Ch 05 - Intercorporate Investments

8/20/2019 Ch 05 - Intercorporate Investments

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Chapter 05 - Analyzing Investing Activities: Intercorporate Investments

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Analyzing Investing Activities:Intercorporate Investments

REVIEW

Intercompany investments play an increasingly larger role in business activities. Companiespursue intercompany activities for several reasons including diversification, expansion, andcompetitive opportunities and returns. This chapter considers our analysis andinterpretation of these intercompany activities as reflected in financial statements. Weconsider current reporting requirements from our analysis perspective--both for what theydo and do not tell us. We describe how current disclosures are relevant for our analysis, andhow we might usefully apply analytical adjustments to these disclosures to improve ouranalysis. We direct special attention to the unrecorded assets and liabilities in intercompanyinvestments.


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OUTLINE

•

Passive investmentsAccounting 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 othercompanies, investment in suppliers, securing sources of supply, etc. The valuation andpresentation of noncurrent investments depends on the degree of influence that theinvestor company has over the investee company. With no influence, debt investmentsother than held-to-maturity bonds and equity investments are accounted for at marketvalue. Once influence is established, equity investments are accounted for under theequity 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 toexercise significant influence over the investee. Conversely, an investment of lessthan 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. Accountingrequirements are: Held-to-maturity securities are reported at amortized cost.Noncurrent available-for-sale securities are reported at fair value. Influentialsecurities are accounted for under the equity method.

b. Standards indicate that a position of more than 20% of the voting stock might givethe investor the ability to exercise significant influence over the operating andfinancial policies of the investee. When such an ability to exercise influence isevident, the investment should be accounted for under the equity method. Basicallythis means at cost, plus the equity in the earnings or losses of the investee sinceacquisition (with the addition of certain other adjustments). Evidence of an investor'sability to exercise significant influence over operating and financial policies of theinvestee is reflected in several ways such as management representation andparticipation. While eligibility to use the equity method is based on the percent ofvoting stock outstanding, that can include, for example, convertible preferred stock,the percent of earnings that can be picked up under the equity method depends onownership of common stock only.

2. a. The accounting for investments in common stock representing over 20% of equityrequires the equity method. While use of the equity method is superior to reportingcost, one must note that this is not equivalent to fair market value—which, dependingon the circumstances, can be significantly higher or lower than the carrying amountunder 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 influenceover that investee is arbitrary—an assumption made in the interest of accountinguniformity. If such influence is absent, then there is some question regarding theinvestor's ability to realize the amount reported.

b. A loss in value of an investment that is other than a temporary decline should berecognized the same as a loss in value for other long-term assets. This statementsuggests considerable judgment and interpretation and, in the past, has resulted incompanies 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 ofsuch a loss, the analyst must be alert to situations where hope rather than reasonsupports the carrying amount of an investment. It must be recognized that the equitymethod reflects only current operating losses rather than the capital losses thatoccur when the earning power of an investment deteriorates or disappears.

3. Some weaknesses and inconsistencies pertaining to the accounting for marketablesecurities 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 largerinterest, and in some instances an even smaller interest than 20 percent, need not beadjusted to market. Instead, it is reported using the equity method, which may attimes yield values significantly below and at other times above, market.

•

With regard to such relatively substantial blocks of securities, the values at which theyare carried on the balance sheet may be substantially different that their realizablevalues.

4. Generally, investments in marketable securities are one use of excess cash available tomanagers. Other uses include financing growth projects, paying down debt, payingdividends, or buying back stock. In certain instances, the purchase of investmentsecurities is viewed as an admission by the company that they have no positive netpresent value growth projects available to direct its monies.

5. Hedging activities are designed to protect the company against fluctuations in marketinstruments. 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 acertain 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 cashflows. Swaps are typically used to hedge risks such as interest rate and foreign currencyrisks.

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 anoption contract. This option is likely to be exercised if the security price on that futuredate is higher than the contract price and not otherwise.

9. A hedge transaction is a transaction executed in an attempt to protect the companyagainst a specific market risk.

10. To qualify for hedge accounting, a derivative instrument must hedge either the fair valueor 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 attributableto a specific risk. An example of a cash flow hedge is a floating-for-fixed interest rateswap. This swap hedges the cash flows related to an interest-bearing financialinstrument. An example of a fair value hedge is a fixed future commitment to sell a fixedquantity of a commodity at a specified price. This transaction hedges the fair value ofthe commodity against loss before the time that it is sold.

12. In fair value accounting, both the hedging instrument and the hedged asset or liabilityare recorded at fair value in the balance sheet. All realized and unrealized gains andlosses on both the hedging instrument and the hedged asset or liability are immediatelyrecognized in income.

Unrealized gains and losses relating to the effective portion of a cash flow hedge areimmediately recorded as part of other comprehensive income up to the effective date ofthe transaction. After the effective date of the transaction, the gains and losses aretransferred to income. The cash flow hedging instrument is recorded at fair value on thebalance sheet. However, there is no offsetting asset or liability as in the case of a fairvalue 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 anyunrealized 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 rememberthat consolidated financial statements are not prepared as legal documents.Consolidated financial statements disregard legal technicalities in favor of economicsubstance to reflect the economic reality of a business entity under centralized control.From the analysts' viewpoint, consolidated statements are often more meaningful thanseparate financial statements in providing a fair presentation of financial condition andthe results of operations.

15. The consolidated balance sheet obscures rather than clarifies the margin of safetyenjoyed by specific creditors. To gain full comprehension of the financial position ofeach part of the consolidated group, an analyst needs to examine the individual financialstatements of each subsidiary. Specifically, liabilities shown in the consolidated financialstatements 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 bythe individual corporation that incurred the liability. If, on the other hand, a parentcompany guarantees a specific liability of a subsidiary, then the creditor would have theguarantee 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 dohave 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, andamortization rates used can differ. This can impair homogeneity and the validity ofratios, trends, and key relations.

•

Companies in relatively poor financial condition may be combined with soundcompanies, 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 inthe 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 preferredstock) cannot be determined because the minority interest is usually shown as acombined amount in the consolidated balance sheet.

•

Consolidated financial statements do not reveal restrictions on use of cash forindividual 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 necessary—it is a subsequent event required to be disclosed. Also,the contingency conditions involving additional consideration are adequatelydisclosed. Still, it would have been more informative had the note disclosed themarket value of net assets or stocks issued.

b. This must be accounted for by the purchase method. Since the more readilydeterminable value in this case is the consideration given in the form of the BestCompany 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 maynot be goodwill to be recognized—this depends on a comparison of the market valueof its net assets to the$1,057,386 purchase price.

c. The contingency is based on the earnings performance of the acquired companiesover the next five years—but the total amount payable in stock is limited to 151,500shares, to a maximum of $2 million.

d. During the course of the next five years, if the acquired companies earn cumulativelyover $1 million, then the Best Company will record the additional payment when theoutcome of the contingency is determined beyond a reasonable doubt. The paymentsare considered additional consideration in the purchase and will either increase thecarrying 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 thefuture. If the liabilities are issued at an interest rate that is substantially above orbelow the current effective rate for similar securities, the appropriate amount ofpremium or discount should be recorded.

b. The general rule for determining the total cost of assets acquired for stock is to valuethe assets acquired at the fair value of the stock given (as traded in the market) or fairvalue of assets received, whichever is more clearly evident. If there is no readymarket 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 leadingup to the purchase and the use of independent appraisals.

19. Usually, the purchase method of accounting for a business combination is preferablefrom an analyst's viewpoint. Since purchase accounting recognizes the acquisitionvalues on which the buyer and seller actually bargained, the balance sheet likely reflectsmore realistic (economic) values for both assets and liabilities. Moreover, the incomestatement likely better reflects the actual results of operations due to accountingprocedures 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 theidentifiable tangible and intangible assets acquired less the liabilities assumed.

b. It is possible that the market values of identifiable assets acquired less liabilitiesassumed 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 goodwillshould not be recorded unless the value assigned to such long-term assets is firstreduced to zero. If negative goodwill must be recorded, it is recorded as anextraordinary 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, computedat proper current interest rates, less allowances for uncollectibility and collectioncosts.

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

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

g. Raw Materials are recorded at current replacement costs.

h. Plant and Equipment are recorded at current replacement costs unless the expectedfuture 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 atappropriate current interest rates.

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

21. A crude way of adjusting for omitted values in a pooling combination is to estimate thedifference between the market value and the recorded book value of the net assetsacquired, and then to amortize this difference on some reasonable basis. The resultwould 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 assetsacquired in the combination. In periods of high stock market price levels, purchaseaccounting can introduce inflated values when net assets (particularly the intangibles) ofacquired 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, remainon a company's balance sheet and may require future write-downs if impaired. Thisconcern 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, ineffect, "buy" earnings for the acquiring company. To illustrate, say that Company Xhas earnings of $1 million, or $1 per share on 1 million shares outstanding, and thatits PE is 50. Now, let’s assume it purchases Company Y at 10 times it earnings of$5,000,000 ($50 million price) by issuing an additional 1,000,000 shares of X valued at

$50 per share. Then:Earnings of Combined Entity are: X earnings .... $1,000,000

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 pershare 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 companiescombined can sometimes show results that are better than the total effect of eachseparately. This can occur through combination of vertical, horizontal, or other basis

of company integration. Consider the following example:Company S: PE = 10

EPS = $1.00Earnings = $1,000,000

Number of shares = 1,000,000Company T: PE = 10

Earnings = $1,000,000Assume Company S buys Company T at a bargain of 10 times earnings and itassumes $1,000,000 after-tax savings from efficiencies. Then:

Combined entity:S earnings .................................. $1,000,000T earnings .................................. 1,000,000

Savings from merger ................. 1,000,000New earnings ............................. $3,000,000

New number of shares .............. 2,000,000New EPS ..................................... $1.50

The EPS of the combined entity increases 50 percent (relative to Company S) as aresult of this merger.

b. For adjustment purposes, the financial statements should be pooled as if the twocompanies had been merged prior to the years under consideration—with anyintercompany sales eliminated. This would give the best indication of the earningspotential. However, adjusting backwards to reflect merger savings subsequentlyrealized 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 tocompare the acquiring company’s actual results with the new merged company'srecord to get an idea of the success of the acquisition program. One “trick” in theacquisition game is to look for companies with “satisfactory” performance in twoprior years (say, Year 1 and Year 2) and a good subsequent year (Year 3). Suchcompanies 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 theacquiring company’s 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 littlerelation to its real value based on the demonstrated superior earning power of theacquired 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 thelight of current economic conditions. Some circumstances that can affect such estimatesare:•

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 islocated (or the U.S. dollar). All financial statement elements of the foreign entity mustthen 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 currentexchange rate, except that revenues and expenses are to be translated at the averageexchange rates prevailing during the period. The current method generally considersthe effect of exchange rate changes to be on the net investment in a foreign entityrather 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 andaccumulated as a separate component of stockholders' equity (Other ComprehensiveIncome or Loss) until such time that the net investment in the foreign entity is sold orliquidated. To the extent that the sale or liquidation represents realization, therelevant amounts should be removed from the separate equity component andincluded as a gain or loss in the determination of the net income of the period duringwhich the sale or liquidation occurs.

27. A The accounting standards for foreign currency translation have as its majorobjectives: (1) to provide information that is generally compatible with the expectedeconomic 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 asmeasured in the primary currency of the economic environment in which the entityoperates, which is referred to as its functional currency. Moreover, in adopting thefunctional currency approach, the FASB had the following goals of foreign currencytranslation in mind: (1) to present the consolidated financial statements of an enterprisein conformity with U.S. GAAP, and (2) to reflect in consolidated financial statements thefinancial results and relations of the individual consolidated entities as measured in theirfunctional currencies. The Board's approach is to report the adjustment resulting fromtranslation of foreign financial statements not as a gain or loss in the net income of theperiod 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 currencytranslation:(a) The accounting insulates net income from balance sheet translation gains and

losses, but not transaction gains and losses and income statement translationeffects.

(b) Under current GAAP, all balance sheet items, except equity, are translated at thecurrent rate; thus, the translation exposure is measured by the size of equity or thenet 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 certaindebt covenants) and book value per share of the translated balance sheet, but not ofthe foreign currency balance sheet. Since the entire equity capital is the measure ofexposure to balance sheet translation gain or loss, that exposure may be even moresubstantial, particularly with regard to a subsidiary financed with low debt and highequity. The analyst can estimate the translation adjustment impact by multiplyingyear-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 statementtranslation effect" less difficult.

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


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EXERCISES

Exercise 5-1 (20 minutes)

a. Usual objectives underlying the holding of both current and noncurrent portfoliosof securities are:Current—for temporary investments of excess cash in highly liquid investments.Noncurrent—for 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 alwaysclassified as current. Held-to-maturity securities are classified as noncurrent,except for the reporting period immediately prior to maturity. Available-for-salesecurities are classified as current or noncurrent based on management’s intentregarding sale. Influential securities are noncurrent unless their sale is imminent.

Marketable securities that are temporary investments of cash specificallydesignated for special purposes such as plant expansion or sinking fundrequirements 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. Unrealizedlosses on noncurrent investments (and current investments in available-for salesecurities) are included as a separate component of shareholders' equity. Someanalysts treat much if not all of these unrealized gains and losses as anothercomponent of adjusted net income.


a. When available-for-sale securities are marked to market, an asset account isadjusted to market (either upward or downward) and an equity account isincreased when marked up or decreased when marked down.

b. If the investments being marked to market were trading securities instead ofavailable-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 beincluded 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 sellsecurities with unrealized gains and increase its reported income.


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a. Passive interest investments declared to be available-for-sale or tradingsecurities are reported at fair market value on the balance sheet. Passive interestinvestments declared to be held-to-maturity are reported at historical cost.

Significant influential investments are reported at historical cost increased by apro rata share of investee net income and decreased by a pro rata share ofdividends declared by the investee company. Controlling interests investmentsare reported using consolidation procedures.

b. Passive interest investments declared to be trading or available-for-salesecurities are reported at fair market value. Fluctuations in the value of tradingsecurities are reported in net income in the period of the fluctuation. Fluctuationsin the value of available-for-sale securities are reported in comprehensive incomeof each period.

c. Held-to-maturity securities are reported at historical cost because period toperiod value fluctuations are arguably less relevant since the company intends tohold the security to maturity and receive the maturity value of the investment. Onone hand, not reporting the volatility in the value of held-to-maturity securitiesseems appropriate since the company does not intend to sell the security at itshigher 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.


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

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

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


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d. The first necessary condition for consolidation is control, as typically evidencedby ownership of a majority voting interest. As a general rule, ownership by onecompany, directly or indirectly, of over fifty percent of the outstanding votingshares 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 onits own operations (for example, C1's accounting records are not affected by thefact it has only one stockholder).

b. For SEC filing purposes, consolidated statements would be presented for Co. Xand Co. C1 and Co. C2 as if these three separate legal entities were one combinedentity. C1 or C2 would probably not be consolidated if controlled onlytemporarily. C3 would be shown as a one-line consolidation (both balance sheetand income statement) under the equity method.

c. The analyst likely would request the following types of information (onlyconsolidated statements normally are available):

(1) Consolidated Co. X with subsidiaries C1 and C2 (C3 would be a one-lineconsolidation).

(2) Co. X statements only (all three investee companies, C1, C2, and C3 would beone-line consolidations).

(3) Separate statements for one or more of the investee companies (C1, C2, andC3).

(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 combiningstatements (such as only C1 and C2) also are useful. For example, if C1 is aforeign subsidiary, the analyst may ask for a partial consolidation excludingC1, with separate statements for C1. Also, loan covenants (or loan collateral)frequently cover only selected companies, and a partial consolidation orcombined statements are necessary to assess safety margins.

d. Co. X will show an asset "investment in common stock of subsidiary" valued ateither cost or equity. (The equity method would be required only if noconsolidated statements were presented.) Note: Co. X owns shares of commonstock of Co. C1—that 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 balancesheet. However, the stockholders' equity of C2 is split into two parts: 80 percentis added to the stockholders' equity of Co. X and 20 percent is shown on aseparate line (above Co. X's stockholders' equity) as "minority ownership of C2"

(frequently just simply called "minority interest"). The portion of the 80 percentrepresenting the past purchase by Co. X would be eliminated (in consolidation)against the "investment in subsidiary."

Exercise 5-5—concluded

f. Co. X must purchase enough additional common stock from the otherstockholders in C3 or purchase enough new shares issued by C3 to increase itsownership to more than 50 percent of C3's common stock. (Alternatively, C1 orC2 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 salesand intercompany receivables and payables).

Exercise 5-6A (20 minutes)

a. The choice of the functional currency would make no difference for the reportedsales numbers. This is because sales are translated at rates on the transactiondate, 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. Thismeans the translation gain or loss is based only on those assets and liabilitiesthat are translated at current rates. When the functional currency is the localcurrency (Home Brite Company), all assets and liabilities are translated at currentexchange 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 areincluded in reported net income. When the functional currency is the localcurrency, the translation gain or loss appears on the balance sheet as a separatecomponent of shareholders' equity (in comprehensive income or loss), thusbypassing the net income statement.

(CFA Adapted)


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PROBLEMS

Problem 5-1 (20 minutes)

a. Investments Reported on the Balance Sheet:Able Corp. bonds ............................ $ 330Bryan Co. bonds ....................................................... 825Caltran, Inc. bonds ................................................... 515Available-for-sale equity securities ..................... 1,600Trading equity securities .................................... 950Total ....................................................................... $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).


1. Since the aggregate market value of the portfolio exceeds cost, there is no writedown of the individual security whose market value declined to less than one-halfof its cost. Stockholders' equity will be increased (decreased) to the extent thatthe 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 questiondoes not use the classified balance sheet format. In this case, the analyst must besure to review note disclosures regarding the classification of investments (if notprovided on the face of the balance sheet).

3. This is not a reclassification between categories as the securities remain in theavailable-for-sale category. However, the analyst should note that management iscontemplating 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 tradingsecurity).


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a. Effects of Investments on Simpson Corp.:2004 (Fair Value Method Applies):Sales: Investment has no effect on Simpson’s sales.

Net income: Simpson’s net income increases by the 2004 dividend incomefrom Bailey Company (BC) of $10,000 (computed as:[$1,000,000 dividend /1,000,000 shares = $1.00 per share] x10,000 shares = $10,000)

Cash flows: Dividends received (1% of $1,000,000) $ 10,000Cost of shares (10,000 shares x $10) (100,000)Net cash flow $(90,000)

2005 (Equity Method Applies)Sales: Investment has no effect on Simpson’s sales.Net income: Simpson’s 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, Simpson’s carrying value of the investment in BC is thehistorical 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) $100,000Add: Percentage share of 2004 earnings (1% x $2,000,000) 20,000Less: 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 $ 110,000Add: Original cost of additional shares ($11 x 290,000) 3,190,000Add: Percentage share of 2005 earnings (30% x $2,200,000) 660,000Less: 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 thiscase, 100%) and Simpson in control of BC, the consolidation method is used tocombine BC’s financial statements with those of Simpson. In a consolidation,only the purchase method is available to account for the investment–pooling ofinterest is not allowed.


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

($ thousands) Investment

Cost of Acquisition ............................... $40,000Net 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 BowmanCo.

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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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 assumptiongiven subsequent purchases), the price appreciation of $1 per share will bypassthe income statement.

• Cash flow effect equals the dividend income of $10. If the outflow due to the stockpurchase 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 = dividendincome 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 atJan. 1, Year 7.

As of December 31, Year 7 (the equity method applies):Step one—the equity method is applied retroactively to the prior years of ownership(that is, Year 6).Original cost (10 shares x $10) ........................................................... $ 100

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

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

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

statements would be consolidated with those of Potter. The purchase method is theonly available choice under current GAAP. Under this method, all assets andliabilities for Francisco are restated to fair market value. To do this, one must knowfair market values. Also, information about off-balance sheet items (such asidentifiable intangibles) that may need to be recognized must be obtained. Due tothese 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 acquiredcompany’s net assets does not necessarily indicate that goodwill is recorded.


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

ASSETS

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

LIABILITIES AND EQUITY Current liabilities .................................................................. $140Long-term liabilities .............................................................. 180Shareholders' equity ............................................................ 180

Total liabilities and equity .................................................... $500

*Goodwill computation:Cash payment .............................................................. $180Fair value of net assets acquired ($165 - $20) .......... 145

$ 35

b. The basic difference between pooling and purchase accounting for businesscombinations is that in the pooling case there is a high likelihood of not recordingall assets acquired and paid for by the acquiring company. This results in an

understatement of assets and, consequently, an overstatement of current andfuture net income. This is because pooling accounting is limited to recording onlybook values of the acquired company’s net assets, which do not necessarilyreflect current fair values of net assets. Given the inflationary tendencies of mosteconomies, pooling tends to understate asset values. The understatement ofassets under pooling leads to an understatement of expenses (from lack of costallocations) and to an overstatement of gains realized on the disposition of theseassets.


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a. They are reported in "other assets" [166] at an amount of $155.8 million underinvestments 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 forintangibles, principally goodwill [107]. This implies that most of the purchaseprice was in effect for some form of superior earning power (residual income)assumed to be enjoyed by the acquired companies.

d. Analytical entry to reflect the Year 11 acquisitions:Working capital items ...................................... 5.1Fixed assets net ............................................... 4.7Intangibles, principally goodwill .................... 132.3

Other assets ..................................................... 1.5Minority interest ............................................... 36.5Cash (or other consideration) ................... 180.1

e. (1) The change in the cumulative translation adjustment accounts [101] forEurope 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 maybe due to sales of businesses by Arnotts Ltd. [169A], which may haveinvolved the removal of a proportionate part of the account as well as gains orlosses on translation in Year 11. This is corroborated by item [93] that shows a

reduction in the cumulative translation account due to sales of foreignoperations.


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5-22

CASES

Case 5-1 (45 minutes)

a. (1) Pooling Accounting:Investment in Wheal .......................................... 110,000

Capital Stock—Axel ..................................... 110,000

(2) Purchase Accounting:

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

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

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

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

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

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

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

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

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


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a. When mergers occur, the resulting company is different than either of the twoformer, separate companies. Consequently, it is often difficult to assess theperformance of the combined entity relative to that of the two former companies.

While this problem extends to both purchase and pooling methods, it isespecially 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 theconsideration exchanged and the fair value of the acquired assets and liabilities.As a result, the assets of the combined company are usually understated. Sincethe assets are understated, combined equity is understated and expenses alsoare understated. This means that return on assets and return on equity ratios areoverstated.

b. Tyco’s high price-to-earnings ratio was primarily driven by its relatively highstock price. Its high stock price meant that poolings could be completed with

relatively fewer of its shares being given in consideration. Accordingly, a highprice is crucial to Tyco’s ability to execute, and continue to execute, acquisitionsat a favorable price.

c. When large charges are recorded in conjunction with acquisitions, subsequentperiods are relieved of these charges. This means that future net income isincreased because the items currently written off will not have to be written off infuture periods. As a result, the reported net income in future periods may bemisleadingly high. It is important that analysts assess the nature and amount ofwrite-offs related to acquisitions to see if such charges are actually related topast/current events or more appropriately should be carried to future periods. If

such misstatements are identified, net income in the period of the acquisitionshould be adjusted upward to compensate for the over-charge, and the reportednet income of future periods should be commensurately reduced.

d. Cost-cutting can be valuable when the costs that are cut relate to redundantprocesses or other non-value added processes. However, cost-cutting can haveadverse consequences for the future of the company if the costs that are cutrelate to activities that bring future value—such potential costs include researchand development or management training.

e. When the market perceives a company to have low quality financial reporting, thestock price of the company can fall precipitously for at least two importantreasons. First, the market will assign a higher discount rate to the company toprice protect itself against accounting risk or the risk of misleading financialinformation. Second, the integrity of management is called into question. As aresult, the market will not be willing to pay as much for the stock of the companygiven the commensurate increase in risk.


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5-24

Case 5-2—continued

f. Focusing on earnings before special items can be a useful tool when attemptingto measure earnings that is more reflective of the permanent earnings streamand, consequently, more reflective of future earnings. However, several

companies record repeated special item charges. These companies areessentially overstating earnings for several periods (not including those withspecial charges) and then catching up by recording the huge charge. Analystsmust be careful to identify such companies so that they are not relying onoverstated earnings of the company in predicting future performance. For suchcompanies, it is prudent to assign a portion of the charges to several periods todevelop an approximation of the ongoing earnings of the company.


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a. See table below.b. See table below.

TransactionNewmont’s

Strategy

AccountingTreatment 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 callson 50,000 ounces

with strike price

$454 linked to the

forward sale.

To provide anupside potential for

40% of the forward

sales in case of

break out of gold

price above $454.

No unrealized gain orloss 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 floorof $300 and

ceiling of $380.

To raise immediate

cash to service

debt. Secondary

objective, to hedgedownside 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 ondate 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 comprehensiveincome. 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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5-26

Case 5-3—continued (parts a & b)

TransactionNewmont’s

Strategy

AccountingTreatment 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 2.35million 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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c. Forward sales: Economically, this agreement locks in the cash flows associatedwith 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 ofsale. Earlier method does reflect the economics. SFAS 133 treatment recognizesthe change in value over time even though no cash will change hands until thedate of sale.

Prepaid sale: Economically, this agreement locks the cash flows associated withthe sales into a specified range. The deferred revenue treatment is consistentwith the economics. Hedge accounting treatment, both before SFAS 133 andunder SFAS 133, is consistent with the economics as there is no incomestatement impact until the date of sale.

Prepaid sale (35,900 ounces) and forward purchase (35,900 ounces): Consideredsimultaneously, the economic impact of these transactions is a wash and theaccounting treatment reflects this offsetting effect.

Purchased put option: Economically, this option sets a floor on the sales price of2.85 million ounces of product. The accounting treatment, both before SFAS 133and under SFAS 133 should be a good reflection of the economic reality.

Written call option: Economically, this option exposes the company to lowersales prices in the future. The value of this option will change over time. Thus, theaccounting treatment is an adequate reflection of the economics.

d. The justification for not allowing the hedging treatment comes from the fact thatthe written calls are not hedging a specific transaction or event. SFAS 133requires that the derivative be tied to a specific transaction, not just an overallbusiness risk.

e. Newmont’s criticism is valid if hedging is defined in terms of firm-wide risk, ratherthan in terms of transaction risk. From the firm-wide perspective, Newmont iscorrect in describing the economic impact as only being the opportunity cost ofselling at a higher price in the future.

f. The economic reality is that Newmont was unable to benefit fully from the suddenincrease in gold prices because of its various hedging arrangements. Thefinancial statements exaggerate the opportunity costs of the hedging program,primarily because the loss recognized on the written options is not offset by anincrease in the value of the gold reserves.


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5-28

Case 5-4A (65 minutes)

a. Trial Balance in U.S. Dollars:

SWISSCO

Trial BalanceDecember 31, Year 8

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

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

Purchases .............................................. 1,000,000A .37 370,000Total debits ............................................ 2,400,000 898,700

Sales ....................................................... 2,000,000A .37 740,000Allowance for Doubtful Accounts ....... 10,000 C .38 3,800Accounts Payable ................................. 80,000 C. .38 30,400Note Payable .......................................... 20,000 C .38 7,600Capital Stock ......................................... 100,000 H .30 30,000Retained Earnings 1/1/Year 8 ............... 190,000 [2] 61,000Translation Adjustment ........................ ________ [3] 25,900Total credits ........................................... 2,400,000 898,700

Notes: C = Current rate; A = Average rate; H = Historical rate[1] Dollar amount needed to state cost of goods sold at average rate:

€ Rate $Inventory, 1/1/Year 8 150,000 56,700 To BalancePurchases 1,000,000 A .37 370,000Goods available for sale 1,150,000 426,700Inventory, 12/31/Year 8 120,000 C .38 45,600Cost of goods sold 1,030,000 A .37 381,100

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


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5-29

Case 5-4A—continued

b.

SWISSCO Income Statement (In Dollars)

For the Year Ended Dec. 31, Year 8Sales .................................................................. $740,000Beginning inventory ........................................ $ 56,700 [1]Purchases ......................................................... 370,000Goods available ................................................ 426,700Ending inventory (€ 120,000 x $0.38) ............. (45,600) [1]Cost of goods sold ........................................... 381,100Gross profit ....................................................... 358,900Depreciation expense ...................................... 37,000Other expenses (including taxes) ................... 74,000 111,000Net income ........................................................ $247,900

[1] See Note 1 to translated trial balance.

SWISSCO Balance Sheet (In Dollars)

At December 31, Year 8

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

LIABILITIES AND E QUITY Accounts payable .................................................. $30,400Note payable ........................................................... 7,600Total liabilities ........................................................ 38,000

Capital stock ........................................................... 30,000Retained earnings: 1/1/Year 8 ............................... 61,000

Add: Income for Year 8 .......................................... 247,900 308,900Equity Adjustment from translation offoreign currency statements ................................ 25,900 [B]

Stockholders' equity .............................................. 364,800Total liabilities and equity ..................................... $402,800


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Notes: [A] Ending Inventory € 120,000 x 0.38[B] First time this account appears in the financial statements.

c. Unisco Corp. Entry to Record its Share in SwissCo Year 8 Earnings:

Investment in SwissCo Corporation .......................... 185,925Equity in Subsidiary's Income .............................. 185,925

To record 75% equity in SwissCo's earnings of $247,900.

Note: While not specifically required by the problem, the parent would also pickup 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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5-31

Case 5-5A (60 minutes)

a. With the dollar as the functional currency, FI originally translated itsstatements using the "temporal method." Now that the pont is the functionalcurrency, 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 20.50Accounts receivable ....................... 700 4.0 175.00Inventory .......................................... 455 4.0 113.75Fixed assets (net) .......................... 360 4.0 90.00

Total assets ..................................... 1,597 399.25

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

*Translation adjustment = 600 (1/3.0 - 1/4.0) = 600 (1/12) = (50.00)+465 (1/3.5 -1/4.0) = 465 (1/28) = (16.61)

(66.61)


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FUNI, INC.Income Statement

For Year Ended Dec. 31, Year 9

Ponts(millions ) Exchange RatePonts/$ Dollars(millions)

Sales ............................................... 3,500 3.5 1,000.00Cost of sales .................................. (2,345) 3.5 (670.00)Depreciation expense ..................... (60) 3.5 (17.14)Selling expense .............................. (630) 3.5 (180.00)Net income ...................................... 465 132.86

b. (1) Dollar: Inventory and fixed assets translated at historical rates. Translation

gain (loss) computed based on net monetary assets.Pont: All assets and liabilities translated at current exchange rates.

Translation gain (loss) computed based on net investment (allassets and liabilities).

(2) Dollar: Cost of sales and depreciation expenses translated at historicalrates. Translation gain (loss) included in net income (volatilityincreased).

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.

Documents

Ch 05 - Intercorporate Investments