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Chapter 5

Analyzing Investing Activities: Special Topics

REVIEW
Intercompany and international activities play an increasingly larger role in business activities. Companies pursue
intercompany activities for several reasons including diversification, expansion, and competitive opportunities and returns.
International activities provide similar opportunities but offer unique and often riskier challenges. This chapter considers our
analysis and interpretation of these company activities as reflected in financial statements. We consider current reporting
requirements from our analysis perspective--both for what they do and do not tell us. We describe how current disclosures
are relevant for our analysis, and how we might usefully apply analytical adjustments to these disclosures to improve our
analysis. We direct special attention to the unrecorded assets and liabilities in intercompany investments, the interpretation of
international operations in financial statements, and the risks assumed in intercompany and international activities.

Instructor's Solutions Manual 5-1


OUTLINE

Section 1: Intercompany Activities



Intercorporate Investments
Consolidated Financial Statements
Equity Method Accounting
Analysis Implications of Intercorporate Investments


Business Combinations
Accounting Mechanics of Business Combinations
Analysis Implications of Business Combinations
Comparison of Pooling versus Purchase Accounting for Business
Combinations

Section 2: International Activities



Reporting of International Activities
International Accounting and Auditing Practices
Translation of Foreign Currencies
Analysis Implications of Foreign Currency Translation

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Instructor's Solutions Manual 5-3
ANALYSIS OBJECTIVES

Analyze financial reporting for intercorporate investments.

Interpret consolidated financial statements.

Analyze implications of both the purchase and pooling methods of accounting for
business combinations.

Interpret goodwill arising from business combinations.

Describe international accounting and auditing practices.

Analyze foreign currency translation disclosures.

Distinguish between foreign currency translation and transaction gains and losses.

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QUESTIONS
1. From a strict legal viewpoint, the statement is basically correct. Still, we must remember that consolidated financial
statements are not prepared as legal documents. Consolidated financial statements disregard legal technicalities in favor
of economic substance to reflect the economic reality of a business entity under centralized control. From the analysts'
viewpoint, consolidated statements are often more meaningful than separate financial statements in providing a fair
presentation of financial condition and the results of operations.

2. The consolidated balance sheet obscures rather than clarifies the margin of safety enjoyed by specific creditors. To gain
full comprehension of the financial position of each part of the consolidated group, an analyst needs to examine the
individual financial statements of each subsidiary. Specifically, liabilities shown in the consolidated financial statements do
not operate as a lien upon a common pool of assets. The creditors, secured and unsecured, have recourse in the event of
default only to assets owned by the individual corporation that incurred the liability. If, on the other hand, a parent
company guarantees a specific liability of a subsidiary, then the creditor would have the guarantee as additional security.

3. Consolidated financial statements generally provide the most meaningful presentation of the financial condition and the
results of operations of the combined entity. Still, they do have certain limitations, including:
The financial statements of the individual companies in the group may not be prepared on a comparable basis.
Accounting principles applied, valuation bases, and amortization rates used can differ. This can impair homogeneity
and the validity of ratios, trends, and key relations.
Companies in relatively poor financial condition may be combined with sound companies, obscuring information
necessary for effective analysis.
The extent of intercompany transactions is unknown unless consolidating financial statements (worksheets) are
presented. The latter reveal the adjustments involved in the consolidation process, but are rarely disclosed.
Unless disclosed, it is difficult to estimate how much of consolidated retained earnings are actually available for
payment of dividends.
The composition of the minority interest (such as between common and preferred stock) cannot be determined
because the minority interest is usually shown as a combined amount in the consolidated balance sheet.
Consolidated financial statements do not reveal restrictions on use of cash for individual companies nor the
intercompany cash flows.
Consolidation of nonhomogeneous subsidiaries (such as finance or insurance subsidiaries) can distort ratios and other
relations.

Instructor's Solutions Manual 5-5


4. a. This disclosure is necessaryit is a subsequent event required to be disclosed. Also, the contingency conditions
involving additional consideration are adequately disclosed. Still, it would have been more informative had the note
disclosed the market value of net assets or stocks issued.
b. This must be accounted for by the purchase method. Since the more readily determinable value in this case is the
consideration given in the form of the Best Company stock, the investment should be recorded at $1,057,386 (48,063
shares x $22 market price at acquisition). In the consolidated statements, there may or may not be goodwill to be
recognizedthis depends on a comparison of the market value of its net assets to the$1,057,386 purchase price.

c. The contingency is based on the earnings performance of the acquired companies over the next five yearsbut the
total amount payable in stock is limited to 151,500 shares, to a maximum of $2 million.

d. During the course of the next five years, if the acquired companies earn cumulatively over $1 million, then the Best
Company will record the additional payment when the outcome of the contingency is determined beyond a reasonable
doubt. The payments are considered additional consideration in the purchase and will either increase the carrying
values of tangible assets or the "excess of cost over net tangible assets" (goodwill) account.

5. a. The total cost of the assets is the present value of the amounts to be paid in the future. If the liabilities are issued at an
interest rate that is substantially above or below the current effective rate for similar securities, the appropriate amount
of premium or discount should be recorded.

b. The general rule for determining the total cost of assets acquired for stock is to value the assets acquired at the fair
value of the stock given (as traded in the market) or fair value of assets received, whichever is more clearly evident. If
there is no ready market for either the stock or the assets acquired, the valuation has to be based on the best means of
estimation, including a detailed review of the negotiations leading up to the purchase and the use of independent
appraisals.

6. a. Consolidation NOT required.


b. Consolidation NOT required.
c. Consolidation NOT required.
d. Consolidation NOT required.
e. Consolidation required.
f. Consolidation NOT required.
g. Consolidation required.

7. Usually, the purchase method of accounting for a business combination is preferable from an analyst's viewpoint. Since
purchase accounting recognizes the acquisition values on which the buyer and seller actually bargained, the balance
sheet likely reflects more realistic (economic) values for both assets and liabilities. Moreover, the income statement likely

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better reflects the actual results of operations due to accounting procedures such as cost allocation of more appropriate
asset values.

8. a. Goodwill represents the excess of the total cost over the fair value assigned to the identifiable tangible and intangible
assets acquired less the liabilities assumed.

b. It is possible that the market values of identifiable assets acquired less liabilities assumed exceed the cost (purchase
price) of the acquired company. In this case, the values otherwise assignable to noncurrent assets (except for
marketable securities) acquired should be reduced by a proportionate part of the excess. Negative goodwill should not
be recorded unless the value assigned to such long-term assets is first reduced to zero. If negative goodwill must be
recorded, it is recorded as an extraordinary gain (net of tax) below income from continuing operations

c. Marketable Securities are recorded at current net realizable values.

d. Receivables are recorded at the present value of amounts to be received, computed at proper current interest rates,
less allowances for uncollectibility and collection costs.

e. Finished Goods are recorded at selling prices less cost of disposal and reasonable profit allowance.

f. Work-in-Process is recorded at the estimated selling price of the finished goods less the sum of the costs to complete,
costs of disposal, and a reasonable profit allowance.

g. Raw Materials are recorded at current replacement costs.

h. Plant and Equipment are recorded at current replacement costs unless the expected future use of these assets
indicates a lower value to the acquirer.

i. Land and Mineral Reserves are recorded at appraised market values.

j. Payables are recorded at present values of amounts to be paid, determined at appropriate current interest rates.

k. The goodwill of the acquired company is not carried forward to the acquiring company's accounting records.

9. A crude way of adjusting for omitted values in a pooling combination is to estimate the difference between the market
value and the recorded book value of the net assets acquired, and then to amortize this difference on some reasonable
basis. The result would be approximately comparable to the net income reported using purchase accounting. Admittedly,
the information available for making such adjustments is limited.

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10. Analysis should be alert to the appropriateness of the valuation of the net assets acquired in the combination. In periods of
high stock market price levels, purchase accounting can introduce inflated values when net assets (particularly the
intangibles) of acquired companies are valued on the basis of the high market price of the stock issued. Such values, while
determined on the basis of temporarily inflated stock prices, remain on a company's balance sheet and may require future
write-downs if impaired. This concern also extends to temporarily depressed stock prices and its related implications.

11. a. An acquisition program aimed at purchasing companies with lower PE ratios can, in effect, "buy" earnings for the
acquiring company. To illustrate, say that Company X has earnings of $1 million, or $1 per share on 1 million shares
outstanding, and that its PE is 50. Now, lets assume it purchases Company Y at 10 times it earnings of $5,000,000 ($50
million price) by issuing an additional 1,000,000 shares of X valued at $50 per share. Then:
Earnings of Combined Entity are: X earnings.....$1,000,000
Y earnings..... 5,000,000
$6,000,000

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11 continued
The new number of shares outstanding is 2,000,000, providing an EPS of $3.00 (computed as $6 million divided by 2
million shares). Also, note that earnings per share increases from $1 to $3 per share for Company X by means of this
acquisition.

We should recognize the synergistic effect in this case. That is, two companies combined can sometimes show
results that are better than the total effect of each separately. This can occur through combination of vertical,
horizontal, or other basis of company integration. Consider the following example:
Company S: PE = 10
EPS = $1.00
Earnings = $1,000,000 Number of shares = 1,000,000
Company T: PE = 10
Earnings = $1,000,000
Assume Company S buys Company T at a bargain of 10 times earnings and it assumes $1,000,000 after -tax savings
from efficiencies. Then:
Combined entity:
S earnings....................................$1,000,000
T earnings.................................... 1,000,000
Savings from merger................... 1,000,000
New earnings...............................$3,000,000
New number of shares................ 2,000,000
New EPS....................................... $1.50

The EPS of the combined entity increases 50 percent (relative to Company S) as a result of this merger.

b. For adjustment purposes, the financial statements should be pooled as if the two companies had been merged prior to
the years under considerationwith any intercompany sales eliminated. This would give the best indication of the
earnings potential. However, adjusting backwards to reflect merger savings subsequently realized is a bit tenuous. It is
probably better to use the actual combined figures, with mental adjustments by the analyst. Too many "adjusted for
merger savings" statements bear little relation to the historical record. Also, the analyst may want to compare the
acquiring companys actual results with the new merged company's record to get an idea of the success of the
acquisition program. One trick in the acquisition game is to look for companies with satisfactory performance in
two prior years (say, Year 1 and Year 2) and a good subsequent year (Year 3). Such companies are prime acquisition
candidates since the Year 3 pooled statements would look good in comparison with pooled years 1 and 2. An analysis
of the acquiring companys results alone versus the combined entity would reveal this trick.

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12. The amount of goodwill that is carried on the acquirer's statement too often bears little relation to its real value based on
the demonstrated superior earning power of the acquired company. Should the goodwill become impaired, the resulting
write-down could significantly impact earnings and the market value of the company.

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13. All factors supporting the estimates of the benefit periods should be reexamined in the light of current economic
conditions. Some circumstances that can affect such estimates are:
A new invention that renders a patented device obsolete.
Significant shifts in customer preferences.
Regulatory sanctions against a segment of the business.
Reduced market potential because of an increased number of competitors.

14. The analyst should realize that there are differences in accounting principles across countries and, hence, should be
familiar with international accounting practices. The analyst should also verify the reputation of the independent auditors
before relying on them. Also, the analyst should be familiar with the provisions governing the translation of foreign
financial statements into dollars.

15. Problems in the accounting for and the analysis of foreign operations can be grouped into two broad classifications:
(a) Problems related to differences in accounting principles, auditing standards, and other reporting or economic
practices that are peculiar to the foreign country where the operations are conducted.
(b) Problems that arise from the translation of foreign assets, liabilities, equities, and results of operations into U.S. dollars.

16. The major provisions of accounting for foreign currency translation (SFAS 52) are:
The translation process requires that the functional currency of the entity be identified first. Ordinarily it will be the
currency of the country where the entity is located (or the U.S. dollar). All financial statement elements of the foreign
entity must then be measured in terms of the functional currency in conformity with GAAP.
Under the current rate method (most commonly used), translation from the functional currency into the reporting
currency, if they are different, is to be at the current exchange rate, except that revenues and expenses are to be
translated at the average exchange rates prevailing during the period. The current method generally considers the
effect of exchange rate changes to be on the net investment in a foreign entity rather than on its individual assets and
liabilities (which was the focus of SFAS 8).
Translation adjustments are not included in net income but are disclosed and accumulated as a separate component of
stockholders' equity (Other Comprehensive Income or Loss) until such time that the net investment in the foreign entity
is sold or liquidated. To the extent that the sale or liquidation represents realization, the relevant amounts should be
removed from the separate equity component and included as a gain or loss in the determination of the net income of
the period during which the sale or liquidation occurs.

17. The accounting standards for foreign currency translation have as its major objectives: (1) to provide information that is
generally compatible with the expected economic effects of a change in exchange rate on an enterprise's cash flows and
equity, and (2) to reflect in consolidated statements the financial results and relations as measured in the primary currency
of the economic environment in which the entity operates, which is referred to as its functional currency. Moreover, in

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adopting the functional currency approach, the FASB had the following goals of foreign currency translation in mind: (1) to
present the consolidated financial statements of an enterprise in conformity with U.S. GAAP, and (2) to reflect in
consolidated financial statements the financial results and relations of the individual consolidated entities as measured in
their functional currencies. The Board's approach is to report the adjustment resulting from translation of foreign financial
statements not as a gain or loss in the net income of the period but as a separate accumulation as part of equity (in
comprehensive income).

18. Following are some analysis implications of the accounting for foreign currency translation:
(a) The accounting insulates net income from balance sheet translation gains and losses, but not transaction gains and
losses and income statement translation effects.
(b) Under current GAAP, all balance sheet items, except equity, are translated at the current rate; thus, the translation
exposure is measured by the size of equity or the net investment.
(c) While net income is not affected by balance sheet translation, the equity capital is. This affects the debt-to-equity ratio
(the level of which may be specified by certain debt covenants) and book value per share of the translated balance
sheet, but not of the foreign currency balance sheet. Since the entire equity capital is the measure of exposure to
balance sheet translation gain or loss, that exposure may be even more substantial, particularly with regard to a
subsidiary financed with low debt and high equity. The analyst can estimate the translation adjustment impact by
multiplying year-end equity by the estimated change in the period to period rate of exchange.
(d) Under current GAAP, translated reported earnings will vary directly with changes in exchange rates, and this makes
estimation by the analyst of the "income statement translation effect" less difficult.
(e) In addition to the above, income will also include the results of completed foreign exchange transactions. Also, any
gain or loss on the translation of a current payable by the subsidiary to parent (which is not of a long-term capital
nature) will pass through consolidated net income.

19. The following two circumstances require use of the temporal method of translation.
(a) When by its nature, the foreign operation is merely an extension of the parent and consequently the dollar is its
functional currency.
(b) When hyperinflation (as defined) causes the translation of nonmonetary assets at the current rate to result in
unrealistically low carrying values. In such cases, in effect, the foreign currency has lost its usefulness as a measure of
performance and a more stable unit (such as the dollar) is used.

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EXERCISES

Exercise 5-1 (30 minutes)

a. Under purchase accounting, goodwill is reported if the purchase price exceeds fair value of the acquired
tangible and intangible net assets.

b. All identifiable tangible and intangible assets acquired, either individually or by type, and liabilities assumed in a
business combination, whether or not shown in the financial statements of Moore, should be assigned a portion
of the cost of Moore, normally equal to the fair values at date of acquisition. Then, the excess of the cost of
Moore over the sum of the amounts assigned to identifiable tangible and intangible assets acquired less the
liabilities assumed is recorded as goodwill.

c. Consolidated financial statements should be prepared to present financial position and operating results in a
manner more meaningful than in separate statements. Such statements often are more useful for analysis
purposes.

d. The first necessary condition for consolidation is control, as typically evidenced by ownership of a majority
voting interest. As a general rule, ownership by one company, directly or indirectly, of over fifty percent of the
outstanding voting shares of another company is a condition necessary for consolidation.

Instructor's Solutions Manual 5-13


Exercise 5-2 (35 minutes)

a. Each of the four corporations will maintain separate accounting records based on its own operations (for
example, C1's accounting records are not affected by the fact it has only one stockholder).

b. For SEC filing purposes, consolidated statements would be presented for Co. X and Co. C1 and Co. C2 as if
these three separate legal entities were one combined entity. C1 or C2 would probably not be consolidated if
controlled only temporarily. C3 would be shown as a one- line consolidation (both balance sheet and income
statement) under the equity method.

c. The analyst likely would request the following types of information (only consolidated statements normally are
available):

(1) Consolidated Co. X with subsidiaries C1 and C2 (C3 would be a one-line consolidation).
(2) Co. X statements only (all three investee companies, C1, C2, and C3 would be one-line consolidations).
(3) Separate statements for one or more of the investee companies (C1, C2, and C3).
(4) Consolidating statements (which would provide everything in (1)-(3) except separate statements for C3, and
would also show the elimination entries).
(5) Sometimes partial consolidations (such as Co. X plus C2) or combining statements (such as only C1 and C2)
also are useful. For example, if C1 is a foreign subsidiary, the analyst may ask for a partial consolidation
excluding C1, with separate statements for C1. Also, loan covenants (or loan collateral) frequently cover only
selected companies, and a partial consolidation or combined statements are necessary to assess safety
margins.

d. Co. X will show an asset "investment in common stock of subsidiary" valued at either cost or equity. (The equity
method would be required only if no consolidated statements were presented.) Note: Co. X owns shares of
common stock of Co. C1that is, Co. X does not own any of C1's assets or liabilities.

e. Instead of an "investment in common stock of subsidiary," Co. X's balance sheet would now include all of the
assets and liabilities of C1.

f. No change. Consolidated financial statements present two or more legal entities as if they are one.

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Exercise 5-2continued

g. 100 percent of C2's assets and liabilities are included in the consolidated balance sheet. However, the
stockholders' equity of C2 is split into two parts: 80 percent is added to the stockholders' equity of Co. X and 20
percent is shown on a separate line (above Co. X's stockholders' equity) as "minority ownership of C2"
(frequently just simply called "minority interest"). The portion of the 80 percent representing the past purchase
by Co. X would be eliminated (in consolidation) against the "investment in subsidiary."

h. Co. X must purchase enough additional common stock from the other stockholders in C3 or purchase enough
new shares issued by C3 to increase its ownership to more than 50 percent of C3's common stock.
(Alternatively, C1 or C2 could purchase the additional shares.)

i. There would be no intercompany investment or intercompany dividends. But any other intercompany
transactions must be eliminated (such as intercompany sales and intercompany receivables and payables).

j. No change. Instead, there would be a two-step consolidation (first C1 plus C2, then Co. X plus C1 consolidated).
Any gain or loss on the transaction would be eliminated in consolidation.

k. No change. The additional investment by Co. X would be eliminated against the additional invested capital for
C1 in the consolidation.

Instructor's Solutions Manual 5-15


Exercise 5-3 (40 minutes)

a. There are several approaches for comparing financial statements of companies using different international
accounting principles. They include:
Adopt the Foreign Corporation's Financial Statements: Here an attempt is made to analyze the foreign
corporation's financial statements from the perspective of a local investor and apply local valuation methods.
This may include a comparison with local enterprises since their financial statements are assumed to be
prepared on a similar and comparable basis.
Comparable Approach: This approach attempts to restate the earnings figures on a comparable basis using
U.S. GAAP, IASC standards, or another set of accounting practices in an appropriate manner acceptable by
the analyst.
Assessment of the Quality of Earnings: In assessing the quality of earnings, a scale or standard is developed
by the analyst. This scale or standard may incorporate considerations for such accounting choices as
inventory valuation, depreciation methods, accounting for pensions, as well as the treatment of accounting
for research and development.
Cash Flow Basis: Applied on a worldwide basis, an attempt is made to analyze the cash flows of
investments. Consideration of cash flow definitions may include cash from operations, earnings before
interest and taxes (EBIT), or changes in the financial position. The overriding rule is to analyze the
investment from a cash flow perspective.
Asset Valuation Model: An analyst can attempt to mark the assets to market values and then subtract the
indebtedness to arrive at a value for the enterprise. Alternatively, an analyst can employ a model such as the
residual income equity valuation model to obtain company value.
Dividend Valuation Model: Using a dividend valuation approach, the investor can focus on dividends (or free
cash flows) to arrive at an estimated value of the investment.

b. (1) An upward revaluation of fixed assets would increase depreciation expense on the income statement and
reduce net income. A downward revaluation of fixed assets would reduce depreciation expense on the
income statement and increase net income. Under U.S. GAAP, except in rare cases, only downward
revaluation of fixed assets is permitted. In some foreign countries, upward revaluation is also permitted as
well as current expensing of a fixed asset which can greatly distort net income for an accounting period.

(2) Under U.S. GAAP, goodwill is only recorded if purchased and then it must be carried on the balance sheet at
net book value, unless impaired. In some countries, purchased goodwill can be immediately written off
against shareholders' equity. Immediate write off of goodwill against shareholders' equity avoids potential

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future write-downs. In countries where goodwill is recorded and amortized, the longer (shorter) the
amortization period, the higher (lower) reported earnings will be. The IASC encourages a maximum of 20
years, but a longer period can be used if justified.

Instructor's Solutions Manual 5-17


Exercise 5-3continued

(3) Discretionary reserves highly depend on the convictions of management. The usual impact of discretionary
reserves on net income is to smooth the net income, allowing management to "look better" in bad years (and
not as great in good years). The creation of a discretionary reserve, when charged to income, lowers net
income in that year. Absence of the charge in a later year, or use of the reserve to cover expenses of that
year, increases net income in the later year. Discretionary reserves against fixed assets (revaluation or
impairment) will affect future depreciation charges and, therefore, net income. "Excess" depreciation
charges can also be used to lower net income in a good year.

Exercise 5-4 (20 minutes)

a. The choice of the functional currency would make no difference for the reported sales numbers. This is because
sales are translated at rates on the transaction date, or average rates, regardless of the choice of the functional
currency.

b. When the U.S. dollar is the functional currency (Bethel Company), some assets and liabilities (mainly inventory
and fixed assets) are translated at historic rates. The monetary assets and liabilities are translated at current
exchange rates. This means the translation gain or loss is based only on those assets and liabilities that are
translated at current rates. When the functional currency is the local currency (Home Brite Company), all assets
and liabilities are translated at current exchange rates, and common and preferred stock are translated at
historic rates. The translation gain or loss is based on the net investment in each local currency.

c. When the U.S. dollar is the functional currency, all translation gains or losses are included in reported net
income. When the functional currency is the local currency, the translation gain or loss appears on the balance
sheet as a separate component of shareholders' equity (in comprehensive income or loss), thus bypassing the
net income statement.
(CFA Adapted)

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Exercise 5-5 (30 minute)

a. (1) Functional currency: The functional currency approach presumes an enterprise can operate and generate
cash flows in a number of separate economic environments. The currency in that primary economic
environment is the functional currency for those operations. It is also presumed that the company can
commit to a long-term position in a specific economic environment and does not currently intend to liquidate
that position. Most companies likely will consider each foreign country in which they do business as a
primary economic environment for operations in that country and, therefore, the functional currency for the
company's operation will probably be the local currency.

(2) Translation: This is when a company converts a financial statement in foreign currency to dollar-based
financial statements. As exchange rates change, translation adjustments are produced because assets and
liabilities are translated in current exchange rates while equity accounts are translated in historical rates.
Specifically, the translation process expresses the functional currency net assets, at their dollar equivalent--
using the current rate--and creates an adjusting entry to balance the dollar-based equity. The translation
adjustment does not affect net income until a specific investment is wholly or substantially liquidated. At that
time, the component of the translation adjustment account related to that specific investment is removed
from the translation adjustment account and included in the determination of gain or loss on sale of that
specific investment component. Because the translation process is performed only for the purpose of
preparing financial statements and it does not anticipate that the foreign currency accounts will be liquidated
and exchanged into dollars, translation adjustments are not included in net income but are deferred as
adjustments to the equity section in the balance sheet (as part of comprehensive income).

b. A fundamental problem arises in the translation of foreign currency financial statements when nonmonetary
assets are translated in current exchange rates and the functional currency is highly inflationary. This situation
is referred to as the "disappearing plant." SFAS 52 has tried to address itself to this problem. A special
provision of SFAS 52 requires that the dollar be the presumptive functional currency when the economic
environment is highly inflationary. The prescribed test for a highly inflationary economy is the accumulative
inflation of approximately 100% over a three-year period. Therefore, by requiring companies in highly
inflationary economies to be remeasured to a dollar basis, SFAS 52 avoids the erosion of nonmonetary accounts
(such as plant and equipment) that otherwise would arise from translation and use of current exchange rates.

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PROBLEMS

Problem 5-1 (40 minutes)

a. Computation of Burrys Investment in Bowman Co.

($ in thousands) Investment
Cost of Acquisition................................. $40,000
Net income for Year 6............................. 1,600 [1]

Dividends for Year 6 .............................. (800) [2]

Net loss for Year 7................................... (480) [3]

Dividends for Year 7............................... (640) [4]

Investment at Dec. 31, Year 7................. $39,680

Notes ($000s):
[1] 80% of $2,000 net income
[2] 80% of $1,000 dividends
[3] 80% of $(600) net loss
[4] 80% of $800 dividends

b. The strengths associated with use of the equity method in this case include:
It reduces the balance in the investment account in Year 7 due to the net loss. Note: Just recording dividend
income would obscure the loss.
It recognizes goodwill on the balance sheet (via inclusion in the investment balance) and, therefore, it reflects
the full cost of the investment in Bowman Co.

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The possible weaknesses with use of the equity method in this case include:
Lack of detailed information (one-line consolidation).
Dollar earned by Bowman may not be equivalent to dollar earned by Burry.

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Problem 5-2 (40 minutes)
a. For Year 6:
No effect on sales.
Net income effect equals the dividend income of $10 (1% of $1,000, or $1 per share) since the investment is
accounted for under the market method. Also, assuming the shares are classified as available-for-sale (a
reasonable assumption given subsequent purchases), the price appreciation of $1 per share will bypass the
income statement.
Cash flow effect equals the dividend income of $10. If the outflow due to the stock purchase is included: Net cash
flow = dividend income less purchase price = $10 - $100 = $(90).
For Year 7 (the equity method applies):
No effect on sales.
Net income effect equals the percentage share of Francisco earnings for Year 7, or 30% of $2,200 = $660.
Cash flow effect equals the dividend income of $360 (computed as 30% of $1,200). If the outflow due to the stock
purchase is included: Net cash flow = dividend income less purchase price = $360 - $3,190 = $(2,830).
b. As of December 31, Year 6:
At December 31, Year 6, the carrying value of the investment in Francisco is $110 (computed as 10 shares x $11 per
share). The $11 per share figure is the fair value at Jan. 1, Year 7.
As of December 31, Year 7 (the equity method applies):
Step onethe equity method is applied retroactively to the prior years of ownership (that is, Year 6).
Original cost (10 shares x $10)........................................................... $100
Add: Percentage share of Year 6 earnings (1% x $2,000)................ 20
Less: Dividends received in Year 6..................................................... (10)
Net carrying value at Jan. 1, Year 7.................................................... $110
Step twothe equity method is applied throughout Year 7.
Net carrying value, Jan. 1, Year 7........................................................ $ 110
Add: Original cost of additional shares (290 shares x $11) ............ 3,190
Add: Percentage share of Year 7 earnings (30% x $2,200) ............. 660
Less: Dividends received in Year 7..................................................... (360)
Net carrying value at Dec. 31, Year 7.................................................. $3,600

c. For Year 8, with ownership in excess of 50% (indeed, 100%), Franciscos financial statements would be
consolidated with those of Potter. The purchase method is the only available choice under current GAAP. Under this

5-22 Financial Statement Analysis, 8th Edition


method, all assets and liabilities for Francisco are restated to fair market value. To do this, one must know fair market
values. Also, information about off-balance sheet items (such as identifiable intangibles) that may need to be
recognized must be obtained. Due to these implications to asset and liability values in applying purchase accounting,
knowing that the initial purchase price is in excess of the book value of the acquired companys net assets does not
necessarily indicate that goodwill is recorded.

Instructor's Solutions Manual 5-23


Problem 5-3 (35 minutes)

a. Pierson, Inc., Pro Forma Combined Balance Sheet

ASSETS
Current assets................................................................................ $135
Land................................................................................................. 70
Buildings, net................................................................................. 130
Equipment, net............................................................................... 130
Goodwill.......................................................................................... 35 *
Total assets.................................................................................... $500

LIABILITIES AND EQUITY


Current liabilities.................................................................... $140
Long-term liabilities............................................................... 180
Shareholders' equity.............................................................. 180
Total liabilities and equity..................................................... $500

*Goodwill computation:
Cash payment..........................................................................................................................
$180
Fair value of net assets acquired ($165 - $20)......................................................................
145
$ 35

b. The basic difference between pooling and purchase accounting for business combinations is that in the pooling
case there is a high likelihood of not recording all assets acquired and paid for by the acquiring company. This
results in an understatement of assets and, consequently, an overstatement of current and future net income.
This is because pooling accounting is limited to recording only book values of the acquired companys net
assets, which do not necessarily reflect current fair values of net assets. Given the inflationary tendencies of
most economies, pooling tends to understate asset values. The understatement of assets under pooling leads
to an understatement of expenses (from lack of cost allocations) and to an overstatement of gains realized on
the disposition of these assets.

5-24 Financial Statement Analysis, 8th Edition


Problem 5-4 (35 minutes)

a. They are reported in "other assets" [166] at an amount of $155.8 million under investments in affiliates, which
also includes $28.3 million as goodwill.

b. No, disclosure is limited to this note.

c. These acquisitions indicate that of the $180.1 million paid, $132.3 million is for intangibles, principally goodwill
[107]. This implies that most of the purchase price was in effect for some form of superior earning power
(residual income) assumed to be enjoyed by the acquired companies.

d. Analytical entry to reflect the Year 11 acquisitions:


Working capital items...................................... 5.1
Fixed assets net............................................... 4.7
Intangibles, principally goodwill..................... 132.3
Other assets...................................................... 1.5
Minority interest................................................ 36.5
Cash (or other consideration)................... 180.1

e. (1) The change in the cumulative translation adjustment accounts [101] for Europe is most likely due to
significant translation losses in Year 11.

(2) In the case of Australia, the decrease in the credit balance of the account may be due to sales of businesses
by Arnotts Ltd. [169A], which may have involved the removal of a proportionate part of the account as well as
gains or losses on translation in Year 11. This is corroborated by item [93] that shows a reduction in the
cumulative translation account due to sales of foreign operations.

Instructor's Solutions Manual 5-25


Problem 5-5 (25 minutes)

a. The assets and liabilities related to Fisher Price are aggregated and then segregated in the following separate
accounts:
[61] Net current assets of discontinued operations
[68] Net non-current assets of discontinued operations
[76] Payable to Fisher-Price

b. The intangible account [67], which consists primarily of goodwill, shows only a small decline for Years 10 and
11. Moreover, these declines are less than the amortization reported [143]. Given the information disclosed,
there are no obvious reasons that would explain Quakers increasing level of goodwill amortization (Year
9=$55.6, Year 10=$71.2, Year 11=$86.5 million). [One possibility is that transactions occurred in these accounts,
but Quaker deemed them immaterial for full-disclosure purposes.]

c. Gains and losses on these foreign currency forward contracts [160] are reflected in the cumulative exchange
adjustment account [88].

d. Because of the hyper-inflationary conditions confronting the Brazilian subsidiaries, the functional currency of
these subsidiaries will be deemed to be the U.S. dollar. Consequently, the temporal method of translation will
apply. This means that translation gains and losses are reflected in net income.

5-26 Financial Statement Analysis, 8th Edition


CASES

Case 5-1 (45 minutes)

a. (1) Pooling Accounting:


Investment in Wheal ........................................... 110,000
Capital StockAxel ...................................... 110,000

(2) Purchase Accounting:

Investment in Wheal............................................ 350,000


Capital StockAxel ...................................... 110,000
Other Contributed CapitalAxel ................ 240,000

b. (1) Pooling Worksheet Entries:


Capital StockWheal ........................................ 100,000
Other Contributed CapitalWheal ................... 10,000
Investment in Wheal...................................... 110,000

(2) Purchase Worksheet Entries:


Inventory ............................................................. 25,000
Property, Plant, and Equipment......................... 100,000
Secret Formula (Patent)...................................... 30,000
Goodwill............................................................... 40,000
Long-Term Debt................................................... 2,000
Accounts Receivable..................................... 5,000
Accrued Employee Pensions....................... 2,000
Investment in Wheal...................................... 190,000

Capital StockWheal ........................................ 100,000


Other Contributed CapitalWheal ................... 25,000
Retained EarningsWheal ............................... 35,000

Instructor's Solutions Manual 5-27


Investment in Wheal...................................... 160,000

c. Consolidated Retained Earnings at Dec. 31, Year 4


Pooling
Purchase
Retained Earnings, Axel.............................................. $150,000 $150,000
Retained Earnings, Wheal........................................... 35,000
Consolidated Retained Earnings................................ $185,000 $150,000

5-28 Financial Statement Analysis, 8th Edition


Case 5-2 (65 minutes)

a. Trial Balance in U.S. Dollars:

SWISSCO
Trial Balance
December 31, Year 8
Trial Exchange Trial
Balance Rate Balance
(in ) Code $/ (in $)
Cash........................................................ 50,000 C .38 19,000
Accounts Receivable............................ 100,000 C .38 38,000
Property, Plant, and Equipment, net.... 800,000 C .38 304,000
Depreciation Expense........................... 100,000 A .37 37,000
Other Expenses (including taxes)....... 200,000 A .37 74,000
Inventory 1/1/Year 8............................... 150,000 A [1] 56,700
Purchases............................................... 1,000,000 A .37 370,000
Total debits............................................. 2,400,000 898,700

Sales....................................................... 2,000,000 A .37 740,000


Allowance for Doubtful Accounts........ 10,000 C .38 3,800
Accounts Payable.................................. 80,000 C. .38 30,400
Note Payable.......................................... 20,000 C .38 7,600
Capital Stock.......................................... 100,000 H .30 30,000
Retained Earnings 1/1/Year 8............... 190,000 [2] 61,000
Translation Adjustment......................... ________ [3] 25,900
Total credits........................................... 2,400,000 898,700

Notes: C = Current rate; A = Average rate; H = Historical rate

Instructor's Solutions Manual 5-29


[1] Dollar amount needed to state cost of goods sold at average rate:
Rate $
Inventory, 1/1/Year 8 150,000 56,700 To Balance
Purchases 1,000,000 A .37 370,000
Goods available for sale 1,150,000 426,700
Inventory, 12/31/Year 8 120,000 C .38
45,600
Cost of goods sold 1,030,000 A .37 381,100

[2] Dollar balance at Dec. 31, Year 7


[3] Amount to balance.

5-30 Financial Statement Analysis, 8th Edition


Case 5-2continued
b.
SWISSCO
Income Statement (In Dollars)
For the Year Ended Dec. 31, Year 8
Sales.................................................................. $740,000
Beginning inventory......................................... $ 56,700 [1]
Purchases.......................................................... 370,000
Goods available................................................ 426,700
Ending inventory ( 120,000 = $0.36)............. (45,600) [1]
Cost of goods sold........................................... 381,100
Gross profit....................................................... 358,900
Depreciation expense...................................... 37,000
Other expenses (including taxes).................. 74,000 111,000
Net income........................................................ $247,900

[1] See Note 1 to translated trial balance.

Instructor's Solutions Manual 5-31


SWISSCO
Balance Sheet (In Dollars)
At December 31, Year 8
ASSETS
Cash.......................................................................... $ 19,000
Accounts receivable............................................... $38,000
Less: Allowances for doubtful accounts.............. 3,800 34,200
Inventory................................................................... 45,600 [A]
Property, plant, and equipment, net...................... 304,000
Total assets.............................................................. $402,800

LIABILITIES AND EQUITY


Accounts payable.................................................... $30,400
Note payable............................................................ 7,600
Total liabilities......................................................... 38,000
Capital stock............................................................ 30,000
Retained earnings: 1/1/Year 8................................ 61,000
Add: Income for Year 8........................................... 247,900 308,900
Equity Adjustment from translation of
foreign currency statements................................. 25,900 [B]
Stockholders' equity............................................... 364,800
Total liabilities and equity...................................... $402,800

Notes: [A] Ending Inventory 120,000 x 0.38


[B] First time this account appears in the financial statements.

5-32 Financial Statement Analysis, 8th Edition


Case 5-2continued

c. Unisco Corp. Entry to Record its Share in SwissCo Year 8 Earnings:

Investment in SwissCo Corporation........................... 185,925


Equity in Subsidiary's Income............................... 185,925
To record 75% equity in SwissCo's earnings of $247,900.

Note: While not specifically required by the problem, the parent would also pick up the translation adjustment as
follows:

Investment in SwissCo Corporation........................... 19,425


Equity adjustment from translation of
foreign currency statements (75% x $25,900).... 19,425

Case 5-3 (60 minutes)

a. With the dollar as the functional currency, FI originally translated its statements using the "temporal method."
Now that the pont is the functional currency, FI must use the "current method" as follows:

FUNI, INC.
Balance Sheet
December 31, Year 9
Ponts Exchange Rate Dollars
(millions) Ponts/$ (millions)
ASSETS
Cash 82 4.0 20.50
...................................................................
Accounts receivable 700 4.0 175.00
...................................................................
Inventory 455 4.0 113.75

Instructor's Solutions Manual 5-33


...................................................................
Fixed assets (net) 360 4.0 90.00
...................................................................
Total assets 1,597 399.25
...................................................................

LIABILITIES AND EQUITY


Accounts payable 532 4.0 133.00
...................................................................
Capital stock 600 3.0 200.00
...................................................................
Retained earnings 465 132.86
...................................................................
Translation adjustment (66.61)*
...................................................................
Total liabilities and equity 1,597 399.25

*Translation adjustment = 600 (1/3.0 - 1/4.0) = 600 (1/12) = (50.00)


+465 (1/3.5 -1/4.0) = 465 (1/28) = (16.61)
(66.61)

5-34 Financial Statement Analysis, 8th Edition


Case 5-3continued

FUNI, INC.
Income Statement
For Year Ended Dec. 31, Year 9
Ponts Exchange Rate Dollars
(millions) Ponts/$ (millions)
Sales 3,500 3.5 1,000.00
...................................................................
Cost of sales (2,345) 3.5 (670.00
................................................................... )
Depreciation expense (60) 3.5 (17.14)
...................................................................
Selling expense (630) 3.5 (180.00
................................................................... )
Net income 465 132.86

b. (1) Dollar: Inventory and fixed assets translated at historical rates. Translation gain (loss) computed based on
net monetary assets.
Pont: All assets and liabilities translated at current exchange rates. Translation gain (loss) computed
based on net investment (all assets and liabilities).
(2) Dollar: Cost of sales and depreciation expenses translated at historical rates. Translation gain (loss)
included in net income (volatility increased).
Pont: All revenues and expenses translated at average rates for period. Translation gain (loss) in separate
component of stockholder equity (in comprehensive income). Net income less volatile.

(3) Dollar: Financial statement ratios skewed.


Pont: Most ratios in dollars are the same as ratios in ponts.

Instructor's Solutions Manual 5-35


Case 5-4 (50 minutes)

a. IPR&D represents costs related to research and development projects where technological feasibility has not
yet been achieved. Specifically, a valuable technology has not yet been developed from the research and
development work. The cost amounts associated with IPR&D are expensed in the period of the acquisition.

b. Sapient first identified significant research projects for which technological feasibility had not been established.
The value assigned to purchased in-process technology was determined by estimating the costs to develop the
purchased in-process technology into commercially viable products, estimating the resulting cash flows from
the projects, and then discounting the cash flows to their present value. The rates used to discount the net
cash flows are based on venture capital rates of return. Venture capital rates of return are high to compensate
venture capitalists for the higher risk that they assume. The company selects a high discount rate to value the
IPR&D projects because the ultimate success of these projects is very uncertain.

c. Expenditures on these projects have been approximately $2.5 million. An estimated $625,000 is necessary to
complete these projects. The additional costs will be expensed in the period that they are incurred.

d. Research and development costs are expensed as incurred. However, in an acquisition, R&D efforts may be
expensed or capitalized based on whether the related efforts have resulted in a usable technology. The value
being capitalized by acquiring firms have already been expensed in the financial statements of the developing
company. Likewise, the costs necessary to bring non-technically feasible work to technical feasibility will be
expensed. This is construed by some as a logical inconsistency. More importantly, the designation of having or
not having reached technological feasibility is highly arbitrary and has substantial financial statement
consequences. This is why the FASB believes a new and comprehensive review of accounting for R&D is
necessary. Accordingly, analysts should be careful to assess the impact of IPR&D during a business
acquisition.

5-36 Financial Statement Analysis, 8th Edition


Case 5-5 (50 minutes)

a. When mergers occur, the resulting company is different than either of the two former, separate companies.
Consequently, it is often difficult to assess the performance of the combined entity relative to that of the two
former companies. While this problem extends to both purchase and pooling methods, it is especially apparent
when the pooling method is used. Under pooling accounting, the book values of the two companies are
combined. Lost is the fair value of the consideration exchanged and the fair value of the acquired assets and
liabilities. As a result, the assets of the combined company are usually understated. Since the assets are
understated, combined equity is understated and expenses also are understated. This means that return on
assets and return on equity ratios are overstated.

b. Tycos high price-to-earnings ratio was primarily driven by its relatively high stock price. Its high stock price
meant that poolings could be completed with relatively fewer of its shares being given in consideration.
Accordingly, a high price is crucial to Tycos ability to execute, and continue to execute, acquisitions at a
favorable price.

c. When large charges are recorded in conjunction with acquisitions, subsequent periods are relieved of these
charges. This means that future net income is increased because the items currently written off will not have to
be written off in future periods. As a result, the reported net income in future periods may be misleadingly high.
It is important that analysts assess the nature and amount of write-offs related to acquisitions to see if such
charges are actually related to past/current events or more appropriately should be carried to future periods. If
such misstatements are identified, net income in the period of the acquisition should be adjusted upward to
compensate for the over-charge, and the reported net income of future periods should be commensurately
reduced.

d. Cost-cutting can be valuable when the costs that are cut relate to redundant processes or other non-value
added processes. However, cost-cutting can have adverse consequences for the future of the company if the
costs that are cut relate to activities that bring future valuesuch potential costs include research and
development or management training.

e. When the market perceives a company to have low quality financial reporting, the stock price of the company
can fall precipitously for at least two important reasons. First, the market will assign a higher discount rate to
the company to price protect itself against accounting risk or the risk of misleading financial information.

Instructor's Solutions Manual 5-37


Second, the integrity of management is called into question. As a result, the market will not be willing to pay as
much for the stock of the company given the commensurate increase in risk.

5-38 Financial Statement Analysis, 8th Edition


Case 5-5continued

f. Focusing on earnings before special items can be a useful tool when attempting to measure earnings that is
more reflective of the permanent earnings stream and, consequently, more reflective of future earnings.
However, several companies record repeated special item charges. These companies are essentially overstating
earnings for several periods (not including those with special charges) and then catching up by recording the
huge charge. Analysts must be careful to identify such companies so that they are not relying on overstated
earnings of the company in predicting future performance. For such companies, it is prudent to assign a portion
of the charges to several periods to develop an approximation of the ongoing earnings of the company.

Instructor's Solutions Manual 5-39