Analyzing Investing Activities: Intercorporate Investments: Review

Chapter 05 - Analyzing Investing Activities: Intercorporate Investments
Chapter 5
Analyzing Investing Activities:
Intercorporate Investments
REVIEW
Intercompany investments play an increasingly larger role in business activities.

Companies pursue intercompany activities for several reasons including diversification,
expansion, and competitive opportunities and returns. This chapter considers our
analysis and interpretation of these intercompany 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.
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OUTLINE
Passive investments
Accounting for Investment Securities
Disclosure of Investment Securities
Analyzing Investment Securities

Investments with Significant Influence
Equity Method Accounting
Analysis Implications of Equity Investments

Business Combinations
Accounting Mechanics of Business Combinations
Analysis Implications of Business Combinations
Comparison of Pooling versus Purchase Accounting for Business
Combinations
Derivative Securities
Defining a Derivative
Classification and Accounting for Derivatives
Disclosure of Derivatives
Analysis of Derivatives
Appendix 5A: International Activities

Appendix 5B: Investment Return Analysis
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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 derivative securities and their implications for analysis.
Analyze foreign currency translation disclosures.
Analyze investment returns.
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QUESTIONS
1. Long-term investments are usually investments in assets such as debt instruments,
equity securities, real estate, mineral deposits, or joint ventures acquired with longer-
term goals. Such goals often include the acquisition of control or affiliation with other
companies, investment in suppliers, securing sources of supply, etc. The valuation
and presentation of noncurrent investments depends on the degree of influence that
the investor company has over the investee company. With no influence, debt
investments other than held-to-maturity bonds and equity investments are accounted
for at market value. Once influence is established, equity investments are accounted
for under the equity method or consolidated with the statements of the investor
company.
a. In the absence of evidence to the contrary, an investment (direct or indirect) in

20% or more of the voting stock of an investee carries the presumption of an
ability to exercise significant influence over the investee. Conversely, an
investment of less than 20% in the voting stock of the investee leads to the
presumption of a lack of such influence unless the ability to influence can be
demonstrated. Accounting requirements are: Held-to-maturity securities are
reported at amortized cost. Noncurrent available-for-sale securities are reported at
fair value. Influential securities are accounted for under the equity method.
b. Standards indicate that a position of more than 20% of the voting stock might give
the investor the ability to exercise significant influence over the operating and
financial policies of the investee. When such an ability to exercise influence is
evident, the investment should be accounted for under the equity method.
Basically this means at cost, plus the equity in the earnings or losses of the
investee since acquisition (with the addition of certain other adjustments).
Evidence of an investor's ability to exercise significant influence over operating
and financial policies of the investee is reflected in several ways such as
management representation and participation. While eligibility to use the equity
method is based on the percent of voting stock outstanding, that can include, for
example, convertible preferred stock, the percent of earnings that can be picked
up under the equity method depends on ownership of common stock only.
2. a. The accounting for investments in common stock representing over 20% of equity
requires the equity method. While use of the equity method is superior to
reporting cost, one must note that this is not equivalent to fair market value
which, depending on the circumstances, can be significantly higher or lower than
the carrying amount under the equity method.
An analyst also must remember that the presumption that an investment holding
of 20% or more of the voting securities of an investee results in significant
influence over that investee is arbitraryan assumption made in the interest of
accounting uniformity. If such influence is absent, then there is some question
regarding the investor's ability to realize the amount reported.
b. A loss in value of an investment that is other than a temporary decline should be

recognized the same as a loss in value for other long-term assets. This statement
suggests considerable judgment and interpretation and, in the past, has resulted
in companies being very slow to recognize losses in their investments. Since
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accounting does not consider a decline in market value to be conclusive evidence

of such a loss, the analyst must be alert to situations where hope rather than
reason supports the carrying amount of an investment. It must be recognized that
the equity method reflects only current operating losses rather than the capital
losses that occur when the earning power of an investment deteriorates or
disappears.
3. Some weaknesses and inconsistencies pertaining to the accounting for marketable

securities carried as noncurrent assets include:
The classification of securities as noncurrent investments is based on
management intent, a subjective notion.
Changes in the fair value of noncurrent available-for-sale securities bypass net
income.
Equity securities of companies in which the enterprise has a 20 percent or larger
interest, and in some instances an even smaller interest than 20 percent, need not
be adjusted to market. Instead, it is reported using the equity method, which may
at times yield values significantly below and at other times above, market.
With regard to such relatively substantial blocks of securities, the values at which
they are carried on the balance sheet may be substantially different that their
realizable values.
4. Generally, investments in marketable securities are one use of excess cash available
to managers. Other uses include financing growth projects, paying down debt, paying
dividends, or buying back stock. In certain instances, the purchase of investment
securities is viewed as an admission by the company that they have no positive net
present value growth projects available to direct its monies.
5. Hedging activities are designed to protect the company against fluctuations in market
instruments. Speculative activities seek to profit on fluctuations in market
instruments.
6. A futures contract is an agreement between two or more parties to purchase or sell a

certain commodity or financial asset at a future date and at a definite price.
7. A swap contract is an arrangement between two or more parties to exchange future

cash flows. Swaps are typically used to hedge risks such as interest rate and foreign
currency risks.
8. An option contract gives a party the right, but not an obligation, to execute a
transaction. An option to purchase a security at a specified price at a future date is an
example of an option contract. This option is likely to be exercised if the security
price on that future date is higher than the contract price and not otherwise.
9. A hedge transaction is a transaction executed in an attempt to protect the company

against a specific market risk.
10. To qualify for hedge accounting, a derivative instrument must hedge either the fair
value or the cash flows of an asset, liability, or some other exposure.
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11. A cash flow hedge is designed to hedge exposure to volatility in cash flows
attributable to a specific risk. An example of a cash flow hedge is a floating-for-fixed
interest rate swap. This swap hedges the cash flows related to an interest-bearing
financial instrument. An example of a fair value hedge is a fixed future commitment to
sell a fixed quantity of a commodity at a specified price. This transaction hedges the
fair value of the commodity against loss before the time that it is sold.
12. In fair value accounting, both the hedging instrument and the hedged asset or
liability are recorded at fair value in the balance sheet. All realized and unrealized
gains and losses on both the hedging instrument and the hedged asset or liability are
immediately recognized in income.
Unrealized gains and losses relating to the effective portion of a cash flow hedge are
immediately recorded as part of other comprehensive income up to the effective date
of the transaction. After the effective date of the transaction, the gains and losses are
transferred to income. The cash flow hedging instrument is recorded at fair value on
the balance sheet. However, there is no offsetting asset or liability as in the case of a
fair value hedge. Instead, the offset in the balance sheet occurs through
accumulated comprehensive income, which is part of equity.
13. Speculative derivatives are recorded at fair value on the balance sheet and any
unrealized or realized gains or losses are immediately recorded in net income.
14. 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.
15. 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.
16. 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.
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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.
17. 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.
18. 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.
19. 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 better reflects the actual results of operations due to
accounting procedures such as cost allocation of more appropriate asset values.
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20. 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.
21. 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.
22. 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
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write-downs if impaired. This concern also extends to temporarily depressed stock

prices and its related implications.
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23. 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
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
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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.
24. 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.
25. 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.
26.A 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.
27. A 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 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
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loss in the net income of the period but as a separate accumulation as part of equity
(in comprehensive income).
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28. A 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.
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EXERCISES
Exercise 5-1 (20 minutes)
a. Usual objectives underlying the holding of both current and noncurrent

portfolios of securities are:
Currentfor temporary investments of excess cash in highly liquid
investments.
Noncurrentfor investment income, appreciation value, control purposes of
another entity, or to secure sources of supplies or avenues of sales.
b. Securities should be classified as follows: Trading securities are always

classified as current. Held-to-maturity securities are classified as noncurrent,
except for the reporting period immediately prior to maturity. Available-for-sale
securities are classified as current or noncurrent based on managements
intent regarding sale. Influential securities are noncurrent unless their sale is
imminent. Marketable securities that are temporary investments of cash
specifically designated for special purposes such as plant expansion or
sinking fund requirements are classified as noncurrent.
Unrealized losses on trading securities (which are classified as current

assets) are the only unrealized losses to flow through the income statement.
Unrealized losses on noncurrent investments (and current investments in
available-for sale securities) are included as a separate component of
shareholders' equity. Some analysts treat much if not all of these unrealized
gains and losses as another component of adjusted net income.
a. When available-for-sale securities are marked to market, an asset account is

adjusted to market (either upward or downward) and an equity account is
increased when marked up or decreased when marked down.
b. If the investments being marked to market were trading securities instead of

available-for-sale securities, then an asset account would be adjusted to
market. In addition, a gain or loss account that flows through income would
also be included to reflect the change in market value (and equity would
change accordingly when income is closed to it).
c. Although under available-for-sale accounting unrealized gains are not

recorded, realized gains are reflected in reported income. Microsoft, therefore,
can sell securities with unrealized gains and increase its reported income.
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a. Passive interest investments declared to be available-for-sale or trading

securities are reported at fair market value on the balance sheet. Passive
interest investments declared to be held-to-maturity are reported at historical
cost. Significant influential investments are reported at historical cost
increased by a pro rata share of investee net income and decreased by a pro
rata share of dividends declared by the investee company. Controlling
interests investments are reported using consolidation procedures.
b. Passive interest investments declared to be trading or available-for-sale

securities are reported at fair market value. Fluctuations in the value of
trading securities are reported in net income in the period of the fluctuation.
Fluctuations in the value of available-for-sale securities are reported in
comprehensive income of each period.
c. Held-to-maturity securities are reported at historical cost because period to

period value fluctuations are arguably less relevant since the company
intends to hold the security to maturity and receive the maturity value of the
investment. On one hand, not reporting the volatility in the value of held-to-
maturity securities seems appropriate since the company does not intend to
sell the security at its higher or lower current value. On the other hand,
management intent can change, and such changes in market value directly
impact the value of the company.
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.
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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.Exercise 5-5 (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.
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e. 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."
Exercise 5-5concluded
f. 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.)
g. 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).
Exercise 5-6A (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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PROBLEMS
Problem 5-1 (20 minutes)
a. Investments Reported on the Balance Sheet:

Able Corp. bonds ............................ $ 330
Bryan Co. bonds ........................................................825
Caltran, Inc. bonds ....................................................515
Available-for-sale equity securities ......................1,600
Trading equity securities ..................................... 950
Total........................................................................$4,220
b. Reporting of Unrealized Value Fluctuations:

Unrealized price fluctuations on available-for-sale securities are reported in
comprehensive income (Bryan Co. bonds and available-for-sale equity
securities).
Unrealized price fluctuations on trading securities are reported in net
income (Caltran bonds and trading equity securities).
1. Since the aggregate market value of the portfolio exceeds cost, there is no
write down of the individual security whose market value declined to less than
one-half of its cost. Stockholders' equity will be increased (decreased) to the
extent that the excess of market over cost has increased (decreased) over the
period. There is no effect on the income statement.
2. This situation is similar to 1 above. The only difference is that the firm in
question does not use the classified balance sheet format. In this case, the
analyst must be sure to review note disclosures regarding the classification of
investments (if not provided on the face of the balance sheet).
3. This is not a reclassification between categories as the securities remain in

the available-for-sale category. However, the analyst should note that
management is contemplating a sale in the near future.
4. The increase in fair value of the security should be credited to shareholders'

equity. (Since the security is classified as noncurrent, it cannot be a trading
security).
5-18
a. Effects of Investments on Simpson Corp.:

2004 (Fair Value Method Applies):
Sales: Investment has no effect on Simpsons sales.
Net income: Simpsons net income increases by the 2004 dividend income
from Bailey Company (BC) of $10,000 (computed as:
[$1,000,000 dividend /1,000,000 shares = $1.00 per
share] x 10,000 shares = $10,000)
Cash flows: Dividends received (1% of $1,000,000) $ 10,000
Cost of shares (10,000 shares x $10) (100,000)
Net cash flow $(90,000)
2005 (Equity Method Applies)

Sales: Investment has no effect on Simpsons sales.
Net income: Simpsons net income increases by 30% share earnings
of Bailey Company (BC) (computed as: [300,000 shares /
1,000,000 shares = 30%] x $2,200,000 income =
$660,000)
Cash flows: Dividends received (30% of $1,200,000) $ 360,000
Cost of shares (290,000 shares x $11) (3,190,000)
Net cash flow $(2,830,000)
b. Carrying (Book) Value of Investment in Bailey Company:

2004 (Fair Value Method Applies)
At December 31, 2004, Simpsons carrying value of the investment in BC is
the historical cost of $100,000 (10,000 shares * $10 per share).
2005 (Equity Method Applies)Two Steps

(i) Equity method is applied retroactively to prior years of ownership
(2004):
Original cost ($10 x 10,000 shares) $100,000
Add: Percentage share of 2004 earnings (1% x $2,000,000) 20,000
Less: Dividends received in 2004 (10,000)
Net carrying value at January 1, 2004 ($11 per share) $110,000
(ii) Equity method is carried through year-end 2005:

Net carrying value at January 1, 2004 $ 110,000
Add: Original cost of additional shares ($11 x 290,000) 3,190,000
Add: Percentage share of 2005 earnings (30% x $2,200,000) 660,000
Less: Dividends received in 2005 (360,000)
Net carrying value at December 31, 2005 ($12 per share) $3,600,000
c. Accounting method for 2006. For 2006, with ownership in excess of 50% (in
this case, 100%) and Simpson in control of BC, the consolidation method is
used to combine BCs financial statements with those of Simpson. In a
consolidation, only the purchase method is available to account for the
investmentpooling of interest is not allowed.
5-19
a. Computation of Burrys Investment in Bowman Co.
($ 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.
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.
5-20

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 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.
5-21
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.
5-22
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.
5-23
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
Capital StockWheal ........................................ 100,000

Other Contributed CapitalWheal ................... 25,000
Retained EarningsWheal ............................... 35,000
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
5-24
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. 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.
5-25
Case 5-2continued
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.
5-26
a. See table below.

b. See table below.
Accounting
Newmonts Treatment by
Transaction Strategy Newmont Accounting Treatment under SFAS 133
(pre-SFAS 133)
Forward Sales of To lock-in the price No unrealized gain or Classification: Cash Flow Hedge.
125,000 ounces of future gold sales. loss recorded in the The fair value of the forward sale (future) recorded as asset and
from Indonesian Hedge. books. Realized gains liability (as the case may be) in the balance sheet until the date
mine @ $454 per and losses recorded of actual sale. The compensating effect goes to accumulated
ounce when sold. comprehensive income. Any change in fair value of forward sale
(future) is recognized in other comprehensive income. At the
time of sale, accumulated comprehensive income is adjusted
with net income so that the amount recognized as revenue is
$454/ounce.
Purchased calls To provide an No unrealized gain or Classification: Fair-Value Hedge of above fixed commitment. The
on 50,000 ounces upside potential for loss recorded in the forward sale commitment @ $454/ounce is the hedged item for
with strike price 40% of the forward books. Realized gains this instrument. The call is recorded at fair value. The net
$454 linked to the sales in case of and losses recorded income effect is the difference between the value of the call and
forward sale. break out of gold when sold. the value of the equivalent quantity (50,000 ounces) of forward
price above $454. sales. The effect of 50,000 ounces of the above forward sale is
removed from accumulated comprehensive income and other
comprehensive income (because it is now recorded in net
income). The purchase cost of the call is amortized over its
holding period.
Prepaid Sale in To raise immediate No unrealized gains Classification: Cash Flow Hedge.
July 1999: 483,333 cash to service and losses are Note the fair value of the instrument is non-zero only when the
ounces at various debt. Secondary recognized. Realized gold price is above $380 or below $300. Fair value is recorded in
prices with a floor objective, to hedge price recorded on the balance sheet and offset by accumulated comprehensive
of $300 and ceiling downside risk date of sale. income. Any change in fair value is recognized in other
of $380. below $300 per Prepaid amount comprehensive income. At time of sale, accumulated
ounce, but provide computed @ $300 per comprehensive income is adjusted with net income so that the
upside potential up ounce and treated as realized amount (variable between $300 and $380 per ounce) is
to $380. A hedge deferred revenue that recorded as revenue. The deferred revenue accounting is
with some limited is adjusted when unchanged.
upside potential actual sales occur to
within a range. reflect the actual
sales proceeds.
5-27
Case 5-3continued (parts a & b)
Accounting
Newmonts Treatment by
Transaction Strategy Newmont Accounting Treatment under SFAS 133
(pre-SFAS 133)
Prepaid Sales in To raise immediate No unrealized gains Classification: Cash Flow Hedge. Accounting effects similar to
July 1999: 35,900 cash to service and losses the first instrument in this table (forward sale on Indonesian
per annum at debt. Yet, first recognized on either mine).
some fixed price instrument locks-in security. Realized
(no information sales price, the (fixed) price on
given about fixed second instrument forward sale adjusted
price). reverses it. So the by the value of
objective is clearly forward purchase
not hedging recorded when sold,
related. whereby the revenue
recorded is identical
Forward purchase to actual realization. Classification: Fair Value Hedge of the forward sale (which is a
in July 1999 of fixed commitment). Recorded at fair value and any unrealized
identical Treated as deferred gains and losses on both the forward sale and purchase
quantities at revenue that is recorded in net income. Together both the sale and purchase
prices ranging adjusted when actual have no effect on income or balance sheet.
from $263 to $354. sales occur.
Purchased Put To provide No unrealized gains Classification: Difficult to say. Probably fair-value hedge
Option in August downside risk and losses because it is not linked to forecast sale of gold. Fair value of
1999 for 2.85 protection for 2.85 recognized. Cost of puts and equivalent quantity of gold reported at fair value in
million ounces. million ounces but put options amortized balance sheet. Unrealized gains and losses on puts and
allow for upside over term. equivalent quantity of gold charged to net income.
potential.
Written Call To finance the put All unrealized gains Classification: Speculative transaction. Fair value on balance
Options in August purchase. and losses recorded sheet and all unrealized gains and losses charged to net income.
1999 for 2.35 in net income.
million ounces.
5-28
Case 5-3continued
c. Forward sales: Economically, this agreement locks in the cash flows

associated with sales. There is no potential for gain or loss on this sales
price. As a result, risk is removed. The accounting treatment does reflect the
economics of this transaction as there is no impact until the date of sale.
Purchased calls: Economically this agreement makes the lock in of $454 on
40% of the forward sales a floor sales price, with no economic impact until the
date of sale. Earlier method does reflect the economics. SFAS 133 treatment
recognizes the change in value over time even though no cash will change
hands until the date of sale.
Prepaid sale: Economically, this agreement locks the cash flows associated
with the sales into a specified range. The deferred revenue treatment is
consistent with the economics. Hedge accounting treatment, both before
SFAS 133 and under SFAS 133, is consistent with the economics as there is no
income statement impact until the date of sale.
Prepaid sale (35,900 ounces) and forward purchase (35,900 ounces):
Considered simultaneously, the economic impact of these transactions is a
wash and the accounting treatment reflects this offsetting effect.
Purchased put option: Economically, this option sets a floor on the sales price
of 2.85 million ounces of product. The accounting treatment, both before
SFAS 133 and under SFAS 133 should be a good reflection of the economic
reality.
Written call option: Economically, this option exposes the company to lower
sales prices in the future. The value of this option will change over time. Thus,
the accounting treatment is an adequate reflection of the economics.
d. The justification for not allowing the hedging treatment comes from the fact
that the written calls are not hedging a specific transaction or event. SFAS 133
requires that the derivative be tied to a specific transaction, not just an overall
business risk.
e. Newmonts criticism is valid if hedging is defined in terms of firm-wide risk,

rather than in terms of transaction risk. From the firm-wide perspective,
Newmont is correct in describing the economic impact as only being the
opportunity cost of selling at a higher price in the future.
f. The economic reality is that Newmont was unable to benefit fully from the
sudden increase in gold prices because of its various hedging arrangements.
The financial statements exaggerate the opportunity costs of the hedging
program, primarily because the loss recognized on the written options is not
offset by an increase in the value of the gold reserves.
5-29
Case 5-4A (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............................................... 1,000,000A .37 370,000
Total debits............................................. 2,400,000 898,700
Sales....................................................... 2,000,000A .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

[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
Case 5-4Acontinued
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 x $0.38)............. (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.
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

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
5-31
Notes: [A] Ending Inventory 120,000 x 0.38

[B] First time this account appears in the financial statements.
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
5-32
Case 5-5A (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
...................................................................
Fixed assets (net) 360 4.0 90.00
...................................................................
Total assets 1,597 399.25
...................................................................

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)
5-33
Case 5-5continued
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.
5-34

Analyzing Investing Activities: Intercorporate Investments: Review

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Analyzing Investing Activities: Intercorporate Investments: Review

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Chapter 05 - Analyzing Investing Activities: Intercorporate Investments

Intercompany investments play an increasingly larger role in business activities.

Analyze financial reporting for intercorporate investments.

Interpret consolidated financial statements.

Interpret goodwill arising from business combinations.

Describe derivative securities and their implications for analysis.

Analyze foreign currency translation disclosures.

Analyze investment returns.

a. In the absence of evidence to the contrary, an investment (direct or indirect) in

b. A loss in value of an investment that is other than a temporary decline should be

accounting does not consider a decline in market value to be conclusive evidence

3. Some weaknesses and inconsistencies pertaining to the accounting for marketable

6. A futures contract is an agreement between two or more parties to purchase or sell a

7. A swap contract is an arrangement between two or more parties to exchange future

9. A hedge transaction is a transaction executed in an attempt to protect the company

16. Consolidated financial statements generally provide the most meaningful

The extent of intercompany transactions is unknown unless consolidating

17. a. This disclosure is necessaryit is a subsequent event required to be disclosed.

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

d. Receivables are recorded at the present value of amounts to be received,

f. Work-in-Process is recorded at the estimated selling price of the finished goods

g. Raw Materials are recorded at current replacement costs.

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

write-downs if impaired. This concern also extends to temporarily depressed stock

The new number of shares outstanding is 2,000,000, providing an EPS of $3.00

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

Exercise 5-1 (20 minutes)

a. Usual objectives underlying the holding of both current and noncurrent

b. Securities should be classified as follows: Trading securities are always

Unrealized losses on trading securities (which are classified as current

Exercise 5-2 (12 minutes)

a. When available-for-sale securities are marked to market, an asset account is

b. If the investments being marked to market were trading securities instead of

c. Although under available-for-sale accounting unrealized gains are not

Exercise 5-3 (20 minutes)

a. Passive interest investments declared to be available-for-sale or trading

b. Passive interest investments declared to be trading or available-for-sale

c. Held-to-maturity securities are reported at historical cost because period to

Exercise 5-4 (30 minutes)

a. Under purchase accounting, goodwill is reported if the purchase price

b. All identifiable tangible and intangible assets acquired, either individually or

c. Consolidated financial statements should be prepared to present financial

d. The first necessary condition for consolidation is control, as typically

a. Each of the four corporations will maintain separate accounting records

(1) Consolidated Co. X with subsidiaries C1 and C2 (C3 would be a one-line

d. Co. X will show an asset "investment in common stock of subsidiary" valued

g. There would be no intercompany investment or intercompany dividends. But

Exercise 5-6A (20 minutes)

Problem 5-1 (20 minutes)

a. Investments Reported on the Balance Sheet:

b. Reporting of Unrealized Value Fluctuations:

Problem 5-2 (30 minutes)

3. This is not a reclassification between categories as the securities remain in

4. The increase in fair value of the security should be credited to shareholders'

Problem 5-3 (45 minutes)

a. Effects of Investments on Simpson Corp.:

2005 (Equity Method Applies)

b. Carrying (Book) Value of Investment in Bailey Company:

2005 (Equity Method Applies)Two Steps

(ii) Equity method is carried through year-end 2005:

Problem 5-4 (40 minutes)

a. Computation of Burrys Investment in Bowman Co.