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Analyzing Investing Activities: Intercorporate Investments
REVIEW Intercompany investments play an increasingly larger role
in business activities. Companies pursue intercompany activities
for several reasons including diversification, expansion, and
competitive opportunities and returns. This chapter considers our
analysis and interpretation of these intercompany activities as
reflected in financial statements. We consider current reporting
requirements from our analysis perspective--both for what they do
and do not tell us. We describe how current disclosures are
relevant for our analysis, and how we might usefully apply
analytical adjustments to these disclosures to improve our
analysis. We direct special attention to the unrecorded assets and
liabilities in intercompany investments.
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OUTLINE
Passive investments Accounting for Investment Securities
Disclosure of Investment Securities Analyzing Investment
Securities
Investments with Significant Influence Equity Method Accounting
Analysis Implications of Equity Investments
Business Combinations Accounting Mechanics of Business
Combinations Analysis Implications of Business Combinations
Comparison of Pooling versus Purchase Accounting for Business
Combinations
Derivative Securities Defining a Derivative Classification and
Accounting for Derivatives Disclosure of Derivatives Analysis of
Derivatives
Appendix 5A: International Activities Appendix 5B: Investment
Return Analysis
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ANALYSIS OBJECTIVES Analyze financial reporting for
intercorporate investments. Interpret consolidated financial
statements. Analyze implications of both the purchase and pooling
methods of accounting for
business combinations. Interpret goodwill arising from business
combinations. Describe derivative securities and their implications
for analysis. Analyze foreign currency translation disclosures.
Analyze investment returns.
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QUESTIONS 1. Long-term investments are usually investments in
assets such as debt instruments,
equity securities, real estate, mineral deposits, or joint
ventures acquired with longer-term goals. Such goals often include
the acquisition of control or affiliation with other companies,
investment in suppliers, securing sources of supply, etc. The
valuation and presentation of noncurrent investments depends on the
degree of influence that the investor company has over the investee
company. With no influence, debt investments other than
held-to-maturity bonds and equity investments are accounted for at
market value. Once influence is established, equity investments are
accounted for under the equity method or consolidated with the
statements of the investor company.
a. In the absence of evidence to the contrary, an investment
(direct or indirect) in 20%
or more of the voting stock of an investee carries the
presumption of an ability to exercise significant influence over
the investee. Conversely, an investment of less than 20% in the
voting stock of the investee leads to the presumption of a lack of
such influence unless the ability to influence can be demonstrated.
Accounting requirements are: Held-to-maturity securities are
reported at amortized cost. Noncurrent available-for-sale
securities are reported at fair value. Influential securities are
accounted for under the equity method.
b. Standards indicate that a position of more than 20% of the
voting stock might give the investor the ability to exercise
significant influence over the operating and financial policies of
the investee. When such an ability to exercise influence is
evident, the investment should be accounted for under the equity
method. Basically this means at cost, plus the equity in the
earnings or losses of the investee since acquisition (with the
addition of certain other adjustments). Evidence of an investor's
ability to exercise significant influence over operating and
financial policies of the investee is reflected in several ways
such as management representation and participation. While
eligibility to use the equity method is based on the percent of
voting stock outstanding, that can include, for example,
convertible preferred stock, the percent of earnings that can be
picked up under the equity method depends on ownership of common
stock only.
2. a. The accounting for investments in common stock
representing over 20% of equity
requires the equity method. While use of the equity method is
superior to reporting cost, one must note that this is not
equivalent to fair market valuewhich, depending on the
circumstances, can be significantly higher or lower than the
carrying amount under the equity method. An analyst also must
remember that the presumption that an investment holding of 20% or
more of the voting securities of an investee results in significant
influence over that investee is arbitraryan assumption made in the
interest of accounting uniformity. If such influence is absent,
then there is some question regarding the investor's ability to
realize the amount reported.
b. A loss in value of an investment that is other than a
temporary decline should be
recognized the same as a loss in value for other long-term
assets. This statement suggests considerable judgment and
interpretation and, in the past, has resulted in companies being
very slow to recognize losses in their investments. Since
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accounting does not consider a decline in market value to be
conclusive evidence of such a loss, the analyst must be alert to
situations where hope rather than reason supports the carrying
amount of an investment. It must be recognized that the equity
method reflects only current operating losses rather than the
capital losses that occur when the earning power of an investment
deteriorates or disappears.
3. Some weaknesses and inconsistencies pertaining to the
accounting for marketable
securities carried as noncurrent assets include: The
classification of securities as noncurrent investments is based on
management
intent, a subjective notion. Changes in the fair value of
noncurrent available-for-sale securities bypass net income. Equity
securities of companies in which the enterprise has a 20 percent or
larger
interest, and in some instances an even smaller interest than 20
percent, need not be adjusted to market. Instead, it is reported
using the equity method, which may at times yield values
significantly below and at other times above, market.
With regard to such relatively substantial blocks of securities,
the values at which they are carried on the balance sheet may be
substantially different that their realizable values.
4. Generally, investments in marketable securities are one use
of excess cash available to
managers. Other uses include financing growth projects, paying
down debt, paying dividends, or buying back stock. In certain
instances, the purchase of investment securities is viewed as an
admission by the company that they have no positive net present
value growth projects available to direct its monies.
5. Hedging activities are designed to protect the company
against fluctuations in market
instruments. Speculative activities seek to profit on
fluctuations in market instruments. 6. A futures contract is an
agreement between two or more parties to purchase or sell a
certain commodity or financial asset at a future date and at a
definite price. 7. A swap contract is an arrangement between two or
more parties to exchange future cash
flows. Swaps are typically used to hedge risks such as interest
rate and foreign currency risks.
8. An option contract gives a party the right, but not an
obligation, to execute a transaction.
An option to purchase a security at a specified price at a
future date is an example of an option contract. This option is
likely to be exercised if the security price on that future date is
higher than the contract price and not otherwise.
9. A hedge transaction is a transaction executed in an attempt
to protect the company
against a specific market risk. 10. To qualify for hedge
accounting, a derivative instrument must hedge either the fair
value
or the cash flows of an asset, liability, or some other
exposure.
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11. A cash flow hedge is designed to hedge exposure to
volatility in cash flows attributable to a specific risk. An
example of a cash flow hedge is a floating-for-fixed interest rate
swap. This swap hedges the cash flows related to an
interest-bearing financial instrument. An example of a fair value
hedge is a fixed future commitment to sell a fixed quantity of a
commodity at a specified price. This transaction hedges the fair
value of the commodity against loss before the time that it is
sold.
12. In fair value accounting, both the hedging instrument and
the hedged asset or liability are recorded at fair value in the
balance sheet. All realized and unrealized gains and losses on both
the hedging instrument and the hedged asset or liability are
immediately recognized in income.
Unrealized gains and losses relating to the effective portion of
a cash flow hedge are immediately recorded as part of other
comprehensive income up to the effective date of the transaction.
After the effective date of the transaction, the gains and losses
are transferred to income. The cash flow hedging instrument is
recorded at fair value on the balance sheet. However, there is no
offsetting asset or liability as in the case of a fair value hedge.
Instead, the offset in the balance sheet occurs through accumulated
comprehensive income, which is part of equity.
13. Speculative derivatives are recorded at fair value on the
balance sheet and any
unrealized or realized gains or losses are immediately recorded
in net income. 14. From a strict legal viewpoint, the statement is
basically correct. Still, we must remember
that consolidated financial statements are not prepared as legal
documents. Consolidated financial statements disregard legal
technicalities in favor of economic substance to reflect the
economic reality of a business entity under centralized control.
From the analysts' viewpoint, consolidated statements are often
more meaningful than separate financial statements in providing a
fair presentation of financial condition and the results of
operations.
15. The consolidated balance sheet obscures rather than
clarifies the margin of safety
enjoyed by specific creditors. To gain full comprehension of the
financial position of each part of the consolidated group, an
analyst needs to examine the individual financial statements of
each subsidiary. Specifically, liabilities shown in the
consolidated financial statements do not operate as a lien upon a
common pool of assets. The creditors, secured and unsecured, have
recourse in the event of default only to assets owned by the
individual corporation that incurred the liability. If, on the
other hand, a parent company guarantees a specific liability of a
subsidiary, then the creditor would have the guarantee as
additional security.
16. Consolidated financial statements generally provide the most
meaningful presentation of
the financial condition and the results of operations of the
combined entity. Still, they do have certain limitations,
including: The financial statements of the individual companies in
the group may not be
prepared on a comparable basis. Accounting principles applied,
valuation bases, and amortization rates used can differ. This can
impair homogeneity and the validity of ratios, trends, and key
relations.
Companies in relatively poor financial condition may be combined
with sound companies, obscuring information necessary for effective
analysis.
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The extent of intercompany transactions is unknown unless
consolidating financial statements (worksheets) are presented. The
latter reveal the adjustments involved in the consolidation
process, but are rarely disclosed.
Unless disclosed, it is difficult to estimate how much of
consolidated retained earnings are actually available for payment
of dividends.
The composition of the minority interest (such as between common
and preferred stock) cannot be determined because the minority
interest is usually shown as a combined amount in the consolidated
balance sheet.
Consolidated financial statements do not reveal restrictions on
use of cash for individual companies nor the intercompany cash
flows.
Consolidation of nonhomogeneous subsidiaries (such as finance or
insurance subsidiaries) can distort ratios and other relations.
17. a. This disclosure is necessaryit is a subsequent event
required to be disclosed. Also,
the contingency conditions involving additional consideration
are adequately disclosed. Still, it would have been more
informative had the note disclosed the market value of net assets
or stocks issued.
b. This must be accounted for by the purchase method. Since the
more readily determinable value in this case is the consideration
given in the form of the Best Company stock, the investment should
be recorded at $1,057,386 (48,063 shares x $22 market price at
acquisition). In the consolidated statements, there may or may not
be goodwill to be recognizedthis depends on a comparison of the
market value of its net assets to the$1,057,386 purchase price.
c. The contingency is based on the earnings performance of the
acquired companies over the next five yearsbut the total amount
payable in stock is limited to 151,500 shares, to a maximum of $2
million.
d. During the course of the next five years, if the acquired
companies earn cumulatively over $1 million, then the Best Company
will record the additional payment when the outcome of the
contingency is determined beyond a reasonable doubt. The payments
are considered additional consideration in the purchase and will
either increase the carrying values of tangible assets or the
"excess of cost over net tangible assets" (goodwill) account.
18. a. The total cost of the assets is the present value of the
amounts to be paid in the
future. If the liabilities are issued at an interest rate that
is substantially above or below the current effective rate for
similar securities, the appropriate amount of premium or discount
should be recorded.
b. The general rule for determining the total cost of assets
acquired for stock is to value
the assets acquired at the fair value of the stock given (as
traded in the market) or fair value of assets received, whichever
is more clearly evident. If there is no ready market for either the
stock or the assets acquired, the valuation has to be based on the
best means of estimation, including a detailed review of the
negotiations leading up to the purchase and the use of independent
appraisals.
19. Usually, the purchase method of accounting for a business
combination is preferable
from an analyst's viewpoint. Since purchase accounting
recognizes the acquisition values on which the buyer and seller
actually bargained, the balance sheet likely reflects more
realistic (economic) values for both assets and liabilities.
Moreover, the income statement likely better reflects the actual
results of operations due to accounting procedures such as cost
allocation of more appropriate asset values.
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20. a. Goodwill represents the excess of the total cost over the
fair value assigned to the
identifiable tangible and intangible assets acquired less the
liabilities assumed. b. It is possible that the market values of
identifiable assets acquired less liabilities
assumed exceed the cost (purchase price) of the acquired
company. In this case, the values otherwise assignable to
noncurrent assets (except for marketable securities) acquired
should be reduced by a proportionate part of the excess. Negative
goodwill should not be recorded unless the value assigned to such
long-term assets is first reduced to zero. If negative goodwill
must be recorded, it is recorded as an extraordinary gain (net of
tax) below income from continuing operations
c. Marketable Securities are recorded at current net realizable
values. d. Receivables are recorded at the present value of amounts
to be received, computed
at proper current interest rates, less allowances for
uncollectibility and collection costs.
e. Finished Goods are recorded at selling prices less cost of
disposal and reasonable
profit allowance. f. Work-in-Process is recorded at the
estimated selling price of the finished goods less
the sum of the costs to complete, costs of disposal, and a
reasonable profit allowance.
g. Raw Materials are recorded at current replacement costs. h.
Plant and Equipment are recorded at current replacement costs
unless the expected
future use of these assets indicates a lower value to the
acquirer. i. Land and Mineral Reserves are recorded at appraised
market values. j. Payables are recorded at present values of
amounts to be paid, determined at
appropriate current interest rates. k. The goodwill of the
acquired company is not carried forward to the acquiring
company's accounting records. 21. A crude way of adjusting for
omitted values in a pooling combination is to estimate the
difference between the market value and the recorded book value
of the net assets acquired, and then to amortize this difference on
some reasonable basis. The result would be approximately comparable
to the net income reported using purchase accounting. Admittedly,
the information available for making such adjustments is
limited.
22. Analysis should be alert to the appropriateness of the
valuation of the net assets
acquired in the combination. In periods of high stock market
price levels, purchase accounting can introduce inflated values
when net assets (particularly the intangibles) of acquired
companies are valued on the basis of the high market price of the
stock issued. Such values, while determined on the basis of
temporarily inflated stock prices, remain on a company's balance
sheet and may require future write-downs if impaired. This concern
also extends to temporarily depressed stock prices and its related
implications.
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23. a. An acquisition program aimed at purchasing companies with
lower PE ratios can, in
effect, "buy" earnings for the acquiring company. To illustrate,
say that Company X has earnings of $1 million, or $1 per share on 1
million shares outstanding, and that its PE is 50. Now, lets assume
it purchases Company Y at 10 times it earnings of $5,000,000 ($50
million price) by issuing an additional 1,000,000 shares of X
valued at $50 per share. Then: Earnings of Combined Entity are: X
earnings .... $1,000,000
Y earnings .... 5,000,000 $6,000,000
The new number of shares outstanding is 2,000,000, providing an
EPS of $3.00 (computed as $6 million divided by 2 million shares).
Also, note that earnings per share increases from $1 to $3 per
share for Company X by means of this acquisition. We should
recognize the synergistic effect in this case. That is, two
companies combined can sometimes show results that are better than
the total effect of each separately. This can occur through
combination of vertical, horizontal, or other basis of company
integration. Consider the following example:
Company S: PE = 10 EPS = $1.00 Earnings = $1,000,000 Number of
shares = 1,000,000
Company T: PE = 10 Earnings = $1,000,000
Assume Company S buys Company T at a bargain of 10 times
earnings and it assumes $1,000,000 after-tax savings from
efficiencies. Then:
Combined entity: S earnings ..................................
$1,000,000 T earnings .................................. 1,000,000
Savings from merger ................. 1,000,000 New earnings
............................. $3,000,000 New number of shares
.............. 2,000,000 New EPS
..................................... $1.50
The EPS of the combined entity increases 50 percent (relative to
Company S) as a
result of this merger.
b. For adjustment purposes, the financial statements should be
pooled as if the two companies had been merged prior to the years
under considerationwith any intercompany sales eliminated. This
would give the best indication of the earnings potential. However,
adjusting backwards to reflect merger savings subsequently realized
is a bit tenuous. It is probably better to use the actual combined
figures, with mental adjustments by the analyst. Too many "adjusted
for merger savings" statements bear little relation to the
historical record. Also, the analyst may want to compare the
acquiring companys actual results with the new merged company's
record to get an idea of the success of the acquisition program.
One trick in the acquisition game is to look for companies with
satisfactory performance in two prior years (say, Year 1 and Year
2) and a good subsequent year (Year 3). Such companies are prime
acquisition candidates since the Year 3 pooled statements
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would look good in comparison with pooled years 1 and 2. An
analysis of the acquiring companys results alone versus the
combined entity would reveal this trick.
24. The amount of goodwill that is carried on the acquirer's
statement too often bears little
relation to its real value based on the demonstrated superior
earning power of the acquired company. Should the goodwill become
impaired, the resulting write-down could significantly impact
earnings and the market value of the company.
25. All factors supporting the estimates of the benefit periods
should be reexamined in the
light of current economic conditions. Some circumstances that
can affect such estimates are: A new invention that renders a
patented device obsolete. Significant shifts in customer
preferences. Regulatory sanctions against a segment of the
business. Reduced market potential because of an increased number
of competitors.
26.A The major provisions of accounting for foreign currency
translation (SFAS 52) are:
The translation process requires that the functional currency of
the entity be identified first. Ordinarily it will be the currency
of the country where the entity is located (or the U.S. dollar).
All financial statement elements of the foreign entity must then be
measured in terms of the functional currency in conformity with
GAAP.
Under the current rate method (most commonly used), translation
from the functional currency into the reporting currency, if they
are different, is to be at the current exchange rate, except that
revenues and expenses are to be translated at the average exchange
rates prevailing during the period. The current method generally
considers the effect of exchange rate changes to be on the net
investment in a foreign entity rather than on its individual assets
and liabilities (which was the focus of SFAS 8).
Translation adjustments are not included in net income but are
disclosed and accumulated as a separate component of stockholders'
equity (Other Comprehensive Income or Loss) until such time that
the net investment in the foreign entity is sold or liquidated. To
the extent that the sale or liquidation represents realization, the
relevant amounts should be removed from the separate equity
component and included as a gain or loss in the determination of
the net income of the period during which the sale or liquidation
occurs.
27. A The accounting standards for foreign currency translation
have as its major
objectives: (1) to provide information that is generally
compatible with the expected economic effects of a change in
exchange rate on an enterprise's cash flows and equity, and (2) to
reflect in consolidated statements the financial results and
relations as measured in the primary currency of the economic
environment in which the entity operates, which is referred to as
its functional currency. Moreover, in adopting the functional
currency approach, the FASB had the following goals of foreign
currency translation in mind: (1) to present the consolidated
financial statements of an enterprise in conformity with U.S. GAAP,
and (2) to reflect in consolidated financial statements the
financial results and relations of the individual consolidated
entities as measured in their functional currencies. The Board's
approach is to report the adjustment resulting from translation of
foreign financial statements not as a gain or loss in the net
income of the period but as a separate accumulation as part of
equity (in comprehensive income).
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28. A Following are some analysis implications of the accounting
for foreign currency
translation: (a) The accounting insulates net income from
balance sheet translation gains and
losses, but not transaction gains and losses and income
statement translation effects.
(b) Under current GAAP, all balance sheet items, except equity,
are translated at the current rate; thus, the translation exposure
is measured by the size of equity or the net investment.
(c) While net income is not affected by balance sheet
translation, the equity capital is. This affects the debt-to-equity
ratio (the level of which may be specified by certain debt
covenants) and book value per share of the translated balance
sheet, but not of the foreign currency balance sheet. Since the
entire equity capital is the measure of exposure to balance sheet
translation gain or loss, that exposure may be even more
substantial, particularly with regard to a subsidiary financed with
low debt and high equity. The analyst can estimate the translation
adjustment impact by multiplying year-end equity by the estimated
change in the period to period rate of exchange.
(d) Under current GAAP, translated reported earnings will vary
directly with changes in exchange rates, and this makes estimation
by the analyst of the "income statement translation effect" less
difficult.
(e) In addition to the above, income will also include the
results of completed foreign exchange transactions. Also, any gain
or loss on the translation of a current payable by the subsidiary
to parent (which is not of a long-term capital nature) will pass
through consolidated net income.
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EXERCISES Exercise 5-1 (20 minutes) a. Usual objectives
underlying the holding of both current and noncurrent
portfolios
of securities are: Currentfor temporary investments of excess
cash in highly liquid investments. Noncurrentfor investment income,
appreciation value, control purposes of
another entity, or to secure sources of supplies or avenues of
sales. b. Securities should be classified as follows: Trading
securities are always
classified as current. Held-to-maturity securities are
classified as noncurrent, except for the reporting period
immediately prior to maturity. Available-for-sale securities are
classified as current or noncurrent based on managements intent
regarding sale. Influential securities are noncurrent unless their
sale is imminent. Marketable securities that are temporary
investments of cash specifically designated for special purposes
such as plant expansion or sinking fund requirements are classified
as noncurrent.
Unrealized losses on trading securities (which are classified as
current assets)
are the only unrealized losses to flow through the income
statement. Unrealized losses on noncurrent investments (and current
investments in available-for sale securities) are included as a
separate component of shareholders' equity. Some analysts treat
much if not all of these unrealized gains and losses as another
component of adjusted net income.
Exercise 5-2 (12 minutes) a. When available-for-sale securities
are marked to market, an asset account is
adjusted to market (either upward or downward) and an equity
account is increased when marked up or decreased when marked
down.
b. If the investments being marked to market were trading
securities instead of
available-for-sale securities, then an asset account would be
adjusted to market. In addition, a gain or loss account that flows
through income would also be included to reflect the change in
market value (and equity would change accordingly when income is
closed to it).
c. Although under available-for-sale accounting unrealized gains
are not recorded,
realized gains are reflected in reported income. Microsoft,
therefore, can sell securities with unrealized gains and increase
its reported income.
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Exercise 5-3 (20 minutes) a. Passive interest investments
declared to be available-for-sale or trading
securities are reported at fair market value on the balance
sheet. Passive interest investments declared to be held-to-maturity
are reported at historical cost. Significant influential
investments are reported at historical cost increased by a pro rata
share of investee net income and decreased by a pro rata share of
dividends declared by the investee company. Controlling interests
investments are reported using consolidation procedures.
b. Passive interest investments declared to be trading or
available-for-sale
securities are reported at fair market value. Fluctuations in
the value of trading securities are reported in net income in the
period of the fluctuation. Fluctuations in the value of
available-for-sale securities are reported in comprehensive income
of each period.
c. Held-to-maturity securities are reported at historical cost
because period to
period value fluctuations are arguably less relevant since the
company intends to hold the security to maturity and receive the
maturity value of the investment. On one hand, not reporting the
volatility in the value of held-to-maturity securities seems
appropriate since the company does not intend to sell the security
at its higher or lower current value. On the other hand, management
intent can change, and such changes in market value directly impact
the value of the company.
Exercise 5-4 (30 minutes) a. Under purchase accounting, goodwill
is reported if the purchase price exceeds
fair value of the acquired tangible and intangible net assets.
b. All identifiable tangible and intangible assets acquired, either
individually or by
type, and liabilities assumed in a business combination, whether
or not shown in the financial statements of Moore, should be
assigned a portion of the cost of Moore, normally equal to the fair
values at date of acquisition. Then, the excess of the cost of
Moore over the sum of the amounts assigned to identifiable tangible
and intangible assets acquired less the liabilities assumed is
recorded as goodwill.
c. Consolidated financial statements should be prepared to
present financial
position and operating results in a manner more meaningful than
in separate statements. Such statements often are more useful for
analysis purposes.
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d. The first necessary condition for consolidation is control,
as typically evidenced
by ownership of a majority voting interest. As a general rule,
ownership by one company, directly or indirectly, of over fifty
percent of the outstanding voting shares of another company is a
condition necessary for consolidation.Exercise 5-5 (35 minutes)
a. Each of the four corporations will maintain separate
accounting records based on
its own operations (for example, C1's accounting records are not
affected by the fact it has only one stockholder).
b. For SEC filing purposes, consolidated statements would be
presented for Co. X
and Co. C1 and Co. C2 as if these three separate legal entities
were one combined entity. C1 or C2 would probably not be
consolidated if controlled only temporarily. C3 would be shown as a
one-line consolidation (both balance sheet and income statement)
under the equity method.
c. The analyst likely would request the following types of
information (only
consolidated statements normally are available):
(1) Consolidated Co. X with subsidiaries C1 and C2 (C3 would be
a one-line consolidation).
(2) Co. X statements only (all three investee companies, C1, C2,
and C3 would be one-line consolidations).
(3) Separate statements for one or more of the investee
companies (C1, C2, and C3).
(4) Consolidating statements (which would provide everything in
(1)-(3) except separate statements for C3, and would also show the
elimination entries).
(5) Sometimes partial consolidations (such as Co. X plus C2) or
combining statements (such as only C1 and C2) also are useful. For
example, if C1 is a foreign subsidiary, the analyst may ask for a
partial consolidation excluding C1, with separate statements for
C1. Also, loan covenants (or loan collateral) frequently cover only
selected companies, and a partial consolidation or combined
statements are necessary to assess safety margins.
d. Co. X will show an asset "investment in common stock of
subsidiary" valued at
either cost or equity. (The equity method would be required only
if no consolidated statements were presented.) Note: Co. X owns
shares of common stock of Co. C1that is, Co. X does not own any of
C1's assets or liabilities.
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e. 100 percent of C2's assets and liabilities are included in
the consolidated balance
sheet. However, the stockholders' equity of C2 is split into two
parts: 80 percent is added to the stockholders' equity of Co. X and
20 percent is shown on a separate line (above Co. X's stockholders'
equity) as "minority ownership of C2" (frequently just simply
called "minority interest"). The portion of the 80 percent
representing the past purchase by Co. X would be eliminated (in
consolidation) against the "investment in subsidiary."
Exercise 5-5concluded f. Co. X must purchase enough additional
common stock from the other
stockholders in C3 or purchase enough new shares issued by C3 to
increase its ownership to more than 50 percent of C3's common
stock. (Alternatively, C1 or C2 could purchase the additional
shares.)
g. There would be no intercompany investment or intercompany
dividends. But any
other intercompany transactions must be eliminated (such as
intercompany sales and intercompany receivables and payables).
Exercise 5-6A (20 minutes) a. The choice of the functional
currency would make no difference for the reported
sales numbers. This is because sales are translated at rates on
the transaction date, or average rates, regardless of the choice of
the functional currency.
b. When the U.S. dollar is the functional currency (Bethel
Company), some assets
and liabilities (mainly inventory and fixed assets) are
translated at historic rates. The monetary assets and liabilities
are translated at current exchange rates. This means the
translation gain or loss is based only on those assets and
liabilities that are translated at current rates. When the
functional currency is the local currency (Home Brite Company), all
assets and liabilities are translated at current exchange rates,
and common and preferred stock are translated at historic rates.
The translation gain or loss is based on the net investment in each
local currency.
c. When the U.S. dollar is the functional currency, all
translation gains or losses are
included in reported net income. When the functional currency is
the local currency, the translation gain or loss appears on the
balance sheet as a separate component of shareholders' equity (in
comprehensive income or loss), thus bypassing the net income
statement.
(CFA Adapted)
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Chapter 05 - Analyzing Investing Activities: Intercorporate
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5-16
PROBLEMS Problem 5-1 (20 minutes) a. Investments Reported on the
Balance Sheet: Able Corp. bonds ............................ $ 330
Bryan Co. bonds
....................................................... 825
Caltran, Inc. bonds
................................................... 515
Available-for-sale equity securities ..................... 1,600
Trading equity securities .................................... 950
Total
.......................................................................
$4,220 b. Reporting of Unrealized Value Fluctuations:
Unrealized price fluctuations on available-for-sale securities
are reported in comprehensive income (Bryan Co. bonds and
available-for-sale equity securities).
Unrealized price fluctuations on trading securities are reported
in net income (Caltran bonds and trading equity securities).
Problem 5-2 (30 minutes) 1. Since the aggregate market value of
the portfolio exceeds cost, there is no write
down of the individual security whose market value declined to
less than one-half of its cost. Stockholders' equity will be
increased (decreased) to the extent that the excess of market over
cost has increased (decreased) over the period. There is no effect
on the income statement.
2. This situation is similar to 1 above. The only difference is
that the firm in question
does not use the classified balance sheet format. In this case,
the analyst must be sure to review note disclosures regarding the
classification of investments (if not provided on the face of the
balance sheet).
3. This is not a reclassification between categories as the
securities remain in the
available-for-sale category. However, the analyst should note
that management is contemplating a sale in the near future.
4. The increase in fair value of the security should be credited
to shareholders'
equity. (Since the security is classified as noncurrent, it
cannot be a trading security).
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Chapter 05 - Analyzing Investing Activities: Intercorporate
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5-17
Problem 5-3 (45 minutes) a. Effects of Investments on Simpson
Corp.:
2004 (Fair Value Method Applies): Sales: Investment has no
effect on Simpsons sales. Net income: Simpsons net income increases
by the 2004 dividend income
from Bailey Company (BC) of $10,000 (computed as: [$1,000,000
dividend /1,000,000 shares = $1.00 per share] x 10,000 shares =
$10,000)
Cash flows: Dividends received (1% of $1,000,000) $ 10,000 Cost
of shares (10,000 shares x $10) (100,000) Net cash flow
$(90,000)
2005 (Equity Method Applies)
Sales: Investment has no effect on Simpsons sales. Net income:
Simpsons net income increases by 30% share earnings of
Bailey Company (BC) (computed as: [300,000 shares /1,000,000
shares = 30%] x $2,200,000 income = $660,000)
Cash flows: Dividends received (30% of $1,200,000) $ 360,000
Cost of shares (290,000 shares x $11) (3,190,000)
Net cash flow $(2,830,000) b. Carrying (Book) Value of
Investment in Bailey Company: 2004 (Fair Value Method Applies)
At December 31, 2004, Simpsons carrying value of the investment
in BC is the historical cost of $100,000 (10,000 shares * $10 per
share).
2005 (Equity Method Applies)Two Steps
(i) Equity method is applied retroactively to prior years of
ownership (2004): Original cost ($10 x 10,000 shares) $100,000 Add:
Percentage share of 2004 earnings (1% x $2,000,000) 20,000 Less:
Dividends received in 2004 (10,000) Net carrying value at January
1, 2004 ($11 per share) $110,000 (ii) Equity method is carried
through year-end 2005: Net carrying value at January 1, 2004 $
110,000 Add: Original cost of additional shares ($11 x 290,000)
3,190,000 Add: Percentage share of 2005 earnings (30% x $2,200,000)
660,000 Less: Dividends received in 2005 (360,000) Net carrying
value at December 31, 2005 ($12 per share) $3,600,000 c. Accounting
method for 2006. For 2006, with ownership in excess of 50% (in
this
case, 100%) and Simpson in control of BC, the consolidation
method is used to combine BCs financial statements with those of
Simpson. In a consolidation, only the purchase method is available
to account for the investmentpooling of interest is not
allowed.
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Chapter 05 - Analyzing Investing Activities: Intercorporate
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5-18
Problem 5-4 (40 minutes) a. Computation of Burrys Investment in
Bowman Co.
($ thousands) InvestmentCost of Acquisition
................................ $40,000 Net income for Year 6
............................ 1,600 [1] Dividends for Year 6
............................. (800) [2] Net loss for Year 7
................................. (480) [3] Dividends for Year 7
.............................. (640) [4] Investment at Dec. 31,
Year 7 ............... $39,680
Notes ($000s):
[1] 80% of $2,000 net income [2] 80% of $1,000 dividends [3] 80%
of $(600) net loss [4] 80% of $800 dividends
b. The strengths associated with use of the equity method in
this case include:
It reduces the balance in the investment account in Year 7 due
to the net loss. Note: Just recording dividend income would obscure
the loss.
It recognizes goodwill on the balance sheet (via inclusion in
the investment balance) and, therefore, it reflects the full cost
of the investment in Bowman Co.
The possible weaknesses with use of the equity method in this
case include:
Lack of detailed information (one-line consolidation). Dollar
earned by Bowman may not be equivalent to dollar earned by
Burry.
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Chapter 05 - Analyzing Investing Activities: Intercorporate
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5-19
Problem 5-5 (40 minutes) a. For Year 6:
No effect on sales. Net income effect equals the dividend income
of $10 (1% of $1,000, or $1 per
share) since the investment is accounted for under the market
method. Also, assuming the shares are classified as
available-for-sale (a reasonable assumption given subsequent
purchases), the price appreciation of $1 per share will bypass the
income statement.
Cash flow effect equals the dividend income of $10. If the
outflow due to the stock purchase is included: Net cash flow =
dividend income less purchase price = $10 - $100 = $(90).
For Year 7 (the equity method applies): No effect on sales. Net
income effect equals the percentage share of Francisco earnings for
Year 7, or
30% of $2,200 = $660. Cash flow effect equals the dividend
income of $360 (computed as 30% of $1,200).
If the outflow due to the stock purchase is included: Net cash
flow = dividend income less purchase price = $360 - $3,190 =
$(2,830).
b. As of December 31, Year 6: At December 31, Year 6, the
carrying value of the investment in Francisco is $110
(computed as 10 shares x $11 per share). The $11 per share
figure is the fair value at Jan. 1, Year 7.
As of December 31, Year 7 (the equity method applies): Step
onethe equity method is applied retroactively to the prior years of
ownership
(that is, Year 6). Original cost (10 shares x $10)
........................................................... $ 100
Add: Percentage share of Year 6 earnings (1% x $2,000)
................ 20 Less: Dividends received in Year 6
.................................................... (10)Net
carrying value at Jan. 1, Year 7
................................................... $ 110
Step twothe equity method is applied throughout Year 7. Net
carrying value, Jan. 1, Year 7
....................................................... $ 110 Add:
Original cost of additional shares (290 shares x $11) ............
3,190 Add: Percentage share of Year 7 earnings (30% x $2,200)
............. 660 Less: Dividends received in Year 7
.................................................... (360)Net
carrying value at Dec. 31, Year 7
................................................. $3,600
c. For Year 8, with ownership in excess of 50% (indeed, 100%),
Franciscos financial
statements would be consolidated with those of Potter. The
purchase method is the only available choice under current GAAP.
Under this method, all assets and liabilities for Francisco are
restated to fair market value. To do this, one must know fair
market values. Also, information about off-balance sheet items
(such as identifiable intangibles) that may need to be recognized
must be obtained. Due to these implications to asset and liability
values in applying purchase accounting, knowing that the initial
purchase price is in excess of the book value of the acquired
companys net assets does not necessarily indicate that goodwill is
recorded.
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Chapter 05 - Analyzing Investing Activities: Intercorporate
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5-20
Problem 5-6 (35 minutes) a. Pierson, Inc., Pro Forma Combined
Balance Sheet
ASSETS Current assets
........................................................................
$135 Land
........................................................................................
70 Buildings, net
.........................................................................
130 Equipment, net
.......................................................................
130 Goodwill
..................................................................................
35 * Total assets
............................................................................
$500 LIABILITIES AND EQUITY Current liabilities
..................................................................
$140 Long-term liabilities
.............................................................. 180
Shareholders' equity
............................................................ 180
Total liabilities and equity
.................................................... $500 *Goodwill
computation:
Cash payment
.............................................................. $180
Fair value of net assets acquired ($165 - $20) .......... 145 $
35
b. The basic difference between pooling and purchase accounting
for business
combinations is that in the pooling case there is a high
likelihood of not recording all assets acquired and paid for by the
acquiring company. This results in an understatement of assets and,
consequently, an overstatement of current and future net income.
This is because pooling accounting is limited to recording only
book values of the acquired companys net assets, which do not
necessarily reflect current fair values of net assets. Given the
inflationary tendencies of most economies, pooling tends to
understate asset values. The understatement of assets under pooling
leads to an understatement of expenses (from lack of cost
allocations) and to an overstatement of gains realized on the
disposition of these assets.
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Chapter 05 - Analyzing Investing Activities: Intercorporate
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5-21
Problem 5-7 (35 minutes) a. They are reported in "other assets"
[166] at an amount of $155.8 million under
investments in affiliates, which also includes $28.3 million as
goodwill. b. No, disclosure is limited to this note. c. These
acquisitions indicate that of the $180.1 million paid, $132.3
million is for
intangibles, principally goodwill [107]. This implies that most
of the purchase price was in effect for some form of superior
earning power (residual income) assumed to be enjoyed by the
acquired companies.
d. Analytical entry to reflect the Year 11 acquisitions:
Working capital items ...................................... 5.1
Fixed assets net ...............................................
4.7 Intangibles, principally goodwill .................... 132.3
Other assets .....................................................
1.5 Minority interest
............................................... 36.5 Cash (or other
consideration) ................... 180.1
e. (1) The change in the cumulative translation adjustment
accounts [101] for
Europe is most likely due to significant translation losses in
Year 11. (2) In the case of Australia, the decrease in the credit
balance of the account may
be due to sales of businesses by Arnotts Ltd. [169A], which may
have involved the removal of a proportionate part of the account as
well as gains or losses on translation in Year 11. This is
corroborated by item [93] that shows a reduction in the cumulative
translation account due to sales of foreign operations.
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Chapter 05 - Analyzing Investing Activities: Intercorporate
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5-22
CASES Case 5-1 (45 minutes) a. (1) Pooling Accounting:
Investment in Wheal ..........................................
110,000 Capital StockAxel .....................................
110,000
(2) Purchase Accounting:
Investment in Wheal ..........................................
350,000 Capital StockAxel .....................................
110,000 Other Contributed CapitalAxel ............... 240,000 b.
(1) Pooling Worksheet Entries: Capital StockWheal
....................................... 100,000 Other Contributed
CapitalWheal .................. 10,000 Investment in Wheal
..................................... 110,000
(2) Purchase Worksheet Entries: Inventory
............................................................ 25,000
Property, Plant, and Equipment ........................ 100,000
Secret Formula (Patent) .................................... 30,000
Goodwill
..............................................................
40,000 Long-Term Debt
................................................. 2,000 Accounts
Receivable ................................... 5,000 Accrued
Employee Pensions ...................... 2,000 Investment in Wheal
..................................... 190,000
Capital StockWheal .......................................
100,000 Other Contributed CapitalWheal .................. 25,000
Retained EarningsWheal .............................. 35,000
Investment in Wheal .....................................
160,000
c. Consolidated Retained Earnings at Dec. 31, Year 4 Pooling
Purchase
Retained Earnings, Axel
............................................. $150,000 $150,000
Retained Earnings, Wheal ..........................................
35,000 Consolidated Retained Earnings
............................... $185,000 $150,000
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Chapter 05 - Analyzing Investing Activities: Intercorporate
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5-23
Case 5-2 (50 minutes) a. When mergers occur, the resulting
company is different than either of the two
former, separate companies. Consequently, it is often difficult
to assess the performance of the combined entity relative to that
of the two former companies. While this problem extends to both
purchase and pooling methods, it is especially apparent when the
pooling method is used. Under pooling accounting, the book values
of the two companies are combined. Lost is the fair value of the
consideration exchanged and the fair value of the acquired assets
and liabilities. As a result, the assets of the combined company
are usually understated. Since the assets are understated, combined
equity is understated and expenses also are understated. This means
that return on assets and return on equity ratios are
overstated.
b. Tycos high price-to-earnings ratio was primarily driven by
its relatively high
stock price. Its high stock price meant that poolings could be
completed with relatively fewer of its shares being given in
consideration. Accordingly, a high price is crucial to Tycos
ability to execute, and continue to execute, acquisitions at a
favorable price.
c. When large charges are recorded in conjunction with
acquisitions, subsequent
periods are relieved of these charges. This means that future
net income is increased because the items currently written off
will not have to be written off in future periods. As a result, the
reported net income in future periods may be misleadingly high. It
is important that analysts assess the nature and amount of
write-offs related to acquisitions to see if such charges are
actually related to past/current events or more appropriately
should be carried to future periods. If such misstatements are
identified, net income in the period of the acquisition should be
adjusted upward to compensate for the over-charge, and the reported
net income of future periods should be commensurately reduced.
d. Cost-cutting can be valuable when the costs that are cut
relate to redundant
processes or other non-value added processes. However,
cost-cutting can have adverse consequences for the future of the
company if the costs that are cut relate to activities that bring
future valuesuch potential costs include research and development
or management training.
e. When the market perceives a company to have low quality
financial reporting, the
stock price of the company can fall precipitously for at least
two important reasons. First, the market will assign a higher
discount rate to the company to price protect itself against
accounting risk or the risk of misleading financial information.
Second, the integrity of management is called into question. As a
result, the market will not be willing to pay as much for the stock
of the company given the commensurate increase in risk.
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Chapter 05 - Analyzing Investing Activities: Intercorporate
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5-24
Case 5-2continued f. Focusing on earnings before special items
can be a useful tool when attempting
to measure earnings that is more reflective of the permanent
earnings stream and, consequently, more reflective of future
earnings. However, several companies record repeated special item
charges. These companies are essentially overstating earnings for
several periods (not including those with special charges) and then
catching up by recording the huge charge. Analysts must be careful
to identify such companies so that they are not relying on
overstated earnings of the company in predicting future
performance. For such companies, it is prudent to assign a portion
of the charges to several periods to develop an approximation of
the ongoing earnings of the company.
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Chapter 05 - Analyzing Investing Activities: Intercorporate
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5-25
Case 5-3 (120 minutes) a. See table below. b. See table
below.
Transaction
Newmonts
Strategy
Accounting Treatment by
Newmont (pre-SFAS 133)
Accounting Treatment under SFAS 133
Forward Sales of 125,000 ounces from Indonesian mine @ $454 per
ounce
To lock-in the price of future gold sales. Hedge.
No unrealized gain or loss recorded in the books. Realized gains
and losses recorded when sold.
Classification: Cash Flow Hedge. The fair value of the forward
sale (future) recorded as asset and liability (as the case may be)
in the balance sheet until the date of actual sale. The
compensating effect goes to accumulated comprehensive income. Any
change in fair value of forward sale (future) is recognized in
other comprehensive income. At the time of sale, accumulated
comprehensive income is adjusted with net income so that the amount
recognized as revenue is $454/ounce.
Purchased calls on 50,000 ounces with strike price $454 linked
to the forward sale.
To provide an upside potential for 40% of the forward sales in
case of break out of gold price above $454.
No unrealized gain or loss recorded in the books. Realized gains
and losses recorded when sold.
Classification: Fair-Value Hedge of above fixed commitment. The
forward sale commitment @ $454/ounce is the hedged item for this
instrument. The call is recorded at fair value. The net income
effect is the difference between the value of the call and the
value of the equivalent quantity (50,000 ounces) of forward sales.
The effect of 50,000 ounces of the above forward sale is removed
from accumulated comprehensive income and other comprehensive
income (because it is now recorded in net income). The purchase
cost of the call is amortized over its holding period.
Prepaid Sale in July 1999: 483,333 ounces at various prices with
a floor of $300 and ceiling of $380.
To raise immediate cash to service debt. Secondary objective, to
hedge downside risk below $300 per ounce, but provide upside
potential up to $380. A hedge with some limited upside potential
within a range.
No unrealized gains and losses are recognized. Realized price
recorded on date of sale. Prepaid amount computed @ $300 per ounce
and treated as deferred revenue that is adjusted when actual sales
occur to reflect the actual sales proceeds.
Classification: Cash Flow Hedge. Note the fair value of the
instrument is non-zero only when the gold price is above $380 or
below $300. Fair value is recorded in the balance sheet and offset
by accumulated comprehensive income. Any change in fair value is
recognized in other comprehensive income. At time of sale,
accumulated comprehensive income is adjusted with net income so
that the realized amount (variable between $300 and $380 per ounce)
is recorded as revenue. The deferred revenue accounting is
unchanged.
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Chapter 05 - Analyzing Investing Activities: Intercorporate
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5-26
Case 5-3continued (parts a & b)
Transaction
Newmonts
Strategy
Accounting Treatment by
Newmont (pre-SFAS 133)
Accounting Treatment under SFAS 133
Prepaid Sales in July 1999: 35,900 per annum at some fixed price
(no information given about fixed price). Forward purchase in July
1999 of identical quantities at prices ranging from $263 to
$354.
To raise immediate cash to service debt. Yet, first instrument
locks-in sales price, the second instrument reverses it. So the
objective is clearly not hedging related.
No unrealized gains and losses recognized on either security.
Realized (fixed) price on forward sale adjusted by the value of
forward purchase recorded when sold, whereby the revenue recorded
is identical to actual realization. Treated as deferred revenue
that is adjusted when actual sales occur.
Classification: Cash Flow Hedge. Accounting effects similar to
the first instrument in this table (forward sale on Indonesian
mine). Classification: Fair Value Hedge of the forward sale (which
is a fixed commitment). Recorded at fair value and any unrealized
gains and losses on both the forward sale and purchase recorded in
net income. Together both the sale and purchase have no effect on
income or balance sheet.
Purchased Put Option in August 1999 for 2.85 million ounces.
To provide downside risk protection for 2.85 million ounces but
allow for upside potential.
No unrealized gains and losses recognized. Cost of put options
amortized over term.
Classification: Difficult to say. Probably fair-value hedge
because it is not linked to forecast sale of gold. Fair value of
puts and equivalent quantity of gold reported at fair value in
balance sheet. Unrealized gains and losses on puts and equivalent
quantity of gold charged to net income.
Written Call Options in August 1999 for 2.35 million ounces.
To finance the put purchase.
All unrealized gains and losses recorded in net income.
Classification: Speculative transaction. Fair value on balance
sheet and all unrealized gains and losses charged to net
income.
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Chapter 05 - Analyzing Investing Activities: Intercorporate
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5-27
Case 5-3continued c. Forward sales: Economically, this agreement
locks in the cash flows associated
with sales. There is no potential for gain or loss on this sales
price. As a result, risk is removed. The accounting treatment does
reflect the economics of this transaction as there is no impact
until the date of sale. Purchased calls: Economically this
agreement makes the lock in of $454 on 40% of the forward sales a
floor sales price, with no economic impact until the date of sale.
Earlier method does reflect the economics. SFAS 133 treatment
recognizes the change in value over time even though no cash will
change hands until the date of sale. Prepaid sale: Economically,
this agreement locks the cash flows associated with the sales into
a specified range. The deferred revenue treatment is consistent
with the economics. Hedge accounting treatment, both before SFAS
133 and under SFAS 133, is consistent with the economics as there
is no income statement impact until the date of sale. Prepaid sale
(35,900 ounces) and forward purchase (35,900 ounces): Considered
simultaneously, the economic impact of these transactions is a wash
and the accounting treatment reflects this offsetting effect.
Purchased put option: Economically, this option sets a floor on the
sales price of 2.85 million ounces of product. The accounting
treatment, both before SFAS 133 and under SFAS 133 should be a good
reflection of the economic reality. Written call option:
Economically, this option exposes the company to lower sales prices
in the future. The value of this option will change over time.
Thus, the accounting treatment is an adequate reflection of the
economics.
d. The justification for not allowing the hedging treatment
comes from the fact that
the written calls are not hedging a specific transaction or
event. SFAS 133 requires that the derivative be tied to a specific
transaction, not just an overall business risk.
e. Newmonts criticism is valid if hedging is defined in terms of
firm-wide risk, rather
than in terms of transaction risk. From the firm-wide
perspective, Newmont is correct in describing the economic impact
as only being the opportunity cost of selling at a higher price in
the future.
f. The economic reality is that Newmont was unable to benefit
fully from the sudden
increase in gold prices because of its various hedging
arrangements. The financial statements exaggerate the opportunity
costs of the hedging program, primarily because the loss recognized
on the written options is not offset by an increase in the value of
the gold reserves.
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Chapter 05 - Analyzing Investing Activities: Intercorporate
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5-28
Case 5-4A (65 minutes) a. Trial Balance in U.S. Dollars: SWISSCO
Trial Balance December 31, Year 8 Trial Exchange Trial Balance Rate
Balance (in ) Code $/ (in $)
Cash .......................................................
50,000 C .38 19,000 Accounts Receivable
............................ 100,000 C .38 38,000 Property, Plant,
and Equipment, net ... 800,000 C .38 304,000 Depreciation Expense
........................... 100,000 A .37 37,000 Other Expenses
(including taxes) ....... 200,000 A .37 74,000 Inventory 1/1/Year 8
.............................. 150,000 A [1] 56,700 Purchases
.............................................. 1,000,000A .37
370,000 Total debits ............................................
2,400,000 898,700
Sales .......................................................
2,000,000A .37 740,000 Allowance for Doubtful Accounts .......
10,000 C .38 3,800 Accounts Payable
................................. 80,000 C. .38 30,400 Note Payable
.......................................... 20,000 C .38 7,600
Capital Stock ......................................... 100,000 H
.30 30,000 Retained Earnings 1/1/Year 8 ............... 190,000 [2]
61,000 Translation Adjustment ........................ ________ [3]
25,900 Total credits ...........................................
2,400,000 898,700
Notes: C = Current rate; A = Average rate; H = Historical rate
[1] Dollar amount needed to state cost of goods sold at average
rate:
Rate $ Inventory, 1/1/Year 8 150,000 56,700 To Balance Purchases
1,000,000 A .37 370,000 Goods available for sale 1,150,000 426,700
Inventory, 12/31/Year 8 120,000 C .38 45,600 Cost of goods sold
1,030,000 A .37 381,100
[2] Dollar balance at Dec. 31, Year 7 [3] Amount to balance.
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Chapter 05 - Analyzing Investing Activities: Intercorporate
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5-29
Case 5-4Acontinued b.
SWISSCO Income Statement (In Dollars) For the Year Ended Dec.
31, Year 8
Sales
..................................................................
$740,000 Beginning inventory
........................................ $ 56,700 [1] Purchases
......................................................... 370,000
Goods available ................................................
426,700 Ending inventory ( 120,000 x $0.38) ............. (45,600)
[1] Cost of goods sold ...........................................
381,100 Gross profit
....................................................... 358,900
Depreciation expense ...................................... 37,000
Other expenses (including taxes) ................... 74,000 111,000
Net income ........................................................
$247,900
[1] See Note 1 to translated trial balance.
SWISSCO Balance Sheet (In Dollars) At December 31, Year 8
ASSETS Cash
........................................................................
$ 19,000 Accounts receivable
.............................................. $38,000 Less:
Allowances for doubtful accounts ............. 3,800 34,200
Inventory
.................................................................
45,600 [A] Property, plant, and equipment, net
..................... 304,000 Total assets
............................................................
$402,800
LIABILITIES AND EQUITY Accounts payable
.................................................. $30,400 Note
payable ...........................................................
7,600 Total liabilities
........................................................ 38,000
Capital stock
........................................................... 30,000
Retained earnings: 1/1/Year 8 ...............................
61,000 Add: Income for Year 8
.......................................... 247,900 308,900 Equity
Adjustment from translation of foreign currency statements
................................ 25,900 [B] Stockholders' equity
.............................................. 364,800 Total
liabilities and equity .....................................
$402,800
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Chapter 05 - Analyzing Investing Activities: Intercorporate
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5-30
Notes: [A] Ending Inventory 120,000 x 0.38 [B] First time this
account appears in the financial statements.
c. Unisco Corp. Entry to Record its Share in SwissCo Year 8
Earnings:
Investment in SwissCo Corporation ..........................
185,925 Equity in Subsidiary's Income
.............................. 185,925
To record 75% equity in SwissCo's earnings of $247,900.
Note: While not specifically required by the problem, the parent
would also pick up the translation adjustment as follows:
Investment in SwissCo Corporation ..........................
19,425 Equity adjustment from translation of
foreign currency statements (75% x $25,900) ... 19,425
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Chapter 05 - Analyzing Investing Activities: Intercorporate
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5-31
Case 5-5A (60 minutes)
a. With the dollar as the functional currency, FI originally
translated its statements using the "temporal method." Now that the
pont is the functional currency, FI must use the "current method"
as follows:
FUNI, INC. Balance Sheet
December 31, Year 9
Ponts (millions)
Exchange Rate Ponts/$
Dollars (millions)
ASSETS Cash ................................................ 82
4.0 20.50 Accounts receivable ....................... 700 4.0
175.00 Inventory .......................................... 455 4.0
113.75 Fixed assets (net) .......................... 360 4.0 90.00
Total assets ..................................... 1,597 399.25
LIABILITIES AND EQUITY Accounts payable ..........................
532 4.0 133.00 Capital stock .................................. 600
3.0 200.00 Retained earnings .......................... 465 132.86
Translation adjustment ................. (66.61)* Total liabilities
and equity .............. 1,597 399.25
*Translation adjustment = 600 (1/3.0 - 1/4.0) = 600 (1/12) =
(50.00)
+465 (1/3.5 -1/4.0) = 465 (1/28) = (16.61) (66.61)
-
Chapter 05 - Analyzing Investing Activities: Intercorporate
Investments
5-32
Case 5-5continued
FUNI, INC. Income Statement
For Year Ended Dec. 31, Year 9
Ponts (millions)
Exchange Rate Ponts/$
Dollars (millions)
Sales ............................................... 3,500 3.5
1,000.00 Cost of sales .................................. (2,345)
3.5 (670.00) Depreciation expense ..................... (60) 3.5
(17.14) Selling expense .............................. (630) 3.5
(180.00) Net income ...................................... 465
132.86
b. (1) Dollar: Inventory and fixed assets translated at
historical rates. Translation
gain (loss) computed based on net monetary assets. Pont: All
assets and liabilities translated at current exchange rates.
Translation gain (loss) computed based on net investment (all
assets and liabilities).
(2) Dollar: Cost of sales and depreciation expenses translated
at historical rates. Translation gain (loss) included in net income
(volatility increased).
Pont: All revenues and expenses translated at average rates for
period. Translation gain (loss) in separate component of
stockholder equity (in comprehensive income). Net income less
volatile.
(3) Dollar: Financial statement ratios skewed. Pont: Most ratios
in dollars are the same as ratios in ponts.