245,000 and the company pays income
tax at a rate of 50%.
•
Provision for warranty repairs for the year was $70,000 while depreciation expense
for the same period amounted to $157,500.
•
Chive Ltd. paid a $3,500 interest penalty for late federal income tax installments.
Up to the fiscal year ended March 31, 20x0, the company's temporary difference, and
hence, deferred income tax balance, resulted only from its purchase of depreciable assets,
the net book value and undepreciated capital cost of which, at the end of that year were
$1,575,000 and $1,330,000 respectively.
Required Calculate the taxable income and the balance in the deferred income tax account at March
31, 20x1. Prepare the journal entries to record the provision for income taxes.
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CMA Accelerated Program – Corporate Taxation and Financial Accounting 2
Problem 3
The following is an extract from the accounting records of Cinnamon Ltd.:
Accounting income
Depreciation expense
Capital cost allowance claimed
20x2
$232,500
77,500
116,250
20x1
$(170,500)
77,500
NIL
20x0
$155,000
77,500
120,500
The company's fiscal year end is December 31. There was a credit balance in the deferred
income tax account at January 1, 20x0, in the amount of $186,000. This amount was
based on a tax rate of 42%. Cinnamon Ltd. 's income tax rate was also 42% in 20x0, 20x1
and 20x2.
Required a)
b)
c)
Prepare the journal entries to record income taxes for 20x0, 20x1 and 20x2. Show
all calculations.
Prepare a partial income statement for 20x1.
What is the balance in the DIT Account at the end of 20x2?
Problem 4
Crandall Corporation was formed in 20xl . Relevant information pertaining to 20xl,
20x2 and 20x3 are as follows:
20xl
$ 100,000
20x2
$ 100,000
20x3
$ 100,000
Accounting income includes the following:
Depreciation (assets have a cost of $120,000)
Pension expense
Warranty expense
Dividend income
10,000
5,000
3,000
2,000
10,000
7,000
3.000
2,000
12,000
10,000
3,000
3,000
Taxable income includes the following:
Capital cost allowance
Pension funding (amount paid)
Warranty costs
25,000
7,000
1,000
15,000
8,000
4,000
7,000
9,000
3,000
40%
44%
48%
Net income before income tax
Tax rate - enacted in each year
Required
Prepare the journal entry to record the income tax expense for each year.
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CMA Accelerated Program – Corporate Taxation and Financial Accounting 2
Problem 5
Homer Company had the following deferred tax amounts at the beginning of the year
20x0:
•
•
Deferred income tax asset - (associated with warranties) of $10,000
Deferred income tax liability - (associated with depreciation) of $250,000
Information related to the year 20x0 was as follows:
Accounting income before tax
Items included in arriving at income before tax:
Entertainment expense
Dividends received from a Canadian corporation
Depreciation expense
Warranty expense
Additional information:
Capital cost allowance
Warranty costs paid
$ 1,000,000
$ 25,000
70,000
300,000
50,000
$ 400,000
30,000
In the March 20x0 budget speech, the Finance Minister regretfully stated that he was
forced to raise the income tax rate for the year 20x1 and later years to 45%. This was a
sad surprise to Canadians since the income tax rate had been 40%. The intended change
was enacted into law in November 20x0.
Required
Calculate (i) the income tax expense for the year 20x0 and (ii) the deferred tax amounts
as they would appear on the Statement of Financial Position as at December 31, 20x0
(include both IFRS and ASPE presentations)
Problem 6
The accounting records of Geoff Corp, a real estate developer, indicated income before
taxes and discontinued operations of $850,000 for its year ended December 31, 20x5 and
$525,000 for the year ended December 31, 20x6. The following additional data are
available.
1.
Geoff Corp. pays an annual life insurance premium of $9,000 covering the top
management team. The company is the named beneficiary in each case.
2.
The net book value of the company's property, plant, and equipment at January 1,
20x5 was $1,256,000, and the UCC at that date was $998,000. Geoff recorded
depreciation expense of $175,000 and $180,000 in 20x5 and 20x6, respectively.
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CMA Accelerated Program – Corporate Taxation and Financial Accounting 2
All assets are in one class for CCA purposes and are subject to a 20% CCA rate.
The company disposed of one asset in each of 20x5 and 20x6. Details with
regards to the assets disposed and additions is as follows:
Year
20x5
20x6
Original
Cost
$80,000
120,000
Disposals
Net Book
Value
$50,000
80,000
Proceeds
$60,000
140,000
Additions
$250,000
180,000
3.
Geoff deducted $211,000 as a restructuring charge in determining income for
20x4. At December 31, 20x4, an accrued liability of $199,500 remained
outstanding relative to the restructuring. This expense is deductible for tax
purposes, but only as the actual costs are incurred and paid for. As the actual
restructuring of operations took place in 20x5 and 20x6, the liability was reduced
to $68,000 at the end of 20x5 and $0 at the end of 20x6.
4.
In 20x5, property held for development was sold and a profit of $52,000 was
recognized in income. Because the sale was made with delayed payment terms,
the profit is taxable only as Geoff receives payment from the purchaser. A 10%
down payment was received in 20x5, with the remaining 90% expected in equal
amounts over the following three years.
5.
Nontaxable dividends of $2,250 were received from taxable Canadian
corporations in 20x5, and $2,750 in 20x6.
6.
In addition to the income before taxes identified above, Geoff reported a beforetax gain on discontinued operations of $18,800 in 20x5.
7.
The tax rate to the end of 20x5 was 30%. The tax rate for the year 20x6 onwards
is 32%. This change in tax rate was not known in 20x5.
Required (a)
(b)
(c)
(d)
Determine the balance of any deferred income tax asset or liability account at
December 31, 20x4.
Determine 20x5 and 20x6 taxable income.
Prepare the journal entries to record current and deferred income tax expense for
20x5 and 20x6.
Identify how the deferred income tax asset or liability account(s) will be reported
on the December 31, 20x5 and 20x6 Statement of Financial Positions under both
IFRS and ASPE.
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CMA Accelerated Program – Corporate Taxation and Financial Accounting 2
Problem 7
Reno Ltd., in the first year of its operations, reported the following information regarding
its operations:
a.
b.
c.
d.
e.
f.
Income before tax for the year was $1,300,000 and the tax rate was 35%.
Depreciation was $140,000 and CCA was $67,000. Net book value at year-end
was $820,000, while UCC was $893,000.
The warranty program generated an estimated cost (expense) on the income
statement of $357,000 but the cash paid out was $264,000. The $93,000 liability
resulting from this was shown as a current liability. On the income tax return, the
cash paid is the amount deductible.
Entertainment expenses of $42,000 were included in the income statement but
were not allowed to be deducted for tax purposes.
Franchise fee revenues of $90,000 were received. The company amortized the
franchise fees over the life of the franchise of 10 years. For tax purposes, the
franchise fees are taxable when received.
The company recorded a pension expense of $60,000 and made payments to the
pension plan trustee of $20,000
In the second year of its operations, Reno Ltd. reported the following information:
g.
h.
i.
j.
k.
l.
Income before income tax for the year was $1,550,000 and the tax rate was 37%.
Assets whose original cost was $100,000 were sold for $60,000. The net book
value of these assets was $85,000.
Depreciation was $140,000 and the CCA was $370,000. Net book value at year
end was $595,000, while UCC, was $463,000.
The estimated costs of the warranty program were $387,000 and the cash paid out
was $342,000. The liability had a balance of $138,000.
The company received dividends of $75,000 from another Canadian Company.
The investment is accounted for using the cost method.
The company recorded a pension expense of $75,000 and made payments to the
pension plan trustee of $200,000
Required Calculate tax expense, any related Statement of Financial Position amounts for both
years. Prepare the journal entries for both years.
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CMA Accelerated Program – Corporate Taxation and Financial Accounting 2
SOLUTIONS
Multiple Choice Questions
1.
c
2.
c
3.
a
Temporary difference at Dec 31, 20x3 =
Net book value: $400,000 x 3/5
UCC: $400,000 - 80,000 - 128,000
Deferred Income Tax Liability
$240,000
192,000
$48,000
x 30%
$14,400
4.
d
Temporary Difference = $24,000 ÷ .4 = $60,000
CCA = $400,000 + 60,000 = $460,000
5.
a
$300,000 x 30% = $90,000
6.
d
Temporary difference on litigation expense: $800,000 x 30% = $240,000
7.
d
On Installment sales: $600,000 x 30% = $180,000
8.
d
CCA = $90,000 x 20% x 1/2 = $9,000
Depreciation = $9,000
9.
b
$150,000 x 35% = $52,500 dr. since we are paying more taxes this year (i.e.
we will pay less taxes next year when this timing difference reverses out).
10.
d
Answer (a) result in a deferred income tax asset. A warranty liability will be
deductible in the deferred as costs are incurred. This will result in deductible
amounts giving rise to a deferred income tax asset today. Answers (b) and (c)
pertain to a permanent difference. Permanent differences do not give rise to
deferred income tax amounts.
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CMA Accelerated Program – Corporate Taxation and Financial Accounting 2
Problem 1
Income before taxes
Income tax
- Current
- Deferred
Net income
$235,000
$45,000
60,750
Income before taxes
Depreciation
CCA
Loss on sale of depreciable asset
Warranties
Less loss carry over
Taxable Income
Current portion of income tax expense
Deferred income tax account, December 31, 20x1
On NBV/UCC, beginning of year: $157,500 / .45
Excess of CCA over depreciation
Loss on sale of depreciable assets
On Warranty: 40,000 x 45%
105,750
$129,250
Taxable
Income
$ 235,000
200,000
(300,000)
5,000
40,000
180,000
(80,000)
100,000
x 45%
$45,000
$350,000
100,000
(5,000)
445,000
x 45%
$200,250 cr
18,000 dr
$182,250 cr
Deferred income tax expense = 182,250 – (157,500 – 36,000 On Loss CF) = $60,750
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CMA Accelerated Program – Corporate Taxation and Financial Accounting 2
Problem 2
Income before taxes
$700,000
Permanent Differences:
Interest expense
Dividends from taxable Canadian corporations
3,500
(35,000)
Timing Differences:
Depreciation
CCA
Provision for warranties
Gain on sale of depreciable asset: $192,500 - 70,000
157,500
(245,000)
70,000
(122,500)
$528,500
x 50%
$264,250
DIT Account Balance, December 31, 20x1:
On depreciable assets:
NBV, end of year ($1,575,000 - 157,500 Dep - 70,000 Disposal)
UCC, end of year: (1,330,000 - 245,000 CCA - 192,500 Disposal)
$1,347,500
892,500
455,000
x 50%
227,500 cr
35,000 dr.
$192,500 cr.
On Warranty: $70,000 x 50%
The DIT expense is equal to: $192,500 cr. - 122,500 cr. Opening DIT Account*
= $70,000
* (1,575,000 Opening NBV - 1,330,000 Opening UCC) x 50%
Alternatively, the DIT expense can be calculated by taking the sum of the timing
differences times the tax rate: 140,000 x 50% = $70,000. Note that this only works where
there has been no tax rate change.
The journal entries to record the provision for income taxes is as follows:
Income tax expense - current
Income taxes payable
Income tax expense - deferred
DIT Account
Page 117
$264,250
$264,250
70,000
70,000
© CMA Ontario - 2011
CMA Accelerated Program – Corporate Taxation and Financial Accounting 2
Problem 3
Accounting income
Depreciation expense
Capital cost allowance claimed
Taxable income
20x0
$155,000
77,500
(120,500)
112,000
20x1
$(170,500)
77,500
NIL
(93,000)
20x2
$232,500
77,500
(116,250)
193,750
x 42%
x 42%
x 42%
$47,040
($39,060)*
$81,375
$186,000
$204,060
$171,510
Current portion of income tax expense
DIT Account
Balance, beginning of year
Change during year:
20x0: $43,000 x 42%
20x1: ($77,500 x 42%)
20x2: $38,750 x 42%
Balance, end of year
18,060
(32,550)
$204,060
$171,510
16,275
$187,785
* carried back to 20x0
a)
20x0
20x1
20x2
Page 118
Income tax expense - current
Income taxes payable
$47,040
Income tax expense - deferred
DIT Account
18,060
Income taxes receivable
Income tax benefit - current
39,060
DIT Account
Income tax benefit - deferred
32,550
Income tax expense - current
Income taxes payable
81,375
Income tax expense - deferred
DIT Account
16,275
$47,040
18,060
39,090
32,550
81,375
16,275
© CMA Ontario - 2011
CMA Accelerated Program – Corporate Taxation and Financial Accounting 2
b)
Cinnamon Ltd.
Partial Income Statement
for the Year Ending December 31, 20x1
Loss before income taxes
Income tax benefit
$(170,500)
Current
Deferred
Net loss
c)
$39,060
32,550
71,610
$ (98,890)
$187,785 per schedule above
Page 119
© CMA Ontario - 2011
CMA Accelerated Program – Corporate Taxation and Financial Accounting 2
Problem 4
Net income before tax
Permanent differences:
Dividend income
Timing differences
Warranty expense
Warranty costs
Depreciation
CCA
Pension expense
Pension funding
Taxable income
Tax rate
Income tax payable
Income tax expense:
Current
Deferred (see schedule)
Income tax expense
20xl
$ 100,000
20x2
$ 100,000
20x3
$ 100,000
-2,000
-2,000
-3,000
3,000
-1,000
10,000
-25 000
5,000
-7,000
$ 83,000
40%
$33,200
3,000
-4,000
10,000
-15,000
7,000
-8,000
$ 91,000
44%
$40,040
3,000
-3,000
12,000
-7,000
10,000
-9,000
$103,000
48%
$49,440
$ 33,200
6,000
$ 39,200
$40,040
3,680
$43,720
$49,440
-2,000
$47,440
Temporary Differences and DIT - 20x1
Warranty - $2,000 x 40%
Fixed Assets: 110,000 NBV - 95,000 UCC = 15,000 x 40%
Pension Asset: $2,000 x 40%
Net DIT
Classification (IFRS)
Long-term assets (Warranty)
Long-term liabilities (Fixed Assets & Pension)
Classification (ASPE)
Current Assets (Warranty)
Long-term liabilities (Fixed Assets & Pension)
Temporary Differences and DIT - 20x2
Warranty: $1,000 x 44%
Fixed Assets: 100,000 NBV - 80,000 UCC = 20,000 x 44%
Pension Asset: $3,000 x 44%
Net DIT
Less DIT - beginning of year
Increase = DIT portion of Income Tax Expense
Page 120
$800
6,000
800
$6,000
Dr.
Cr.
Cr.
Cr.
$800
6,800
$800
6,800
440
8,800
1,320
9,680
6,000
3,680
Dr.
Cr.
Cr.
Cr.
Cr.
© CMA Ontario - 2011
CMA Accelerated Program – Corporate Taxation and Financial Accounting 2
Classification (IFRS)
Long-term assets (Warranty)
Long-term liability (Fixed Assets & Pension)
440
10,120
Classification (ASPE)
Current Assets (Warranty)
Long-term liabilities (Fixed Assets & Pension)
440
10,120
Temporary Differences and DIT - 20x3
Warranty: $1,000 x 48%
Fixed Assets: 88,000 NBV - 73,000 UCC = 15,000 x 48%
Pension Asset: $2,000 x 48%
Net DIT
Less DIT - beginning of year
Decrease = DIT portion of Income Tax Expense (credit)
480
7,200
960
7,680
9,680
2,000
Classification (IFRS)
Long-term assets (Warranty)
Long-term liability (Fixed Assets & Pension)
480
8,160
Classification (ASPE)
Current Assets (Warranty)
Long-term liabilities (Fixed Assets & Pension)
480
8,160
Page 121
Dr.
Cr.
Cr.
Cr.
Cr.
© CMA Ontario - 2011
CMA Accelerated Program – Corporate Taxation and Financial Accounting 2
Journal Entries:
20xl
Income tax expense – current
Income taxes payable
Income tax expense – deferred
DIT Account
20x2
Income tax expense – current
Income taxes payable
Income tax expense – deferred
DIT Account
20x3
Income tax expense – current
Income taxes payable
DIT Account
Income tax expense – deferred
Page 122
33,200
33,200
6,000
6,000
40,040
40,040
3,680
3,680
49,440
49,440
2,000
2,000
© CMA Ontario - 2011
CMA Accelerated Program – Corporate Taxation and Financial Accounting 2
Problem 5
Income before taxes
$1,000,000
Permanent differences Nondeductible portion of entertainment expenses: $25,000 x 50%
Dividends received from a Canadian Corporation
12,500
(70,000)
Timing Differences
Depreciation expense
CCA
300,000
(400,000)
Warranty expense
Warranty costs paid
50,000
(30,000)
Taxable income
$862,500
Tax rate
40%
Current portion of income tax expense
Temporary differences - beginning of year:
$10,000 ÷ .4 | $250,000 ÷ .4
Change in temporary differences
Temporary differences - end of year:
DIT Balances, end of year
Less DIT Balances, beginning of year
Increase
$345,000
Warranty
Amort.
$25,000
20,000
45,000
$625,000
100,000
725,000
x 45%
x 45%
20,250
10,000
326,250
250,000
$10,250
$76,250
DIT expense = $76,250 - 10,250 = $66,000
Income tax expense
Current
Deferred
$345,000
66,000
$411,000
Statement of Financial Position Presentation (IFRS):
DIT Long-Term Assets
DIT Long-Term Liabilities
$20,250
326,250
Statement of Financial Position Presentation (ASPE):
FIT Current Assets
FIT Long-Term Liabilities
$20,250
326,250
Page 123
© CMA Ontario - 2011
CMA Accelerated Program – Corporate Taxation and Financial Accounting 2
Problem 6
(a)
On NBV/UCC: $1,256,000 - 998,000 = $258,000 x 30%
On the restucturing charge: $199,500 x 30%
Net DIT Account
$77,400 cr.
59,850 dr.
$17,550 cr.
Statement of Financial Position Presentation Current Asset
DIT
Long-Term liabilities
DIT
(b)
Income before taxes and discontinued items
Permanent differences
Life insurance premiums
Dividends
Non taxable portion of capital gain: $20,000 x 1/2
Timing differences
Depreciation
CCA:
$998,000 x 20% + (250,000 - 60,000) x 20% x 1/2
$969,400 x 20% + (180,000 - 120,00) x 20% x 1/2
Gain on sale of assets
Capital gain
Restructuring charges
Profit on land development
Taxable profit on land development
Taxable income
Add taxes on income for discontinued operations
$18,800 x 30%
Taxes payable
Page 124
$59,850
$77,400
20x5
20x6
$850,000
$525,000
9,000
(2,250)
9,000
(2,750)
(10,000)
175,000
180,000
(218,600)
(10,000)
(199,880)
(60,000)
20,000
(131,500)
(68,000)
(52,000)
5,200
15,600
624,850
408,970
x 30%
x 32%
$187,455
$130,870
5,640
$193,095
$130,870
© CMA Ontario - 2011
CMA Accelerated Program – Corporate Taxation and Financial Accounting 2
(c)
NBV
UCC
$1,256,000
250,000
(50,000)
(175,000)
$998,000
250,000
(60,000)
(218,600)
Balance, end of 20x5
1,281,000
969,400
Additions
Disposals
Depreciation/CCA
180,000
(80,000)
(180,000)
180,000
(120,000)
(199,880)
$1,201,000
$829,520
Balance, beginning of 20x5
Additions
Disposals
Depreciation/CCA
Balance, end of 20x6
DIT Account, end of 20x5:
On NBV/UCC: $1,281,000 - 969,400 = $311,600 x 30%
On restucturing charges: $68,000 x 30%
On land development gain: ($52,000 - 5,200) x 30%
$93,480 cr.
20,400 dr.
14,040 cr.
$87,120 cr.
DIT expense, 20x5: $87,120 - 17,550 = $69,570
DIT Account, end of 20x6:
On NBV/UCC: $1,201,000 - 829,520 = $371,480 x 32%
On land development gain: ($52,000 - 5,200 - 15,600) x 32%
$118,874 cr.
9,984 cr.
128,858 cr.
DIT expense, 20x6: $128,858 - 87,120 = $41,738
20x5
20x6
Page 125
Income tax expense - current
Discontinued Operations Gain
Income tax payable
$187,455
5,640
Income tax expense - deferred
DIT Account
69,570
Income tax expense - current
Income tax payable
130,870
Income tax expense - deferred
DIT Account
41,738
$193,095
69,570
130,870
41,738
© CMA Ontario - 2011
CMA Accelerated Program – Corporate Taxation and Financial Accounting 2
(d)
IFRS 20x5
20x6
Long-Term Assets
DIT
Long-Term Liabilities
DIT ($93,480 + 14,040)
Long-Term Liabilities
DIT (118,874 + 9,984)
$20,400
107,520
128,858
ASPE 20x5
20x6
Page 126
Current Assets
FIT [20,400 - $14,040 / 3]
Long-Term Liabilities
FIT [$93,480 + (14,040 x 2/3)]
Current Liabilities
FIT ($9,984 / 2)
Long-Term Liabilities
FIT [118,874 + (9,984/2)]
$15,720
102,840
4,992
123,866
© CMA Ontario - 2011
CMA Accelerated Program – Corporate Taxation and Financial Accounting 2
Problem 7
Calculation of Current Income Taxes Payable:
Income before taxes
Permanent differences
Entertainment expenses
Dividends received from taxable Canadian corp.
Year 1
$1,300,000
Year 2
$1,550,000
42,000
(75,000)
Timing Differences
Depreciation
CCA
Loss on sale of asset (85,000 - 60,000)
140,000
(67,000)
140,000
(370,000)
25,000
357,000
(264,000)
387,000
(342,000)
Amortization of franchise fee revenues
Franchise fee revenues
(9,000)
90,000
(9,000)
Pension expense
Payments made to pension plan trustee
60,000
(20,000)
1,629,000
x 35%
$570,150
75,000
(200,000)
1,181,000
x 37%
$436,970
Warranty expense
Warranty costs incurred
Current income taxes payable
DIT Account, end of Year 1
NBV/UCC: $893,000 – 820,000 = $73,000 x 35%
Warranty liability: $93,000 x 35%
Franchise: $81,000 x 35%
Pension liability: $40,000 x 35%
25,550 dr.
32,550 dr.
28,350 dr.
14,000 dr.
$100,450 dr.
Income tax expense, Year 1
Net income before taxes
Provision for income taxes
Current
Deferred
Net Income
Page 127
$1,300,000
$570,150
(100,450)
469,700
$830,300
© CMA Ontario - 2011
CMA Accelerated Program – Corporate Taxation and Financial Accounting 2
Classification of DIT Account on Statement of Financial Position, Year 1
Long-Term assets
DIT
$100,450
DIT Account, end of Year 2:
NBV/UCC difference: 132,000 x 37%
Warranty liability: 138,000 x 37%
Franchise fee: (90,000 - 9,000 - 9,000) = 72,000 x 37%
Pension Account: $85,000 dr.* x 37%
*
48,840
51,060
26,640
31,450
2,590
Cr.
Dr.
Dr.
Cr.
Cr.
Total pension expense in years less total contributions made in Years 1 and 2:
$60,000 + 75,000 – 20,000 – 200,000 = $85,000 dr.
Income tax expense, Year 2
Net income before taxes
Provision for income taxes
Current
Deferred (100,450 + 2,590)
Net Income
$1,550,000
$436,970
103,040
540,010
$1,009,990
Classification of DIT Balances on Statement of Financial Position, Year 2
Long-Term Assets
DIT ($51,060 + 26,640)
$77,700
Long-Term Liabilities
DIT ($48,840 + 31,450)
$80,290
Page 128
© CMA Ontario - 2011
CMA Accelerated Program – Corporate Taxation and Financial Accounting 2
2.
Accounting Policies, Changes in Accounting Estimates and Errors
Selection and application of accounting policies
When an IFRS specifically applies to a transaction, other event or condition, the
accounting policy or policies applied to that item shall be determined by applying the
IFRS. (IAS 8.7)
Otherwise, management is expected to use judgment in developing and applying an
accounting policy that results in information that is:
(a)
relevant to the economic decision-making needs of users, and
(b)
reliable. (IAS 8.10)
In making this judgment, management must refer to the following sources in descending
order:
•
the requirement in IFRS's dealing with similar and related issues, and
•
the definitions, recognition criteria and measurement concepts for assets,
liabilities, income and expenses in the Framework. (IAS 8.11)
In addition, management may also consider the most recent pronouncements of other
standard-setting bodies that use a similar conceptual framework to develop accounting
standards, other accounting literature and accepted industry practices, to the extent that
these do not conflict with the two sources listed in paragraph 11. (IAS 8.12)
Change in an accounting policy
Accounting policies are defined as the specific principles, bases, conventions, rules and
practices applied by an entity in preparing and presenting financial statements (IAS 8.5).
There is a general presumption that the accounting policies followed by an enterprise are
consistent within each accounting period and from one period to the next (IAS 8.13). A
change in an accounting policy may be made only if the change: (a) is required by an
IFRS, or (b) results in the financial statements providing reliable and more relevant
information about the effects of transactions, other events or conditions on the entity's
financial position, financial performance and cash flows. (IAS 8.14)
The accounting treatment for a change in accounting policy is retrospective treatment;
that is, all comparative financial figures are restated as if the newly adopted accounting
policy had been adopted originally.
When a change in an accounting policy is applied retrospectively, the financial
statements of all prior periods presented for comparative purposes should be restated to
give effect to the new accounting policy, except in those circumstances when the effect of
the new accounting policy is not reasonably determinable for individual prior periods. In
such circumstances, an adjustment should be made to the opening balance of retained
earnings of the current period, or such earlier period as is appropriate, to reflect the
cumulative effect of the change on prior periods. (IAS 8.22 to 8.25)
Page 129
© CMA Ontario - 2011
CMA Accelerated Program – Corporate Taxation and Financial Accounting 2
Under IFRS, most changes in accounting policy will arise from those imposed by the
International Accounting Standards Board when they publish a new standard. Under
ASPE, changes in accounting policy will arise from new standards, but may also arise if a
firm changes internal accounting policies. For example, if a private company subject to
ASPE changes their depreciation policy from straight line to diminishing balance, then
this will be treated as a change in accounting policy and will be applied retrospectively.
However if the entity is subject to IFRS, then a change from the straight-line method to
diminishing balance method could only occur if they realize that the revenue generation
pattern of their assets is not what they expect them to be. The change in depreciation
methods in this case will be treated as a change in accounting estimate and applied
prospectively. This is discussed in the next section.
Example 1: In December 20x5, the Morrow Company, a private company subject to
ASPE, has decided to change its depreciation policy on its building from the diminishing
balance to the straight-line method. The motivation for the change is that the straight-line
method results in the financial statements being more reliable and relevant. The building
was purchased on January 1, 20x2, for $450,000 and was being depreciated at 4% per
annum, diminishing balance. Using the straight-line method, it will be depreciated over
40 years with an estimated residual value of $50,000. The annual depreciation charge
under the straight-line method will be: ($450,000 - 50,000) ÷ 40 years = $10,000 per
year.
A summary of the actual depreciation charges taken to date and what the depreciation
charges using the straight-line method would have been are:
Diminishing-Balance
Depreciation
Accumulated
Expense
Depreciation
20x2
20x3
20x4
20x5
$18,000
17,280
16,589
15,925
$18,000
35,280
51,869
67,794
Straight -Line
Depreciation
Accumulated
Expense
Depreciation
$10,000
10,000
10,000
10,000
$10,000
20,000
30,000
40,000
Assuming a calendar year end, the Morrow Company will present the 20x4 comparative
figures along with its 20x5 financial statements. The 20x4 figures will have to be
restated as follows:
•
the 20x4 opening accumulated depreciation balance will have to be reduced by
$15,280 ($35,280 - 20,000); the corresponding adjustment will be made to retained
earnings and to the DIT account (assuming a tax rate of 40%):
Accumulated Depreciation
Deferred Income Tax Account ($15,280 x 40%)
Retained Earnings ($15,280 x 60%)
Page 130
$15,280
$6,112
9,168
© CMA Ontario - 2011
CMA Accelerated Program – Corporate Taxation and Financial Accounting 2
•
•
the 20x4 depreciation expense will have to be restated to $10,000
the 20x5 depreciation expense will have to be recorded at $10,000 also.
Change in an accounting estimate
Many items in financial statements cannot be measured with precision but can only be
estimated. Estimation involves judgments based on the most recent available reliable
information. Examples of accounting estimates are:
• residual value of a fixed asset,
• estimated useful life of a fixed asset,
• allowance for doubtful accounts,
• percentage of completion of long-term projects, and
• warranty obligations.
Whenever a change is made to an accounting estimate, the accounting treatment is
prospective; that is, no restatement of previous balances are made. (IAS 8.36)
Example 2: The Barlow Company acquired a building on January 1, 20x0, for $500,000.
The building is being depreciated on the straight-line basis over 40 years with no residual
value. We are now in December 20x5 and have determined that the building had in fact
an estimated useful life of only 30 years with an estimated residual value of $80,000.
The company year-end is December 31.
The net book value of the building as at January 1, 20x5, is as follows:
Cost
Less Accumulated depreciation:
$500,000 x 5/40
Net book value
$500,000
62,500
$437,500
We now want to depreciate this amount over the remaining useful life of the building of
25 years (30 years total less 5 years gone by). The depreciation charge for 20x5 will be
$14,300 [($437,500 - 80,000) ÷ 25 years].
Correction of an error in prior period financial statements
Sometimes it is necessary to correct a material error made in financial statements that
have already been issued. Such an error can be the result of a error in computation,
misinterpretation of information, an oversight, or from a misappropriation of assets. The
accounting treatment for errors is retrospective. That is, the error is corrected in the year
in which it took place. Comparative financial statements are restated with the correction
made. (IAS 8.42)
Example 3: The Marlow Company is in the process of preparing its December 31, 20x5,
financial statements and discovers that an error was made in the 20x4 statements. The
Page 131
© CMA Ontario - 2011
CMA Accelerated Program – Corporate Taxation and Financial Accounting 2
inventory listing for the December 31, 20x4, inventory was added to $354,000 when it
should have been $454,000. The error is material and it wants to correct it.
The 20x4 cost of goods sold will have to be restated by reducing it by $100,000. This
will increase 20x4 net income by $100,000. The opening inventory balance will also
have to be restated on the comparative Statement of Financial Position and in the
calculation of the 20x5 cost of goods sold.
Impact of Taxes
Whenever a retrospective adjustment is made to retained earnings, the net impact on
retained earnings has to be net of tax.
A change in accounting policy or an accounting error will either impact income taxes
receivable/payable or the DIT account:
•
if the change in accounting policy/accounting error impacts temporary
differences, then we need to adjust the DIT account accordingly. For example, if
we change from straight-line to declining balance in accounting for capital assets,
then this will impact the net book value of the assets and consequently will have
an impact on the difference between net book value and UCC, a temporary
difference.
•
if the change in accounting policy/accounting error do not impact temporary
differences, then we will either credit income taxes payable or debit income taxes
receivable. For example, if we change from FIFO to weighted average cost flow
assumption for inventory (both acceptable for tax purposes), then this change
would result in either an income tax liability or an income tax receivable.
Example 1 – on January 1, 20x2 a machine is purchased for $500,000. The useful life of
the machine is 10 years and the residual value is $100,000. The company’s accounting
policy is to use the diminishing method of depreciation at the rate of 20%. During, 20x5
the company (subject to ASPE) decides to switch to the straight line method of
depreciation. Assuming a tax rate of 40%, a fiscal year that coincides with the calendar
year and that this change qualifies as a change in accounting policy, this change will
result in an adjustment to opening retained earnings as follows.
First we calculate the difference in the new book value of the asset at January 1, 20x5:
NBV using DDB:
Net book value of machine = $500,000 x 0.803
NBV using straight line:
Cost
Less accumulated depreciation ($500,000 – 100,000) /10 x 3 years
Increase in net book value due to accounting change
Page 132
$256,000
$500,000
120,000
380,000
$124,000
© CMA Ontario - 2011
CMA Accelerated Program – Corporate Taxation and Financial Accounting 2
The increase in net book value will increase the NBV/UCC temporary difference, thereby
resulting in a credit to the DIT account in the amount of $124,000 x 40% = $49,600.
The journal entry to record the cumulative effect of the accounting policy change:
Accumulated depreciation
DIT Account
Retained Earnings
$124,000
49,600
74,400
Example 2 – on October 31, 20x4 a two year insurance policy was purchased in the
amount of $240,000 and was expensed to insurance expense. No adjustment was made at
December 31, 20x4, the company’s year end. This error was discovered during 20x5 after
the 20x4 financial statements were issued. The company’s tax rate is 40%.
The adjusting entry as at January 1, 20x5 needs to debit prepaid insurance by $220,000.
Also, because this $220,000 was also deducted for income tax purposes we owe CRA
$220,000 x 40% = $88,000.
The journal entry to correct this error will be:
Prepaid insurance
Income taxes payable
Retained Earnings
$220,000
$88,000
132,000
Example 3 – This example is one where both the DIT Account and income taxes
payable/receivable are affected. Again, assume that the company’s fiscal year is the
calendar year and that the tax rate is 40%.
On January 2, 20x3, land costing $250,000 is purchased and is debited to the equipment
account by error. This error is discovered in 20x5. The company amortizes equipment on
the diminishing balance at the rate of 10%.
The depreciation taken in the years 20x3 and 20x4 must be removed:
20x3: $250,000 x 10% = $25,000
20x4: $225,000 x 10% = $22,500
Total = $47,500
Because the company debited the land to the equipment account, CCA was taken in the
amount of (assuming Class 8):
20x3: $250,000 x 10% = $25,000
20x4: $225,000 x 20% = $45,000
Total = $70,000
Page 133
© CMA Ontario - 2011
CMA Accelerated Program – Corporate Taxation and Financial Accounting 2
Because we were not entitled to this claim, we owe CRA: $70,000 x 40% = $28,000.
Finally, this transaction created a credit in the DIT Account of $70,000 – 47,500 =
$22,500 x 40% = $9,000.
The journal entry to correct this error will be:
Land
Equipment
Accumulated depreciation
DIT Account
Income taxes payable
Retained earnings ($47,500 x .6)
Page 134
$250,000
$250,000
47,500
9,000
28,000
28,500
© CMA Ontario - 2011
CMA Accelerated Program – Corporate Taxation and Financial Accounting 2
Problems with Solutions
Multiple Choice Questions
1.
When a company subject to ASPE changes its method of depreciation from
straight-line to diminishing balance, the change should be accounted for
a.
Retrospectively with restatement of prior years.
b.
Retrospectively without restatement of prior years.
c.
All in the year of change.
d.
Over the remaining service life of the asset.
2.
An asset purchased January 1, 20x4, costing $10,000, with a 10-year useful life
and no residual value, was depreciated under the straight-line method during its
first four years. During 20x8, the total useful life was re-estimated to be 17
years. What is the amount of depreciation expense in for the year ended
December 31, 20x8?
a.
$462.
b.
$412.
c..
$464.
d.
$500.
3.
A company made a retrospective accounting change in 20x6. Only the net
incomes of 20x5 and 20x6 were affected. Therefore, the comparative retained
earnings statements featuring both years should disclose which of the following?
a.
cumulative effect adjusting the January 20x4 retained earnings balance.
b.
a cumulative effect adjusting the January 1, 20x5 and 20x6 retained
earnings balances.
c.
a cumulative effect adjusting the January 1, 20x6 retained earnings
balance.
d.
No cumulative effect.
4.
A company using a perpetual inventory system neglected to record a purchase of
merchandise on account at year end. This merchandise was omitted from the yearend physical count. How will these errors affect assets, liabilities, and shareholders'
equity at year end and net income for the year?
a)
b)
c)
d)
Page 135
Assets
No effect
No effect
Understate
Understate
Liabilities
Understate
Overstate
Understate
No effect
Equity
Overstate
Understate
No effect
Understate
Net Income
Overstate
Understate
No effect
Understate
© CMA Ontario - 2011
CMA Accelerated Program – Corporate Taxation and Financial Accounting 2
5.
On January 1, 20x0, Bleeker Co., a private company subject to ASPE, purchased a
machine (its only amortizable asset) for $300,000. The machine has a five-year
life, and no residual value. The diminishing depreciation method (40%) has been
used for financial statement reporting and the capital cost allowance for income tax
reporting. Effective January 1, 20x3, for financial statement reporting, Bleeker
decided to change to the straight-line method for depreciation of the machine.
Assume that Bleeker can justify the change.
Bleeker's income before income taxes, and before the cumulative effect of the
accounting change (if any), for the year ended December 31, 20x3, is $224,080.
The income tax rate for 20x3, as well as for the years 20x0-20x2, is 30%. What
amount should Bleeker report as net income for the year ended December 31,
20x3?
a) $190,000.
b) $171,640.
c) $133,000.
d) $91,000.
6.
On January 1, 20x0, Lane Corporation, a private company subject to ASPE,
acquired machinery at a cost of $400,000. Lane adopted the diminishing balance
method of depreciation (rate = 25%) for this equipment and had been recording
depreciation over an estimated life of eight years, with no residual value. At the
beginning of 20x3, a decision was made to change to the straight-line method of
depreciation for this equipment. Assuming a 30% tax rate, the cumulative effect of
this accounting change, net of tax, is
a) $81,250
b) $56,875
c) $52,500
d) 51,406
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CMA Accelerated Program – Corporate Taxation and Financial Accounting 2
7.
Hannah Company began operations on January 1, 20x2, and uses the FIFO method
in costing its raw material inventory. Management is contemplating a change to the
WA method and is interested in determining what effect such a change will have
on operating income. Accordingly, the following information has been developed:
Final Inventory
FIFO
WA
Operating income calculated under the
FIFO method
20x2
20x3
$210,000
180,000
$270,000
225,000
375,000
450,000
Based upon the above information, a change to the WA method in 20x3 would
result in an operating income for 20x3 of
a) $405,000
b) $450,000
c) $435,000
d) $495,000
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© CMA Ontario - 2011
CMA Accelerated Program – Corporate Taxation and Financial Accounting 2
Problem 1
Bologna Ltd., which commenced operations on November 1, 20x3, has always used
FIFO to value inventory. At the year end, October 31, 20x5, management decided to
change to the Weighted Average method in order to achieve a better matching of costs
with revenue on the income statement. Bologna uses a perpetual inventory system.
Analysis of inventory costs reveals the following:
October 31, 20x4
October 31, 20x5
FIFO
Weighted
Average
$130,000
170,000
$125,000
150,000
Required Prepare the entry(ies) at October 31, 20x5, relating to the inventory of Bologna Ltd.,
assuming that the books have not yet been closed. Why have you chosen this particular
method of accounting for this change? Explain fully. Assume a tax rate of 40%.
Problem 2
Cognac Limited bought a machine at the beginning of 20x0 which cost $10,000 and had a
ten-year estimated useful life, with a $1,000 residual value. At the end of 20x5, the
company determined that the machine would last an additional two years only, after
which a $1,500 residual value is expected. The company uses straight-line depreciation.
Required Prepare the entry for the 20x5 depreciation expense, assuming that the books have not yet
been closed. Why have you chosen this particular method of accounting for this change?
Explain fully.
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© CMA Ontario - 2011
CMA Accelerated Program – Corporate Taxation and Financial Accounting 2
Problem 3
Travis Corporation has just completed its financial statements for the reporting year
ended December 31, 20x5. The pretax income amount is $160,000. The accounts have
not been closed for December 31, 20x5. Further consideration and review of the records
revealed the following items related to the 20x5 statements:
a.
On January 1, 20x1, a machine was acquired that cost $10,000. The estimated
useful life was 10 years, and the residual value was $2,000. At the time of
acquisition, the full cost of the machine was incorrectly debited to the land
account. Assume straight-line depreciation. The machine belongs to Class 8 20% for CCA purposes.
b.
On January 1, 20x3, a long-term investment of $18,000 was made by purchasing a
$20,000, 8% bond of XT Corporation. The investment account was debited for
$18,000. Each year, starting on December 31, 20x3, the company has recognized
and reported investment revenue on these bonds of $1,600. The bonds mature in
10 years from the date of purchase. Assume any depreciation would be straight
line and the net method is used to record the investment.
c.
The 20x4 ending inventory was overstated by $7,000.
d.
A $11,000 purchase of merchandise occurred on December 18, 20x4. Because the
merchandise was on hand on December 31, 20x4, it was included in the 20x4
ending inventory. The purchase was recorded on January 18, 20x5, when the
invoice was paid.
Required
1.
Prepare any correcting and adjusting entries that should be made on December 31,
20x5. Assume a tax rate of 40%.
2.
Compute the correct pretax income for 20x5. Set up an appropriate schedule that
reflects each change and the correct pretax income for 20x5.
Page 139
© CMA Ontario - 2011
CMA Accelerated Program – Corporate Taxation and Financial Accounting 2
Problem 4
The Lisgar Company is in the process of preparing its adjusting entries for the year 20x9
and has come across the following items:
i.
It was discovered that a Truck costing $120,000 was expensed during the year
20x6. The truck was acquired on January 3, 20x6. The useful life of the truck is
10 years and a residual value of $20,000. The company uses the diminishing
balance method to depreciate its capital assets at a rate of 20%. The asset is a
Class 10 asset (30%). The truck was never added to the UCC class in 20x6.
ii.
The company’s building was acquired at a cost of $1,500,000 on January 1, 20x0.
The residual value and useful life of the building was estimated to be $200,000
and 40 years respectively, at the time. You now estimate that the residual value of
the building will only be $100,000 and the total estimated useful life to be 35
years. Depreciation is on the straight line basis and has already been recorded for
the year 20x9.
Required Prepare the journal entries to record the adjustments required by the above. Assume a tax
rate of 35%.
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© CMA Ontario - 2011
CMA Accelerated Program – Corporate Taxation and Financial Accounting 2
Problem 5
In examining the books of Carlyle Company, you discover the following errors:
a) Incorrect exclusion from the ending inventory of goods costing $4,000 for which the
purchase was not recorded.
b) Inclusion in the ending inventory of goods costing $8,000, although the purchase was
not recorded. The goods in question were being held on consignment from Alta
Company.
c) Incorrect exclusion of $3,000 from the inventory count at the end of the period. The
goods were in transit (f.o.b. shipping point); the invoice was received and the
purchase was recorded.
d) Items on the receiving dock that were being held for return to the vendor because of
damage were incorrectly included in inventory and a purchase of $6,000 was
recorded.
The records (uncorrected) showed the following amounts:
e)
f)
g)
h)
Purchases, $140,000
Income before tax, $25,000
Accounts payable, $28,000
Inventory at end of the period, $40,000
Required Determine the corrected amounts for items (e) through (h).
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© CMA Ontario - 2011
CMA Accelerated Program – Corporate Taxation and Financial Accounting 2
Problem 6
The Holbrook Company which uses the straight-line method of depreciation, purchased
three machines on the first day of business in January 20x0. Details of the purchase are as
follows:
MACHINE X
Cost
Estimated life
Estimated scrap
$15,000
5 years
None
MACHINE Y
$15,000
6 years
$ 2,400
MACHINE Z
$15,000
8 years
$ 600
During the first week of business in January 20x5, Machine X was sold for $2,000. This
prompted management to re-examine not only the useful life expectancy but also the
scrap expectancy of machines Y and Z. They decided that Machine Y had a remaining
life of three years as of January 1, 20x5, and that the scrap evaluation of $2,400 was
about right. Machine Z's estimated scrap value is $0 and has a remaining useful life of 4
years.
Required Prepare journal entries to reflect all of the events and information related to the three
machines during 20x5, including depreciation expense.
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© CMA Ontario - 2011
CMA Accelerated Program – Corporate Taxation and Financial Accounting 2
Problem 7
L. G. Conn Manufacturing is preparing its year-end financial statements. The controller is
confronted with several decisions about statement presentation with regard to the
following items:
1. When the year-end physical inventory adjustment was made for the current year, the
prior year's physical inventory sheets for an entire warehouse were discovered to have
been misplaced and excluded from last year's count.
2. The method of accounting used for financial reporting purposes for certain
receivables has been approved for tax purposes during the current tax year by the
Canada Revenue Agency. This change for tax purposes will cause both deferred and
current taxes payable to change substantially.
3. Management has decided to switch from the FIFO method to the Weighted Average
method for all inventories.
4. Conn's Custom Division manufactures large-scale, custom-designed machinery on a
contract basis. Management decided to switch front the completed-contract method to
the percentage-of-completion method of accounting for long-term contracts. The
switch from completed contract method was done because is no longer allowable.
5. The vice-president of sales indicated that one product line has lost its customer appeal
and will be phased out over the next three years. Therefore, a decision has been made
to lower the estimated lives of related production equipment from the remaining five
years to three years.
6. Estimating the lives of new products in the Leisure Products Division has become
very difficult because of the highly competitive conditions in this market. Therefore,
the practice of deferring and amortizing preproduction costs has been abandoned in
favour of expensing such costs as they are incurred.
7. The MTV Building was converted from a sales office to offices for the accouting
department at the beginning of this year. Therefore, the expense related to this
building will now appear as all administrative expense rather than as a selling
expense on current and future years' income statements.
Required For each of the seven changes or errors L. G. Conn Manufacturing has made in the
current year. Identify and explain whether the change is a change in accounting principle,
a change in estimate, or an error. If any of the changes is not one of these items, explain
why.
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© CMA Ontario - 2011
CMA Accelerated Program – Corporate Taxation and Financial Accounting 2
Problem 8
Your employer approaches you for help regarding the financial statements prepared for
the years ending December 31, 20x1 and 20x2. The owner is not satisfied with the
previous accountant's work and has asked you to check on the accuracy of the statements
prepared. Your examination reveals the following:
a) An invoice for a $5,000 shipment of goods was received and the purchase recorded
on December 26, 20x1. The goods were shipped f.o.b. destination, did not arrive until
January 3, 20x2, and were not included in the December 31, 20x1, inventory count.
b) A three-year insurance policy was purchased for $2,400 on June 30, 20x1, and the
full amount was expensed at that time.
c) Accrued wages at the end of 20x1 and 20x2 amounted to $500 and $400,
respectively. The accountant did not make the necessary year-end adjustments.
d) On October 1, 20x1, the company purchased at par $10,000 of 8 percent corporate
bonds. The bonds were dated October 1, 20x1, and paid interest semi-annually. The
accountant recorded interest revenue when the cash was received.
e) Depreciation was not recorded in 20x1 and 20x2. The amounts were $1,600 for 20x1
and $2,000 for 20x2.
Required Indicate the amount of the understatement (U) or overstatement (O) of each of the above
errors. Indicate no effect by N. Treat each item independently. Ignore taxes.
Net Income
20x1
20x2
Total Assets, 12/31
20x1
20x2
Total Liabilities, 12/31
20x1
20x2
a)
Etc…
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© CMA Ontario - 2011
CMA Accelerated Program – Corporate Taxation and Financial Accounting 2
Problem 9
McGraw Corporation is a medium-sized privately held Canadian corporation that
operates stores across Canada selling a wide variety of home gym equipment. The
company was founded in the mid-1980s by a group of businessmen who were convinced
that there was an opportunity for a company that catered to the physical fitness boom.
After a slow start, McGraw prospered and, in 20x3, it owned more than 50 stores.
The company's 20x3 fiscal year has just ended and you, as assistant controller, have been
involved in preparing draft financial statements. The executive committee, consisting of
the company president, four vice-presidents, and the controller, spent all Monday
morning reviewing the 20x3 draft financial statements.
Following the meeting, Joe Wilson, the controller, called you into his office to brief you
on the proceedings. After thanking you for your work on the financial statements and
passing along the general comments of the executive committee, he outlined a number of
issues he wished you to investigate.
The committee discussed changes in accounting policy and practice that it was
considering for this year. An inventory accounting error was also discussed. The
committee wished to have an explanation of how each item should be reflected in the
financial statements and of each item's dollar impact on net income for 20x3. The notes
that Mr. Wilson took during the meeting are shown in Exhibit 1.
Also, the committee spent time discussing existing accounting policies and some
alternatives that might be adopted in the future. Several committee members were
confused about the pros and cons of the alternatives and the effects they would have on
the firm's operating results and financial position. Mr. Wilson's notes on the discussion
are in Exhibit 2.
To satisfy investors and creditors, management would like to present a steady growth in
accounting income. A significant portion of the company's financing is obtained through
bank loans and the bank loan agreements require audited financial statements.
Mr. Wilson has asked you to prepare a report, complete with your recommendations, to
be circulated to the members of the executive committee.
Required:
Write the report requested by Mr. Wilson.
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© CMA Ontario - 2011
CMA Accelerated Program – Corporate Taxation and Financial Accounting 2
Exhibit 1
Notes from Financial Statements Review Meeting
Proposed Changes for 20x3
1. Change in depreciation method:
• was straight-line, $400,000 per year.
• proposed change to diminishing balance, $600,000 for 20x3 year.
• uncertain as to whether information is available to restate specific prior years.
2. Leasehold improvements:
• leasehold improvements of $450,000 made in fiscal 20x0, useful life estimated at 10
years.
• "Improvements" now obsolete: major renovations planned for early next month.
Useful life should have been four years.
• president suggests writing undepreciated balance off to retained earnings since cost
should have been matched to revenues in prior periods. If not, president favors
extraordinary item treatment.
3. Inventory error:
• error in determination of the closing inventory, fiscal 20x1, discovered last week.
• inventory as reported approximately $200,000 understated.
4. Note: tax rate is 45%.
Exhibit 2
Notes from Financial Statement Review Meeting
Proposed Policies for Future Implementation
1.
•
•
•
•
Inventory:
proposed change is from FIFO to LIFO inventory valuation.
LIFO closing inventory value about $500,000 lower than FIFO for 20x3.
LIFO opening inventory about $700,000 lower than FIFO for 20x3.
other Canadian companies generally use FIFO.
2. Doubtful accounts:
• existing policy is to age receivables and estimate uncollectible portion based on past
experience.
• proposed change is direct write-off of accounts as soon as they are deemed
uncollectible.
• tighter credit policy to be instituted for fiscal 20x3.
• vice-president, administration, expects improved collections.
3. Bond interest:
• 25-year, $10 million debenture issued in fiscal 20x3, at 1 % premium amortized on a
straight-line basis.
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CMA Accelerated Program – Corporate Taxation and Financial Accounting 2
•
proposal is to use the effective interest method.
4. Warranty expense:
• results from two-year product guarantee on electronic exercise bicycles being offered
in fiscal 20x3 for the first time.
• current method is to write off expenses as incurred.
• proposed change is to estimate and accrue cost.
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© CMA Ontario - 2011
CMA Accelerated Program – Corporate Taxation and Financial Accounting 2
SOLUTIONS
Multiple Choice Questions
1.
a
Changes in accounting principle should be accounted for retrospectively. All
prior year financial results should be restated.
2.
a
NBV as at Jan 1, 20x8: $10,000 x 6/10
Depreciation for 20x8: $6,000 /13 years remaining
3.
c
No prior effect for the January 1, 20x5 retained earnings balance.
4.
c
5.
c
Net income before taxes before change
Add back depreciation using diminishing balance
$300,000 x .63 x 40%
Less depreciation using SL:
$300,000 / 5
Net income before tax after change
6,000
462
$224,080
25,920
-60,000
$190,000
Net income = $190,000 x .7 = $133,000
6.
b
Accumulated Depreciation (Diminishing Balance) =
$400,000 – (400,000 x .75 x .75 x .75)
Accumulated Depreciation (SL) = $400,000 / 8 x 3
$231,250
150,000
81,250
x .7
$56,875
7.
c
Page 148
Operating income - FIFO
Opening inventory
Ending inventory
Operating income – LIFO
$450,000
30,000
-45,000
$435,000
© CMA Ontario - 2011
CMA Accelerated Program – Corporate Taxation and Financial Accounting 2
Problem 1
In this problem we are making a change from FIFO to WA and want to know the impact
on the financial statements. These are twofold:
1.
on the opening Statement of Financial Position - if the inventory goes down by
$5,000, then R/E has to go down for the Statement of Financial Position to stay in
balance.
2.
on current year net income: if the opening inventory goes down by $5,000, then
COGS goes down and income goes up. If the ending inventory goes down by
$20,000, then COGS goes up and income goes down. Net effect on income is a
decrease of $15,000.
In our first entry, we credit COGS because by the end of the year, the beginning
inventory has been sold and is in COGS. Note that the net effect of the two journal entries
is to decrease income by $15,000.
Retained earnings - $5,000 x 0.6
Income taxes receivable - $5,000 x 0.4
Cost of goods sold
$3,000
2,000
Cost of goods sold
Merchandise inventory
20,000
$ 5,000
20,000
This is a change in accounting policy, and is applied retrospectively to enable users of the
financial statements to evaluate the relative performance of the company from one year to
the next using the same accounting policies. This is done to maintain confidence in the
financial accounting information generated, and so that meaningful evaluation may be
performed.
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© CMA Ontario - 2011
CMA Accelerated Program – Corporate Taxation and Financial Accounting 2
Problem 2
Depreciation expense (4,000/3)
Accumulated depreciation
$1,333
$1,333
Calculation:
Cost
Depreciation to date (10,000 - 1,000)/10 x 5
Net book value
Less residual value
Depreciable amount
$10,000
4,500
5,500
1,500
4,000
This is a change in accounting estimate, and has been accounted for prospectively. An
accounting estimate is made with the best information available at any particular time. If
new information becomes available, the estimate is always revised for current and future
periods only. Changes in estimates are normal recurring corrections and adjustments, a
natural part of the accounting process, and as such, they do not require retrospective
treatment.
Page 150
© CMA Ontario - 2011
CMA Accelerated Program – Corporate Taxation and Financial Accounting 2
Problem 3
1a)
Accounting error: Machine
Machine
Land
Depreciation Expense (20x5)
Retained Earnings (20x1 – 20x4) - ($800 x 4)
Accumulated depreciation
$10,000
$10,000
800
3,200
4,000
The tax effect of this transaction is calculated separately and consists of two
elements: (1) one due to the fact that retrospective CCA can be taken on this asset
for the years 20x1 - 20x4 and (2) the deferred income tax element due to the fact
that there will be a difference between net book value and UCC at the end of 20x4.
(1)
Retrospective CCA
20x1: $10,000 x 20% x ½
20x2: $9,000 x 20%
20x3: $7,200 x 20%
20x4: $5,760 x 20%
Income taxes receivable ($5,392 x 40%)
Retained Earnings
(2)
$1,000
1,800
1,440
1,152
$5,392
2,156
2,156
Net book value of asset, Dec 31, 20x4
($10,000 - 3,200 Accumulated Depreciation)
UCC at Dec 31, 20x4:
($10,000 - 5,392 Accumulated CCA)
Temporary difference at Dec 31, 20x4
Retained Earnings ($2,192 x 40%)
DIT Account
$6,800
4,608
$2,192
876
876
b) Accounting error: bonds – failing to amortize the discount on bonds.
Investment in Bonds ($2,000 / 10 x 3 years)
Interest revenue (20x5)
Retained Earnings (20x3 – 20x4) - $400 x 60%
DIT Account - $400 x 40%
Page 151
600
200
240
160
© CMA Ontario - 2011
CMA Accelerated Program – Corporate Taxation and Financial Accounting 2
c) Accounting error: Inventory
Retained Earnings - $7,000 x 60%
Income taxes receivable - $7,000 x 40%
Cost of goods sold
4,200
2,800
7,000
Accounting error: Inventory
d) The inventory is correct, but last year’s purchases are understated and this year’s
purchased are overstated.
Retained Earnings - $11,000 x 60%
Income taxes receivable - $11,000 x 40%
Cost of goods sold
2.
Pre-tax income (before restatement)
Error: Machine
Error: Bonds
Error: Inventory
Error: Inventory
Restated Pre-Tax Net Income
Page 152
6,600
4,400
11,000
$160,000
(800)
200
7,000
11,000
$177,400
© CMA Ontario - 2011
CMA Accelerated Program – Corporate Taxation and Financial Accounting 2
Problem 4
i.
Capitalize truck Truck
Retained earnings ($120,000 x 0.65)
Income Taxes Payable
$120,000
$78,000
42,000
Record Depreciation Net book value of truck as at December 31, 20x8:
$120,000 x .803 = $61,440
Depreciation expense for 20x6 - 20x8 = $120,000 - 61,440 = $58,560
Retained earnings
Accumulated depreciation
58,560
58,560
Record taxes receivable on CCA –
CCA - 20x6: $120,000 x 30% x 1/2 = $18,000
20x7: $102,000 x 30% = 30,600
20x8: $71,400 x 30% = 21,420
Total CCA = $70,020
Income taxes payable (70,020 x 35%)
Retained earnings
24,507
24,507
Record DIT Account –
NBV = $61,440
UCC = $120,000 – 70,020 = $49,980
Retained earnings
DIT Account ($11,460 x 35%)
4,011
4,011
Record 20x9 Depreciation Depreciation expense ($61,440 x 20%)
Accumulated depreciation
Page 153
12,288
12,288
© CMA Ontario - 2011
CMA Accelerated Program – Corporate Taxation and Financial Accounting 2
ii.
Net book value of building at Dec 31, 20x8;
Cost
Accumulated depreciation
(1,500,000 - 200,000) / 40 x 9 years
$1,500,000
2
Depreciation expense in 20x8 should be
($1,207,500 - 100,000) / 26
Depreciation expense recorded
Adjustment required
Depreciation expense
Accumulated depreciation
Page 154
2
1
(292,500)
$1,207,500
$42,596
32,500
$10,096
10,096
10,096
© CMA Ontario - 2011
CMA Accelerated Program – Corporate Taxation and Financial Accounting 2
Problem 5
a)
b)
c)
d)
Purchases
Adjustments:
a) Incorrect exclusion
d) Incorrect inclusion
$140,000
Pre-tax income
Adjustments:
b) Cost of goods sold understated
c) Cost of goods sold overstated
$ 25,000
Accounts payable
Adjustments:
a) Purchase excluded
d) Purchase included
$ 28,000
Inventory
Adjustments:
a) Incorrect exclusion
b) Incorrect inclusion
c) Incorrect exclusion
d) Incorrect inclusion
$40,000
Page 155
4,000
(6,000)
$138,000
(8,000)
3,000
$ 20,000
4,000
(6,000)
$26,000
4,000
-8,000
3,000
-6,000
$33,000
© CMA Ontario - 2011
CMA Accelerated Program – Corporate Taxation and Financial Accounting 2
Problem 6
Machine X:
Cash
Accumulated depreciation--machinery ($3,000 x 5)
Machinery
Gain on disposal of machinery
2,000
15,000
15,000
2,000
Machine Y:
Depreciation expense
700
Accumulated depreciation—machinery
Old depreciation expense: [($15,000 - $2,400) = 6 years = $2,100
Accumulated depreciation @ Jan 1, 20x5: $2,100 x 5 years = $10,500
Net book Value: $15,000 - $10,500 = $4,500
New depreciation expense = ($4,500 - $2,400) / 3 years = $700
Machine Z:
Depreciation expense
1,500
Accumulated depreciation—machinery
Depreciation Expense = ($15,000 - $600) / 8 years = $1,800
Accumulated depreciation @ Jan 1, 20x5: $1,800 x 5 years = $9,000
Net Book Value = $15,000 - $9,000 = $6,000
New depreciation expense = $6,000 / 4 years = $1,500
Page 156
700
1,500
© CMA Ontario - 2011
CMA Accelerated Program – Corporate Taxation and Financial Accounting 2
Problem 7
1. This oversight is a mistake that should be corrected. Such a correction is considered a
change due to an error.
2. Neither the method of accounting for certain receivables nor the method of
accounting for income taxes (interperiod allocation) was changed. The only change is
for tax purposes. However, the change may affect deferred taxes on the Statement of
Financial Position and the amount of income tax expense on the income statement.
3. Both FIFO and Weighted Average are generally accepted accounting principles, and
this change is a change in accounting principle.
4. This a change is a change in accounting principle since we are moving from an
accounting principle that is no longer acceptable (competed contract method) to an
accounting principle that is acceptable (percentage of completion).
5. The change to a three-year remaining life for the purpose of calculating depreciation
on production equipment is a change in estimate due to a change in circumstances.
6. The change to expensing pre-production costs (writing the costs off in one year as
opposed to several years) is a change in estimate due to a change in circumstances.
7. This is an expense classification change arising from a change in the use of the
building for a different purpose. Thus, it is not one of the four types mentioned.
Problem 8
a)
b)
c)
d)
e)
Net Income
Total Assets, 12/31
20x1
20x2
20x1
20x2
U $5,000
O $5,000
N
N
U $2,000*
O $ 800
U $2,000
U $1,200
O $ 500
U $ 100
N
N
U $200**
N
U $ 200
U $ 200
O $1,600
O $2,000
O $1,600
O $3,600
Total Liabilities, 12/31
20x1
20x2
O $5,000
N
N
N
U $ 500
U $ 400
N
N
N
N
* $2,400 – [(2,400/3) x 6/12 months]
** $10,000 x 8% x 3/12 months
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CMA Accelerated Program – Corporate Taxation and Financial Accounting 2
Problem 9
Report
TO:
FROM:
SUBJECT:
Joe Wilson, Controller
C.M. Accountant, Assistant Controller
Accounting Policies
This report is in response to your request for recommendations on proposed changes,
including an inventory error, to the 20x3 financial statements, and on changes in
accounting policy considered for the future.
Proposed Changes for 20x3
1. Depreciation Method
•
•
If the information is available:
It should be put through as a retrospective change in accounting policy.
Cumulative effects on prior years' financials should be adjusted to opening retained
earnings, to show opening retained earnings as restated.
Other accounts such as accumulated depreciation must be adjusted.
Comparative financials should be restated for comparative purposes.
•
Disclosure of the adjustment should be made in a note to the financial statements.
•
If information to restate specific prior years is unavailable, adjustment should be
made to opening retained earnings only. Note disclosure of circumstances should be
made.
•
If insufficient information exists to restate opening retained earnings, only the current
year's figures can be changed (i.e., accounted for prospectively) and note disclosure
should be made.
•
More desirable to restate prior years for comparative consistency (etc.); effort should
be made to trace costs of fixed assets.
•
Effect of change is to reduce reported income by $110,000
[i.e., 200,000 (1 - .45)] this year.
•
Recommendation
Report change as described above, and explain fully in note disclosure the reasons for
the change and the benefit of decreased income tax, to satisfy investors and creditors
who may be concerned because of decrease in income.
•
•
•
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2. Leasehold improvements
•
•
•
•
Change in estimate of useful life must be accounted for prospectively, not
retrospectively. Only in the case of an error would an adjustment to retained earnings
be appropriate.
Prior period adjustment (write-off to retained earnings) is not allowed.
Item represents a normal business risk: "extraordinary item" treatment is not allowed
under IFRS.
Recommendation
Write off an additional $270,000 (i.e., $450,000 x 6/10) in 20x2, causing net income
to decrease by $148,500 (i.e., $270,000 x .55).
3. Inventory Error
•
•
•
•
•
Proper treatment is to adjust opening retained earnings for the effect of error, to arrive
at a restated opening retained earnings. Prior year's comparative figures should be
restated.
Effect on 20x3 opening retained earnings is nil (the error has "washed").
But 20x1 closing inventory is 20x2 opening inventory: 20x2 income is misstated by
$200,000 (overstated), and 20x1 income is $200,000 understated.
Affects trends, comparisons, evaluations; must be corrected even though it does not
affect the 20x3 operating results.
Income tax adjustments will be required and will affect net income.
Policies Considered for Future
1.
•
•
•
•
•
•
•
•
Inventory (FIFO to LIFO)
LIFO puts more recent costs on income statement.
Matches more recent costs with current revenues.
Older costs go on Statement of Financial Position; understates replacement cost of
inventory to a greater degree than FIFO.
Effect in 20x3 is to increase income before tax by $200,000. This would seem to be
consistent with the objective of steady growth.
Possible problems with operating lines - cash flow will be the same, but collateral
base in dollars will be lower, as inventory is valued lower. No real difference in
substance, as it is the same inventory, and it should not present a problem.
However, most lenders are accustomed to FIFO cost flows, and this company would
not be comparable to similar companies that use FIFO. Lenders may require both
valuations.
Industry practice is to use FIFO; LIFO is not acceptable for tax purposes. Therefore,
there would be the added cost of two systems, and deferred taxes would be affected.
Recommendations
For the above reasons, the change to LIFO would not be desirable.
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2. Doubtful Accounts
•
•
•
•
•
•
•
Direct write-off does not match cost to revenue.
Even if collection rates are expected to improve, some estimate of doubtful accounts
should be possible.
Estimates promote smoothing of income as delay until write-off may provide
"bumpy" expense patterns.
Statement of Financial Position valuation of receivable under direct write-off is
suspect: does not reflect estimate of collectible amounts.
The change may not be material.
Tighter credit policy and improved collections may justify a reduction in the
percentage used to estimate allowance for doubtful accounts.
Recommendation
The change does not appear to be desirable. The company desires a steady growth in
accounting income and the existing policy promotes this.
3. Bond Interest
• amortization results in even expense patterns over the bond's life.
• Effective interest rate method has a declining expense pattern: higher early expense.
This would produce a higher income in later years (company objective) but lower
current earnings.
• Straight-line amortization is $100,000/25 = $4,000 per year.
• Amounts are likely immaterial to users and trends, since the discount is only 1%.
•
Recommendation
The effective interest rate method is preferable since it provides for better matching
and expense recognition and is the only method allowable under IFRS.
4. Warranty Expense
• No history of warranty offers - accruals may be difficult to estimate.
• Accrual of expense promotes smoothing; better matching of revenue from sales to
expenses incurred.
• Expending costs as incurred may provide for "bumpy" expense patterns – adds
volatility to earnings.
• Statement of Financial Position would reflect estimated warranty liability if accruals
were made: current liability would reduce working capital.
•
Recommendation
It will be preferable to estimate the expense as reasonably as possible (based on the
experience in 20x3 and 20x4) so that the expense will be matched to the sales made in
20x4.
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CMA Accelerated Program – Corporate Taxation and Financial Accounting 2
3.
Investments
Investments in the shares of another corporation can broadly be classified as non-strategic
or strategic investments. Strategic investments occur when we take a significant equity
position in another company and are in a position to either control the other company or
significantly influence its operational or financial policies. By their very nature, strategic
investments are classified as long-term investments.
Non-Strategic Investments
Non-strategic investments consist of passive investments. IFRS 9 classifies these
investments in two broad categories:
(1)
at amortized cost - to be considered for classification at amortized cost, a financial
asset must meet both of the following conditions:
(a)
the asset is held within a business model whose objectives is to hold assets
in order to collect contractual cash flows, and
(b)
the contractual terms of the financial asset give rise on specific dates to
cash flows that are solely payments and interest on the principal amount
outstanding. (IFRS 9 para. 4.2)
(2)
at fair value - this classification is defined broadly as the default classification is
the financial asset is not classified at amortized cost. However the standard allows
an entity to classify a financial asset that otherwise meets the 'amortized cost'
definition to be classified at fair value through profit and loss if 'doing so
eliminates or significantly reduces a measurement or recognition inconsistency
that would otherwise arise from measuring assets or liabilities or recording the
gains and losses on them on different bases'. (IFRS 9 para. 4.5)
Reclassification can only occur if an entity changes its business model for managing
financial assets. If that were to happen, then all affected financial assets would get
reclassified.
Accounting for investments classified as fair value through profit and loss
The investments are initially recorded at their initial acquisition costs. Any transaction
costs on acquisition of FVTPL investments are expensed. Subsequent measurement is at
fair value unless there is no quoted market price, in which case they are measured at cost.
Any gains and losses on the re-measurement of these investments flows through income.
Any income (interest, dividends) are recognized as income when earned.
If the investment is in the bonds of another entity, the bonds are recorded at amortized
cost using the effective interest method and are adjusted to fair value at period end. The
effective interest rate is defined as the rate that exactly discounts estimated future cash
flows through the expected life of the financial instrument.
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Example 1: on March 31, 20x4 an entity purchases 1,000 shares of the XYZ Corporation
for $35 per share. Transaction costs amount to $1,000. This investment is classified as
fair value through profit and loss. At December 31, 20x4 (the entity's year-end), the
market price per share rises to $42. At December 31, 20x5, the market price per share is
$31. The shares are sold on July 12, 20x6 for $28 per share. Transaction costs on the sale
was $850.
The journal entries to record all of the above transactions are as follows:
Mar 31, 20x4
Dec 31, 20x4
Dec 31, 20x5
Jul 12, 20x6
Page 162
FVTPL Investments
$35,000
Transaction cost expense
1,000
Cash
(1,000 shares x $35) + $1,000 Transaction Costs
FVTPL Investments
Unrealized gain on FVTPL Investments
Adjust to fair value: 1,000 x $42 = $42,000
7,000
Unrealized loss on FVTPL Investments
FVTPL Investments
Adjust to fair value: 1,000 x $31 = $31,000
$42,000 - 31,000 = $11,000
11,000
Cash (1,000 x $28) - $850
Loss on disposal of FVTPL Investments
FVTPL Investments
27,150
3,850
$36,000
7,000
11,000
31,000
© CMA Ontario - 2011
CMA Accelerated Program – Corporate Taxation and Financial Accounting 2
Example 2: on December 31, 20x2, an entity purchases $200,000 of semi-annual, 6%, 15
year bonds for $212,230. The fair value of the bonds at December 31, 20x3 is $210,000
and at December 31, 20x4 is $216,000. The bond are sold on July 2, 20x5 for $214,500.
Interest payments are on June 30 and December 31.
We need to calculate the yield to maturity of the bonds on the date they were purchased:
N = 30
PV = -212,230
PMT = 6,000
FV = 200,000
Compute I/Y = 2.7% x 2 = 5.4% annually
The journal entries to record these transactions are as follows:
Dec 31, 20x2
Jun 30, 20x3
Dec 31, 20x3
Jun 30, 20x4
Dec 31, 20x4
Page 163
FVTPL Investments
Cash
$212,230
$212,230
Cash
FVTPL Investments
Interest income ($212,230 x 2.7%)
6,000
Cash
FVTPL Investments
Interest income ($212,230 - 270) x 2.7%
6,000
Unrealized loss on FVTPL Investments
FVTPL Investments
Adjust to fair value:
Carrying value = $212,230 - 270 - 277
Market value
1,683
Cash
FVTPL Investments
Interest income ($211,683 x 2.7%)
6,000
Cash
FVTPL Investments
Interest income ($211,683 - 285) x 2.7%
6,000
FVTPL Investments
Unrealized gain on FVTPL Investments
Adjust to fair value
Carrying value = $210,000 - 285 - 292
Fair value
6,577
270
5,730
277
5,723
1,683
$211,683
210,000
$ 1,683
285
5,715
292
5,708
6,577
$209,423
216,000
$ 6,577
© CMA Ontario - 2011
CMA Accelerated Program – Corporate Taxation and Financial Accounting 2
Jun 30, 20x5
Jul 2, 20x5
Cash
FVTPL Investments
Interest income ($211, 106 x 2.7%)
Cash
Loss on disposal of FVTPL Investments
FVTPL Investments ($216,000 - 300)
6,000
300
5,700
214,500
1,200
215,700
Accounting for Amortized Cost Investments
Interest is recognized in income using the effective interest method; gains and losses
from the sale of these investments are recognized in the income statements. Any
transaction costs on acquisition of amortized cost are capitalized.
Example: on December 31, 20x4, an entity purchases $500,000 of semi-annual, 7%, 20
year bonds for $465,906 plus transaction costs of $3,500. Interest payments are on June
30 and December 31.
The effective interest rate is the rate that exactly discounts estimated future cash flows
through the expected life of the financial instrument:
N = 40
PV = -469,406
PMT = 17,500
FV = 500,000
Compute I/Y = 3.8% x 2 = 7.6% annually
The journal entries for the years 20x4 to 20x5 are as follows:
Dec 31, 20x4
Jun 30, 20x5
Dec 31, 20x5
Page 164
Amortized Cost Investments
Cash
$469,406
$469,406
Cash
Amortized Cost Investments
Interest income ($469,406 x 3.8%)
17,500
337
Cash
Amortized Cost Investments
Interest income
($469,406 + 337) x 3.8%
17,500
350
17,837
17,850
© CMA Ontario - 2011
CMA Accelerated Program – Corporate Taxation and Financial Accounting 2
Accounting for Fair Value through OCI Investments
An entity may, at initial recognition, elect to classify an investment in an equity
instrument as fair value through other comprehensive income (FVTOCI). In order to be
classified as FVTOCI, the investment must not be held for trading. Any FVTOCI
investments are carried at fair value, any changes in fair value flow to other
comprehensive income. Transaction costs are capitalized. When the asset is sold, any
unrealized gain or loss that has accumulated on the financial asset get recycled directly to
retained earnings (i.e. they do not flow through the income statement). Dividends
declared on FVTOCI investments are recorded as investment income in the incoe
statement.
Example 1 - on June 30, 20x5 you purchase the shares of another company for $15,000.
The investment is classified as an FVTOCI investment. On October 15, 20x5 we receive
a dividend cheque for these shares in the amount of $600. At December 31, 20x5 (the
year-end date), the fair market value of the shares is $16,500. On February 12, 20x6, the
investment is sold for $16,900.
The following journal entries will be recorded with regards to this investment:
Jun 30, 20x5
Oct 15, 20x5
Dec 31, 20x5
Feb 12, 20x6
FVTOCI Investments
Cash
$15,000
Cash
Investment income
600
600
FVTOCI Investments
Other Comprehensive Income
1,500
FVTOCI Investments
Other Comprehensive Income
400
Cash
FVTOCI Investments
Other Comprehensive Income
Retained earnings
Page 165
$15,000
1,500
400
16,900
16,900
1,900
1,900
© CMA Ontario - 2011
CMA Accelerated Program – Corporate Taxation and Financial Accounting 2
Example 2 - At December 31, 20x2, immediately before the year-end adjustments, an
entity has the following FVTOCI investments:
Investment 1
Investment 2
Investment 3
Original
Cost
$250,000
100,000
150,000
$500,000
Carrying
Value
$200,000
120,000
220,000
$540,000
The market values of these investments at December 31, 20x2 was as follows:
Investment 1
Investment 2
Investment 3
$220,000
150,000
245,000
$615,000
At December 31, 20x2 the following journal entry will be made to reflect the change in
market values of the FVTOCI investments:
FVTOCI Investments
OCI - FVTOCI Revaluation
$75,000
$75,000
The statement of comprehensive income would appear as follows (the net income is
assumed to be $300,000):
Net income
Other Comprehensive Income
Net holding gain on FVTOCI Investments
Comprehensive income
$300,000
75,000
$375,000
The balance on the OCI account relating to FVTOCI investments at December 31, 20x2
will be a credit of $115,000 (the aggregate market value of $615,000 less the aggregate
original cost of $500,000.
During 20x3, Investment 1 was sold for $270,000. First we record the increase in market
value of the investment:
FVTOCI Investments
OCI - FVTOCI Investments
$50,000
$50,000
Second, we record the sale of the investment:
Cash
FVTOCI Investments
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$270,000
$270,000
© CMA Ontario - 2011
CMA Accelerated Program – Corporate Taxation and Financial Accounting 2
Lastly, we transfer the unrealized gain on this investment to Retained Earnings:
OCI - FVTOCI Investments
Retained Earnings
Sales price of $270,000 less original cost of $250,000
20,000
20,000
At year-end, the market values of the remaining investments are:
Investment 2
Investment 3
180,000
200,000
$380,000
The carrying values of Investment 2 and Investment 3 before the year-end adjustment is
$150,000 and $245,000 respectively for a total of $395,000. The investments need to be
written down by $15,000:
OCI - FVTOCI Investments
FVTOCI Investments
$15,000
$15,000
The activity in the OCI account for the current year can be summarized as follows:
Opening Balance
Other Comprehensive Income
$115,000
Removal of
accumulated OCI on
sale of Investment 1
Year-end Adjustment
to Market Value
Ending Balance
20,000 50,000
Adjustment to
Investment 1 prior to
sale
15,000
$130,000*
* Check ending balance in OCI:
Investment 2
Investment 3
Original
Cost
$ 100,000
150,000
$250,000
Market
Value
$ 180,000
200,000
$380,000
Balance in OCI = $380,000 – 250,000 = $130,000
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CMA Accelerated Program – Corporate Taxation and Financial Accounting 2
If we assume that the net income was $222,000, the bottom portion of the statement of
comprehensive income would appear as follows:
Net income
Other Comprehensive Income
Net holding gain on FVTOCI Investments during the
year
($50,000 Gain - Investment 1 - $15,000 Year end Adjustment)
Reclassification adjustment to Retained Earnings
for realized gain
Comprehensive income
$222,000
$35,000
(20,000)
15,000
$237,000
Impairment of Financial Assets
Loans and receivables, held-to-maturity investments and FVTOCI investments are
subject to an annual impairment test. Impairment occurs if there is objective evidence of
impairment, i.e. a loss event that has an impact on the future cash flows of the asset.
For loans and receivables and held-to-maturity investments, which are carried at
amortized cost, the impairment loss would be equal to the difference between the asset's
carrying value and the present value of the estimated future cash flows discounted at the
financial asset's original effective interest rate. (IAS 39.63) Impairment losses can be
reversed in the future if there is a recovery (IAS 39.65).
For FVTOCI assets, if there is objective evidence of impairment, any losses recognized
in other comprehensive income are reclassified to income (IAS 39.67). The standard does
not allow the reversal of impairment losses for FVTOCI equity investments (IAS 39.69).
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CMA Accelerated Program – Corporate Taxation and Financial Accounting 2
ASPE Differences •
ASPE dies not classify financial instruments by their trading intentions. The
classification is by reference to their nature: equity, debt or derivative financial
instruments.
•
Equity instruments carried in an active market and freestanding derivatives must
be measured at fair value with all gains and losses flowing to income. All others
are measured at historical cost unless the entity opts to measure at fair value. This
choice must be made on acquisition and is irrevocable.
•
Debt instruments can be carried at fair value or amortized cost. If amortized cost,
the amortization of premium/discounts on debt securities can be done using the
effective interest rate method or the straight-line method.
•
Transaction costs are capitalized unless measured at fair value, in which case they
are expensed.
•
Impairment: the carrying value is compared to the higher of (i) the amounts
recoverable by holding the asset, (ii) fair value. ASPE permits a reversal of
impairment to the extent of the pre-impairment value.
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CMA Accelerated Program – Corporate Taxation and Financial Accounting 2
Strategic Investments
The method of accounting for intercorporate equity investments4 can be determined by
use of the following decision tree:
Does the investor control
the investee corporation?
Yes
No
Consolidate
Can the investor exercise
significant influence over
the investee corporation?
Yes
Equity Method
No
Available for Sale
As outlined in the decision tree, there are three methods of accounting for long-term
investments. Passive investments (defined as an investment that does not give the
investor significant influence over the financial oroperating policies of the investee
company) are accounted for as available for sale investments. The equity method is used
in situations where the investor is able to significantly influence the investee’s operating
and financial policies. When the investor controls the investee, ownership of greater than
50%, the financial statements of the two parties must be consolidated.
Investment in Associates
An associate is an entity, including an unincorporated entity such as a partnership, over
which the investor has significant influence and that is neither a subsidiary nor an interest
in a joint venture (IAS 28.2)
Significant influence is the power to participate in the financial and operational policy
decisions of the investee but is not control or joint control over these policies (IAS 28.2)
The following points may be construed as indicators of significant influence:
• representation on the board of directors,
• participation in policy-making processes,
• material intercompany transactions,
• interchange of managerial personnel, and
• provision of technical information (IAS 28.7)
4
Excluding those classified as fair value through profit and loss.
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CMA Accelerated Program – Corporate Taxation and Financial Accounting 2
The determination of significant influence is a matter of professional judgment. For
example, if you own 35% of the stock of a corporation and a single other investor owns
65%, you may not be in a position to exercise significant influence. On the other hand, if
you own the single largest block of shares with an ownership percentage of 35%, you are
likely to have significant influence over the strategic operating, investing and financing
policies of an investee, even though you do not control the investee. The standard states
that 'if an investor holds, directly or indirectly (i.e. though subsidiaries), 20% or more of
the voting power of the investee, it is presumed that the investor has significant influence,
unless it can be clearly demonstrated that this is not the case (IAS 28.6).
The equity method is the method of accounting for investments in associates. The initial
investment is recorded at its original cost. Any dividends declared by the investee
corporation reduce the investment account (i.e. are treated as a return on equity). The
investment income is calculated as our share of the net income of the investee corporation
and is debited to the investment account. The investment account therefore behaves in a
similar way to the retained earnings account: it increases by the investor’s share of the
income of the investee corporation and decreases by the investor corporation’s share of
dividends declared.
The following example demonstrates the use of the cost method and the equity method in
accounting for intercorporate investments.
Example: Alpha Company purchases 18% of the stock of Beta Company (a public
company) on January 1, 20x1, for $500,000. Both companies have calendar year ends.
On January 1, 20x2, it purchases a further 20% for $600,000. With 38% total ownership,
Alpha is now capable of exercising significant influence over the affairs of Beta
Company. The following information is available with regards to Beta Company:
Year
20x1
20x2
20x3
20x4
Income
$1,000,000
1,500,000
(300,000)
(500,000)
Dividends
$400,000
500,000
---
Market Value
of Investment
At December 31
$600,000
900,000
850,000
1,000,000
20x1
During the year 20x1, Alpha is presumed to not have significant influence over the affairs
of Beta and opted to classify the investment as FVTPL The accounting entry in 20x1 is
relatively straightforward - the $72,000 ($400,000 x 18%) of dividends Alpha will
receive from Beta constitute investment income:
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CMA Accelerated Program – Corporate Taxation and Financial Accounting 2
Cash
$72,000
Investment income (or Dividend income)
$72,000
The investment must be recorded at market value as follows:
Investment in Beta
Gain on FVTPL investments
100,000
100,000
20x2
On January 1, 20x2, the additional stock purchase increases Alpha's ownership of Beta so
that Alpha now has significant influence over Beta. The equity method must be applied
as of January 1, 20x2. The investment account - Investment in Beta now stands at
January 1, 20x1 Purchase
January 1, 20x2
$1,200,000 ($500,000
+ $100,000 Increase in Market Value + $600,000
Purchase
). The entries in 20x2 will be as follows:
Cash
$190,000
Investment in Beta
To record dividends received from Beta
($500,000 x 38% = $190,000)
Investment in Beta
Investment income
To record our share of Beta's income
(1,500,000 x 38% = $570,000)
$190,000
$570,000
$570,000
As of December 31, 20x2, the Investment in Beta account will be:
Page 172
Balance - January 1, 20x2
Less dividends received
Add investment income
$1,200,000
(190,000)
570,000
Balance - December 31, 20x2
$1,580,000
© CMA Ontario - 2011
CMA Accelerated Program – Corporate Taxation and Financial Accounting 2
20x3 - 20x4
Beta Corporation has incurred losses and has paid no dividends; therefore, the investment
account must be written down to the extent of our share in these losses. The journal
entries for both years are as follows:
20x3
20x4
Investment loss
Investment in Beta
To record our share of Beta's loss
($300,000 x 38% = $114,000)
$114,000
Investment loss
Investment in Beta
To record our share of Beta's loss
($500,000 x 38% = $190,000)
$190,000
$114,000
$190,000
The balance in the investment account at the end of 20x4 will be as follows:
Balance - January 1, 20x3
Share of loss - 20x3
Share of loss - 20x4
$1,580,000
(114,000)
(190,000)
Balance - December 31, 20x4
$1,276,000
The carrying value of the investment in Beta is subject to an impairment test as described
in the Capital Assets section.
Business Combinations
A business combination is defined as a transaction whereby one business unites with or
obtains control over the assets of another business.
The form of business combination can be as follows:
c.
purchase of shares of another entity,
d.
purchase of assets, or
e. purchase of an unincorporated entity.
The discussion for the remainder of the lesson focuses on how to account for the first
form of business combination. This situation arises when one company (parent) acquires
control of the other company (subsidiary) generally by purchasing greater than 50% of
the voting shares. Under these circumstances the parent company must prepare
consolidated financial statements at its fiscal year-end. These consolidated financial
statements in simple terms represent the financial statements of the individual companies
added together.
Control is the power to govern the financial and operating policies of an entity so as to
obtain benefits from its activities. Generally this is accomplished through share
ownership (i.e. more than 50% of the shares). In other circumstances it can be
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accomplished by the irrevocable right to vote more than 50% of the shares. The fact of
control determines whether of not we have a subsidiary. Subsidiaries, by definition, must
be consolidated with the parent company's financial statements.
Application of the Consolidation Process at Acquisition
Example, Part A: Assume that on January 1, 20x5, P Ltd. purchases 100% of the shares
of S Ltd. for cash consideration of $2,000,000. Statement of Financial Positions, as at
December 31, 20x4, for both companies, are as follows:
Current assets
Capital assets - net
Patent - net
Current liabilities
Long-term debt
Common stock
Retained earnings
P Ltd.
Book Value
S Ltd.
Book Value
S Ltd.
Fair Value
$2,500,000
4,000,000
--
$ 750,000
600,000
100,000
$ 800,000
1,500,000
200,000
$6,500,000
$1,450,000
$1,000,000
3,000,000
1,000,000
1,500,000
$ 400,000
600,000
200,000
250,000
$6,500,000
$1,450,000
$ 400,000
650,000
---
Other information:
• the fair value differential of $50,000 on current assets relate solely to inventory; S
Ltd. uses the first-in, first-out method of inventory valuation;
• the capital assets of S Ltd. represent equipment that has a remaining useful life of five
years; these assets are being depreciated on the straight-line basis;
• S Ltd.'s patent has 10 years remaining; depreciation is taken on the straight-line basis;
• S Ltd.'s long-term debt is due on December 31, 20x9.
At the date of acquisition, the first accounting exercise is to allocate the purchase price to
the various assets and liabilities of S Ltd. that were acquired. In this case, P Ltd. is
paying $2,000,000 for the fair market value of the net assets of S Ltd. The purchase
price allocation is as follows:
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Purchase price
Total Assets of S Ltd.
Net assets acquired - at book value ($1,450,000
Total Liabilities of S Ltd.
- $1,000,000
)
$2,000,000
450,000
Purchase price discrepancy
Allocated to:
Current assets ($800,000 - $750,000)
Capital assets ($1,500,000 - $600,000)
Intangibles ($200,000 - $100,000)
Long-term debt ($650,000 - $600,000)
Goodwill
1,550,000
$ 50,000
900,000
100,000
(50,000)
1,000,000
$ 550,000
The above calculation shows that there is a discrepancy of $1,550,000 between the
purchase price and the net book value of the assets of S Ltd. that were acquired. This
difference is called the purchase price discrepancy. We notice that several of S Ltd.'s
assets and liabilities have a fair value at the time of purchase that differs from the book
value. Reference to the calculation above, shows that $1,000,000 of the purchase price
discrepancy can be explained by this difference between the fair value of the net assets of
S Ltd. and their book value.
The unallocated balance of the purchase price discrepancy is assigned rather arbitrarily to
goodwill. The assumption of this assignment is that the purchase price of $2,000,000,
being an arm's length transaction, was for the purchase of S Ltd. as a going concern. The
value of a going concern is the sum of the fair value of its net assets plus a premium for
future earnings. This premium is commonly called goodwill and is set up on the
consolidated Statement of Financial Position as an intangible asset. Goodwill is subject to
an annual impairment test which is discussed later in this section.
The information in the purchase price allocation is used to prepare the first elimination
entry required to consolidate S and P Ltd. For consolidation purposes, this entry
eliminates the account called “Investment in S Ltd.”, which is recorded in the books of P
Ltd. On consolidation, P and S Ltd. are considered to be one entity. A business entity
cannot have an investment in itself. Therefore, the investment account must be removed
or eliminated from the consolidated financial statement.
This entry also records the net assets of S Ltd. acquired at their fair values and sets up the
new asset of Goodwill on the consolidated Statement of Financial Position. It's important
to note that goodwill may only appear in a financial statement if it has been purchased.
For example, assume a business is established, and over the years a loyal clientele
develops. The owner knows that the fair market value of the business is greater than its
book value. This difference is not attributable to a specific asset but is attributable to the
strong customer loyalty. We would call this difference goodwill. The owner may not
make an accounting entry to record this goodwill. This amount would only be
recognized for accounting purposes on the purchase of the business by a third party.
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The Consolidated Statement of Financial Position of P Ltd. at acquisition is determined
by adding the assets and liabilities of P Ltd. and S Ltd. together, and adjusting for items
such as the purchase price discrepancy :
P Ltd.
Consolidated Statement of Financial Position
as at January 1, 20x5
P Ltd.
Purchase of S Ltd.
Current assets ($2,500,000
- 2,000,000
S Ltd.
+ 800,000 )
P Ltd.
S Ltd.
Capital assets ($4,000,000
+ 1,500,000 )
Patent
Goodwill
$1,300,000
5,500,000
200,000
550,000
$7,550,000
P Ltd.
S Ltd.
Current liabilities ($1,000,000
+ 400,000 )
P Ltd.
S Ltd.
Long-term debt ($3,000,000
+ 650,000 )
Common stock
Retained earnings
$1,400,000
3,650,000
1,000,000
1,500,000
$7,550,000
A few comments:
•
The current assets are reduced by $2,000,000 to account for the purchase of S Ltd.
which occurred on January 1, 20x5. The entry to record the purchase made in P
Ltd.'s books would have reduced current assets by $2,000,000 and set-up an
investment in S Ltd. account for the same amount. This investment account is
eliminated on consolidation with the elimination entry discussed above.
•
The consolidated Statement of Financial Position is meant to show all assets
under the control of P Ltd. Therefore, the common stock and retained earnings of
S Ltd. are not reflected on the consolidated Statement of Financial Position at
acquisition. The common stock shown on the consolidated Statement of Financial
Position represents the common interest of P's shareholders. The Retained
Earnings of S Ltd. as at December 31, 20x4, were earned by S Ltd. and not by P
Ltd., thus they are not shown on the consolidated Statement of Financial Position.
•
in rare cases, the goodwill generated by the purchase price allocation is negative.
Any negative goodwill balances are written off to income (IFRS 3.34).
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Nonwholly Owned Subsidiaries
The method used to allocate the purchase price is called the acquisition method (IFRS
3.32). We impute the purchase price as if a 100% acquisition has occurred and allocate
based on 100% value.
Example, Part B - Assume now that P purchased 80% of the outstanding common
shares of S for $2,000,000 on January 1, 20x5.
The purchase price allocation is as follows:
Purchase price imputed at 100% ($2,000,000 / 0.80)
Net assets acquired - at book value
($1,450,000 - $1,000,000)
Purchase price discrepancy
Allocated to:
Current assets ($800,000 - $750,000)
Capital assets ($1,500,000 - $600,000)
Intangibles ($200,000 - $100,000)
Long-term debt ($650,000 - $600,000)
Goodwill
$2,500,000
450,000
2,050,000
$50,000
900,000
100,000
(50,000)
1,000,000
$1,050,000
A new account is introduced at this time called the noncontrolling interest in S. This
account is part of Shareholders’ Equity on the Statement of Financial Position. The
account represents the noncontrolling interest in the net assets of S at the Statement of
Financial Position date. In this example, the initial noncontrolling interest is 20% of the
fair value of S’s net assets: 2,500,000 x 20% = $500,000
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The consolidated Statement of Financial Position of P at the date of acquisition of S is as
follows:
P Ltd.
Consolidated Statement of Financial Position
as at January 1, 20x5
P Ltd.
Paid to purchase shares of S Ltd.
Current assets ($2,500,000
- 2,000,000
S Ltd. Book Value
Fair Value Increment on Inventory
+ 750,000
+ 50,000
)
Cost of S Ltd. Capital Assets
Capital assets ($4,000,000 + 600,000
Fair Value Increment
+ 900,000
)
Book Value of S Ltd.
Fair Value Increment
Patent ($100,000
+ 100,000
)
Goodwill
P Ltd.
$1,300,000
5,500,000
200,000
1,050,000
$8,050,000
S Ltd.
Current liabilities ($1,000,000
+ 400,000
)
P Ltd.
S Ltd.
Fair Value Decrement
Long-term debt ($3,000,000
+ 600,000
+ 50,000
)
$1,400,000
3,650,000
Noncontrolling interest in S
Common stock
Retained earnings
500,000
1,000,000
1,500,000
$8,050,000
When we consolidate P and S, we include 100% of the assets and liabilities of S, even
though we only own 80% of these amounts. The reason for this approach is because the
consolidated Statement of Financial Position brings together the net assets under common
control. P effectively controls 100% of the net assets of S. This reasoning is supported
by the definition of an asset: An asset is defined as a resource controlled by the entity as
a result of past events and from which future economic benefits are expected to flow to
the entity.
Accounting for a Subsidiary Investment on the Parent Company Books
Once a long-term investment has been identified as a subsidiary, the parent company
must report consolidated financial statements. The process of preparing consolidated
financial statements is essentially taking the company financial statements of the parent
company and the subsidiary and combining them to prepare the consolidated financial
statements. The point being, each company maintains its own set of books.
Therefore, the parent company needs to account for the investment in the subsidiary in its
books. Generally, the parent company will choose to use the cost method as it is simpler
to use. It is also required under IAS 27(38).
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Equity Method and Purchase Price Discrepancy
Our discussion of the application of the equity method did not consider the effect of the
purchase price discrepancy. When an equity purchase is made, the purchase price must be
allocated to the fair value differentials of the assets and liabilities in exactly the same way
as we would for a business combination with one notable exception – we do not apply the
entity method in the allocation of the purchase price. Instead, we use what is called the
parent company approach whereby we allocate only the purchased share of fair value
increments. Any amortization of the purchase price discrepancy will simply adjust
investment income.
Take the Consolidation example above, but assume that on December 31, 20x4, P. Ltd
purchases 25% of S. Ltd for $550,000. The purchase price discrepancy would be as
follows:
Purchase price
Net assets acquired: $450,000 x 25%
Purchase price discrepancy
Allocated to:
Current assets: $50,000 x 25%
Capital assets: $900,000 x 25%
Intangibles: $100,000 x 25%
Long-term debt: ($50,000) x 25%
Goodwill
$550,000
112,500
437,500
$ 12,500
225,000
25,000
(12,500)
250,000
$187,500
Recall that...
• the fair value differential of $50,000 on current assets relate solely to inventory; S
Ltd. uses the first-in, first-out method of inventory valuation;
• the capital assets of S Ltd. represent equipment that has a remaining useful life of five
years; these assets are being depreciated on the straight-line basis;
• S Ltd.'s patent has 10 years remaining; depreciation is taken on the straight-line basis;
• S Ltd.'s long-term debt is due on December 31, 20x9.
Assume that S Ltd’s net income for the year ended December 31, 20x5 was $400,000 and
that dividends of $100,000 were declared.
The investment income that P Ltd. would record is calculated as follows:
Share of S’s Income: $400,000 x 25%
Amortization of purchase price discrepancy Current assets
Capital assets: $225,000 / 5
Intangible assets: $25,000 / 10
Long-term debt: $12,500 / 5
Investment income
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$100,000
($12,500)
(45,000)
(2,500)
2,500
(57,500)
$42,500
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CMA Accelerated Program – Corporate Taxation and Financial Accounting 2
The balance in the Investment Account would be as follows:
Initial Investment, December 31, 20x4
Investment income
Share of dividends: $100,000 x 25%
Investment Account Balance, December 31, 20x5
$550,000
42,500
(25,000)
$567,500
Goodwill does not get amortized nor is it subject to an impairment test when we have a
significant influence investment. However, the investment account as a whole is subject
to an annual impairment test.
Post-Acquisition Consolidation
What about the consolidation of subsidiaries in the years following the acquisition? The
general process is as follows:
1.
the purchase price allocation is calculated normally. Preparing an amortization
schedule for the purchase price allocation may be useful.
2.
the consolidated income statement is prepared by adding up all of the accounts –
combining all of the parent’s amounts with 100% of the subsidiary’s amounts and ensuring that:
•
any dividends received from the subsidiary are removed from the accounts
of the parent company if the cost method is used by the parent company to
account for the investment in the subsidiary. Conversely, if the equity
method is used, then the investment income using the equity method needs
to be removed from the accounts of the parent company.
•
any intercompany revenues / expenses have to be removed in the
consolidation process.
•
because all revenues and expenses of the subsidiary are consolidated with
those of the parent, we need to account for the fact that we may not ‘own’
100% of these revenues and expenses (i.e. if the subsidiary is non—
wholly owned). A noncontrolling interest must be calculated and
deducted from income. This will be equal to the subsidiary’s net income
adjusted for the purchase price discrepancy amortization times the
noncontrolling interest percentage ownership. If the subsidiary has a loss,
the noncontrolling interest is added to income.
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3.
in preparation for the consolidated statement of retained earnings for years
subsequent to the first year, the opening consolidated retained earnings must be
calculated as follows:
Parent Company Retained Earnings
$XXX
Subsidiary Company Retained Earnings
Less Subsidiary Company Retained Earnings at acquisition
Subsidiary Company Post-Acquisition increase
in Retained Earnings
Amortization of PPD
XXX
-XXX
XXX
±XXX
XXX
%
Times the parent company ownership %
Consolidated Retained Earnings
4.
XXX
$XXX
the consolidated Statement of Financial Position is prepared much like the
consolidated Statement of Financial Position at acquisition:
•
all assets and liabilities of the parent and 100% of the assets and liabilities
of the subsidiary are added together,
•
any unamortized purchase price discrepancy amounts are added/deducted
to the assets and liabilities, and
•
a noncontrolling interest liability is calculated as the net assets of the
subsidiary adjusted for any unamortized purchase price discrepancy times
the noncontrolling interest percentage.
Example - On January 1, 20x1, the Brown Company acquired 65% of the outstanding
shares of the Moran Company in return for cash in the amount of $5,850,000. On this
date, the book values and the fair values for the Moran Company's Statement of Financial
Position accounts were as follows:
Cash and current receivables
Inventories
Land
Plant and equipment (net)
Current liabilities
Long-term liabilities
Common shares
Retained earnings
Book values
$ 325,000
5,010,000
2,960,000
3,470,000
$11,765,000
Fair values
$325,000
4,900,000
3,400,000
4,000,000
950,000
2,980,000
5,350,000
2,485,000
$11,765,000
950,000
3,410,000
On the acquisition date, the remaining useful life of the Moran Company's plant and
equipment was 10 years. The long-term liabilities mature on June 30,20x3. The land is
still on the company's books at December 31, 20x1.
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The condensed Statement of Financial Positions and income statements of the Brown
Company and its subsidiary, the Moran Company, for the year ending December 31,
20x1, are as follows:
Revenues
Cost of goods sold
Depreciation expense
Other expenses
Net income
Retained earnings, beginning
Dividends
Retained earnings, ending
Cash and current receivables
Inventories
Land
Plant and equipment (net)
Investment in Moran Co.
Current liabilities
Long-term liabilities
Common shares
Retained earnings
Brown Co.
Moran Co.
$16,540,000
$2,635,000
8,970,000
2,350,000
790,000
12,110,000
1,460,000
375,000
465,000
2,300,000
4,430,000
4,600,000
210,000
335,000
2,485,000
150,000
$8,820,000
$2,670,000
Brown Co.
Moran Co.
$2,400,000
6,865,000
4,500,000
8,800,000
5,850,000
$28,415,000
$ 760,000
4,500,000
2,960,000
3,890,000
$12,110,000
1,595,000
8,000,000
10,000,000
8,820,000
1,110,000
2,980,000
5,350,000
2,670,000
$28,415,000
$12,110,000
Additional Information –
1.
2.
3.
The Brown Company carries its investment in the Moran Company using the cost
method.
The Moran Company paid $100,000 in management fees to the Brown Company.
A goodwill impairment test as at December 31, 20x1 establishes the permanent
value of the goodwill in the Moran Company at $680,000.
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The first step is to calculate the purchase price discrepancy:
Purchase Price imputed at 100%: $5,850,000 / 0.65
Net assets acquired – Net Asses of Moran ($5,350,000 + 2,485,000)
Purchase Price Discrepancy
Allocation Inventories: $4,900,000 – 5,010,000
($110,000)
Land: $3,400,000 – 2,960,000
440,000
530,000
Plant and equipment: $4,000,000 – 3,470,000
Long-term liabilities: $3,410,000 – 2,980,000
(430,000)
Goodwill
$9,000,000
7,835,000
1,165,000
430,000
$735,000
Purchase price discrepancy amortization schedule –
PPD Amortization Schedule -
Inventories (1)
Land
Plant and equipment (10)
Long-term liabilities (2.5)
Goodwill
Balance
Jan 1, 20x1
($110,000)
440,000
530,000
(430,000)
735,000
$1,165,000
Amortization
20x1
$110,000
(53,000)
172,000
(55,000)
$174,000
Balance
Dec 31, 20x1
$440,000
477,000
(258,000)
680,000
$1,339,000
Brown Co.
Consolidated Statement of Income and Retained Earnings
for the year ended December 31, 20x1
Revenues ($16,540,000 Brown + 2,635,000 Moran – 100,000 Mgmt Fees
– 97,500 Dividends from Moran)
Cost of goods sold ($8,970,000 + 1,460,000 – 110,000 Amort PPD – Inv)
Depreciation expense ($2,350,000 + 375,000 + 53,000 Amort PPD – P&E)
Goodwill impairment loss
Other expenses ($790,000 + 465,000 – 100,000 Mgmt Fees
– 172,000 PPD Amort – LTD)
Net income – entity
Noncontrolling interest ($335,000 Moran’s Net Income
+ 174,000 Amortization PPD) x 35%
Consolidated net income
Consolidated retained earnings, Jan 1, 20x1
Dividends
Consolidated retained earnings, Dec 31, 20x1
Page 183
$18,977,500
(10,320,000)
(2,778,000)
(55,000)
(983,000)
4,841,500
178,150
4,663,350
4,600,000
210,000
$9,053,350
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CMA Accelerated Program – Corporate Taxation and Financial Accounting 2
Note that for the purpose of these notes, the income statement format as above will be
used. However, IAS 1 mandates the following presentation for the bottom portion of the
income statement:
Net income
$4,841,500
Net income attributed to:
Owners of the parent
Noncontrolling interests
$4,663,350
178,150
$4,841,500
Consolidated Retained Earnings at December 31, 20x1 can be calculated independently
as follows:
Brown Co. Retained Earnings, December 31, 20x1
Moran Co. Retained Earnings, December 31, 20x1
Moran Co. Retained Earnings at acquisition
Subsidiary Company Post-Acquisition increase
in Retained Earnings
Add amortization of PPD
$8,820,000
$2,670,000
2,485,000
Times Brown Co. ownership %
Consolidated Retained Earnings
185,000
174,000
359,000
65%
233,350
$9,053,350
Brown Co.
Consolidated Statement of Financial Position
as at December 31, 20x1
Cash and current receivables ($2,400,000 + 760,000)
Inventories ($6,865,000 + 4,500,000)
Land (4,500,000 + 2,960,000 + 440,000 PPD)
Plant and equipment ($8,800,000 + 3,890,000 + 477,000 PPD)
Goodwill
$3,160,000
11,365,000
7,900,000
13,167,000
680,000
$36,272,000
Current liabilities ($1,595,000 + 1,110,000)
Long-term liabilities (8,000,000 + 2,980,000 + 258,000 PPD)
Noncontrolling interest liability ($8,020,000 Net Assets of Moran
+ $1,339,000 Unamortized PPD) x 35%
Common stock
Retained earnings
$2,705,000
11,238,000
Page 184
3,275,650
10,000,000
9,053,350
$36,272,000
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If Brown Company has used the equity method5 to account for its investment in Moran,
then the investment income would have been calculated as follows:
Share of Moran’s net income: $335,000 x 65%
Add amortization of PPD: $174,000 x 65%
Investment income using equity
$217,750
113,100
$330,850
If we recalculate what Brown’s net income would have been had the equity method been
used, we get the following result:
Brown Co. Net Income – Cost Method
Less dividends received from Moran
Add investment income calculated using the equity method
Brown Co. Net Income – Equity Method
$4,430,000
(97,500)
330,850
$4,663,350
Note that the net income using the equity method is equal to the consolidated net income.
This is not a coincidence.
The Investment in Moran account using the equity method can be calculated using three
different approaches. First approach is the T-Account view:
Purchase price
Add investment income
Less dividends
Investment account balance, December 31, 20x1
$5,850,000
330,850
(97,500)
$6,083,350
The second approach takes into account that the investment account at any point in time
is equal to the parent company’s share of the subsidiary’s net assets plus any unamortized
purchase price discrepancy:
Brown’s share of the net assets of Moran: $8,020,000 x 65%
Unamortized PPD: $1,339,000 x 65%
$5,213,000
870,350
$6,083,350
5
Although the equity method cannot be used to account for a subsidiary on the company's financial
statements, this example simply shows how the equity method is applied. The same procedures would be
used for a significant influence investment.
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The third approach is similar to the calculation of consolidated retained earnings. The
investment account is equal to the initial purchase price less any amortization of PPD
plus our share of the post acquisition increase in retained earnings:
Purchase price
Moran Co. Retained Earnings, December 31, 20x1
Moran Co. Retained Earnings at acquisition
Subsidiary Company Post-Acquisition increase
in Retained Earnings
Add amortization of PPD
Times Brown Co. ownership %
$5,850,000
$2,670,000
2,485,000
185,000
174,000
359,000
65%
233.350
$6,083,350
Goodwill Impairment Test
IAS 36, Impairment of Assets deals with the impairment test of both tangible and
intangible assets. We will deal only with the impairment of asset test as it relates to
goodwill.
IAS 36 requires that goodwill be tested for impairment annually (or more often, if there is
an indication of impairment). At a basic level, the recoverable amount of goodwill is
compared to its carrying amount. If the recoverable amount is higher than the carrying
amount, then no impairment needs to be accrued. However, if the recoverable amount is
less than the carrying amount of goodwill, then goodwill needs to be written down to the
recoverable amount.
The impairment test is done at the level of the Cash Generating Unit (CGU) which is
defined by IAS 36, para 6 as ‘the smallest identifiable group of assets that generates cash
inflows that are largely independent of the cash inflows from other assets or groups of
assets. For example, if you purchase a subsidiary which operates two operating segments
whose cash flows are independent of each other, then we have a minimum of two CGU’s.
We need to investigate whether the assets of each of the operating segment can be further
broken down into more CGUs, since the breakdown of a CGU has to be made at the
lowest possible level. The minimum number of CGU’s of a corporation is defined as the
number of operating segments that the corporation operates in as defined by IFRS 8 –
Operating Segments.
Whenever a business combination occurs, the total goodwill generated by the transaction
must be allocated between all of the CGUS’s on the date of acquisition.
The recoverable amount is defined as the greater of fair value or value in use (VIU).
Value in use is equal to the present value of cash flows expected from the future use and
sale of assets at the end of their useful lives.
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Because it is impossible to estimate the recoverable amount of goodwill directly, the
impairment test is done at the CGU level by comparing the value in use of CGU to the
consolidated carrying value of the CGU’s identifiable assets. Any impairment loss is
allocated as follows:
(i)
to any goodwill allocated to the CGU, and
(ii)
to other assets of the CGU on a prorata basis of the carrying amount of
each asset in the unit (IAS 36, para 104)
Example – on January 1, 20x3, Parent Company purchases 100% of the shares of
Subsidiary Inc. for $20,000. Subsidiary Inc. operates three distinct segments and each
segment is considered a cash-generating unit. The purchase price allocation was as
follows:
Segment 1
Segment 2
Segment 3
Allocation of
Purchase Price
Fair Value of
Identifiable
Assets
Goodwill
$ 5,000
12,000
3,000
$4,000
10,000
2,500
$1,000
2,000
500
$20,000
$16,500
$3,500
At the end of 20x3, a value-in-use calculation was made of the recoverable amounts of
each segment provided the following results:
Segment 1
Segment 2
Segment 3
$5,400
9,000
4,500
The carrying values of each segment at December 31, 20x3 is as follows:
Segment 1
Segment 2
Segment 3
Identifiable
Assets – net of
depreciation
Goodwill
Total
Carrying
Value
$3,700
9,500
2,400
1,000
2,000
500
$4,700
11,500
2,900
An impairment loss must be recognized for segment 2 only in the amount of $11,500 –
9,000 = $2,500. This is first allocated to goodwill of $2,000, bringing it down to zero.
The balance of $500 needs to be allocated to the identifiable assets of Segment 2 on a
pro-rata basis.
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Assume that the fair value of the identifiable assets of Segment 2 consist of the
following:
Land
Property, plant and equipment
Less Accumulated Depreciation
$2,500
10,500
(3,500)
$9,500
The allocation of the remaining $500 would be as follows:
Carrying
Amount
Land
Property, plant and equipment
$2,500
7,000
$9,500
%
26.3%
73.7%
Allocation
$131
369
$500
One of the disadvantages of this impairment test is that it does not measure whether
goodwill has really been impaired since the method arbitrarily allocates the impairment
loss first to goodwill, i.e. it assumes that goodwill has been impaired. On the other hand,
goodwill is protected by:
(i)
internally generated goodwill occurring after the business combination,
and
(ii)
unrecognized identifiable net assets on the date of acquisition.
Both of these generate future cash flows but are not recorded in the carrying amounts of
the assets. Consequently, the value in use may be somewhat inflated.
Goodwill must be tested for impairment annually, but need not necessarily be done at
year end. Also, not all CGU’s need to be tested for impairment at the same time.
An impairment charge cannot subsequently be reversed if the value in use of the assets
increases about the carrying amount of the assets.
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Joint Ventures
A joint venture is an arrangement whereby two or more parties (the venturers) jointly
control a specific business undertaking and contribute resources towards its
accomplishment. The life of the joint venture is limited to that of the undertaking which
may be of short or long-term duration depending on the circumstances. A distinctive
feature of a joint venture is that the relationship between the venturers is governed by an
agreement (usually in writing) which establishes joint control. Decisions in all areas
essential to the accomplishment of a joint venture require the consent of the venturers, as
provided by the agreement; none of the individual venturers is in a position to unilaterally
control the venture. This feature of joint control distinguishes investments in joint
ventures from investments in other enterprises where control of decisions is related to the
proportion of voting interest held.
The key feature of a joint venture, therefore, is that no venturer has control. On this basis
alone, the accounting for joint ventures will differ from a business combination.
Accounting for joint ventures can be done using one of two approaches: (1) equity
method or (2) proportionate consolidation (IAS 31.30 and IAS 31.38).
Proportionate consolidation is a method of accounting whereby a venturer's share of each
of the assets, liabilities, income and expenses of a jointly controlled entity is combined
line by line with similar items in the venturer's financial statements or reported as
separate line items in the venturer's financial statements. (IAS 31.3)
ASPE Differences •
Subsidiaries: entities can opt to use consolidation, the equity method, the cost
method or fair value. All subsidiaries have to be accounted for using the same
method. If consolidation or equity method are used, then the methods described in
this chapter apply. If the subsidiary’s shares are quoted in an active market, the
shares cannot be recorded at cost.
•
Significant influence investments can be accounted for using either the equity or
cost method. If the shares are traded in an active market, the cost method cannot be
used. If this case, the only two options available are fair value or equity. If the
equity method is used, no amortization of the purchase price discrepancy needs to
be considered in the calculation of equity income, i.e. equity income will simply
equal the income in the associate multiplied by the percentage ownership.
Investments and income for investments reported at cost and equity have to be
disclosed separately.
•
Joint Ventures can be accounted for at either the equity or proportionate
consolidation approaches.
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What the future holds –
In May 2011, the International Accounting Standards Board issued two new standards:
IFRS 10 – Consolidated Financial Statements
IFRS 11 – Joint Arrangements
IFRS 10 does not change the mechanics of consolidation. The change is in how we
determine which subsidiaries are to be consolidated. An investor now determines whether
it is a parent by assessing whether it controls the investee. An investor controls an
investee when it is exposed, or has rights, to variable returns from its involvement with
the investee and has the ability to affect those returns through its power over the investee.
Thus, an investor controls an investee if and only if the investor has all the following:
(a)
power over the investee,
(b)
exposure, or rights, to variable returns from its involvement with the investee, and
(c)
the ability to use its power over the investee to affect the amount of the investor’s
returns.
This means that it is conceivable that a less than 50% owned investment could be treated
as a subsidiary. Example 4 if IFRS 10 reads as follows:
An investor acquires 48 per cent of the voting rights of an investee. The remaining
voting rights are held by thousands of shareholders, none individually holding
more than 1 per cent of the voting rights. None of the shareholders has any
arrangements to consult any of the others or make collective decisions. When
assessing the proportion of voting rights to acquire, on the basis of the relative
size of the other shareholdings, the investor determined that a 48 per cent interest
would be sufficient to give it control. In this case, on the basis of the absolute size
of its holding and the relative size of the other shareholdings, the investor
concludes that it has a sufficiently dominant voting interest to meet the power
criterion without the need to consider any other evidence of power.
IFRS 11 removes the option of proportional consolidation for joint ventures. All joint
ventures must be accounted for using the equity method.
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Problems with Solutions
Multiple Choice Questions
1.
On January 1, 20x8, Bean Co. purchased a 30% interest in Dod Co. for $250,000.
On this date, Dod's shareholders' equity was $500,000. The carrying value of Dod's
identifiable net assets was equal to book value. Bean correctly reports this
significant influence investment using the equity method. Both companies have a
December 31 year end. For the year ended December 31, 20x8, Dod reported net
income of $150,000 and paid dividends of $40,000.
Which of the following is the amount that Bean would report as its investment in
Dod at December 31, 20x8?
a) $250,000
b) $283,000
c) $277,500
d) $360,000
2.
INV owns 10% of the shares of PLA Inc. For five years now, PLA has been paying
a regular dividend at the end of its fiscal year. PLA's year end is December 31,
while INV's is September 30. When should the dividend be recognized as revenue
in INV's books?
a) On September 30, since there is reasonable certainty that it will be paid
b) On the day on which INV receives the cheque
c) On the day on which PLA's board of directors adopts a resolution declaring a
dividend
d) On the day that PLA mails the cheque, the postmark providing proof
3.
Price Co. has gradually been acquiring shares of Berry Co. and now owns 37% of
the outstanding voting common shares. The remaining 63% of the shares are held
by members of the family of the company founder. To date, the family has elected
all members of the board of directors, and Price Co. has not been able to obtain a
seat on the board. Price is hoping eventually to buy a block of shares from an
elderly family member and thus one day own 60%.
How should the investment in Berry Co. be reported in the financial statements of
Price Co.?
a) Consolidation
b) Fair Value though Other Comprehensive Income
c) Equity method
d) Fair Value through Profit and Loss
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4.
Which of the following is the best definition of the accounting term business
combination?
a) One company obtains control of all of the assets of another company
b) One company acquires a controlling block of the shares of another
company
c) One company unites with or obtains control over another company
d) One company purchases and transfers title to the net assets of another
company
5.
When a parent company consolidates a wholly owned subsidiary, what amount will
appear as "common shares" in the equity section of the consolidated Statement of
Financial Position?
a) The book value of the parent's common shares plus the book value of the
subsidiary's common shares
b) The book value of the parent's common shares plus the fair value of the
subsidiary's common shares
c) The fair value of the parent's common shares on the date of the purchase of
the subsidiary
d) The book value of the parent's common shares at the date of consolidation
6.
When one company controls another company, IAS require that the parent report
the subsidiary on a consolidated basis. Which of the following best describes the
primary reason for this recommendation?
a) To report the combined retained earnings of the two companies, allowing
shareholders to better predict dividend payments
b) To allow for taxation of the combined entity
c) To report the total resources of the combined economic entity under the
control of the parent's shareholders
d) To meet the requirements of federal and provincial securities commissions
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The following information applies to questions 7 and 8, although each question should be
considered independently.
A parent company acquires 80% of the shares of a subsidiary for $400,000. The carrying
value of the subsidiary's net assets is $380,000. The market value of the net assets of the
subsidiary is equal to book value.
7.
Which of the following represents the amount of goodwill that should be recorded
at the time of the acquisition?
a) $16,000
b) $20,000
c) $96,000
d) $120,000
8.
Which of the following represents the noncontrolling shareholder's interest that
should be recorded when the acquisition takes place?
a) $70,000
b) $76,000
c) $80,000
d) $100,000
9.
PK owns 18% of the outstanding shares of KM, and holds 22.2% of the seats on
KM’s board of directors. PK has a significant level of intercompany transactions
with KM. Another company, ZZ, owns 20% of the shares of KM and has 33.3% of
the seats on KM’s board of directors. The remaining shares of KM are widely held.
Which of the following accounting methods would you recommend for PK?
a) PK should report its interest in KM using the cost method
b) PK should report its interest in KM using the equity method
c) PK should report its interest in KM using fair value method
d) PK should report its interest in KM using the consolidation method
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10.
On July 1, 20x9, X Ltd. acquired 75% of Y Ltd.’s outstanding voting shares for
$300,000. Y Ltd.’s identifiable assets and liabilities were equal to their carrying
values on July 1, 20x9. During 20x9, Y Ltd. paid $40,000 in cash dividends to its
shareholders. The following condensed Statement of Financial Position
information relates to Y Ltd.:
Dec. 31, 20x9 Jan. 1, 20x9
Total assets
$520,000
$450,000
Total liabilities
$100,000
$100,000
Common shares – no par
186,000
186,000
Retained earnings
234,000
164,000
$520,000
$450,000
In its single entity financial statements, what amount should X Ltd. report as 20x9
earnings from its subsidiary, Y Ltd.? Assume that income is earned evenly
throughout the year, that dividends are paid in equal quarterly amounts and that X.
Ltd. uses the equity method to account for its investment in Y Ltd. on its single
entity financial statements.
a) $110,000.
b) $82,500.
c) $52,500.
d) $41,250.
e) $26,250.
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The following information applies to questions 11-17
On December 31, 20x2, the Parker Corporation purchased 75% of the shares of Simmons
Ltd. for $4,500,000. At that date Simons Ltd. has common stock of $3,000,000 and
retained earnings of $2,000,000. Simmons Ltd’s asset and liabilities had fair value
differentials as follows:
Inventory
Plant and equipment
Long-term debt
Book
Value
$700,000
8,400,000
2,000,000
Market
Value
$625,000
8,600,000 Remaining useful life = 8 years
1,900,000 Matures on December 31, 20x12
The financial statements at December 31, 20x7 are as follows:
Statements of Income and Retained Earnings Parker
Simmons
$3,500,000
$2,300,000
1,000,000
500,000
300,000
700,000
2,500,000
850,000
350,000
120,000
400,000
1,720,000
Net income
Retained earnings, beginning
Dividends
1,000,000
6,700,000
200,000
580,000
4,500,000
100,000
Retained earnings, end of year
$7,500,000
$4,980,000
$2,300,000
8,500,000
4,500,000
$1,800,000
9,680,000
$15,300,000
$11,480,000
$1,600,000
4,000,000
2,200,000
7,500,000
$1,000,000
2,500,000
3,000,000
4,980,000
$15,300,000
$11,480,000
Revenues
Expenses
Cost of sales
Depreciation
Interest expense
Other operating expenses
Statement of Financial Positions Current assets
Plant and equipment – net
Investment in Parker
Current liabilities
Long-term debt
Common stock
Retained earnings
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11.
The amount of goodwill resulting from this transaction is…
a) $468,750
b) $581,250
c) $775,000
d) $918,750
12.
The amortization of the purchase price discrepancy in the year 20x3 is…
a) $30,000 debit
b) $30,000 credit
c) $40,000 debit
d) $40,000 credit
13.
The consolidated net income (after deducting the noncontrolling interest) for the
year 20x7 is…
a) $1,333,750
b) $1,408,750
c) $1,435,000
d) $1,505,000
14.
The noncontrolling interest liability that would appear on the consolidated
Statement of Financial Position as at December 31, 20x7 is…
a) $1,250,000
b) $1,875,000
c) $1,995,000
d) $2,220,000
15.
The plant and equipment that would appear on the consolidated Statement of
Financial Position as at December 31, 20x7 is…
a) $18,180,000
b) $18,236,250
c) $18,255,000
d) $18,330,000
16.
The Consolidated Retained Earnings as at December 31, 20x7 is…
a) $8,526,250
b) $9,660,000
c) $9,735,000
d) $12,480,000
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17.
Had Parker used the equity method to account for its investment in Simmons, what
would the balance in the Investment in Simmons account be at December 31, 20x7?
a) $4,500,000
b) $6,735,000
c) $6,585,000
d) $6,660,000
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Problem 1
During 20x0, Holdco Ltd. decided to invest in the shares of a number of "Hi-tech"
companies. The data on Holdco Ltd.'s temporary investments at December 31, 20x0, is
shown below:
Investments
Cost
Number
of Shares
Market Value as at
December 31, 20x0
$ 72,000
51,000
28,000
30,000
45,000
10,000
20,000
7,000
5,000
9,000
$ 70,000
63,000
31,000
26,000
44,000
$226,000
51,000
$234,000
Company Name
XYZ Computer
Satellite Systems
Strategic Air Defense Systems
Generic Engineering
Cellulose Telephone
Recent discussions have brought to management's attention that there are different
methods of accounting for investments. Management is quite unfamiliar with these
different methods and has approached you for this information.
Required a) As chief accountant for Holdco, advise management of two alternative methods of
accounting for investments and indicate the effect each has on Statement of Financial
Position and income statement information. Support your answers with calculations.
b) On January 10, 20x1, all the XYZ Computer shares are sold for $75,000, and all the
Strategic Air Defense Systems shares are sold for $35,000. Assuming these
investments are classified as available for sale investments, write the journal entries
to record the two sales.
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c) The market values of the remaining investments at December 31, 20x1 is as follows:
Satellite Systems
Generic Engineering
Cellulose Telephone
$45,000
20,000
36,000
$101,000
Assume Holdco’s net income for the year ended December 31, 20x1 is $119,000.
Prepare the bottom portion of the Statement of Comprehensive income for the year
ended December 31, 20x1 starting with the Net Income line.
Problem 2
Mable Company has a portfolio of equity investments consisting of the following (all
investments were purchased in 20x0):
Security A
B
C
Cost
$20,000
14,000
32,000
December 31 Market Value
20x0
20x1
20x2
$18,000
$19,500
$16,000
12,500
14,000
10,500
29,800
28,500
31,000
$66,000
$60,300
$62,000
$57,500
Required a)
b)
Assuming these investments are classified as fair value through other
comprehensive income (FVTOCI), calculate the balance in Other Comprehensive
Income at the end of each year.
Assuming these investments are classified as Fair Value through Profit and Loss
investments (FVTPL), calculate the amount of unrealized trading gain or loss for
each year.
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Problem 3
On August 1, 20x4, the Cedric Company acquired $100,000 face value, 12% bonds for
$97,525 cash plus accrued interest receivable. These ten-year bonds were dated June 1,
20x0, and interest was payable semi-annually. The company intended to hold these bonds
until maturity and their business model is such that these bonds are classified at
amortized cost.
As a result of a change in plans, however, the company sold these bonds on the market at
96 plus accrued interest on September 30, 20x5.
Required Prepare all relevant dated journal entries with respect to these bonds for the period
August 1, 20x4 to their sale on September 30, 20x5. Reversing entries are not required.
Assume a year end of December 31.
Problem 4
The Huey Corporation purchased the following securities during the year ended
December 31, 20x4:
Security
Larry Inc.
Moe Co.
Curly Co.
Purchase
Price
$75,000
60,000
30,000
Market Value
At December 31, 20x4
$60,000
40,000
35,000
The following transactions occurred in 20x5:
•
•
sold Larry and Curly for $55,000 and $45,000 respectively
purchased Luey Co stock for $100,000
At the end of 20x5, the market values of Moe and Luey were $55,000 and $120,000
respectively.
Required –
Prepare all journal entries relative to these transactions for the years 20x4 and 20x5
assuming the securities are classified as…
a.
Fair value through profit and loss.
b.
Fair value through other comprehensive income. For this part, also show how
the transactions will affect the Statement of Comprehensive income for the
year ended December 31, 20x5.
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Problem 5
The Cross Manufacturing Company purchased Government of Canada Bonds on January
2, 20x3. The bonds mature in 12 years, have a face value of $2,000,000, pay coupons on
June 30 and Dec 31 of each year. The coupon rate is 5.2% and the yield-to-maturity of
the bonds at the time they were purchased was 4.6%. Cross Manufacturing Company
management classifies these bonds as fair value through profit and loss.
The year-end of the company is December 31. The bonds trade at 106 and 103 on
December 31, 20x3 and 20x4 respectively.
Required –
Prepare all journal entries relative to this bond for the years 20x3 and 20x4.
Problem 6
The Grafton Company purchased 2,000 of the 10,000 outstanding shares of Prince Ltd.
on January 2, 20x4, for $300,000. At that date, summary Statement of Financial Position
data was as follows:
Cash
Plant and equipment
Land
$100,000
1,200,000
400,000
$1,700,000
Liabilities
Common stock
Retained earnings
400,000
800,000
500,000
$1,700,000
For the year ended June 30, 20x4, Prince Ltd. reported net income of $200,000.Dividends
of $40,000 were paid on April 30, 20x4. Assume that income accrues evenly.
Requireda) Prepare all the necessary journal entries on the books of Grafton, with respect to the
investment for the year ended June 30, 20x4, assuming that Grafton accounts for the
investment in Prince as an Associate.
b) Discuss the relevant factors in the determination of whether or not significant
influence exists. As well as listing the factors, explain why they may have an impact
on the determination of significant influence.
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Problem 7
Jack Company acquired 15 percent of the outstanding voting common shares of Ernst
Company. Jack also made a loan to Ernst that is convertible into voting common shares
of Ernst and is secured by voting common shares of List Company, which is a wholly
owned subsidiary of Ernst. For as long as the loan is outstanding, Jack will have several
seats on Ernst's board of directors. Jack also has options to purchase a substantial number
of shares of List.
Required What method of accounting should Jack Company use to account for its investment in
Ernst? Explain.
Problem 8
Jaenicke Corporation has been manufacturing industrial products for over 30 years.
Jaenicke decided to diversify into the home products industry and purchased 60 percent
of the outstanding common shares of Arbor Company for $8.1 million in cash on
December 1, 20x1, the first day of the 20x1-20x2 fiscal year for both Jaenicke and Arbor.
The book value of Arbor's total shareholders' equity was $10 million as at December 1,
20x1. Jaenicke deermined that the fair value of the net assets acquired were equal to their
respective book values and ascribed the entire purchase price discrepancy to goodwill.
Arbor reported net income of $900,000 for the 20x1-20x2 fiscal year. Dividends in the
amount of $300,000 were declared and paid by Arbor in the 20x1-20x2 fiscal year
Jaenicke uses the equity method to account for its investment in Arbor. At November 30,
20x2 an impairment test indicates that the value of goodwill should be $2,800,000.
Required a.
Prepare a schedule to compute the balance of investment in Arbor common that
would appear on the Statement of Financial Position of Jaenicke Corporation at
November 30, 20x2.
b.
When Jaenicke determined that goodwill had been impaired, what factors might
have led to this determination?
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Problem 9
On January 2, 20x2, Knox Company purchased for cash, 60 percent of the 20,000
outstanding common shares of Sipple Corporation at $15 per share. The following
additional data were available for Sipple Corporation on January 2, 20x2:
Assets not subject to depreciation
Assets subject to depreciation
Liabilities
Contributed capital
Retained earnings
Book
Values
$160,000
120,000
$280,000
$ 20,000
200,000
60,000
$280,000
In 20x2 Sipple Corporation reported net income of $50,000 and paid cash dividends of
$12,000. The annual impairment test shows that the value of goodwill at the end of 20x2
is $50,000.
Required Prepare journal entries on the books of Knox Company for 20x2 related to its investment
in Sipple Corporation, assuming that Knox uses the equity method to account for its
investment in Sipple. Show calculations.
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Problem 10
On January 1,20x5, the Perkins Company purchased 70% of the outstanding voting
shares of the Staton Company for $850,000 in cash. On that date, the Staton Company
had retained earnings of $400,000 and no-par common stock of $500,000. On the
acquisition date, the identifiable assets and liabilities of the Staton Company had fair
values that were equal to their carrying values except for the building, which had a fair
value $200,000 greater than its carrying value, and long-term liabilities, which had fair
values that were $100,000 greater than their carrying values. The building had a
remaining useful life of ten years on January 1, 20x5, and the long-term liabilities mature
on December 31, 20x11. Both companies use the straight-line method to calculate all
depreciation and amortization. The trial balance of the Perkins Company and the Staton
Company on December 31,20x9, were as follows:
Perkins
Staton
Cash
$ 50,000
$ 10,000
Current receivables
250,000
100,000
Inventories
3,000,000
520,000
Equipment (net)
6,150,000
2,500,000
Buildings(net)
2,600,000
500,000
Investment in Staton (at cost)
850,000
Cost of goods sold
2,000,000
400,000
Depreciation expense
300,000
100,000
Other expenses
200,000
150,000
Dividends declared
200,000
20,000
Total debits
Current liabilities
Long-term liabilities
Common stock
Retained earnings
Sales revenue
Other revenues
Total credits
$15,600,000
$4,300,000
$
$ 170,000
1,100,000
500,000
1,600,000
900,000
30,000
$4,300,000
300,000
4,000,000
3,000,000
4,500,000
3,500,000
300,000
$15,600,000
Required:
Prepare, for the Perkins Company and its subsidiary, the Staton Company, the
following:
a.
The consolidated income statement for the year ending December 31, 20x9.
b.
Calculate consolidated net income and the ending balance of consolidated
retained earnings directly.
c.
The consolidated Statement of Financial Position at December 31, 20x9.
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Problem 11
On January 2, 20x2, Prague Limited acquired 80% of the outstanding voting shares of
Sofia Limited for $1,600,000 in cash. The Statement of Financial Position of Sofia
Limited and the fair values of its identifiable assets and liabilities were as follows:
Book value
Fair value
Assets
Cash
Accounts receivable
Inventory
Land
Building (net)
Patents (net)
Total assets
$ 100,000
300,000
600,000
800,000
1,000,000
200,000
$3,000,000
$ 100,000
300,000
662,500
900,000
1,200,000
150,000
Liabilities and shareholders' equity
Accounts payable
14% bonds payable, due December 31, 20x9
Common shares
Retained earnings
Total liabilities and shareholders' equity
$ 500,000
1,000,000
950,000
550,000
$3,000,000
$ 500,000
1,100,000
At acquisition date, the building had a remaining useful life of ten years with zero net
residual value, while the patent had a remaining economic life of eight years. The
following goodwill impairment losses were calculated:
20x4
20x7
$50,000
62,500
Both companies use the FIFO method to cost their inventories and the straight-line
method to calculate all depreciation and amortization. Prague Limited uses the cost
method to account for its long-term investment in Sofia Limited.
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CMA Accelerated Program – Corporate Taxation and Financial Accounting 2
The net incomes and retained earnings for the two companies for the year ended
December 31, 20x7, were determined as follows:
Sales
Gain on sale of land
Investment income
Rental revenue
Prague
$4,000,000
Sofia
$1,900,000
200,000
40,000
70,000
Total revenue
4,040,000
2,170,000
Cost of goods sold
Selling and administrative expense
Interest expense
Depreciation: building
Depreciation: equipment
Patent amortization
Rental expense
2,000,000
855,000
250,000
300,000
150,000
800,000
680,000
140,000
100,000
125,000
25,000
Total expenses
3,590,000
1,870,000
Net income
Retained earnings, Jan. 1
Dividends
450,000
2,000,000
100,000
300,000
900,000
50,000
$2,350,000
$1,150,000
Retained earnings, Dec. 31
35,000
The Statement of Financial Positions for the two companies at December 31, 20x7, were
as follows:
Assets
Cash
Accounts receivable
Inventory
Investment in Sofia Ltd. (cost)
Land
Building (net)
Equipment (net)
Patents (net)
Total assets
Liabilities and shareholders' equity
Accounts payable
14% bonds payable, due Dec. 31, 20x9
Notes payable
Common shares
Retained earnings
Total liabilities and shareholders' equity
Page 206
Prague
Sofia
$ 300,000
800,000
800,000
1,600,000
900,000
1,200,000
1,250,000
$ 150,000
500,000
400,000
$6,850,000
$1,000,000
2,000,000
1,500,000
2,350,000
$6,850,000
800,000
400,000
1,200,000
50,000
$3,500,000
$ 400,000
1,000,000
950,000
1,150,000
$3,500,000
© CMA Ontario - 2011
CMA Accelerated Program – Corporate Taxation and Financial Accounting 2
Additional Information:
1.
2.
In 20x7, Sofia sold one half of the land that was on hand on January 2, 20x2 to an
unrelated company.
Prague Limited's entire rental expense relates to equipment rented from Sofia
Limited.
Required:
Prepare, for the Prague Company and its subsidiary, the Sofia Company, the
following:
a.
The consolidated income statement for the year ending December 31, 20x7.
b.
Calculate consolidated net income and the ending balance of consolidated
retained earnings directly.
c.
The consolidated Statement of Financial Position at December 31, 20x7.
Page 207
© CMA Ontario - 2011
CMA Accelerated Program – Corporate Taxation and Financial Accounting 2
Problem 12
The following financial statements at December 31, 20x5, reflect the ownership by Parco
of Subco.
Parco and Subco Ltd.
Individual and Consolidated Statement of Financial Positions
December 31, 20x5
Parco
Subco
Consolidated
$ 270,000
310,000
880,000
$ 180,000
$ 450,000
210,000
1,090,000
41,111
$1,460,000
$ 390,000
$1,581,111
$
$
60,000
$ 140,000
180,000
800,000
400,000
200,000
130,000
800,000
424,000
37,111
$1,460,000
$ 390,000
$1,581,111
ASSETS
Current
Investment in Subco - at cost
Fixed assets (net)
Goodwill
LIABILITIES AND EQUITIES
Current
Long term
Shareholders' equity
Capital stock
Retained earnings
Noncontrolling interest
80,000
180,000
Additional Information:
1. Parco purchased its interest in Subco on January 1,20x0.
2. There have been no intercompany transactions.
3. Goodwill at acquisition was $44.444.
Required:
Based on the financial statements presented above:
a.
b.
c.
What percentage of ownership does Parco have in Subco?
What was the balance in Subco's retained earnings account at the date of
acquisition?
How is the consolidated retained earnings figure of $424,000 calculated?
Page 208
© CMA Ontario - 2011
CMA Accelerated Program – Corporate Taxation and Financial Accounting 2
Problem 13
On June 30, 20x1, Putnam Corporation acquired 80% of the outstanding common stock
of Simons Ltd. for $4,326,000 in cash plus Putnam Corporation common stock estimated
to have a fair market value of $1,200,000. On the date of acquisition, the fair market
value and book value of each of Simons Ltd.'s assets were generally equal, except for
inventory, which was undervalued by $225,000, and plant and equipment (net), which
was overvalued by $1,000,000. The shareholders' equity of Simons at that time was
$4,440,000, consisting of Common Stock of $2,900,000 and Retained Earnings of
$1,540,000.
Statement of Financial Positions at June 30, 20x6, are as follows:
ASSETS
Cash and marketable securities
Accounts receivable
Inventory
Plant and equipment (net)
Other long-term investments
Investment in Simons Ltd.
LIABILITIES & SHAREHOLDERS' EQUITY
Current liabilities
Long-term debt
Common shares
Retained earnings
Putnam Corp.
Simons Ltd.
$ 4,432,000
2,153,000
2,940,000
17,064,000
2,038,000
5,526,000
$ 321,000
950,000
1,206,000
7,161,000
3,240,000
0
$34,153,000
$12,878,000
$ 3,025,000
12,135,000
10,000,000
8,993,000
$ 2,090,000
4,000,000
2,900,000
3,888,000
$34,153,000
$12,878,000
Additional Information:
1. Simons Ltd. had income of $1,460,000 for the year ended June 30,20x6. Dividends of
$480,000 were declared during the fiscal year but were not paid until August 12,
20x6. Putnam had income of $2,650,000 and dividends of $1,000,000 for the same
period.
2. The plant and equipment that was overvalued on the date of acquisition had
a remaining useful life of twenty years at that date.
3. Both companies follow the straight-line method for depreciating plant and
equipment.
Required:
a.
Calculate the following balanced directly:
(i)
Consolidated net income for the year ended June 30, 20x6
(ii)
Consolidated retained earnings as at June 30, 20x6
b.
Prepare the consolidated Statement of Financial Position for Putnam Corporation
and its subsidiary, Simons Ltd., at June 30, 20x6.
Page 209
© CMA Ontario - 2011
CMA Accelerated Program – Corporate Taxation and Financial Accounting 2
Problem 14
Pan Corporation acquired 85% of San Company on January 1, 20x0, for $5,000,000. At
that time, San’s assets and liabilities had the following book and fair values:
Cash
Accounts receivable
Inventory
Capital assets, net
Book Value
$ 320,000
640,000
1,600,000
3,000,000
$5,560,000
Fair Value
$ 320,000
640,000
1,700,000
2,850,000
$1,060,000
800,000
2,000,000
1,700,000
$5,560,000
1,060,000
860,000
Accounts payable
Long-term liabilities
Common shares
Retained earnings
The capital assets consisted of machinery with a remaining useful life of 6 years as of
January 1, 2000. The long-term liabilities mature on December 31, 20x9. Pan uses the
cost method to account for its investment in San.
The companies’ Statement of Financial Positions at December 31, 20x4 were as follows:
Cash
Accounts receivable
Inventory
Capital assets, net
Investment in San
Accounts payable
Long-term liabilities
Common shares
Retained earnings
Pan
400,000
1,900,000
2,600,000
4,200,000
5,000,000
$14,100,000
$ 6,200,000
$ 900,000
1,600,000
6,000,000
5,600,000
$14,100,000
$ 1,300,000
800,000
2,000,000
2,100,000
$ 6,200,000
$
San
$ 500,000
1,100,000
1,800,000
2,800,000
Pan had its consolidated goodwill balance in San appraised each year end. There was no
goodwill impairment except for impairment of $176,471 and $235,294, calculated by
independent valuators, for fiscal 20x1 and 20x4, respectively.
Page 210
© CMA Ontario - 2011
CMA Accelerated Program – Corporate Taxation and Financial Accounting 2
Statements of Income and Retained Earnings
Revenues
Cost of goods sold
Interest expense
Depreciation expense
Other expenses
Net income
Retained earnings, beginning
Dividends declared
Retained earnings, ending
Pan
$3,600,000
1,400,000
140,000
480,000
480,000
1,100,000
4,700,000
(200,000)
$ 5,600,000
San
$2,500,000
1,100,000
40,000
250,000
610,000
500,000
1,700,000
(100,000)
$ 2,100,000
Required 1.
2.
3.
4.
Prepare a consolidated statement of income and retained earnings for the year
ended December 31, 20x4.
Provide a proof of the ending Consolidated Retained balance.
Provide a proof of the Consolidated Net Income.
Prepare the consolidated Statement of Financial Position as at December 31,
20x4.
Page 211
© CMA Ontario - 2011
CMA Accelerated Program – Corporate Taxation and Financial Accounting 2
SOLUTIONS
Multiple Choice Questions
1.
b
Investment income – Share of Dod’s net income:
$150,000 x 30%
$45,000
Investment account balance: $250,000 + 45,000 – 12,000 Div
$283,000
$500,000
380,000
$120,000
2.
c
3.
b
4.
c
5.
d
6.
c
7.
d
Purchase price imputed at 100%: $400,000 / 0.80
Net assets acquired at FMV
Goodwill
8.
d
$500,000 x 20% = $100,000
9.
b
Because of (1) the number of seats on the board of directors, (2) the
significant company of intercompany transactions and (3) the fact that no
other shareholder has a controlling interest, PK company likely has significant
influence over the operating, financial and strategic policies of KM. The
equity method should therefore be used.
10.
d
X Ltd. would use the equity method in reporting Y Ltd. in its single entity
financial statements. Therefore, 20x9 earnings from Y Ltd. should be
recorded as $41,250, i.e., ($234,000 beginning retained earnings - $164,000
ending retained earnings + $40,000 dividends) x 75% x ½ year.
Page 212
© CMA Ontario - 2011
CMA Accelerated Program – Corporate Taxation and Financial Accounting 2
11.
c
Purchase price imputed at 100%: $4,500,000 / 0.75
Less MV of net assets acquired:
$5,000,000 – 75,000 + 200,000 + 100,000
Alternatively Purchase price imputed at 100%
Net assets acquired
Purchase price discrepancy
Allocation Inventory
Plant and equipment
Long-term debt
Goodwill
$6,000,000
5,225,000
$775,000
$6,000,000
5,000,000
1,000,000
($75,000)
200,000
100,000
225,000
$775,000
PPD Amortization Schedule
Inv
P+E
LTD
Goodwill
Dec 31,x2
($75,000)
200,000
100,000
775,000
$1,000,000
x3 – x6
$75,000
(100,000)
(40,000)
x7
Dec 31, x8
($25,000)
(10,000)
($65,000)
($35,000)
$75,000
50,000
775,000
$900,000
12.
d
Inventory: $75,000 x 100%
Plant and equipment: $200,000 /8
Long-term debt: $100,000 / 10
13.
a
Parker net income
Less dividends received from Simmons: $100,000 x 75%
Share of Simmon’s Income: $580,000 x 75%
Amortization of PPD: 35,000 x 75%
14.
d
($7,980,000 + 900,000) x 25% = $2,220,000
15.
c
$8,500,000 + 9,680,000 + 75,000 = $18,225,600
Page 213
$75,000
(25,000)
(10,000)
$40,000
$1,000,000
(75,000)
435,000
(26,250)
$1,333,750
© CMA Ontario - 2011
CMA Accelerated Program – Corporate Taxation and Financial Accounting 2
16.
17.
b
d
Page 214
P’s R/E, end of year
S’s R/E, end of year
Less R/E at acquisition
Post acquisition increase
Amortization of PPD
Share of S’s Net Assets: $7,980,000 x 75%
Unamortized PPD: $900,000 x 75%
$7,500,000
$4,980,000
2,000,000
2,980,000
(100,000)
2,880,000
x 75%
2,260,000
$9,660,000
$5,985,000
675,000
$6,660,000
© CMA Ontario - 2011
CMA Accelerated Program – Corporate Taxation and Financial Accounting 2
Problem 1
a)
Accounting for financial assets depends on the company's business model. The
default classification is at fair value through profit and loss (FVTPL). If the
financial asset is not classified as held for trading and is an equity instrument, the
entity has the option of classifying the financial asset as fair value through other
comprehensive income. Such a classification is irrevocable. Any unrealized gains
or losses would flow through Other Comprehensive Income. Realized gains/losses
would get reclassified from Other Comprehensive Income directly to Retained
Earnings.
Either way, the securities have to be recorded at fair market value on the Statement
of Financial Position at December 31, 20x0:
XYZ Computer
Satellite Systems
Strategic Air Defence Systems
Generic Engineering
Cellulose Telephone
Unrealized
gain (loss)
($2,000)
12,000
3,000
(4,000)
(1,000)
$ 8,000
The difference in accounting treatment lies with how the net unrealized gain will
be recorded. If the securities are classified as FVTOCI, then the net unrealized
gain will be part of the Other Comprehensive Income section of Shareholders'
Equity. If the securities are classified as FVTPL investments, then the net
unrealized gain flows through net income.
b)
Sale of XYZ FVTOCI Investments
OCI – FVTOCI Revaluation
To record the change in market value
($75,000 – 70,000)
OCI – FVTOCI Revaluation
Retained Earnings
To remove the unrealized gain from OCI.
Cash
FVTOCI Investments
Page 215
$5,000
$5,000
3,000
3,000
75,000
75,000
© CMA Ontario - 2011
CMA Accelerated Program – Corporate Taxation and Financial Accounting 2
Sale of Strategic Air Defense FVTOCI Investments
OCI – FVTOCI Revaluation
To record the change in market value
($35,000 – 31,000)
$4,000
$4,000
OCI – FVTOCI Revaluation
Retained Earnings
To remove the unrealized gain from OCI.
7,000
7,000
Cash
FVTOCI Investments
c)
Opening Bal
Removal of
accumulated OCI on
sale of XYZ
Removal of
Accumulated OCI on
sale of Strategic Air
Defense
Year-end Adjustment
to Market Value
Ending Balance
35,000
35,000
Other Comprehensive Income
$8,000
Adjustment to XYZ
prior to sale
3,000 5,000
Adjustment to
Strategic Air Defense
prior to Sale
7,000 4,000
32,000*
$25,000**
* Calculation of adjustment required to OCI:
Satellite Systems
Generic Engineering
Cellulose Telephone
Carrying
Value
$63,000
26,000
44,000
$133,000
Market
Value
$45,000
20,000
36,000
$101,000
Reduction in market value = $133,000 – 101,000 = $32,000
Page 216
© CMA Ontario - 2011
CMA Accelerated Program – Corporate Taxation and Financial Accounting 2
** Check ending balance in OCI:
Satellite Systems
Generic Engineering
Cellulose Telephone
Original
Cost
$51,000
30,000
45,000
$126,000
Market
Value
$45,000
20,000
36,000
$101,000
Balance in OCI = $126,000 – 101,000 = $25,000
Net income
Other Comprehensive Income
Net holding loss on FVTOCI Investments during the
year
($5,000 Gain XYZ + 4,000 Gain Strategic Air Defense
- 32,000 Loss Y/E)
Reclassification adjustment to Retained Earnings for
realized net gain
($3,000 XYZ + 7,000 Strategic Air Defense)
Comprehensive income
Page 217
$119,000
($23,000)
(10,000)
(33,000)
$86,000
© CMA Ontario - 2011
CMA Accelerated Program – Corporate Taxation and Financial Accounting 2
Problem 2
(a)
Other Comprehensive Income
20x0: Adjustment to
Market Value:
$60,300 – 66,000
Bal, Dec 31, 20x0
$5,700
5,700
1,700
Bal, Dec 31, 20x1
4,000
20x3: Adjustment to
Market Value:
$57,500 – 62,000
4,500
Bal, Dec 31, 20x2
b)
20x1: Adjustment to
Market Value:
$62,000 – 60,300
$8,500
In 20x0, an unrealized holding loss of $5,700 will be charged to income.
In 20x1, an unrealized holding gain of $1,700 ($5,700 - 4,000) will be credited to
income.
In 20x2, an unrealized holding loss of $4,500 ($4,000 – 8,500) will be charged to
income.
Page 218
© CMA Ontario - 2011
CMA Accelerated Program – Corporate Taxation and Financial Accounting 2
Problem 3
First we must calculate the YTM on the date the bonds were purchased:
N = 12, PV = -97,525 PMT = 6,000, FV = 100,000
CPY I/Y = 6.3%
Aug 1, 20x4
Dec 1, 20x4
Dec 31, 20x4
Jun 1, 20x5
Sep 30, 20x5
Page 219
Investment in amortized cost securities
Investment income*
Cash
* $100,000 x 12% x 2/12
$97,525
2,000
Cash ($100,000 x 12% x ½)
Investment in amortized cost securities
Investment income
($97,525 x 6.3%)
6,000
144
Accrued interest receivable
($100,000 x 12% x 1/12)
Investment in amortized cost securities
Investment income
($97,525 + 144) x 6.3% x 1/6
$99,525
6,144
1,000
26
1,026
Cash
Investment in amortized cost securities
Accrued interest receivable
Investment income
($97,525 + 144 + 26) x 6.3% x 5/6
6,000
128
Cash (100,000 x 12% x 4/12)
Investment in amortized cost securities
Investment income
($97,525 + 144 + 26 + 128) x 6.3% x 4/6
4,000
109
Cash ($100,000 x 0.96)
Loss on sale of amortized cost securities
Investment in amortized cost securities
96,000
1,932
1,000
5,128
4,109
97,932
© CMA Ontario - 2011
CMA Accelerated Program – Corporate Taxation and Financial Accounting 2
Problem 4
a.
Purchase
Price
$75,000
60,000
30,000
$165,000
Larry Inc.
Moe Co.
Curly Co.
Dec 31, 20x4
During 20x5
Unrealized loss on FVTPL
investments
FVTPL Investments
Market
Value
$60,000
40,000
35,000
$135,000
30,000
30,000
Sale of Larry
Cash
Loss on sale of FVTPL Investments
FVTPL Investments
55,000
5,000
60,000
Sale of Curly
Cash
Gain on sale of FVTPL
Investments
FVTPL Investments
45,000
10,000
35,000
Purchase of Luey
FVTPL Investments
Cash
Dec 31, 20x5
FVTPL Investments
Unrealized gain on FVTPL
Investments
Moe Co.
Luey Co.
Page 220
100,000
100,000
35,000
35,000
Carrying
Value
Market
Value
$ 40,000
100,000
$140,000
$ 55,000
120,000
$175,000
© CMA Ontario - 2011
CMA Accelerated Program – Corporate Taxation and Financial Accounting 2
b.
Dec 31, 20x4
During 20x5
OCI – FVTOCI Revaluation
FVTOCI Investments
30,000
30,000
Sale of Larry
OCI – FVTOCI Revaluation
FVTOCI Investments
5,000
5,000
Retained Earnings
OCI – FVTOCI Revaluation
20,000
Cash
FVTOCI Investments
55,000
20,000
55,000
Sale of Curly
FVTOCI Investments
OCI – FVTOCI Revaluation
10,000
OCI – FVTOCI Revaluation
Retained Earnings
15,000
Cash
FVTOCI Investments
45,000
10,000
15,000
45,000
Purchase of Luey
FVTOCI Investments
Cash
Dec 31, 20x5
FVTOCI Investments
OCI – FVTOCI Revaluation
Moe Co.
Luey Co.
Page 221
100,000
100,000
35,000
35,000
Carrying
Value
Market
Value
$ 40,000
100,000
$140,000
$ 55,000
120,000
$175,000
© CMA Ontario - 2011
CMA Accelerated Program – Corporate Taxation and Financial Accounting 2
c)
Opening Balance
Other Comprehensive Income
30,000
Adjustment to Larry
prior to sale
Removal of
Accumulated OCI on
sale of Curly
5,000 20,000
15,000 10,000
Year-end Adjustment
to Market Value
35,000
Ending Balance
$15,000*
Removal of
accumulated OCI on
sale of Larry
Adjustment to Curly
prior to Sale
* Check ending balance in OCI:
Moe Co.
Luey Co.
Original
Cost
$ 60,000
100,000
$160,000
Market
Value
$ 55,000
120,000
$175,000
Balance in OCI = $175,000 – 160,000 = $15,000
Net income
Other Comprehensive Income
Net holding gain on FVTOCI Investments during the
year
($10,000 Gain Curly + 35,000 Gain Y/E - 5,000 Loss Larry)
Reclassification adjustment to Retained Earnings for
realized net loss
($20,000 Larry - 15000 Curly)
Comprehensive income
Page 222
$XXX
$40,000
5,000
45,000
$XXX
© CMA Ontario - 2011
CMA Accelerated Program – Corporate Taxation and Financial Accounting 2
Problem 5
Purchase price of bonds:
N = 24, I = 2.3, PMT = 52,000, FV = 2,000,000
CPT PV = 2,109,720
Jan 2, 20x3
Jun 30, 20x3
Dec 31, 20x3
Jun 30, 20x4
Dec 31, 20x4
Page 223
FVTPL Investments
Cash
$2,109,720
$2,109,720
Cash
FVTPL Investments
Investment Income
($2,109,720 x 2.3%)
52,000
Cash
FVTPL Investments
Investment Income
($2,109,720 – 3,476)
= $2,106,244 x 2.3%
52,000
FVTPL Investments
Gain on FVTPL Investments
To adjust to market value:
Carrying value: $2,109,720 – 3,476 – 3,556
Market value: $2,000,000 x 1.06
Holding gain
17,312
Cash
FVTPL Investments
Investment Income
($2,106,244 – 3,556)
= $2,102,688 x 2.3%
52,000
Cash
FVTPL Investments
Investment Income
($2,102,688 – 3,638)
= $2,099,050 x 2.3%
52,000
3,476
48,524
3,556
48,444
17,312
$2,102,688
2,120,000
$ 17,312
3,638
48,362
3,722
48,278
© CMA Ontario - 2011
CMA Accelerated Program – Corporate Taxation and Financial Accounting 2
Loss on FVTPL Investments
FVTPL Investments
Carrying value of bond, Dec 31, 20x3
Less amortization of premium – 20x4
$3,638 + 3,722
Carrying value before fair value adjustment
Market value: $2,000,000 x 1.03
Holding loss
Page 224
52,640
52,640
$2,120,000
7,360
2,112,640
2,060,000
$ 52,640
© CMA Ontario - 2011
CMA Accelerated Program – Corporate Taxation and Financial Accounting 2
Problem 6
a)
Investment income = share of Prince income:
$200,000 x 20% x ½ year
$20,000
Journal entries:
Investment in Prince
Cash
Investment in Prince
Investment income
Cash (40,000 x 20%)
Investment in Prince
b)
$300,000
$300,000
20,000
20,000
8,000
8,000
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 management personnel or
provision of technical information, as well as the pattern of share ownership.
These factors are highly interrelated, and each by itself may not be indicative of
significant influence. The relative importance of each factor would be evaluated
within the context of the situation, and the determination in any particular case
would be a judgemental decision.
If the investor holds a small percentage the voting interest in the investee, it
should be presumed that the investor does not have the ability to exercise
significant influence, unless such ability is clearly demonstrated. The holding of a
larger portion of the outstanding shares would not necessarily guarantee
significant influence, as there could be a larger shareholder, although the
existence of a larger shareholder would not preclude the exercise of significant
influence in a particular case.
However, as a general rule, significant influence is presumed to exist when 20%
or more of the shares of the other company are controlled. Because the %
ownership in this case is 20% exactly, then a strong case would have to be made
to show that no significant influence exists.
Page 225
© CMA Ontario - 2011
CMA Accelerated Program – Corporate Taxation and Financial Accounting 2
Problem 7
The issue is whether Jack has significant influence over Ernst. Given that less than 20%
of the shares were purchased, a case would have to be made to establish significant
influence. There are two factors that suggest significant influence:
•
The fact that Jack has made a loan to Ernst which is convertible into voting
common shares of List, a wholly-owned subsidiary of Ernst.
•
Jack has several seats on Ernst's board of directors as long as the loan is
outstanding and has options to purchase a substantial number of shares of List.
The evidence suggests that Jack actually is in a position to exercise significant influence
over Ernst, even though Jack owns only 15% of the voting common of Ernst. Therefore,
Jack should account for its investment in Ernst by the equity method.
Problem 8
a.
Jaenicke Corporation
Investment in Arbor Common
November 30, 20x2
Purchase price
Investment income*
Dividends received (.6 x $300,000)
Balance, Nov 30, 20x2
Purchase price imputed at 100%: $8,100,000 / 0.60
Net assets acquired
Goodwill
* Investment income
Arbor’s net income
Less goodwill impairment loss: $3,500,000 – 2,800,000
$8,100,000
120,000
(180,000)
$8,040,000
$13,500,000
10,000,000
$3,500,000
$900,000
(700,000)
200,000
x 60%
$120,000
b.
Some indicators of impairment:
• internal reporting indicates Arbor is not performing to expectations
• external economic factors having a negative impact on investee performance
• major change in the competitive environment, i.e. new competitors in business
area or new product launches by competitor
Page 226
© CMA Ontario - 2011
CMA Accelerated Program – Corporate Taxation and Financial Accounting 2
Problem 9
Calculations:
Purchase price imputed at 100%:
(12,000 shares x $15) = $180,000 / 0.6
Net assets acquired
Goodwill
$300,000
260,000
$40,000
Since the impairment test shows goodwill to be $50,000 at year end, no adjustment is
necessary.
Investment income = Share of Sipple Income: $50,000 x 60%
$30,000
Journal entries:
Investment in Sipple Co. common
Cash
180,000
Investment in Sipple Co. common
Investment income
30,000
Cash
Investment in Sipple Co. common
($12,000 x 60%)
Page 227
180,000
30,000
7,200
7,200
© CMA Ontario - 2011
CMA Accelerated Program – Corporate Taxation and Financial Accounting 2
Problem 10
Purchase Price Allocation Purchase price imputed at 100%: $850,000 / 0.70
Net assets acquired
PPD
Allocation:
Equipment
Long-term liabilities
Goodwill
$1,214,286
900,000
314,286
$200,000
(100,000)
100,000
$214,286
PPD Amortization Schedule -
Building (10)
Bonds payable (7)
Goodwill
Total
a.
Balance
Jan 1, 20x5
20x5 – 20x8
(4)
20x9
Balance
Dec 31, 20x9
$200,000
(100,000)
214,286
($80,000)
57,143
-
($20,000)
14,286
-
$100,000
(28,571)
214,286
$314,286
($22,857)
($5,714)
$285,715
Consolidated Statement of Income (000's)
for the year ending December 31, 20x9
Sales (3,500,000 + 900,000)
Other revenues ($300,000 + 30,000 – 14,000 Dividends from Staton)
COGS (2,000,000 + 400,000)
Depreciation (300,000 + 100,000 + 20,000 PPD)
Other expenses (200,000 + 150,000 – 14,286 PPD)
Net income – entity
Noncontrolling Interest (Schedule)
Consolidated net income
Consolidated retained earnings, beginning of year (Schedule)
Dividends
Consolidated retained earnings, end of year
Noncontrolling Interest in Staton’s Net Income
Staton’s net income
Amortization of PPD
Page 228
$4,400,000
316,000
(2,400,000)
(420,000)
(335,714)
1,560,286
(82,286)
1,478,000
5,324,000
(200,000)
$6,602,000
$280,000
(5,714)
274,286
x 30%
$82,286
© CMA Ontario - 2011
CMA Accelerated Program – Corporate Taxation and Financial Accounting 2
Consolidated Retained Earnings - Beginning of year
Perkins Retained Earnings – beginning
Staton Retained Earnings – beginning
- at acquisition
Post acquisition increase
Amortization of PPD – 20x5 – 20x8
b.
$4,500,000
$1,600,000
400,000
1,200,000
(22,857)
1,177,143
x 70%
824,000
$5,324,000
Consolidated Net Income - Direct
for the year ending December 31, 20x9
Perkins Net Income
Less dividends received from Staton
Share of Staton's net income : $274,286 x 70%
$1,300,000
(14,000)
192,000
$1,478,000
Consolidated Retained Earnings - Ending (Direct)
Perkins Retained Earnings – end
$4,500,000 R/E Begin + 1,300,000 Net Income
– 200,000 Dividends
Staton Retained Earnings - end
$1,600,000 R/E Begin + 280,000 Net Income
– 20,000 Dividends
- at acquisition
Post acquisition increase
Amortization of PPD – 20x5 – 20x9:
$22,857 + 5,714
Page 229
$5,600,000
$1,860,000
400,000
1,460,000
(28,571)
1,431,429
x 70%
1,002,000
$6,602,000
© CMA Ontario - 2011
CMA Accelerated Program – Corporate Taxation and Financial Accounting 2
d.
Perkins Company
Consolidated Statement of Financial Position
as at December 31, 20x9
ASSETS
Cash (50,000 + 10,000)
Accounts receivable (250,000 + 100,000)
Inventory (3,000,000 + 520,000)
Equipment - net (6,150,000 + 2,500,000)
Buildings - net (2,600,000 + 500,000 + 100,000 PPD)
Goodwill
$60,000
350,000
3,520,000
8,650,000
3,200,000
214,286
$15,994,286
LIABILITIES AND SHAREHOLDERS’ EQUITY
Current liabilities (300,000 + 170,000)
Long-term liabilities (4,000,000 + 1,100,000 + 28,571 PPD)
Common Stock
Retained Earnings
Noncontrolling Interest (Schedule)
$ 470,000
5,128,571
3,000,000
6,602,000
793,715
$15,994,286
Noncontrolling Interest in the Net Assets of Staton Staton’s net assets $2,100,000 Net Assets Beginning of Year + 280,000 Net Income
– 20,000 Dividends
Unamortized PPD
$2,360,000
285,715
2,645,715
x 30%
$793,715
Page 230
© CMA Ontario - 2011
CMA Accelerated Program – Corporate Taxation and Financial Accounting 2
Problem 11
Purchase Price Allocation Purchase price imputed at 100%: $1,600,000 / 0.80
Net assets acquired
PPD
Allocation:
Inventory
Land
Building
Patents
Bonds payable
Goodwill
$2,000,000
1,500,000
500,000
62,500
100,000
200,000
(50,000)
(100,000)
212,500
$287,500
PPD Amortization Schedule -
Inventory
Land
Building (10)
Patents (8)
Bonds payable (8)
Goodwill
Total
Page 231
Balance
Jan 1, 20x2
$62,500
100,000
200,000
(50,000)
(100,000)
287,500
20x2-20x6
(5)
($62,500)
20x7
Balance
Dec 31, 20x7
(100,000)
31,250
62,500
(50,000)
($50,000)
(20,000)
6,250
12,500
(62,500)
$50,000
80,000
(12,500)
(25,000)
175,000
$500,000
($118,750)
($113,750)
$267,500
© CMA Ontario - 2011
CMA Accelerated Program – Corporate Taxation and Financial Accounting 2
a.
Prague Limited
Consolidated Statement of Income (000's)
for the year ending December 31, 20x7
Sales (4,000 + 1,900)
Gain on sale of land (200 - 50 PPD)
Rental revenue (70 - 35 Intercompany Rental Income)
COGS (2,000 + 800)
Selling and administrative (855 + 680)
Interest expense (250 + 140 – 12.5 PPD)
Depreciation - building (300 + 100 + 20 PPD)
Depreciation - equipment (150 + 125)
Patent amortization (25 – 6.25 PPD)
Goodwill impairment loss
Net income – Entity
Noncontrolling Interest - Schedule
Consolidated net income
Consolidated retained earnings, beginning of year (Schedule)
Dividends
Consolidated retained earnings, end of year
$5,900.00
150.00
35.00
(2,800.00)
(1,535.00)
(377.50)
(420.00)
(275.00)
(18.75)
(62.50)
596.25
(37.25)
559.00
2,185.00
(100.00)
$2,644.00
Noncontrolling Interest in Sofia’s Net Income
Sofia’s net income
Amortization of PPD
$300.00
(113.75)
186.25
x 20%
$37.25
Consolidated Retained Earnings - Beginning of year (000's)
Prague Retained Earnings - beginning
Sofia Retained Earnings - beginning
- at acquisition
Post acquisition increase
Amortization of PPD – 20x2 – 20x6
Page 232
$2,000.00
$900.00
550.00
350.00
(118.75)
231.25
x 80%
185.00
$2,185.00
© CMA Ontario - 2011
CMA Accelerated Program – Corporate Taxation and Financial Accounting 2
b.
Consolidated Net Income - Direct
for the year ending December 31, 20x7 (000's)
Prague Net Income
Less dividends received from Sofia
Sofia's net income
Amortization of PPD
$450.00
(40.00)
300.00
(113.75)
186.25
x 80%
149.00
$559.00
Consolidated Retained Earnings - Ending (Direct) (000's)
Prague Retained Earnings - end
Sofia Retained Earnings - end
- at acquisition
Post acquisition increase
Amortization of PPD – 20x2 – 20x7
Page 233
$2,350.00
$1,150.00
550.00
600.00
(232.50)
367.50
x 80%
294.00
$2,644.00
© CMA Ontario - 2011
CMA Accelerated Program – Corporate Taxation and Financial Accounting 2
c.
Prague Limited
Consolidated Statement of Financial Position
as at December 31, 20x7
ASSETS
Cash (300 + 150)
Accounts receivable (800 + 500)
Inventory (800 + 400)
Land (900 + 800 + 50 PPD)
Building (1,200 + 400 + 80 PPD)
Equipment (1,250 + 1,200)
Patents (50 – 12.5 PPD)
Goodwill
$450.00
1,300.00
1,200.00
1,750.00
1,680.00
2,450.00
37.50
175.00
$9,042.50
LIABILITIES AND SHAREHOLDERS’ EQUITY
Accounts payable (1,000 + 400)
Bonds payable (1,000 + 25 PPD)
Note payable
Common Stock
Retained Earnings
Noncontrolling Interest
1,400.00
1,025.00
2,000.00
1,500.00
2,644.00
473.50
$9,042.50
Noncontrolling Interest in the Net Assets of Sofia
Sofia’s net assets
Unamortized PPD
$2,100.00
267.50
2,367.50
x 20%
$473.50
Page 234
© CMA Ontario - 2011
CMA Accelerated Program – Corporate Taxation and Financial Accounting 2
Problem 12
a.
Noncontrolling interest liability / Net assets of Subco
= $37,111 / (330,000 + 41,111)
= 10% noncontrolling interest %
Parco’s percentage ownership of Subco is 90%
b.
c.
Purchase price (Investment in Subco account balance) imputed at
100%: $310,000 / 0.90
Less goodwill at acquisition
= Net assets of Subco at acquisition
Less Common Stock
Retained earnings at acquisition
$344,444
44,444
300,000
200,000
$100,000
Parco’s Retained Earnings – Dec 31, 20x5
$400,000
Subco’s Retained Earnings – Dec 31, 20x5
Less Retained Earnings at acquisition
Post acquisition increase in Retained Earnings
Less goodwill impairment ($44,444 – 41,111)
Consolidated Retained Earnings
Page 235
$130,000
100,000
30,000
(3,333)
26,667
x 90%
24,000
$424,000
© CMA Ontario - 2011
CMA Accelerated Program – Corporate Taxation and Financial Accounting 2
Problem 13
Purchase Price Allocation Purchase price imputed at 100%: $5,526,000 / 0.80
Net assets acquired
PPD
Allocation:
Inventory
Plant and equipment
Goodwill
$6,907,500
4,440,000
2,467,500
$225,000
(1,000,000)
(775,000)
$3,242,500
PPD Amortization Schedule -
Inventory (1)
Plant & Equip (20)
Goodwill
Total
a.
(i)
(ii)
Balance
Jun 30, 20x1
$225,000
(1,000,000)
3,242,500
20x2 – 20x5
(4)
($225,000)
200,000
-
20x6
50,000
-
Balance
Jun 30, 20x6
($750,000)
3,242,500
$2,467,500
($25,000)
$50,000
$2,492,500
Putnam Corp. Net Income
Share of Simons Ltd. dividends: $480,000 x 80%
Share of Simons’ net income
$1,460,000
Amortization of PPD
50,000
1,510,000
x 80%
Consolidated Net Income
$2,650,000
(384,000)
Putnam Corp. Retained Earnings
$8,993,000
Simons’ Retained Earnings
Less Retained Earnings at acquisition
Post Acquisition Increase
Amortization of PPD: ($25,000) + 50,000
Page 236
$3,888,000
1,540,000
2,348,000
25,000
2,373,000
x 80%
1,208,000
$3,474,000
1,898,400
$10,891,400
© CMA Ontario - 2011
CMA Accelerated Program – Corporate Taxation and Financial Accounting 2
b.
Putnam Corp.
Consolidated Statement of Financial Position
As at June 30, 20x6
ASSETS
Cash and marketable securities ($4,432,000 + 321,000)
Accounts receivables ($2,153,000 + 950,000
– 384,000 Dividends Receivable from Simons)
Inventory ($2,940,000 + 1,206,000)
Plant & equipment – net ($17,064,000 + 7,161,000 – 750,000 PPD)
Other long-term investments ($2,038,000 + 3,240,000)
Goodwill
$ 4,753,000
2,719,000
4,146,000
23,475,000
5,278,000
3,242,500
$43,613,500
LIABILITIES AND SHAREHOLDERS’ EQUITY
Current liabilities ($3,025,000 + 2,090,000
– 384,000 Dividends Payable to Putnam)
Long-term debt ($12,135,000 + 4,000,000)
Common shares
Retained earnings
Noncontrolling interest (Schedule)
Simon’s Net Assets
Unamortized PPD
$4,731,000
16,135,000
10,000,000
10,891,400
1,856,100
$43,613,500
$6,788,000
2,492,500
9,280,500
x 20%
$1,856,100
Page 237
© CMA Ontario - 2011
CMA Accelerated Program – Corporate Taxation and Financial Accounting 2
Problem 14
Purchase price: $5,000,000 / 0.85
Net assets acquired
PPD
Allocation:
Inventory
Capital assets
Long-term liabilities
Goodwill
$5,882,353
3,700,000
2,182,353
$100,000
(150,000)
(60,000)
(110,000)
$2,292,353
PPD Amortization Schedule Amortization
Inventory
Capital assets
Long-term liabilities
Goodwill
1.
Balance
Jan 1, 20x0
20x0-20x3
$100,000
(150,000)
(60,000)
2,292,353
$2,182,353
(100,000)
100,000
24,000
(176,471)
($152,471)
Balance
20x4 Dec 31, 20x4
25,000
6,000
(235,294)
($204,294)
(25,000)
(30,000)
1,880,588
$1,825,588
Pan Ltd.
Consolidated Statement of Income and Retained Earnings
For the tear ended December 31, 20x4
Revenues ($3,600,000 + 2,500,000 – 85,000 Dividends from San)
Cost of goods sold (1,400,000 + 1,100,000)
Interest expense (140,000 + 40,000 – 6,000 Amort PPD)
Depreciation (480,000 + 250,000 – 25,000 Amort PPD)
Goodwill impairment expense
Other expenses (480,000 + 610,000)
Net income – entity
Non Controlling Interest (Schedule)
Consolidated net income
Consolidated Retained Earnings - Beginning (Schedule)
Dividends
Consolidated Retained Earnings - End
Page 238
$6,015,000
(2,500,000)
(174,000)
(705,000)
(235,294)
(1,090,000)
1,310,706
(44,356)
1,266,350
4,570,400
(200,000)
$5,636,750
© CMA Ontario - 2011
CMA Accelerated Program – Corporate Taxation and Financial Accounting 2
Noncontrolling Interest in San’s Net income
San’s net income
Amortization of PPD
$500,000
(204,294)
295,706
x 15%
$44,356
Consolidated Retained Earnings - Jan 1, 20x4
Pan's retained earnings - Jan 1, 20x4
San's R/E at Jan 1, 20x4
San's R/E at acquisition
Post acquisition increase
Amortization of PPD
2.
$1,700,000
1,700,000
0
(152,471)
(152,471)
x 85%
Consolidated Retained Earnings - Dec 31, 20x4
Pan's retained earnings - Dec 31, 20x4
San's R/E at Dec 31, 20x4
San's R/E at acquisition
Post acquisition increase
Amortization of PPD ($152,471 + 204,294)
3.
$4,700,000
Pan’s net income
Less dividends from San
Share of San's net income
San's net income
Amortization PPD
Consolidated net income
Page 239
(126,600)
$4,570,400
$5,600,000
$2,100,000
1,700,000
400,000
(356,765)
43,235
x 85%
36,750
$5,636,750
$1,100,000
(85,000)
$500,000
(204,294)
295,706
x 85%
251,350
$1,266,350
© CMA Ontario - 2011
CMA Accelerated Program – Corporate Taxation and Financial Accounting 2
4.
Pan Ltd.
Consolidated Statement of Financial Position as at Dec 31,
20x4
ASSETS
Cash ($400,000 + 500,000)
Accounts Receivable (1,900,000 + 1,100,000)
Inventory (2,600,000 + 1,800,000)
Capital Assets (4,200,000 + 2,800,000 – 25,000 PPD)
Goodwill
LIABILITIES AND SHAREHOLDERS’ EQUITY
Accounts payable (900,000 + 1,300,000)
Long-term liabilities (1,600,000 + 800,000 + 30,000 PPD)
Common shares
Retained earnings
Noncontrolling interest (Schedule)
Noncontrolling interest in San’s Net Assets
San’s net asssets
Unamortized PPD
Page 240
$
900,000
3,000,000
4,400,000
6,975,000
1,880,588
$17,155,588
$ 2,200,000
2,430,000
6,000,000
5,636,750
888,838
$17,155,588
$4,100,000
1,825,588
5,925,588
x 15%
$888,838
© CMA Ontario - 2011
CMA Accelerated Program – Corporate Taxation and Financial Accounting 2
4.
Operating Segments
Consolidated financial statements are required in order to report financial results of the
parent company and its subsidiaries as one economic entity. However, these statements
increase the difficulty of analyzing a corporation because they could mask high-risk
ventures and poor investments; different lines of business may have different earnings
potential. It is possible for a consolidated income statement to show a healthy profit
when some of its business segments are experiencing serious financial difficulties. This is
addressed by IFRS 8 - Operating Segments.
The core principle of the standard is that 'an entity shall disclose information to enable
users of its financial statements to evaluate the nature and financial effects of the business
activities in which it engages and the economic environments in which it operates.' (IFRS
8.1)
The definition of an operating segment uses the “management method” to determine what
are reportable segments. The management method requires disclosure of segment
information based on the way management reviews it.
An operating segment is defined as a component of an entity:
(a)
that engages in business activities from which it may earn revenues and incur
expenses (including revenues and expenses relating to transactions with other
components of the same entity),
(b)
whose operating results are regularly reviewed by the enterprise’s chief operating
decision maker to make decisions about resources to be allocated to the segment
and assess its performance, and
(c)
for which discrete financial information is available. (IFRS 8.5)
Generally, an operating segment is one that is headed by a segment manager who is
directly accountable to and maintains regular contact with the chief operating decision
maker to discuss operating activities, financial results, forecasts or plans for the segment.
(IFRS 8.9)
Reportable Segments
Once operating segments have been identified, the next step is to determine which
segments are reportable, i.e. require separate disclosure. First, we need to determine if
some operating segments can be aggregated. Two or more segments may be aggregated
into a single operating segment is aggregation is consistent with the core principle, the
segments have similar economic characteristics, and the segments are similar in each of
the following respects:
•
the nature of products and services;
•
the nature of the production process;
•
the type or class of customer for their products and services;
•
the method used to distribute their products or provide their services; and
Page 241
© CMA Ontario - 2011
CMA Accelerated Program – Corporate Taxation and Financial Accounting 2
•
if applicable, the nature of the regulatory environment, for example, banking,
insurance or public utilities. (IFRS 8.12)
The second step is to determine if the operating segments meet the quantitative
thresholds. An entity shall report separately information about an operating segment that
meets any of the following quantitative thresholds:
(a)
(b)
(c)
Its reported revenue, including both sales to external customers and intersegment
sales or transfers, is 10 percent or more of the combined revenue, internal and
external, of all reported operating segments.
The absolute amount of its reported profit or loss is 10 percent or more of the
greater, in absolute amount, of:
(i) the combined reported profit of all operating segments that did not report a
loss, or
(ii) the combined reported loss of all operating segments that did report a loss.
Its assets are 10 percent or more of the combined assets of all operating segments.
(IFRS 8.13)
Note that operating segments that do not meet any of the quantitative thresholds may be
considered reportable, and separately disclosed, if management believes that information
about the segment would be useful to users of the financial statements (IFRS 8.13).
For example, assume that we have eight operating segments with the following
characteristics:
Segment:
A
B
C
D
E
F
G
H
Revenues
$1,000
600
2,000
500
800
1,800
300
2,600
$9,600
Income
$250
50
(100)
100
(200)
190
30
180
$500
Assets
$1,500
1,200
2,600
750
1,600
3,400
200
2,750
$14,000
Revenue test: any segment whose revenues exceed $960 (9,600 x 10%) would be
reportable - these include segments A, C, F and H.
Income test: absolute amount of profit of these segments who reported a profit =
$800; absolute amount of loss of these segments who reported a loss = $300. The
greater of the two is $800. Thus, any segment whose absolute income or loss
exceeds $80 ($800 x 10%) are reportable - these include segments A, C, D, E, F
and H.
Page 242
© CMA Ontario - 2011
CMA Accelerated Program – Corporate Taxation and Financial Accounting 2
Asset test - any segment whose assets exceed $1,400 (14,000 x 10%) would be
reportable - these include segments A, C, E, F and H.
Consequently, all but segments B and G would be reportable. Segments B and G
would be grouped with another segment whose line of business most closely
resembles that of segments B and G.
As well, there is a requirement that the total revenue generated by separately disclosed
operating segments must be at least 75%; otherwise, you would need to disclose
additional operating segments (even though they might not have met the quantitative
thresholds) to get up to the 75%. (IFRS 8.15)
All other non-reportable segments are combined and disclosed in an 'all other segments'
category. The source of revenue of the non-reportable segments needs to be disclosed.
(IFRS 8.16)
Segment disclosures
There are fundamentally three overall disclosure requirements:
(a)
General Information - the following needs to be disclosed:
the factors used to identify the entity's reportable segments, including the
basis of organization (for example, whether management has chosen to
organize the entity around differences in products and services,
geographical areas, regulatory environments, or a combination of factors
and whether operating segments have been aggregated; and
types of revenues and services from which each reportable segment
derives its revenues. (IFRS 8.22)
(b)
Information about profit and loss, assets and liabilities - a measure of profit and
loss and total assets must be reported for each reportable segment. If segment
liabilities are regularly reported to the chief operating decision maker, then these
have to be disclosed also.
The following amounts have to be disclosed, but only if they are included in the
measure of segment profit or loss reviewed by the chief operating decision maker:
•
revenues from external customers;
•
revenues from transactions with other operating segments of the same
entity;
•
interest revenue;
•
interest expense;
•
depreciation and amortization;
•
material items of income and expenses when these were disclosed
separately on the consolidated statement of income;
•
the entity's interest in the profit or loss of associates and joint ventures
accounted for by the equity method;
Page 243
© CMA Ontario - 2011
CMA Accelerated Program – Corporate Taxation and Financial Accounting 2
•
income tax expense or income; and
•
material non-cash items other than depreciation and amortization
(IFRS 8.23)
The following asset disclosures have to be made, but only if they are included in
the reports reviewed by the chief operating decision maker:
•
the amount of investment in associates and joint ventures accounted for by
the equity method; and
•
the amount of additions to non-current assets other than financial
instruments, deferred tax assets or pension assets. (IFRS 8.24)
(c)
Reconciliations - for all amounts listed below, a reconciliation between the
segment totals and the amounts shown on the entity's statement of income;
•
revenues;
•
profit or loss;
•
assets;
•
liabilities (if reported); and
•
other materials items. (IFRS 8.28)
Entity Wide Disclosures
Three additional disclosures are required:
(a)
information about products and services: the revenues from external customers for
each product and service, or each group of products and services. (IFRS 8.32)
(b)
Information about geographical areas - the following have to be disclosed:
•
revenues from external customers, and
•
non-current assets (other than financial instruments, deferred tax assets,
pension assets)
For each of the above, disclosure is required for (i) revenues and assets
attributed/located to/in the entity's country of domicile and (ii) attributed to all
foreign countries in total.
If assets in an individual foreign county are material, those assets should be
disclosed separately. (IFRS 8.33)
For both (a) and (b) an disclosure exemption is available if the necessary information is
not available and the cost to develop it would be excessive, in which case that fact shall
be disclosed.
(c)
Information about major customers - if revenues from transactions with a single
external customer amount to 10% or more of total revenues, that fact should be
disclosed along with the segment reporting the revenues. The identity of the
external customer need not be disclosed. (IFRS 8.34)
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5.
Interim Financial Reporting
Interim reporting deals with the preparation of financial statements other than at yearend. As we shorten the accounting period, the number of estimates that need to be made
increases. This is a good example of the trade-off between relevance and reliability:
although the provision of interim financial statements are relevant to the shareholders,
these may be less reliable due to the number of estimates that have to be made. Examples
of such estimates are as follows:
• management bonuses and the like that can only be determined once the final net
income figure for the year is known,
• the value of inventory that is confirmed when an inventory count is made at year end;
inventory counts are not necessarily made for purposes of interim financial
statements; this problem is compounded when the company does not keep perpetual
records and therefore must estimate the inventory amount,
• income taxes where the tax provision can only be made when the final net income
figure is known,
• depreciation: the annual depreciation number is contingent on purchases of fixed
assets that may occur later in the year.
To deal with these problems, two schools of thought have emerged with respect to
interim reporting: the discrete period approach and the integral period approach.
The discrete period approach assumes that each interim period is treated as an
individual period. Therefore, any adjustments and estimates would be the same as we
would make when preparing annual financial statements. In essence, we would be
treating the interim period as if it were a year. Income taxes would be calculated as if the
net income for the interim period was the net income for the year; depreciation expense
would be calculated on the basis of the assets on hand; and bonuses would be calculated
using the interim period net income.
The integral period approach assumes that the interim period is a part of a year.
Income taxes would be calculated by estimating the annual income and applying the
resulting tax rate to the interim period net income. Depreciation expense would be
calculated by making an estimate of future fixed asset purchases. Bonuses would be
calculated by estimating what the total annual bonus would be and accruing some of it to
the interim period.
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IAS 34 is a bit of a mixture of both approaches but tends to favour the discrete approach:
each financial report, annual or interim is evaluated on its own for conformity to IFRSs
(IAS 34.2).
Minimum Components/Form and Content of Interim Financial Statements
The following financial statements must be published:
•
statement of financial position;
•
statement of comprehensive income;
•
statement of changes in equity;
•
statement of cash flows; and
•
selected explanatory notes. (IAS 34.8)
The entity can choose to present full or condensed financial statements; if condensed,
then the minimum disclosures are the subtotals presented in the annual financial
statements. However, additional line items shall be included if their omission would
make the condensed interim financial statements misleading. (IAS 34.10)
Basic and diluted EPS must be published for the interim period. (IAS 34.11)
Notes from the annual financial statements that are still relevant to the interim financial
statements do not have to be replicated in the interim financial statements (IAS 34.15).
Generally, the following needs to be disclosed:
•
a statement to the effect that the same accounting policies as in the annual report
are followed;
•
explanatory comments about the seasonality or cyclicality of interim operations;
•
unusual items;
•
changes in debt and equity securities;
•
nature and changes in estimates;
•
dividends paid;
•
material subsequent events;
•
the effect of changes in the composition of the entity during the interim period
(i.e. business combinations obtaining or losing control of subsidiaries and longterm investments, restructurings and discontinued operations); and
•
changes in contingent liabilities or contingent assets since the end of the last
annual period. (IAS 34.16).
Specific guidance is also provided with regards to segmented information that needs to be
disclosed (IAS 34.16g).
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Financial information to be disclosed
In addition to the amounts for the interim period, the following information must be
disclosed:
Statement of financial position
Balance at the end of interim period
Previous fiscal year balance
Statement of comprehensive income
Amount for the current period
Cumulative amount since the
beginning of the year.
Amount for the same period from the
previous year
Cumulative amount since the
beginning of the year to the end of
the same period last year
Statement of changes in equity
Cumulative amount since the
beginning of the year.
Cumulative amount since the
beginning of the year to the end of
the same period last year
Statement of cash flows
Cumulative amount since the
beginning of the year.
Cumulative amount since the
beginning of the year to the end of
the same period last year
Recognition and Measurement
IAS 34.28 states that the entity shall apply the same accounting policies in its interim
financial statements as are applied in its annual financial statements, i.e. the principles for
recognizing assets, liabilities, income and expenses for interim periods are the same as in
annual financial statements. However, the frequency of an entity's reporting (i.e.
quarterly) shall not affect the measurement of its annual results. To achieve that
objective, measurements for interim reporting purposes shall be made on a year-to-date
basis. This acknowledges that an interim period is part of the larger financial year.
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Three examples are provided:
•
if losses on inventory write-down, restructuring and impairment were taken in a
previous quarter and the estimate changes in a subsequent quarter, then this
change in estimate is recorded in the subsequent quarter;
•
a cost that does not meet the definition if an asset at the end of an interim period is
not deferred in the statement of financial position either to await future
information as to whether it has met the definition of an asset or to smooth
earnings over interim periods within a financial year; and
•
income tax expense is recognized in each interim period based on the best
estimate of the weighted average annual income tax rate expected for the full
financial year.
Revenues that are received seasonally, cyclically, or occasionally OR costs that are
incurred unevenly within a financial year shall not be anticipated or deferred as of an
interim date if anticipation of deferral would not be appropriate at the end of the entity's
financial year. (IAS 34.37 and IAS 34.39)
Note that securities regulation may override (NI 152 in Canada) the required disclosures
from IAS 34 and as a result, Canadian companies will likely have to continue to disclose
more information than required by IAS 34.
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6.
Foreign Currency Transactions
Current Transactions
Current transactions arise in situations where a Canadian company is either selling to, or
purchasing from a foreign entity, and the resulting account receivable or payable is
denominated in a foreign currency.
With respect to accounting for current transactions denominated in a foreign currency, all
foreign currency denominated transactions have to be translated at the exchange rate in
effect when the transaction is recorded in the books of account and that any resulting
monetary Statement of Financial Position items be translated at the current rate (spot rate
in effect at the Statement of Financial Position date).
Monetary items are those Statement of Financial Position items that are contractually
fixed or are convertible into a fixed amount of currency (IAS 21.16). Examples of
monetary items are, cash, accounts receivable and payable, available for sale and trading
investments and long-term receivables and debt.
Non-monetary items are recorded at their historical values on the Statement of Financial
Position. Examples of these items include inventory, land, property, plant and equipment
and intangible assets.
The accounting treatment for current foreign currency denominated transactions is as
follows:
•
When the transaction occurs, the resulting payable or receivable is recorded using the
rate of exchange in effect on that day, known as the current rate. (IAS 21.21)
•
When the transaction is settled, there will normally be a difference between the
amount set up in the books and the amount paid or received because of fluctuating
foreign exchange rates. This difference is recorded as a foreign currency gain or loss
on the income statement. Remember, the payable or receivable is stated in the
foreign currency, as such, the payment or receipt will be in the foreign currency. The
recording of the payment or receipt will be done using the current rate on the payment
date. The exchange rate on the payment date will almost always be different than the
exchange rate on the transaction date.
•
If financial statements are prepared between the transaction and settlement dates, then
the foreign denominated balances must be translated at the exchange rate in effect on
the financial statement date. If there is a difference in the exchange rates between the
transaction date and the financial statement date then, a foreign exchange gain or loss
is recorded in the income statement. (IAS 21.23)
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Note that the account ‘FX Gains/Losses’ is used to capture all foreign exchange gains and
losses arising from foreign exchange transactions.
Example 1: The Baker Company purchased inventory from a U.S. company on July 20,
20x5, for $US 40,000. The amount is payable on August 20, 20x5, in U.S. dollars. The
relevant exchange rates are as follows:
July 20, 20x5
July 31, 20x5
August 20, 20x5
$US 1.00
$US 1.00
$US 1.00
=
=
=
$C 1.25
$C 1.26
$C 1.28
On July 20, 20x5, the transaction would be recorded at the $1.25 rate:
Inventory
Accounts Payable
$US 40,000 x 1.25 = $C 50,000
$50,000
$50,000
On August 20, 20x5, the Baker Company will need $C 51,200 ($US 40,000 x 1.28) to
settle this transaction. The difference is a foreign exchange loss:
Accounts payable
FX Gains/Losses
Cash
$50,000
1,200
$51,200
Assume now that the Baker Company has a July 31 year-end. The accounts payable
balance, being a monetary liability, needs to be written up to its Canadian dollar
equivalent as at the financial statement date, $50,400 ($US 40,000 x 1.26).
FX Gains/Losses
Accounts Payable
$400
$400
On the settlement date, the revised entry would be as follows:
Accounts payable
FX Gains/Losses
Cash
$50,400
800
$51,200
------------IAS 21.22 allows the use of average rates, i.e. a monthly or weekly average rate at which
all transactions denominated in a particular currency could be translated at one average
rate as opposed to using the rate on the date of each transaction. But, if exchange rates
fluctuate significantly, then the spot rates on each transaction dates must be used.
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Long-term receivables or debt
Long-term debt and notes receivable are subject to the same rules as current balances.
They are monetary assets and liabilities and, must be set up using the exchange rate in
effect when the transaction occurred. Similarly, these balances must also be translated
for year-end purposes, using the exchange rate in effect at the Statement of Financial
Position date. Any resulting foreign exchange gain or loss is reflected in total in the
income statement for that period
Example 2: Assume that the Allison Company takes out SF 10,000,000 of long-term
debt denominated in Swiss francs on January 1, 20x2. The debt is repayable in its
entirety in four years on December 31, 20x5. Interest is payable at the rate of 8% at the
end of each year. The relevant exchange rates are shown below. Assume a calendar
year-end.
January 1, 20x2
December 31, 20x2
Average rate for the year
SF 1
SF 1
SF 1
=
=
=
$C 0.5522
$C 0.5263
$C 0.5361
The Canadian dollar proceeds on this issue of long-term debt will be $5,522,000 (SF
10,000,000 x .5522). The following entry will record that transaction:
Cash
Long-term debt
$5,522,000
$5,522,000
On December 31, 20x2, the Allison Company will make its first interest payment of SF
800,000 or $421,040 (SF 800,000 x $0.5263). This figure represents the amount of cash
in Canadian dollars required to pay the interest charge on the long-term debt.
The amount of the interest expense cannot, however, be recorded at $421,040. Interest
expense is a cost directly related to the use of borrowed funds. Interest expense accrues
daily as we continue to use the borrowed funds. For example, the interest expense
accruing on January 15, 20x2, should in theory, be recorded using the exchange rate in
effect on that date. Calculating interest expense this way, however, would require a
tremendous amount of recordkeeping. Instead, we simply translate the interest expense
using the average annual exchange rate as a surrogate. Consequently, in this case the
interest expense should be translated at the average exchange rate for the 20x2 year.
Interest expense (SF 800,000 x .5361)
FX Gains/Losses
Cash
$428,880
$7,840
421,040
At the end of 20x2, the long-term debt should be recorded at: SF 10,000,000 x $0.5263 =
$5,263,000. This is a $259,000 decrease from the amount recorded when the loan was
taken out. The journal entry to record this increase is as follows:
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Long-term debt
FX Gains/Losses
$259,000
$259,000
Offetting Foreign Denominated Balances with Forward Contracts
Forward contracts are often used to manage an organization's exposure to foreign
currency exchange rate fluctuations. A business could purchase a forward exchange
contract to offset a foreign currency denominated account payable. The purchase of a
forward exchange contract means that the company has entered into a contract to
purchase foreign currency at a stipulated rate, at a specific time in the future. In this
manner the company has fixed its exposure to foreign currency exchange rate
fluctuations.
A forward contract is called an executory contract. This means that no exchange occurs
on the date the forward contract is entered into, rather a commitment to exchange one
currency against another in the future is made. Another example of an executory contract
is when a company places an order for goods. The goods are not recorded in the books
until received. Therefore, the forward contract is not entered on the books of the company
on the date the forward contract is taken out since its intrinsic value is zero.
Example 3: Assume that on December 3, 20x4 equipment costing US$100,000 is ordered
from a US supplier. The equipment is delivered on January 3, 20x5 and payment is due
on April 3, 20x5. Relevant exchange rates are as follows:
Spot Rates December 3, 20x4
January 2, 20x5
January 16, 20x5
February 28, 20x5
April 3, 20x5
US$1 = $CAN 1.240
US$1 = $CAN 1.246
US$1 = $CAN 1.248
US$1 = $CAN 1.253
US$1 = $CAN 1.262
Forward Rates December 3, 20x4 – 120 day forward
January 2, 20x5 – 90 day forward
January 16, 20x5 – 75 day forward
February 28, 20x5 – 60 day forward
US$1 = $CAN 1.252
US$1 = $CAN 1.254
US$1 = $CAN 1.255
US$1 = $CAN 1.258
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Example 3A – Assume that the forward contract is taken on January 16, 20x5.
The receipt of the equipment on January 2, 20x5 will be recorded at the spot rate as
follows:
Equipment ($US100,000 x $1.246)
Accounts Payable
$124,600
$124,600
On April 3, 20x5, the date of settlement, you will (1) clear out the Accounts Payable, (2)
pay the bank $125,500C and in exchange you will receive $US100,000 which you will
use to pay your supplier. The difference between the debit to the accounts payable and
the credit to cash is the foreign exchange loss.
Accounts payable
FX Gains/Losses
Cash ($US100,000 x 1.255)
124,600
900
125,500
Example 3B - This example assumes the same information as in 3A with the exception
that the company’s year end is February 28, 20x5.
The receipt of the equipment on January 2, 20x5 will be recorded at the spot rate as
follows:
Equipment ($US100,000 x $1.246)
Accounts Payable
$124,600
$124,600
At February 28, both the accounts payable and forward contract balances are adjusted.
The accounts payable balance is adjusted to the spot rate and the forward contract is
adjusted to the forward rate at February 28. The forward rate chosen is the one that comes
the closest to the settlement date.
FX Gains/Losses
Accounts Payable
To adjust the accounts payable to $125,300
Forward Contract
FX Gains/Losses
To record the change in value of the Forward
Contract:
Fair Value on Jan 16: 100,000 x 1.255
Fair Value on Feb 28: 100,000 x 1.258
$700
$700
300
300
125,500
125,800
300
On April 3, 20x5, the date of settlement, you will (1) clear out the Accounts Payable, (2)
pay the bank $125,500C and in exchange you will receive $US100,000 which you will
use to pay your supplier, and (3) clear out the balance in the Forward Contract account.
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The difference between the debit to the accounts payable and the credit to cash is the
foreign exchange loss.
Accounts payable
FX Gains/Losses
Forward Contract
Cash ($US100,000 x 1.255)
125,300
500
300
125,500
Note that the total FX Gain/Loss is still (as in example 3B) a net of $900 ($700 – 300 +
500 = $900).
ASPE Differences - None
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Problems with Solutions
Problem 1
Entecs Limited entered into a forward exchange contract on January l, 20x7, to buy
$100,000 US on December 31, 20x7, for $140,000 Cdn. The US dollars will be used for
repaying a US loan due on December 31, 20x7. On January l, 20x7, the spot rate for
buying $1 US is $1.36 Cdn.
Explain why the company would agree to enter into such a contract?
Problem 2
On January 2, 20x7, Canadian Company receives a shipment of inventory costing
100,000 Corbs from an Amandaland (a fictitious country) supplier. The invoice requires
payment on March 1, 20x7. The current exchange rate is Corb 1 = $0.50 (unchanged
since Dec 31, 20x6).
Canadian Company does not have the cash to pay this debt before March 1, 20x7 and is
concerned about exposure to exchange rate fluctuations. For example, if the exchange
rate at March 1, 20x7 is Corb 1 = $0.60, the company will pay $C60,000 and incur an
exchange loss of $10,000.
On January 3, 20x7, Canadian Company decides to enter into a forward exchange
contract. Canadian Company contracts to receive 100,000 Corb on March 1, 20x7 at a
rate of 1 Corb = $0.54. The rate of $0.54 is the forward rate which sets the amount that
Canadian Company will pay on March 1, 20x7. Assume that on March 1, 20x7 the
exchange rate is 1 Corb = $.60.
The company's year-end is January 31. On January 31, 20x7 the spot rate was Corb 1 =
$0.57 and the forward rate for a 30 day contract was Corb 1 = $0.59.
Required:
Prepare all journal entries related to this transaction.
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Problem 3
On April 15, 20x5, Domestic Corporation sells some of its product in Switzerland for SF
100,000 on credit. The resulting receivable is due May 15, 20x5. On April 16, 20x5
Domestic Corporation buys a forward contract to pay SF100,000 on May 15, 20x5. The
commitment to pay SF100,000 will offset the commitment to receive SF100,000 from the
Swiss customer.
Spot rate on April 15, 20x5
One month forward
Spot rate on May 15, 20x5
SF1 = $0.7961
SF1 = $0.7939
SF1 = $0.7800
Required:
1.
2.
Prepare the journal entries to record the above transactions.
Assume that the year-end is April 30th and the exchange rate in effect at April 30,
20x5 is SFI = $.8050. Prepare the journal entries to reflect the transactions.
Assume that the 15 day forward rate at April 30 is SF1 = $0.80.
Problem 4
Ottawa Utilities Ltd. Borrowed $7,000,000 in U.S. funds on January 1, 20x4, at an annual
interest rate of 10 percent. The loan is due on December 31, 20x6 and interest is payable
at December 31 of every year. The Canadian exchange rates for U.S. dollars for 20x4 are
as follows:
January 1, 20x4
December 31, 20x4
December 31, 20x5
December 31, 20x6
Spot Rate
Average Rate for the Year
$1.456
$1.462
$1.357
$1.558
$1.458
$1.398
$1.487
Required
Prepare the journal entries to record the transactions in 20x4, 20x5 and 20x6. The
company’s year-end is December 31.
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SOLUTIONS
Problem 1
The forward exchange contract is a form of hedging, which is a way to manage risk of
exposure to foreign currency fluctuations and protects against foreign currency loss.
Entecs Limited would agree to the contract if it is risk averse or expects the cost of the
US dollar to be higher than $1.40 on December 31, 20x7. With the forward exchange
contract, the most that they will lose is the $0.04 per dollar.
Problem 2
Jan 2, 20x7
Jan 31, 20x7
Mar 1, 20x7
Page 257
Inventory
Accounts payable (Corb)
(100,000 Corb x 0.50)
$50,000
$50,000
FX Gains/Losses
Accounts Payable
To adjust the Accounts Payable to 100,000
Corb x $0.57 = $57,000
7,000
Forward Contract
FX Gains/Losses
To adjust for the increase in the value of the
forward exchange contract: 100,000 Corb x
(0.59 - 0.54)
5,000
Accounts payable
FX Gains/Losses
Forward Contract
Cash (100,000 x 0.54)
7,000
5,000
57,000
2,000
5,000
54,000
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CMA Accelerated Program – Corporate Taxation and Financial Accounting 2
Problem 3
1.
Apr 15, 20x5
May 15, 20x5
2.
Apr 15, 20x5
Apr 30, 20x5
May 15, 20x5
Page 258
Accounts receivable (SF)
Sales
SF100,000 x 0.7961
79,610
Cash
FX Gains/Losses
Accounts receivable
79,390
220
Accounts receivable (SF)
Sales
SF100,000 x 0.7961
79,610
79,610
79,610
79,610
Accounts Receivable (SF)
FX Gains/Losses
To adjust to SF100,000 x 0.8050 = $80,500
890
FX Gains/Losses
Forward Contract
To adjust to SF100,000 x 0.80 = $80,000
From SF100,000 x 0.7939
610
Cash
Forward Contract
FX Gains/Losses
Accounts Receivable
890
610
79,390
610
500
80,500
© CMA Ontario - 2011
CMA Accelerated Program – Corporate Taxation and Financial Accounting 2
Problem 4
Jan 1, 20x4
Dec 31,20x4
Cash
Loan Payable
FX Gains/Losses
Loan Payable
Adjust bank loan balance to $US
7,000,000 x $1.462 = 10,234,000
Interest expense (700,000 x $1.458)
FX Gains/Losses
Cash (700,000 x $1.462)
Dec 31, 20x5
Dec 31, 20x6
$10,192,000
42,000
42,000
1,020,600
2,800
1,023,400
Loan Payable
FX Gains/Losses
Adjust bank loan balance to $US
7,000,000 x $1.357 = $9,499,000
735,000
Interest expense (700,000 x $1.398)
FX Gains/Losses
Cash (700,000 x $1.357)
978,600
735,000
28,700
949,900
FX Gains/Losses
Loan Payable
Adjust bank loan balance to $US
7,000,000 x $1.558 = $10,906,000
1,407,000
Interest expense (700,000 x $1.487)
FX Gains/Losses
Cash (700,000 x $1.558)
1,040,900
49,700
Loan payable
Cash
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$10,192,000
1,407,000
1,090,600
10,906,000
10,906,000
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CMA Accelerated Program – Corporate Taxation and Financial Accounting 2
7.
Foreign Currency Translation
When a Canadian company conducts business in a foreign country through a subsidiary,
the results of those foreign operations must be consolidated with the financial statements
of the Canadian company. The first step in this process is the translation of the foreign
subsidiary's financial statements into Canadian dollars (or into whatever the presentation
currency used by the Canadian parent company, i.e. many Canadian companies present
their consolidated financial statements in US dollars).
The methodology used to translate the financial statements of the foreign operation
depends on the functional currency of the foreign operation. The functional currency is
defined as the currency of the primary economic environment in which the entity
operates (IAS 21.8).
The following two primary factors are used to determine a foreign operation's functional
currency:
•
the currency:
(i)
that mainly influences the sales price for goods and services (this will
often be the currency in which sales prices for its goods and services are
denominated and settled, and
(ii)
of the country whose competitive forces and regulations mainly determine
the sales price of its goods and services.
•
the currency that mainly influences labour, material and other costs of providing
goods or services (this will often be the currency in which such costs are
denominated and settled). IAS 21.9
The following two secondary factors can also provide evidence of a foreign operation's
functional currency:
•
the currency in which funds from financing activities (i.e. issuing debt and equity
instruments) are generated.
•
the currency in which receipts from operating activities are usually retained.
IAS 21.10
The following additional factors are considered in determining the functional currency of
a foreign operation, and whether its functional currency is the same as that of the
reporting entity:
•
whether the activities of the foreign operation are carried out as an extension of
the reporting entity, rather than being carried out with a significant degree of
autonomy. An example of the former is when the foreign operation only sells
goods imported from the reporting entity and remits the proceeds to it. An
example of the latter is when the operation accumulates cash and other monetary
items, incurs expenses, generates income and arranges borrowings, all
substantially in its local currency.
•
whether transactions with the reporting entity are a high or a low proportion of the
foreign operation's activities.
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•
•
whether cash flows from the activities of the foreign operation directly affect the
cash flows of the reporting entity and are readily available for remittance to it.
whether cash flows from the activities of the foreign operation are sufficient to
service existing and normally expected debt obligations without funds being made
available by the reporting entity. IAS 21.11
When the above indicators are mixed and the functional currency is not obvious,
management uses its judgment to determine the functional currency that most faithfully
represents the economic effects of the underlying transactions, events and conditions. As
part of this approach, management gives priority to the primary indicators in paragraph 9
before considering the indicators in paragraphs 10 and 11, which are designed to provide
additional supporting evidence to determine an entity's functional currency. IAS 21.12
An entity's functional currency reflects the underlying transactions, events and conditions
that are relevant to it. Accordingly, once determined, the functional currency is not
changed unless there is a change in those underlying transactions, events and conditions.
IAS 21.13
If the functional currency of the foreign operation is the local currency in the country the
foreign operation is located, then the method of accounting used is the current rate
method.
If the functional currency of the foreign operation is the currency of the reporting entity
(the parent company), then the method of accounting used is the temporal method6.
If the functional currency of the foreign operation changes, the change in accounting
treatment will be applied prospectively. (IAS 21.35)
6
Under previous Canadian GAAP, if the functional currency of the foreign operation was the currency of
the country the foreign operation was located, we would say that the foreign operation was self-sustaining.
If the functional currency was the currency of the reporting entity, we would say the foreign operation was
integrated.
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The differences in accounting treatment between the current rate and temporal methods is
summarized as follows:
Functional Currency
Reporting Entity
Local Currency
Method of accounting
Temporal
Current Rate
Revenue and expenses
Historical rate; rate on date
transaction occurs
Current Rate; annual
average rate used as
surrogate.
Depreciation
Historical rate
Annual average rate
Monetary items
Current rate
Current rate
Non-monetary items
Historical rate
Current rate
Share capital
Historical rate
Historical rate
Retained earnings
Accumulation of translated net income. Dividends
translated at rate on day dividend is declared.
Income Statement -
Statement of Financial
Position -
Shareholders' equity
Application of the Temporal Method
The temporal method is used for translation of the financial statements when the
functional currency of the foreign operation is the currency of the reporting entity (i.e. the
Canadian dollar). Monetary items are translated at the exchange rate in effect at the
Statement of Financial Position date. Nonmonetary items are translated at the historic
rate.
The essential feature of a monetary item is the right to receive (or obligation to deliver) a
fixed or determinable number of units of currency. (IAS 21.16)
Examples of monetary items: cash, accounts receivable, long-term receivables, current
liabilities, and long-term debt. Examples of nonmonetary items are: inventory, prepaid
expenses, capital assets, deferred tax balances, pension liabilities, and shareholders’
equity accounts.
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Revenues and expenses are translated using the rate of exchange in effect on the date they
arose (with the exception of depreciation or amortization which is translated at the
historical rate). Recall that IAS 21.22 allows the use of average rates, i.e. a monthly or
weekly average rate at which all transactions denominated in a particular currency could
be translated at one average rate as opposed to using the rate on the date of each
transaction. But, if exchange rates fluctuate significantly, then the spot rates on each
transaction dates must be used.)
Translation adjustments on monetary balances are taken into income in the period as an
exchange gain or loss.
Depreciation/amortization is recorded at the rate in place when the related asset that gave
rise to the depreciation/amortization was acquired.
The translation of monetary balances results in an exchange gain/loss resulting from the
translation of monetary balances.
Steps in calculating the exchange gain/loss on net monetary assets:
Step 1 Calculate the opening net monetary balance at the beginning of the year in the
foreign currency.
Step 2 Calculate the closing net monetary balance at the end of the year in the foreign
currency.
Step 3 List all of the transactions that affected the monetary balance in the year.
Step 4 Translate all of the balances at the respective rates of translation.
Step 5 Calculate the closing balance of net monetary assets using all of the respective
rates in the year. These are the rates used in recording transactions for the year.
Step 6 Compute the actual closing balance of net monetary assets using the year end rate.
Step 7 Calculate the exchange gain/loss on translation of net monetary assets.
The only figure that is ever plugged or balanced is the retained earnings figure in the first
year that the company translates its financial statements. In subsequent years, net income
is calculated on the income statement and retained earnings is calculated as the
cumulative amount of earnings less dividends declared. Following this approach, it is
very easy to determine if an error has been made in translation because the final
Statement of Financial Position will not balance.
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Application of the Current Rate Method:
The exposure to foreign exchange rate fluctuations is limited by the company's
investment in the foreign subsidiary. This accounting for a foreign operation reflects this
fact and does not allow foreign exchange fluctuations to impact on the consolidated
income statement. Any adjustments on the translation of net assets are included as part of
shareholder's equity in an account called Cumulative Translation Adjustment which is
part of Other Comprehensive Income.
The translation of the financial statements is straightforward using the current rate
method. All assets and liabilities are translated at the current rate; all revenues and
expenses are translated at the average rate. Common stock is translated at the historic rate
and retained earnings is the cumulative amount of net income less dividends. Retained
earnings will generally be a plug in the first year that the statements are translated. The
increase or decrease in the cumulative translation adjustment of the year is then
determined by analyzing the change in net assets.
By using the current rate method to translate the financial statements, the underlying
nature of the subsidiary's financial statements remains intact since all assets and all
liabilities are translated at the current rate at the Statement of Financial Position date.
Using the current rate method, the unit of measure is the foreign currency. In contrast,
using the temporal method changes the underlying nature of the subsidiary's financial
statements; the unit of measure is the Canadian dollar.
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Example 1: On January 3, 20x4, Cantex Inc., a Canadian company, incorporates Cantex
(U.S.A) Inc. Cantex Inc. invests $US 1,000,000 in Cantex (U.S.A) Inc.
The financial statements for the years ending December 31, 20x4 and 20x5, are as
follows:
Cantex (U.S.A) Inc.
Income Statement for the year ended December 31
($US)
20x4
20x5
Sales (Note 1)
$5,000,000
$10,000,000
Cost of goods sold
Opening inventory
Purchases (Note 2)
Ending inventory
-4,500,000
(1,500,000)
1,500,000
8,000,000
(3,000,000)
3,000,000
6,500,000
2,000,000
3,500,000
250,000
100,000
650,000
400,000
100,000
1,300,000
1,000,000
1,800,000
$1,000,000
$ 1,700,000
Gross margin
Depreciation (Note 3)
Interest
Other (Note 1)
Net income
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Cantex (U.S.A) Inc.
Statement of Financial Position as at December 31
($US)
20x4
Cash
Accounts receivable
Inventory (FIFO)
Fixed assets (Note 3)
Accumulated depreciation
Accounts payable
Note payable (Note 4)
Common stock
Retained earnings (Note 5)
20x5
$ 500,000
250,000
1,500,000
1,500,000
(250,000)
$
50,000
400,000
3,000,000
2,500,000
(650,000)
$3,500,000
$5,300,000
$ 500,000
1,000,000
1,000,000
1,000,000
$ 700,000
1,000,000
1,000,000
2,600,000
$3,500,000
$5,300,000
Note 1 - Sales and other expenses are incurred evenly throughout the year.
Note 2 - Purchases
January 3
July 1
Note 3 - Fixed Asset acquisitions
January 3
July 1
20x4
$2,000,000
2,500,000
$4,500,000
20x5
$7,000,000
1,000,000
$8,000,000
$1,000,000
500,000
$1,500,000
$
-1,000,000
$1,000,000
The fixed assets acquired are depreciated on a straight-line basis over five years.
Note 4 - The note payable was issued on January 3, 20x4, bears interest at 10% payable
on December 31 of every year and is due on December 31, 20x8.
Exchange rates:
January 3, 20x4
July 1, 20x4 = Average for 20x4
December 31, 20x4
July 1, 20x5 = Average for 20x5
December 31, 20x5
$US 1
$US 1
$US 1
$US 1
$US 1
=
=
=
=
=
$C 1.3894
$C 1.3692
$C 1.3260
$C 1.2751
$C 1.2309
Note 5 – Dividends were declared and paid on December 31, 20x5.
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The translated Statement of Financial Position as at January 3, 20x4, will be as follows
under both the current rate and temporal methods:
Cantex (U.S.A) Inc.
Statement of Financial Position as at January 3, 20x4
($C)
$US
Cash
Common stock
$C
1,000,000
(1,000,000)
1.3894
1.3894
1,389,400
(1,389,400)
(1) APPLICATION OF THE CURRENT RATE METHOD
Cantex (U.S.A) Inc.
Translated Income Statement for the Year ended December 31, 20x4
$US
Sales
Cost of goods sold
Depreciation
Interest
Other
Net income
5,000,000
(3,000,000)
(250,000)
(100,000)
(650,000)
1,000,000
$C
1.3692
1.3692
1.3692
1.3692
1.3692
6,846,000
(4,107,600)
(342,300)
(136,920)
(889,980)
1,369,200
Note that the translated net income is equal to the $US income multiplied by the average
rate. This will always be the case when using the current rate method since all income
statement items are multiplied by the average rate.
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Cantex (U.S.A) Inc.
Translated Statement of Financial Position as at December 31, 20x4
$US
Cash
Accounts receivable
Inventory
Fixed assets
Accumulated depreciation
500,000
250,000
1,500,000
1,500,000
(250,000)
$C
1.3260
1.3260
1.3260
1.3260
1.3260
3,500,000
Accounts payable
Note payable
Common stock
Retained earnings
Cumulative translation adjustment
500,000
1,000,000
1,000,000
1,000,000
-3,500,000
663,000
331,500
1,989,000
1,989,000
(331,500)
4,641,000
1.3260
1.3260
1.3894
663,000
1,326,000
1,389,400
1,369,200
(106,600)
4,641,000
Refer to the Statement of Financial Position and note that all assets and liabilities are
translated at the current rate at year-end. The common stock is translated at the historical
rate, in this case the rate in effect on January 3, 20x4, when the corporation was formed.
The retained earnings is simply the translated net income. A balancing problem arises
because not all balances are translated using the same rate. The balancing figure is
known as the cumulative translation adjustment, and forms part of shareholders’ equity.
When a foreign operation's functional currency is the currency of the country it operates
in, the value of the investment of the parent is at risk or exposed to fluctuations in the
foreign exchange rate. The exchange gains and losses referred to above, are the gains
and losses on the parent’s investment in the foreign operation due to changes in the
exchange rate during the year, or the period of ownership.
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We can calculate the cumulative translation adjustment by comparing the translated value
of the parent’s investment in the subsidiary as it arose over the year, to the translated
value of the investment using the year-end rate.
$US
$C
Net assets, January 3, 20x4
Increase = net income for the year 20x4
Net assets, December 31, 20x4
1,000,000
1,000,000
2,000,000
1.3894
1.3692
1,389,400
1,369,200
2,758,600
Net assets translated
2,000,000
1.3260
(2,652,000)
Cumulative translation adjustment
(Other Comprehensive Income)
(106,600)
The cumulative translation adjustment of $106,600 can be explained in the following
way. Assume you invest $C 1,389,400 in the U.S. at the beginning of the year. The
investment earns $C 1,369,200 during the first year. By your calculations, your
investment totaling $US 2,000,000 is worth $C 2,758,600 at the end of the year.
However, if you dispose of this investment for $US 2,000,000 at year-end, you would
receive only $C 2,652,000 ($US 2,000,000 x 1.3260). Your investment has lost $C
106,600 due to a decline in the foreign exchange rate during the year. Due to the
independent nature of the foreign operation, the recognition of this foreign exchange loss
is deferred in shareholders’ equity as part of other comprehensive income until the parent
sells its investment in the foreign subsidiary.
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(2) APPLICATION OF THE TEMPORAL METHOD
Cantex (U.S.A) Inc.
Translated Income Statement for the Year ended December 31, 20x4
$US
$C
Sales
5,000,000
1.3692
6,846,000
Cost of goods sold
Purchase # 1
Purchase # 2
Less ending inventory (Note 1)
2,000,000
2,500,000
(1,500,000)
1.3894
1.3692
1.3692
2,778,800
3,423,000
(2,053,800)
Gross margin
Depreciation – Purchase # 1
Depreciation – Purchase # 2
Interest
Other
Income before translation gain
Translation gain (Note 2)
Net income
3,000,000
4,148,000
2,000,000
2,698,000
200,000
50,000
100,000
650,000
1.3894
1.3692
1.3692
1.3692
277,880
68,460
136,920
889,980
1,000,000
1,373,240
1,000,000
1,324,760
--
72,800
1,000,000
1,397,560
Note 1 – Ending inventory:
Since the company is using the FIFO method for inventory valuation, it is
assumed that the ending inventory was purchased in Purchase # 2.
Note 2 – Translation gains and losses:
A subsidiary that is classified as integrated with the parent company, is treated for
accounting purposes as an extension of the parent. Any transactions in foreign
currency are treated as if the parent entered into the transactions directly.
Translation gains and losses are determined as explained in Part 2 of this lesson.
Gains and losses are only determined on an annual basis on monetary assets and
liabilities. Non-monetary items are translated at their historical exchange rates
and therefore, gains and losses are only recognized when realized. Monetary
items are translated using the current rate at the Statement of Financial Position
date recognizing gains and losses due to the movement of the exchange rate
during the year. Translation gains and losses on net monetary assets are
recognized in full in the income statement for the period.
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CMA Accelerated Program – Corporate Taxation and Financial Accounting 2
Translation gain or loss on net monetary items:
To determine the translation gain or loss on net monetary assets, we need to do the
following:
(3) Calculate the net monetary asset (liability) position at year-end, (in this case, cash +
accounts receivable – accounts payable – note payable = $US -750,000)
(4) Determine the accumulation of the year-end position by starting with the opening net
monetary asset position and adjusting for the changes throughout the year to prove
the year-end balance of $US -750,000. Translate each of these items using the rate in
effect when the transaction occurred, or the average rate as appropriate. Total the
translated amounts to arrive at the Canadian dollar value of the net monetary asset
position based on exchange rates in effect throughout the year, when the transactions
occurred.
(5) Translate the net monetary asset position at year-end, using the exchange rate in
effect at year-end.
(6) Compare the Canadian dollar amount for the net monetary asset position at year-end
as determined under b and c. The difference, is the translation gain or loss that must
be recognized in full on the income statement for the period.
$US
Net monetary assets, beginning of year
Sales
Purchase # 1
Purchase # 2
Interest expense
Other expenses
Fixed asset purchase # 1
Fixed asset purchase # 2
Net monetary assets, end of year
Translated
Translation gain on net monetary items
$C
1,000,000
5,000,000
(2,000,000)
(2,500,000)
(100,000)
(650,000)
(1,000,000)
(500,000)
-750,000
1.3894
1.3692
1.3894
1.3692
1.3692
1.3692
1.3894
1.3692
1,389,400
6,846,000
(2,778,800)
(3,423,000)
(136,920)
(889,980)
(1,389,400)
(684,600)
-1,067,300
-750,000
1.326
-994,500
$ 72,800
Remember that the temporal method attempts to simulate a situation where the Canadian
parent company is conducting business in a foreign country from Canada. Imagine that
we are doing just that in this case. At the beginning of the year, we open a U.S. dollar
bank account with a local Canadian bank and deposit $C 1,389,400. The credit to our
bank account will be $US 1,000,000. We then enter into the following transactions:
1. Make a sale on July 1 for $US 5,000,000 and receive payment on the same day.
Amount is deposited in our U.S. bank account.
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2. On January 3, make a purchase of $US 2,000,000 of inventory. A cheque is drawn on
January 3 on the U.S. bank account.
3. On July 1, make a purchase of $US 2,500,000 of inventory. A cheque is drawn on
January 3 on the U.S. bank account.
(3) On July 1, make an interest payment on the note payable for $US 100,000 and other
expenses of $US 650,000. Amounts drawn from the U.S. bank account.
(4) On January 3, purchase fixed assets costing $US 1,000,000. Amount paid from the
U.S. bank account on the same day.
(5) On July 1, purchase fixed assets costing $US 500,000. Amount paid from the U.S.
bank account on the same day.
The Canadian company would make the following journal entries with regards to the
above transactions:
1. Cash – U.S.
Sales
6,846,000
2. Purchases
Cash – U.S.
2,778,800
3. Purchases
Cash – U.S.
3,423,000
4. Interest expense
Other expenses
Cash – U.S.
136,920
889,980
5. Fixed assets
Cash – U.S.
1,389,400
6. Fixed assets
Cash – U.S.
684,600
6,846,000
2,778,800
3,423,000
1,026,900
1,389,400
684,600
At the end of the year, the general ledger will show the following balance in the Cash –
U.S. account:
Debit
Balance, January 3, 20x4
Transaction # 1
Transaction # 2
Transaction # 3
Transaction # 4
Transaction # 5
Transaction # 6
Page 272
Credit
6,846,000
2,778,800
3,423,000
1,026,900
1,389,400
684,600
Balance
$1,389,400
8,235,400
5,456,600
2,033,600
1,006,700
-382,700
-1,067,300
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CMA Accelerated Program – Corporate Taxation and Financial Accounting 2
At year-end, we have to restate all foreign currency denominated monetary assets and
liabilities. The U.S. bank account has a balance of $US -750,000 and translates to $C
-994,500 ($US -750,000 x 1.326). Therefore, we must increase the Cash – U.S. account
to $994,500. We do so by writing the following entry:
Cash – U.S.
Foreign exchange gain
72,800
72,800
Through this somewhat lengthy analogy, we are able to show that the temporal method
translates the foreign transactions as though they were incurred by the Canadian parent
company directly.
We can now prepare the translated Statement of Financial Position:
Cantex (U.S.A) Inc.
Statement of Financial Position as at December 31, 20x4
($C)
$US
Cash
Accounts receivable
Inventory
Fixed assets
Accumulated depreciation
500,000
250,000
1,500,000
1,500,000
(250,000)
$C
1.3260
1.3260
1.3692
Note 1
Note 2
3,500,000
Accounts payable
Note payable
Common stock
Retained earnings
500,000
1,000,000
1,000,000
1,000,000
4,775,960
1.3260
1.3260
1.3894
3,500,000
Note 1: Fixed assets
Fixed asset purchase # 1
Fixed asset purchase # 2
Note 2: Accumulated depreciation
On fixed asset purchase # 1
On fixed asset purchase # 2
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663,000
331,500
2,053,800
2,074,000
(346,340)
663,000
1,326,000
1,389,400
1,397,560
4,775,960
1,000,000
500,000
1,500,000
1.3894
1.3692
1,389,400
684,600
2,074,000
200,000
50,000
250,000
1.3894
1.3692
277,880
68,460
346,340
© CMA Ontario - 2011
CMA Accelerated Program – Corporate Taxation and Financial Accounting 2
Reporting Foreign Operations
Reporting foreign operations deals with the ultimate consolidation of the foreign
subsidiary financial statements with that of the Canadian parent company. This topic is
somewhat complex and a detailed study of it is not required here.
An overview of the major conceptual issues is presented below:
•
before the foreign subsidiary statements are translated, they must be adjusted
to conform to IFRS.
•
once the adjustments are made and the foreign subsidiary financial statements
are translated, they can be consolidated with the parent company financial
statements.
•
because it relates to assets and liabilities of the foreign subsidiary, the
purchase price discrepancy must be translated also. This is a consolidation
adjustment that does not appear on the foreign subsidiary financial statements;
therefore, further foreign exchange gains or losses may be realized on
translation of the purchase price discrepancy and related amortization.
•
when a Canadian company purchases a foreign subsidiary, the historical rate
is to be used when translating the foreign subsidiary’s non-monetary assets
and liabilities, common stock and retained earnings as at the date of
acquisition is the foreign exchange rate on the date of acquisition – regardless
of when the non-monetary assets and liabilities were purchased.
For example, P Corp., a Canadian company, purchases 80% of the Stock of S Corp., a
Mexican company, on June 25, 20x5. The non-monetary assets and liabilities, common
stock and retained earnings as at June 25, 20x5, would be translated using the exchange
rate in effect on June 25, 20x5. This rate then becomes the historical rate for these items.
ASPE Differences The difference are mainly one of terminology:
When IFRS says…
ASPE will say…
The functional currency of the foreign
subsidiary is the Canadian dollar.
The foreign subsidiary is integrated and the
temporal method is used.
The functional currency of the foreign
subsidiary is the local currency of the
foreign subsidiary's country.
The foreign subsidiary is self-sustaining
and the current rate method is used.
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Problems with Solutions
Problem 1
The Statement of Financial Positions as at December 31, 20x6 and December 31, 20x7,
as well as the Statement of Income and Change in retained Earnings for the year ending
December 31, 20x7 for Spencer Inc., A British Company, in pounds, (£, thereafter) are as
follows:
Spencer Inc.
Statement of Financial Positions
as at December 31
(in British pounds)
20x7
20x6
Cash
Accounts receivable
Inventories
Plant and equipment (net)
Land
£ 212,000
350,000
1,856,000
4,900,000
600,000
£7,918,000
£ 187,000
327,000
1,528,000
5,320,000
800,000
£8,162,000
Current liabilities
Long-term liabilities
Common Stock
Retained Earnings
£
£ 143,000
1,000,000
5,600,000
1,419,000
£8,162,000
Page 275
87,000
700,000
5,600,000
1,531,000
£7,918,000
© CMA Ontario - 2011
CMA Accelerated Program – Corporate Taxation and Financial Accounting 2
Spencer Inc.
Statement of Income and Change in Retained Earnings
for the year ending December 31
(in British pounds)
Sales
Gain on sale of land
Expenses
Cost of goods sold
Depreciation
Selling and administration
Interest
Loss on debt retirement
Net income
Dividends
Increase in retained earnings
£6,611,000
125,000
6,736,000
4,672,000
420,000
1,230,000
84,000
50,000
6,456,000
280,000
(168,000)
£ 112,000
Additional Information:
1. On December 31, 20x2, the date of incorporation of Spencer Inc., the common stock
was issued for £5,600,000. Of the proceeds, £800,000 was used to acquire Land and
£4,400,000 was used to acquire Plant and Equipment with an estimated useful life of
20 years. This Plant and Equipment is being amortized on a straight line basis.
2.
One quarter of the Land which was acquired on the date of acquisition was sold on
July 1, 20x7 for £325,000.
3.
Spencer Inc. still owns all of the Plant and Equipment that was acquired when the
company was formed. In addition, a further £2,000,000 of Plant and Equipment was
acquired on January 1, 20x6. This more recently acquired Plant and Equipment was
estimated to have a useful life of 10 years at the time of its acquisition.
4.
The acquisition of Plant and Equipment described in item 3 was financed with
£1,000,000 of internally generated funds along with £1,000,000 of debt financing.
The stated interest rate on the debt is 12% per annum, with payments required on
July 1 and January 1 of each year. The debt was issued on January 1, 20x6 at its
maturity value and is scheduled to mature on January 1, 20x16. On January 1,
20x7, 30% of this debt was retired through a payment of £350,000 in cash, resulting
in a loss of £50,000.
5.
The December 31, 20x6 inventory was acquired on October 1, 20x6 and the
December 31, 20x7 inventory was acquired on October 1, 20x7.
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6.
The dividends were declared on December 31, 20x7.
7.
Selected spot rates for the U.K. pound are as follows:
December 31, 20x2
December 31, 20x3
January 1, 20x6
October 1, 20x6
December 31, 20x6
July 1, 20x7 (= average rate for 20x7)
October 1, 20x7
December 31, 20x7
£ = 2.20
£ = 2.18
£ = 2.15
£ = 2.10
£ = 2.08
£ = 2.04
£ = 2.02
£ = 2.00
Required –
Assuming that Spencer's functional currency is the Canadian Dollar (i.e. integrated),
provide a translated statement of income and retained earnings and Statement of
Financial Position for the year 20x7.
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Problem 2
PK Company decided to expand its operations by acquiring 80% of SK Company, which
is based in Seattle, Washington, at a cost of C$1,200,000 on December 31, 20x8.
The financial statements of SK on December 31, 20x9, were as follows:
SK COMPANY
Statement of Financial Positions (US$)
20x9
20x8
Cash
Accounts receivable
Inventory
Equipment (net)
$190,000
380,000
750,000
120,000
$1,440,000
$200,000
300,000
600,000
150,000
$1,250,000
Accounts payable
Bonds payable
Common shares
Retained earnings
$240,000
400,000
200,000
600,000
$1,440,000
$180,000
400,000
200,000
470,000
$1,250,000
SK COMPANY
Statement of Income and Retained Earnings (US$)
For the year ended December 31, 20x9
Sales
Cost of goods sold:
Gross profit
Selling and administration
Depreciation
Other expenses
$ 2,000,000
1,250,000
750,000
-300,000
-30,000
-170,000
Net income before taxes
Income taxes - current
250,000
120,000
Net income
Retained earnings - January 1, 20x9
130,000
470,000
Retained earnings - December 31, 20x9
Page 278
$ 600,000
© CMA Ontario - 2011
CMA Accelerated Program – Corporate Taxation and Financial Accounting 2
Additional information
•
Exchange rates:
January 1, 20x5
December 31, 20x8 / January 1, 20x9
October 31, 20x9
December 31, 20x9
Average for 20x9
US$1 = C$1.25
US$1 = C$1.30
US$1 = C$1.38
US$1 = C$1.40
US$1 = C$1.37
•
Inventory on hand at December 31, 20x9, was purchased on October 31, 20x9.
•
The bonds were issued on January 1, 20x5, and mature on December 31, 20x15.
Interest of 10% per annum is payable at the end of the year and is included in
Other Expenses.
•
All sales, purchases, and other expenses are incurred evenly throughout the year.
Required Assuming that SK's functional currency is the Canadian dollar (i.e integrated), translate
the December 31, 20x9 statement of income and retained earnings into Canadian dollars.
Problem 3
Using the information for Cantex Inc. (example problem) prepare a translated income
statement and Statement of Financial Position for 20x5 on the assumption that Cantex
(U.S.A.)'s functional currency is the US dollar (i.e. self-sustaining).
Problem 4
Using the information for Cantex Inc. (example problem), prepare a translated income
statement and Statement of Financial Position for 20x5 on the assumption that Cantex
(U.S.A.) 's functional currency is the Canadian dollar (i.e. integrated).
Page 279
© CMA Ontario - 2011
CMA Accelerated Program – Corporate Taxation and Financial Accounting 2
Problem 5
On January 2, 20x4, Chisnall Corp. purchased 100% of the outstanding shares of
Flanagan Ltd. Flanagan operates in the country of Lalaland whose currency is the Lala
(Ll). The financial statements of Flanagan as at December 31, 20x6 are as follows:
Flanagan Ltd.
Income Statement
for the year ended December 31, 20x6
Sales
Cost of goods sold
Depreciation
Interest
Gain on sale of fixed assets
Other operating expenses
Income tax expense
Net Income
10,000,000
(7,000,000)
(410,000)
(110,000)
30,000
(1,300,000)
(352,000)
858,000
Flanagan Ltd.
Statement of Financial Position
as at December 31, 20x6
Cash
Accounts receivable
Inventory
Land
Fixed assets
Less Accumulated Depreciation
Current liabilities
Long-term debt
Common stock
Retained earnings
20x6
75,000
310,000
350,000
300,000
3,990,000
(1,235,000)
3,790,000
20x5
50,000
170,000
250,000
100,000
3,600,000
(900,000)
3,270,000
182,000
1,100,000
1,200,000
1,308,000
3,790,000
120,000
1,400,000
1,200,000
550,000
3,270,000
Other Information 1.
On December 31, 20x6, an asset with an original cost of LL 110,000 was sold for
LL 65,000. This asset had been purchased prior to January 2, 20x4.
2.
All fixed assets in place on January 1, 20x6 were purchased in 20x2 at an average
rate of 1Ll = $0.60C.
Page 280
© CMA Ontario - 2011
CMA Accelerated Program – Corporate Taxation and Financial Accounting 2
3.
Asset purchases in 20x6 occurred on April 1, 20x6. All assets are depreciated on
the straight line basis over 10 years. It is company policy to take a full year of
depreciation expense in the year of acquisition.
4.
Land was purchased on July 2, 20x6. All land on January 1, 20x6 was purchased
in 20x2 when the exchange rate was 1Ll = $0.55C.
5.
Dividends were declared and paid on August 30, 20x6.
6.
The December 31, 20x5 inventory was purchased on November 15, 20x5 and the
December 31, 20x6 inventory was purchased on November 25, 20x6.
7.
No dividends were declared or paid in 20x4 and 20x5. The net loss for the year
ended 20x4 was $150,000 and the net income for 20x5 was $260,000.
8.
Relevant rates are as follows:
Jan 2, 20x4
Average 20x4
Nov 15, 20x5
Dec 31, 20x5
Average 20x5
Apr 1, 20x6
Jul 2, 20x6
Aug 30, 20x6
Nov 25, 20x6
Dec 31, 20x6
20x6 Average
1Ll =
1Ll =
1Ll =
1Ll =
1Ll =
1Ll =
1Ll =
1Ll =
1Ll =
$0.75C
$0.77C
$0.83C
$0.82C
$0.80C
$0.82C
$0.85C
$0.86C
$0.88C
$0.86C
$0.84C
Required a.
b.
Assume that Flanagan's functional currency is the Canadian dollar (i.e.
integrated), prepare a translated income statement and Statement of Financial
Position for the year 20x6.
Repeat (a) assuming that Flanagan's functional currency is the Lala (i.e. selfsustaining).
Page 281
© CMA Ontario - 2011
CMA Accelerated Program – Corporate Taxation and Financial Accounting 2
SOLUTIONS
Problem 1
Gain/loss on Net Monetary Items
Opening balance
Sales
Proceeds on sale of land
Purchases (4,672 - 1,528 + 1,856)
Selling and administration expenses
Interest expense
Redemption of Long-term liabilities (loss)
Dividends
Ending balance
Translated
Gain
£
-629,000
6,611,000
325,000
(5,000,000)
(1,230,000)
(84,000)
(50,000)
(168,000)
-225,000
Rate
2.08
2.04
2.04
2.04
2.04
2.04
2.08
2.00
$C
-1,308,320
13,486,440
663,000
(10,200,000)
(2,509,200)
(171,360)
(104,000)
(336,000)
-479,440
-225,000
2.00
-450,000
29,440
Translated Income Statement
Sales
Gain on sale of land
Cost of goods sold
Depreciation
Selling and administration
Interest
Loss on debt retirement
Foreign exchange gain
Net income
Retained Earnings, beginning
Dividends
Retained Earnings, ending
£
6,611,000
125,000
(4,672,000)
(420,000)
(1,230,000)
(84,000)
(50,000)
Rate
2.04
Note 1
Note 2
Note 3
2.04
2.04
Note 4
280,000
1,419,000
(168,000)
1,531,000
Note 5
2.00
Translated Statement of Financial Position – Dec 31, 20x7
£
Cash
212,000
Accounts receivable
350,000
Inventories
1,856,000
Plant and equipment - net
4,900,000
Land
600,000
Current liabilities
(87,000)
Long-term liabilities
(700,000)
Common Stock
(5,600,000)
Retained earnings
(1,531,000)
Page 282
Rate
2.00
2.00
2.02
Note 6
2.20
2.00
2.00
2.20
-
$C
13,486,440
223,000
(9,659,680)
(914,000)
(2,509,200)
(171,360)
(104,000)
29,440
380,640
2,954,480
(336,000)
2,999,120
$C
424,000
700,000
3,749,120
10,700,000
1,320,000
(174,000)
(1,400,000)
(12,320,000)
(2,999,120)
© CMA Ontario - 2011
CMA Accelerated Program – Corporate Taxation and Financial Accounting 2
Note 1 - Gain on sale of land
Proceeds
Cost
Gain
Note 2 - Cost of Goods Sold
Opening Inventory
Purchases
Ending Inventory
Note 3 - Depreciation
Dec 31, x2 acquisition: 4,400,000 ÷ 20
Jan 1, x6 acquisition: 2,000,000 ÷ 10
Note 4 - Loss on Debt Retirement
Premium on debt retirement
£
325,000
(200,000)
125,000
Rate
2.04
2.20
$C
663,000
(440,000)
223,000
1,528,000
5,000,000
(1,856,000)
4,672,000
2.10
2.04
2.02
3,208,800
10,200,000
(3,749,120)
9,659,680
220,000
200,000
420,000
2.20
2.15
484,000
430,000
914,000
50,000
2.08
104,000
Note 5 - Translated Statement of Financial Position – Dec 31, 20x6
£
Rate
Net monetary items
(629,000)
2.08
Inventories
1,528,000
2.10
Plant and equipment
Dec 31, x2 acquisition:
4,400,000 ÷ 20 x 16
3,520,000
2.20
Jan 1, x6 acquisition: 2,000,000 ÷ 10 x 9
1,800,000
2.15
Land
800,000
2.20
Common Stock
(5,600,000)
2.20
Retained earnings
(1,419,000)
Plug
Note 6 – Plant and Equipment
Dec 31, x2 acquisition: 4,400,000 ÷ 20 x 15
Jan 1, x6 acquisition: 2,000,000 ÷ 10 x 8
Page 283
3,300,000
1,600,000
4,900,000
2.20
2.15
$C
(1,308,320)
3,208,800
7,744,000
3,870,000
1,760,000
(12,320,000)
(2,954,480)
7,260,000
3,440,000
10,700,000
© CMA Ontario - 2011
CMA Accelerated Program – Corporate Taxation and Financial Accounting 2
Problem 2
Gain/Loss on Net Monetary Items Net monetary items – beginning
(200,000 + 300,000 – 180,000 - 400,000)
Sales
Purchases
Selling and administrative expenses
Other expenses
Income taxes
Net monetary items – end
Translated
Loss on net current monetary assets
$US
Rate
$C
-80,000
2,000,000
-1,400,000
-300,000
-170,000
-120,000
-70,000
-70,000
1.30
1.37
1.37
1.37
1.37
1.37
-104,000
2,740,000
-1,918,000
-411,000
-232,900
-164,400
-90,300
-98,000
$7,700
1.40
Translated Statement of Income and Retained Earnings – December 31, 20x9
Sales
Cost of Goods Sold
Selling and administration
Depreciation
Other expenses
Income taxes
Translation loss
Net income
Retained Earnings, beginning of year
Retained Earnings, end of year
(1) Cost of goods sold
Opening inventory
Purchases
Ending inventory
Page 284
$US
2,000,000
-1,250,000
-300,000
-30,000
-170,000
-120,000
Rate
1.37
(1)
1.37
1.30
1.37
1.37
130,000
470,000
600,000
1.30
600,000
1,400,000
-750,000
1,250,000
1.30
1.37
1.38
$C
2,740,000
-1,663,000
-411,000
-39,000
-232,900
-164,400
-7,700
222,000
611,000
833,000
780,000
1,918,000
-1,035,000
1,663,000
© CMA Ontario - 2011
CMA Accelerated Program – Corporate Taxation and Financial Accounting 2
Problem 3
Cantex (U.S.A) Inc.
Translated Income Statement and Statement of Retained Earnings
for the Year ended December 31, 20x5
$US
Net income
Retained earnings, Jan 1, 20x5
Dividends
Retained earnings, December 31, 20x5
$C
1,700,000
1,000,000
(100,000)
2,600,000
1.2751
1.2309
2,167,670
1,369,200
(123,090)
3,413,780
Cantex (U.S.A) Inc.
Translated Statement of Financial Position as at December 31, 20x5
$US
Cash
Accounts receivable
Inventory
Fixed assets
Accumulated depreciation
$C
50,000
400,000
3,000,000
2,500,000
(650,000)
1.2309
1.2309
1.2309
1.2309
1.2309
5,300,000
Accounts payable
Note payable
Common stock
Retained earnings
Cumulative translation adjustment
6,523,770
700,000
1,000,000
1,000,000
2,600,000
--
1.2309
1.2309
1.3894
5,300,000
Cumulative translation adjustment - Proof
61,545
492,360
3,692,700
3,077,250
(800,085)
861,630
1,230,900
1,389,400
3,413,780
(371,940)
6,523,770
$US
$C
Net assets, January 3, 20x5
Net income for the year 20x5
Dividends
Net assets, December 31, 20x5
2,000,000
1,700,000
(100,000)
3,600,000
1.3260
1.2751
1.2309
2,652,000
2,167,670
(123,090)
4,696,580
Net assets translated
Increase in CTA (loss)
Balance, December 31, 20x4
Cumulative translation adjustment – end of year
3,600,000
1.2309
(4,431,240)
265,340
106,600 dr.
$371,940 dr.
Page 285
© CMA Ontario - 2011
CMA Accelerated Program – Corporate Taxation and Financial Accounting 2
Problem 4
Calculation of translation gain on net
monetary liabilities
Net monetary liabilities, beginning of year
Sales
Purchase # 1
Purchase # 2
Interest expense
Other expenses
Fixed asset purchase
Dividend
Net current monetary liabilities, end of year
$US
(750,000)
10,000,000
(7,000,000)
(1,000,000)
(100,000)
(1,300,000)
(1,000,000)
(100,000)
(1,250,000)
1.3260
1.2751
1.3260
1.2751
1.2751
1.2751
1.2751
1.2309
$C
(994,500)
12,751,000
(9,282,000)
(1,275,100)
(127,510)
(1,657,630)
(1,275,100)
(123,090)
(1,983,930)
Translated
(1,250,000)
1.2309
(1,538,625)
Translation gain on net monetary liabilities
$ 445,305
Cantex (U.S.A) Inc.
Translated Income Statement and Statement of Retained Earnings
for the Year ended December 31, 20x5
$US
Sales
Cost of goods sold
Opening Inventory
Purchase # 1
Purchase # 2
Less ending inventory
10,000,000
$C
1.2751
12,751,000
1,500,000
7,000,000
1,000,000
(1,000,000)
1.3692
1.3260
1.2751
1.2751
2,053,800
9,282,000
1,275,100
(1,275,100)
(2,000,000)
1.3260
(2,652,000)
6,500,000
8,683,800
Gross margin
3,500,000
4,067,200
Depreciation – Purchase # 1
Depreciation – Purchase # 2
Depreciation – Purchase # 3
Interest
Other
200,000
100,000
100,000
100,000
1,300,000
Income before translation gain
Translation gain (Note 2)
Net income
Page 286
1.3894
1.3692
1.2751
1.2751
1.2751
277,880
136,920
127,510
127,510
1,657,630
1,800,000
2,327,450
1,700,000
1,739,750
--
445,305
1,700,000
2,185,055
© CMA Ontario - 2011
CMA Accelerated Program – Corporate Taxation and Financial Accounting 2
Net income (per previous page)
Retained Earnings – beginning of year
Dividends
Retained Earnings – end of year
1,700,000
1,000,000
(100,000)
2,600,000
1.2309
2,185,055
1,397,560
(123,090)
3,459,525
Cantex (U.S.A) Inc.
Translated Statement of Financial Position as at December 31, 20x5
($C)
$US
Cash
Accounts receivable
Inventory
Fixed assets
Accumulated depreciation
50,000
400,000
3,000,000
2,500,000
(650,000)
$C
1.2309
1.2309
Note 1
Note 2
5,300,000
Accounts payable
Note payable
Common stock
Retained earnings
700,000
1,000,000
1,000,000
2,600,000
6,941,455
1.2309
1.2309
1.3894
5,300,000
Note 1: Fixed asset purchase # 1
Fixed asset purchase # 2
Fixed asset purchase # 3
Note 2: Accumulated depreciation
Depreciation expense in 20x4
Depreciation expense in 20x5
Page 287
1,000,000
500,000
1,000,000
2,500,000
61,545
492,360
3,927,100
3,349,100
(888,650)
861,630
1,230,900
1,389,400
3,459,525
6,941,455
1.3894
1.3692
1.2751
1,389,400
684,600
1,275,100
3,349,100
346,340
542,310
888,650
© CMA Ontario - 2011
CMA Accelerated Program – Corporate Taxation and Financial Accounting 2
Problem 5
Part (a)
Note: in order to solve this problem, we first need to analyze the fixed asset and
accumulated depreciation accounts:
Fixed Assets - Beginning
+ Additions (unknown)
- Disposals
Fixed Assets - Ending
LL 3,600,000
500,000
(110,000)
LL 3,990,000
Accumulated Depreciation - Beginning
+ Depreciation Expense - Old Assets:
LL 3,600,000 / 10
+ Depreciation Expense - New Assets:
LL 500,000 / 10
- Accumulated Depreciation on disposals
Fixed Assets - Ending
LL
Gain on sale =
Proceeds
Less NBV of asset sold (110,000 - 75,000)
Gain
900,000
360,000
50,000
(75,000)
LL 1,235,000
LL 65,000
35,000
LL30,000
Loss on Net Monetary Liabilities Net monetary liabilities – beginning
(50,000 + 170,000 – 120,000 - 1,400,000)
Sales
Purchases
Interest
Other operating expenses
Income tax expense
Purchase of land
Purchase of fixed assets
Proceeds on sale of fixed assets
Dividends
Net monetary liabilities – beginning
(75,000 + 310,000 – 182,000 - 1,100,000)
Translated
FX Loss
Page 288
Ll
Rate
$C
(1,300,000)
10,000,000
(7,100,000)
(110,000)
(1,300,000)
(352,000)
(200,000)
(500,000)
65,000
(100,000)
0.82
0.84
0.84
0.84
0.84
0.84
0.85
0.82
0.86
0.86
$(1,066,000)
8,400,000
(5,964000)
(92,400)
(1,092,000)
(295,680)
(170,000)
(410,000)
55,900
(86,000)
(897,000)
(897,000)
0.86
(720,180)
(771,420)
51,240
© CMA Ontario - 2011
CMA Accelerated Program – Corporate Taxation and Financial Accounting 2
Translated Statement of Financial Position as at December 31, 20x5
Ll
Rate
Net monetary liabilities
(1,300,000)
0.82
Inventory
250,000
0.83
Land
100,000
0.75
Fixed Assets
3,600,000
0.75
Accumulated Depreciation
(900,000)
0.75
Common Stock
(1,200,000)
0.75
Retained Earnings
(550,000)
PLUG
$C
$(1,066,000)
207,500
75,000
2,700,000
(675,000)
(900,000)
(341,500)
Translated Statement of Income and Retained Earnings for the year ended Dec 31, 20x6
Sales
Cost of goods sold
Depreciation - Old Assets
- New Assets
Interest
Other operating expenses
Income tax expense
Gain on sale of fixed assets
FX Loss
Net Income
Retained Earnings, beginning
Dividends
Retained Earnings, ending
*Cost of Goods sold
Inventory, beginning
Purchases
Inventory, ending
** Gain on sale of fixed assets
Proceeds
NBV of assets
Page 289
Ll
10,000,000
(7,000,000)
(360,000)
(50,000)
(110,000)
(1,300,000)
(352,000)
30,000
858,000
550,000
(100,000)
1,308,000
Rate
0.84
*
0.75
0.82
0.84
0.84
0.84
**
0.86
$C
8,400,000
(5,863,500)
(270,000)
(41,000)
(92,400)
(1,092,000)
(295,680)
29,650
(51,240)
723,830
341,500
(86,000)
979,330
250,000
7,100,000
(350,000)
7,000,000
0.83
0.84
0.88
207,500
5,964,000
(308,000)
5,863,500
65,000
35,000
30,000
0.86
0.75
55,900
26,250
29,650
© CMA Ontario - 2011
CMA Accelerated Program – Corporate Taxation and Financial Accounting 2
Translated Statement of Financial Position as at December 31, 20x6
Ll
Rate
Net monetary liabilities
(897,000)
0.86
Inventory
350,000
0.88
Land - Old
100,000
0.75
- New
200,000
0.85
Fixed Assets - Old
3,490,000
0.75
- New
500,000
0.82
Accumulated Depreciation - Old
(1,185,000)
0.75
- New
(50,000)
0.82
Common Stock
(1,200,000)
0.75
Retained Earnings
(1,308,000)
Page 290
$C
$(771,420)
308,000
75,000
170,000
2,617,500
410,000
(888,750)
(41,000)
(900,000)
(979,330)
© CMA Ontario - 2011
CMA Accelerated Program – Corporate Taxation and Financial Accounting 2
Part (b)
Translated Retained Earnings as at January 1, 20x6
Retained Earnings, January 1, 20x4
20x4 Loss
20x5 Net income
Ll
440,000
(150,000)
260,000
550,000
Rate
0.75
0.77
0.80
$C
$330,000
(115,500)
208,000
422,500
Translated Statement of Income and Retained Earnings for the year ended Dec 31, 20x6
Net income
Retained earnings, beginning
Dividends
Ll
858,000
550,000
(100,000)
1,308,000
Rate
0.84
0.86
Translated Statement of Financial Position as at December 31, 20x6
Ll
Rate
Net assets
2,508,000
0.86
Common Stock
(1,200,000)
0.75
Retained Earnings
(1,308,000)
Cumulative translation adjustment
$C
720,720
422,500
(86,000)
1,057,220
$C
2,156,880
(900,000)
(1,057,220)
(199,660)
Cumulative Translation Adjustment as at December 31, 20x6
Net assets - Jan 1, 20x4
20x4 Loss
20x5 Net income
20x6 Net income
20x6 Dividends
Ll
1,640,000
(150,000)
260,000
858,000
(100,000)
2,508,000
Rate
0.75
0.77
0.80
0.84
0.86
$C
1,230,000
(115,500)
208,000
720,720
(86,000)
1,957,220
Translated
2,508,000
0.86
2,156,880
199,660
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CMA Accelerated Program – Corporate Taxation and Financial Accounting 2
8.
Financial Instruments
The majority of financial instruments have already been covered. These include:
bonds payable
FVTPL and FVTOCI investments, and
amortized cost investments.
This section deals with (1) financial instruments have the characteristics of both debt and
equity, in which case the debt and equity components have to be split (i.e. convertible
bonds) and (2) a very basic introduction to accounting for hedges.
Compound Instruments
The definition of what constitutes a financial liability and an equity instruments are
critical to how this split is made.
A financial liability is defined as a contractual obligation to deliver cash or another
financial asset to another party in the future. An equity instrument shows evidence of a
residual interest in the assets of the corporation once all liabilities have been settled.
The separation of a compound financial instrument into its liability and equity
components is done using the incremental approach as follows:
1.
measure the fair value of the liability component,
2.
measure the value of the equity component by deducting the fair value of the
liability component from the fair value of the instrument as a whole. (IAS 32.31)
Convertible Bonds
Convertible bonds are compound financial instruments that have both the attributes of
debt and equity. The obligation to deliver cash in the future is a debt attribute and the
right to acquire common stock is an attribute of equity. A company issuing convertible
debt will receive a higher cash proceed and will have to pay a lower interest rate on the
bond issue as opposed to a straight bond issue.
The journal entry to record the issue of the convertible bonds would be as follows:
Cash
Bonds payable
Contributed Surplus – Conversion Rights
Page 292
XXX
XXX
XXX
© CMA Ontario - 2011
CMA Accelerated Program – Corporate Taxation and Financial Accounting 2
On conversion, we debit the book value of the bonds converted, debit the Contributed
Surplus related to the bonds converted. The credit to Common Stock is simply the sum of
two. This is referred to as the book value method:
Bonds payable
Contributed Surplus – Conversion Rights
Common Stock
XXX
XXX
XXX
If the bonds are retired at maturity, then the Contributed Surplus – Conversion Rights is
allocated to general Contributed Surplus.
Example – on January 2, 20x2 the Harrison Corporation issues $10,000,000 of 8%, 10
year convertible bonds. Interest payment dates are June 30 and December 31. You
receive proceeds of $10,975,000 for the bond issue. Bonds with similar risk but without
conversion features yield 7%.
The proceeds that would have been received had the bonds not been convertible are:
Enter
Compute
N
20
I/Y
3.5
PV
PMT
400000
FV
10000000
X=
10,710,620
Therefore, we received an additional $264,380 ($10,975,000 – 10,710,620) for the
conversion feature. The journal entry to record the issuance of the bonds is as follows:
Cash
Bonds payable
Contributed Surplus – Conversion Rights
$10,975,000
$10,710,620
264,380
Assume that on July 2, 20x6, 40% of the bonds are converted into common shares. The
book value of the bonds at that date is $10,450,078:
Enter
Compute
N
11
I/Y
3.5
PV
PMT
400000
FV
10000000
X=
10,450,078
The journal entry to record the conversion of the bonds is as follows:
Bonds payable ($10,450,078 x 40%)
Contributed Surplus – Conversion Rights
($264,380 x 40%)
Common Stock
Page 293
$4,180,031
105,752
$4,285,783
© CMA Ontario - 2011
CMA Accelerated Program – Corporate Taxation and Financial Accounting 2
Debt with Detachable Stock Warrants
In order to induce the sale of bonds, some corporation sell bonds with detachable
warrants. Each warrant provides the holder the option of purchase a share of the common
stock of the corporation at a specified price (the exercise price), usually within a specific
timeframe. The total proceeds received from the bond issue will be greater when there are
detachable stock warrants than without. Therefore, the proceeds received on the bond
issue must be split between the bonds (credit Bond Payable) and the warrants (credit
Contributed Surplus – Warrants):
Cash
Bonds payable
Contributed Surplus – Warrants
XXX
XXX
XXX
Warrants have the same features as stock options in that they allow the holder to purchase
common stock of the corporation at a pre-specified price (the exercise price).
When the warrants are exercised, the sum of the cash received on the exercise of the
warrants plus the amount of contributed surplus associated with the warrants exercised
become the credit to common stock:
Cash
Contributed Surplus – Warrants
Common Stock
XXX
XXX
XXX
Example – the Ibrahim Corporation issued $10,000,000 of face value bonds on
December 31, 20x3. Each $1,000 bond comes with two detachable warrants allowing the
holder to purchase a share of the common stock of Ibrahim at a price of $35. The total
proceeds on the bond issue were $10,450,000.
Assume that the bonds would have issued at par had the warrants not been included. The
issue would be recorded as follows:
Cash
Bonds payable
Contributed Surplus – Warrants
$10,450,000
$10,000,000
450,000
Perpetual Debt
Perpetual debt is debt that will never be repaid. At first glance, we would be tempted to
classify perpetual debt as an equity instrument. However, because (1) there is no residual
equity ownership and (2) due to the fact that the value of regular bonds is mostly driven
by the present value of the coupon payments (i.e. the majority of the value of a long—
term bond is derived from the present value of the coupon payments), then we conclude
that the value of perpetual debt is driven mostly by a contractual obligation to pay
interest. Therefore, we classify perpetual debt as a financial liability.
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CMA Accelerated Program – Corporate Taxation and Financial Accounting 2
Redeemable/Convertible Preferred Shares
Redeemable preferred shares have a fixed term and are redeemable by the corporation at
a set point in time in the future. These meet the definition of a financial liability because
the corporation is contractually obligated to pay cash on redemption. In addition, any
dividends declared on redeemable preferred shares are treated as interest expense.
Similarly, if the preferred shares are redeemable at the option of the holder, because they
constitute a potential contractual obligation in the future to pay cash, they are classified
as financial liabilities.
When the corporation issued convertible preferred shares, the proceeds need to be split
between Preferred Shares and Contributed Surplus – Convertible Preferred Shares using
either the incremental approach as described in the discussion on convertible bonds.
Accounting for Derivatives
A derivative is a financial instrument that derives its value from some other security or
index. For example, a contract allowing you to purchase a particular asset within a
designated amount of time, at a predetermined price is a financial instrument that derives
its value from changes in the price of the underlying asset. For example, a call option to
purchase the shares of a corporation at a prespecified price over a given period is a
derivative whose value is derived from the value of the shares of the corporation on
which you purchased an option contract on. Financial futures, forward contracts, options,
and interest rate swaps are some of the most commonly used derivatives.
All derivatives are accounted for as fair value through profit and loss investments. They
are initially recorded at the amount of cash paid to enter into the contract. Any changes in
the value in the derivative over the life of the derivative are recorded as gains or losses in
the statement of income.
Example: on January 2, 20x5 you purchase 10,000 call options on the shares of the XYZ
Corporation. The exercise price of the options is $25 (equal to the market price of the
shares on January 2, 20x5). The exercise price is $40 (meaning you can purchase shares
of the XYZ corporation for $40) and the contract expires on June 30, 20x5. The cost of
purchasing the call option is $3,500 and is recorded as follows:
Call Options - XYZ Corporation
Cash
$3,500
$3,500
Assume the company's year end falls on March 31, 20x5. At that time the market value of
the call options is $18,000. The increase in market value would be recorded as follows:
Call Options - XYZ Corporation
Unrealized holding gain - Income
Page 295
14,500
14,500
© CMA Ontario - 2011
CMA Accelerated Program – Corporate Taxation and Financial Accounting 2
Hedge Accounting
Hedging means taking an action that is expected to produce exposure to a particular type
of risk that is precisely the opposite of an actual risk to which a company already is
exposed. For example, a company purchases 1,000 shares of the ABC Corporation for
$100,000 as a short term investment classified as a fair value through profit and loss
investment. The plan is to hold this investment for 6 months and then liquidate it and use
the cash for a planned capital investment. The downside risk is that the value of the
shares of the ABC Corporation will decrease by the time they are sold. To offset this risk,
we purchase a put option contract to sell 1,000 shares of ABC Corporation within the
next 6 months at an exercise price of $100 per share. If the price of the shares decreases,
we will exercise the put option and not lose any of our investment. If the price of the
shares increase, the put options will expire and all we lose is the cost of entering into the
contract.
Note that a company could enter into this type of transaction and opt to not apply hedge
accounting. In this case, they would simply account for the investment in the shares of
ABC Company as a fair value through profit and loss investment. They would account
for the investment in put options as a derivative, i.e. as a fair value through profit and loss
investment as discussed in the previous section.
However, the company can elect to apply hedge accounting. If they do so, they must meet
the following criteria (IAS 39.88)
•
at the inception of the hedge there is a formal designation and documentation of
hedging relationship and the entity's risk management objectives and strategy for
undertaking the hedge, and
•
the hedge is expected to be highly effective in achieving offsetting changes in the
fair value or cash flow attributable to the hedge risk, consistently with the
originally documented risk management strategy for that particular hedging
relationship, and
•
for cash flow hedges, a forecast transaction that is the subject of the hedge must
be highly probable and must present an exposure to variations in cash floes that
could ultimately affect profit or loss, and
•
the effectiveness of the hedge can be reliably measured, i.e. the fair value or cash
flows of the hedged item that are attributable to the hedged risk and in the fair
value of hedging instrument can be reliably measured, and
•
the hedge is assessed on an ongoing basis and determined actually to have been
highly effective throughout the financial reporting period for which the hedge was
designated.
There are generally two types of hedges: fair value hedges and cash flow hedges. Each
will be explored at a very basic level.
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CMA Accelerated Program – Corporate Taxation and Financial Accounting 2
Fair Value Hedges
A fair value hedge is when a derivative instrument is used to hedge the exposure of a
financial asset or liability. Hedging a foreign currency exposure using a forward contract
is an example of a fair value hedge.
As an example of a fair value hedge, assume that you purchase 500 shares of another
corporation at a cost of $10,000. This investment is classified as a FVTOCI investment.
You are taking a risk that the market value of the shares will fluctuate in the future and
decide to purchase a put-option contract to sell 500 shares of the other corporation’s stock
at a cost of $200. A put option gives you the option to sell the shares at a fixed price (the
exercise price) which is usually equal to the market price of the stock on the day it is
acquired. In this example, this means that by purchasing the put option contract we have
the option of selling our stock at a price of $20 per share.
The journal entries to record the purchase of the shares and the purchase of the put option
contract is as follows:
FVTOCI investments
Cash
Put Option Contract
Cash
$10,000
$10,000
200
200
At year end, assume that the shares are trading at $17. This means that the value of the
put option contract would increase in value by 500 shares x $3 – the decrease in the
market price relative to the exercise price. Normally, an unrealized loss on FVTOCI
Investments will flow through Other Comprehensive Income. However, when the
investment is hedged, an exception is made and the unrealized loss and gain will flow
through the income statement. This is the advantage of the hedge - without hedge
accounting, the changes in fair value of the investment would flow to OCI and the
adjustments to market value of the derivative would flow to income, thereby causing an
accounting mismatch. The journal entries to record the change in market value of the
available for sale investments and the put option contract are as follows:
Unrealized loss – 500 shares x ($20 – 17)
FVTOCI investments
1,500
Put Option Contract
Unrealized gain
1,300
Page 297
1,500
1,300
© CMA Ontario - 2011
CMA Accelerated Program – Corporate Taxation and Financial Accounting 2
Cash Flow Hedges
A cash flow hedge is when we are hedging a future cash flow stream. For example, you
issue bonds that pay a variable interest rate. The risk you are taking is that future interest
rates will increase, thereby causing your cash interest payments to increase. You enter
into an interest rate swap whereby you pay a fixed amount of interest to another party in
exchange to receiving a variable interest revenue. You then use this revenue to pay the
interest on your bonds.
Example - On December 31, 20x7, you issue 10 year bonds with a face value of
$10,000,000 paying prime + 2%. The prime rate at December 31, 20x7 is 6%. In order to
hedge any future interest rate fluctuations, you enter into a 10 year interest rate swap
agreement with a third party whereby you agree to pay a fixed amount of interest of 8%
on a notional value of $10,000,000. In exchange, you will receive a variable rate of
interest equal to prime + 2%. Assume interest is paid annually.
The journal entry to record the bonds payable on December 31, 20x7 is as follows. Note
that no entry is required to record the swap agreement since no cash changed hands on
the date of the agreement.
Cash
Bonds payable
$10,000,000
$10,000,000
Assume that, on December 31, 20x8, the prime rate is 7.5%. This means that you will
receive a cash settlement from the other party of the swap agreement of $10,000,000 x
1.5% = $150,000. The journal entry to record the interest expense and the cash receipt on
the swap agreement is:
Interest expense ($10,000,000 x 9.5%)
Cash
Cash
Interest expense
$950,000
$950,000
150,000
150,000
Note that your interest expense is equal to the original prime rate of 6% plus 2% = 8%, or
a net of $10,000,000 x 8% = $800,000.
When the prime rate moves, the value of the interest rate swap agreement will also
change. Since interest rates went up, the value of the swap agreement will also increase.
If we assume that the value of the contract has increased by $75,000, then we would
record the increase as follows:
Interest rate swap agreement
OCI
Page 298
$75,000
$75,000
© CMA Ontario - 2011
CMA Accelerated Program – Corporate Taxation and Financial Accounting 2
Any subsequent changes in the fair value of the swap agreement would flow through
OCI.
Assume that in 20x9, the prime rate dropped to 4%. The cash paid to the swap partner
will be: $10,000,000 x (8% - 6%) = $200,000.
Interest expense ($10,000,000 x 6%)
Cash
Interest expense
Cash
$600,000
$600,000
200,000
200,000
Note that your interest expense is equal to $800,000, the same amount as in 20x8.
Assume that the market value of the interest swap agreement drops by $100,000, the
decrease would be recorded as follows:
OCI
Interest rate swap agreement
$100,000
$100,000
ASPE Differences •
compound financial instruments that include both a debt and equity component - the
entity may opt to measure the equity component at zero value.
•
When convertible securities are converted into common shares, the market value
method is used: the credit to common shares is at the market value of the common
shares issued. Any difference between the book value of the converted instruments
and the fair value of the common shares is shown as a gain or loss item in the
statement of income.
•
hedge accounting is limited to:
hedges of an anticipated purchase or sale of a commodity or an anticipated
transaction in a foreign currency,
interest rate or cross-currency rate swaps, or
hedges of net investments in a self-sustaining foreign operation
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© CMA Ontario - 2011
CMA Accelerated Program – Corporate Taxation and Financial Accounting 2
Problems with Solutions
Problem 1
Hannah Ltd. issued $8,000,000 of 8 year, 6% convertible bonds on December 31, 20x5
for proceeds of $7,950,000. Interest is payable on June 30 and Dec 31 of every year.
Similar bonds without conversion privileges yield 7%. On July 1, 20x8, $2,500,000 of
these bonds are converted into 40,000 common shares. The market value of the shares on
that date was $75 per share.
Required –
a.
b.
c.
d.
Prepare the journal entry to record the issuance of the bonds on December 31,
20x5.
Prepare the journal entries to record interest expense for the year 20x6.
Prepare the journal entry to record the conversion of the bonds on July 1, 20x8.
Assume that the balance of the bonds are retired at maturity. Prepare the journal
entry to record the retirement of the bonds.
Problem 2
The Jerome Corporation issued $10,000,000 of 10 year, 7% bonds on December 31, 20x2
for total proceeds of $10,597,000. Each $1,000 bond came with 6 detachable warrants
allowing the holder to purchase one share of the corporation within the next 2 years at a
price of $25, the market price of the stock on December 31, 20x2. The yield to maturity
on debt with similar maturity and risk is 6.6%.
Required –
a.
b.
Prepare the journal entry to record the issuance of the bonds on December 31,
20x2.
Assume that on July 2, 20x4, 40,000 warrants are converted into common stock.
The stock was trading at $60 on that date. Prepare the journal entry to record the
exercise of the warrants.
Page 300
© CMA Ontario - 2011
CMA Accelerated Program – Corporate Taxation and Financial Accounting 2
Problem 3
On June 1, 20x4 you purchase 10,000 shares of the Harry Corporation for $7.50 per
share. On the same day you purchase a put option contract to sell 10,000 shares of the
Harry Corporation at an exercise price of $7.50. The cost of the contract is $300. You
have designated the purchase of the put options as a hedge.
Required –
a.
b.
c.
Write the journal entries on June 1, 20x4
Write the journal entries on December 31, 20x4 assuming that the shares of the
Harry Corporation are trading at $10.20.
Write the journal entries on December 31, 20x4 assuming that the shares of the
Harry Corporation are trading at $5.50.
Problem 4
On January 2, 20x3, you issue 15 year bonds with a face value of $50,000,000 paying
LIBOR + 2%. The LIBOR rate at that date is 5.5%. In order to hedge any future interest
rate fluctuations, you enter into a 15 year interest rate swap agreement with a third party
whereby you agree to pay a fixed amount of interest of 7.5% on a notional value of
$50,000,000. In exchange, you will receive a variable rate of interest equal to LIBOR +
2%. Assume interest is paid annually. You have designated the investment as a hedge and
will use hedge accounting.
Required –
a.
b.
c.
Write the journal entries on January 2, 20x3.
Write the journal entries on December 31, 20x3 assuming that the LIBOR rate is
4.2% and that the value of the swap agreement has dropped by $80,000.
Write the journal entries on December 31, 20x3 assuming that the LIBOR rate is
6.7% and that the value of the swap agreement has increased by $90,000.
Page 301
© CMA Ontario - 2011
CMA Accelerated Program – Corporate Taxation and Financial Accounting 2
SOLUTIONS
Problem 1
a.
The proceeds that would have been received had the bonds not been convertible
are:
Enter
Compute
N
16
I/Y
3.5
PV
PMT
240000
FV
8000000
X=
7,516,235
The journal entry to record the issuance of the bonds is as follows:
Cash
Bonds payable
Contributed Surplus – Conversion Rights
b.
$7,950,000
$7,516,235
433,765
Interest expense ($7,516,235 x 3.5%)
Bonds Payable
Cash
263,068
23,068
240,000
Interest expense
($7,516,235 + 23,068) x 3.5%
Bonds Payable
Cash
c.
263,876
23,876
240,000
The book value of the bonds on July 1, 20x8 is:
Enter
Compute
N
11
I/Y
3.5
PV
PMT
240000
FV
8000000
X=
7,639,938
The journal entry to record the conversion of the bonds is as follows:
Bonds payable ($7,639,938 x 31.25%*)
Contributed Surplus – Conversion Rights
($433,765 x 31.25%)
Common Stock
*
$2,387,481
135,552
$2,523,033
$2,500,000 / 8,000,000 = 31.25%
Note that the market value of the shares is not relevant.
Page 302
© CMA Ontario - 2011
CMA Accelerated Program – Corporate Taxation and Financial Accounting 2
d.
Bonds payable ($8,000,000 – 2,500,000)
Cash
$5,500,000
$5,500,000
Contributed Surplus – Conversion Rights
($433,765 – 135,552)
Contributed Surplus
298,213
298,213
Problem 2
a.
The proceeds that would have been received had the bonds not been convertible
are:
Enter
Compute
N
20
I/Y
3.3
PV
PMT
350,000
FV
10,000,000
X=
10,289,462
The allocation of proceeds to the warrants is: $10,597,000 - 10,289,462 =
$307,538
The journal entry to record the issuance of the bonds is as follows:
Cash
Bonds payable
Contributed Surplus – Warrants
b.
Page 303
Cash (40,000 x $25)
Contributed Surplus – Warrants
$307,538 x 40,000 / 60,000
Common stock
$10,597,000
$10,289,462
307,538
$1,000,000
205,025
$1,205,025
© CMA Ontario - 2011
CMA Accelerated Program – Corporate Taxation and Financial Accounting 2
Problem 3
a.
FVTOCI investments
Cash
Put Option Contract
Cash
b.
c.
$75,000
$75,000
300
300
FVTOCI investments (10,000 x 2.70)
Unrealized gain (P&L)
27,000
Unrealized loss (P&L)
Put Option Contract
27,300
Unrealized loss (P&L) (10,000 x $2.00)
FVTOCI investments
20,000
Put Option Contract
Unrealized gain (P&L)
19,700
Page 304
27,000
27,300
20,000
19,700
© CMA Ontario - 2011
CMA Accelerated Program – Corporate Taxation and Financial Accounting 2
Problem 4
a.
b.
c.
Jan 2, 20x3
Dec 31, 20x3
Dec 31, 20x3
Cash
Bonds payable
Interest expense
Cash
Interest paid to bondholders =
$50,000,000 x 6.2%
$50,000,000
3,100,000
3,100,000
Interest expense
Cash
Cash payment to swap partner =
$50,000,000 x 1.3%
= $650,000
650,000
OCI
Interest Rate Swap Agreement
80,000
Interest expense
Cash
Interest paid to bondholders =
$50,000,000 x 8.7%
Cash
Interest expense
Cash receipt from swap partner =
$50,000,000 x 1.2%
= $600,000
Interest Rate Swap Agreement
OCI
Page 305
$50,000,000
650,000
80,000
4,350,000
4,350,000
600,000
600,000
90,000
90,000
© CMA Ontario - 2011