CH 05 Analyzing Investing Activities Intercorporate Investments

Chapter 05 - Analyzing Investing Activities: Intercorporate Investments
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 arbitrary—an 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 necessary—it 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 recognized—this 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 years—but 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 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, let’s 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 consideration—with 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 company’s 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 company’s 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 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:
Current—for temporary investments of excess cash in highly liquid investments.
Noncurrent—for 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 management’s 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. C1—that 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 5-5—concluded
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).
5-16
a. Effects of Investments on Simpson Corp.:

2004 (Fair Value Method Applies):
Sales: Investment has no effect on Simpson’s sales.
Net income: Simpson’s 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 Simpson’s sales.
Net income: Simpson’s 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, Simpson’s 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) $3,600,000
c. Accounting method for 2006. For 2006, with ownership in excess of 50% (in this
case, 100%) and Simpson in control of BC, the consolidation method is used to
combine BC’s financial statements with those of Simpson. In a consolidation,
only the purchase method is available to account for the investment–pooling of
interest is not allowed.
5-17
a. Computation of Burry’s Investment in Bowman Co.
($ 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.
5-18

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 one—the 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 two—the 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%), Francisco’s 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
company’s net assets does not necessarily indicate that goodwill is recorded.
5-19
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 company’s 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.
5-20
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.
5-21
CASES
Case 5-1 (45 minutes)
a. (1) Pooling Accounting:

Investment in Wheal .......................................... 110,000
Capital Stock—Axel ..................................... 110,000
(2) Purchase Accounting:
Investment in Wheal .......................................... 350,000

Capital Stock—Axel ..................................... 110,000
Other Contributed Capital—Axel ............... 240,000
b. (1) Pooling Worksheet Entries:

Capital Stock—Wheal ....................................... 100,000
Other Contributed Capital—Wheal .................. 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 Stock—Wheal ....................................... 100,000

Other Contributed Capital—Wheal .................. 25,000
Retained Earnings—Wheal .............................. 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
5-22
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. Tyco’s 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 Tyco’s 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 value—such 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.
5-23
Case 5-2—continued
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.
5-24
a. See table below.

b. See table below.
Accounting
Newmont’s 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 loss recorded in the The fair value of the forward sale (future) recorded as asset
from Indonesian sales. Hedge. books. Realized gains and liability (as the case may be) in the balance sheet until the
mine @ $454 per and losses recorded date of actual sale. The compensating effect goes to
ounce when sold. accumulated 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.
on 50,000 ounces upside potential for loss recorded in the The forward sale commitment @ $454/ounce is the hedged
with strike price 40% of the forward books. Realized gains item for this instrument. The call is recorded at fair value. The
$454 linked to the sales in case of and losses recorded net income effect is the difference between the value of the call
forward sale. break out of gold when sold. and the value of the equivalent quantity (50,000 ounces) of
price above $454. forward 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
prices with a floor objective, to hedge price recorded on in the balance sheet and offset by accumulated comprehensive
of $300 and downside risk date of sale. income. Any change in fair value is recognized in other
ceiling 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.
5-25
Case 5-3—continued (parts a & b)
Accounting
Newmont’s 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
1999 for 2.35 in net income. income.
million ounces.
5-26
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. Newmont’s 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.
5-27
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.
5-28
Case 5-4A—continued
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
5-29
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
5-30
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)
5-31
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.
5-32

CH 05 Analyzing Investing Activities Intercorporate Investments

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CH 05 Analyzing Investing Activities Intercorporate Investments

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Chapter 05 - Analyzing Investing Activities: Intercorporate Investments

Analyzing Investing 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 20%

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 of

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

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

• The extent of intercompany transactions is unknown unless consolidating financial

17. a. This disclosure is necessary—it is a subsequent event required to be disclosed. Also,

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

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

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

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

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

Unrealized losses on trading securities (which are classified as current assets)

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 recorded,

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 exceeds

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

c. Consolidated financial statements should be prepared to present financial

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

(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 at

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

Exercise 5-6A (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 the

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 Burry’s Investment in Bowman Co.

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

Problem 5-5 (40 minutes)

Problem 5-6 (35 minutes)

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

LIABILITIES AND EQUITY