Question

QUESTION 1 (9 marks) Your firm has recently been chosen as the auditor of Rocky Mountain Unlimited, a company which was formed on October 15, 2014. Mr. Summit owns 70% of the voting shares of Rocky Mountain Unlimited and his wife owns the remaining 30%. On October 31, 2014, Rocky Mountain Unlimited acquired all of the voting shares of Foothills, a company which was founded by Mr. Summit's wife four years ago. Foothills will sell Rocky Mountain chocolate making supplies to Rocky Mountain Unlimited at a gross profit of 25%. In a meeting with Mr. Summit, he asks your audit partner the following questions. a) Why do accounting standards require that profits on sales of inventory between a subsidiary and its parent must be eliminated? My wife is working hard to ensure that Foothills is a profitable company and it seems unfair that the profits of this company will not be reflected in Rocky Mountain' financial statements. (3 marks) b) Foothills owns some packaging equipment with a net book value of $45,000. At the time that Rocky Mountain Unlimited bought Foothills was estimated to be worth $45,000. However, our tax advisor has suggested that Foothills should sell the equipment to Rocky Mountain Unlimited for S40,000. The equipment is really only currently worth $40,000 because it is becoming obsolete due to the recent introduction of superior technology. Foothills can use the tax loss that the sale will generate because the company has been paying a lot of income taxes since it was formed. Assuming the sale takes place, how should we account for this equipment? (3 marks) An intercompany gain on the sale of land is eliminated in the preparation of the consolidated statements in the year that the gain was recorded. Will the gain be eliminated in the preparation of subsequent consolidated statements? Explain (3 marks) REQUIRED Draft responses to each of Mr. Summit's questions, for use by your audit partner in a follow-up meeting with Mr. Summit to discuss his concerns. (3 marks per item; 9 marks total).

Answer 1

An Audit Firm is engaged as an auditor of Rocky Mountain Unlimited. Questions are being asked by Mr. Summit, owner of the company to the audit partner of the engaging Audit Firm.

Following are the responses to questions being asked by Mr. Summit to the Audit Partner of the Audit Firm:

(a) In preparation of Consolidated Financial Statements of Rocky Mountain Unlimited, accounting standards requires

- Consolidation of items of Assets, Liabilities, Revenue & Expenditure on a line by line basis;

- Make Investment Elimination;

- Knock off all the related party transactions; and

- eliminate all the unrealised profits standing in the value of assets.

Accounting Standards requires the company to prepare the Consolidated Financial Statements as that of its own by recognizing the actual profits made from outside the group & by eliminating profits made within itself.

(b) The packaging equipment will have book value in the books of Rocky Mountain Unlimited at $45,000 i.e. the price at which the equipment was valued at the time of acquisition of Foothills by Rocky Mountain Unlimited. The sale at $40,000 of the equipment will create a loss of $5,000 in the consolidated financial statements of Rocky Mountain Unlimited.

(c) Yes, the gain will be eliminated in the subsequent consolidated financial statements. In separate financial statements in the subsequent year, the gain will be standing in the Opening Balance of the Retained Earnings. So, accordingly the elimination entry for intercompany gain will be carried forward from the previous year & will be having an impact in the Opening Balance of Retained Earnings.