On January 2, Year 1, Poplar Ltd. purchased 80% of the outstanding shares of Spruce Ltd. for $2,000,000. At that date, Spruce had common shares of $500,000 and retained earnings of $1,250,000 and accumulate depreciation of $600,000. Poplar acquired the Spruce shares to obtain control of mineral rights owned by Spruce. At the date of acquisition, these mineral rights were valued at $750,000, were not recognized on Spruce’s separate-entity balance sheet, and had an indefinite useful life. Except for the mineral rights, the carrying amount of the recorded assets and liabilities of Spruce were equal to their fair values. On December 31, Year 4, the trial balances of the two companies were as follows:
• The Year 4 net incomes of the two companies are as follows:
Poplar Ltd......... $1,100,000
Spruce Ltd. ......... 521,500
• The mineral rights owned by Spruce have increased in value since the date of acquisition and were worth $925,000 at December 31, Year 4.
• On January 2, Year 2, Spruce sold equipment to Poplar for $500,000. The equipment had a carrying amount of $400,000 at the time of the sale. The remaining useful life of the equipment was five years.
• The Year 4 opening inventories of Poplar contained $500,000 of merchandise purchased from Spruce during Year 3. Spruce had recorded a gross profit of $200,000 on this merchandise.
• During Year 4, Spruce’s sales to Poplar totalled $1,000,000. These sales were made at a gross profit rate of 40%.
• Poplar’s ending inventory contains $300,000 of merchandise purchased from Spruce.
• Other expenses include depreciation expense and copyright amortization expense.
• On January 2, Year 2, Poplar issued 8%, 7-year bonds with a face value of $500,000 for $514,000. Interest is paid annually on December 31. On January 2,
Year 4, Spruce purchased one-half of this issue on the open market at a cost of $242,500. Intercompany bond gains (losses) are to be allocated between the two affiliates.
• Tax allocation will be at a rate of 40%.
(a) Prepare the following consolidated financial statements:
(i) Income statement
(ii) Retained earnings statement
(iii) Balance sheet
(b) Calculate the December 31, Year 4, balance in the account “Investment in Spruce” if Poplar had used the equity method to account for its investment.
(c) Explain how the recognition of gains on the elimination of intercompany bond holdings is consistent with the principle of recording gains only when they are realized.