CASE FOR KING AND QUEEN

In the course of the audit of King Limited (King), you, the CA, while reviewing the draft financial statements for the year ended August 31, Year 17, noticed that King's investment in Queen Limited (Queen) was measured on the cost basis. In Year 16, it had been measured on the equity basis. Representing a 22% interest in Queen, this investment had been made 10 years ago to infuse fresh equity, with a view to protecting King's source of supply for drugs.

King's controller informed you that Queen had suffered a large loss in Year 17, as shown by the May interim financial statements. King's representative on Queen's board of directors had resigned because King's purchases from Queen now constitute less than 5% of its total purchases. In addition, Queen had been uncooperative in providing profit data in time to make the year-end equity adjustment. Consequently, King's controller had revised the method of accounting for the investment in Queen.

You then found out that King's managers are planning a share issue in Year 18 and do not want their earnings impaired by Queen's poor performance. However, they are reluctant to divest themselves of Queen in case the rumoured development by Queen of a vaccine for a serious viral disease materializes.

When you approached Queen's managers, they refused to disclose any information on Queen's operations. You then learned from a stockbroker friend that Queen's poor results were due to its market being undercut by generic drug manufacturers. The loss had been increased when Queen's management wrote off most of Queen's intangible assets. You summarized the relevant information on the treatment of the investment for your audit file (Exhibit I).

Required: Discuss how King should report its investment in Queen, and describe what should be disclosed in the notes to the Year 17 financial statements. Assume that King and Queen are public companies.

EXHIBITI YOUR (THE CA'S) NOTES ON KING'S INVESTMENT IN QUEEN'S SHARES Extracts from King's draft financial statements for the year ended August 31, Year 17, in thousands of dollars, follow: Year 16 Year 17 $25,000 $27,400 Investment in Queen (Note 1) Retained Earnings: Opening balance Plus: Net earnings Less: Prior-period adjustment (Note 2) dividends Closing balance $ 2,350 7.300 9,650 $ 6,500 4,500 11,000 2,400 2,250 $ 6,350 3,150 $ 6,500 Note 1: The investment in Queen originally cost $25 million. The carrying value under the equity method at the end of Year 16 was $27.4 million. The equity adjustment for Year 16 involved the elimination of King's share of the $5 million unrealized profit included in ending inven- tory, on sales from Queen to King. Note 2: In the nine months ended May 31, Year 17, Queen reported a net loss of $140 million after writing off development and patent costs as unusual items. At the end of Year 17, King changed its method of accounting for the investment from the equity method to the cost method and reduced the investment account from $27.4 million back to its original cost of $25 million. The unrealized profit in King's ending inventory for Year 17 amounts to $1 million. King has not made any adjustment for its share of this unrealized profit in the investment account. Stock market trading in Queen's common shares has been heavy in the last year. Prices were as follows: August 31, Year 16 February 28, Year 17 August 31, Year 17 $20 5 13 King owns 2,000,000 common shares of Queen. Queen did not pay any dividends in Year 16 or Year 17