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Chapter 7
CASES
Case 7-1
In this case, students are asked to compare the accounting for an intercompany transaction
depending on whether the investee company was a controlled entity, a significantly influenced
entity, or a related party.
Case 7-2
In this case, students are asked to discuss how a loss on intercompany bondholdings should be
allocated to the parent and/or to the subsidiary.
Case 7-3
In this real life case, students are asked to determine the economic benefits of transferring a
machine from the subsidiary to the parent in order to increase the tax savings from depreciation
expense. The case also requires a discussion of various alternatives for reporting the tax
savings on the consolidated income statement.
Case 7-4
In this case taken from a CPA exam, students are asked to prepare a memo for the partner to
address the accounting implications and disclosure requirements for transactions involving
convertible debentures and spin off of a division from a subsidiary to the parent and then to a
newly created subsidiary.
Case 7-5
In this case taken from a CPA exam, students are asked to discuss accounting issues involving
revenue recognition related to multiple deliverables, intercompany transactions involving
depreciable assets, inventory valuation and asset retirement obligation.
Case 7-6
In this case taken from a CPA exam, students are asked to prepare a memo for the partner to
address the accounting issues for a new client in the waste management business. The
accounting issues include intercompany transactions in capital assets, revenue recognition,
contingencies and capitalization of expenditures.
3. Yes. The realization of the intercompany profit through the adjustment to consolidated
depreciation is considered to be in effect an indirect sale of a portion of the equipment to
customers outside the consolidated entity. Further, if a depreciable asset is sold to a third
party, the remaining intercompany profit is then realized.
4. No. The only time an adjustment of this kind affects the non-controlling interest calculation
is when the subsidiary was the selling company in the transaction that created the original
intercompany gain.
5. As long as the purchaser continues to depreciate the depreciable asset an adjustment will
be required on consolidation to change depreciation expense to what it would have been
6. As the purchaser uses the depreciable asset and earns a profit by selling its own goods
and services to outsiders, a portion of the previously unrecognized gain is considered to be
realized from a consolidation viewpoint. As each year passes, the amount of unrealized
gain is reduced and, in turn, the adjustment of beginning retained earnings is reduced.
7. Rather than simply eliminating the unrealized gain from the purchaser’s cost of the asset,
both the cost of the asset and accumulated depreciation are adjusted to the amounts that
would have been reported by the seller had the intercompany transaction not occurred.
This usually means that the cost and accumulated amortization are both increased i.e.
grossed up to get to the target amount.
*8. The consolidated financial statements should report account balances as if the
intercompany transaction has not occurred. The transfer from cumulative other
comprehensive income to retained earnings should be reversed on consolidation. In turn,
the equipment should be remeasured to fair value with the adjustment to fair value being
added to/subtracted from cumulative other comprehensive income.
*9. This statement is true. There should never be a gain on the consolidated income statement
from an intercompany sale of equipment regardless of whether the companies are using
the historical cost model or the fair value model to value the equipment because there has
not been a transaction with outsiders. However, there could be a gain or loss on the
separate entity income statement for the selling entity because the transaction may occur
at a point in time when the financial statements have not been updated to the most recent
fair value for the equipment. For example, the equipment may have been updated to fair
value at the end of the previous period but the sale took place late in the current year when
the fair value was higher than previously reported.
(a) The purchasing affiliate acted as an agent for the issuing affiliate; gains or losses are
allocated to the issuer.
(b) Gains or losses are allocated to the purchasing affiliate because it made the open
market purchase of the bonds.
Copyright 2016 McGraw-Hill Education. All rights reserved.
Solutions Manual, Chapter 7 7
(c) Gains or losses are allocated to the parent company because it controls the actions
of the affiliates.
(d) Gains or losses are allocated to both the purchasing and the issuing affiliates.
Approach (d) is conceptually superior because each affiliate will actually record the gain
(loss) so allocated when it amortizes the premiums or discounts that caused the
consolidated gains (losses) in the first place. As a result, the eliminations in consolidated
statements mirror the entries made by both the purchaser and the issuer.
12. The holdback of a gain from an intercompany sale of an asset results in the creation of a
deferred tax asset in the preparation of the consolidated balance sheet because, although
the selling affiliate has recorded the tax in its income statement, it will not be an expense of
the entity until the asset is sold to outsiders. The adjustment in the preparation of a
consolidated income statement creating a gain on bond retirement results in a deferred tax
liability in the consolidated balance sheet because none of the constituent affiliates has paid
(or recorded) the tax on the gain, but will do so in future periods when they amortize the
premiums or discounts that caused the gain.
13. Gains (losses) on the intercompany sales of assets are realized for consolidated purposes
when the assets have been used up or sold outside the entity. This event occurs in periods
subsequent to the period in which the selling affiliate recorded the gain.
Gains (losses) resulting from the elimination of intercompany bondholdings are realized for
consolidation purposes in the period in which the intercompany acquisition takes place.
The affiliates' share of the gain (loss) is recorded in subsequent periods when the
discounts or premiums that caused the gain (loss) are amortized by each affiliate.
14. Gains should be recognized when they are realized i.e., when there has been a transaction
with outsiders and consideration has been given/received. When the parent acquires the
Copyright 2016 McGraw-Hill Education. All rights reserved.
8 Modern Advanced Accounting in Canada, Eighth Edition
subsidiary’s bonds for cash in the open market, it is transacting with an outsider and giving
cash as consideration. From the separate entity perspective, the parent is investing in
bonds. However, from a consolidated point of view, the parent is retiring the bonds of the
subsidiary when it purchases the bonds from the outside entity. Therefore, when the
investment in bonds is offset against the bonds payable on consolidation, any difference in
the carrying amounts is recorded as a gain or loss on the deemed retirement of the bonds.
15. The matching principle requires that expenses be matched to revenues. When
intercompany bond holdings are eliminated, a gain or loss on the deemed retirement of the
bonds is recognized on the consolidated financial statements. In turn, the income tax on
the gain or loss must be recognized to match to the gain or loss. Since the income tax is
not currently payable or receivable but deferred until the temporary differences reverse, it
is set up as deferred income tax.
SOLUTIONS TO CASES
Case 7-1
1. If Enron controlled LIM2, Enron did overstate its earnings by reporting a profit of $67 million
on a transaction with LIM2. When consolidated financial statements are prepared, the
intercompany transaction between Enron and LIM2 would be eliminated and the fibre optic
cable would be remeasured to the carrying value of this asset prior to the sale. The profit on
the fibre optic cable would only be recognized on the consolidated income statement when
LIM2 sells this cable to outsiders or through reduced depreciation expense over the useful
life of this asset.
2. If Enron only had significant influence over LIM2, it would use the equity method to report its
investment. Since Enron does not control LIM2, it would not be able to dictate the selling
price of the cable. Since Enron only has significant influence, the interests of the other
shareholders would have to be considered in setting the price. It would be similar to Enron
selling to outsiders. IAS 28 states that profit pertaining to the other shareholders’ interest
would be considered realized and need not be eliminated; only the investor’s percentage
interest in the investee times the profit must be eliminated. The unrealized profit would be
eliminated from equity method income.
If the transaction were to be reported at carrying amount, Enron would not report the gain. If
the transaction were to be reported at exchange amount under IAS 24, Enron would be able
to report the gain.
In most of the situations considered in this question, Enron should not have reported the gain.
Gains from intercompany transactions are typically eliminated and not reported on the seller’s
financial statement. Gains are typically not reported until they are realized in a transaction with
a non-related party. This requirement applies to consolidated financial statements and
investments reported under the equity method but does not necessarily apply under related
party transactions.
Case 7-2
(a)
This case is designed to give life to a theoretical accounting issue discussed within the chapter: If
a subsidiary's debt is retired, should the resulting gain or loss be assigned to the parent or to the
subsidiary? The case attempts to illustrate that no clear-cut solution to this question can be found.
This lack of an absolute answer makes financial accounting both intriguing and frustrating.
Interesting class discussion can be generated from this issue.
Students should note that the decision as to assignment only becomes necessary because of the
presence of the non-controlling interest. Regardless of the level of ownership, all intercompany
balances are eliminated on consolidation. Not until the time that the non-controlling interest
computations are made does the identity of the specific party become important.
All financial and operating decisions are assumed to be made in the best interest of the business
entity as a whole. This debt would not have been retired unless corporate officials believed that
Penston/Swansan would benefit from the decision. Thus, a strong argument can be made against
any assignment to either separate party.
(b)
Case 7-3
(a) The following amounts would be reported on the separate-entity financial statements:
(b) 40% of Slum’s after-tax gain on the sale of the machine would now be credited to the non-
controlling interest i.e., ($88,000 - $26,400) x 40% = $24,640. Since this amount is
greater than the overall tax saving of $20,000, Plum would realize an overall loss of
$4,640 on the intercompany transaction. From Plum’s perspective, it is not a good
financial decision.
(c) As a result of the intercompany transaction, amortization expense has increased from
$28,000 to $50,000 per year. The extra $22,000 must be eliminated on consolidation so
that only $28,000 of amortization expense is reported on the consolidated income
statement. Income tax on the $22,000 must also be eliminated. Three alternatives are
presented below for the elimination of tax on the excess amortization for each of Years 6
to 9:
The controller’s suggestion of 30% can be supported on the basis that the total tax eliminated
over 4 years will be $26,400 which is equal to the tax paid by Slum when the gain was reported
for tax purposes. This results in reporting a tax saving of $13,400 on amortization expense of
$28,000 on the consolidated income statement. This is $5,000 per year more than Slum’s tax
saving of $8,400 per year before it sold the machine to Plum. This fairly presents the actual
situation because Plum is achieving an incremental tax benefit of $5,000 per year (i.e. $20,000
overall gain spread over 4 years) as a result of the intercompany transaction.
The other option can initially be supported on the basis that it would report a tax saving of
Copyright 2016 McGraw-Hill Education. All rights reserved.
12 Modern Advanced Accounting in Canada, Eighth Edition
$8,400 on amortization expense of $28,000 on the consolidated income statement which is
consistent with what was reported before the intercompany transaction occurred. However, it
would eliminate a total of $46,400 of tax over 4 years, which is $20,000 more than the tax paid
on the original sale of the machine. Therefore, this alternative does not fairly present the true
tax situation for the consolidated entity or the non-controlling interest. The manager’s
suggestion would produce similar results as the other option.
Case 7-4
Memo to: Partner
From: Stephanie Baker, CPA
Subject: Canadian Developments Limited (CDL) Engagement
As requested, I have analyzed the accounting implications, financial statement disclosure, and other
matters of importance relating to several transactions that CDL entered into during the Year 8 fiscal
year.
Overall, the policies suggested by CDL management lead me to conclude that there is a bias
towards adopting policies that maximize earnings and provide a strong balance sheet in order to
attract new investors.
Likelihood of conversion
The classification of the debenture will depend on the likelihood of the debenture being converted
to common shares. In this instance, the holders of the debentures are a relatively small group
(major shareholder (53%) and large institutions), and CDL may be able to find out from them what
their intentions are. If the majority of the holders confirm their intention to convert, the question of
uncertainty will be largely resolved.
CDL has the option to trigger (force) conversion by repaying the debt at maturity by issuing
common shares. The existence of the option, however, is not sufficient to permit accounting for the
Unusual features
The lower interest rate on the debenture indicates that a large portion of the security's value lies in
the conversion feature, thus increasing the likelihood of conversion.
Other factors
There are other, less critical, factors that can be considered in determining whether the debenture
should be classified as debt or equity:
• In common with other forms of debt the debenture pays interest and therefore the return is not
dependent on earnings.
• The legal form of the instrument is debt; if CDL were liquidated, this debenture would take
precedence over equity.
• The debentures can be redeemed by the holder at the purchase price.
The most important consideration in this decision is the intention of CDL and the debt holders
regarding conversion. If we can establish that conversion is likely, then I would support the
client's classification of this debenture as equity.
There should be full disclosure in the notes to the financial statements regarding the
classification of this transaction. We must ensure that the income statement treatment of the
interest payments is consistent with the balance sheet presentation. That is, if this debenture is
classified as equity, then the interest payments should be disclosed as dividends. If Revenue
Canada requires debt treatment, then the dividends should be disclosed net of tax.
There will be no effect on CDL's basic earnings per share figure regardless of the balance sheet
treatment given to this transaction because the amount available to the common shareholders
Classification
Since the preferred shares are mandatorily redeemable in five years' time, they do not
constitute a part of CDL's permanent capital. CDL should classify share capital according to the
substance i.e. debt, which would result in the preferred shares being excluded from the
permanent equity section of the balance sheet.
Investors contribute cash to enterprises so that they can earn a return on their investment.
Whether a payment is made each year or not, an investor expects ultimately to receive the
return earned annually. In the case of a preferred share issue that is mandatorily redeemable,
the return will be provided either annually or at maturity, usually in a fixed form.
Copyright 2016 McGraw-Hill Education. All rights reserved.
Solutions Manual, Chapter 7 15
In this instance, the return has been fixed at $40 million payable in five years' time. The $40
million represents both a return of capital and income over the five-year period until maturity. In
substance, the earnings on the invested capital are accruing over the five years and will be paid
out in one lump sum. Accounting for the substance of the transaction suggests discounting the
$40 million payment and accruing the annual dividend each year as a form of interest expense.
The conversion will need to be disclosed in the notes to the financial statements.
Case 7-5
Given the changes at BSL during the year, new accounting treatments will be applied. It
appears that Jack has incorrectly handled some of the new situations from an accounting
perspective. Because the changes typically affect more than one of the companies, they have
been discussed from a transactional level rather than an entity level.
If there is objective and reliable evidence of fair value for all units of accounting in an
arrangement, the arrangement consideration should be allocated to the separate units of
accounting based on their relative fair values. In this case, we need to determine if the tank
itself, the delivery and installation costs, and the maintenance package represent separate units
of accounting. The items are considered as separate units of accounting if:
1) The item has value to the customer on a stand-alone basis; the item has value on a stand-
alone basis if it is sold separately by any vendor or the customer could resell the delivered
item on a stand-alone basis. In the context of a customer's ability to resell the delivered item,
this criterion does not require the existence of an observable market for that deliverable.
2) There is objective and reliable evidence of the fair value of the item; and
3) The items include arrangements with respect to general rights of return (if applicable).
The maintenance contract therefore appears to meet the criteria to be considered a separate
unit of accounting and should be accounted for as such. The value allocated to the maintenance
package should be accounted for as deferred revenue. The amounts will be brought into income
as the maintenance services are rendered over time.
The sale of the trucks and trailers to Transport appears to have been handled incorrectly. BSL
and Transport have both recorded this transfer, which took place after the subsidiary was set
up, at the exchange amount, shown by the $84,000 gain appearing on BSL’s income statement
and the $400,000 of property, plant and equipment appearing on Transport’s balance sheet
($431,000 purchase price less approximately $31,000 of amortization for the period).
The sale of trucks and trailers by BSL to Transport represents a related party transaction that is
not in the normal course of operations for either of these businesses, since a sale of a capital
asset is not considered to be in the course of normal operations. Secondly, because Transport
is a 100%-owned subsidiary, the ownership has not significantly changed. For these two
reasons, the carrying amount must be used to value this transaction. There is no impact at the
consolidated level because the transaction would be eliminated.
For Transport, the assets (trucks and trailers) must be recorded at their carrying amount of
$347,000, and the difference between the assets and the note payable of $431,000 ($84,000)
would be a reduction to equity.
The other related party transactions between BSL and its subsidiaries (Transport and Tanks),
the interest payments and the rent for the property (which are both at fair market value), are in
Copyright 2016 McGraw-Hill Education. All rights reserved.
18 Modern Advanced Accounting in Canada, Eighth Edition
the normal course of business and should be recorded at the exchange amount (3840.18). Jack
appears to be handling these transactions correctly. There should be disclosure of the fact that
the subsidiaries received free rent from the parent company for the first two months of the year
(in other words, the rent agreement for new location started in March, and based on the rental
income in the financial statements, rent was free prior to that date).
Management may wish to disclose the guarantee made to the environmental authority by BSL
related to Tanks’ operating license in the notes to the consolidated audited financial statements
because it increases the overall risk of BSL on a consolidated basis. In Tanks’ stand-alone
statement, management needs to consider whether it should disclose the fact that Tanks
benefits from a guarantee from BSL of Tanks’ obligations since it is being provided for free. It is
likely that this related party transaction should be disclosed.
Tanks has capitalized the $20,000 of training costs incurred to have Sean Piper certified as a
fuel tank installer. While it might be argued that there are future benefits to Sean Piper being
certified in order to operate the business and legally earn revenue, training costs are generally
not capitalized under Canadian GAAP. It is too difficult to ascertain a) whether there will actually
be any benefits (future revenue), and b) if there are, the appropriate period over which to
amortize the benefits. In this particular case, the main reason for the uncertainty is that there is
no way of guaranteeing that Sean will stay. Even though he owns 25% of the company, he
could decide tomorrow to leave or to stop being an installer. Therefore, there is no way of
controlling the use of the asset. Tanks should therefore expense the training costs in the year
incurred. The Handbook provides examples of expenditures that are not part of the cost of an
intangible, and training costs are included on that list, making the recommended treatment
option even clearer.
However, we have noted that the value of the license itself does not appear to have been
recorded as an intangible asset in Tanks. There is no indication of the cost of the license or how
Copyright 2016 McGraw-Hill Education. All rights reserved.
Solutions Manual, Chapter 7 19
long it is good for, but if the amount is large enough and has future benefit to Tanks,
management may want to capitalize the cost as an intangible asset.
Inventory Valuation
The owners have decided to stockpile scrap metal inventory this year. In the past, scrap metal
was not a material amount ($10,000 on the balance sheet of BSL). BSL is stockpiling the
inventory because management expects the price at which they can sell the metal to increase
above normal conditions.
In addition to establishing the inventory quantity, BSL needs to ensure it has properly valued its
large inventory of scrap metal in order to ensure that the inventory has been accounted for in
accordance with GAAP; in other words, at the lower of cost or net realizable value (NRV). The
challenge in establishing the NVR of the entire inventory amount is coming up with the quantity.
The metal prices should be fairly easy for management to obtain since there is a market for
scrap metal.
Warranty Provision
There may be a need for a warranty provision related to the tank installations. Additional
information is required to ascertain if this is the appropriate accounting treatment.
Case 7-6
To: Partner
From: CPA
Subject: Enviro Facilities Inc. Engagement
Overview
The Enviro Facilities Inc. (EFI) engagement has considerable risk associated with it. In
reviewing the file, I noted a number of events that raise concerns about the integrity of EFI’s
management. These events include:
1) management’s refusal to notify the bank of its error in converting foreign funds and the
inclusion of the amount of the error in income;
2) the change in the accounting estimate of the useful lives of assets, which has the effect of
increasing income;
3) the ongoing dispute with the provincial tax auditors;
4) the patent infringement suit; and
5) the rumour that an affiliated company may not comply with environmental legislation.
Moody’s has put EFI’s credit rating on alert for downgrading due to a toughening of
environmental legislation. EFI therefore has an incentive to improve the appearance of its
financial statements so as to influence Moody’s decision. A downgrade in the credit rating
would be costly to EFI as it would increase the cost of borrowing.
EFI’s managers and owners probably have an incentive to report higher income because of the
If the issue is not resolved by the time we sign the financial statements, we must decide whether
this issue should be disclosed as a contingent liability or whether the amount should be accrued
in the financial statements. If we determine that the liability is likely and the $6,314,000 is a
reasonable estimate, then it should be accrued. We should consult our tax department to help
us in this regard. The risk to us is that there could be inadequate disclosure of a material event,
which is especially crucial because of the possible sale of the shares. Conversely, disclosure
when the likelihood of the liability being realized is small may reduce the proceeds that the
current owners of the company could receive.
Bank error
The treatment of the bank error results in income being increased by $7,459,168 ($9,000,000 –
$10,000,000 / 6.49), an amount that is material. This misstatement of income could influence
the decisions of potential buyers and bond-rating agencies. Clearly, including the amount in
Copyright 2016 McGraw-Hill Education. All rights reserved.
22 Modern Advanced Accounting in Canada, Eighth Edition
income is not correct accounting. The money does not belong to EFI, and the bank could ask
for repayment once they discover the error. The amount of the error should be set up as a
liability, not included as revenue. Of course, the liability may never be paid if the bank does not
notice the error. If EFI refuses to change its method of accounting for the error, we should point
out that the amount is taxable. The company may then agree to change its accounting
approach since it imposes real economic costs. Our firm should also question whether we
should remain associated with EFI given their unwillingness to return money that clearly does
not belong to them.
The award against EFI made by the court in the patent infringement case is unusual. Aggrieved
parties normally receive a straightforward payment as compensation. The payment is usually
treated as an expense for accounting purposes. In this case, however, EFI is receiving
something that could have value, so the accounting is more complex. Various accounting
approaches could reasonably be used. First, since the purchase is a court-imposed penalty, the
$18 million share purchase could be considered to be a $20 million fine and shares to have
been acquired at zero cost. This approach would be unattractive to EFI since it would have a
significant effect on the income statement at a time when it is very concerned about the bottom
line (because of the potential sale of the shares and the alert placed on EFI’s credit rating). An
alternative approach would be to record the shares as an asset on the balance sheet at $20
million. This approach would be attractive to EFI’s management because the income statement
would be unaffected.
It is clear that EFI may be receiving an asset because of the court decision. The first step would
be to determine whether the shares would meet the definition of an asset. According to the
IFRS Framework, paragraph 49, “An asset is 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”. The
shares will be controlled by EFI and are the result of a past event (the court ruling); however
whether or not there will be any future benefits depends on the performance of Waste Systems.
If EFI is likely to derive a future benefit from the shares, then the definition of an asset has been
met.
The next question to be resolved is what the asset is worth. If the shares are to be recorded on
the balance sheet at $20 million, they must be worth $20 million. If the market value is less than
Copyright 2016 McGraw-Hill Education. All rights reserved.
Solutions Manual, Chapter 7 23
$20 million, then the amount in excess of the fair market value should be expensed since that
amount represents a penalty. Since Waste Systems Integrated Limited is a private company, it
could be difficult to arrive at a reasonable estimate of its fair market value. I strongly suggest
that we have a valuation done of the company so that we have authoritative support for the
value. Such support is especially important in view of EFI management’s concern about the
income-statement figures at the present time. That Waste Systems had been in financial
difficulty is an indication that its market value is low.
If we determine that Waste Systems has a value greater than zero and should be recorded as
an asset, a number of accounting issues will need to be resolved. We must determine whether
the shares should be considered a long- or short-term asset and whether we should
consolidate, or use the equity method. We cannot make these accounting decisions until we
have found out, for example, whether there are restrictions on EFI’s ability to sell the shares. (If
there are, accounting as a financial asset would be appropriate; otherwise, we must determine
what management’s intentions are.) Similarly, we need to find out what proportion of Waste
Systems EFI owns, to help determine the method of accounting for the investment.
Waste-disposal sites
EFI has significantly lengthened the estimated lives of its waste disposal sites and decreased
the estimated cost of sealing and cleaning up the sites. The change has a significant effect on
income, which is important because the owners are considering selling their shares. Waste-
disposal sites represent 64% of EFI’s assets and 41% of operating expenses. The disposal
sites will be an important consideration for prospective purchasers, and they may rely on the
financial statements. Thus we must exercise great care in this highly risky part of the audit.
Compounding the problem is the fact that EFI changed consulting engineers this year and the
new engineers, Cajanza Consulting Engineers (Cajanza), recommended the changes.
However, there may be an independence problem. EFI owes Cajanza $2.9 million, and the
amounts owing date back to Year 4. It is not clear why this amount has been outstanding for so
long, but EFI may be using the debt to influence Cajanza’s judgment or Cajanza may feel
pressure to provide results favorable to EFI to secure its money. It is difficult to understand how
the costs of sealing and cleaning up sites can decrease at a time when environmental regulation
is increasing, so the reduction in estimated costs requires some attention.
Given the circumstances and the incentives for management to increase earnings, additional
audit steps should be taken to satisfy us that the estimated lives and clean-up costs are
reasonable. One approach would be for us to engage an engineering firm to assess the lives
and clean-up costs of the sites.
In any case, it will be necessary for the changes in estimates to be disclosed in the notes.
EFI amortizes the costs of locating new waste-disposal sites and negotiating agreements with
municipalities. This approach is debatable and requires professional judgment to resolve.
IAS 16 states that the cost of an item of property, plant and equipment includes any costs
directly attributable to bringing the asset to the location and condition necessary for it to be
capable of operating in the manner intended by management. One could argue that locating
new waste-disposal sites and negotiating agreements with municipalities is a cost of bringing
the asset to the location and condition necessary for it to be capable of operating in the manner
intended by management.
On the other hand, one could argue that the cost associated with negotiating a contract would
be considered an administrative cost and would be expensed as incurred. According to IAS
16.19 “Examples of costs that are not costs of an item of property, plant and equipment are …
administration and other general overhead costs.”
We will have to discuss this matter with management to determine their rational for capitalizing
Copyright 2016 McGraw-Hill Education. All rights reserved.
Solutions Manual, Chapter 7 25
the cost. If we deem that it is not a cost of bringing the asset to the location and condition
necessary for use, the cost will need to be expensed.
Onkon-Lakerton contract
EFI has recognized the guaranteed portion of the contract with the Onkon-Lakerton municipality
as revenue. The revenue recognition criteria [IAS 18.20] states that “when the outcome of a
transaction involving the rendering of services can be estimated reliably, revenue associated
with the transaction shall be recognized by reference to the stage of completion of the
transaction at the balance sheet date. The outcome of a transaction can be estimated reliably
when all the following conditions are satisfied:
a) the amount of revenue can be measured reliably;
b) it is probable that the economic benefits associated with the transaction will flow to the
entity;
c) the stage of completion of the transaction at the balance sheet date can be measured
reliably; and
d) the costs incurred for the transaction and the costs to complete the transaction can be
measured reliably.
EFI may be able to support their position that the outcome of the contract with Onkon-Lakerton
can be estimated reliably, due to the guaranteed minimum revenue of $3.4 million per year.
However, IFRS still requires that revenue recognition be based on the stage of completion of
the transaction. EFI has not performed any of the work in relation to the contract. Indeed, the
contract period has not yet even begun. Therefore, EFI cannot recognize the $3.4 million of
revenue related to this contract.
US subsidiary lawsuits
Two US subsidiaries of the company are being sued for improper disposal of hazardous waste.
The alleged activities took place before EFI acquired the subsidiaries, and the sale-purchase
agreement provides for a price adjustment in the event of this type of liability. Provided that the
agreement covers the situation in question, including costs of litigation, and the previous owner
is able and willing to meet the obligation, then no additional audit work is necessary and it is not
necessary to make any disclosure in the financial statements.
If we conclude that there is some probability that EFI will be responsible for some or all of the
claims, we will have to consider a provision should be recorded in accordance with IAS 37.
In anticipation of the sale of shares by the owners, EFI plans to dispose of waste sites whose
clean-up costs exceed their carrying amount. This transaction would be a related party
transaction and must be disclosed in the notes of the financial statements [per IAS 24], which
would draw attention to the users that the company was transferring the assets.
We must determine whether EFI will be free of liabilities after selling the sites. EFI may be liable
contractually or legally for any future clean-up costs that result from past ownership. If potential
liabilities exist, they must be reported in the financial statements.
With regard to the rumour that Enviro (Bermuda) does not plan to comply with environmental
legislation, it is not necessary for us to do anything at this point because the information is only
a rumour and nothing illegal has been done yet. We should, however, be alert for information
that substantiates the rumours.
The new cost-accounting system will have an effect on the financial statements, so we need to
consider the effect of the changes carefully. Compost is a by-product of the waste-collection
process. Cost allocation to by-products is arbitrary. Costs can be allocated according to the
amount of revenue generated by the sale of compost or on the basis of direct costs, or by
allocating just the incremental costs. What management needs to know is the incremental cost
of producing compost so that management can determine whether it is profitable to make and
Copyright 2016 McGraw-Hill Education. All rights reserved.
Solutions Manual, Chapter 7 27
sell compost.
An effect of the new cost accounting system will be to increase income in the first year because
some of the costs of the waste-disposal business that would previously have been expensed
will now be included in inventory as part of the cost of the compost. Only actual costs can be
capitalized. We need to determine if the standard cost approximates actual cost. If not, an
adjustment must be made to reflect actual costs. Depending upon the magnitude of the
allocated costs and inventory, we should consider retroactive treatment.
Overall conclusion
The effects of the bank error, the sales-tax audit, and the treatment of the waste disposal sites,
etc., raise the possibility that the financial statements may be materially misstated.
Management seems to have taken steps that have had the effect of increasing the net income
and the assets on the balance sheet. We must consider whether we should resign from the
engagement altogether because of the questionable integrity of management. Among other
integrity concerns, the company’s handling of the bank error and changes in accounting
estimates, apparently to window-dress the statements, should make us question whether we
want to be associated with this client.
SOLUTIONS TO PROBLEMS
Problem 7-1
Before tax 40% tax After tax
Asset profit – Y Company selling
January 1, Year 2 – sale 45,000 18,000 27,000
Depreciation Year 2 9,000 3,600 5,400
Balance December 31, Year 2 36,000 14,400 21,600 (a)
Depreciation Year 3 9,000 3,600 5,400 (b)
Balance December 31, Year 3 27,000 10,800 16,200
Problem 7-2
Equipment gain
Before Tax 40% tax After tax
Year 2 sale – Sally selling 15,000
Depreciation Years 2 and 3 (3,000 × 2) 6,000
Balance December 31, Year 3 9,000 3,600 5,400
Depreciation Year 4 3,000 1,200 1,800 (a)
Balance December 31, Year 4 6,000 2,400 3,600 (b)
Problem 7-3
Intercompany profits – subsidiary selling
Intercompany Rent
Year 5 (42,000 × 3/12) $10,500 (f)
Parent Company
Corrected Consolidated Income Statements
Years 5 and 6
Year 5 Year 6
Miscellaneous revenues $875,000 $950,000
Miscellaneous expense 419,800 497,340
Rent expense (70,200 – (f) 10,500) 59,700
Problem 7-4
(a) Before tax 40% tax After tax
Equipment (Parent selling)
Gain on sale, Dec. 31, Year 2 $500,000 $200,000 $300,000 (a)
Depreciation Year 3
(500,000 / 5) 100,000 40,000 60,000 (b)
Balance, Dec. 31, Year 3 400,000 160,000 240,000 (c)
Depreciation Year 4 100,000 40,000 60,000 (d)
Balance, Dec. 31, Year 4 $300,000 $120,000 $180,000 (e)
Dividends received by Hanna from Fellow (200,000 x 80%) 160,000 (f)
(b)
Equipment (same as above) $10,500,000
Accumulated depreciation (same as above) 3,950,000
Problem 7-5
(a) (in 000s) i) ii) iii) iv)
NORD’s own income 200 200 200 200
HABS’s own income 500 500
Less: unrealized profit (500) (500)
HABS’s adjusted income 0 0
Consolidated net income 200
NORD’s ownership 75%
NORD’s share of HABS’s income 0
Dividend income from HABS (75% x 100) 75
NORD’s total income 200 200 275
Consolidated net income attributable to:
NORD’s shareholders 200
NCI (75% x 0) 0
200
When the parent controls the subsidiary, the consolidated financial statements best reflect the
financial position and results of operations of the combined entities. At the date of acquisition,
the net assets of the subsidiary including goodwill are reported at fair values. The net assets of
the parent are reported at their carrying values. Therefore, the consolidated financial
statements do not reflect the fair value of all assets and liabilities. However, the assets and
liabilities are reported at the values required by generally accepted accounting principles.
Problem 7-6
Amortization
Balance Balance
(b)
Dec. 31 Investment in Garden Company 50,845
Equity method income 50,845
To record 90% of adjusted subsidiary income
(56,494* × 90%)
(c) A loss is recognized on the consolidated books when the subsidiary purchased the
parent’s bonds in the open market because the bonds are deemed to be retired from a
consolidated point of view. However, the bonds have not been retired from a separate
company perspective. On the separate entity books, the discount on the bonds will
continue to be amortized and income tax will be determined based on the amortization of
the premium or discount. The total loss recognized over the remaining term of the bonds
through the amortization of the discount will equal the loss on the deemed retirement –
only the timing is different. Therefore, these differences are considered to be timing
differences and would give rise to a deferred income tax asset.
(d) The debt-to-equity ratio would increase. Debt would stay the same while equity would
decrease due to the reduction in NCI under the parent company extension theory.
Problem 7-7
(a) Before tax 40% tax After tax
Equipment (Subsidiary selling)
Gain on sale, Jan. 1, Year 5 $240,000 $96,000 $144,000 (a)
Depreciation for January, Year 6
($240,000 / 4 / 12) 5,000 2,000 3,000 (b)
Balance, Jan. 31, Year 6 $235,000 $94,000 $141,000 (c)
Dividends received by Goodkey from Jingya (600,000 x 100%) 600,000 (d)
Goodkey Co.
Consolidated Income Statement
For month ended January 31, Year 5
Sales (10,000,000 + 6,000,000) $16,000,000
Gain on sale of equipment (0 + 240,000 – (a) 240,000) 0
(b)
Everything would be the same except for other income on Goodkey’s separate entity income
statement. Under the equity method, it should exclude the dividends received from Jingya and
should include Goodkey’s share of Jingya’s net income from a consolidated viewpoint, which is
$190,000 calculated as follows:
(c)
Everything would remain the same as in part (a) except for the following:
Goodkey’s other income (800 – (d) 600 + 80% x (d) 600) 680,000
Consolidated net income would remain the same at $2,880,000 but it would be attributable
as follows:
Attributable to:
Shareholders of parent (2,880 – 190) $2,690,000
Non-controlling interest ([1,091 – (c) 141] x 20%) 190,000
Intercompany profits
Before tax 40% tax After tax
Land gain – M selling
realized in Year 9 10,000 4,000 6,000 (e)
Income of K 25,500
Add: realized profit in opening inventory (f) 7,200
32,700
Less: Amortization of acquisition differential (a) 1,250
Unrealized profit in ending inventory (g) 3,000
Adjusted profit 28,450
M Co.
Consolidated Income Statement
Year 9
Sales (600,000 + 350,000 – (d) 90,000) $860,000
Interest revenue (6,700 – (b) 6,000) 700
Gain on land sale (8,000 + (e) 10,000) 18,000
Total revenues 878,700
Cost of goods sold
(334,000 + 225,000 – (d) 90,000 – (f) 12,000 + (g) 5,000) 462,000
Distribution expense (80,000 + 70,000 – (h) 2,600 + (a) 1,250) 148,650
Administrative expense (147,000 + 74,000 – (c) 50,000) 171,000
Interest expense (1,700 + 6,000 – (b) 6,000) 1,700
Income tax expense
(20,700 + 7,500 + (e) 4,000 + (f) 4,800 – (g) 2,000 + (h) 1,040) 36,040
Total expenses 819,390
Profit 59,310
Attributable to:
Shareholders of M 53,620
Non-controlling interest (i) 5,690
$ 59,310
(b)
M Co.
Income Statement
December 31, Year 9
Sales $600,000
Interest revenue 6,700
Dividend income from subsidiary (20,000 x 80%) 16,000
622,700
Cost of goods sold 334,000
Distribution expense 80,000
Administrative expense 147,000
Copyright 2016 McGraw-Hill Education. All rights reserved.
Solutions Manual, Chapter 7 43
Interest expense 1,700
Income tax expense 20,700
583,400
Profit $ 39,300
Problem 7-9
Calculation, allocation, and amortization of acquisition differential
Total 70% 30%
Cost of investment, Jan. 1, Year 6 483,000 483,000
Fair value of NCI 195,000 195,000
678,000
Carrying amounts of Gold's net assets:
Ordinary shares 500,000
Retained earnings 40,000
Total shareholders' equity 540,000 378,000 162,000
Acquisition differential 138,000 105,000 33,000
Allocation: FV - CA
Inventory (12,000)
Land 50,000
Plant and equipment 70,000 108,000 75,600 32,400
Balance – goodwill 30,000 29,400 600
Investment 227,000
Par value 200,000
Realized loss to Pure 27,000 10,800 16,200
Problem 7-10
Copyright 2016 McGraw-Hill Education. All rights reserved.
46 Modern Advanced Accounting in Canada, Eighth Edition
Calculation, allocation, and amortization of acquisition differential
Intercompany profits
Alternative calculation:
Consolidated retained earnings, Dec. 31, Year 7 11,240,400
Retained earnings – Poplar Dec. 31, Year 7 – cost
method (10,000,000 + 1,100,000 – 600,000) 10,500,000
Difference 740,400
Investment in Spruce – cost method 2,000,000
Investment in Spruce – equity method, Dec. 31, Year 7 2,740,400
(c)
Gains should be recognized when they are realized i.e., when there has been a transaction with
outsiders and consideration has been given/received. When the parent acquires the
subsidiary’s bonds for cash in the open market, it is transacting with an outsider and giving cash
as consideration. From the separate entity perspective, the parent is investing in bonds.
However, from a consolidated point of view, the parent is retiring the bonds of the subsidiary
when it purchases the bonds from the outside entity. Therefore, when the investment in bonds
is offset against the bonds payable on consolidation, any difference in the carrying amounts is
recorded as a gain or loss on the deemed retirement of the bonds.
Problem 7-11
Cost of bonds 150,064
Par value of bonds 800,000 (a)
Less: unamortized discount 73,065 (b)
Carrying amount of bonds 726,935
Intercompany portion (160,000 / 800,000) 20% 145,387
Loss to the entity 4,677 (c)
Tax at 40% 1,871 (d)
Copyright 2016 McGraw-Hill Education. All rights reserved.
Solutions Manual, Chapter 7 51
Realized loss after tax 2,806 (e)
Beta
Realized gain (loss) on bonds (i) (14,613) (j) (5,845) (k) (8,768)
Interest elimination loss (gain) (m) (2,995) (1,198) (1,797)
Balance December 31, Year 4 gain (loss) (11,618) (4,647) (6,971) (o)
Cash 27,000
Investment in Beta Corporation 27,000
90% × 30,000 dividends from Beta
Problem 7-12
Parent Co.
Realized loss (gain) July 1, Year 7 (b) (18,750) (7,500) (11,250)
Interest elimination gain (loss)
Year 7* (1,875) (750) (1,125)
Balance loss (gain) Dec. 31, Year 7 (16,875) (6,750) (10,125) (f)
Sub. Co.
Realized loss (gain) July 1, Year 7 (c) 20,000 8,000 12,000
Interest elimination gain (loss)
Year 7* 2,000 800 1,200
Balance loss (gain) Dec. 31, Year 7 18,000 7,200 10,800 (g)
Parent Co.
Consolidated Income Statement
Year 7
Problem 7-13
Intercompany bond purchase – Oct. 1, Year 5
Realized gain to entity ((a) 8,000 – (b) 3,200) (before tax) 4,800 (c)
60% 60%
Before tax After tax Before tax After tax
Entity Palmer
Realized gain (loss) Oct. 1,
Year 5 (c) 4,800 2,880 (b) (3,200) (1,920)
Interest elimination
loss (gain)* 300 180 (200) (120)
Balance gain (loss)
Dec. 31, Year 5 4,500 2,700 (3,000) (1,800) (e)
Scott
Realized gain (loss) Oct. 1,
Year 5 (a) 8,000 4,800
Interest elimination
loss (gain)* 500 300
Balance gain (loss)
Dec. 31, Year 5 7,500 4,500 (f)
* ¼ x 3/12
Cash 9,100
Investment in Scott Corporation 9,100
70% × $13,000 Share of Scott's dividends
(a)
(b)
Current assets
Cash (175 + 91) $266
Accounts receivable (261 + 242 – (i) 182) 321
Inventory (26 + 305 – (g) 135) 796
Intangible assets
Internet domain names $100
Goodwill 75
(c)
Subsidiary’s retained earnings, beginning of year $279
Unrealized profit in beginning inventory (h) (63)
216
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Solutions Manual, Chapter 7 59
Subsidiary’s common shares 500
716
Unamortized acquisition differential (d) (317 + 21) 338
$1,054
NCI’s share (40%) $421.6
(d)
i) RAV’s separate entity income would decrease because it would report dividend income from
ENS of $153.6 (60% x $256) instead of equity method income of $250.8.
ii) Consolidated net income would remain the same because intercompany dividends and
other intercompany transactions are eliminated and only income from outsiders is reported.
Income from outsiders remains the same.
(e)
See journal entries below.
Income tax and other expenses 912,000 448,000 6 42,000 7 54,000 1,280,000
10 4,000 11 72,000
Total expenses 3,600,000 2,883,000 5,794,000
Profit $ 1,779,800 $ 447,000 $ 1,943,000
Attributable to
Non-controlling interest 12 163,200 0 163,200
Shareholders of RAV 1,779,800
Total $ 1,342,000 $ 895,000
5 Sales 650,000
Cost of sales 650,000
To eliminate intercompany sales
Problem 7-15
Year 10 income statements
P Company S Company
Sales $687,000 $416,000
Interest income 2,000
Equity method income 125,763
Gain on sale of land 7,000
Total revenues 819,763 418,000
Cost of sales 412,200 249,600
Interest expense 16,500
Selling and admin. expense 48,000 24,000
Income tax expense 15,000 9,690
Total expenses 491,700 283,290
Net income $328,063 $134,710
Realized gain to entity, July 1, Year 10 ((d) 2,000 – (e) 250) $1,750 (f)
P Company
Realized gain (loss) July 1, Year 10 (e)$(250) $(100) $(150)
Interest elimination gain (loss) Year 10* (50) (20) (30)
Balance gain (loss), Dec. 31, Year 10 $(200) $(80) $(120) (i)
S Company
Realized gain July 1, Year 10 (d) 2,000 800 1,200
Interest elimination gain Year 10* 400 160 240
Copyright 2016 McGraw-Hill Education. All rights reserved.
Solutions Manual, Chapter 7 65
Balance gain Dec. 31, Year 10 $1,600 $640 $960 (j)
½ year 8,250
Intercompany portion (40,000/ 200,000) 20% $1,650
Interest revenue – S Company
8% × (c) 40,000 × ½ 1,600
Purchase discount amortized (c) 400 2,000
Interest elimination loss – Year 10 (g) $350
Intercompany profits
Before tax 40% tax After tax
Land – S selling – realized in Year 10
(28,000 – 21,000) $7,000 $2,800 $4,200 (l)
(b) P Co.
Consolidated Retained Earnings Statement
Year 10
Problem 7-16
Champlain NCI
(80%) (20%)
Cost of 80% investment in Samuel 129,200
Fair value of NCI’s Interest in Samuel (14 x 2,000) 28,000
Champlain’s share
(80% x subtotal + Goodwill) 79,600 26,000 20,600 33,000 (d)
NCI’s share
(20% x subtotal + Goodwill) 15,600 4,400 3,950 7,250 (e)
Intercompany profits
Before tax 40% tax After tax
(b) When the gain on the sale of the equipment is eliminated on consolidation, the equipment
is restated to its carrying value on Champlain’s books prior to the intercompany sale. The
carrying value represents Champlain’s original cost less accumulated amortization based
on the historical cost. After the consolidation adjustment, the equipment is reported at the
historical cost to the consolidated entity net of accumulated amortization.
(e)
See below for summary of journal entries.
$433,128 $433,128
7 Sales 92,000
Cost of sales 92,000
To eliminate intercompany sales
1
0 Accounts payable 21,000
Accounts receivable 21,000
1
1 Dividend payable 4,400
Dividend receivable 4,400
To eliminate intercompany dividend receivable and payable
1
2 Investment in Samuel 8,400
Deferred income tax asset 5,600
Accumulated depreciation 7,000
Equipment 21,000
To eliminate intercompany gain on sale of equipment at beginning of Year 8
1
3 Accumulated depreciation 3,500
Depreciation expense 3,500
Income tax expense 1,400
Deferred income tax asset 1,400
To eliminate excess depreciation from intercompany gain on sale of equipment
1
4 Investment in Samuel 4,200
Deferred income tax asset 2,800
Land 7,000
To eliminate intercompany gain on sale of land at beginning of Year 8
1
5 Non-controlling interest-SFP 1,098
Non-controlling interest-P&L 1,098
To record NCI's share of income for the year
1
6 Non-controlling interest-SFP 2,200
Dividends paid (20% x 11,000) 2,200
To record NCI's share of dividends paid
Notes
a Consolidated retained earnings, beginning of Year 8
(= Champlain's retained earnings, beginning of Year 8 under equity method) $ 52,468
Champlain's retained earnings, beginning of Year 8 under cost method 45,500
$
Difference between cost and equity method, beginning of Year 8 6,968
Amortization
Balance Balance
Jan. 1/4 Years 4 to 8 Year 9 Dec. 31/9
Inventory $100 $100 - -
Equipment (10-year life) 500 250 $50 $200 (a)
Goodwill 10,650 9,350 190 1,110 (b)
$11,250 $9,700 $240 $1,310 (c)
Intercompany profits
Before tax 40% tax After tax
Opening inventory – Dandy selling (3,400 x 50%) $1,700 $680 $1,020 (d)
(b)
Calculation of consolidated retained earnings – Jan. 1, Year 9
Handy’s retained earnings $10,620
Unrealized gain on sale of equipment (g) (108)
Subtotal 10,512
Dandy’s retained earnings, beginning of Year 9 $7,050
Dandy’s retained earnings, at acquisition 6,500
Change in retained earnings since acquisition 550
Cumulative differential amortization and impairment (c) (9,700)
Unrealized profit in beginning inventory (d) (1,020)
(10,170)
Handy’s share @ 70% (7,119)
Consolidated retained earnings $3,393
Handy Company
Consolidated Statement of Retained Earnings
For the year ended December 31, Year 9
7 Sales 5,900
Cost of sales 5,900
To eliminate intercompany sales
Notes
a Consolidated retained earnings, beginning of Year 9
(= Handy's retained earnings, beginning of Year 9 under equity
method) $ 3,393
Handy's retained earnings, beginning of Year 9 under cost method 10,620
Difference between cost and equity method, beginning of Year 9 $ (7,227)
(CGA-Canada adapted)
Problem 7-18
Under historical cost accounting and ignoring the intercompany sale, depreciation
expense would be $500,000 / 10 years = $50,000 per year. The equipment would be
reported as follows on the balance sheet:
Year 1 Year 2 Year 3
Cost 500,000 500,000 500,000
Accumulated depreciation 50,000 100,000 150,000
Under the revaluation model and ignoring the intercompany sale, the equipment would
be reported as follows on the balance sheet:
Year 1 Year 2 Year 3
Grossed up cost 511,111 520,000 528,571
Grossed up accumulated depreciation 51,111 104,000 158,571
Carrying amount = fair value 460,000 416,000 370,000
The amounts are grossed up using the ratio of fair value / carrying amount under
historical cost model.
Under the revaluation model and ignoring the intercompany sale, the depreciation
expense would be reported as follows on the income statement:
Year 1 Year 2 Year 3
Carrying amount beginning of year 500,000 460,000 416,000
Remaining useful life 10 9 8
Depreciation expense for the year 50,000 51,111 52,000
Under the revaluation model and ignoring the intercompany sale, accumulated other
comprehensive income (AOCI) would be reported as follows on the balance sheet:
Using the above figures, the financial statement presentation would be as follows for the
separate entity and consolidated financial statements:
The germ of the best patriotism is in the love that a man has for
the home he inhabits, for the soil he tills, for the trees that gives him
shade, and the hills that stand in his pathway. I teach my son to love
Georgia—to love the soil that he stands on—the body of my old
mother—the mountains that are her springing breasts, the broad
acres that hold her substance, the dimpling valleys in which her
beauty rests, the forests that sing her songs of lullaby and of praise,
and the brooks that run with her rippling laughter. The love of home
—deep rooted and abiding—that blurs the eyes of the dying soldier
with the vision of an old homestead amid green fields and clustering
trees—that follows the busy man through the clamoring world,
persistent though put aside, and at last draws his tired feet from the
highway and leads him through shady lanes and well-remembered
paths until, amid the scenes of his boyhood, he gathers up the
broken threads of his life and owns the soil his conqueror—this—this
lodged in the heart of the citizen is the saving principle of our
government. We note the barracks of our standing army with its
rolling drum and its fluttering flag as points of strength and
protection. But the citizen standing in the doorway of his home—
contented on his threshold—his family gathered about his
hearthstone—while the evening of a well-spent day closes in scenes
and sounds that are dearest—he shall save the Republic when the
drum tap is futile and the barracks are exhausted.
This love shall not be pent up or provincial. The home should be
consecrated to humanity, and from its roof-tree should fly the flag of
the Republic. Every simple fruit gathered there—every sacrifice
endured, and every victory won, should bring better joy and
inspiration in the knowledge that it will deepen the glory of our
Republic and widen the harvest of humanity! Be not like the peasant
of France who hates the Paris he cannot comprehend—but emulate
the example of your fathers in the South, who, holding to the
sovereignty of the States, yet gave to the Republic its chief glory of
statesmanship, and under Jackson at New Orleans, and Taylor and
Scott in Mexico, saved it twice from the storm of war. Inherit without
fear or shame the principle of local self-government by which your
fathers stood! For though entangled with an institution foreign to this
soil, which, thank God, not planted by their hands, is now swept
away, and with a theory bravely defended but now happily adjusted
—that principle holds the imperishable truth that shall yet save this
Republic. The integrity of the State, its rights and its powers—these,
maintained with firmness, but in loyalty—these shall yet, by lodging
the option of local affairs in each locality, meet the needs of this vast
and complex government, and check the headlong rush to that
despotism that reason could not defend, nor the armies of the Czar
maintain, among a free and enlightened people. This issue is
squarely made! It is centralized government and the money power
on the one hand—against the integrity of the States and rights of the
people on the other. At all hazard, stand with the people and the
threatened States. The choice may not be easily made. Wise men
may hesitate and patriotic men divide. The culture, the strength, the
mightiness of the rich and strong government—these will tempt and
dazzle. But be not misled. Beneath this splendor is the canker of a
disturbed and oppressed people. It was from the golden age of
Augustus that the Roman empire staggered to its fall. The integrity of
the States and the rights of the people! Stand there—there is safety
—there is the broad and enduring brotherhood—there, less of glory,
but more of honor! Put patriotism above partisanship—and wherever
the principle that protects the States against the centralists, and the
people against the plutocrats, may lead, follow without fear or
faltering—for there the way of duty and of wisdom lies!
Exalt the citizen. As the State is the unit of government he is the
unit of the State. Teach him that his home is his castle, and his
sovereignty rests beneath his hat. Make himself self-respecting, self-
reliant and responsible. Let him lean on the State for nothing that his
own arm can do, and on the government for nothing that his State
can do. Let him cultivate independence to the point of sacrifice, and
learn that humble things with unbartered liberty are better than
splendors bought with its price. Let him neither surrender his
individuality to government, nor merge it with the mob. Let him stand
upright and fearless—a freeman born of freemen—sturdy in his own
strength—dowering his family in the sweat of his brow—loving to his
State—loyal to his Republic—earnest in his allegiance wherever it
rests, but building his altar in the midst of his household gods and
shrining in his own heart the uttermost temple of its liberty.
Go out, determined to magnify the community in which your lot is
cast. Cultivate its small economies. Stand by its young industries.
Commercial dependence is a chain that galls every day. A factory
built at home, a book published, a shoe or a book made, these are
steps in that diffusion of thought and interest that is needed. Teach
your neighbors to withdraw from the vassalage of distant capitalists,
and pay, under any sacrifice, the mortgage on the home or the land.
By simple and prudent lives stay within your own resources, and
establish the freedom of your community. Make every village and
cross-roads as far as may be sovereign to its own wants. Learn that
thriving country-sides with room for limbs, conscience, and liberty
are better than great cities with congested wealth and population.
Preserve the straight and simple homogeneity of our people.
Welcome emigrants, but see that they come as friends and
neighbors, to mingle their blood with ours, to build their houses in our
fields, and to plant their Christian faith on our hills, and honoring our
constitution and reverencing our God, to confirm the simple beliefs in
which we have been reared, and which we should transmit unsullied
to our children. Stand by these old-fashioned beliefs. Science hath
revealed no better faith than that you learned at your mother’s knee
—nor has knowledge made a wiser and a better book than the worn
old Bible that, thumbed by hands long since still, and blurred with the
tears of eyes long since closed, held the simple annals of your family
and the heart and conscience of your homes.
Honor and emulate the virtues and the faith of your forefathers—
who, learned, were never wise above a knowledge of God and His
gospel—who, great, were never exalted above an humble trust in
God and His mercy!
Let me sum up what I have sought to say in this hurried address.
Your Republic—on the glory of which depends all that men hold dear
—is menaced with great dangers. Against these dangers defend her,
as you would defend the most precious concerns of your own life.
Against the dangers of centralizing all political powers, put the
approved and imperishable principle of local self-government.
Between the rich and the poor now drifting into separate camps,
build up the great middle class that, neither drunk with wealth, nor
embittered by poverty, shall lift up the suffering and control the
strong. To the jangling of races and creeds that threaten the courts of
men and the temples of God, oppose the home and the citizen—a
homogeneous and honest people—and the simple faith that
sustained your fathers and mothers in their stainless lives and led
them serene and smiling into the valley of the shadow.
Let it be understood in my parting words to you that I am no
pessimist as to this Republic. I always bet on sunshine in America. I
know that my country has reached the point of perilous greatness,
and that strange forces not to be measured or comprehended are
hurrying her to heights that dazzle and blind all mortal eyes—but I
know that beyond the uttermost glory is enthroned the Lord God
Almighty, and that when the hour of her trial has come He will lift up
His everlasting gates and bend down above her in mercy and in
love. For with her He has surely lodged the ark of His covenant with
the sons of men. Emerson wisely said, “Our whole history looks like
the last effort by Divine Providence in behalf of the human race.” And
the Republic will endure. Centralism will be checked, and liberty
saved—plutocracy overthrown and equality restored. The struggle
for human rights never goes backward among English-speaking
peoples. Our brothers across the sea have fought from despotism to
liberty, and in the wisdom of local self-government have planted
colonies around the world. This very day Mr. Gladstone, the wisest
man that has lived since your Jefferson died—with the light of
another world beating in his face until he seems to have caught the
wisdom of the Infinite and towers half human and half divine from his
eminence—this man, turning away from the traditions of his life,
begs his countrymen to strip the crown of its last usurped authority,
and lodge it with the people, where it belongs. The trend of the times
is with us. The world moves steadily from gloom to brightness. And
bending down humbly as Elisha did, and praying that my eyes shall
be made to see, I catch the vision of this Republic—its mighty forces
in balance, and its unspeakable glory falling on all its children—chief
among the federation of English-speaking people—plenty streaming
from its borders, and light from its mountain tops—working out its
mission under God’s approving eye, until the dark continents are
opened—and the highways of earth established, and the shadows
lifted—and the jargon of the nations stilled and the perplexities of
Babel straightened—and under one language, one liberty, and one
God, all the nations of the world hearkening to the American drum-
beat and girding up their loins, shall march amid the breaking of the
millennial dawn into the paths of righteousness and of peace!