lls5e chap12 sols

Chapter 12Reporting and Interpreting Investments in Other Corporations

ANSWERS TO QUESTIONS

1. A short-term investment is one that meets the two tests of (1) ready marketability and (2) management intention to convert it to cash in the short run. In contrast, a long-term investment is one that does not meet both of these tests. Most long-term investments are marketable securities, either stocks or bonds. A short-term investment is classified as a current asset on the balance sheet, while long-term investments are reported as noncurrent assets.

2. For passive investments in bonds, companies may report the investment at unamortized cost if the intent is to hold the bonds until maturity. Otherwise, the investments in bonds are to be accounted for using the same market value method as is used for passive investments in equity securities. Each year-end, the investments are adjusted to market value. Passive equity investments are those in which the investor has less than 20% of the outstanding shares of voting common stock, unless there is evidence to the contrary.

When a company can exert significant influence over the investing and financing decisions of another company, the equity method is used to account for and report the investment. In applying the equity method, considered a “one-line consolidation,” dividends received from the investee company reduce the investment account; the investor’s percentage share of the investee’s net income or loss is included as income or loss on the investor’s income statement with a corresponding change in the investment account. The ability to exert significant influence over an investee company is presumed if the investor owns between 20% and 50% of the outstanding shares of voting common stock.

When an investor owns over 50% of the outstanding shares of voting common stock, the investor has control over the investee. Consolidated statements are prepared.

3. Only bonds that management has the plans and ability to hold until maturity can be reported in the held-to-maturity portfolio. The investment in held-to-maturity bonds is reported on the balance sheet at unamortized cost, not market value, at the end of each year.

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2007 Financial Accounting, 5/e 12-1

4. When shares of capital stock of another company are purchased as an investment, they are measured and recorded at cost in accordance with the cost principle. Cost is defined as the total expenditures incurred in obtaining the other shares. The total outlay includes the market price plus all commissions and other buying costs.

5. Under the market value method, revenues are measured by the investor company in periods during which the other company declares a cash dividend. Unrealized gains and losses are recorded when the stock price increases or decreases.

6. Under the equity method, investment revenue is measured on a proportionate basis by the investor company when earnings are reported by the investee company, rather than when the dividends are received. This is because the equity method is applied in the situation where the investor company has a sufficient number of the shares of voting stock of the other company to exercise a significant influence. When a significant influence can be exercised over the dividend policies of another corporation, it means that income of the other corporation can be obtained, almost at will, by the investor company. Thus, when the investee company reports income, the investor company should record a proportionate share of that income as investment revenue because it is considered earned under the requirements of the revenue principle.

7. Under the equity method, dividends received from the investee company (the other company) are not recorded as revenue because to record the dividends as revenue would involve double counting. There would be double counting because the investor company has already shown, as revenue earned, its proportionate share of the earnings of the investee company. Because the dividends from the investee company are paid out of those earnings, to record them as revenue by the investor company would be double counting. As a consequence, under the equity method, a dividend received from the investee company is debited to Cash and credited to the Investment account.

8. A combination by purchase typically occurs when one corporation acquires a controlling interest in the voting common stock of another corporation by purchasing the shares either through the expenditure of cash, other assets, or by incurrence of debt.

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2007 12-2 Solutions Manual

9. When there is a combination by purchase, goodwill is usually recognized on the consolidated financial statements. Goodwill occurs when the parent company pays a price for the shares of the subsidiary acquired which includes not only the regular assets of the subsidiary, but an additional amount which is deemed to represent a payment for the reputation and customer appeal which the subsidiary has developed. The amount identified with this customer appeal and good reputation is known as goodwill. In preparing the consolidated statements under combination by purchase, the goodwill must be recognized as an asset and is not expensed unless impaired.

10. A parent-subsidiary relationship exists when one company owns a sufficient number of voting shares of the capital stock of another company to exercise control over it. The number of shares usually required to establish a parent-subsidiary relationship is more than 50 percent. The investing company is known as the parent and the other corporation is called the subsidiary. Both corporations continue as separate legal entities and each prepares its own separate financial statements. However, because of their special relationship, they are viewed for financial measuring and reporting purposes as a single economic entity. Therefore, the parent company (but not the subsidiary) is required to prepare consolidated financial statements.

11. The basic concept underlying consolidated statements is that, when there is a parent-subsidiary relationship (the parent company owns more than 50 percent of the voting stock of the other corporation and there is economic compatibility), it must be viewed as a single economic entity.

At the end of each period, both companies prepare their own separate financial statements; then, under the concept of consolidated statements, these separate statements are combined, or aggregated, by the parent on an item-by-item basis to develop the consolidated financial statements. Thus, the consolidated statements do not affect the accounting for the parent or the subsidiaries, but affect only the reporting phase of the combined entity.

12. The basic element that must be present before consolidated statements are appropriate is: control of another entity—control is assumed to exist when more than 50 percent of the voting stock of another entity is owned by one investor.


13. In combining the separate financial statements of a parent and a subsidiary in the consolidation process, each item on the financial statements of each company is added on a line-by-line basis to obtain the consolidated amount. However, before aggregation (i.e., consolidation) in this manner, certain intercompany amounts must be eliminated. These intercompany amounts are items that are strictly between the two companies and if not eliminated would result in double counting. For example, the investment account on the parent company’s books, in effect, represents the assets of the subsidiary. When the assets of the subsidiary, item by item, are added to those of the parent, the investment account must be eliminated, otherwise the assets would be included in the consolidated amounts twice. In a similar manner the proportionate share of owners’ equity of a subsidiary owned by the parent must be eliminated.

MULTIPLE CHOICE

1. c) 2. d) 3. c) 4. d) 5. d)

6. c) 7. c) 8. b) 9. d) 10. c)


Authors’ Recommended Solution Time(Time in minutes)

Mini-exercises Exercises ProblemsAlternate Problems

Cases and Projects

No. Time No. Time No. Time No. Time No. Time1 3 1 10 1 20 1 20 1 202 3 2 15 2 30 2 30 2 153 6 3 20 3 45 3 45 3 304 6 4 20 4 40 4 40 4 205 6 5 20 5 40 5 20 5 106 6 6 20 6 40 6 30 6 207 6 7 25 7 20 7 20 7 208 6 8 10 8 30 8 *9 5 9 10 9 20

10 10 10 10 10 3011 5 11 10

12 2513 20

* Due to the nature of this project, it is very difficult to estimate the amount of time students will need to complete the assignment. As with any open-ended project, it is possible for students to devote a large amount of time to these assignments. While students often benefit from the extra effort, we find that some become frustrated by the perceived difficulty of the task. You can reduce student frustration and anxiety by making your expectations clear. For example, when our goal is to sharpen research skills, we devote class time to discussing research strategies. When we want the students to focus on a real accounting issue, we offer suggestions about possible companies or industries.

MINI-EXERCISES

M12–1.

C More than 50 percent ownership.D Bonds held to maturity.A Less than 20 percent ownership.B At least 20 percent but not more than 50 percent ownership.A Current market value.D Original cost less any amortization of premium or discount associated with the

purchase.


B Original cost plus proportionate part of the income of the investee lessproportionate part of the dividends declared by investee.

M12–2.

Investment in bonds (+A)...................................................... 1,070,000 Cash (A)........................................................................... 1,070,000

M12–3.

December 2, 2008:Investment in TS (+A)............................................................ 224,000 Cash (A)........................................................................ 224,000Purchased 8,000 shares (16%) of Cox Corporation common stock at $28 per share.

December 15, 2008:Cash (+A).............................................................................. 16,000 Investment income (+R, +SE)........................................ 16,000Cash dividend received (8,000 shares x $2 = $16,000).

December 31, 2008:Net unrealized loss/gain – TS (+Loss, SE).......................... 24,000 Allowance to value at market – TS (A).......................... 24,000 Market Cost = Allowance Balance Unadjusted Balance = Adjustment$200,000 $224,000 $24,000 $0 $24,000M12–4.

December 2, 2008:Investment in SAS (+A)......................................................... 224,000 Cash (A)........................................................................ 224,000Purchased 8,000 shares (16%) of Cox Corporation common stock at $28 per share.

December 15, 2008:Cash (+A).............................................................................. 16,000 Investment income (+R, +SE)........................................ 16,000Cash dividend received (8,000 shares x $2 = $16,000).

December 31, 2008:Net unrealized loss/gain – SAS (SE).................................... 24,000 Allowance to value at market – SAS (A)....................... 24,000

Market Cost = Allowance Balance Unadjusted Balance = AdjustmentMcGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2007 12-6 Solutions Manual

$200,000 $224,000 $24,000 $0 $24,000

M12–5.Balance Sheet Income Statement

Transaction Assets LiabilitiesStockholders’

Equity Revenues ExpensesNet

Income12/2 +224,000

–224,00012/15 +16,000 +16,000 +16,000 +16,00012/31 –24,000 –24,000 +24,000 –24,000




Income12/2 +224,000

–224,00012/15 +16,000 +16,000 +16,000 +16,00012/31 –24,000 –24,000

M12–7.

July 2, 2008:Cash (+A).............................................................................. 30,000 Investments in associated companies (A)..................... 30,000Cash dividend received (10,000 shares x $3 = $30,000).

December 31, 2008:Investments in associated companies (+A)........................... 50,000 Equity in earnings of associated companies (+R, +SE).. 50,000Recognize earnings from associated company (25% x $200,000)




Income7/2 +30,000

–30,00012/31 +50,000 +50,000 +50,000 +50,000


M12–9.

Property and equipment (+A)................................................ 630,000Goodwill (+A) ........................................................................ 70,000 Bonds payable (+L)........................................................ 100,000 Cash (–A) ...................................................................... 600,000

M12–10.

2007 2008 2009Net income $195,000 $201,000 $212,000

Average total assets* $60,000 $101,000 $139,500

Return on assets = 3.25 1.99 1.52

* 2007: ($52,000 + $68,000)/2 = $60,000 2008: ($68,000 + $134,000)/2 = $101,000 2009: ($134,000 + $145,000)/2 = $139,500

Return on assets measures how much a company earned for each dollar of investment in assets. For M.A.D. Company, the ratio has declined every year, suggesting that management is utilizing total assets of the firm less efficiently over time. Asset growth has not generated proportionate increases in net income.

M12–11.

Disney reports a large amount of goodwill because it has purchased other businesses, paying more than the fair market value of the net assets of the acquired companies.EXERCISES

E12–1.

Req. 1

July 1, 2007:Investment in bonds (+A)...................................................... 10,000,000 Cash (–A)........................................................................ 10,000,000

Req. 2

Dec 31, 2007: Cash (+A)............................................................................. 500,000 Interest revenue (+R, +SE)............................................. 500,000


($10 million x 10% x 6/12 of a year)

E12–2.

Questions Method of MeasurementMarket Value Method Equity Method

a Less than 20%. At least 20% but not more than 50%.

b At cost: 1,000 shares x $19 = $19,000.

At cost: 5,000 shares x $19 = $95,000.

c When Co. B declares a cash dividend; not for any holding gains and losses on securities-available-for-sale.

When Co. B reports income or loss for the period; not when dividends are declared or paid.

d Record increases and decreases based on stock price changes through the valuation allowance.

Increase the investment account for proportionate part of income, less proportionate part of dividends and losses, of Co. B.

e 1,000 shares x $15 = $15,000market value.

Cost of $95,000 plus $12,500 ($50,000 x 25%) equity in investee’s earnings minus $2,500 ($10,000 x 25%) dividends received equals $105,000.

f Company A owns 5% of Company B (1,000 shares ÷ 20,000 shares outstanding). $10,000 dividends declared x 5% = $500 dividend revenue for Company A.

$50,000 Company B net income x 25% = $12,500 equity in earnings of investee.

g 1,000 x ($19 – $15) = $4,000 reported in stockholders’ equity.

None.


E12–3.

June 30, 2007:Investment in TS (+A)............................................................ 200,000 Cash (–A)........................................................................... 200,000

Dec 31, 2007:Allowance to value at market – TS (+A)................................ 40,000 Net unrealized loss/gain – TS (+Gain, +SE)...................... 40,000

Dec. 31, 2008:Allowance to value at market – TS (+A)................................ 70,000 Net unrealized loss/gain – TS (+Gain, +SE)...................... 70,000

Dec. 31, 2009:Net unrealized loss/gain – TS (+Loss, –SE).......................... 60,000 Allowance to value at market – TS (–A)............................ 60,000

Computations:

Year Market Cost = Allowance Balance Unadjusted Balance = Adjustment2007 $240,000 $200,000 +$40,000 $0 +$40,0002008 310,000 200,000 +110,000 + 40,000 + 70,0002009 250,000 200,000 + 50,000 + 110,000 60,000

Feb. 14, 2010:Cash (+A) (10,000 shares x $22).......................................... 220,000 Loss on sale of investment (+Loss, –SE).............................. 30,000 Investment in TS (–A)........................................................ 200,000 Allowance to value at market – TS (–A)............................ 50,000

Note: The net unrealized loss/gain is an income statement account. This item is reported on the current income statement and affects the computation of net income. It is closed to Retained Earnings at the end of each year.


E12–4.

June 30, 2007:Investment in SAS (+A)......................................................... 200,000 Cash (–A)........................................................................... 200,000

Dec. 31, 2007:Allowance to value at market – SAS (+A)............................. 40,000 Net unrealized loss/gain – SAS (+SE)............................... 40,000


Dec. 31, 2009:Net unrealized loss/gain – SAS (–SE)................................... 60,000 Allowance to value at market – SAS (–A).......................... 60,000

Computations:

Year Market Cost = Allowance Balance Unadjusted Balance = Adjustment2007 $240,000 $200,000 +$40,000 $0 +$40,0002008 310,000 200,000 +110,000 + 40,000 + 70,0002009 250,000 200,000 + 50,000 + 110,000 60,000

Feb. 14, 2010:Cash (+A) (10,000 shares x $22).......................................... 220,000 Net unrealized loss/gain – SAS (–SE)................................... 50,000 Allowance to value at market – SAS (–A).......................... 50,000 Investment in SAS (–A)...................................................... 200,000 Gain on sale of investment (+Gain, +SE).......................... 20,000

Note: The net unrealized loss/gain account is a balance sheet account. It does not affect the computation of net income each year. Because it is a balance sheet account, it maintains its balance from year to year. Therefore, the decline in stock price that occurs in 2009 is reported as an adjustment to the net unrealized loss/gain account. When the stock is sold in 2010, the net unrealized loss/gain is closed along with the Allowance to Value at Market account, and the difference between the purchase price (original cost) and the selling price is reported as a gain on the income statement.


E12–5.

March 10, 2006:Investment in TS (+A)............................................................ 250,000 Cash (–A)........................................................................... 250,000


Dec. 31, 2007:Net unrealized loss/gain – TS (+Loss, –SE).......................... 75,000 Allowance to value at market – TS (–A)............................ 75,000


Computations:

Year Market Cost = Allowance Balance Unadjusted Balance = Adjustment2006 $275,000 $250,000 +$25,000 $0 +$25,0002007 200,000 250,000 50,000 + 25,000 75,0002008 210,000 250,000 40,000 50,000 + 10,000

Sept. 12, 2009:Cash (+A) (5,000 shares x $39)............................................ 195,000 Allowance to value at market – TS (+A)................................ 40,000Loss on sale of investment (+Loss, –SE).............................. 15,000 Investment in TS (–A)........................................................ 250,000

Note: The net unrealized loss/gain is an income statement account. This item is reported on the current income statement and affects the computation of net income. It is closed to Retained Earnings at the end of each year.


E12–6.

March 10, 2006:Investment in SAS (+A)......................................................... 250,000 Cash (–A)........................................................................... 250,000


Dec. 31, 2007:Net unrealized loss/gain – SAS (–SE)................................... 75,000 Allowance to value at market – SAS (–A).......................... 75,000


Computations:

Year Market Cost = Allowance Balance Unadjusted Balance = Adjustment2006 $275,000 $250,000 +$25,000 $0 +$25,0002007 200,000 250,000 50,000 + 25,000 75,0002008 210,000 250,000 40,000 50,000 + 10,000

Sept. 12, 2009:Cash (+A) (5,000 shares x $39)............................................ 195,000 Allowance to value at market – SAS (+A)............................. 40,000Loss on sale of securities (+Loss, –SE)................................ 55,000 Investment in SAS (–A)...................................................... 250,000 Net unrealized loss/gain – SAS (+SE)............................... 40,000

Note: The unrealized loss/gain account is a balance sheet account. It does not affect the computation of net income each year. Because it is a balance sheet account, it maintains its balance from year to year. Therefore, the decline in stock price that occurs in 2007 is reported as an adjustment to the net unrealized loss/gain account and the increase in stock price that occurs in 2008 is also reported as an adjustment to the net unrealized loss/gain account. When the stock is sold in 2009, the net unrealized loss/gain is closed along with the Allowance to Value at Market account, and the difference between the purchase price and the selling price is reported as a loss on the income statement.


E12–7.

Req. 1

The equity method must be used because the company owns 35% (21,000 ÷ 60,000) of the total shares outstanding of Nueces Corporation. The equity method must be used when there is at least 20% but not more than 50% ownership in existence. The Felicia Company must use the equity method because it can exercise significant influence, but not control, over the operating and financing policies of Nueces Corporation.

Req. 2

January 10, 2008:Investment in associated companies (+A)............................. 252,000 Cash (–A)........................................................................... 252,000Purchased 21,000 shares (35%) of the common stock of Nueces Corp. at $12 per share.

December 31, 2008:Investment in associated companies (+A)............................. 31,500 Equity in earnings of associated companies (+R, +SE)..... 31,500To record 35% of the revenue reported by Nueces Corp. ($90,000 x 35% = $31,500)

December 31, 2008:Cash (+A).............................................................................. 12,600 Investment in associated companies (–A)......................... 12,600To record 35% of cash dividends paid by Nueces Corp.(21,000 shares x $.60 = $12,600)

No entry is made under the equity method to record changes in market value.

Req. 3

Balance Sheet—At December 31, 2008Long-term Investments:Investment in associated companies (equity basis*) .................................... $270,900

Income Statement—For the Year Ended December 31, 2008Equity in earnings of associated companies................................................. $ 31,500

* Investment in Associated CompaniesCost 252,000% Investee’s net income 31,500 12,600 % Investee’s dividends declared

270,900


E12–8.

Req. 1 Investing activities Purchase of investments in associated companies –252,000

Req. 2 Operating activities Net Income Adjusted for:

Equity in earnings of associated companies –31,500 (no cash received)

Dividends received from associated companies +12,600 (cash received)

E12–9.

(in millions)Assets (+A, not detailed)....................................................... 550Goodwill (+A) ........................................................................ 320 Liabilities (+L, not detailed) ............................................... 170 Cash (–A)........................................................................... 700

E12–10.

1. Return on Assets =

Net Income Average Total Assets

$117,879 = .20 (20%) ($538,671 + $641,716) 2

2. ROA measures how much the firm earned for each dollar of investment. It is the broadest measure of profitability and management effectiveness, independent of financing strategy.


E12–11.

Consolidation is an accounting process that brings together financial information from two or more companies to make it appear as if there is a single economic entity. These companies may have engaged in transactions with each other during the year (these transactions are called intercompany transactions). Some examples are lending money or selling merchandise. During consolidation, intercompany transactions are eliminated or reversed so that on the consolidated statements, it appears as if the transactions never took place.

It is necessary to eliminate intercompany transactions because a single economic entity cannot logically do business with itself. It makes no sense, for example, to report as a liability an amount that an entity owes itself.

E12–12.

Req. 1Investment in Co. S (100%) (+A)........................................... 80,000 Cash (–A)................................................................... 80,000Purchased all of the outstanding stock (4,000 shares) of Co. S.

Req. 2Purchase price for 100% interest in Co. S..................................................... $80,000Market value of Company S net assets purchased equaled book value

($60,000 – $9,000).................................................................................... 51,000Goodwill purchased....................................................................................... $29,000


E12–12. (continued)

Req. 3

COMPANY P AND ITS SUBSIDIARY, COMPANY S (100% OWNED)Consolidated Balance Sheet (purchase method)January 1, 2007 (immediately after acquisition)

Separate Balance Sheets

Company P Company S EliminationsConsolidated Balance Sheet

Assets: Cash.................................. $ 12,000 $18,000 $ 30,000 Investment in Co. S (at cost) 80,000 – 80,000 Property and equipment (net) 48,000 42,000 90,000 Goodwill............................. + 29,000 29,000 Totals............................. $140,000 $60,000 $149,000Liabilities: Liabilities............................ $ 40,000 $ 9,000 $ 49,000Stockholders’ Equity: Common stock, Co. P........ 90,000 90,000 Common stock, Co. S........ 40,000 – 40,000 Retained earnings, Co. P. . 10,000 10,000 Retained earnings, Co. S. . 11,000 – 11,000 Totals............................. $140,000 $60,000 $149,000

E12–13.

Goodwill calculation:Purchase price $100,000Market value of net assets 96,000Goodwill $ 4,000

Additional Depreciation ($6,000 3 years) $ 2,000

Revenues ($500,000 + 75,000) $575,000Expenses ($350,000 + $50,000 + $2,000)

402,000

Net Income $173,000

PROBLEMS

P12–1.


Req. 1When the bonds are purchased, the company increases Investment in Bonds Held-to-Maturity and decreases Cash.

Req. 2When interest is received on the investments, Cash increases and Interest Revenue increases. The bonds were purchased at par; the Investment in Bonds Held-to-Maturity account is not affected.

Req. 3No journal entry is required. A decrease in the market value of bonds in the held-to-maturity portfolio is not recorded.


P12-2.

Req. 1

March 1, 2006Investment in TS (+A) ........................................................... 200,000 Cash (–A)........................................................................... 200,000

Dec. 31, 2006Net unrealized loss/gain – TS (+Loss, –SE).......................... 30,000 Allowance to value at market – TS (–A)............................ 30,000

Dec. 31, 2007Allowance to value at market – TS (+A)................................ 70,000 Net unrealized loss/gain – TS (+Gain, +SE)...................... 70,000


Req. 2

March 1, 2006Investment in SAS (+A)......................................................... 200,000 Cash (–A)........................................................................... 200,000

Dec. 31, 2006Net unrealized loss/gain – SAS (–SE)................................... 30,000 Allowance to value at market – SAS (–A).......................... 30,000

Dec. 31, 2007Allowance to value at market – SAS (+A)............................. 70,000 Net unrealized loss/gain – SAS (+SE)............................... 70,000


Computations:

Year Market Cost = Allowance Balance Unadjusted Balance = Adjustment2006 $170,000 $200,000 $30,000 $0 $30,0002007 240,000 200,000 + 40,000 30,000 + 70,0002008 310,000 200,000 +110,000 + 40,000 + 70,000


P12–3.

Req. 1

The market value method must be used for both the Q common stock and R preferred stock. The market value method must be used for Q common stock because only 14% of it is owned. If less than 20% of the outstanding stock is owned, it is assumed there can be no exercise of significant influence or control; therefore, the market value method must be used. The market value method is used for R preferred stock, regardless of the level of ownership, because it is nonvoting stock; there is no significant influence or control.

Req. 2

2008 2009 a. Acquisition of the investments:

Investment in SAS (+A)*.................... 423,000 Cash (–A)....................................... 423,000

Q common stock: 12,600 shares x $5 = $ 63,000R preferred stock: 12,000 shares x $30 = 360,000 Total investment.................................. $423,000

* Investment is classified as a security available for sale because management intends to hold the investment long term.

b. Income reported by Corporations Q & R:No entry is required for either the common or preferred stock because, under the market value method, revenue is recognized only when dividends are declared.

c. Dividends received:Cash (+A).......................................... 22,710 24,540 Investment income (+R, +SE)........ 22,710 24,540

2008: Q common stock: 12,600 shares x $.85 = $10,710R preferred stock: 12,000 shares x $1.00 = 12,000 Total......................................................... $22,710

2009: Q common stock: 12,600 shares x $.90 = $11,340R preferred stock: 12,000 shares x $1.10 = 13,200 Total......................................................... $24,540


P12–3. (continued)

2008 2009d. Market value effects:

Net unrealized gain/loss – SAS (–SE) 24,600 Allowance to value at market – SAS (–A) 24,600

Allowance to value at market - SAS (+A) 12,000 Net unrealized gain/loss - SAS (+SE) 12,000

Computations:

Year Market Cost = Allowance Balance Unadjusted Balance = Adjustment 2008 Q $50,400 $63,000 $12,600 $0 $12,600 (12,600 x $4)

R 348,000 360,000 12,000 0 12,000 (12,000 x $29) 24,600

2009 Q 50,400 63,000 12,600 12,600 0 (12,600 x $4)

R 360,000 360,000 0 12,000 + 12,000 (12,000 x $30) + 12,000

Req. 3a. Balance Sheet: 2008 2009

Long-term Investments: Investment in SAS (at market)........................................... $398,400 $410,400

b. Stockholders’ Equity: Net unrealized loss/gain – SAS......................................... (24,600) (12,600)

c. Income Statement: Investment income............................................................. 22,710 24,540


P12–4.Req. 1

Aug. 4, 2007 Investment in TS (+A)............................................................45,000 Cash (–A)........................................................................... 45,000

Dec. 31, 2007 Allowance to value at market – TS (+A)................................ 7,000 Net unrealized loss/gain – TS (+Gain, +SE)...................... 7,000

June 1, 2008 Cash (+A).............................................................................. 2,000 Investment income (+R, +SE)............................................ 2,000

Dec. 31, 2008 Net unrealized loss/gain – TS (+Loss, –SE).......................... 5,000 Allowance to value at market – TS (–A)............................ 5,000


Dec. 31, 2009 Net unrealized loss/gain – TS (+Loss, –SE).......................... 9,000 Allowance to value at market – TS (–A)............................ 9,000

Computations for Year-End Adjustments to Market:Year Market Cost = Allowance Balance Unadjusted Balance = Adjustment2007 $52,000 $45,000 +$7,000 $0 +$7,0002008 47,000 45,000 + 2,000 + 7,000 5,0002009 38,000 45,000 7,000 + 2,000 9,000

Req. 2 Aug. 4, 2007 Investment in SAS (+A).........................................................45,000

Cash (–A)........................................................................... 45,000

Dec. 31, 2007 Allowance to value at market – SAS (+A)............................. 7,000 Net unrealized loss/gain – SAS (+SE)............................... 7,000


Dec. 31, 2008 Net unrealized loss/gain – SAS (–SE)................................... 5,000 Allowance to value at market – SAS (–A).......................... 5,000


Dec. 31, 2009 Net unrealized loss/gain – SAS (–SE)................................... 9,000 Allowance to value at market – SAS (–A).......................... 9,000



Req. 3

Aug. 4, 2007Investment in associated companies(+A).............................. 45,000 Cash (–A)........................................................................... 45,000

Dec. 31, 2007Investment in associated companies (+A)............................. 15,000 Equity in earnings of associated companies (+R, +SE)..... 15,000 (30% x $50,000)

June 1, 2008Cash (+A).............................................................................. 2,000 Investment in associated companies (–A)......................... 2,000


June 1, 2009Cash (+A).............................................................................. 2,000 Investment in associated companies (–A)......................... 2,000



P12–5.

Req. 1CASE A The market value method must be used by Company D because it owns 12%

(3,600 ÷ 30,000) of the total outstanding common shares of Company C. The market value method must be used when less than 20% of the outstanding shares are owned because the investor (Company D) cannot exercise significant influence or control.

CASE B The equity method must be used by Company D because it owns 35% (10,500 ÷ 30,000) of the outstanding common shares of Company C. The equity method must be used if the level of ownership is at least 20% but not more than 50% because the investor (Company D) can exercise significant influence, but not control, over the operating and financing policies of Company C.

Req. 2Case A-12% Case B-35%

a. January 1, 2007 purchase:

Investment in SAS (+A)..................... 90,000 (3,600 shares x $25) Cash (–A)................................... 90,000Investment in assoc. co. (+A)............ 262,500 (10,500 shares x $25) Cash (–A)................................... 262,500

b. Income reported by Company C: None

Investment in assoc. company (+A). . 17,500 Equity in earnings of assoc. co. (+R, +SE)...................................... 17,500 ($50,000 x 35%)

c. Dividends declared and paid by Co. C:Cash (+A) ......................................... 3,060 Investment income (+R, +SE)........ 3,060*

Cash (+A).......................................... 8,925 Investment in assoc. company (–A) 8,925*

*Computations $25,500 x 12% = $3,060$25,500 x 35% = $8,925

d. Net unrealized loss/gain (–SE).......... 10,800 None Allowance to value at market– SAS (–A)................................................ 10,8003,600 shares x ($22 market – $25 cost) =


$10,800.




Balance Sheet:Investments: Investment in SAS (1) $79,200 Investment in associated company (2).. $271,075Stockholders’ Equity: Other comprehensive income: Net unrealized loss/gain – SAS........ (10,800) NoneIncome Statement: Investment income................................. Equity in earnings of associated co. .....

3,060None

None 17,500

(1) Cost $90,000 – Allowance to value at market $10,800 = $79,200 market value (reported on balance sheet)

(2) Cost $262,500 + % Investee’s net income $17,500 – % Investee’s dividends declared $8,925 = $271,075 book value (reported on balance sheet)

Req. 4

Assets (investments), stockholders’ equity (retained earnings), and revenues (from investments) are different because (1) different methods of recognizing revenue are required and (2) adjustments for changes in market value are recorded only under the market value method.


P12–6.

Req. 1CASE

AThe market value method must be used by the company because it owns 10% (10,000 ÷ 100,000) of the total shares of the outstanding common stock of Ship Corporation. The market value method must be used when less than 20% of the outstanding stock is owned because the investor cannot exercise either significant influence or control.

CASE B

The equity method must be used by the company because it owns 40% (40,000 ÷ 100,000) of the total shares of the outstanding common stock of Ship Corporation. The equity method must be used when at least 20% but not more than 50% of the outstanding stock is owned, because the investor can exercise significant influence, but not control, over the operating and financing policies of the other company.


a. Jan. 10, 2008 Stock acquisition:Investment in SAS (+A)..................... 200,000 (10,000 shares x $20) Cash (–A)................................... 200,000Investment in assoc. co. (+A)............ 800,000 (40,000 shares x $20) Cash (–A)................................... 800,000

b. Net income of Ship Co.: None1

Investment in assoc. company (+A). . 120,000 Equity in earnings of assoc. co. (+R, +SE) ($300,000 x 40%)........ 120,000

c. Dividends paid by Ship Corporation:Cash (+A).......................................... 6,000 Investment income (+R, +SE)........ 6,000 (10,000 shares x $.60)Cash (+A).......................................... 24,000 Investment in assoc. company (–A) 24,000 (40,000 shares x $.60)

d. Year-end valuation:Net unrealized loss/gain – SAS (–SE) 20,000 None2

Allowance to value at market – SAS (–A)........................................ 20,000

[10,000 x ($18 market – $20 cost) = $20,000]1 Not recorded under market value method. 2 Not recorded under the equity method.



Req. 3Case A Case B

a. Balance Sheet:Long-term Investments: Investment in SAS, at market (1)....................................... $180,000 Investment in assoc. co. (2)............................................... $896,000

b. Stockholders’ Equity Other comprehensive income: Net unrealized loss/gain – SAS.................................... (20,000)

c. Income Statement: Investment income............................................................ Equity in earnings of assoc. co. .......................................

6,000120,000

(1) Cost $200,000 – Allowance to value at market $20,000 = Market value $180,000 reported on the balance sheet

(2) Cost $800,000 + % Investee’s net income $120,000 – % Investee’s dividends declared $24,000 = $896,000 reported on the balance sheet

Req. 4

The amounts reported in Requirement (3) are different because of (1) the two different approaches used in recognizing investment revenue and (2) adjustments for changes in market value that are made only under the market value method.

P12–7.

Since Oscar Company acquired 45% (40,500/90,000) of Selma’s outstanding common stock, this investment is accounted for using the equity method.

Statement of Cash Flows:Operating activities

Net Income $xxx,xxx Adjusted for:

Equity in earnings of associated companies (no cash received) –99,000Dividends received from associated companies (cash received) +81,000

Investing activitiesPurchase of investments in associated companies –1,336,500

(Note that the change in market value does not have any effect on the cash flow statement.)


P12–8.

Req. 1

Purchase price for the net assets $120,000Market value of net assets acquired* 83,000Goodwill purchased $ 37,000

*$23,000 cash + $72,000 property and equipment – $12,000 liabilities = $83,000

Req. 2Property and equipment (+A)................................................ 72,000Goodwill (+A) ........................................................................ 37,000 Liabilities (not detailed) (+L) ............................................. 12,000 Cash (–A) ($120,000 paid - $23,000 received)................. 97,000

Req. 3Pronti Company

Consolidated Balance SheetJanuary 4, 2007 (immediately after acquisition)

Cash $ 21,000 ($141,000 - $120,000) Property and equipment (net) 204,000 ($132,000 + $72,000)Goodwill 37,000 Total assets $262,000

Liabilities $ 39,000 ($27,000 + $12,000)Common stock 120,000Retained earnings 103,000 Total liabilities and stockholders’ equity $262,000


P12–9.

Req. 12003 2002 2001

Net income $3,077 $4,079 $389Average total

assets*$166,718 $169,131.5 $167,765

Return on assets = .018 (or 1.8%) .024 (or 2.4%) .002 (or 0.2%)

* 2003: ($165,968 + 167,468)/2 = $166,718 2002: ($167,468+ 170,795)/2 = $169,131.5 2001: ($170,795+ 164,735)/2 = $167,765

Req. 2ROA measures how much the firm earned for each dollar of investment. It is the broadest measure of profitability and management effectiveness, independent of financing strategy. Verizon’s ROA increased in 2002, but decreased in 2003, suggesting that management’s efficiency at utilizing assets to generate income is changing over time.


P12-10

Req. 1

January 4, 2008:Investment in Syracuse Co. (8,000 shares) (+A).................. 96,000 Cash (8,000 shares x $12) (–A)......................................... 96,000Purchased 100% of stock of Syracuse Co. at $12 per share.

Req. 2Purchase price for 100% interest in Syracuse Co. ....................................... $96,000Market value of net assets purchased ($23,000 + $72,000 – $12,000)........ 83,000Goodwill purchased....................................................................................... $13,000

Req. 3

The assets of Syracuse Company will be included on the consolidated balance sheet prepared by Penn Company at their market values at date of acquisition. This is a combination by purchase; therefore, the cost principle is applied.

Req. 4PENN COMPANY AND SUBSIDIARY

Consolidated Balance Sheet January 4, 2008 (immediately after acquisition)

Separate Balance Sheets

Penn Company

SyracuseCompany Eliminations

Consolidated Balance Sheet

Assets: Cash.................................. $ 22,000 $23,000 $ 45,000 Investment in Syracuse Co. 96,000 – 96,000 Property & equipment (net). . 132,000 65,000 + 7,000 204,000 Goodwill............................. + 13,000 13,000 Totals............................. $250,000 $88,000 $262,000Liabilities: Liabilities............................ $ 27,000 $12,000 $ 39,000Stockholders’ Equity: Common stock, Penn........ 120,000 120,000 Common stock, Syracuse.. 40,000 – 40,000 Retained earnings, Penn... 103,000 103,000 Retained earnings, Syrac. . 36,000 – 36,000 Totals............................. $250,000 $88,000 $262,000


ALTERNATE PROBLEMS

AP12–1.

Req. 1When the bonds are purchased, the company increases Investment in Bonds Held-to-Maturity and decreases Cash.

Req. 2When interest is received on the investments, Cash increases (based on the stated rate) and Interest Revenue increases (based on the effective rate). The bonds were purchased at a premium, so the Investment in Bonds Held-to-Maturity account is decreased for the difference between the cash received and the interest revenue recorded.

Req. 3No journal entry is required. A decrease in the market value of bonds in the held-to-maturity portfolio is not recorded.


AP12–2.

Req. 1

Sept 15, 2007Investment in TS (+A)............................................................ 160,000 Cash (– A) (5,000 shares x $32)........................................ 160,000


Dec. 31, 2008Net unrealized loss/gain – TS (+Loss, –SE).......................... 45,000 Allowance to value at market – TS (– A)........................... 45,000

Dec. 31, 2009Net unrealized loss/gain – TS (+Loss, –SE).......................... 20,000 Allowance to value at market – TS (– A)........................... 20,000

Computations for Year-End Adjustments to Market:Year Market Cost = Allowance Balance Unadjusted Balance = Adjustment2007 $170,000 $160,000 +$10,000 $0 +$10,0002008 125,000 160,000 35,000 +10,000 45,0002009 105,000 160,000 55,000 35,000 20,000

Req. 2

Sept 15, 2007Investment in SAS (+A)......................................................... 160,000 Cash (– A).......................................................................... 160,000


Dec. 31, 2008Net unrealized loss/gain – SAS (– SE).................................. 45,000 Allowance to value at market – SAS (– A)......................... 45,000

Dec. 31, 2009Net unrealized loss/gain – SAS (– SE).................................. 20,000 Allowance to value at market – SAS (– A)......................... 20,000


AP12–3.

Req. 1

The market value method of accounting for long-term investments must be used in this situation because 6% of the outstanding voting stock of Seven Corporation is owned. The market value method must be used when less than 20% of the outstanding stock is owned because the investor company cannot exercise significant influence or control.

Req. 2

a. Acquisition: 2008 2009Investment in SAS (+A)..................... 360,000 Cash (– A)...................................... 360,000Purchased 12,000 shares of Seven Corp. no-par stock at $30 per share.

b. Income reported by Seven Company:Revenue should not be recognized by the company on the basis of Seven Corp. income in either 2008 or 2009 because, under the market value method, revenue is not recognized until dividends are declared.

c. Dividends received:Cash (+A).......................................... 3,600 4,800 Investment income (+R, +SE)........ 3,600 4,800 2008: $60,000 x 6% = $3,6002009: $80,000 x 6% = $4,800

d. Market value effects:Net unrealized loss/gain – SAS (– SE) 24,000 Allowance to value at market – SAS (– A) .............................................. 24,000Allowance to value at market – SAS (+A) 12,000 Net unrealized loss/gain – SAS (+ SE) 12,000

Computations for Year-End Adjustments to Market:Year Market Cost = Allowance Balance Unadjusted Balance = Adjustment2008 $336,000 $360,000 $24,000 $0 $24,000 (12,000 x $28)2009 348,000 360,000 12,000 24,000 + 12,000 (12,000 x $29)


AP12–3. (continued)

Req. 32008 2009

a. Balance sheet:Long-term Investments: Investment in SAS (at market)........................................... $336,000 $348,000

b. Stockholders’ Equity: Other comprehensive income: Net unrealized gain/loss – SAS ................................... (24,000) (12,000)

c. Income Statement: Investment income............................................................. 3,600 4,800


AP12–4.

Req. 1CASE A The market value method must be used by the company because it owns 15%

(30,000 ÷ 200,000) of the total shares. When ownership is less than 20% the market value method must be used because the investor cannot exercise either significant influence or control.

CASE B The equity method must be used by the company because it owns 40% (80,000 ÷ 200,000) of the total shares. When ownership is at least 20% but not more than 50%, the equity method must be used because the investor can exercise significant influence, but not control, over the operating and financing policies of the other company.

Req. 2

Case A-15% Case B-40%January 10, 2009:Investment in SAS (+A)............................ 450,000 (30,000 shares x $15) Investment in associated company (+A) .. (80,000 shares x $15)

1,200,000

Cash (– A)......................................... 450,000 1,200,000Purchased common stock at $15 per share.

December 31, 2009: None1

Investment in associated company (+A)... 36,000 Equity in earnings of investee (+R, +SE) 36,000CASE B—$90,000 x 40% = $36,000

December 31, 2009:Cash (+A).................................................. 18,000 48,000 Investment in assoc. company (–A)...... 48,000 Investment income (+R, +SE)............... 18,000CASE A—30,000 x $.60 = $18,000CASE B—80,000 x $.60 = $48,000

December 31, 2009:Net unrealized loss/gain – SAS (–SE) ..... 180,000 None2

Allowance to value at market – SAS (–A) 180,000CASE A—30,000 shares x ($9 market price

– $15 cost) = $180,000 unrealized loss

1 Not recorded under market value method. 2 Not recorded under the equity method.


AP12–4. (continued)

Req. 3Case A Case B

December 31, 2009:Balance sheet (partial): Investments: Investment in common stock, Boston Corporation.......... $270,000 $1,188,000 Stockholders’ Equity: Other comprehensive income: Net unrealized loss/gain – SAS.................................. (180,000) None

Income Statement (partial): Investment income............................................................. 18,000 Equity in earnings of investee............................................ 36,000

AP12–5.On the Statement of Cash Flows:

Case A Case BOperating Activities: Net income $ xxx,xxx $xxx,xxx Adjusted for: Equity in earnings of assoc. co. (no cash received) – 36,000 Dividends received + 48,000

Investing Activities: Purchase of investments – 450,000 – 1,200,000


AP12–6.

Req. 1

Purchase price for the net assets $120,000Market value of net assets acquired* 111,000Goodwill purchased $ 9,000

*($13,000 cash + $180,000 property and equipment – $82,000 liabilities)

Req. 2Property and equipment (+A)................................................ 180,000Goodwill (+A) ........................................................................ 9,000 Liabilities (not detailed) (+L) ............................................. 82,000 Cash (–A) ($120,000 paid – $13,000 received)................. 107,000

Req. 3Kappa Company

Consolidated Balance SheetJune 1, 2008 (immediately after acquisition)

Cash $ 69,000 ($189,000 - $120,000)Property and equipment (net) 532,000 ($352,000 + $180,000)Goodwill 9,000 Total assets $610,000

Liabilities $175,000 ($93,000 + $82,000)Common stock 250,000Retained earnings 185,000 Total liabilities and stockholders’ equity $610,000


AP12–7.

Req. 12003 2002 2001

Net income $502 $277 $236Average total

assets*$8,236.5 $8,701.5 $8,672.0

Return on assets = .061 (or 6.1%) .032 (or 3.2%) .027 (or 2.7%)

* 2003: ($8,177 + 8,296)/2 = $8,236.5 2002: ($8,296 + 9,107)/2 = $8,701.5 2001: ($9,107 + 8,237)/2 = $8,672.0

Req. 2ROA measures how much the firm earned for each dollar of investment. It is the broadest measure of profitability and management effectiveness, independent of financing strategy. Marriott International’s ROA increased each year, suggesting that management is more efficient at utilizing assets over time to generate income.CASES AND PROJECTS

FINANCIAL REPORTING AND ANALYSIS CASES

CP12-1

Req. 1Note 1 indicates that short-term investments consist of auction rate securities, corporate debt securities, U.S. treasury debt/agency and commercial paper.

Req. 2The Statement of Cash Flows indicates that Pacific Sunwear of California received $ 1,150,125,000 of cash during fiscal 2004 when its available-for-sale short-term investments matured and $36,957,000 when its held-to-maturity short-term investments matured.

Req. 3

ROA Analysis 2004 2003Net Income / Average Total

Assets $106,904 = 0.162 $661,132.5*

$80,200 = 0.145 $554,240**

* $(677,778 + 644,487)/2**$(644,487 + 463,993)/2

This implies that the company has increased its performance from 2003 to 2004.


CP12–2.

Req. 1American Eagle reported $314,546,000 on its balance sheet as at January 29, 2005, for short-term investments. Note 2 indicates that these consisted of tax-exempt municipal bonds, taxable federal agency notes, corporate bonds and auction rate securities.

Req. 2The company purchased investments for $483,083,000 during fiscal 2004, as disclosed on its statement of cash flows.

Req. 3A balance of $10,136,000 was reported for goodwill on the January 29, 2005, balance sheet. The change in goodwill during fiscal 2004 was zero. Since goodwill can only result from the acquisition of another company at a price which exceeds the individual fair market values of the assets and liabilities, it is unlikely that the company purchased another company during this time period. The notes do not indicate that American Eagle acquired any companies over this time period. They do discuss that they disposed of their Bluenotes division during fiscal 2003.

Req. 4

ROA Analysis 2004 2003Net Income / Average Total

Assets $213,343 = 0.192$1,113,036.5*

$59,622 = 0.069$867,634**

* $(1,293,659 + 932,414)/2** $(932,414 + 802,854)/2

This implies that the company has decreased its performance from 2003 to 2004.


CP12–3.

Req. 1

ROA AnalysisAmerican Eagle

OutfittersPacific Sunwear of

CaliforniaProfit Margin Net Income

Net Sales $213,343

= 0.113 $1,881,241

$106,904 = 0.087$1,229,762

Asset Turnover Net Sales Average Total Assets

$1,881,241 =1.69$1,113,036.5*

$1,229,762 = 1.86$661,132.5**

Return on Assets Net Income Average Total Assets

$213,343 = 0.192$1,113,036.5

$106,904 = 0.162 $661,132.5

* $(1,293,659 + 932,414)/2** $(677,778 + 644,487)/2

American Eagle Outfitters provided the higher return on assets.

Req. 2The difference in ROA results primarily from profitability differences, not efficiency. Although Pacific Sunwear of California is slightly more efficient than American Eagle Outfitters, American Eagle’s higher profitability gives it the advantage in ROA.

Req. 3 Industry Average

American Eagle Outfitters

Pacific Sunwear of California

ROA = 8.40% 19.2% 16.2%

Both American Eagle Outfitters’ and Pacific Sunwear of California’s Return on Assets are above the industry average. This means that they are both using their assets better to generate profits. The extreme difference in ROA is probably due to American Eagle and Pacific Sunwear of California using leased stores that are not included as assets on the Balance Sheet.


Beth Kern, 06/07/05,

This question will be revised when the Industry Ratio Report is finished.

CP12–4.

Req. 1

Under the equity method, the investment amount (i.e., $560,000) was increased by the proportionate share in income reported by the investee corporation and decreased by the proportionate share of the dividends declared by the investee corporation. Thus, the increase in the investment account was caused by an excess of investment income over dividends received.

Req. 2

The net increase in the investment account was $160,000 (i.e., $720,000 – $560,000). Dividends during 2008 reduced the investment account by the amount of $80,000; therefore, investment revenue must be $240,000 (i.e., $160,000 + $80,000).

Req. 3

If the market value method were used, investment revenue for 2008 would be $80,000 (the amount of dividends received). The unrealized gain does not affect the income statement because the securities would be classified as available for sale (held long term).

Req. 4

The market price of Trevor stock increased during 2008; therefore, the amount of the investment account balance would be $600,000.

CP12–5.

Under the purchase method of accounting in this country, the excess of the cost of the investment over the book value of the assets is used to revalue the tangible assets to their fair market value and record goodwill. Prior to 2001, goodwill was recorded on the balance sheet as an intangible asset and amortized over a period not to exceed 40 years. Under new rules, goodwill is not amortized, but is reviewed annually for possible impairment.

In England, tangible assets are also recorded at fair market value after an acquisition similar to our purchase method. The major difference is the treatment of goodwill. The recorded amount of goodwill is subtracted from retained earnings and not recorded as an asset. As a result, the combined entity in England will show a lower amount for total assets, but net income will not be affected by the rules in either country.

The amount for “significant owned brands” in the Diageo note would typically be included in goodwill for a U.S. company. In England, the amount for owned brands is not expensed unless there is a permanent decline in value.


CRITICAL THINKING CASES

CP12–6.

This case deals with inside information. The plan to acquire 80% of another company is significant because, when announced, it will affect the stock price of the other company. It is wrong both legally and ethically to trade on insider information regardless the size of your proposed investment. It is also wrong to pass insider information on to another individual even if you do not profit directly from the information.

CP12-7.

The assets, liabilities, revenues and expenses of the two companies will be added together. It is unlikely that the two companies have significant intercompany transactions such as intercompany sales. The analyst cannot simply add the two financial statements together because the investment account must be eliminated and the assets of the acquired company stated at their fair value. Unfortunately, this information is not available publicly. Because the assets of the subsidiary are restated to fair value, the return on assets ratio for the combined company will be less than a weighted average of the two companies before consolidation.

FINANCIAL REPORTING AND ANALYSIS PROJECTS

CP12–8

The solutions to this project will depend on the company and/or accounting period selected for analysis.


lls5e chap12 sols

Documents

single economic entity

american eagle outfitters

exert significant influence

separate financial statements

net unrealized loss gain

auction rate securities

hill irwin financial accounting

consolidated financial statements