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Chapter 05 - Analyzing Investing Activities: Intercorporate Investments 5-1 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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  • Chapter 05 - Analyzing Investing Activities: Intercorporate Investments

    5-1

    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 valuewhich, 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 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 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.

    Exercise 5-2 (12 minutes) 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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    Exercise 5-3 (20 minutes) 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.

    Exercise 5-4 (30 minutes) a. Under purchase accounting, goodwill is reported if the purchase price exceeds

    fair value of the acquired tangible and intangible net assets. b. All identifiable tangible and intangible assets acquired, either individually or by

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

    c. Consolidated financial statements should be prepared to present financial

    position and operating results in a manner more meaningful than in separate statements. Such statements often are more useful for analysis purposes.

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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).

    Problem 5-2 (30 minutes) 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).

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    Problem 5-3 (45 minutes) 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.

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    Problem 5-4 (40 minutes) a. Computation of Burrys Investment in Bowman Co.

    ($ thousands) InvestmentCost 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.

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    Problem 5-5 (40 minutes) a. For Year 6:

    No effect on sales. Net income effect equals the dividend income of $10 (1% of $1,000, or $1 per

    share) since the investment is accounted for under the market method. Also, assuming the shares are classified as available-for-sale (a reasonable assumption given subsequent purchases), the price appreciation of $1 per share will bypass the income statement.

    Cash flow effect equals the dividend income of $10. If the outflow due to the stock purchase is included: Net cash flow = dividend income less purchase price = $10 - $100 = $(90).

    For Year 7 (the equity method applies): No effect on sales. Net income effect equals the percentage share of Francisco earnings for Year 7, or

    30% of $2,200 = $660. Cash flow effect equals the dividend income of $360 (computed as 30% of $1,200).

    If the outflow due to the stock purchase is included: Net cash flow = dividend income less purchase price = $360 - $3,190 = $(2,830).

    b. As of December 31, Year 6: At December 31, Year 6, the carrying value of the investment in Francisco is $110

    (computed as 10 shares x $11 per share). The $11 per share figure is the fair value at Jan. 1, Year 7.

    As of December 31, Year 7 (the equity method applies): Step onethe equity method is applied retroactively to the prior years of ownership

    (that is, Year 6). Original cost (10 shares x $10) ........................................................... $ 100 Add: Percentage share of Year 6 earnings (1% x $2,000) ................ 20 Less: Dividends received in Year 6 .................................................... (10)Net carrying value at Jan. 1, Year 7 ................................................... $ 110

    Step twothe equity method is applied throughout Year 7. Net carrying value, Jan. 1, Year 7 ....................................................... $ 110 Add: Original cost of additional shares (290 shares x $11) ............ 3,190 Add: Percentage share of Year 7 earnings (30% x $2,200) ............. 660 Less: Dividends received in Year 7 .................................................... (360)Net carrying value at Dec. 31, Year 7 ................................................. $3,600

    c. For Year 8, with ownership in excess of 50% (indeed, 100%), Franciscos financial

    statements would be consolidated with those of Potter. The purchase method is the only available choice under current GAAP. Under this 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.

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    Problem 5-6 (35 minutes) a. Pierson, Inc., Pro Forma Combined Balance Sheet

    ASSETS Current assets ........................................................................ $135 Land ........................................................................................ 70 Buildings, net ......................................................................... 130 Equipment, net ....................................................................... 130 Goodwill .................................................................................. 35 * Total assets ............................................................................ $500 LIABILITIES AND EQUITY Current liabilities .................................................................. $140 Long-term liabilities .............................................................. 180 Shareholders' equity ............................................................ 180 Total liabilities and equity .................................................... $500 *Goodwill computation:

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

    b. The basic difference between pooling and purchase accounting for business

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

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    Problem 5-7 (35 minutes) a. They are reported in "other assets" [166] at an amount of $155.8 million under

    investments in affiliates, which also includes $28.3 million as goodwill. b. No, disclosure is limited to this note. c. These acquisitions indicate that of the $180.1 million paid, $132.3 million is for

    intangibles, principally goodwill [107]. This implies that most of the purchase price was in effect for some form of superior earning power (residual income) assumed to be enjoyed by the acquired companies.

    d. Analytical entry to reflect the Year 11 acquisitions:

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

    e. (1) The change in the cumulative translation adjustment accounts [101] for

    Europe is most likely due to significant translation losses in Year 11. (2) In the case of Australia, the decrease in the credit balance of the account may

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

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    CASES Case 5-1 (45 minutes) a. (1) Pooling Accounting: Investment in Wheal .......................................... 110,000 Capital StockAxel ..................................... 110,000

    (2) Purchase Accounting:

    Investment in Wheal .......................................... 350,000 Capital StockAxel ..................................... 110,000 Other Contributed CapitalAxel ............... 240,000 b. (1) Pooling Worksheet Entries: Capital StockWheal ....................................... 100,000 Other Contributed CapitalWheal .................. 10,000 Investment in Wheal ..................................... 110,000

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

    Capital StockWheal ....................................... 100,000 Other Contributed CapitalWheal .................. 25,000 Retained EarningsWheal .............................. 35,000 Investment in Wheal ..................................... 160,000

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

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

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    Case 5-2 (50 minutes) a. When mergers occur, the resulting company is different than either of the two

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

    b. Tycos high price-to-earnings ratio was primarily driven by its relatively high

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

    c. When large charges are recorded in conjunction with acquisitions, subsequent

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

    d. Cost-cutting can be valuable when the costs that are cut relate to redundant

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

    e. When the market perceives a company to have low quality financial reporting, the

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

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    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.

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    Case 5-3 (120 minutes) a. See table below. b. See table below.

    Transaction

    Newmonts

    Strategy

    Accounting Treatment by

    Newmont (pre-SFAS 133)

    Accounting Treatment under SFAS 133

    Forward Sales of 125,000 ounces from Indonesian mine @ $454 per ounce

    To lock-in the price of future gold sales. Hedge.

    No unrealized gain or loss recorded in the books. Realized gains and losses recorded when sold.

    Classification: Cash Flow Hedge. The fair value of the forward sale (future) recorded as asset and liability (as the case may be) in the balance sheet until the date of actual sale. The compensating effect goes to 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 on 50,000 ounces with strike price $454 linked to the forward sale.

    To provide an upside potential for 40% of the forward sales in case of break out of gold price above $454.

    No unrealized gain or loss recorded in the books. Realized gains and losses recorded when sold.

    Classification: Fair-Value Hedge of above fixed commitment. The forward sale commitment @ $454/ounce is the hedged item for this instrument. The call is recorded at fair value. The net income effect is the difference between the value of the call and the value of the equivalent quantity (50,000 ounces) of 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 July 1999: 483,333 ounces at various prices with a floor of $300 and ceiling of $380.

    To raise immediate cash to service debt. Secondary objective, to hedge downside risk below $300 per ounce, but provide upside potential up to $380. A hedge with some limited upside potential within a range.

    No unrealized gains and losses are recognized. Realized price recorded on date of sale. Prepaid amount computed @ $300 per ounce and treated as deferred revenue that is adjusted when actual sales occur to reflect the actual sales proceeds.

    Classification: Cash Flow Hedge. Note the fair value of the instrument is non-zero only when the gold price is above $380 or below $300. Fair value is recorded in the balance sheet and offset by accumulated comprehensive income. Any change in fair value is recognized in other comprehensive income. At time of sale, accumulated comprehensive income is adjusted with net income so that the realized amount (variable between $300 and $380 per ounce) is recorded as revenue. The deferred revenue accounting is unchanged.

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    Case 5-3continued (parts a & b)

    Transaction

    Newmonts

    Strategy

    Accounting Treatment by

    Newmont (pre-SFAS 133)

    Accounting Treatment under SFAS 133

    Prepaid Sales in July 1999: 35,900 per annum at some fixed price (no information given about fixed price). Forward purchase in July 1999 of identical quantities at prices ranging from $263 to $354.

    To raise immediate cash to service debt. Yet, first instrument locks-in sales price, the second instrument reverses it. So the objective is clearly not hedging related.

    No unrealized gains and losses recognized on either security. Realized (fixed) price on forward sale adjusted by the value of forward purchase recorded when sold, whereby the revenue recorded is identical to actual realization. Treated as deferred revenue that is adjusted when actual sales occur.

    Classification: Cash Flow Hedge. Accounting effects similar to the first instrument in this table (forward sale on Indonesian mine). Classification: Fair Value Hedge of the forward sale (which is a fixed commitment). Recorded at fair value and any unrealized gains and losses on both the forward sale and purchase recorded in net income. Together both the sale and purchase have no effect on income or balance sheet.

    Purchased Put Option in August 1999 for 2.85 million ounces.

    To provide downside risk protection for 2.85 million ounces but allow for upside potential.

    No unrealized gains and losses recognized. Cost of put options amortized over term.

    Classification: Difficult to say. Probably fair-value hedge because it is not linked to forecast sale of gold. Fair value of puts and equivalent quantity of gold reported at fair value in balance sheet. Unrealized gains and losses on puts and equivalent quantity of gold charged to net income.

    Written Call Options in August 1999 for 2.35 million ounces.

    To finance the put purchase.

    All unrealized gains and losses recorded in net income.

    Classification: Speculative transaction. Fair value on balance sheet and all unrealized gains and losses charged to net income.

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    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.

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    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.

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    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

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

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    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

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    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 (millions)

    Exchange Rate Ponts/$

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

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

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

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    Case 5-5continued

    FUNI, INC. Income Statement

    For Year Ended Dec. 31, Year 9

    Ponts (millions)

    Exchange Rate Ponts/$

    Dollars (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.