In the course of the audit of Abbott Drug Limited (ADL), the CPA, while reviewing the draft

financial statements for the year ended August 31, 2020, noticed that ADL's investment in

National Pharmaceuticals Limited (NPL) was valued on the cost basis. In 2019, it had been

valued on the equity basis. Representing a 22% interest in NPL, this investment had been made

10 years ago to inject fresh equity, with a view to protecting ADL's source of supply for drugs.

ADL's controller informed CPA that NPL had suffered a large loss in 2020, as shown by the

May interim financial statements. ADL's representative on NPL's board of directors had

resigned because ADL's purchases from NPL now constituted less than 5% of its total

purchases. In addition, NPL had been uncooperative in providing profit data in time to make the

year-end equity adjustment. Consequently, ADL's controller had revised the method of

accounting for the investment in NPL.

CPA then found out that ADL's managers are planning a share issue in 2021 and do not want

their earnings impaired by NPL's poor performance. However, they are reluctant to divest

themselves of NPL in case the rumoured development by NPL of a new drug to reduce the

impact of Covid-19 materializes.

When CPA approached NPL's managers, they refused to disclose any information on NPL's

operations. CPA then learned from a stockbroker friend that NPL's poor results were due to its

market being undercut by generic drug manufacturers. The loss had been increased when NPL's

management wrote off most of NPL's intangible assets. CPA summarized the relevant

information on the treatment of the investment for his audit file (Exhibit A).

Required

Assumed the role of the CPA, prepare the report, outlining the accounting issues, to the partner in charge of the audit.

EXHIBIT A

CPA's NOTES ON INVESTMENT IN NPL's SHARES

Extracts from ADL's draft financial statements for the year ended August 31, 2020, in thousands

of dollars:

2020 2019

(Draft) (Actual)

Investment in NPL (Note 3) $25,000 (1) $27.400 (2)

Retained earnings:

Opening balance $ 6,500 $ 2,350

plus: net earnings 4,500 7,300

11,000 9,650

less: prior period adjustment (Note 1) (2,400) -

dividends (2,250) (3,150)

Closing balance $ 6,350 $ 6,500

Note 1:

Represents original cost. The 2019 balance has been reduced by the amount of previously recorded

equity interest of $2.4 million. In the nine months ended May 31, 2020, NPL reported a net loss

of $140 million after writing off development and patent costs as unusual items.

Note 2:

Valued on equity basis. Equity adjustment for 2019 involved the elimination of $5.5 million

unrealized profit included in ending inventory, on sales from NPL to ADL. The unrealized profit

in ADL's ending inventory for 2020 amounts to $1.5 million.

Note 3:

Stock market trading in NPL's common shares has been heavy in 2020. Prices for the year are as

follows:

August 31, 2019: $22.00

February 28, 2020: $ 4.00

August 31, 2020: $12.00

ADL owns 2,000,000 common shares of NPL; in neither 2019 nor 2020 did NPL declare or pay

any dividends.