module 9 inter corporate investments

Module 6

Reporting and Analyzing Intercorporate Investments

QUESTIONS

Q6-1. a) Trading securities are reported at their fair market value in the balance sheet. b) Available-for-sale securities are reported at their fair market value in the balance sheet. c) Held-to-maturity securities are reported at their amortized cost in the balance sheet.

Q6-2. An unrealized holding gain (loss) is an increase (decrease) in the fair market value of an asset (in this case, an investment security) that is still owned.

Q6-3. Unrealized holding gains and losses related to trading securities are reported in the current year income statement (and also retained earnings). Unrealized holding gains and losses related to available-for-sale securities are reported as a separate component of stockholders' equity called Other Comprehensive Income (OCI).

Q6-4. Significant influence gives the owner of the stock the ability to influence significantly the operating and financing activities of the company whose stock is owned. Normally, this is accomplished with a 20% through 50% ownership of the company's voting stock.

The equity method is used to account for investments with significant influence. Such an investment is initially recorded at cost; the investment is increased by the proportionate share of the investee company's net income, and equity income is reported in the income statement; the investment account is decreased by dividends received on the investment; and the investment account is reported in the balance sheet at its book value. Unrealized appreciation in the market value of the investment is not recognized.

Q6-5. Yetman Company's investment in Livnat Company is an investment with significant influence, and should, therefore, be accounted for using the equity method. At year-end, the investment should be reported in the balance sheet at $258,000 [$250,000 + (40% $80,000) - (40% x $60,000)].

Q6-6. A stock investment representing more than 50% of the investee company's voting stock is generally viewed as conferring “control” over the investee company. The investor and investee companies must be consolidated for financial reporting purposes.

©Cambridge Business Publishers, 2006Solutions Manual, Module 6 6-1

Q6-7. Consolidated financial statements attempt to portray the financial position, operating results, and cash flows of affiliated companies as a single economic unit so that the scope of the entire (whole) entity is more realistically conveyed.

Q6-8. The $750,000 investment in Murray Company appearing in Finn Company's balance sheet and the $300,000 common stock and $450,000 retained earnings appearing on Murray Company's balance sheet are eliminated. The two balance sheets (less the accounts eliminated) are then summed to yield the consolidated balance sheet.

Q6-9. The $75,000 accounts payable on Dee's balance sheet and the $75,000 accounts receivable on Bradshaw's balance sheet are eliminated. In a consolidation, all intercompany items are eliminated so that the consolidated statements show only the interests of outsiders.

Q6-10. Limitations of consolidated statements include the possibility that the performances of poor companies in a group may be "masked" in consolidation. Likewise, rates of return, other ratios, and percentages calculated from consolidated statements might prove deceptive because they are composites. Consolidated statements also eliminate detail about product lines, divisional operations, and the relative profitability of various business segments. (Some of this information may be available in the footnote disclosures relating to the business segments of certain public firms.) Finally, shareholders and creditors of subsidiary companies find it difficult to isolate amounts related to their legal rights by inspecting only consolidated statements.

©Cambridge Business Publishers, 2006Financial Accounting for MBAs, 2nd Edition6-2

MINI EXERCISES

M6-11 (10 minutes)

a. Available-for-sale securities are reported at market value on the balance sheet. For 2003, this is equal to the original cost ($234 million) plus unrecognized gains ($263 million) and less unrealized losses ($6 million), or $491 million.

b. Unrealized gains (and losses) on available-for-sale securities are reported as a component of Other Comprehensive Income on the balance sheet.

M6-12 (15 minutes)

a. Wasley will report the dividends received of $6,600 (6,000 shares $1.10 per share) as income. If the investment is accounted for as available-for-sale, the increase in the market price of the stock will not be recognized as income until the stock is sold. Unrealized gains (losses) are reported as Other Comprehensive Income in the stockholders’ equity section of the balance sheet.

b. If the investment is accounted for as “trading,” Wasley will report $6,600 of dividend income plus income relating to the increase in the market price of the stock of $6,000 ($13 - $12 price increase for 6,000 shares).

M6-13 (10 minutes)

Abbott Laboratories is accounting for its investment securities as available-for-sale. As such, the unrealized gains of $106,673 million are not recognized in current income. Instead, they are reported as an increase in Other Comprehensive Income (OCI). Abbott Labs’ stockholders’ equity is increased by the unrealized gain, but not its net income and retained earnings.


M6-14 (20 minutes)

a. Given the 30% ownership, “significant influence” is presumed and the investment must be accounted for using the equity method. The year-end balance of the investment account is computed as follows:Beginning balance...................... $1,000,000% Lang income earned............... 30,000 ($100,000 0.3)% Dividends received................. (12,000) ($40,000 0.3)Ending balance............................ $1,018,000

b. 30,000 ($100,000 0.3) - Equity earnings are computed as the reported net income of the investee (Lang Company) multiplied by the percentage of the outstanding common stock owned.

c. (1) In contrast to the market method, the equity method of accounting does not report investments at market value. The unrealized gain of $200,000 is not reflected in either the balance sheet or the income statement.

M6-15 (10 minutes)

Equity income on this investment is computed as the investee company (Penno) earnings multiplied by the percentage of the company owned. In this case, equity earnings equal:

$600,000 40% = $240,000

Note that dividends are treated as a return of investment (reduce the investment balance by $80,000, computed as $200,000 40%), and not as income. Also, the investment is recorded at adjusted cost, not at market value, and unrealized gains (losses) are neither recognized on the balance sheet nor in the income statement.

M6-16 (15 minutes)

a. Merck reports its equity method investments at $2.2 billion on its 2003 balance sheet (5% of total assets). Equity method investments are reported at adjusted cost, not at current market value. Adjusted cost is the original purchase price plus (minus) Merck’s proportionate share of investee companies’ profits (losses), less dividends received.

b. Merck accounts for dividends received on equity method investments as a reduction of the investment balance, not as income.


M6-17 (10 minutes)

The $600,000 investment in Hirst Company appearing on Philipich Company's balance sheet and the $300,000 common stock and $450,000 retained earnings of Hirst Company would be eliminated.

In addition, a $150,000 minority interest [20% of ($300,000 + $450,000)] would appear on the consolidated balance sheet. Many analysts treat the minority interest as an equity account, and FASB has issued an exposure draft requiring presentation as such if the proposal becomes GAAP.

M6-18 (10 minutes)

Benartzi Company net income....................................... $600,00090% of $150,000 Liang Company net income............... 135,000Consolidated net income............................................... $735,000

M6-19 (10 minutes)

Consolidated earnings under the pooling of interests method would be higher because pooling-of-interest does not recognize current market values of assets and goodwill. As a result, consolidated earnings will not be reduced by the depreciation and/or amortization of those additional asset values, nor will subsequent income statements be burdened by the amortization of goodwill.


EXERCISES

E6-20 (30 minutes)Trading Securities

Balance SheetIncome

StatementTransaction Cash

Asset +Noncash Assets

=Liabi-lities

+Contrib. Capital +

Retained Earnings

Revenues – Expenses

1. Purchased 6,000 common shares of Liu, Inc., for $12 per share

-72,000 72,000Investment

2. Received a cash dividend of $1.10 per common share from Liu

6,600 6,600Retained Earnings

6,600Dividend Income

3. Year-end market price of Liu common stock is $11.25 per share.

-4,500Investment

-4,500Retained Earnings

–4,500Unrealized

loss

4. Sold all 6,000 common shares of Liu for $66,900

66,900 -67,500Investment

-600RetainedEarnings

–600Loss on sale

Available-for-Sale Securities

Balance SheetIncome



=Liabi-lities

+Contrib. Capital +

Retained Earnings


1. Purchased 6,000 common shares of Liu, Inc., for $12 per share

-72,000 72,000Investment

2. Received a cash dividend of $1.10 per common share from Liu

6,600 6,600Retained Earnings

6,600Dividend Income

3. Year-end market price of Liu common stock is $11.25 per share.

-4,500Investment -4,500

OCI

4. Sold all 6,000 common shares of Liu for $66,900


+4,500OCI


–5,100Loss on sale


E6-21 (30 minutes)

a. Investments classified as trading

Balance SheetIncome



=Liabi-lities

+Contrib. Capital +

Retained Earnings


1. Ohlson Co. purchases 5,000 common shares of Freeman Co. at $16 cash per share

-80,000+80,000

Investment

2. Ohlson Co. receives a cash dividend of $1.25 per common share from Freeman

+6,250 +6,250Retained Earnings

+6,250Dividend Income

3. Year-end market price of Freeman common stock is $17.50 per share

+7,500Investment

+7,500Retained Earnings

+7,500Unrealized

gain

4. Ohlson Co. sells all 5,000 common shares of Freeman for $86,400 cash

+86,400 -87,500Investment


+1,100Loss on

Sale

b. Investments classified as available-for-sale

Balance SheetIncome



=Liabi-lities

+Contrib. Capital +

Retained Earnings


1. Ohlson Co. purchases 5,000 common shares of Freeman Co. at $16 cash per share

-80,000+80,000

Investment

2. Ohlson Co. receives a cash dividend of $1.25 per common share from Freeman

+6,250 +6,250Retained Earnings


3. Year-end market price of Freeman common stock is $17.50 per share

+7,500Investment

+7,500OCI

4. Ohlson Co. sells all 5,000 common shares of Freeman for $86,400 cash


-7,500OCI


+6,400Gain on Sale


E6-22 (15 minutes)

a. The equity securities investment portfolio is reported at its current market value of $35,287 million. The unrealized gains of $26,772 million are concentrated in its holdings of American Express, Coca-Cola, Gillette, and Wells Fargo.

b. Since unrealized appreciation of investments is reported in Accumulated Other Comprehensive Income (OCI), rather than current income, we know that the investment portfolio is accounted for as available-for-sale.

c. The $12,049 million is the change in the net unrealized gain from 2002 to 2003. BH also recognizes that it will have to pay taxes of $4,158 million on these gains. Note: the reclassification adjustment of $4,129 million represents unrealized gains on investments that were included in AOCI at the beginning of the year and were, subsequently, sold. Since these gains are now recognized in current income (and retained earnings), they need to be removed from AOCI to avoid double-counting the gain in stockholders’ equity (both AOCI and retained earnings).

E6-23 (15 minutes)

a. The equity securities investment portfolio is reported at its current market value of $29,205 million. The cost of the portfolio is $27,857 million, there are $1,475 million in unrealized gains and $127 million ($102 million + $25 million) of unrealized losses.

b. Since the investments are accounted for as available-for-sale, unrealized gains (losses) on investments are reported in Other Comprehensive Income (OCI), rather than current income. The investments are reported on the balance sheet at current market value on the statement date.

c. Impairment losses are recognized in current income when the securities decline in market value and the decline is deemed to be other than temporary. Gains and losses realized from the sale of securities are recognized in current income. A reclassification adjustment is required in Other Comprehensive Income. Since the gains and losses from the sale of securities will be recognized in current income (and retained earnings), they need to be removed from AOCI to avoid double-counting the gains and losses in stockholder’s equity.


E6-24 (20 minutes)

Balance SheetIncome



=Liabi-lities

+Contrib. Capital +

Retained Earnings


1. Purchased 12,000 common shares of Barth Co. at $9 cash per share; the shares represent 30% ownership in Barth

-108,000 108,000Investment

2. Received a cash dividend of $1.25 per common share from Barth


3. Recorded income from Barth stock investment when Barth's net income is $80,000

24,000Investment

24,000Retained Earnings

24,000EquityIncome

4. Sold all 12,000 common shares of Barth for $120,500

120,500 -117,000Investment

3,500Retained Earnings

3,500Gain on Sale

E6-25 (20 minutes)

Balance SheetIncome



=Liabi-lities

+Contrib. Capital +

Retained Earnings


1. Healy Co. purchases 15,000 common shares of Palepu Co. at $8 cash per share; the shares represent 25% ownership of Palepu

-120,000+120,000Investment

2. Healy receives a cash dividend of $0.80 per common share from Palepu


3. Palepu reports annual net income of $120,000

+30,000Investment


+30,000Equity Income

4. Healy sells all 15,000 common shares of Palepu for $140,000 cash

+140,000 -138,0002,000

Retained Earnings

2,000Gain on Sale


E6-26 (30 minutes)

a. Market method accounting—Available-for-sale securities

Balance SheetIncome



=Liabi-lities

+Contrib. Capital +

Retained Earnings


1. Ball purchased 10,000 common shares of Leftwich at $15 cash per share; the shares represent a 15% ownership in Leftwich

-150,000 +150,000Investment

2. Leftwich reported annual net income of $80,000

No Entry

3. Received a cash dividend of $1.10 per common share from Leftwich

+11,000+11,000Retained Earnings


4. Year-end market price of Leftwich common stock is $19 per share

+40,000Investment

+40,000OCI

b. Equity method accounting

Balance SheetIncome



=Liabi-lities

+Contrib. Capital +

Retained Earnings


1. Ball purchased 10,000 common shares of Leftwich at $15 cash per share; the shares represent a 30% ownership in Leftwich

-150,000 +150,000Investment

2. Leftwich reported annual net income of $80,000

+24,000Investment


+24,000EquityIncome

3. Received a cash dividend of $1.10 per common share from Leftwich


4. Year-end market price of Leftwich common stock is $19 per share

No Entry


E6-27 (25 minutes)

a. DuPont’s equity method investments are reported at adjusted cost, not market value. Adjusted cost is the purchase price of the investment, plus the investor’s proportionate share of investee company profits (losses) and less dividends received.

b. DuPont’s investment balance of $1,304 million is after the recognition of a $293 million impairment charge and the reallocation of $329 million as assets held for sale. The pre-reduction balance is, therefore, $1,926 million, which is 46.8%, on average, of the $4,112 million ($8,808 million -$4,696 million) net equity of the investee companies.

c. The reconciliation of the investment balance from 2002 to 2003 is approximated as follows:

(in $ million)

Beginning balance $2,047Equity in net loss of affiliates (55)Dividends received (58)Impairment write-down (293)Reclassification to Assets held for sale (329) Approximate ending balance $1,312There is an $8 million unexplained difference between our computed amount and the $1,304 reported in DuPont’s footnote.

d. The equity method reports only the equity owned as an investment on the balance sheet and equity in earnings on the income statement. As a result, use of this method arguably omits assets and liabilities from the face of the balance sheet and sales and expenses from the income statement (compared with the assets and liabilities and sales and expenses that would be recorded with consolidation). Net income and stockholders’ equity are the same whether the equity method or consolidation is used.

Consequently, ROE is the same. However, profit margins (net income/sales) and asset turnover rates (sales / average net operating assets) will differ with the omission of assets and sales.


E6-28 (25 minutes)

a. The investee company reports total assets of $2,657 million, liabilities of $1,847 million, and equity of $810 million. CAT’s investment balance of $432 million is in excess of its proportionate (50%) interest ($810 million 50% = $405 million), indicating that the investment was acquired for more than book value.

b. CAT reports the investment on its balance sheet at $432 million. Since CAT reports an asset of only $432 million, most of the assets and all of the liabilities of the investee company are not are reported on CAT’s balance sheet. If this investment is critical to CAT’s strategic plan, it arguably does not present a clear picture of the capital investment required to conduct CAT’s business or the degree of financial leverage inherent in its operations, even though its accounting is in conformity with GAAP.

c. If the investee company were to fail, would CAT have to invest additional capital to support it? Probably not from a strictly legal standpoint. Yet, if this type of investment is necessary for CAT’s strategic plans, it might find it difficult to finance future ventures of this type if it does not support the failing investee. This means that there can be an effective liability even when no legal liability exists. Analysts can, of course, replace the equity investment with the assets and liabilities to which it relates (constructive consolidation for analysis purposes) if they feel it to be a better representation of the balance sheet and income statement of the company.

d. The equity method reports only the equity owned as an investment on the balance sheet and equity in earnings on the income statement. As a result, use of this method arguably omits assets and liabilities from the face of the balance sheet and sales and expenses from the income statement (compared with the assets and liabilities and sales and expenses that would be recorded with consolidation). Net income and stockholders’ equity are the same whether the equity method or consolidation is used. Thus, ROE is the same, but profit margins (net income/sales) and asset turnover rates (sales / average net operating assets) will differ with the omission of assets and sales.


E6-29 (30 minutes)

a. The trading stock investments will be reported at $225,300. This is computed using their market values at year-end; specifically, $65,300 + $160,000, or $225,300.

b. The available-for-sale stock investments will be reported at $346,700. This is computed using their market values at year-end; specifically, $192,000 + 154,700, or $346,700.

c. The equity method stock investments will be reported at $236,000. This is computed using their equity method value at year-end; specifically, $100,000 + $136,000, or $236,000.

d. Unrealized holding losses of $5,200 will appear in the 2005 income statement. These losses relate to the trading securities; specifically— Barth: $68,000 - $65,300 = $2,700; Foster: $162,500 - $160,000 = $2,500; total of $2,700 + $2,500 = $5,200.

e. (i) Unrealized holding losses of $7,300 will appear in the stockholders' equity section of the December 31, 2005, balance sheet under other comprehensive income. These losses relate to the available-for-sale securities; specifically— McNichols: $197,000 - $192,000 = $5,000; Patell: $157,000 - $154,700 = $2,300; total of $5,000 + $2,300 = $7,300.

(ii) Unrealized holding losses of $5,200 will appear in the stockholders’ equity section of the December 31, 2005, balance sheet under retained earnings. These losses relate to the trading securities; specifically— Barth: $68,000 - $65,300 = $2,700; Foster: $162,500 - $160,000 = $2,500; total of $2,700 + $2,500 = $5,200.

(iii) Total unrealized holding losses in equity of $12,500—totals of (i) & (ii)

f. (i) A fair market value adjustment to investments of $7,300 will appear in the December 31, 2005, balance sheet. This adjustment relates to the available-for-sale securities. See part (e) for the supporting computations. The fair value adjustment decreases the book value of the available-for-sale securities to their year-end market value.

(ii) A fair market value adjustment to investments of $5,200 will appear in the December 31, 2005, balance sheet. This adjustment relates to the trading securities. See part (e) for supporting computations. The fair value adjustment decreases the book value of the trading securities to their year-end market value.

(iii) Total market value adjustment is $12,500—totals of (i) & (ii)


E6-30 (30 minutes)

a. $340 million = 50% ($1,718.1 million - $1,037.2 million)

b. The receipt of dividends is treated as a reduction of the equity method investment. The reduction in the investment account is offset by an increase in cash, and total assets are unaffected. No income is recorded upon the receipt of the dividend.

c. Abbott Laboratories reports equity income equal to its proportionate share of TAP’s net income or $581 million (50% $1,161.9 million).

d. Undistributed earnings are earnings that have not yet been paid out as dividends, or retained earnings. Of TAP’s $680.9 million of stockholders’ equity, $315 is, apparently, retained earnings. Given the profitability of this company, it appears to pay out a substantial portion of its earnings in dividends. (In fact, the footnotes to Abbott Laboratories’ 2003 10-K reveal that TAP paid it $606 in dividends in 2003, more than Abbott Labs recorded in equity earnings for that year).

e. The equity method reports only the equity owned as an investment on the balance sheet and equity in earnings on the income statement. As a result, use of this method arguably omits assets and liabilities from the face of the balance sheet and sales and expenses from the income statement (compared with the assets and liabilities and sales and expenses that would be recorded with consolidation). Net income and stockholders’ equity are the same whether the equity method or consolidation is used. Thus, ROE is the same. But profit margins (net income/sales) and asset turnover rates (sales / average net operating assets) will differ with the omission of assets and sales.


E6-31 (20 minutes)

Healy MillerConsolidating adjustments Consolidated

Current assets............. $1,700,000 $120,000 $1,820,000

Investment in Miller........ 500,000 (500,000) 0

Plant assets, net.......... 3,000,000 410,000 15,000 3,425,000

Goodwill....................... . . 45,000 45,000

Total assets.................. $5,200,000 $530,000 $5,290,000

Liabilities...................... $ 700,000 $ 90,000 $ 790,000

Contributed Capital..... 3,500,000 400,000 (400,000) 3,500,000

Retained earnings....... 1,000,000 40,000 (40,000) 1,000,000

Total liabilities & stockholders’ equity......

$5,200,000 $530,000 $5,290,000

E6-32 (30 minutes)

Rayburn Company purchased all of Kanodia Company's common stock for cash on January 1, after which the separate balance sheets of the two corporations appeared as follows:

Rayburn KanodiaConsolidating adjustments Consolidated

Investment in Kanodia.........................

$ 600,000(600,000) $ 0

Other assets.................. 2,300,000 700,000 20,000 3,020,000

Goodwill........................ . . 40,000 40,000

Total assets................... $2,900,000 $700,000 $3,060,000

Liabilities....................... $ 900,000 $160,000 $1,060,000

Contributed Capital...... 1,400,000 300,000 (300,000) 1,400,000

Retained earnings........ 600,000 240,000 (240,000) 600,000

Total liabilities & stockholders’ equity.......

$2,900,000 $700,000 $3,060,000


E6-33 (20 minutes)

a. Ryan Company’s Financial Statements Balance Sheet Income Statement

TransactionCash Asset

+Noncash Assets

=Liabi-lities

+Contrib. Capital +

Retained Earnings

Revenues - Expenses

Sale of 30,000 shares of stock by Lev – option A +60,000* +60,000

Sale of 30,000 shares of stock by Lev – option B +60,000* +60,000 +60,000

* New Book Value of Stockholders’ Equity for Lev = $400k + $360k = $760k % owned by Ryan = 40k/80k $760k = $380k.

The investment is currently carried at $320k and, therefore, must be written up by $60,000. The increase can be recorded either as an increase in contributed (paid-in) capital or as a gain, which increases profit and retained earnings.

E6-34 (20 minutes)

a. The investment is initially recorded on Engel’s balance sheet at the purchase price of $16.8 million, including $600,000 of goodwill. Since the market value of Ball is less than the carrying amount of the investment on Engel’s balance sheet, the goodwill may be deemed to be impaired. To determine impairment, the imputed value of the goodwill is determined to be 12.5 million - $12.3 million = $200,000. Since this is less than the carrying amount of the goodwill, it is deemed to be impaired.

b. Goodwill must be written down by $400,000. The write-down will reduce the carrying amount of goodwill by $400,000, and the write-down will be recorded as a loss in Engel’s income statement, thus reducing retained earnings by that amount.


E6-35 (40 minutes)

a. (in $millions)

Current assets, principally cash and marketable securities......$ 1,619.1Deferred tax assets.................................................................... 200.2Property, plant, and equipment.................................................. 571.6Other assets............................................................................... 26.2 Total tangible assets...................................................................$ 2,417.1 12.1%

In-process research and development.......................................$ 2,991.8Identifiable intangible assets, principally developed product technology and core technology................................. 4,803.2Goodwill..................................................................................... 9,774.2

Total intangible assets....................................................................$17,569.2 87.9%

b. All assets of the acquired company are reported on the consolidated balance sheet at their fair market values on the date of the acquisition, not at the their net book value.

c. The tangible assets are accounted for just like any other acquired asset: the receivables are removed when collected, inventories affect future cost of goods sold, and depreciable assets are depreciated over their estimated useful lives. Intangible assets with a determinable life are amortized (depreciated) over that useful life. Finally, intangible assets with an indeterminate useful life are not amortized, but are tested annually for impairment, or more often if circumstances require.

d. In-Process R&D is valued at the discounted present value of expected future cash flows. This is very imprecise and involves significant estimates, both of the expected cash flows and of the discount rate.

e. If the In-Process R&D were estimated at a lesser amount, more of the purchase price would be allocated to goodwill. Current profitability would be higher (less In-Process R&D expense), and future earnings would be impacted only if the goodwill is deemed to be impaired and written down.


E6-36 (60 minutes)a.

Cash paid.......................................................................... $210,000Fair market value of shares issued................................ 180,000Purchase price................................................................ $390,000Less: Book value of Harris.............................................. 280,000Excess payment............................................................... 110,000Excess payment assigned to specific

accounts based on fair market value:—Buildings....................................................................... 40,000—Patent............................................................................ 30,000Goodwill............................................................................ $ 40,000

b.Easton, Harris Consolidation Consolidated

Accounts Inc. Co. Entries Totals

Cash $ 84,000 $ 40,000 $ 124,000

Receivables 160,000 90,000 250,000

Inventory 220,000 130,000 350,000

Investment in Harris 390,000 [S] (280,000) -

[A] (110,000) Land 100,000 60,000 160,000

Buildings, net 400,000 110,000 [A] 40,000 550,000

Equipment, net 120,000 50,000 170,000

Patent 0 - [A] 30,000 30,000

Goodwill - - [A] 40,000 40,000 Totals $1,474,000 $ 480,000 $1,674,000

BalancesAccounts payable $ 160,000 $ 30,000 $ 190,000 Long-term liabilities 380,000 170,000 550,000

Common stock 500,000 40,000 [S] (40,000) 500,000 Additional paid-in capital 74,000 - 74,000

Retained earnings 360,000 240,000 [S] (240,000) 360,000

Totals $1,474,000 $ 480,000 $1,674,000


E6-36—continued

c. The tangible assets are accounted for just like any other acquired asset: the receivables are removed when collected, inventories affect future cost of goods sold, and depreciable assets are depreciated over their estimated useful lives. Intangible assets with a determinable life are amortized (depreciated) over that useful life. Finally, intangible assets with an indeterminate useful life (such as goodwill) are not amortized, but are tested annually for impairment, or more often if circumstances require.

E6-37 (20 minutes)

a. Companies use derivative securities in order to mitigate risks, such as commodity price risks, risks relating to foreign exchange fluctuations, or risks relating to fluctuations in interest rates.

b. Derivatives are reported on the balance sheet as are the assets or liabilities to which they relate. Generally, derivatives and the related assets/liabilities are reported on the balance sheet at fair market value.

c. The unrealized gains (losses) on HP’s derivatives are reported in the Other Comprehensive Income section of its stockholders’ equity. This indicates that they have not yet affected HP’s profits. Once the underlying transaction is settled, these unrealized gains (losses) will be removed from OCI and transferred into current income, thus affecting HP’s profitability.


PROBLEMS

P6-38 (50 minutes)

a. Available-for-sale investments are reported at market value on the balance sheet. Thus, Met Life’s bond investments are reported at:

$139,841 million as of 2002$114,636 million as of 2001

b. Net unrealized gains (losses) for 2002 are$7,506 million ($9,079 million - $1,573 million)

Net unrealized gains (losses) for 2001 are$3,131 million ($5,059 million - $1,928 million)

Since the investments are accounted for as available-for-sale, these unrealized gains (losses) did not affect reported income for 2002 and 2001. (Note: Had these investments been accounted for as trading securities, those unrealized gains (losses) would have affected reported income.)

c. Realized gains (losses) are gains (losses) that occur as a result of

sales of securities. These are reported in the income statement and affect reported income.

Unrealized gains (losses) reflect the difference between the current market price of the security and its acquisition cost. Only unrealized gains (losses) from trading securities are reported in income.

d. The mark-to-market investment return for 2002 and 2001 follows:$ millions 2002 2001Net investment income......................... $8,384 $8,574

Realized gains (losses)......................... $682($1,661 -$979)

$(302)($646 -$948)

Change in unrealized gains (losses)..... $4,375($7,506 - $3,131)

$1,454($3,131 -$1,677)

Total...................................................... $13,441 $9,726

The evaluation of investment performance is difficult as companies have discretion over the timing of realized investment gains (losses) and can, thereby, affect reported income. By including unrealized gains (losses) in the analysis, we are able to get a clearer picture of overall investment performance—albeit, with understanding that these are not yet realized. These returns could then be compared with those of competitors and market rates in general for investments of comparable risk.


P6-39 (60 minutes)

a. General Mills’ accounts for the investments in its joint ventures using the equity method—see middle of its note disclosure. Consolidation is not appropriate because General Mills does not control these entities (not >50% equity interest); also, the market method is inappropriate because General Mills is able to exert “significant influence” in the management of these businesses.

Under the equity method, these investments are reflected on General Mills’ balance sheet at adjusted cost (e.g., beginning balance plus proportionate share of investee company earnings less any dividends received). The proportionate share of investee company earnings is recorded as income by the investor company. Dividends are not income. Instead, under the equity method, they are treated as a return of the investment.

b. The investment balance is always equal to the investor’s proportionate share of the stockholders’ equity of the investee company. In the case of General Mills, the combined net assets (stockholders’ equity) of all joint ventures is $660 million ($587 million current assets + $712 million noncurrent assets - $630 million current liabilities - $9 million noncurrent liabilities); these details are in the table for “Combined Financial Information—Joint Ventures—100% Basis.” Since the investment balance is equal to $326 million, it owns 49.4% ($326 million / $660 million), on average. General Mills will, therefore, report approximately 49.4% of the investee company earnings or approximately $30.1 million ($61 million 49.4%).

c. The $326 million investment balance on General Mills’ balance sheet represents the net equity of the joint ventures that it owns. Its proportionate share of the assets of the joint ventures as well as its proportionate share of the joint ventures’ liabilities is not reflected on its balance sheet, only the net equity. As a result, the actual investing and actual financing amounts required to conduct these operations is not reflected on-balance-sheet. This is the primary criticism of equity method accounting.


P6-39—continued

d. Although General Mills may not have legal liability for the obligations of most, if not all, of its joint ventures, it often has an implicit obligation to stand behind the entities that it has created (which includes their financing). That is, General Mills would be hard-pressed to walk away from one of these entities should it fail to provide for its liabilities.

e. Equity method accounting presents at least two challenges for analysis purposes. (i) Equity method accounting obscures the actual assets and liabilities of the investee company on the books of the investor company. (ii) The equity investments are reported at adjusted cost. As a result, unrealized gains (say, from market value adjustments) are not reflected on the balance sheet or in the income statement.

P6-40 (60 minutes)

a. Yes, each individual company (e.g., parent and subsidiary) maintains its own financial statements. This is necessary to report on the activities of the individual units and to report to the respective stakeholders of each unit.

The purpose of consolidation is to combine these separate statements to more clearly reflect the operations and financial condition of the combined (whole) entity.

b. The Investment in Financial Products Subsidiaries is reported on the parent’s (Machinery and Engine’s) balance sheet at $2,547 million.

This is the same balance as reported for stockholders’ equity of the Financial Products subsidiary.

This relation will always exist so long as the investment is originally purchased at book value (e.g., no goodwill from the purchase).


P6-40—continued

c. The consolidated balance sheet more clearly reflects the actual assets and liabilities of the combined company vis-à-vis that revealed in the equity method of accounting. That is, it better reflects operations as one entity as far as investors and creditors are concerned.

The equity method of accounting that is used by the parent company to account for its investment in the subsidiary reflects only its proportionate share (100% in this case) of the investee company stockholders’ equity and does not report the individual assets and liabilities comprising that equity.

d. The consolidating adjustments generally accomplish three objectives:(i) They eliminate the equity method investment on the parent’s balance sheet and replace it with the actual assets and liabilities of the investee company to which it relates.

(ii) They record any additional assets that are included in the investment balance that may not be reflected on the subsidiary’s balance sheet, like goodwill, for example.

(iii) They eliminate any intercompany sales and receivables/payables.

e. The consolidated stockholders’ equity and the stockholders’ equity of the parent company are equal. This equality will always be the case. The consolidation process replaces the investment account with the assets and liabilities to which it relates. Thus, stockholders’ equity remains unaffected.

f. Consolidated net income will equal the net income of the parent company. The reason for this is that the parent reflects the income of the subsidiary via the equity method of accounting for its investment. The consolidation process merely replaces the equity income account with the actual and individual sales and expenses to which it relates. Net income is unaffected.

g. The equity method of accounting reports investments at adjusted cost (beginning balance plus equity earnings and less dividends received)—this contrasts with the market method. Unrealized gains for a subsidiary are, therefore, not reflected on the consolidated balance sheet and income statement. Instead, the subsidiary is reflected on the balance sheet at its purchase price net of depreciation and amortization, just like any other asset. The consolidation process merely replaces the investment account with the actual assets and liabilities to which it relates. Thus, there can exist substantial unrealized gains subsequent to the acquisition that are not reflected in the consolidated financial statements.


module 9 inter corporate investments

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