fsa_8e_ch05_sm.doc

Chapter 5

Analyzing Investing Activities: Special Topics

REVIEW

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

Instructor's Solutions Manual 5-1

OUTLINE

Section 1: Intercompany Activities

Consolidated Financial Statements

Equity Method Accounting

Analysis Implications of Intercorporate Investments

Accounting Mechanics of Business Combinations

Analysis Implications of Business Combinations

Comparison of Pooling versus Purchase Accounting for Business

Combinations

Section 2: International Activities

International Accounting and Auditing Practices

Translation of Foreign Currencies

Analysis Implications of Foreign Currency Translation

Financial Statement Analysis, 8th Edition5-2

ANALYSIS OBJECTIVES

Analyze financial reporting for intercorporate investments.

Interpret consolidated financial statements.

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

Interpret goodwill arising from business combinations.

Describe international accounting and auditing practices.

Analyze foreign currency translation disclosures.

Distinguish between foreign currency translation and transaction gains and losses.


QUESTIONS

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

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

3. Consolidated financial statements generally provide the most meaningful presentation of the financial condition and the results of operations of the combined entity. Still, they do have certain limitations, including: The financial statements of the individual companies in the group may not be

prepared on a comparable basis. Accounting principles applied, valuation bases, and amortization rates used can differ. This can impair homogeneity and the validity of ratios, trends, and key relations.

Companies in relatively poor financial condition may be combined with sound companies, obscuring information necessary for effective analysis.

The extent of intercompany transactions is unknown unless consolidating financial statements (worksheets) are presented. The latter reveal the adjustments involved in the consolidation process, but are rarely disclosed.

Unless disclosed, it is difficult to estimate how much of consolidated retained earnings are actually available for payment of dividends.

The composition of the minority interest (such as between common and preferred stock) cannot be determined because the minority interest is usually shown as a combined amount in the consolidated balance sheet.

Consolidated financial statements do not reveal restrictions on use of cash for individual companies nor the intercompany cash flows.

Consolidation of nonhomogeneous subsidiaries (such as finance or insurance subsidiaries) can distort ratios and other relations.

4. 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.

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

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

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

7. Usually, the purchase method of accounting for a business combination is preferable from an analyst's viewpoint. Since purchase accounting recognizes the acquisition values on which the buyer and seller actually bargained, the balance sheet likely reflects more realistic (economic) values for both assets and liabilities. Moreover, the income statement likely better reflects the actual results of operations due to accounting procedures such as cost allocation of more appropriate asset values.

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

b. It is possible that the market values of identifiable assets acquired less liabilities assumed exceed the cost (purchase price) of the acquired company. In this case,


the values otherwise assignable to noncurrent assets (except for marketable securities) acquired should be reduced by a proportionate part of the excess. Negative goodwill should not be recorded unless the value assigned to such long-term assets is first reduced to zero. If negative goodwill must be recorded, it is recorded as an extraordinary gain (net of tax) below income from continuing operations

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

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

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

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

g. Raw Materials are recorded at current replacement costs.

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

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

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

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

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

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


11. a. An acquisition program aimed at purchasing companies with lower PE ratios can, in effect, "buy" earnings for the acquiring company. To illustrate, say that Company X has earnings of $1 million, or $1 per share on 1 million shares outstanding, and that its PE is 50. Now, 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....$1,000,000Y earnings.... 5,000,000

$6,000,000


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

We should recognize the “synergistic effect” in this case. That is, two companies combined can sometimes show results that are better than the total effect of each separately. This can occur through combination of vertical, horizontal, or other basis of company integration. Consider the following example:

Company S: PE = 10EPS = $1.00Earnings = $1,000,000Number of shares = 1,000,000

Company T: PE = 10Earnings = $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....................................$1,000,000T earnings.................................... 1,000,000Savings from merger................... 1,000,000New earnings...............................$3,000,000

New number of shares................ 2,000,000New 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 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.

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


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

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

15. Problems in the accounting for and the analysis of foreign operations can be grouped into two broad classifications:(a) Problems related to differences in accounting principles, auditing standards, and

other reporting or economic practices that are peculiar to the foreign country where the operations are conducted.

(b) Problems that arise from the translation of foreign assets, liabilities, equities, and results of operations into U.S. dollars.

16. The major provisions of accounting for foreign currency translation (SFAS 52) are: The translation process requires that the functional currency of the entity be

identified first. Ordinarily it will be the currency of the country where the entity is located (or the U.S. dollar). All financial statement elements of the foreign entity must then be measured in terms of the functional currency in conformity with GAAP.

Under the current rate method (most commonly used), translation from the functional currency into the reporting currency, if they are different, is to be at the current exchange rate, except that revenues and expenses are to be translated at the average exchange rates prevailing during the period. The current method generally considers the effect of exchange rate changes to be on the net investment in a foreign entity rather than on its individual assets and liabilities (which was the focus of SFAS 8).

Translation adjustments are not included in net income but are disclosed and accumulated as a separate component of stockholders' equity (Other Comprehensive Income or Loss) until such time that the net investment in the foreign entity is sold or liquidated. To the extent that the sale or liquidation represents realization, the relevant amounts should be removed from the separate equity component and included as a gain or loss in the determination of the net income of the period during which the sale or liquidation occurs.

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


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

18. Following are some analysis implications of the accounting for foreign currency translation:(a) The accounting insulates net income from balance sheet translation gains and

losses, but not transaction gains and losses and income statement translation effects.

(b) Under current GAAP, all balance sheet items, except equity, are translated at the current rate; thus, the translation exposure is measured by the size of equity or the net investment.

(c) While net income is not affected by balance sheet translation, the equity capital is. This affects the debt-to-equity ratio (the level of which may be specified by certain debt covenants) and book value per share of the translated balance sheet, but not of the foreign currency balance sheet. Since the entire equity capital is the measure of exposure to balance sheet translation gain or loss, that exposure may be even more substantial, particularly with regard to a subsidiary financed with low debt and high equity. The analyst can estimate the translation adjustment impact by multiplying year-end equity by the estimated change in the period to period rate of exchange.

(d) Under current GAAP, translated reported earnings will vary directly with changes in exchange rates, and this makes estimation by the analyst of the "income statement translation effect" less difficult.

(e) In addition to the above, income will also include the results of completed foreign exchange transactions. Also, any gain or loss on the translation of a current payable by the subsidiary to parent (which is not of a long-term capital nature) will pass through consolidated net income.

19. The following two circumstances require use of the temporal method of translation.(a) When by its nature, the foreign operation is merely an extension of the parent and

consequently the dollar is its functional currency.(b) When hyperinflation (as defined) causes the translation of nonmonetary assets at

the current rate to result in unrealistically low carrying values. In such cases, in effect, the foreign currency has lost its usefulness as a measure of performance and a more stable unit (such as the dollar) is used.


EXERCISES

Exercise 5-1 (30 minutes)

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

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

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

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



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.

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

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


Exercise 5-2—continued

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

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

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

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

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



a. There are several approaches for comparing financial statements of companies using different international accounting principles. They include: Adopt the Foreign Corporation's Financial Statements: Here an attempt is

made to analyze the foreign corporation's financial statements from the perspective of a local investor and apply local valuation methods. This may include a comparison with local enterprises since their financial statements are assumed to be prepared on a similar and comparable basis.

Comparable Approach: This approach attempts to restate the earnings figures on a comparable basis using U.S. GAAP, IASC standards, or another set of accounting practices in an appropriate manner acceptable by the analyst.

Assessment of the Quality of Earnings: In assessing the quality of earnings, a scale or standard is developed by the analyst. This scale or standard may incorporate considerations for such accounting choices as inventory valuation, depreciation methods, accounting for pensions, as well as the treatment of accounting for research and development.

Cash Flow Basis: Applied on a worldwide basis, an attempt is made to analyze the cash flows of investments. Consideration of cash flow definitions may include cash from operations, earnings before interest and taxes (EBIT), or changes in the financial position. The overriding rule is to analyze the investment from a cash flow perspective.

Asset Valuation Model: An analyst can attempt to mark the assets to market values and then subtract the indebtedness to arrive at a value for the enterprise. Alternatively, an analyst can employ a model such as the residual income equity valuation model to obtain company value.

Dividend Valuation Model: Using a dividend valuation approach, the investor can focus on dividends (or free cash flows) to arrive at an estimated value of the investment.

b. (1) An upward revaluation of fixed assets would increase depreciation

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

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


amortization period, the higher (lower) reported earnings will be. The IASC encourages a maximum of 20 years, but a longer period can be used if justified.


Exercise 5-3—continued

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


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)


Exercise 5-5 (30 minute)

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

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

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


PROBLEMS

Problem 5-1 (40 minutes)

a. Computation of Burry’s Investment in Bowman Co.

($ in 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.



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).......................................................... $100Add: Percentage share of Year 6 earnings (1% x $2,000)............... 20Less: 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...................................................... $ 110Add: Original cost of additional shares (290 shares x $11) ........... 3,190Add: Percentage share of Year 7 earnings (30% x $2,200) ............ 660Less: 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.



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

ASSETS

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

LIABILITIES AND EQUITY

Current liabilities................................................................... $140Long-term liabilities.............................................................. 180Shareholders' 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.



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..................................... 5.1Fixed assets net............................................... 4.7Intangibles, principally goodwill.................... 132.3Other assets..................................................... 1.5Minority 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.



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

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

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

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


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........................................... 350,000Capital Stock—Axel ..................................... 110,000Other Contributed Capital—Axel ................ 240,000

b. (1) Pooling Worksheet Entries:Capital Stock—Wheal ....................................... 100,000Other Contributed Capital—Wheal .................. 10,000

Investment in Wheal..................................... 110,000

(2) Purchase Worksheet Entries:Inventory ............................................................ 25,000Property, Plant, and Equipment........................ 100,000Secret Formula (Patent)..................................... 30,000Goodwill.............................................................. 40,000Long-Term Debt.................................................. 2,000

Accounts Receivable.................................... 5,000Accrued Employee Pensions....................... 2,000Investment in Wheal..................................... 190,000

Capital Stock—Wheal ....................................... 100,000Other Contributed Capital—Wheal .................. 25,000Retained Earnings—Wheal ............................... 35,000

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

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

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



a. Trial Balance in U.S. Dollars:

SWISSCO

Trial BalanceDecember 31, Year 8

Trial Exchange TrialBalance Rate Balance (in €) Code $/€ (in $)

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

Sales....................................................... 2,000,000A .37 740,000Allowance for Doubtful Accounts....... 10,000 C .38 3,800Accounts Payable................................. 80,000 C. .38 30,400Note Payable......................................... 20,000 C .38 7,600Capital Stock......................................... 100,000 H .30 30,000Retained Earnings 1/1/Year 8............... 190,000 [2] 61,000Translation 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 BalancePurchases 1,000,000 A .37 370,000Goods available for sale 1,150,000 426,700Inventory, 12/31/Year 8 120,000 C .38 45,600Cost of goods sold 1,030,000 A .37 381,100

[2] Dollar balance at Dec. 31, Year 7[3] Amount to balance.


Case 5-2—continued

b.

SWISSCO

Income Statement (In Dollars)For the Year Ended Dec. 31, Year 8

Sales................................................................. $740,000Beginning inventory........................................ $ 56,700 [1]Purchases......................................................... 370,000Goods available............................................... 426,700Ending inventory (€ 120,000 = $0.36)............. (45,600) [1]Cost of goods sold.......................................... 381,100Gross profit...................................................... 358,900Depreciation expense..................................... 37,000Other expenses (including taxes).................. 74,000 111,000Net income....................................................... $247,900

[1] See Note 1 to translated trial balance.

SWISSCO

Balance Sheet (In Dollars)At December 31, Year 8

ASSETS

Cash......................................................................... $ 19,000Accounts receivable.............................................. $38,000Less: Allowances for doubtful accounts............. 3,800 34,200Inventory................................................................. 45,600 [A]Property, plant, and equipment, net..................... 304,000Total assets............................................................. $402,800


Accounts payable.................................................. $30,400Note payable........................................................... 7,600Total liabilities........................................................ 38,000

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

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.......................... 185,925Equity 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.......................... 19,425Equity adjustment from translation of foreign currency statements (75% x $25,900). . . 19,425


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 9Ponts

(millions)Exchange Rate

Ponts/$Dollars

(millions)

ASSETS

Cash ................................................ 82 4.0 20.50Accounts receivable...................... 700 4.0 175.00Inventory......................................... 455 4.0 113.75Fixed assets (net) .......................... 360 4.0 90.00 Total assets..................................... 1,597 399.25


Accounts payable .......................... 532 4.0 133.00Capital stock .................................. 600 3.0 200.00Retained earnings ......................... 465 132.86Translation 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)



FUNI, INC.Income Statement

For Year Ended Dec. 31, Year 9Ponts

(millions)Exchange Rate

Ponts/$Dollars

(millions)

Sales ............................................... 3,500 3.5 1,000.00Cost 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.



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

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

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

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

Kasus 5-4 (50 menit)

a. IPR & D merupakan biaya yang berkaitan dengan proyek penelitian dan pengembangan di mana kelayakan teknologi belum tercapai. Secara khusus, teknologi yang berharga belum dikembangkan dari penelitian dan pengembangan. Jumlah biaya yang terkait dengan HKI & D dibebankan pada periode akuisisi.

b. Sapient pertama kali diidentifikasi proyek-proyek penelitian yang signifikan yang kelayakan teknologi belum didirikan. Nilai yang diberikan untuk membeli teknologi dalam proses ditentukan dengan memperkirakan biaya untuk mengembangkan teknologi yang dibeli dalam


proses menjadi produk komersial, memperkirakan arus kas yang dihasilkan dari proyek, dan kemudian mendiskontokan arus kas ke nilai kini. Harga yang digunakan untuk mendiskonto arus kas bersih didasarkan pada tingkat modal ventura pengembalian. Tarif modal ventura pengembalian yang tinggi untuk mengkompensasi pemodal ventura untuk risiko yang lebih tinggi bahwa mereka menganggap. Perusahaan memilih tingkat diskonto tinggi untuk menilai proyek IPR & D karena keberhasilan akhir dari proyek ini adalah sangat tidak pasti.

c. Pengeluaran pada proyek-proyek ini telah sekitar $ 2,5 juta. Diperkirakan 625.000 $ diperlukan untuk menyelesaikan proyek tersebut. Biaya tambahan akan dibebankan pada periode yang terjadinya.

d. Biaya penelitian dan pengembangan dibebankan pada saat terjadinya. Namun, dalam akuisisi, upaya R & D dapat dibebankan sebagai biaya atau dikapitalisasi berdasarkan apakah upaya terkait telah menghasilkan teknologi yang dapat digunakan. Nilai yang dikapitalisasi dengan mengakuisisi perusahaan telah dibebankan dalam laporan keuangan perusahaan berkembang. Demikian juga, biaya yang diperlukan untuk membawa non-teknis pekerjaan layak untuk kelayakan teknis akan dibebankan. Hal ini ditafsirkan oleh sebagian orang sebagai inkonsistensi logis. Lebih penting lagi, penunjukan memiliki atau tidak telah mencapai kelayakan teknologi sangat sewenang-wenang dan memiliki konsekuensi laporan keuangan yang cukup besar. Inilah sebabnya mengapa FASB percaya review baru dan komprehensif akuntansi untuk R & D diperlukan. Oleh karena itu, analis harus berhati-hati untuk menilai dampak HKI & D



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.



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.

jawaba. Ketika merger terjadi, perusahaan yang dihasilkan berbeda dari salah satu dari dua mantan, perusahaan terpisah. Akibatnya, seringkali sulit untuk menilai kinerja entitas relatif dikombinasikan untuk bahwa dari dua mantan perusahaan. Sementara masalah ini meluas ke kedua metode pembelian dan penyatuan, hal ini terutama terlihat ketika metode pooling digunakan. Di bawah pooling akuntansi, nilai buku kedua perusahaan digabungkan. Kehilangan adalah nilai wajar pertimbangan dipertukarkan dan nilai wajar aktiva dan kewajiban yang diakuisisi. Akibatnya, aset perusahaan gabungan biasanya bersahaja. Karena aset yang bersahaja, ekuitas gabungan bersahaja dan biaya juga yang bersahaja. Ini berarti bahwa pengembalian aset dan kembali pada rasio ekuitas dibesar-besarkan.

b. Tinggi price to earning ratio Tyco terutama didorong oleh harga saham yang relatif tinggi. Harga saham tinggi Its berarti bahwa poolings dapat diselesaikan dengan relatif lebih sedikit sahamnya diberikan dalam pertimbangan. Dengan demikian, harga tinggi sangat penting untuk kemampuan Tyco untuk mengeksekusi, dan terus mengeksekusi, akuisisi dengan harga yang menguntungkan.

c. Ketika biaya besar dicatat dalam hubungannya dengan akuisisi, periode berikutnya adalah lega dari tuduhan ini. Ini berarti bahwa laba bersih masa depan meningkat karena barang-barang saat ini dihapuskan tidak perlu dihapuskan pada periode mendatang. Akibatnya, laba bersih dilaporkan di masa mendatang mungkin menyesatkan tinggi. Adalah penting bahwa analis menilai sifat dan jumlah write-off terkait dengan akuisisi untuk melihat apakah biaya tersebut sebenarnya terkait dengan peristiwa masa lalu / saat ini atau lebih tepat harus dilakukan untuk periode yang akan datang. Jika salah saji tersebut diidentifikasi, laba bersih pada periode akuisisi harus disesuaikan ke atas untuk mengimbangi over-charge, dan laba bersih dilaporkan periode yang akan datang harus commensurately berkurang.

d. Pemotongan biaya dapat berharga ketika biaya yang dipotong berhubungan untuk berlebihan proses atau non-nilai tambah proses lainnya. Namun, pemotongan biaya dapat memiliki konsekuensi yang merugikan bagi masa depan perusahaan jika biaya yang dipotong berhubungan dengan kegiatan yang membawa potensi biaya-nilai seperti masa depan mencakup penelitian dan pengembangan atau pelatihan manajemen.


e. Ketika pasar merasakan sebuah perusahaan untuk memiliki laporan keuangan yang berkualitas rendah, harga saham perusahaan dapat jatuh drastis selama sedikitnya dua alasan penting. Pertama, pasar akan menetapkan tingkat diskonto yang lebih tinggi untuk perusahaan untuk harga melindungi diri terhadap risiko akuntansi atau risiko informasi keuangan yang menyesatkan. Kedua, integritas manajemen dipertanyakan. Akibatnya, pasar tidak akan bersedia membayar lebih banyak untuk saham perusahaan mengingat peningkatan yang sepadan dalam risiko. Kasus 5-5-terus

f. Berfokus pada laba sebelum item khusus dapat menjadi alat yang berguna ketika mencoba untuk mengukur laba yang lebih mencerminkan aliran pendapatan permanen dan, akibatnya, lebih mencerminkan laba masa depan. Namun, catatan beberapa perusahaan mengulangi tuduhan barang khusus. Perusahaan-perusahaan ini pada dasarnya melebih-lebihkan pendapatan selama beberapa periode (tidak termasuk dengan biaya khusus) dan kemudian mengejar dengan mencatat biaya besar. Analis harus berhati-hati untuk mengidentifikasi perusahaan-perusahaan tersebut sehingga mereka tidak bergantung pada pendapatan berlebihan dari perusahaan dalam memprediksi kinerja masa depan. Untuk perusahaan seperti, adalah bijaksana untuk menetapkan sebagian dari biaya untuk beberapa periode untuk mengembangkan perkiraan pendapatan berkelanjutan perusahaan.


fsa_8e_ch05_sm.doc

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