Jennifer Lu is a world- renowned architect. She is in the midst of a divorce with her husband, Johnnie Nu. On the whole the separation has been amicable and civil. Jennifer and Johnnie have agreed to divide the value of their assets equally. One of these assets is her architectural consulting company, Constructive Inspirations Inc. They have agreed that Jennifer would continue to own Constructive Inspirations (CI), but her husband would instead get other assets owned by them of equal value. The two of them have decided that the value of Constructive Inspirations will be based on the higher of CI’s ending owner’s equity, or six times its net income before taxes (but after all expenses) in 20X9. The calculation of both amounts will be guided by current IFRS standards for publicly accountable enterprises (i. e., public companies) as long as the end results are logical and fair to both parties. Both Jennifer and Johnnie are important clients of Accounting Experts LLP. They have approached Accounting Experts LLP for advice on the accounting methods to be adopted for the purpose of valuing CI in relation to their divorce settlement.
Further details about Constructive Inspirations, including items about which the two disagree, are provided below.
CUTTING EDGE DESIGN SUPPLIES Constructive Inspiration purchased 40 percent of the shares of Cutting Edge Design Supplies (CEDS) on January 1, 20X7. The remaining 60 percent of CEDS’s shares were purchased on that date by a group of 15 friends of Jennifer. These friends have no architectural background. Their reasons for investing in CEDS are their belief in Jennifer’s vision, and their conviction that their investment in CEDS will pay off handsomely in the long run. They play no part in the day- to- day operations of CEDS, and have, via a written agreement dated January 1, 20X7, given Constructive Inspirations the authority to make operating and financing decisions in relation to CEDS. One of the employees of CI is on the board of CEDS. On the date of acquisition of CEDS, the carrying values of its assets and liabilities were equal to their fair values except for inventory and a patent. The balance of the purchase price discrepancy of $ 100,000 was allocated to goodwill. The table below provides details on the carrying and fair values of inventory and the patent.

A test for impairment at the end of 20X8 indicated that the acquisition- related goodwill had a value of $ 80,000 at that time. There was no further impairment of this goodwill in 2009. From the beginning, CI has not charged any management fee to CEDS for the time spent by CI’s employees on CEDS operations. Johnnie estimates that the management fee that should have been charged is $ 100,000, $ 125,000, and $ 150,000 for 20X7, 20X8, and 20X9 respectively.
On July 1, 20X8, CI provided a loan of $ 100,000 to CEDS via a 10 percent interest-bearing note payable. CEDS has been prompt in paying the interest on the note to CI. The loan is still outstanding at the end of 20X9.
CEDS sold a piece of equipment purchased by it on February 1, 20X7 to CI on January 1, and 20X8. CEDS had recorded the full year’s depreciation of $ 75,000 on the equipment in 20X7. No depreciation was recorded by CEDS for 20X8. The equipment was originally purchased by CEDS for $ 300,000 and sold to CI for $ 270,000. The equipment had a remaining useful life of 3 years with zero residual value on January 1, 20X8. CI charged a full year’s depreciation in 20X8.
CEDS sold $ 80,000 and $ 90,000 worth of supplies to CI in 20X8 and 20X9 respectively. 20% of the supplies sold in 20X8 and 30% of the supplies sold in 20X9 by CEDS remained in CI’s inventory at year- end. CEDS gross margin on these sales is 40%.
CI has from inception used the cost method to account for its investment in CEDS. CEDS has not declared any dividends since its acquisition by CI.
• CI’s employees have a bonus based on the net income of CI before taxes.
• CI uses a line of credit with a local bank for its working capital needs. The bank bases the terms of the line of credit on the financial statements of CI. CI’s receivables and assets act as collateral for the line of credit.

After having recently graduated with a business degree from university you are presently working for Accounting Experts LLP. The partner of Accounting Experts LLP has asked you to analyze the above case and prepare a report for him. He will be using the report to pre-pare himself for an upcoming meeting with Jennifer and Johnnie.
In your report discuss how the different accounting alternatives available impact the financial affairs of CI, and support your accounting choice by discussing how it serves the users ranked by you as the most important and the objectives of such users. You should also discuss any concerns about the formula used for valuing CI and the “fairness” of using IFRS-based financial statements for determining CI’s value. Ignore incometaxes.

  • CreatedMarch 13, 2015
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