Advanced Accounting 6e Debra Jeter Paul Chaney (Solutions Manual All Chapters, 100% Original Verified, A+ Grade) CHAPTER 1 ANSWERS TO QUESTIONS 1. Internal expansion involves a normal increase in business resulting from increased demand for products and services, achieved without acquisition of preexisting firms. Some companies expand internally by undertaking new product research to expand their total market, or by attempting to obtain a greater share of a given market through advertising and other promotional activities. Marketing can also be expanded into new geographical areas. External expansion is the bringing together of two or more firms under common control by acquisition. Referred to as business combinations, these combined operations may be integrated, or each firm may be left to operate intact. 2. Four advantages of business combinations as compared to internal expansion are: (1) Management is provided with an established operating unit with its own experienced personnel, regular suppliers, productive facilities and distribution channels. (2) Expanding by combination does not create new competition. (3) Permits rapid diversification into new markets. (4) Income tax benefits. 3. The primary legal constraint on business combinations is that of possible antitrust suits. The United States government is opposed to the concentration of economic power that may result from business combinations and has enacted two federal statutes, the Sherman Act and the Clayton Act to deal with antitrust problems. 4. (1) A horizontal combination involves companies within the same industry that have previously been competitors. (2) Vertical combinations involve a company and its suppliers and/or customers. (3) Conglomerate combinations involve companies in unrelated industries having little production or market similarities. 5. A statutory merger results when one company acquires all of the net assets of one or more other companies through an exchange of stock, payment of cash or property, or the issue of debt instruments. The acquiring company remains as the only legal entity, and the acquired company ceases to exist or remains as a separate division of the acquiring company. A statutory consolidation results when a new corporation is formed to acquire two or more corporations, through an exchange of voting stock, with the acquired corporations ceasing to exist as separate legal entities. A stock acquisition occurs when one corporation issues stock or debt or pays cash for all or part of the voting stock of another company. The stock may be acquired through market purchases or through direct purchase from or exchange with individual stockholders of the investee or subsidiary company. 6. A tender offer is an open offer to purchase up to a stated number of shares of a given corporation at a stipulated price per share. The offering price is generally set above the current market price of the shares to offer an additional incentive to the prospective sellers. 7. A stock exchange ratio is generally expressed as the number of shares of the acquiring company that are to be exchanged for each share of the acquired company. 1-1
8. Defensive tactics include: (1) Poison pill – when stock rights are issued to existing stockholders that enable them to purchase additional shares at a price below market value, but exercisable only in the event of a potential takeover. This tactic is effective in some cases. (2) Greenmail – when the shares held by a would-be acquiring firm are purchased at an amount substantially in excess of their fair value. The shares are then usually held in treasury. This tactic is generally ineffective. (3) White knight or white squire – when a third firm more acceptable to the target company management is encouraged to acquire or merge with the target firm. (4) Pac-man defense – when the target firm attempts an unfriendly takeover of the would-be acquiring company. (5) Selling the crown jewels – when the target firms sells valuable assets to others to make the firm less attractive to an acquirer. 9. In an asset acquisition, the firm must acquire 100% of the assets of the other firm, while in a stock acquisition, a firm may gain control by purchasing 50% or more of the voting stock. Also, in a stock acquisition, formal negotiations with the target’s management can sometimes be avoided. Further, in a stock acquisition, there might be advantages in keeping the firms as separate legal entities such as for tax purposes. 10. Does the merger increase or decrease expected earnings performance of the acquiring institution? From a financial and shareholder perspective, the price paid for a firm is hard to justify if earnings per share declines. When this happens, the acquisition is considered dilutive. Conversely, if the earnings per share increases as a result of the acquisition, it is referred to as an accretive acquisition. 11. Under the parent company concept, the writeup or writedown of the net assets of the subsidiary in the consolidated financial statements is restricted to the amount by which the cost of the investment is more or less than the book value of the net assets acquired. Noncontrolling interest in net assets is unaffected by such writeups or writedowns. The economic unit concept supports the writeup or writedown of the net assets of the subsidiary by an amount equal to the entire difference between the fair value and the book value of the net assets on the date of acquisition. In this case, noncontrolling interest in consolidated net assets is adjusted for its share of the writeup or writedown of the net assets of the subsidiary. 12. a) Under the parent company concept, noncontrolling interest is considered a liability of the consolidated entity whereas under the economic unit concept, noncontrolling interest is considered a separate equity interest in consolidated net assets. b) The parent company concept supports partial elimination of intercompany profit whereas the economic unit concept supports 100 percent elimination of intercompany profit. c) The parent company concept supports valuation of subsidiary net assets in the consolidated financial statements at book value plus an amount equal to the parent company’s percentage interest in the difference between fair value and book value. The economic unit concept supports valuation of subsidiary net assets in the consolidated financial statements at their fair value on the date of acquisition without regard to the parent company’s percentage ownership interest. d) Under the parent company concept, consolidated net income measures the interest of the shareholders of the parent company in the operating results of the consolidated entity. Under the 1-2
economic unit concept, consolidated net income measures the operating results of the consolidated entity which is then allocated between the controlling and noncontrolling interests. 13. The implied fair value based on the price may not be relevant or reliable since the price paid is a negotiated price which may be impacted by considerations other than or in addition to the fair value of the net assets of the acquired company. There may be practical difficulties in determining the fair value of the consideration given and in allocating the total implied fair value to specific assets and liabilities. In the case of a less than wholly owned company, valuation of net assets at implied fair value violates the cost principle of conventional accounting and results in the reporting of subsidiary assets and liabilities using a different valuation procedure than that used to report the assets and liabilities of the parent company. 14. The economic entity is more consistent with the principles addressed in the FASB’s conceptual framework. It is an integral part of the FASB’s conceptual framework and is named specifically in SFAC No. 5 as one of the basic assumptions in accounting. The economic entity assumption views economic activity as being related to a particular unit of accountability, and the standard indicates that a parent and its subsidiaries represent one economic entity even though they may include several legal entities. 15. The FASB’s conceptual framework provides the guidance for new standards. The quality of comparability was very much at stake in FASB’s decision in 2001 to eliminate the pooling of interests method for business combinations. This method was also argued to violate the historical cost principle as it essentially ignored the value of the consideration (stock) issued for the acquisition of another company. The issue of consistency plays a role in the recent proposal to shift from the parent concept to the economic entity concept, as the former method valued a portion (the noncontrolling interest) of a given asset at prior book values and another portion (the controlling interest) of that same asset at exchange-date market value. 16. Comprehensive income is a broader concept, and it includes some gains and losses explicitly stated by FASB to bypass earnings. The examples of such gains that bypass earnings are some changes in market values of investments, some foreign currency translation adjustments and certain gains and losses, related to minimum pension liability. In the absence of gains or losses designated to bypass earnings, earnings and comprehensive income are the same.
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ANSWERS TO BUSINESS ETHICS CASE
1. The third item will lead to the reduction of net income of the acquired company before acquisition, and will increase the reported net income of the combined company subsequent to acquisition. The accelerated payment of liabilities should not have an effect on net income in current or future years, nor should the delaying of the collection of revenues (assuming those revenues have already been recorded). 2. The first two items will decrease cash from operations prior to acquisition and will increase cash from operations subsequent to acquisition. The third item will not affect cash from operations. 3. As the manager of the acquired company I would want to make it clear that my future performance (if I stay on with the consolidated company) should not be evaluated based upon a future decline that is perceived rather than real. Further, I would express a concern that shareholders and other users might view such accounting maneuvers as sketchy. 4. a) Earnings manipulation may be regarded as unethical behavior regardless of which side of the acquirer/acquiree equation you’re on. The benefits that you stand to reap may differ, and thus your potential liability may vary. But the ethics are essentially the same. Ultimately the company may be one unified whole as well, and the users that are affected by any kind of distorted information may view any participant in an unsavory light. b) See answer to (a).
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ANSWERS TO ANALYZING FINANCIAL STATEMENTS AFS1-1 Kraft and Cadbury PLC (1) Discuss some of the factors that should be considered in analyzing the impact of this merger on the income statement for the next few years. Factors to consider would include items such as a) cost savings b) increasing global presence and increased revenue (from increased market share) c) gaining access to emerging markets, d) geographical and cultural differences between the two companies. Companies generally project EPS for a few years following the merger, and compare these proforma calculations to the EPS prior to the merger. If the EPS increases, the merger is viewed as accretive. If not, it is dilutive. If costs can be eliminated due to redundancies, this helps move toward an accretive EPS. These costs may be related to personnel, computer systems, advertising, etc. However, the impact on the attitudes and incentives of the remaining personnel is not always easy to predict or to quantify. Synergies, in contrast, may serve to boost EPS and create an even more positive environment going forward than anticipated. (2) Discuss the pros and cons that Kraft might have weighed in choosing the medium of exchange to consummate the acquisition. Do you think they made the right decision? If possible, use figures to support your answer. The use of each to consummate a merger represents an opportunity cost, in that the cash obviously cannot be used elsewhere. A company needs to weigh the alternative uses available at a given point in time. The use of stock increases the denominator of the EPS calculation thus diluting the earnings for a the existing shareholders. This is not necessarily a poor choice, though, as long as the increase in the numerator justifies the impact on the denominator. The current stock price of the two companies determines the exchange ratio, and most companies are more comfortable using stock when its value is high because it takes fewer shares to reach a specified acquisition price. This view is not entirely sound, however, as the price of the target may be inflated also when the market prices are generally higher. The use of debt to consummate a merger is associated with increased interest costs; hence, debt is generally a wiser choice when interest rates are low. (3) In addition to the factors mentioned above, there are sometimes factors that cannot be quantified that enter into acquisition decisions. What do you suppose these might be in the case of Kraft's merger with Cadbury? One issue to consider is the cultural differences between the two companies. If one company has a _______ management style while the other is predominantly ________, the merger can create morale problems for individuals accustomed to being evaluated and treated in a different fashion. (4) This acquisition is complicated by the lack of consistency between the two companies' methods of accounting and currency. Discuss the impact that these issues are likely to have on the merged company in the years following the acquisition. Differences in methods, such as depreciation, approaches to estimated bad debts and other reserves, inventory valuation, etc. can lead to headaches and soaring costs following a merger. Translating currency into uniform denomination, whether dollars or euros, leads to translation gains or losses, which impact either earnings or other comprehensive income and more headaches.
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AFS1-2 Kraft and Cadbury PLC A. Cadbury’s Performance Cadbury
ROE 2009 2008 2007
14.5% 10.3% 9.7%
ROA 2009 2008 2007
Leverage 2009 2.308 2008 2.517 2007 2.717
6.3% 4.1% 3.6%
Profit Margin 2009 8.5% 2008 6.8% 2007 8.6%
Asset Turnover 2009 0.735 2008 0.605 2007 0.414
Asset/MV 2009 0.663 2008 1.079 2007 1.183
Profit Margin (PM%) 2009 8.5% 2008 6.8% 2007 8.6%
NI/CFO 2009 0.973 2008 0.776 2007 0.499
MV/BV 2009 3.483 2008 2.332 2007 2.296
Asset turnover 2009 0.735 2008 0.605 2007 0.414
CFO/Sales 2009 8.8% 2008 8.7% 2007 17.3%
Sales/WC 2009 (19.337) 2008 (7.150) 2007 (2.333)
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WC/Assets 2009 -3.8% 2008 -8.5% 2007 -17.8%
AFS1-1 (continued) Part A Computations ROE
Net Income 2009 509 2008 364 2007 405
Equity 3,522 3,534 4,173
ROE 14.5% 10.3% 9.7%
ROA
Net Income Assets 2009 509 8,129 2008 364 8,895 2007 405 11,338
PM%
Net Income 2009 509 2008 364 2007 405
Sales 5,975 5,384 4,699
PM% 8.5% 6.8% 8.6%
Asset Turn. 2009 2008 2007
Sales 5,975 5,384 4,699
Assets Asset Turn. 8,129 0.735 8,895 0.605 11,338 0.414
NI/CFO Net Income 2009 509 2008 364 2007 405
CFO 523 469 812
NI/CFO 0.973 0.776 0.499
CFO/Sales 2009 2008 2007
CFO 523 469 812
Sales CFO/Sales 5,975 8.8% 5,384 8.7% 4,699 17.3%
Sales/WC 2009 2008 2007
Sales 5,975 5,384 4,699
WC Sales/WC (309) (19.337) (753) (7.150) (2,014) (2.333)
WC/Assets 2009 2008 2007
WC Assets WC/Assets (309) 8,129 -3.8% (753) 8,895 -8.5% (2,014) 11,338 -17.8%
leverage 2009 2008 2007
Assets 8,129 8,895 11,338
Equity Asset/equity 3,522 2.308 3,534 2.517 4,173 2.717
Assets/MV 2009 2008 2007
Assets 8,129 8,895 11,338
MV Asset/MV 12,266 0.663 8,241 1.079 9,581 1.183
MV/Equity 2009 2008 2007
MV 12,266 8,241 9,581
Discussion 1-7
ROA 6.3% 4.1% 3.6%
Equity MV/equity 3,522 3.483 3,534 2.332 4,173 2.296
AFS1-1 (continued) Part A The trend in Cadbury’s performance from 2007 to 2009 is very strong. The profitability ratios all increases. ROE increased from 9.7% to 14.5%, while ROA increased from 3.6% to 6.3%. The profit margin decreased slightly in 2008 but was still strong at 6.8%. The gross margins (not shown) remained fairly constant over the three years averaging around 46%. Cadbury generated more than 8% cash from operation (CFO) in each year. The leverage ratio decreased and the market value to book value ratio increased every year to 3.483 in 2009 (indicating good growth potential). The asset turnover ratio (sales to assets) increased in every year, primarily from increased revenues and decreasing assets. Working capital was negative in every year but also has been improving as Cadbury has been reducing the amount of current liabilities over time.
Gross margin percentages
2007 46.7%
2008 46.7%
2009 46.3%
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Cadbury’s ROE and ROA
The solid lines in each graph represent a line where the ROE or ROA is equal to the three year average ROE or ROA for Cadbury. As shown in the last year (2009) both ratios exceeded the three-year average for both ROE and ROA. Consider the ROA graph. Even though the profit margin percentage was relatively constant (hovering around 8%) because the asset turnover was increasing (increased sales and decreasing assets), ROA was increasing over time. Consider the ROE graph. Because Leverage was decreasing and ROA was increasing, ROE was increasing over time.
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AFS1-2 (continued) B. Kraft Foods Ratio Analysis ROE 2009 2008 2007
11.6% 12.9% 9.5%
ROA 2009 2008 2007
Leverage 2009 2.569 2008 2.826 2007 2.491
4.5% 4.6% 3.8%
Profit Margin 2009 7.8% 2008 7.1% 2007 7.0%
Asset Turnover 2009 0.581 2008 0.641 2007 0.548
Asset/MV 2009 1.663 2008 1.313 2007 1.347
Profit Margin 2009 7.8% 2008 7.1% 2007 7.0%
NI/CFO 2009 0.594 2008 0.696 2007 0.725
MV/BV 2009 1.544 2008 2.152 2007 1.849
Asset turnover 2009 0.581 2008 0.641 2007 0.548
CFO/Sales 2009 13.1% 2008 10.2% 2007 9.6%
Sales/WC 2009 40.243 2008 (35.929) 2007 (5.866)
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WC/Assets 2009 1.4% 2008 -1.8% 2007 -9.3%
AFS1-2 (part b continued) Computations: ROE
Net Income 2009 3,021 2008 2,884 2007 2,590
Equity 25,972 22,356 27,295
ROE 11.6% 12.9% 9.5%
ROA
Net Income Assets 2009 3,021 66,714 2008 2,884 63,173 2007 2,590 67,993
ROA 4.5% 4.6% 3.8%
PM%
Net Income 2009 3,021 2008 2,884 2007 2,590
Sales 38,754 40,492 37,241
PM% 7.8% 7.1% 7.0%
Asset Turn. 2009 2008 2007
Sales 38,754 40,492 37,241
Assets Asset Turn. 66,714 0.581 63,173 0.641 67,993 0.548
NI/CFO Net Income 2009 3,021 2008 2,884 2007 2,590
CFO 5,084 4,141 3,571
NI/CFO 0.594 0.696 0.725
CFO/Sales 2009 2008 2007
CFO 5,084 4,141 3,571
Sales CFO/Sales 38,754 13.1% 40,492 10.2% 37,241 9.6%
Sales/WC 2009 2008 2007
Sales 38,754 40,492 37,241
WC Sales/WC 963 40.243 (1,127) (35.929) (6,349) (5.866)
WC/Assets 2009 2008 2007
WC Assets WC/Assets 963 66,714 1.4% (1,127) 63,173 -1.8% (6,349) 67,993 -9.3%
leverage 2009 2008 2007
Assets 66,714 63,173 67,993
Equity Asset/equity 25,972 2.569 22,356 2.826 27,295 2.491
Assets/MV 2009 2008 2007
Assets 66,714 63,173 67,993
MV Asset/MV 40,111 1.663 48,110 1.313 50,480 1.347
MV/Equity 2009 2008 2007
MV 40,111 48,110 50,480
Equity MV/equity 25,972 1.544 22,356 2.152 27,295 1.849
Discussion The trend in Kraft Food’s performance from 2007 to 2009 is strong. The profitability ratios have generally increased over time with a slight decrease in 2009. ROE increased from 9.5% to 11.6% (decreasing by 1.3% in 2009), while ROA increased from 3.8% to 4.5% (with a 0.1% decline in 2009). The profit margin increased every year and was 7.8% in 2009. The gross margins (not shown) remained fluctuated over the three years averaging around 34%. Kraft generated around 10% cash from operation (CFO) in each year. The leverage ratio has fluctuated and the market value to book value ratio initially increased but then decreased by 0.6 in 2009 (indicating potential growth issues). The asset turnover ratio (sales to assets) is showing an overall increasing trend relative to 2007. Working capital has been negative but turned positive in 2009 current assets have been growing while current liabilities are decreasing. Gross margin percentages
2007 33.8%
2008 32.9%
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2009 36.0%
Kraft Foods ROE and ROA
The solid lines in each graph represent a line where the ROE or ROA is equal to the three year average ROE or ROA for Kraft Foods. As shown in the last two years (2008 and 2009) both ratios exceeded their three-year averages. Consider the ROA graph. Even though the profit margin percentage increased in every year, the increase in the profit margin in 2009 was able to offset the decreased asset turnover keeping ROA constant from 2008 to 2009. Consider the ROE graph. In 2009, ROE dropped even though ROA remained fairly constant from 2008 to 2009 because leverage decreased in 2009.
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ANSWERS TO EXERCISES Exercise 1-1 Part A Normal earnings for similar firms = ($15,000,000 - $8,800,000) x 15% = $930,000 Expected earnings of target: Pretax income of Condominiums, Inc., 2012 Subtract: Additional depreciation on building ($960,000 30%) Target’s adjusted earnings, 2012
$1,200,000 (288,000)
Pretax income of Condominiums, Inc., 2013 Subtract: Additional depreciation on building Target’s adjusted earnings, 2013
$1,500,000 (288,000)
912,000
1,212,000
Pretax income of Condominiums, Inc., 2014 Add: Extraordinary loss Subtract: Additional depreciation on building Target’s adjusted earnings, 2014 Target’s three year total adjusted earnings Target’s three year average adjusted earnings ($3,086,000 3)
$950,000 300,000 (288,000) 962,000 3,086,000 1,028,667
Excess earnings of target = $1,028,667 - $930,000 = $98,667 per year Present value of excess earnings (perpetuity) at 25%:
$98,667 = $394,668 (Estimated Goodwill) 25%
Implied offering price = $15,000,000 – $8,800,000 + $394,668 = $6,594,668.
Part B Excess earnings of target (same as in Part A) = $98,667 Present value of excess earnings (ordinary annuity) for three years at 15%: $98,667 2.28323 = $225,279 Implied offering price = $15,000,000 – $8,800,000 + $225,279 = $6,425,279. Note: The sales commissions and depreciation on equipment are expected to continue at the same rate, and thus do not necessitate adjustments.
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Exercise 1-2 Part A Cumulative 5 years net cash earnings Add nonrecurring losses Subtract extraordinary gains Five-years adjusted cash earnings $831,000 Average annual adjusted cash earnings 5
$850,000 48,000 (67,000) $831,000 $166,200
(a) Estimated purchase price = present value of ordinary annuity of $166,200 (n=5, rate= 15%) $166,200 3.35216 = $557,129 (b) Less: Market value of identifiable assets of Beta Less: Liabilities of Beta Market value of net identifiable assets Implied value of goodwill of Beta
$750,000 320,000
Part B Actual purchase price Market value of identifiable net assets Goodwill purchased
430,000 $127,129 $625,000 430,000 $195,000
Exercise 1-3 Part A Normal earnings for similar firms (based on tangible assets only) = $1,000,000 x 12% = $120,000 Excess earnings = $150,000 – $120,000 = $30,000 (1)
Goodwill based on five years excess earnings undiscounted. Goodwill = ($30,000)(5 years) = $150,000
(2)
Goodwill based on five years discounted excess earnings Goodwill = ($30,000)(3.6048) = $108,144 (present value of an annuity factor for n=5, I=12% is 3.6048)
(3)
Goodwill based on a perpetuity Goodwill = ($30,000)/.20 = $150,000
Part B The second alternative is the strongest theoretically if five years is a reasonable representation of the excess earnings duration. It considers the time value of money and assigns a finite life. Alternative three also considers the time value of money but fails to assess a duration period for the excess earnings. Alternative one fails to account for the time value of money. Interestingly, alternatives one and three yield the same goodwill estimation and it might be noted that the assumption of an infinite life is not as absurd as it might sound since the present value becomes quite small beyond some horizon. Part C Goodwill = [Cost less (fair value of assets less the fair value of liabilities)], Or, Cost less fair value of net assets Goodwill = ($800,000 – ($1,000,000 - $400,000)) = $200,000 1-14
ANSWERS TO ASC (Accounting Standards Codification) EXERCISES ASC1-1 Cross-Reference The conditions determining whether a lease is classified as an operating lease or a capital lease were prescribed in SFAS No. 13, paragraph 7. Where is this located in this Codification? Step 1: Choose the cross reference tab on the opening page of the Codification. Step 2: Use the ‘By Standard’ drop down menu. Choose FAS as the standard type and 013 as the standard number. Click on ‘Generate Report.’ Paragraph 7 of SFAS No. 13 is included in five paragraphs in the Codification; FASB ASC paragraphs 840-10-25 1,29,30,31, and 41. FASB ASC paragraph 840-10-25-1 lists the four basic criteria (transfer of ownership, bargain purchase option, lease term, and minimum lease payments). ASC1-2 Cross-Reference The rules defining the conditions to classify an item as extraordinary on the income statement were originally listed in APB Opinion No 30, paragraph 20. Where is this information located in the Codification? Step 1: Choose the cross reference tab on the opening page of the Codification. Step 2: Use the ‘By Standard’ drop down menu. Choose APB as the standard type and 30 as the standard number. Click on ‘Generate Report.’ Paragraph 20 of APB Opinion No 30 is included in three paragraphs in the Codification; FASB ASC paragraphs 225-20-45-2 and 8 and FASB ASC paragraph 225-20-15-2. The definition for extraordinary item is also included in the master glossary. FASB ASC paragraph 22520-45-2 lists the two criteria to classify an event or transaction as an extraordinary item: unusual nature and infrequency of occurrence. ASC1-3 Disclosure Suppose a firm entered into a capital lease, debiting an asset account and crediting a lease liability account for $150,000. Does this transaction need to be disclosed as part of the statement of cash flows? If so, where? Disclosure requirements are always section 50 in the Codification (ASC xxx-xx-50-x). Presentation of the statement of cash flows is found under general topic number 200 as topic 230, (ASC 230-xx-50-x). Yes FASB ASC paragraphs 230-10-50-3 and 4. Information about all investing and financing activities of an entity during a period that affect recognized assets or liabilities but that do not result in cash receipts or cash payments in the period shall be disclosed. Examples include obtaining an asset by entering into a capital lease. ASC1-4 General Principles Accounting textbooks under the former GAAP hierarchy were considered level 4 authoritative. Where do accounting textbooks stand in the Codification? The topic that established the Codification as authoritative GAAP is Topic 105. FASB ASC paragraph 105-10-05-3 states that accounting textbooks are nonauthoritative accounting guidance and literature.
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ASC1-5 Presentation How many years of comparative financial statements are required under current GAAP? Authoritative guidance for financial statement presentation is found in FASB ASC Topic 205 [, Presentation of Financial Statements] FASB ASC paragraph 205-10-45-2 states that it is desirable that the statement of financial position, the income statement, and the statement of changes in equity be presented for one or more preceding years, as well as for the current year.
ASC1-6 Overview Can the provisions of the Codification be ignored if the item is immaterial? Overview and background requirements are always section 05 in the Codification (ASC xxx-xx-05-x). In the search box on the Codification homepage, search for Immaterial. In the ‘narrow by area’ column, click in the box next to ‘general principles’ since the question asks whether GAAP needs to be followed if an item is immaterial. Click on go. The result indicates that FASB ASC paragraph 105-10-05-6 states that the provisions of the codification need not be applied to immaterial items.
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CHAPTER 2 Note: The letter A indicated for a question, exercise, or problem means that the question, exercise, or problem relates to a chapter appendix. ANSWERS TO QUESTIONS 1(J). At the acquisition date, the fair value of the contingent consideration must be recorded on the parent’s books regardless of whether stock or cash is used to settle the earnout. Whether contingent consideration (based on stock issuance) is classified as a liability or as equity depends on the characteristics of the earnout. Earnouts that are settled with a fixed number of shares will be classified as equity if the earnout target is based solely on the buyer’s operations (which includes the operations of the acquired company) and cannot be based on any external index or comparisons with other companies or industries. If the earnout is settled with a variable number of shares, equity classification is possible if the earnout is based on the parent’s stock price. However, if the number of shares offered in the earnout is inversely related to the parent’s stock price, the earnout would be classified as a liability. Very few earnouts using stock will qualify for equity classification. Changes in the value of stock earnouts classified as a liability will be reflected in earnings, while changes in the value of the stock earnouts classified as equity are not remeasured. . 2.
Pro forma financial statements (sometimes referred to as “as if” statements) are financial statements that are prepared to show the effect of planned or contemplated transactions.
3.
For purposes of the goodwill impairment test, all goodwill must be assigned to a reporting unit. Goodwill impairment for each reporting unit should be tested in a two-step process. In the first step, the fair value of a reporting unit is compared to its carrying amount (goodwill included) at the date of the periodic review. The fair value of the unit may be based on quoted market prices, prices of comparable businesses, or a present value or other valuation technique. If the fair value at the review date is less than the carrying amount, then the second step is necessary. In the second step, the carrying value of the goodwill is compared to its implied fair value. (The calculation of the implied fair value of goodwill used in the impairment test is similar to the method illustrated throughout this chapter for valuing the goodwill at the date of the combination.)
4.
The expected increase was due to the elimination of goodwill amortization expense. However, the impairment loss under the new rules was potentially larger than a periodic amortization charge, and this is in fact what materialized within the first year after adoption (a large impairment loss). If there was any initial stock price impact from elimination of goodwill amortization, it was only a short-term or momentum effect. Another issue is how the stock market responds to the goodwill impairment charge. Some users claim that this charge is a non-cash charge and should be disregarded by the market. However, others argue that the charge is an admission that the price paid was too high, and might result in a stock price decline (unless the market had already adjusted for this overpayment prior to the actual writedown).
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ANSWERS TO BUSINESS ETHICS CASE a and b. The board has responsibility to look into anything that might suggest malfeasance or inappropriate conduct. Such incidents might suggest broader problems with integrity, honesty, and judgment. In other words, can you trust any reports from the CEO? If the CEO is not fired, does this send a message to other employees that ethical lapses are okay? Employees might feel that top executives are treated differently. ANSWERS TO ANALYZING FINANCIAL STATEMENTS EXERCISES AFS2-1 eBay acquires Skype (A) Goodwill computation Acquisition price Net tangible and intangible assets Goodwill
$ 2,593 million 262 million $ 2,331 million
(B) Factors used to determine in the contingent consideration is part of the exchange or not. (FASB ASC paragraphs 805-10-55-24 and 25) The acquirer should consider the following if the contingent payments are made to employees or selling shareholders. 1. Is the selling shareholder a continuing employee? If the contingent payment is canceled if the employee’s employment is terminated, then the consideration might be post-acquisition compensation for services. 2. If the selling shareholder is a continuing employee and the period of required continuing employment is longer than the contingent payment period, the contingent payments might, in substance, be compensation. 3. If the selling shareholder is a continuing employee and the employee’s compensation is reasonable in comparison to other key employees, the contingent payment may indicate additional consideration rather than compensation. 4. If the contingent payment for non-employees is less than the contingent payments for continuing employees, the additional contingent payments for employees may indicated compensation rather than additional consideration. (C) It is not clear why eBay would settle the earnout for $530.3 million when the conditions for having to make the additional contingent payments (up to $1.3 billion) were probably not going to be met. Under current GAAP, if the amount of the contingent payment exceeded the previously expected amount, the difference is reflected in earnings. Under the rules in effect for the Skype transaction the contingent payment was simply an adjustment of goodwill. Because eBay was settling the earnout for approximately a third of the total potential payments indicates that Skype was not performing well. Notice that eBay wrote down$1.39 billion in goodwill at the same time. One potential reason that eBay might have agreed to the payment is that the former CEO of Skype was stepping down and the contingent payment may have been incentive for him to step down. In addition, the earnout may have prevented eBay from selling Skype.
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AFS2-2 eBay Sells Skype
eBay's Income Statement Net revenues Cost of net revenues Gross profit Operating expenses: Sales and marketing Product development General & administrative Provision for trans. & loan losses Amortization of acquired intangible assets Restructuring Impairment of goodwill Total operating expenses Income from operations Interest and other income Income before income taxes
As Reported 2007
2008
Adjustments
Adjusted
2009
2007
2008
2009
2007
2008
2009
$7,672,329
$8,541,261
$8,727,362
-364,564
-550,841
-620,403
$7,307,765
$7,990,420
$8,106,959
1,762,972
2,228,069
2,479,762
-337,338
-434,588
-462,701
1,425,634
1,793,481
2,017,061
5,909,357
6,313,192
6,247,600
(27,226)
(116,253)
(157,702)
5,882,131
6,196,939
6,089,898
1,882,810
1,881,551
1,885,677
1,882,810
1,881,551
1,885,677
619,727
725,600
803,070
619,727
725,600
803,070
904,681
998,871
1,418,389
904,681
998,871
1,075,189
293,917
347,453
382,825
293,917
347,453
382,825
204,104
234,916
262,686
204,104
234,916
262,686
49,119
38,187
-
49,119
38,187
-
-
-
(343,200)
3,905,239
4,237,510
4,447,634
1,390,938
(343,200)
(1,390,938)
5,296,177
4,237,510
4,790,834
(1,390,938)
613,180
2,075,682
1,456,766
1,363,712
137,671
107,882
1,422,385
750,851
2,183,564
2,879,151
Provision for income taxes Net income
(402,600)
(404,090)
(490,054)
$348,251
$1,779,474
$2,389,097
Ratios Gross Margin Percentage Operating Margin Percentage Income before taxes %
2007
2008
2009
77.0%
73.9%
71.6%
8.0%
24.3%
9.8%
25.6%
185,498
1,976,892
1,959,429
1,642,264
(1,400,000)
137,671
107,882
22,385
(1,214,502)
2,114,563
2,067,311
1,664,649
2007
2008
2009
80.5%
77.6%
75.1%
16.7%
27.1%
24.5%
20.3%
33.0%
28.9%
25.9%
20.5%
1,363,712
7.5%
(116,253)
(116,253)
21.1%
25.4%
There are four adjustments to eliminate the effect of Skype from eBay’s books. First, we eliminate the revenues and the direct expenses
2-3
AFS2-2 solution continued: from each year. We eliminated 100% of Skype’s revenues and direct expenses disclosed in the footnotes in 2009 because it was not clear from the disclosure whether those amounts were the amounts included on eBay’s statements or whether they were for the entire year. An acceptable solution would be to eliminate 11.5/12 or 95.8%. Second, the impairment of goodwill was added back in 2007. Third, the gain on the sale of $1.4 million was subtracted from interest and other income in 2009. And finally, the charge from the legal settlement was added back (or subtracted from costs) in 2009. Performance: Including Skype, eBay’s gross margin declined from 77% to 71.6%. Without Skype, the gross margin still declined, but the decline was smaller (80.5% to 75.1%). Including Skype, income before taxes showed a rather large increase in absolute dollars increasing to $2,879,151 from $648,251 (283% increase). After Skype is eliminated we find a decreasing trend from $2,114,563 to 1,664,649 (a 21.3% decline). A similar trend exists for the income before tax as a percentage of revenues. The unadjusted percentage increased from 9.8% to 33% while the adjusted percentage decreased from 28.9% to 20.5%. The most interesting aspect of the numbers is that eBay recorded an impairment charge of $1.4 million in 2007 and then in 2009 recorded an $1.4 million gain on the sale.
2-4
AFS2-3 Measurement Period Adjustments and Contingent Consideration A. The measurement period adjustment was made at the end of the year. FASB ASC Topic 805.30.35.1 states that some changes in the fair value of contingent consideration that the acquirer recognizes after the acquisition date may be the result of additional information about facts and circumstances that existed at the acquisition date that the acquirer obtained after that date. Such changes are measurement period adjustments. However, changes resulting from events after the acquisition date, such as meeting an earnings target, reaching a specified share price, or reaching a milestone on a research and development project, are not measurement period adjustments. The company in the problem did not use a measurement adjustment correctly because they state that ‘the initial terms of the agreement have not been met.’ This is clearly an event that occurred after the date of the acquisition. The company should write down the contingent consideration liability to zero and recognize a gain on revaluation. Note that the English was not corrected in the footnote. They meant to write ‘the initial terms of the agreement have not been met,’ but they wrote ‘have not be met’. Does this provide confidence to the user that the numbers presented are correct? B. The company is silent on the impairment of the intangible assets acquired. What the company should have recorded: Contingent consideration Gain on revaluing (IS)
367,500
Impairment loss (IS) Intellectual property
577,500
What the company actually recorded: Acquisition Intellectual property Date Common stock and PIC Contingent consideration
367,500
577,500
577,500 210,000 367,500
Measurement Period Adjustment
Contingent consideration Goodwill Intellectual property
376,500 210,000
Impairment
Impairment loss (IS) Goodwill
210,000
577,500
210,000
C. Although the overall impact on net income is the same (a reduction of net income of $210,000), the company is supposed to estimate the fair value of the contingent consideration each quarter and record the change in income. Using measurement period adjustments to ‘re-write’ history after events occur gives a potentially misleading impression on the performance of the acquisition. Measurement period adjustments are intended to adjust estimation made on the date of acquisition related to better information about circumstances that existed on the date of acquisition, rather than circumstances that arose subsequent to acquisition. AFS2-4 Emdeon Inc. Acquisition of FVTech (Contingent Consideration) 1. Sellers often keep the cash on the date of the acquisition. Thus, they have incentives to delay payments on debt and to attempt to collect receivables in advance. Including a working capital arrangement helps to mitigate these incentive problems. 2. Contingent consideration is often used to help the acquirer and the acquiree to agree on a selling price. The seller believes the company is worth more because of anticipated future performance and the acquirer unsure about the exact future performance. However, the acquirer is more willing to pay more 2-5
for an acquisition if the future performance exceeds some critical level or if certain milestones are met (such as regulatory approval of a drug patent). The total potential contingent consideration offered is $40,000; thus the total potential consideration offered is $60,303 ($20,005 cash, $58 working capital settlement, and $40,000 of contingent consideration). Maximum contingent consideration to total potential consideration offered is 66.3 percent. The fair value of contingent consideration on the date of acquisition is $14,910 is 37.3 percent of the maximum potential contingent consideration offered ($14,910/$40,000). The fair value of contingent consideration on the date of acquisition is 42.6 percent of the total consideration offered on the date of acquisition ($14,910/$34,973)/ 3. Schedule of changes in fair value for contingent consideration st
1 Qtr Fair value of contingent consideration Beginning of quarter (or DOA) 14,910 Fair value at the end of quarter 15,200 Total change in fair value (290) Previous years (gain) and losses Loss on change in fair value (Gain) on change in fair value Totals
After Measurement Period Adjustment 2nd Qtr 3rd Qtr 4th Qtr 13,850 13,210 640
13,850 11,580 2,270
13,850 7,170 6,680
290
(930)
(2,270)
290 _____
(930)
(1,340)
(4,410)
-0-
-0-
-0-
- 0-
4. Given that the fair value of the contingent consideration has been decreasing, it becomes less likely that any contingent consideration will be paid. If not, reducing the liability for contingent consideration will result in future gains recorded on the books (In theory, this partially offsets the expected lower earnings.) Gains on reduction in the contingent consideration liability can signal future goodwill impairments. AFS2-5 Emdeon Inc. Acquisition of FVTech (Contingent Consideration) 1. The company did reassess the fair value estimates of the identifiable net assets but did not provide an adequate description that the transaction resulted in a gain. The company merely restated the definition of a bargain gain (i.e. that the transaction resulted in an excess of the value of the net assets acquired over the purchase price). 2. A bargain purchase might happen, for example, in a business combination that is a forced sale in which the seller is acting under compulsion. Also, sometimes the seller needs quick access to funds and perhaps the number of buyers is limited (such as a bank with weak performance). The FASB has struggled over time with bargain purchases because the FASB believes that the number of bargains should be very small. 3. Current Assets 24,910 Property, Plant, and Equipmetn 491 Due from Securitization 108,554 Identifiable intangible assets 67,200 Current Liabilities 8,500 Deferred taxes 12,527 Cash 158,901 Gain on bargain purchase 21,227 2-6
ANSWERS TO EXERCISES Exercise 2-1 Part A Receivables Inventory Plant and Equipment Land Goodwill ($2,154,000 - $1,824,000) Liabilities Cash
228,000 396,000 540,000 660,000 330,000
Part B Receivables Inventory Plant and Equipment Land Liabilities Cash Gain on Business Combination ($1,230,000 - $990,000)
228,000 396,000 540,000 660,000
594,000 1,560,000
2-7
594,000 990,000 240,000
Exercise 2-2 Cash Receivables Inventories Plant and Equipment (net) ($3,840,000 + $720,000) Goodwill Total Assets
$680,000 720,000 2,240,000 4,560,000 120,000 $8,320,000
Liabilities Common Stock, $16 par ($3,440,000 + (.50 $800,000)) Other Contributed Capital ($400,000 + $800,000) Retained Earnings Total Equities
1,520,000 3,840,000 1,200,000 1,760,000 $8,320,000
Entries on Petrello Company’s books would be: Cash Receivables Inventory Plant and Equipment Goodwill * Liabilities Common Stock (25,000 $16) Other Contributed Capital ($48 - $16) 25,000
200,000 240,000 240,000 720,000 120,000 320,000 400,000 800,000
* ($48 25,000) – [($1,480,000 – ($800,000 – $720,000) – $320,000] = $1,200,000 – [$1,480,000 – $80,000 – $320,000] = $1,200,000 – $1,080,000 = $120,000
2-8
Exercise 2-3 Accounts Receivable Inventory Land Buildings and Equipment Goodwill Allowance for Uncollectible Accounts ($231,000 - $198,000) Current Liabilities Bonds Payable Premium on Bonds Payable ($495,000 - $450,000) Preferred Stock (15,000 $100) Common Stock (30,000 $10) Other Contributed Capital ($25 - $10) 30,000 Cash
231,000 330,000 550,000 1,144,000 848,000 33,000 275,000 450,000 45,000 1,500,000 300,000 450,000 50,000
Cost paid ($1,500,000 + $750,000 + $50,000) = $2,300,000 Fair value of net assets (198,000 + 330,000 + 550,000 + 1,144,000 – 275,000 – 495,000) = 1,452,000 Goodwill = $848,000 Exercise 2-4 Cash Receivables Inventory Land Plant and Equipment Goodwill* Accounts Payable Bonds Payable Premium on Bonds Payable** Cash
96,000 55,200 126,000 198,000 466,800 137,450 44,400 480,000 45,050 510,000
** Present value of maturity value, 12 periods @ 4%: Present value of interest annuity, 12 periods @ 4%: Total present value Par value Premium on bonds payable
0.6246 $480,000 = 9.38507 $24,000 =
*Cash paid Less: Book value of net assets acquired ($897,600 – $44,400 – $480,000) Excess of cash paid over book value Increase in inventory to fair value (15,600) Increase in land to fair value (28,800) Increase in bond to fair value 45,050 Total increase in net assets to fair value Goodwill
2-9
$299,808 225,242 525,050 480,000 $ 45,050 $510,000 (373,200) 136,800
650 $137,450
Exercise 2-5 Part A
Part B Part C
Current Assets Plant and Equipment Goodwill Liabilities Cash Liability for Contingent Consideration
960,000 1,440,000 120,000 216,000 2,160,000 144,000
Loss on change in Fair Value of Contingent Consideration Liability for Contingent Consideration
56,000
Liability for Contingent Consideration Gain on change in Fair Value of Contingent Consideration
200,000
56,000 200,000
Exercise 2-6 Part A
Part B
Current Assets Plant and Equipment Goodwill Liabilities Cash Liability for Contingent Consideration Liability for Contingent Consideration Common Stock ($10 × 10,000) Paid in Capital – Common Stock
960,000 1,440,000 176,000 216,000 2,160,000 200,000 200,000 100,000 100,000
Platz Company does not adjust the original amount recorded as equity. Exercise 2-7 1. (c) Cost (8,000 shares @ $30) Fair value of net assets acquired Excess of cost over fair value (goodwill)
$240,000 228,800 $ 11,200
2. (c) Cost (8,000 shares @ $30) Fair value of net assets acquired ($90,000 + $242,000 – $56,000) Excess of fair value over cost (gain)
$240,000 276,000 $ 36,000
Exercise 2-8 Current Assets Long-term Assets ($1,890,000 + $20,000) + ($98,000 + $5,000) Goodwill * 2 - 10
362,000 2,013,000 395,000
Liabilities Long-term Debt Common Stock (144,000 $5) Other Contributed Capital (144,000 ($15 - $5))
119,000 491,000 720,000 1,440,000
* (144,000 $15) – [$362,000 + $2,013,000 – ($119,000 + $491,000)] = $395,000 $700,000 $20,000 Total shares issued + = 144,000 $5 $5 Fair value of stock issued (144,000 $15) = $2,160,000
Exercise 2-9 Case A Cost (Purchase Price) Less: Fair Value of Net Assets Goodwill
$130,000 120,000 $ 10,000
Case B Cost (Purchase Price) Less: Fair Value of Net Assets Goodwill
$110,000 90,000 $ 20,000
Case C Cost (Purchase Price) Less: Fair Value of Net Assets Gain
$15,000 20,000 ($ 5,000)
Case A Case B Case C
Goodwill
Assets Current Assets
Long-Lived Assets
$10,000 20,000 0
$20,000 30,000 20,000
$130,000 80,000 40,000
2 - 11
Liabilities $30,000 20,000 40,000
Retained Earnings (Gain) 0 0 5,000
Exercise 2-10 Part A. 2014: Step 1: Fair value of the reporting unit Carrying value of unit: Carrying value of identifiable net assets $330,000 Carrying value of goodwill ($450,000 - $375,000) 75,000
$400,000
405,000 $ 5,000
Excess of carrying value over fair value The excess of carrying value over fair value means that step 2 is required. Step 2: Fair value of the reporting unit Fair value of identifiable net assets Implied value of goodwill Recorded value of goodwill ($450,000 - $375,000) Impairment loss 2015: Step 1: Fair value of the reporting unit Carrying value of unit: Carrying value of identifiable net assets Carrying value of goodwill ($75,000 - $15,000)
$400,000 340,000 60,000 75,000 $ 15,000 $400,000 $320,000 60,000 380,000 $ 20,000
Excess of fair value over carrying value
The excess of fair value over carrying value means that step 2 is not required. 2016: Step 1: Fair value of the reporting unit Carrying value of unit: Carrying value of identifiable net assets Carrying value of goodwill ($75,000 - $15,000)
$350,000 $300,000 60,000
Excess of carrying value over fair value
360,000 $ 10,000
The excess of carrying value over fair value means that step 2 is required. Step 2: Fair value of the reporting unit Fair value of identifiable net assets Implied value of goodwill Recorded value of goodwill ($75,000 - $15,000) Impairment loss
2 - 12
$350,000 325,000 25,000 60,000 $ 35,000
Part B. 2014:
Impairment Loss—Goodwill Goodwill
2015:
No entry
2016:
Impairment Loss—Goodwill Goodwill
15,000 15,000
35,000
35,000 Part C. SFAS No. 142 specifies the presentation of goodwill in the balance sheet and income statement (if impairment occurs) as follows: • The aggregate amount of goodwill should be a separate line item in the balance sheet. • The aggregate amount of losses from goodwill impairment should be shown as a separate line item in the operating section of the income statement unless some of the impairment is associated with a discontinued operation (in which case it is shown net-of-tax in the discontinued operation section). Part D. In a period in which an impairment loss occurs, SFAS No. 142 mandates the following disclosures in the notes: (1) A description of the facts and circumstances leading to the impairment; (2) The amount of the impairment loss and the method of determining the fair value of the reporting unit; (3) The nature and amounts of any adjustments made to impairment estimates from earlier periods, if significant. Exercise 2-11 a. Fair Value of Identifiable Net Assets Book values $500,000 – $100,000 = Write up of Inventory and Equipment: ($20,000 + $30,000) = Purchase price above which goodwill would result
$400,000 50,000 $450,000
b. Equipment would not be written down, regardless of the purchase price, unless it was reviewed and determined to be overvalued originally. c. A gain would be shown if the purchase price was below $450,000. d. Anything below $450,000 is technically considered a bargain. e. Goodwill would be $50,000 at a purchase price of $500,000 or ($450,000 + $50,000).
2 - 13
Exercise 2-12A Cash Accounts Receivable Inventory Land Plant Assets Discount on Bonds Payable Goodwill* Allowance for Uncollectible Accounts Accounts Payable Bonds Payable Deferred Income Tax Liability Cash
20,000 112,000 134,000 55,000 463,000 20,000 127,200 10,000 54,000 200,000 67,200 600,000
Cost of acquisition $600,000 Book value of net assets acquired ($80,000 + $132,000 + $160,000) 372,000 Difference between cost and book value 228,000 Allocated to: Increase inventory, land, and plant assets to fair value ($52,000 + $25,000 + $71,000) (148,000) Decrease bonds payable to fair value (20,000) Establish deferred income tax liability ($168,000 40%) 67,200 Balance assigned to goodwill $127,200 ANSWERS TO ASC (Accounting Standards Codification) EXERCISES ASC2-1 Presentation Does current GAAP require that the information on the income statement be reported in chronological order with the most recent year listed first, or is the reverse order acceptable as well? Alternative one: Step 1: In the search box on the home page, enter ‘chronological order’. Step 2: Two results are obtained. Alternative two: Step 1: Use the drop-down menus under the ‘presentation’ general topic on the homepage and choose ‘Presentation of financial statements’; then under the second drop-down menu, choose ’10-overall’. Step 2: Click on the ‘Expand’ option and scroll through the topics looking for ‘chronological order’. The very last line is SAB Topic 11.E Chronological Ordering of Data. FASB ASC 205-10-S99-9 under SEC guidance indicates that the SEC staff have not preference in what order the data are presented (e.g., the most current data displayed first, etc.) as long as all schedules in the report are ordered in the same chronological order. ASC2-2 General Principles In the 1990s, the pooling of interest method was a preferred method of accounting for consolidations by many managers because of the creation of instant earnings if the acquisition occurred late in the year. Can the firms that used pooling of interest in the 1990s continue to use the method for those earlier consolidations, or were they required to adopt the new standards for previous business combinations retroactively? This issue is related to whether the rules for pooling of interest have been grandfathered or not. 2 - 14
Alternative one: Step 1: Below the search box on the home page, click on ‘advanced search.’ Enter ‘Pooling of interests’ in the text/keyword box and click on exact phrase. Step 2: Three results are obtained and the first alternative is the correct answer. Alternative two: Step 1: Use the drop-down menus under the ‘General Principles’ general topic on the homepage and choose ‘Generally Accepted Accounting Principles’; then under the second drop-down menu, choose ’10-overall’. Step 2: Section 70 is always the section for grandfathered guidance. FASB ASC subparagraph 105-10-70-2(a) lists pooling of interests is listed as a grandfathered method. ASC2-3 Glossary What instruments qualify as cash equivalents? On the Codification homepage, click on ‘Master Glossary’ in the left-hand column. In the ‘glossary term quick find’ menu type ‘cash equivalent’ and hit return. Cash equivalents are short-term, highly liquid investments that have both of the following characteristics: a. Readily convertible to known amounts of cash b. So near their maturity that they present insignificant risk of changes in value because of changes in interest rates. ASC2-4 Overview If guidance for a transaction is not specifically addressed in the Codification, what is the appropriate procedure to follow in identifying the proper accounting? The topic that established the Codification as authoritative GAAP is Topic 105. Step 1: Use the drop-down menus under the ‘General Principles’ general topic on the homepage and choose ‘Generally Accepted Accounting Principles’; then under the second drop-down menu, choose ’10-overall’. Step 2: click on the red ‘Join all Sections’ button. Scroll through the paragraphs. FASB ASC paragraph 105-10-05-2 states that if the guidance for a transaction or event is not specified within a source of authoritative GAAP for that entity, an entity shall first consider accounting principles for similar transactions or events within a source of authoritative GAAP for that entity and then consider nonauthoritative guidance from other sources.
2 - 15
ASC2-5 General List all the topics found under General Topic 200—Presentation (Hint:There are 15 topics). Presentation 205 210 215 220 225
Presentation of Financial Statements Balance Sheet Statement of Shareholder Equity Comprehensive Income Income Statement
230 235 250 255 260
Statement of Cash Flows Notes to Financial Statements Accounting Changes and Error Corrections Changing Prices Earnings Per Share
270 272 274 275 280
Interim Reporting Limited Liability Entities Personal Financial Statements Risks and Uncertainties Segment Reporting
ASC2-6 Cross-Reference The rules providing accounting guidance on subsequent events were originally listed in FASB Statement No. 165. Where is this information located in the Codification? List all the topics and subtopics in the Codification where this information can be found (i.e., ASC XXXXX). Step 1: Choose the cross reference tab on the opening page of the Codification. Step 2: Use the ‘By Standard’ drop down menu. Choose FAS as the standard type and 165 as the standard number. Click on ‘Generate Report.’ FASB ASC subtopic 855-10 [, Subsequent Events – Overall] ASC2-7 Overview Distinguish between an asset acquisition and the acquisition of a business. This is a more difficult issue to find. Alternative one: Step 1: Below the search box on the home page, click on ‘advanced search.’ Enter ‘asset acquisition’ in the text/keyword box and click on exact phrase. Step 2: Sixteen results are obtained. You can narrow the search by clicking on ‘business combinations’ in the Narrow by related term section. Then, notice that the section on ‘related issues’ seems to be where acquisition of assets rather than a business is located. FASB ASC paragraph 805-50-05-3 states that the guidance in the ‘acquisition of assets rather than a business’ subsections address transactions in which the assets acquired and liabilities assumed do not constitute a business. A business is considered an integrated set of activities and assets that is capable of being conducted and managed for the purpose of providing a return in the form of dividends, lower costs, or other economic benefits directly to investors or other owners, members, or participants. Alternative two: 2 - 16
Step 1: Use the drop-down menus under the ‘Broad Transactions’ general topic on the homepage and choose ‘Business Combinations’; then under the second drop-down menu, choose ’10-overall’. Expand the sections. Since nothing is listed related to the search, go to the scope section (805-10-15). FASB ASC subparagraph 805-10-15-4(b) tells you the scope of section 10 does not cover asset acquisitions. Step 2: Go back and search for ‘asset acquisition. ASC2-8 Measurement GAAP requires that firms test for goodwill impairment on an annual basis. One reporting unit performs the impairment test during January while a second reporting unit performs the impairment test during July. If the firm reports annual results on a calendar basis, is this acceptable under GAAP? This can be a difficult issue to find depending on the student’s knowledge of goodwill. If a general search is used with the term ‘goodwill impairment’ the correct section can be found. The student must be aware that ‘subsequent measurement’ would be related to impairment testing of goodwill since impairment tests are subsequent measurements of goodwill. However, since the correct paragraph is paragraph 28, a lot of scrolling is needed. Alternative two Step 1: Use the drop-down menus under the ‘Assets’ general topic on the homepage and choose ‘350 – Intangibles-Goodwill and other’; then under the second drop-down menu, choose ’20-Goodwill’. Expand the sections. Since nothing is listed related to the search, go to the scope section (805-10-15). FASB ASC subparagraph 805-10-15-4(b) tells you the scope of section 10 does not cover asset acquisitions. Step 2: click on subsequent measurement and click on ‘expand’ topics. One of the topics is ‘when to test goodwill impairment’. FASB ASC paragraph 350-20-35-28 states that different reporting units may be tested for impairment at different times. ANSWERS TO PROBLEMS Problem 2-1 Current Assets Plant and Equipment Goodwill* Liabilities Common Stock [(20,000 shares @ $10/share)] Other Contributed Capital [(20,000 ($15 – $10))]
85,000 150,000 100,000
Acquisition Costs Expense Cash
20,000
Other Contributed Capital Cash To record the direct acquisition costs and stock issue costs
6,000
35,000 200,000 100,000
20,000
2 - 17
6,000
* Goodwill = Excess of Consideration of $335,000 (stock valued at $300,000 plus debt assumed of $35,000) over Fair Value of Identifiable Assets of $235,000 (total assets of $225,000 plus PPE fair value adjustment of $10,000) Problem 2-2
Acme Company Balance Sheet October 1, 2011 (000)
Part A. Assets (except goodwill) ($3,900 + $9,000 + $1,300) Goodwill (1) Total Assets
$14,200 1,160 $15,360
Liabilities ($2,030 + $2,200 + $260) Common Stock (180 $20) + $2,000 Other Contributed Capital (180 ($50 – $20)) Retained Earnings Total Liabilities and Equity
$4,490 5,600 5,400 (130) $15,360
(1) Cost (180 $50) Fair value of net assets acquired: Fair value of assets of Baltic and Colt Less liabilities assumed Goodwill
$9,000 $10,300 2,460
2 - 18
7,840 $1,160
Problem 2-2 (continued) Part B. Baltic 2015: Step1: Fair value of the reporting unit $6,500,000 Carrying value of unit: Carrying value of identifiable net assets 6,340,000 Carrying value of goodwill 200,000* Total carrying value 6,540,000 *[(140,000 x $50) – ($9,000,000 – $2,200,000)] The excess of carrying value over fair value means that step 2 is required. Step 2: Fair value of the reporting unit Fair value of identifiable net assets Implied value of goodwill Recorded value of goodwill Impairment loss
$6,500,000 6,350,000 150,000 200,000 $ 50,000
(because $150,000 < $200,000) Colt 2015: Step1: Fair value of the reporting unit $1,900,000 Carrying value of unit: Carrying value of identifiable net assets $1,200,000 Carrying value of goodwill 960,000* Total carrying value 2,160,000 *[(40,000 x $50) – ($1,300,000 – $260,000)] The excess of carrying value over fair value means that step 2 is required. Step 2: Fair value of the reporting unit Fair value of identifiable net assets Implied value of goodwill Recorded value of goodwill Impairment loss
$1,900,000 1,000,000 900,000 960,000 $ 60,000
(because $900,000 < $960,000) Total impairment loss is $110,000. Journal entry: Impairment Loss Goodwill
$110,000 $110,000
2 - 19
Problem 2-3 Present value of maturity value, 20 periods @ 6%: 0.3118 $600,000 = Present value of interest annuity, 20 periods @ 6%: 11.46992 $30,000 = Total Present value Par value Discount on bonds payable Cash Accounts Receivable Inventory Land Buildings Equipment Bond Discount ($40,000 + $68,822) Current Liabilities Bonds Payable ($300,000 + $600,000) Gain on Purchase of Business
$187,080 344,098 531,178 600,000 $68,822 114,000 135,000 310,000 315,000 54,900 39,450 108,822 95,300 900,000 81,872
Computation of Excess of Net Assets Received Over Cost Cost (Purchase Price) ($531,178 plus liabilities assumed of $95,300 and $260,000) Less: Total fair value of assets received Excess of fair value of net assets over cost
$886,478 $968,350 ($ 81,872)
Problem 2-4 Part A January 1, 2014 Accounts Receivable Inventory Land Buildings Equipment Goodwill* Allowance for Uncollectible Accounts Accounts Payable Note Payable Cash Liability for Contingent Consideration *Computation of Goodwill Consideration paid ($720,000 + $100,000) Total fair value of net assets acquired ($1,064,000 - $263,000) Goodwill
2 - 20
72,000 99,000 162,000 450,000 288,000 19,000 7,000 83,000 180,000 720,000 100,000 $820,000 801,000 $ 19,000
Problem 2-4 (continued) Part B January 2, 2013 Loss on Change in Fair Value of Contingent Consideration Liability for Contingent Consideration
20,000 20,000
Part C January 2, 2013 Liability for Contingent Consideration Gain from Change in Fair Value of Contingent Consideration
Problem 2-5
120,000 135,000
Pepper Company Pro Forma Balance Sheet Giving Effect to Proposed Issue of Common Stock and Note Payable for All of the Common Stock of Salt Company under Purchase Accounting December 31, 2013
Cash Receivables
Audited Balance Sheet $180,000 230,000
Inventories Plant Assets Goodwill Total Assets
231,400 1,236,500 _________ $1,877,900
Accounts Payable
$255,900
Notes Payable, 8% Mortgage Payable Common Stock, $20 par Additional Paid-in Capital Retained Earnings Total Liabilities and Equity
0 180,000 900,000 270,000 272,000 $1,877,900
2 - 21
Adjustments 405,000 (60,000) 117,000 134,000 905,000 (1) 181,500 (60,000) 180,000 300,000 152,500 600,000 510,000 (2)
Pro Forma Balance Sheet $585,000 287,000 365,400 2,141,500 181,500 $3,560,400 $375,900 300,000 332,500 1,500,000 780,000 272,000 $3,560,400
Problem 2-5 (continued) Change in Cash Cash from stock issue ($37 30,000) Less: Cash paid for acquisition Plus: Cash acquired in acquisition Total change in cash
$1,110,000 (800,000) 95,000 $ 405,000
Goodwill: Cost of acquisition Net assets acquired ($340,000 + $179,500 + $184,000) Excess cost over net assets acquired Assigned to plant assets Goodwill (1) $690,000 + $215,000
Problem 2-6
$1,100,000 703,500 $396,500 215,000 $ 181,500
(2) ($37 - $20) 30,000
Ping Company Pro Forma Income Statement for the Year 2014 Assuming a Merger of Ping Company and Spalding Company
Sales (1) Cost of goods sold: Fixed Costs (2) Variable Costs (3) Gross Margin
$6,345,972 $824,706 2,464,095
Selling Expenses (4) Other Expenses (5)
$785,910 319,310
Net Income
3,288,801 3,057,171 1,105,220 $1,951,951
$499,411 $1,951,951 – ($952,640 + $499,900) = = $2,497,055 0.20 0.20 Since $2,497,055 is greater than $1,800,000 Ping should buy Spalding.
(1) $3,510,100 + $2,365,800 = $5,875,900 1.2 .9 = (2) ($1,752,360 .30) + ($1,423,800 .30 .70) = (3) $1,752,360 .70
$5,875,900 1.2 $3,510,100
=
$6,345,972 $824,706 $2,464,095
(4) ($632,500 + $292,100) .85 =
$785,910
(5) $172,600 1.85 =
$319,310
2 - 22
Problem 2-7A Part A Receivables Inventory Land Plant Assets Patents Deferred Tax Asset ($60,000 x 35%) Goodwill* Current Liabilities Bonds Payable Premium on Bonds Payable Deferred Tax Liability Common Stock (30,000 $2) Other Contributed Capital (30,000 $26)
Cost of acquisition (30,000 $28) Book value of net assets acquired ($120,000 + $164,000 + $267,000) Difference between cost and book value Allocated to: Increase inventory, land, plant assets, and patents to fair value Deferred income tax liability (35% $266,500) Increase bonds payable to fair value Deferred income tax asset (35% $60,000) Balance assigned to goodwill
Part B Income Tax Expense (Balancing amount) Deferred Tax Liability ($51,125 35%)* Deferred Tax Asset ($6,000 35%) Income Tax Payable ($468,000 35%) * Inventory: $100,000 10 $105,000 Patents, 8 Total
Plant Assets,
$28,000 10,000 13,125 $51,125
2 - 23
125,000 195,000 120,000 567,000 200,000 21,000 154,775 89,500 300,000 60,000 93,275 60,000 780,000
$840,000 551,000 289,000 (266,500) 93,275 60,000 (21,000) $154,775
148,006 17,894 2,100 163,800
CHAPTER 3 Note: The letter A or B indicated for a question, exercise, or problem means that the question, exercise, or problem relates to a chapter appendix. ANSWERS TO QUESTIONS 1. (1) Stock acquisition is greatly simplified by avoiding the lengthy negotiations required in an exchange of stock for stock in a complete takeover. (2) Effective control can be accomplished with more than 50% but less than all of the voting stock of a subsidiary; thus the necessary investment is smaller. (3) An individual affiliate’s legal existence provides a measure of protection of the parent’s assets from attachment by creditors of the subsidiary. 2. The purpose of consolidated financial statements is to present, primarily for the benefit of the shareholders and creditors of the parent company, the results of operations and the financial position of a parent company and its subsidiaries essentially as if the group were a single company with one or more branches or divisions. The presumption is that these consolidated statements are more meaningful than separate statements and necessary for fair presentation. Emphasis then is on substance rather than legal form, and the legal aspects of the separate entities are therefore ignored in light of economic aspects. 3. Each legal entity must prepare financial statements for use by those who look to the legal entity for analysis. Creditors of the subsidiary will use the separate statements in assessing the degree of protection related to their claims. Noncontrolling shareholders, too, use these individual statements in determining risk and the amounts available for dividends. Regulatory agencies are concerned with the net resources and results of operations of the individual legal entities. 4. (1) Control should exist in fact, through ownership of more than 50% of the voting stock of the subsidiary. (2) The intent of control should be permanent. If there are current plans to dispose of a subsidiary, then the entity should not be consolidated. (3) Majority owners must have control. Such would not be the case if the subsidiary were in bankruptcy or legal reorganization, or if the subsidiary were in a foreign country where political forces were such that control by majority owners was significantly curtailed. 5. Consolidated workpapers are used as a tool to facilitate the preparation of consolidated financial statements. Adjusting and eliminating entries are entered on the workpaper so that the resulting consolidated data reflect the operations and financial position of two or more companies under common control. 6. Noncontrolling interest represents the equity in a partially owned subsidiary by those shareholders who are not members in the affiliation and should be accounted and presented in equity, separately from the parents’ shareholders equity. Alternative views have included: presenting the noncontrolling interest as a liability from the perspective of the controlling shareholders; presenting the noncontrolling interest between liabilities and shareholders’ equity to acknowledge its hybrid status; presenting it as a contra-asset so that total assets reflect only the parent’s share; and
3-1
presenting it as a component of owners’ equity (the choice approved by FASB in its most recent exposure drafts). 7. The fair, or current, value of one or more specific subsidiary assets may exceed its recorded value, or specific liabilities may be overvalued. In either case, an acquiring company might be willing to pay more than book value. Also, goodwill might exist in the form of above normal earnings. Finally, the parent may be willing to pay a premium for the right to acquire control and the related economic advantages gained. 8. The determination of the percentage interest acquired, as well as the total equity acquired, is based on shares outstanding; thus, treasury shares must be excluded. The treasury stock account should be eliminated by offsetting it against subsidiary stockholder equity accounts. The accounts affected as well as the amounts involved will depend upon whether the cost or par method is used to account for the treasury stock. 9. None. The full amount of all intercompany receivables and payables is eliminated without regard to the percentage of control held by the parent. 10A. The decision in SFAS No. 109 and SFAS No. 141R [topics 740 and 805] is primarily a display issue and would only affect the calculation of consolidated net income if there were changes in expected future tax rates that resulted in an adjustment to the balance of deferred tax assets or deferred tax liabilities. Prior to SFAS No. 109 and SFAS No. 141R, purchased assets and liabilities were displayed at their net of tax amounts and related figures for amortization and depreciation were based on the net of tax amounts. With the adoption of SFAS No. 109 and SFAS No. 141R, assets and liabilities are displayed at fair values and the tax consequences for differences between their assigned values and their tax bases are displayed separately as deferred tax assets or deferred tax liabilities. Although the amounts shown for depreciation, amortization and income tax expense are different under SFAS No. 109 and SFAS No. 141R, absent a change in expected future tax rates, the amount of consolidated net income will be the same.
ANSWERS TO BUSINESS ETHICS CASE Part 1 Even though the suggested changes by the CFO lie within GAAP, the proposed changes will unfairly increase the EPS of the company, misleading the common investors and other users. It is evident that the CFO is doing it for his or her personal gain rather than for the transparency of financial reporting. Thus, manipulating the reserve in this case comes under the heading of unethical behavior. Taking a stand in such a situation is a difficult and challenging test for an employee who reports to the CFO. Part 2 The tax laws permit individuals to minimize taxes by means that are within the law like using tax deductions, changing one's tax status through incorporation, or setting up a charitable trust or foundation. In the given case the losses reported were phony and the whole scheme was fabricated to illegally benefit certain individuals; hence there appears to be a criminal intent in the scheme. Although there is no reason to pay more tax than necessary, the lack of risk in these types of shelters makes participation in such schemes of questionable ethics, at the best.
3-2
ANSWERS TO ANALYZING FINANCIAL STATEMENTS EXERCISES AFS3-1 eBay’s Acquisitions 1. Acquisition-related costs are costs the acquirer incurs to effect a business combination. Those costs include finder’s fees; advisory, legal, accounting, valuation, and other professional or consulting fees; general administrative costs, including the costs of maintaining an internal acquisitions department; and costs of registering and issuing debt and equity securities. The acquirer shall account for acquisition-related costs as expenses in the periods in which the costs are incurred and the services are received, with one exception. The costs to issue debt are recognized as a deferred charge while the costs to issue equity securities are recognized either as a reduction in paid-in-capital or as an organizational cost and amortized over time. 2. Ratio of acquisition-related costs to purchase price. Purchase Rent.com $435,365 International Websites 81,584 Shopping.com 685,285
Acquisition-related costs $2,000 1,300 7,600
Ratio 0.46% 1.59% 1.11%
3. Journal entry to acquire Rent.com Investment in Rent.com Acquisition expenses Cash (or stock accounts)
435,365 2,000 437,365
4. Since eBay acquired Skype on October 15, 2005 and its yearend is December 31, 2005, eBay can only include income for the last two and a half months (October 15 to December 31). 5. International Classified Websites acquisition: Purchase price Fair value of net tangible and identifiable Intangible assets (81,584-71,771) Goodwill
$81,584 9,813 71,771
Most internet companies do not have a significant amount of physical assets. The value of such businesses tends to be derived from the expected future cash flows to be earned by the business. Thus the value of most internet companies will be recorded in goodwill.
3-3
AFS3-2 eBay’s Acquisitions 1. The growth rates for revenues and profits, including the profit margin ratio (net income divided by net revenues) under the two scenarios are as follows:
Assumed combined
Net Revenue - proforma Net Income - proforma Profit margin %
As reported by eBay Net Revenue- actual Net Income- actual Profit margin %
2004
$3,277,534 684,905 20.9% 2004 3,271,309 778,223 23.8%
Growth 2005 Rates $4,594,954 40.2% 944,057 37.8% 20.5% Growth Rates 4,552,401 39.2% 1,082,043 39.0% 23.8% 2005
Assuming that the results for 2004 and 2005 included Skype, the profit margins would be approximately 3% lower and the growth rate in net income would be slightly more than one percent lower. The growth rate in net revenues would be slightly higher by one percent. It appears that to acquire a one percent increase in revenues, that profits would be lowered by 3 percent of revenues. These numbers raise doubts about the wisdom of the acquisition. However, they reflect past rather than future periods, and the possibility existed at the time of the acquisition that growth in revenues would eventually translate into growth in profits. 2. Sixty percent of Skype’s shareholders opted for a lower cash price in favor of receiving a future contingent payment based on the performance of Skype. Shareholders are offered such payments when they believe that the consideration offered in the acquisition is too low. Ex post we know that Skype never met any of the performance goals and eBay eventually settled the contingent payment for approximately 1/3 of the maximum payment ($1.3 billion). Other factors involved include the shareholders’ tolerance for risk, and the quality of the information presented to them at the time.
3-4
ANSWERS TO EXERCISES Exercise 3-1 a. Common Stock – Saltez Other Contributed Capital - Saltez Retained Earnings - Saltez Property,Plant, and Equipment Investment in Saltez
160,000 92,000 43,000 56,000
b. Common Stock – Saltez Other Contributed Capital – Saltez Property, Plant, and Equipment ($232,000/0.9-[$190,000+$75,000-$29,000]) Retained Earnings – Saltez Investment in Saltez Noncontrolling Interest
190,000 75,000 21,778
351,000
29,000 232,000 25,778
c. Common Stock – Saltez 180,000 Other Contributed Capital – Saltez 40,000 Retained Earnings – Saltez Investment in Saltez Gain on Purchase of Business – Prancer ** Noncontrolling Interest (.2) ($198,750) + $3,450*
4,000 159,000 13,800 43,200
** The ordinary gain to Prancer is $159,000 – (.80)($216,000) = $13,800 * Noncontrolling interest reflects the noncontrolling share of implied value (.20 x $198,750, or $39,750), plus the NCI portion of the bargain (.20 x $17,250) NOTE: We know this is a bargain acquisition in part c because the investment cost of $159,000 implies a total value of $198,750. Since this value is less than the book value of equity of $216,000 [$180,000+$40,000-$4,000], the difference is a bargain of $17,250. This bargain is allocated between the parent (this portion is reflected as a gain) and the NCI. Exercise 3-2 Part A Investment in Save (40,000 $17.50) 700,000 Common Stock Other Contributed Capital ($700,000 – $20,000 – $400,000) Cash
400,000 280,000 20,000
Part B Common Stock – Save Other Contributed Capital – Save Retained Earnings –Save Investment in Save
700,000
320,000 175,000 205,000
3-5
Exercise 3-3 Part A Investment in Sun Company Cash Part B
192,000 192,000
PRUNCE COMPANY AND SUBSIDIARY Consolidated Balance Sheet January 2, 2014 Assets Cash ($260,000 + $64,000 – $192,000) Accounts Receivable Inventory Plant and Equipment (net) Land ($63,000 + $32,000 + $28,333*) Total Assets
$132,000 165,000 171,000 484,000 123,333 $1,075,333
Liabilities and Stockholders’ Equity Accounts Payable Mortgage Payable Total Liabilities
$151,000 111,000 262,000
Noncontrolling Interest ($192,000/0.9 0.1) Common Stock Other Contributed Capital Retained Earnings Total Stockholders’ Equity Total Liabilities and Stockholders’ Equity
$21,333 400,000 208,000 184,000 813,333 $1,075,333
* [$192,000/0.9 – ($70,000 + $20,000 + $95,000)] = $28,333 Exercise 3-4 Part A Investment in Swartz Company ($60 1,500) Common Stock ($20 1,500) Other Contributed Capital ($40 1,500)
90,000
Other Contributed Capital Cash Part B Computation and Allocation of Difference
1,700
30,000 60,000
1,700 Parent Share
Purchase price and implied value Less: Book value of equity acquired Difference between implied and book value Goodwill Balance * $40,000 + $24,000 + $19,000 = $83,000
NonControlling Share $90,000 0 83,000* 0 7,000 0 (7,000) (0) -0-0-
3-6
Entire Value 90,000 83,000 7,000 (7,000) -0-
Exercise 3-4 (continued) Part C
Peach Company and Subsidiary Consolidated Balance Sheet January 1, 2010
Assets Cash ($73,000 + $13,000 - $1,700) Accounts Receivable Inventory Plant and Equipment Land Goodwill* Total Assets Liabilities and Stockholders’ Equity Accounts Payable Notes Payable Total Liabilities
$ 84,300 114,000 83,000 138,000 48,000 7,000 $ 474,300 $84,000 103,000 $187,000
Common Stock ($100,000 + $30,000) Other Contributed Capital ($60,000 + $60,000 - $1,700) Retained Earnings Total Stockholders’ Equity Total Liabilities and Stockholders’ Equity
$130,000 118,300 39,000 287,300 $ 474,300
* Cost of investment less fair value acquired equals goodwill or ($90,000 – $83,000 = $7,000). Recall that the book value of net assets equals the fair value of net assets in this problem. Exercise 3-5 (1) Common Stock–Spruce 900,000 Other Contributed Capital–Spruce 440,000 Retained Earnings–Spruce 150,000 Land [$1,400,000/.90 – ($900,000 + $440,000 + $150,000 - $100,000)] 165,556 Investment in Spruce Company 1,400,000 Treasury Stock 100,000 Noncontrolling Interest ($1,400,000/.90 .10) 155,556 (2) Common Stock–Spruce 900,000 Other Contributed Capital–Spruce 440,000 Retained Earnings–Spruce 150,000 Land 10,000 Investment in Spruce Company 1,160,000 Treasury Stock 100,000 Gain on Purchase of Business - Pool ** 100,000 Noncontrolling Interest # 140,000 ** [$1,160,000 – ($1,050,000 + $990,000 + $180,000 – $820,000) x 90%]= $100,000 # ($1,160,000/.9 = $1,288,889 implied value; NCI=10% x $1,288,889 + $11,111* * 11,111 represents the NCI (10%) share of the bargain gain, which is in total $1,390,000 $1,288,889 + $10,000 (where $10,000 is the write-up of the land).
3-7
Exercise 3-6 Part A
$37,412 Noncontrolling Interest = 15% Noncontrolling Interest $249,412 Implied Value* * Implied Value = Parent’s value $212,000 + NCI $37,412 = $249,412 Common Stock-Shipley Other Contributed Capital-Shipley Retained Earnings-Shipley Land $249,412 - $236,000 Investment in Shipley Company Noncontrolling Interest
Part B
90,000 90,000 56,000 13,412 212,000 37,412
SHIPLEY COMPANY Balance Sheet December 31, 2013 Cash Accounts Receivable Inventory Plant and Equipment Land ($220,412 - $13,412 - $120,000) Total Assets
$ 15,900 22,000 34,600 147,000 87,000 $ 306,500
Accounts Payable Common Stock Other Contributed Capital Retained Earnings Total Equities
$ 70,500 90,000 90,000 56,000 $ 306,500
Exercise 3-7 Part A. Long-term receivable from subsidiary $500,000 Current assets: interest receivable from subsidiary $50,000 Part B. None Exercise 3-8 Investment in Shy Inc. [$2,500,000 + (15,000 $40)] Cash Common Stock Other Contributed Capital ($40 - $2) 15,000
3-8
3,100,000 2,500,000 30,000 570,000
Exercise 3-9 Investment in Shy Inc. [$2,500,000 + (15,000 $40)] Cash Common Stock Other Contributed Capital ($40 - $2) 15,000
Acquisition Expense Deferred Acquisition Charges Acquisition Costs Payable
3,100,000 2,500,000 30,000 570,000
97,000 90,000 7,000
Exercise 3-10A Note: This solution assumes a difference between the basis of acquired assets for accounting and tax purposes for this stock acquisition. Part A Investment in Seely Company Common Stock*** Additional Paid-in-Capital
570,000 95,000 475,000
***Note: Depending on the wording of this exercise, the credit may be cash instead of common stock and additional paid-in-capital. If cash is paid, the credit to cash is $570,000. Part B Common Stock - Seely Other Contributed Capital – Seely Retained Earnings - Seely Difference between Implied and Book Value* Investment in Seely Company Noncontrolling Interest [($570,000/.95) x .05]
80,000 132,000 160,000 228,000 570,000 30,000
* [$570,000/.95 – ($80,000 + $132,000 + $160,000)] Inventory Land Plant Assets Discount on Bonds Payable Goodwill** Deferred Income Tax Liability* Difference between Cost and Book Value *(.40 ($52,000 + $25,000 + $71,000 + $20,000)) **228,000 – [($52,000 + $25,000 + $71,000 + $20,000) x 60%]
3-9
52,000 25,000 71,000 20,000 127,200 67,200 228,000
ANSWERS TO PROBLEMS Problem 3-1 Part A
P COMPANY AND SUBSIDIARY Consolidated Balance Sheet Workpaper November 30, 2014
Case I Current Assets Investment in S Company Difference between Implied and Book Value Long-term Assets Other Assets Total Assets Current Liabilities Long-term Liabilities Common Stock: P Company S Company Retained Earnings P Company S Company Noncontrolling Interest Total Liabilities and Equity Case II Current Assets Investment in S Company Difference between Implied & Book Value Long-term Assets Other Assets Total Assets
P S Company Company 880,000 260,000 190,000
Eliminations Dr. Cr.
(1) 1,400,000 90,000 2,560,000 640,000 850,000
400,000 (2) 40,000 700,000
Noncontrolling Consolidated Interest Balance 1,140,000
(1) 190,000 71,111 (2) 71,111 71,111
1,871,111 130,000 3,141,111
270,000 290,000
910,000 1,140,000
600,000
600,000 180,000 (1) 180,000
470,000
470,000 (40,000)
2,560,000
700,000
780,000 190,000
280,000
(1) 40,000 (2) 21,111 322,222 322,222
400,000 70,000 750,000
21,111 3,141,111
1,060,000 (2)
1,200,000 70,000 2,240,000
21,111
(1) 190,000 8,889 (1) 8,889 8,889
1,591,111 140,000 2,791,111
Current Liabilities 700,000 260,000 Long-term Liabilities 920,000 270,000 Common Stock: P Company 600,000 S Company 180,000 (1) 180,000 Retained Earnings P Company 20,000 S Company 40,000 (1) 40,000 Noncontrolling Interest (1) 21,111 Total Liabilities and Equity 2,240,000 750,000 228,889 228,889 (1) To eliminate investment account and create noncontrolling interest account (2) To allocate the difference between implied value and book value to long-term assets.
960,000 1,190,000
3 - 12
(2)
600,000
20,000 21,111
21,111 2,791,111
Problem 3-1 (continued) Computation and Allocation of Difference (Case I) Parent Share Purchase price and implied value Less: Book value of equity acquired
190,000 126,000
NonControlling Share 21,111 14,000
Entire Value
Difference between implied and book value Increase long-term assets to fair value Balance
64,000 (64,000) -0-
7,111 (7,111) -0-
71,111 (71,111) -0–
Parent Share
Entire Value
190,000 198,000
NonControlling Share 21,111 22,000
211,111* 220,000
(8,000) 8,000 -0-
(889) 889 -0-
(8,889) 8,889 -0–
Parent Share
Entire Value 223,750 140,000 83,750 (83,750) -0–
211,111* 140,000
* $190,000/.90 Computation and Allocation of Difference (Case II)
Purchase price and implied value Less: Book value of equity acquired Difference between implied and book value Decrease long-term assets to fair value Balance * $190,000/.90 Part B Computation and Allocation of Difference
Purchase price and implied value ** Less: Book value of equity acquired
202,500 126,000
NonControlling Share 21,250 14,000
Difference between implied and book value Increase long-term assets to fair value Balance
76,500 (76,500) -0-
7,250 (7,250) -0-
** Parent share = .90*50,000*$4.50 = $202,500 Non-controlling share = .10*50,000*$4.25 = $21,250. This assumes that there was a $0.25 per share control premium paid to acquire the 90% interest.
3 - 13
Problem 3-2 Part A $100,000 Soho Total Par/$10 Par per share = 10,000 shares of Soho issued 8,000 shares acquired/10,000 total shares = 80% Implied Value of Soho (100%) = $120,000/80% = $150,000. Implied Value of Noncontrolling share = $150,000 x 20% = $30,000. Computation and Allocation of Difference Schedule Parent Share Purchase price and implied value Less: Book value of equity acquired: Common stock Other contributed capital Retained earnings Total book value
120,000
NonControlling Share 30,000
150,000*
80,000 13,200 18,800 112,000
20,000 3,300 4,700 28,000
100,000 16,500 23,500 140,000
8,000 (8,000) -0-
2,000 (2,000) -0-
10,000 (10,000) -0-
Difference between implied and book value Plant Assets Balance
Entire Value
*$120,000/.80 Part C $100,000 Soho Total Par/$10 Par per share = 10,000 shares of Soho issued 8,000 shares acquired/10,000 total shares = 80% Implied Value of Soho (100%) = $120,000/80% = $150,000. Implied Value of Noncontrolling share = $150,000 x 20% = $30,000. Computation and Allocation of Difference Schedule Parent Share 160,000
NonControlling Share 30,000
190,000*
80,000 13,200 18,800 112,000
20,000 3,300 4,700 28,000
100,000 16,500 23,500 140,000
Difference between implied and book value 48,000 Plant Assets (48,000) Balance -0-
2,000 (2,000) -0-
50,000 (50,000) -0-
Purchase price and implied value Less: Book value of equity acquired: Common stock Other contributed capital Retained earnings Total book value
8,000 shares at $20 per share plus 2,000 shares at $15 equals $190,000
3 - 14
Entire Value
Problem 3-2 (continued) PERRY COMPANY AND SUBSIDIARY SOHO Part B Consolidated Balance Sheet Workpaper January 1, 2014 Perry Company
Soho Company
Cash Accounts Receivable Inventory Investment in Soho Difference between Implied and Book Value Plant Assets Accumulated Depreciation Total
39,000 53,000 42,000 120,000
19,000 31,000 25,000
160,000 (52,000) 362,000
110,500 (19,500) 166,000
Current Liabilities Mortgage Note Payable Common Stock: Perry Company Soho Company Other Contributed Capital Perry Company Soho Company Retained Earnings: Perry Company Soho Company Noncontrolling Interest Total
18,500 40,000
26,000
Eliminations Debit Credit
Noncontrolling Interest
58,000 84,000 67,000 (1) 120,000 (1) 10,000 (2) 10,000
(2) 10,000 280,500 (71,500) 418,000 44,500 40,000
120,000
120,000 100,000
(1) 100,000
16,500
(1) 16,500
135,000
135,000
48,500
48,500 23,500
362,000
Consolidated Balance
166,000
(1) 23,500 160,000
(1) To eliminate investment account and create noncontrolling interest account. (2) To allocate the difference between implied and book value to plant assets.
3 - 15
(1) 30,000 160,000
30,000
30,000 418,000
Problem 3-3
P COMPANY AND SUBSIDIARY Consolidated Balance Sheet Workpaper August 1, 2014 P S Company Company
Cash Receivables
165,500 366,000
Inventory 261,000 Investment in Bonds 306,000 Investment in S Company Stock 586,500 Difference between Implied and Book Value Plant and Equipment (net) 573,000 Land 200,000 Total Assets 2,458,000 Accounts Payable Accrued Expenses Bonds Payable, 8% Common Stock: P Company S Company Other Contributed Capital: P Company S Company Retained Earnings P Company S Company Noncontrolling Interest Total Advances from P Company Total Liabilities and Equity
174,000 32,400
Eliminations Noncontrolling Consolidated Interest Balance Dr. Cr. 106,000 (b) 35,000 306,500 126,000 (a) 800 (3) 800 457,000 (4) 35,000 108,000 369,000 (2) 40,000 266,000 (1) 586,500
320,000 300,000 960,000
(5) 24,333 (1) 24,333 (5) 24,333
868,667 500,000 2,767,167
58,000 26,000 (3) 800 200,000 (2) 40,000
232,000 57,600 160,000
1,500,000
1,500,000 460,000 (1) 460,000
260,000
260,000 60,000 (1) 60,000
491,600
(a)
800
492,400
156,000 (1) 156,000 (1) 65,167 2,458,000
65,167
65,167
960,000 (4) 35,000 (b) 35,000 811,933 811,933
2,767,167
(a) To establish reciprocity for interest receivable and payable and to recognize interest earned (b) To establish reciprocity for intercompany advances (1) To eliminate Investment in S Company and create noncontrolling interest account (2) To eliminate intercompany bondholdings (3) To eliminate intercompany interest receivable and payable (4) To eliminate intercompany advances (5) To allocate the difference between implied value and book value to plant and equipment
3 - 16
Problem 3-3 (continued) Computation and Allocation of Difference Parent Share Purchase price and implied value 586,500 Less: Book value of equity acquired ($676,000 x .9) 608,400
NonEntire Controlling Value Share 65,167 651,667* 67,600 676,000
Difference between implied and book value Decrease PPE to fair value Balance
(2,433) 2,433 -0-
(21,900) 21,900 -0-
* $586,500/.90
3 - 17
(24,333) 24,333 -0-
Problem 3-4
PHILLIPS COMPANY AND SUBSIDIARIES Consolidated Balance Sheet Workpaper January 2, 2014
Cash Account Receivable Note Receivable Interest Receivable Inventory Investment in Sanchez Company Investment in Thomas Company Equipment Land Total Assets Accounts Payable Note Payable Accrued Interest Payable Common Stock: Phillips Company Sanchez Company Thomas Company Other Contributed Capital: Phillips Company Sanchez Company Thomas Company Retained Earnings Phillips Company Sanchez Company Thomas Company
Phillips Company 7,000 28,000 120,000 225,000 168,000 60,000 180,000
Sanchez Company 43,700 24,000 10,000 300 96,000
Thomas Company 20,000 20,000
Eliminations Dr. Cr.
Noncontrolling Interest
Consolidated Balance 70,700 72,000
(1) 10,000 (2) 300 43,000
259,000 (3) 225,000 (4) 168,000
40,000 80,000
30,000 70,000
788,000
294,000
183,000
28,000
20,000
18,000 10,000
130,000 369,217
(3) 7,250 * * (4) 31,967 * **
900,917 66,000 (1) 10,000 (2) 300
(a)
300
300,000
300,000 120,000 75,000
(3) 120,000 (4) 75,000
40,000
(3) 90,000 (4) 40,000
300,000
300,000 90,000
160,000
160,000 64,000 40,000
(3) 64,000 (a) 300 (4) 39,700 *
Noncontrolling Interest (3)(4)74,917 * *** 74,917 Total Liabilities and Equity 788,000 294,000 183,000 478,517 478,517 * ($40,000 – $300); ** [$225,000/.80 – ($120,000 + $90,000 + $64,000)]; *** [$168,000/.90 – ($75,000 + $40,000 + $40,000 – $300)]; **** ($225,000/.80 x .20) + ($168,000/.90 x .10) (a) To establish reciprocity for interest receivable and payable and to recognize interest earned (1) To eliminate intercompany note receivable and payable (2) To eliminate intercompany interest receivable and payable (3) To eliminate the investment in Sanchez Company and create noncontrolling interest account of $56,250 (4) To eliminate the investment in Thomas Company and create noncontrolling interest account $18,667
74,917 900,917
Problem 3-5 Part A Pat Company Cash balance, 12/31/2013 Less: Cash used in the acquisition of Solo Pat Company Cash balance after acquisition Consolidated Cash balance, 1/1/2014 Less: Pat Company Cash balance after acquisition Difference Less: Cash transfer unrecorded by Solo Solo's cash balance, 1/1/2014
$540,000 236,000 $304,000 $352,000 304,000 48,000 10,000 $38,000
Part B The noncontrolling interest of $28,500 on the consolidated balance sheet is equal to 10% of the total stockholders' equity of Solo Company. Thus, total stockholders' equity of Solo Company is $28,500 $285,000 = 0.10 Part C Total stockholders’ equity of solo from (B) above $285,000 Add: Accounts payable of Solo Company $386,000 – $280,000 = $106,000 + $4,000 of intercompany payables eliminated in consolidation 110,000 Add: Long-term liabilities of Solo Company, $605,500 - $520,000 85,500 Total assets of Solo Company 1/1/2014 $480,500
3 - 19
Problem 3-6
PING COMPANY AND SUBSIDIARY Consolidated Balance Sheet Workpaper July 31, 2014
Ping Company
Santos Company
Cash 320,000 Accounts Receivable 600,000 Note Receivable 100,000 Inventory 1,840,000 Advance to Santos Company 60,000 Investment in Santos Company 2,010,000 Difference between Implied & Book Value Plant and Equipment 3,000,000 Land 90,000 Total Assets 8,020,000
150,000 300,000
Accounts Payable Notes Payable Common Stock: Ping Company Santos Company Other Contributed Capital: Ping Company Santos Company Retained Earnings Ping Company Santos Company Noncontrolling Interest Total Advance from Ping Company Interest Payable Interest Receivable Total Liabilities and Equity
800,000 900,000
Eliminations
(a)
Dr. 60,000
Noncontrolling Interest
Cr. 530,000 880,000
(2) 20,000 (5) 100,000
400,000
2,240,000 (1) 60,000 (3)2,010,000 (3) 40,333 * (6) 40,333
1,500,000 90,000 2,440,000
(6) 40,333
4,500,000 220,333 8,370,333
140,000 100,000
(2) 20,000 (5) 100,000
920,000 900,000
2,400,000
2,400,000 900,000
(3) 900,000
680,000
(3) 680,000
2,200,000
2,200,000
1,720,000
(c) 620,000
7,000
1,727,000
(b) 7,000 (3) 613,000 (3) 223,333
8,020,000
Consolidated Balance
223,333**
223,333
2,440,000 (1) 60,000 (4) 7,000 (c) 7,000 2,534,666 3-20
(a) 60,000 (b) 7,000 (4) 7,000 2,534,666
8,370,333
Problem 3-6 (continued) * [$2,010,000/.90 – ($900,000 + $680,000 + $620,000 - $7,000)] = $40,333; ** $2,010,000/.90 x .10 = 223,333 (a) To establish reciprocity for cash advances (b) To adjust for unrecorded interest expense and interest payable (c) To adjust for unrecorded interest income and interest receivable. (1) To eliminate intercompany advances (2) To eliminate intercompany accounts receivable and accounts payable (3) To eliminate investment in Santos Company and create noncontrolling interest account (4) To eliminate intercompany interest receivable and interest payable (5) To eliminate intercompany note receivable and note payable (6) To allocate the difference between implied and book value to land Problem 3-7
Cash ($700,000 – $594,000 + $ 111,000) Accounts Receivable (net) Inventory Property and Equipment (net) Land Total Assets
PREGO COMPANY AND SUBSIDIARY Consolidated Balance Sheet January 1, 2014 (Part A) $ 217,000 1,122,000 604,000 2,395,000 214,000 $4,552,000
Accounts Payable Notes Payable Long-term Debt Noncontrolling Interest ($500,000 + $80,000 + $80,000) 0.10) Common Stock Other Contributed Capital (part B, $543,000 + [($50 – $20) 11,880] Retained Earnings Total Equities Problem 3-8 Part A Investment in Sara Co. (13,400 $12) Common Stock (13,400 $10) Other Contributed Capital ($26,800 – $4,000) Cash
$ 454,000 649,000 440,000 66,000 1,800,000 543,000 600,000 $4,552,000 160,800 134,000 22,800 4,000
Investment in Rob Co. Cash
50,000 50,000 3-21
(Part B) $ 811,000 1,122,000 604,000 2,395,000 214,000 $5,146,000 $ 454,000 649,000 440,000 66,000 2,037,600 899,400 600,000 $5,146,000
Problem 3-8 (continued) Punto Company & Subsidiaries Consolidated Balance Sheet Workpaper at February 1, 2014 Part B Cash Account Receivable Notes Receivable Merchandise Inventory Prepaid Insurance Investment in Sara Company Investment in Rob Company Difference between Implied and Book Value Advances to Sara Company Advances to Rob Company Land Buildings (net) Equipment (net) Total Assets
Punto Company 111,000 35,000 18,000 106,000 13,500 160,800 50,000
Sara Company 45,000 35,000
Rob Company 17,000 26,000
35,500 2,500
14,000 500
10,000 5,000 248,000 100,000 35,000 892,300
43,000 27,000 10,000 198,000
15,000 16,000 2,500 91,000
Accounts Payable
25,500
20,000
10,500
Income Taxes Payable Notes Payable Bonds Payable Common Stock: Punto Company Sara Company Rob Company Other Contributed Capital: Punto Company Sara Company Rob Company Retained Earnings Punto Company Sara Company Rob Company Noncontrolling Interest Total Liabilities and Equity
30,000
10,000 6,000
Eliminations Dr. Cr. (a) 5,000 (2) 21,000 (3) 12,500
Noncontrolling Interest
(4) 160,800 (5) 50,000 (4) 7,263 ** (5) 11,176 (7) 11,176 (6) 7,263 6,900* (1) 10,000 (1) 5,000 (6) 7,263 (7) 11,176
(1) 15,000 (2) 21,000
313,263 131,824 47,500 923,087
100,000
25,000 40,000 4,000 100,000
434,000
434,000
10,500
144,000
(a)
Consolidated Balance 178,000 75,000 5,500 155,500 16,500
5,000
(3) 12,500
42,000
(4) 144,000 (5) 42,000
38,000
(4) 12,000 (5) 38,000
172,800
172,800 12,000
130,000
130,000 6,000
(4)
6,000
(10,000) 892,300
198,000
91,000
321,202
3-22
(5) 10,000 (4)(5)17,287 * 321,202
17,287
17,287 923,087
Problem 3-8 (continued) (a) To adjust for cash in transit from Punto to Rob (1) To eliminate intercompany advances (2) To eliminate intercompany accounts receivable and accounts payable (3) To eliminate intercompany notes receivable and notes payable (4) To eliminate investment in Sara Company and create noncontrolling interest account of $8,463 (5) To eliminate investment in Rob Company and create noncontrolling interest account of $8,824 (6) To allocate the difference between implied and book value to the under-valuation of Sara’s land (7) To allocate the difference between implied and book value to the over-valuation of Rob’s buildings * [$160,800/.95 x .05] = $8,463 $8,463 (entry 4) + $8,824 (entry 5) = $17,287 ** $160,800/.95 – ($144,000 + $12,000 + $6,000) Computation and Allocation of Difference Parent Share Purchase price and implied value Less: Book value of equity acquired
50,000 59,500
NonControlling Share 8,824 10,500
Difference between implied and book value Decrease buildings to fair value Balance
(9,500) 9,500 -0-
(1,676) 1,676 -0-
Entire Value 58,824* 70,000 (11,176) 11,176 -0-
* $50,000/.85 Part C
PUNTO COMPANY AND SUBSIDIARIES Consolidated Balance Sheet February 1, 2014 Assets Current Assets: Cash Accounts Receivable Notes Receivable Merchandise Inventory Prepaid Insurance Total Current Assets
$178,000 75,000 5,500 155,500 16,500 $ 430,500
Long-Term Assets: Land Buildings(net) Equipment(net) Total Assets
313,263 131,824 47,500 $ 923,087
3-23
Problem 3-8 (continued) Liabilities and Stockholders' Equity Current Liabilities: Accounts Payable Income Tax Payable Notes Payable Total Current Liabilities Bonds Payable Total Liabilities Stockholders’ Equity: Noncontrolling Interest in Subsidiaries Common Stock Other Contributed Capital Retained Earnings Total Stockholders’ Equity Total Liabilities and Stockholders’ Equity
$25,000 40,000 4,000 $ 69,000 100,000 169,000 17,287 434,000 172,800 130,000 754,087 $ 923,087
Problem 3-9 Part A Computation and Allocation of Difference Schedule Parent Share Purchase price and implied value Less: Book value of equity acquired: Common stock (5,250,000 x .90) Other contributed capital Retained earnings Less: Treasury stock Total book value
$5,800,000
NonTotal Controlling Value Share 644,444 6,444,444*
4,725,000 356,400 1,732,500 (1,080,000) 5,733,900
525,000 5,250,000 39,600 396,000 192,500 1,925,000 (120,000) (1,200,000) 637,100 6,371,000
Difference between implied and book value 66,100 Plant assets (66,100) Balance -0*$5,800,000/.90
3-24
7,344 (7,344) -0-
73,444 (73,444) -0-
Problem 3-9 (continued) Pope Company and Subsidiary Worksheet, January 1, 2015 Part B Pope Sun Eliminations Noncontrolling Consolidated Company Company Interest Balances Debit Credit Cash 297,000 165,000 462,000 Accounts Receivable 432,000 468,000 900,000 Notes Receivable 90,000 (1) 90,000 Inventory 1,980,000 1,447,000 3,427,000 Investment in Sun Company 5,800,000 (2) 5,800,000 Difference between Implied and & Book Value (2) 73,444 (3) 73,444 Plant and Equipment (net) 5,730,000 3,740,000 (3) 73,444 9,543,444 Land 1,575,000 908,000 2,483,000 Total $15,904,000 $6,728,000 $16,815,444 Accounts Payable Notes Payable Common Stock ($15 par): Pope Company Sun Company Other Contributed Capital Pope Company Sun Company Treasury Stock Held: Sun Company Retained Earnings Pope Company Sun Company Noncontrolling Interest Total
698,000 2,250,000
247,000 110,000
945,000 2,270,000
(1) 90,000
4,500,000
4,500,000 5,250,000 (2)5,250,000
5,198,000
5,198,000 396,000 (2) 396,000 (1,200,000)
(2)1,200,000
3,258,000
3,258,000 1,925,000 (2)1,925,000
$15,904,000 $6,728,000
7,807,888
(2) 644,444 7,807,888
(1) To eliminate intercompany note receivable and note payable (2) To eliminate Investment in Sun Company and create noncontrolling interest account (3) To allocate the difference between implied and book value to subsidiary plant and equipment.
3-25
644,444
644,444 $16,815,444
Problem 3-10A Part A Investment in Shah Company ($28 25,500) Common Stock ($2 25,500) Other Contributed Capital ($26 25,500)
714,000
Part B Common Stock - S Other Contributed Capital - S 1/1 Retained Earnings - S Difference between Implied and Book Value Investment in Shah Company Noncontrolling Interest [($714,000/.85) x .15]
120,000 164,000 267,000 289,000*
51,000 663,000
714,000 126,000
* ($714,000/.85) – ($120,000 + $164,000 + $267,000) Inventory Land Plant Assets Patents Deferred Tax Asset Goodwill Premium on Bonds Payable Deferred Tax Liability ($266,500 x .35) Difference between Implied and Book Value
28,000 33,500 100,000 105,000 21,000 154,775* 60,000 93,275 289,000
* ($289,000 +60,000-21,000)– [($28,000 + $33,500 + $100,000 + $105,000) (−)]
3 - 26
CHAPTER 4 Note: The letter A or B indicated for a question, exercise, or problem means that the question, exercise, or problem relates to a chapter appendix. ANSWERS TO QUESTIONS 1
Nonconsolidated subsidiaries are expected to be relatively rare. In those situations where a subsidiary is not consolidated, the investment in the subsidiary should be reported in the consolidated statement of financial position at cost, along with other long-term investments.
2.
A liquidating dividend is a return of investment rather than a return on investment. Consequently, the amount of a liquidating dividend should be credited to the investment account rather than to dividend income when the cost method is used, whereas regular dividends are recorded as dividend income under the cost method. If the equity method is used, all dividends are credited to the investment account.
3.
When the parent company uses the cost method, the workpaper elimination of intercompany dividends is made by a debit to Dividend Income and a credit to Dividends Declared. This elimination prevents the double counting of income since the subsidiary's individual revenue and expense items are combined with the parent company's in the determination of consolidated net income. When the parent company uses the equity method, the workpaper elimination for intercompany dividends is made by a debit to the investment account and a credit to Dividends Declared.
4.
When the parent company uses the cost method, dividends received are recorded as dividend income. When the parent company uses the partial equity method, the parent company recognizes equity income on its books equal to its ownership percentage times the investee company’s reported net income. When the parent company uses the complete equity method, the parent recognizes income similar to the partial equity method, but adjusts the equity income for additional charges or credits when the purchase price differs from the fair value of the investee company’s net assets, and for intercompany profits (addressed in chapters 6 and 7).
5.
Consolidated net income consists of the parent company's net income from independent operations plus (minus) any income (loss) earned (incurred) by its subsidiaries during the period, adjusted for any intercompany transactions during the period and for any excess depreciation or amortization implied by a purchase price in excess of book values. Consolidated retained earnings consist of the parent company's retained earnings from its independent operations plus (minus) the parent company's share of the increase (decrease) in its subsidiaries' retained earnings from the date of acquisition.
6.
Investment in S Company 1/1 Retained Earnings, P Company 80% ($461,430 - $16,250)]
356,144 356,144
This adjustment recognizes that P Company's share of S Company's undistributed profits from the date of acquisition to the beginning of the current year is properly a part of beginning-of-year 4-1
consolidated retained earnings. It also enhances the elimination of the investment account. This entry is only needed if the parent company uses the cost method. If the equity method is used, the parent’s retained earnings already reflect the undistributed earnings of the subsidiary. 7.
The noncontrolling interest column accumulates the noncontrolling stockholders' share of subsidiary income, less their share of excess depreciation or amortization implied by fair value adjustments (addressed in detail in chapter 5), dividends (as a reduction), and the beginning noncontrolling interest in equity carried forward from the previous period.
8.
The method used to record the investment on the books of the parent company (cost method, partial equity method, or complete equity method) has no effect on the consolidated financial statements. Only the workpaper elimination procedures are affected.
9.
The two methods for treating the preacquisition revenue and expense items of a subsidiary purchased during a fiscal year are (1) including the revenue and expense items of the subsidiary for the entire period with a deduction at the bottom of the consolidated income statement for the net income earned prior to acquisition (this is the preferred method), and (2) including in the consolidated income statement only the subsidiary's revenue earned and expenses incurred subsequent to the date of purchase.
10. (a) Readers of consolidated financial statements will be unable to evaluate the financial position and results of operations (neither of which is shown separately from the parent's) of the subsidiaries. (b) Because consolidated assets are not generally available to meet the claims of the creditors of a subsidiary, creditors will have to look to the financial statements of the debtor (subsidiary) corporation. Similarly, the creditors of the parent company are most interested in only the assets of the parent company, although large creditors are likely to gain control over or have indirect access to the assets of subsidiaries in the case of parent company default. (c) Because consolidated financial statements are a composite, it is impossible to distinguish a financially weak subsidiary from financially strong ones. (d) Ratio analyses based on consolidated data are not reliable guides, especially when the related group produces a conglomerate of unrelated product lines and services. (e) Consolidated financial statements often do not disclose data about subsidiaries that are not consolidated. (f) A reader of consolidated financial statements cannot assume that a certain amount of unrestricted consolidated retained earnings will be available for dividends. Data on the ability of the individual subsidiaries to pay dividends are frequently unavailable. 11. A consolidated statement of cash flows contains two adjustments that result from the existence of a noncontrolling interest: (1) an adjustment for the noncontrolling interest in net income or loss of the subsidiary in the determination of net cash flow from operating activities, and (2) subsidiary dividend payments to the noncontrolling stockholders must be included with parent company dividends paid in determining cash paid as dividends because the entire amount of the
4-2
noncontrolling interest in net income (loss) is added back (deducted) in determining net cash flows from operating activities. 12. Potential voting rights refer to the rights associated with potentially dilutive securities such as convertible bonds or stocks, or stock options, rights, or warrants that are currently exercisable. These are considered under international standards in determining the applicability of the equity method for investments where the investor may be considered to have significant influence. They are generally not considered under U.S. GAAP. International standards (IFRS) refer to investments that are accounted for under the equity method as “investments in associates.” 13B.
No. The recognition and display of a deferred tax asset or deferred tax liability relating to the assignment of the difference between implied value and book value is necessary without regard to whether the affiliates file consolidated income tax returns or separate income tax returns.
14B
An assumption must be made as to whether the undistributed income will be realized in a future dividend distribution or as a result of the sale of the subsidiary. This is necessary because the calculation of the tax consequences differs depending on the assumption made. Dividend distributions are subject to a dividends received exclusion, whereas gains or losses on disposal are not. In addition, gains or losses on disposal may be taxed at different tax rates than dividend distributions. Although capital gains are currently taxed at the same rates as ordinary income, the rates have been different in the past and may be again in the future.
15B
The amounts calculated under these two approaches would be different (1) if the affiliates had different marginal tax rates, (2) if the affiliates were in different tax jurisdictions, or (3) when expected future tax rates differ from the tax rate used in determining the tax paid or accrued by the selling affiliate.
16B
When the affiliates file separate returns, two types of temporary differences may arise: 1. Deferred income tax consequences that arise in the consolidated financial statements because of undistributed subsidiary income, and 2. Deferred income tax consequences that arise in the consolidated financial statements because of the elimination of unrealized intercompany profit.
ANSWERS TO BUSINESS ETHICS CASE Surreptitiously installing spyware on computers can be an unethical practice (the word surreptitious implies that the customer is unaware of the activity). The programs run in the background and can significantly slow down the computer’s operating performance. Sometimes these programs are used to pass on the consumer browsing history and may leak personal information to the advertising firm.
4-3
ANSWERS TO FINANCIAL STATEMENT ANALYSIS EXERCISES AFS4-1 GE Financial Statements A. GE uses the equity method to account for the investment in GECS. The investment account on GE’s books has a balance of $68,984 and $70,833 for the years 2010 and 2009 respectively. Notice that the balance in the investment account equals the ending balance of stockholders’ equity for GECS for the same years. Thus the investment account changes exactly by the amount that the subsidiary equity accounts change. Because GE owns 100% of GECS (and created this subsidiary), the equity method is the only method that would keep these two amounts equal. In essence, the parent’s investment account mirrors the activity in the subsidiary’s equity. B.
The 2010 consolidated balances for assets and liabilities are $751,216 and $781,901, which differ from the balances for GE’s assets and liabilities of $218,763 and $209,942. On the other hand, the 2005 consolidated balance for equity (excluding noncontrolling interests) equals the equity balance of GE’s equity at $118,936. On GE’s books, the assets and liabilities of GECS are recorded net in the investment account (i.e. the investment account represents the net assets of GECS). When the firm prepares consolidated financial statements, the investment account is eliminated and replaced by the individual assets and liabilities of GECS. While some consolidated amounts are simply the sum of GE’s and GECS’s individual accounts (such as inventories), other accounts do not simple add across (such as short-term borrowings, receivables, and payables). One reason these accounts may not add across is due to the elimination of intercompany transactions. The equity accounts of GECS disappear altogether in the consolidated totals.
C.
None of this minority interest is related to GE’s investment in GECS since GE owns 100%. Under current GAAP, minority interest (or noncontrolling interest) is also recorded at fair value. In the past, the minority interest was maintained at historical cost. The current standard does not require previously recorded minority interest to be adjusted to fair value. Under IFRS, there is more flexibility with respect to recording the noncontrolling interest at fair value, at historical cost, or at a hybrid reflecting fair value for identifiable assets but not for goodwill. As U.S. GAAP and IFRS converge, this is one issue that needs to be resolved or clarified.
D.
The current presentation that GE uses is very informative because it shows financial statements for each company (GE and GECS separately). This allows the user to see the nature of the types of accounts that GECS is involved in, as well as their magnitude (financing receivables and long-term borrowings, for example). In addition, it is crucial that the reader is able to see the accounts for the consolidated entity. For instance, if GE simply used the equity method to record GECS (without consolidation), it would appear that GE is only responsible for $95,729 of liabilities (see GE’s unconsolidated columns), when in reality, GECS has debt of $538,530. This debt is reflected in the consolidated columns. GECS's debt is not recorded as a line item on GE's books if the equity method is used and consolidation does not occur. It would be considered 'off balance sheet' debt. If undisclosed, this might be viewed in some respects as similar to the type of off-balance sheet debt in some of the partnerships that got Enron into so much trouble.
4-4
AFS4-2 eBay Acquires Skype This problem can be used to discuss the changes in GAAP regarding contingent payments. At the time of the Skype acquisition, contingent payments were only recorded if the contingency was already met. Otherwise, when the payment was made, the additional consideration was considered an increase in consideration (increase in goodwill). However, under current rules, the fair value of the contingency is recorded on the date of acquisition with subsequent changes in the contingent payment recognized in income. A. Journal entry to record the investment in Skype (using former GAAP): Investment in Skype ($ millions) Cash Capital stock
2,600 1,300 1,300
Journal entry to record the investment in Skype (using current GAAP): Expected fair value assumes that the full expected contingency will be settled. Investment in Skype ($ millions) 3,900 Cash 1,300 Capital stock 1,300 Liability for contingent consideration 1,300 B. The $1.3 billion cash component is listed under Cash from Investing Activities on the Statement of Cash Flows. The remaining two items are footnote disclosures. The amount of the investment acquired by issuing common stock is disclosed in the notes under ‘supplemental cash flow information.’ The expected contingent payment would also be disclosed under ‘supplemental cash flow information.’ AFS4-3 Various Acquisitions A. Income is only recognized on the parent’s books from the date of acquisition.
Company Acquired Rent.com International classified websites Shopping.com Skype Total Income
Fraction Date Acquired of year February 1, 2005 11/12 April 1, 2005 September 1, 2005 October 14, 2005
9/12 4/12 2.5/12
Total Income Acquired
Income 2005 Income Acquired 12,000 11,000 5,000 20,000 120,000 $ 157,000
3,750 6,667 25,000 $ 46,417
B. All of the following must be disclosed: FASB ASC sub-paragraph 805-10-50-2(h) 1. The amounts of revenue and earnings of the acquiree since the acquisition date included in the consolidated income statement for the reporting period ($46,417 in the problem).
4-5
AFS4-3 Various Acquisitions (continued) 2. The revenue and earnings of the combined entity for the current reporting period as though the acquisition date for all business combinations that occurred during the year had been as of the beginning of the annual reporting period (supplemental pro forma information), or $157,000 in the example. 3. If comparative financial statements are presented, the revenue and earnings of the combined entity for the comparable prior reporting period as though the acquisition date for all business combinations that occurred during the current year had occurred as of the beginning of the comparable prior annual reporting period (supplemental pro forma information). No information was provided in the problem to determine the amounts.
4-6
Answers to Exercises Exercise 4-1 Part A – Cost Method 2014 Investment in Song Company Cash
387,000 387,000
Cash Dividend Income (.8 $25,000)
20,000 20,000
2015 Cash Dividend Income (.8 $50,000)
40,000 40,000
2016 Cash Investment in Song Company (.8 $35,000) (liquidating dividend) Part B – Partial Equity Method 2014 Investment in Song Company Cash
28,000 28,000
387,000 387,000
Investment in Song Company Equity Income (.8 $63,500)
50,800
Cash Investment in Song Company
20,000
50,800
20,000
2015 Investment in Song Company Equity Income (.8 $52,500)
42,000 42,000
Cash Investment in Song Company
40,000 40,000
2016 Equity Loss (.8 x $55,000) Investment in Song Company
44,000 44,000
Cash Investment in Song Company (.8 $35,000)
4-7
28,000 28,000
Exercise 4-1 (continued) Part C – Complete Equity Method Parent Share Cost of investment Book value acquired($475,000 x .80) Difference between Implied and Book value Allocated to undervalued depreciable assets Balance
Noncontrolling Entire Share Value
387,000 380,000 7,000 (7,000) -0-
96,750 95,000 1,750 (1,750) -0-
483,750 * 475,000 8,750 (8,750) -0-
* $387,000/.80 Amortization per year Parent ($7,000/10) = $700 2014 Investment in Song Company Cash
387,000 387,000
Investment in Song Company Equity Income (.8 $63,500)
50,800
Equity Income ($7,000/10) Investment in Song Company
700
Cash Investment in Song Company
20,000
50,800
700
20,000
2015 Investment in Song Company Equity Income (.8 $52,500)
42,000 42,000
Equity Income ($7,000/10) Investment in Song Company
700
Cash Investment in Song Company
40,000
700
40,000
2016 Equity Loss (.8 x $55,000) Investment in Song Company
44,000 44,000
Equity Income ($7,000/10) Investment in Song Company
700 700
Cash Investment in Song Company (.8 $35,000)
4-8
28,000 28,000
Exercise 4-2 Workpaper entries 12/31/18 – Cost Method Investment in Salt Company Retained Earnings 1/1 - Park Company To establish reciprocity (.90 ($160,000 – $50,000))
99,000
Dividend Income Dividends Declared - Salt Company
9,000
99,000
9,000
Common Stock - Salt Company 450,000 Retained Earnings 1/1/18 - Salt Company 160,000 Land 16,667 Investment in Salt Company ($465,000 + $99,000) Noncontrolling Interest ($51,667 + .10 x ($160,000 – $50,000)
564,000 62,667
Computation and Allocation of Difference between Implied and Book Value Acquired Parent Share Purchase price and implied value Less: Book value of equity acquired: Difference between implied and book value Allocated to undervalued land Balance *$465,000/.90
465,000 450,000 15,000 (15,000) -0-
NonControlling Share 51,667 50,000 1,667 (1,667) -0-
Entire Value 516,667 * 500,000 16,667 (16,667) -0-
Exercise 4-3 Workpaper entries 12/31/17 – Equity Method The balance in the investment account at the beginning of the year is $532,000, which is computed as: [$494,000 + (.95 x ($160,000 – $120,000))] = $532,000 Common Stock - Succo Company Other Contributed Capital - Succo Company Retained Earnings 1/1/17 - Succo Company Investment in Succo Company Noncontrolling Interest*
300,000 100,000 160,000 532,000 28,000
* $520,000 x .05 + (.05 x ($160,000 - $120,000)) = 28,000 Equity Income ($40,000)(.95) Dividends Declared ($19,000)(.95) Investment in Succo Company
38,000 18,050 19,950
In this instance, the partial and complete equity methods result in the same entries because the amount paid for the acquisition of Succo is exactly 95% of Succo’s book value. Thus, there are no asset adjustments and no excess amortization or depreciation to consider. The equity income under the complete equity method is the same as under the partial equity method (95% of reported income of Succo). 4-9
Exercise 4-4 Parent Share Purchase price and implied value Less: Book value of equity acquired: Difference between implied and book value Goodwill Balance
310,000 293,250 16,750 (16,750) -0-
NonControlling Share 54,706 51,750 2,956 (2,956) -0-
Entire Value 364,706 * 345,000 19,706 (19,706) -0-
* $310,000/.85 Part A – Workpaper entries 12/31/17 - Equity Method Investment in Serena Company Dividends Declared - Serena Company (.85)($12,000) Equity Loss (.85)($10,000 loss)
18,700
Common Stock - Serena Company Other Contributed Capital - Serena Company Retained Earnings 1/1/17 - Serena Company Difference between Implied and Book Value (Goodwill) Investment in Serena Company ($310,000 – $6,375*) Noncontrolling Interest
240,000 55,000 42,500 a 19,706
10,200 8,500
303,625 53,581
* [($50,000 - $42,500) x .85] = 6,375; ** $54,706 - [($50,000 - $42,500) x .15] = $53,581 a
$42,500 = $20,500 at year-end plus 2012 loss of $10,000 plus 2012 dividends of $12,000
Goodwill Difference between Implied and Book Value
19,706 19,706
The partial equity and the complete equity methods result in the same entries because the excess of the cost over fair value of net assets is allocated to goodwill, a non-amortizable asset. If any of this excess is allocated to depreciable assets or intangible assets with limited lives (subject to amortization), additional expenses will be recorded under the complete equity method. Part B – Workpaper entries 12/31/17 - Cost Method Retained Earnings 1/1 - Poco Company Investment in Serena Company To establish reciprocity (.85 ($50,000 – $42,500))
6,375
Investment in Serena Company Dividends Declared - Serena Company
10,200
Common Stock - Serena Company Other Contributed Capital - Serena Company Retained Earnings 1/1/17- Serena Company Difference between Implied and Book Value Investment in Serena Company ($310,000 – $6,375) Noncontrolling Interest
240,000 55,000 42,500 19,706
6,375
10,200
4 - 10
303,625 53,581
Exercise 4-4 (continued) Goodwill Difference between Implied and Book Value
19,706 19,706
Exercise 4-5 Workpaper Entries and Noncontrolling Interest Cost of investment Less: excess cost allocated to land Book value acquired (90%)
$ 650,000 20,000 $ 630,000
Total stockholders’ equity - Set Company ($630,000/.90) Less: Retained earnings, 1/1/14 Common stock, Set Company, 1/1/14
700,000 190,000 $ 510,000
Computation and Allocation of Difference between Implied and Book Value Acquired Parent Share Purchase price and implied value Less: Book value of equity acquired: Difference between implied and book value Goodwill Balance
$650,000 630,000 20,000 (20,000) -0-
NonControlling Share 72,222 70,000 2,222 (2,222) -0-
Entire Value 722,222 * 700,000 22,222 (22,222) -0-
* $650,000/.90 Part A Eliminating entries – cost method Dividend Income (.90)($50,000) Dividends Declared - Set Company
45,000 45,000
Common Stock - Set Company ($700,000 – $190,000) Retained Earnings 1/1/14 - Set Company Difference between Implied and Book Value Investment in Salt Company Noncontrolling Interest
510,000 190,000 22,222
Land
22,222
650,000 72,222
Difference between Implied and Book Value
22,222
Part B Eliminating entries – equity method Equity Income (.90)($132,000) 118,800 Dividends Declared - Set Company (.90)($50,000) Investment in Set Company
45,000 73,800
Common Stock - Set Company Retained Earnings 1/1/14 - Set Company Difference between Implied and Book Value Investment in Salt Company Noncontrolling Interest 4 - 11
510,000 190,000 22,222 650,000 72,222
Exercise 4-5 (continued) Land
22,222 Difference between Implied and Book Value
22,222
Part C Noncontrolling Interest $72,222 + (.1 $132,000) - (.1 $50,000) = $80,422 The noncontrolling interest will be the same regardless of the method used to account for the investment on Plate Company’s books. Exercise 4-6 Journal and Workpaper Entries - Equity Method Part A Journal Entries Investment in Sales Cash
350,000 350,000
Investment in Sales ($148,000)(.85) Equity in Subsidiary Income
125,800
Cash ($50,000)(.85) Investment in Sales
42,500
125,800 42,500
Part B Workpaper Entries Equity in Subsidiary Income Dividends Declared - Sales Investment in Sales
125,800 42,500 83,300
Common Stock - Sales Other Contributed Capital – Sales Retained Earnings 1/1 – Sales Difference between Implied and Book Value Investment in Sales Noncontrolling Interest Land
100,000 40,000 140,000 131,765 350,000 61,765
131,765 Difference between Implied and Book Value
131,765
Computation and Allocation of Difference between Implied and Book Value Acquired Parent Share Purchase price and implied value Less: Book value of equity acquired: Difference between implied and book value Land increase Balance
350,000 238,000 112,000 (112,000) -0-
* $350,000/.85
4 - 12
NonEntire Controlling Value Share 61,765 411,765 * 42,000 280,000 19,765 131,765 (19,765) (131,765) -0-0-
Exercise 4-7 Journal and Workpaper Entries - Equity Method Part A Journal Entries Investment in Sales (.85)($190,000) Equity in Subsidiary Income
161,500 161,500
Cash
42,500 Investment in Sales (.85)($50,000)
Part B Workpaper Entries Equity in Subsidiary Income Dividends Declared - Sales Investment in Sales
42,500
161,500 42,500 119,000
Common Stock - Sales Other Contributed Capital – Sales Retained Earnings 1/1 – Sales* Difference between Implied and Book Value Investment in Sales ($350,000 + $83,300**) Noncontrolling interest ($61,765 + $14,700***) Goodwill Difference between Implied and Book Value * $140,000 + ($148,000 - $50,000) ** ($148,000 - $50,000) x .85 *** ($148,000 - $50,000) x .15
4 - 13
100,000 40,000 238,000 131,765 433,300 76,465 131,765 131,765
Exercise 4-8 Workpaper Entries and Consolidate Net Income - Cost Method Part A Workpaper Entries 2010 Dividend Income (.80 $2,000) Dividends Declared - Smith Company
1,600 1,600
Common Stock – Smith Other Contributed Capital – Smith Retained Earnings 1/1/10 - Smith Difference between Implied and Book Value Subsidiary Income Purchased * Investment in Smith Company Noncontrolling Interest
25,000 10,000 10,000 2,500 15,000
Land
2,500
50,000 12,500
Difference between Implied and Book Value
2,500
Computation and Allocation of Difference between Implied and Book Value Acquired Parent Share Purchase price and implied value Less: Book value of equity acquired: Equity Subsidiary Income purchased** Total book value Difference between implied and book value Goodwill Balance
50,000
NonControlling Share 12,500
Entire Value 62,500 *
36,000 12,000 48,000 2,000 (2,000) -0-
9,000 3,000 12,000 500 (500) -0-
45,000 15,000 60,000 2,500 (2,500) -0-
* $50,000/.80 4 $45,000) = 15,000 12 Estimated Retained Earnings of Smith on date of acquisition** Retained earnings, 1/1 $ 10,000 Smith earnings to 5/1 = (4/12)($45,000) 15,000 Retained earnings, 5/1 $ 25,000
**
Subsidiary Income Purchased (
2011 Investment in Smith Retained Earnings 1/1 Peters To establish reciprocity (.80 ($53,000 – $25,000**)
22,400
Common Stock - Smith 25,000 Other Contributed Capital - Smith 10,000 Retained Earnings 1/1/11 - Smith 53,000 Land 2,500 Investment in Smith Company ($50,000 + $22,400) Noncontrolling Interest ($12,500+ .20 x ($53,000 – $25,000) 4 - 14
22,400
72,400 18,100
Exercise 4-8 (continued) Part B Consolidated Net Income Peters Company's reported net income Less: dividend income from Smith Peters' income from independent operations Plus: Peter's share of Smith's net income in 2010 since acquisition (.80)(8/12)($45,000) Less: Peter's share of Smith's net loss in 2010 (.80 $5,000) Consolidated net income Consolidated Retained Earnings Peter's 12/31 retained earnings ($80,000 + $64,000 - $15,000) Plus: Peter's share of the increase in Smith's retained earnings from the date of acquisition to the current date: (.80 ($53,000 – $25,000)) (.80 ($48,000 – $25,000))
2010 64,000 (1,600) 62,400 24,000 86,400
(4,000) 33,500
129,000
161,500
22,400 $151,400
Exercise 4-9 Journal and Workpaper Entries - Equity Method Part A Journal Entries Investment in Star Cash
210,000 210,000
Investment in Star (0.90 (3/12) $60,000) Equity in Subsidiary Income To account for prorated stake in equity
13,500
Cash (0.90 $10,000) 9,000 Investment in Star To account for reduction in equity due to dividends
4 - 15
2011 37,500 0 37,500
13,500
9,000
18,400 $179,900
Exercise 4-9 (continued) Part B Workpaper Entries Equity in Subsidiary Income (0.90)(3/12)($60,000) Dividends Declared – Star (.90)($10,000) Investment in Star
13,500 9,000 4,500
Common Stock - Star 70,000 Other Contributed Capital – Star 30,000 Retained Earnings – Star * 115,000 Difference between Implied and Book Value ** 18,333 Investment in Star Noncontrolling Interest Goodwill 18,333 Difference between Implied and Book Value * Retained earnings on 10/1/10 Retained earnings on 1/1/10 Income purchased to 10/1/10 (9/12 x $60,000) Retained earnings on 10/1/10
210,000 23,333 18,333
$ 70,000 45,000 $ 115,000
**Computation and Allocation of Difference between Implied and Book Value Acquired Parent Share Purchase price and implied value Less: Book value of equity acquired: Equity Subsidiary Income purchased Total book value Difference between implied and book value Goodwill Balance
210,000
NonControlling Share 23,333
233,333 *
153,000 40,500 193,500 16,500 (16,500) -0-
17,000 4,500 21,500 1,833 (1,833) -0-
170,000 45,000 ** 215,000 18,333 (18,333) -0-
* $210,000/.90 ** $60,000 x 9/12
4 - 16
Entire Value
Exercise 4-10 Consolidated Statement of Cash Flows Part A Cash flows from operating activities - Direct Method Cash received from customers* Less cash paid for: Merchandise purchases** Selling expenses*** Administrative expenses**** Net cash flow from operating activities
$ 612,000 $323,000 138,000 102,000
* Beginning accounts receivable Plus: Sales Less: ending accounts receivable Cash received from customers
$229,000 701,000 (318,000) $612,000
** Cost of Sales Less: beginning inventory Plus: ending inventory Accrual basis purchases Plus: beginning accounts payable Less: ending accounts payable Cash paid for merchandise purchased
$263,000 (194,000) 234,000 303,000 99,000 (79,000) $323,000
***Accrual selling expenses Less: beginning prepaid selling expenses Plus: ending prepaid selling expenses Plus: beginning accrued selling expenses Less: ending accrued selling expenses Cash paid for administrative expenses
$122,000 (26,000) 30,000 96,000 (84,000) $138,000
**** Accrual administrative expenses Plus beginning accrued administrative expenses Less ending accrued administrative expenses Cash paid for administrative expenses
$85,000 56,000 (39,000) $102,000
Part B Cash flows from operating activities - Indirect Method Consolidated net income Adjustments to convert net income to net cash flows from operating activities: Depreciation expense Increase in accounts receivable Increase in inventory Increase in prepaid selling expenses Decrease in accounts payable Decrease in accrued selling expenses Decrease in accrued administrative expenses Net cash flow from operating activities
4 - 17
$ 155,000
76,000 (89,000) (40,000) (4,000) (20,000) (12,000) (17,000) $49,000
563,000 $ 49,000
Exercise 4-11 Part A **Computation and Allocation of Difference between Implied and Book Value Acquired Parent Share Purchase price and implied value Less: Book value of equity acquired: Difference between implied and book value Land Balance Goodwill Balance
$268,000 192,000
NonControlling Share 67,000 48,000
Entire Value 335,000 240,000
76,000 (16,000) 60,000 (60,000) -0-
19,000 (4,000) 15,000 (15,900) -0-
95,000 (20,000) 75,000 (75,000) -0-
Part B Investment in Sulfurst Cash
268,000 268,000
Part C (1) – Cost Method 2017 Cash Dividend Income (.8 $24,000)
19,200 19,200
2018 Cash Dividend Income (.8 $21,600)
17,280 17,280
(2) – Partial Equity Method 2017 Investment in Song Company Equity in Subsidiary Income (.8 $40,000)
32,000
Cash (.8 $24,000) Investment in Song Company
19,200
2018 Investment in Song Company Equity in Subsidiary Income (.8 $45,000)
36,000
32,000
19,200
Cash Investment in Song Company (.8 $21,600)
4 - 18
36,000 17,280 17,280
Exercise 4-12 (continued) (3) – Complete Equity Method 2017 Investment in Song Company Equity in Subsidiary Income (.8 $40,000)
32,000
Cash (.8 $24,000) Investment in Song Company
19,200
2018 Investment in Song Company Equity in Subsidiary Income (.8 $45,000)
36,000
32,000
19,200
Cash Investment in Song Company (.8 $21,600)
36,000* 17,280 17,280
*NOTE: There is no difference between the partial and complete equity methods in this exercise because the difference between implied value and book value was attributable to land and goodwill, and no impairment occurred. Had there been differences attributable to depreciable or amortizable assets, then the entries would have been adjusted under the complete equity method to reflect the impact of excess depreciation and/or amortization.
Exercise 4-12 1. Since the income statement includes the account ‘equity in net loss of subsidiary,’ we know that the equity method is being used. 2. Therefore, the controlling interest in consolidated income is the solution to the retained earnings T account, or $195,000. Retained Earnings - Pressing 1/1 380,000 Dividends 75,000 Controlling interest in consolidated income ? 12/31 500,000 Controlling interest in consolidated income = ($500,000 - $380,000 + $75,000) = $195,000. 3. From part 2, income from its independent operations is equal to consolidated income plus the equity loss, or ($195,000 + $55,000) = $250,000.
4 - 19
Exercise 4-12 (continued) 4. Since there is no difference between implied and book value, Pressing Inc.’s retained earnings will equal consolidated retained earnings under both the partial and complete equity methods. Therefore, the ending balance in consolidated retained earnings is $500,000. 5. Consolidated dividends equal Pressing Inc.’s dividends of $75,000. Because the subsidiary is wholly owned, all its dividends are eliminated. 6. The beginning balance in Stressing’s retained earnings is the solution to the following T-account. Retained Earnings - Stressing 1/1 Begin. Bal. -?Dividends 24,000 Loss 55,000 12/31 260,000 Therefore, the beginning balance is ($260,000 + $24,000 + $55,000) = $339,000 7. There is no difference between the implied and book value at acquisition. Workpaper entries Investment in Stressing Dividends Declared –Stressing Equity in Subsidiary Income (Loss) Common Stock – Stressing Other Contributed Capital – Stressing Retained Earnings – Stressing Difference between Implied and Book Value Investment in Stressing
79,000 24,000 55,000 20,000 380,000 339,000 0 739,000
8. Retained earnings would reflect only the income from its independent operations plus the dividend income from Stressing each year (instead of Stressing’s earnings). 9. A. The first entry from part 7 would be replaced by the following: Dividend Income Dividends Declared - Stressing Company
24,000 24,000
B. In addition, an entry would be needed to convert to equity/establish reciprocity in the amount of the change in Stressing’s retained earnings from acquisition to the beginning of the current year. C. After the reciprocity entry, the entry to eliminate the investment account is the same as shown in part 7.
4 - 20
Exercise 4-13 Cash flows from operating activities: Consolidated net income
$155,889
Adjustments to convert consolidated net income to net cash flow from operating activities Depreciation expense (($540,000 + $750,000 + $166,666*) – $1,385,555) Increase in inventories ($454,000 – $190,000 – $140,000) Decrease in accrued payables ($111,000 – $150,000 – $90,000) Net cash flow from operating activities
71,111 (124,000) (129,000)
Cash flows from investing activities: Acquired Lazytoo company (net of cash acquired)
(181,889) (26,000)
(590,000)
Cash flows from financing activities: Proceeds from the issuance of bonds Cash dividends paid ($10,000 + (.10)($5,000)) Net cash flow from financing activities Decrease in cash
300,000 (10,500) 289,500 ($326,500)
* $600,000/0.9 – [($200,000 + $300,000)] = $166,667; this is equivalent to doing a CAD Schedule, in which the purchase price is used to derive Implied Value of $666,667. Implied Value minus Book Value of Equity yields the Difference between IV and BV, which is allocated to mark up PPE of the sub. Exercise 4-14 Part A – Cost Method (1) Undistributed income is expected to be received as future dividend. Set Company net income $132,000 Set Company dividends 50,000 Undistributed income 82,000 Percent owned 70% Plenty Company’s share of undistributed income 57,400 Percent of dividends taxed 20% Future dividends that are taxed 11,480 Income tax rate 40% Deferred tax liability $ 4,592 Workpaper Entry Tax Expense Deferred Tax Liability
4,592 4,592
4 - 21
Exercise 4-14 (continued) (2) Undistributed income is expected to be received as future capital gain. Set Company net income Set Company dividends Undistributed income Percent owned Plenty Company’s share of undistributed income Capital gains tax rate Deferred tax liability Workpaper Entry Tax Expense Deferred Tax Liability Part B – Partial Equity Method
$132,000 50,000 82,000 70% 57,400 20% $11,480
11,480 11,480
(1) Undistributed income is expected to be received as future dividend. Set Company net income $132,000 Set Company dividends 50,000 Undistributed income 82,000 Percent owned 70% Plenty Company’s share of undistributed 57,400 Percent of dividends taxed 20% Future dividends that are taxed 11,480 Income tax rate 40% Deferred tax liability $4,592 Plenty Company’s Journal Entry Tax Expense Deferred Tax Liability
4,592 4,592
(2) Undistributed income is expected to be received as future capital gain. Set Company net income $132,000 Set Company dividends 50,000 Undistributed income 82,000 Percent owned 70% Plenty Company’s share of undistributed 57,400 Capital gains tax rate 20% Deferred tax liability $11,480 Plenty Company’s Journal Entry Tax Expense Deferred Tax Liability
11,480 11,480
Part C – Complete Equity Method The answer is the same as the partial equity method since the difference between implied and book value relates to land. 4 - 22
ANSWERS TO ASC (Accounting Standards Codification) EXERCISES ASC4-1 Presentation A company reported net income of $15,000, including an extraordinary loss of $3,000. Another company owns 40% of this company and uses the equity method to account for the investment. On the investee company’s books, does the investee report the net income of $15,000 as a single amount on its income statement? Alternative 1 Step 1: Use the drop-down menus under the ‘Presentation’ general topic on the homepage and choose ‘225-Income Statement; then using the second pull-down menu choose ‘Extraordinary and Unusual Items’. Step 2: Click on the red ‘join all sections’ button. Scroll through the paragraphs for guidance on investees reporting extraordinary items. Under section 60 for relationships, paragraph 60-1 states that the guidance for investee extraordinary items is found in paragraph 323-10-45-1. Equity investments in common stock shall be shown on the balance sheet as a single amount. However, the investor’s share of extraordinary items is classified with extraordinary items on the investor’s income statement (FASB ASC paragraph 323-10-45-2) Alternative 2 Step 1: in the search box, enter ‘equity method extraordinary.’ Step 2: 13 results are returned. The first option is the correct guidance. ASC4-2 Glossary Is a correction of an error in the financial statements considered an accounting change? On the Codification homepage, click on ‘Master Glossary’ in the left-hand column. In the ‘glossary term quick find’ menu type ‘accounting change’ and hit return. The correction of an error is not an accounting change and is addressed separately from accounting changes in Topic 250 Accounting Changes and Error Corrections. ASC4-3 Presentation A company changed its method of accounting for inventory and determined that it was impractical to determine the cumulative effect for all prior periods. The company decided to use the new method on a prospective basis. Is this acceptable under current GAAP? Step 1: Use the drop-down menus under the ‘presentation’ general topic on the homepage and choose ‘250 Accounting Changes and Error Corrections;’ then under the second drop-down menu, choose ’10overall’. Step 2: Click on the ‘Expand’ option. Under accounting changes is a subject called ‘impracticability.’ This paragraph (45-9) defines what impracticability means, but does not answer the question. If you scroll one paragraph earlier, you find the correct answer in paragraph 45-7. You apply to new method on a prospective basis at the earliest date practicable. ASC4-4 Scope Describe the equity method for accounting for investments. In order to qualify for the equity method, describe the conditions that must be met. Step 1: Use the drop-down menus under the ‘assets’ general topic on the homepage and choose ‘323 – Equity Method and Joint Ventures;’ then under the second drop-down menu, choose ’10-overall’.
4 - 23
Step 2: Click on section 15 which is always the ‘Scope and Scope exceptions’ for the guidance in that section. In FASB ASC paragraph 323-10-15-3 states that the guidance in Topic 323 apply to investments in common stock that give the investor the ability to exercise significant influence over the operating and financial policies of an investee even if the investor holds 50% or less of the common stock of the investee. . ASC4-5 Measurement Suppose that a company accounts for an investment using the equity method. Describe the appropriate accounting if the combined loss reported by the investee exceeds the investor’s balance in the investment account. Step 1: Use the drop-down menus under the ‘assets’ general topic on the homepage and choose ‘323 – Equity Method and Joint Ventures;’ then under the second drop-down menu, choose ’10-overall’. Step 2: Click on section 35 which is always the ‘Subsequent Measurement’ for the guidance in that section. Scroll though the paragraphs until you find ‘Equity Method Losses.’ FASB ASC paragraphs 323-10-35-19, 20, 21, and 22 provide the appropriate guidance. In general the investor will discontinue applying the equity method if the investment account is reduced to zero and shall not provide for additional losses. If the investee subsequently reports net income, the investor shall resume the equity method only after the share of unrecognized losses equals newly earned income. ASC4-6 Recognition Can a firm choose a fair value option for reporting some of its investments on the balance sheet? If so, describe the conditions that must be met. The answer to this exercise requires that the student be familiar with Fair Value accounting in Topic 825 Financial Instruments. Alternative 1: In the search box, enter ‘fair value option.’ Even though 158 results are returned, the third option is the correct solution. FASB ASC paragraphs 825-10-25-1 through 4. An entity may choose to elect the fair value option only on the date the one of the following occurs: the entity first recognizes the eligible item or the accounting treatment for the investment in another company changes because the investment becomes subject to the equity method of accounting or the investor ceases to consolidate a subsidiary because the investor no longer holds a majority interest. Alternative 2: Using this alternative, you are less certain about how to start your search. Step 1: Use the drop-down menus under the ‘assets’ general topic on the homepage and choose ‘323 – Investments – Debt and Equity Securities;’ then under the second drop-down menu, choose ’10overall’. Step 2: Click on section 15 which is always the ‘Scope’ section for the guidance in that section. Scrolling through the scope paragraphs, you will find subparagraph 15-7(c) which discusses the fair value option in paragraph 825-10-25-1
4 - 24
Answers to Problems Problem 4-1 Journal Entries - Cost Method Year 2011 2012 2013 2014
Net Income Cumulative Net Cumulative (Loss) Income Dividends 1,997,800 1,997,800 500,000 476,000 2,473,800 1,000,000 (179,600) 2,294,200 1,500,000 (323,800) 1,970,400 2,000,000
Part A – Cost Method 2011 Investment in Singer Co. Cash
Undistributed Income 1,497,800 1,473,800 794,200 (29,600)
4,972,000 4,972,000
Cash (.90)($500,000) Dividend Income
450,000
Cash (.90)($500,000) Dividend Income
450,000
Cash (.90)($500,000) Dividend Income
450,000
450,000
2012 450,000
2013 450,000
2014 Cash (.90)($500,000) 450,000 Dividend Income Investment in Singer Co. (.90 $29,600) To account for liquidating dividend Part B – Partial Equity Method 2011 Investment in Singer Co. Cash Cash (.90)($500,000) Investment in Singer Co. Investment in Singer Co. Equity in Subsidiary Income (.90)($1,997,800)
423,360 26,640
4,972,000 4,972,000 450,000 450,000 1,798,020 1,798,020
2012 Cash (.90)($500,000) Investment in Singer Co.
450,000
Investment in Singer Co. Equity in Subsidiary Income (.90)($476,000)
428,400
450,000 428,400
4 - 25
Problem 4-1 (continued) 2013 Cash (.90)($500,000) Investment in Singer Co.
450,000 450,000
Equity in Subsidiary Income (.90)($179,600) 161,640 Investment in Singer Co.
161,640
Cash (.90)($500,000) Investment in Singer Co.
450,000
2014 450,000
Equity in Subsidiary Income (.90)($323,800) 291,420 Investment in Singer Co.
291,420
Part C – Complete Equity Method Computation and Allocation of Difference between Implied and Book Value Acquired Parent Share Purchase price and implied value Less: Book value of equity acquired: Difference between implied and book value Undervalued depreciable assets (15 year life) Balance
4,972,000 4,961,160 10,840 (10,840) -0-
NonEntire Controlling Value Share 552,444 5,524,444 * 551,240 5,512,400 1,204 12,044 (1,204) (12,044) -0-0-
* $4,972,000/.90 2011 Investment in Singer Co. Cash Cash (.90)($500,000) Investment in Singer Co. Investment in Singer Co. Equity Income (.90)($1,997,800)
4,972,000 4,972,000 450,000 450,000 1,798,020 1,798,020
Equity in Subsidiary Income ($10,840/15 years) Investment in Singer Co.
723 723
2012 Cash (.90)($500,000) Investment in Singer Co.
450,000
Investment in Singer Co. Equity Income (.90)($476,000)
428,400
450,000 428,400
Equity in Subsidiary Income ($10,840/15 years) Investment in Singer Co.
4 - 26
723 723
2013 Cash (.90)($500,000) Investment in Singer Co.
450,000 450,000
Equity in Subsidiary Income (.90)($179,600) 161,640 Investment in Singer Co. Equity in Subsidiary Income ($10,840/15 years) Investment in Singer Co.
161,640
723 723
2014 Cash (.90)($500,000) Investment in Singer Co.
450,000 450,000
Equity in Subsidiary Income (.90)($323,800) 291,420 Investment in Singer Co. Equity in Subsidiary Income ($10,840/15 years) Investment in Singer Co.
4 - 27
291,420
723 723
Problem 4-2 Part A – Parry Corporation uses the cost method. If the cost method is used, Parry Corporation recognizes dividends received as income. Part B Workpaper - Cost Method
Parry Corporation and Subsidiary Consolidated Statements Workpaper For the Year Ended December 31, 2011 Parry Sent Eliminating Entries Consolidated Corp. Company Balances Dr. Cr.
Income Statement Sales Dividend Income Total Revenue Cost of Goods Sold Other Expenses Total Cost and Expense Net Income to Retained Earnings
Retained Earnings Statement Retained Earnings 1/1 Parry Corporation Sent Company Net Income from above Dividend Declared Parry Corporation Sent Company Retained Earnings 12/31 Balance Sheet Cash Accounts Receivable Inventory 12/31 Investment in Sent Company Difference between Implied and Book Value Land Total Assets Accounts Payable Common Stock: Parry Corporation Sent Company Retained Earnings from above Total Liabilities and Equity
476,000 154,500 630,500 3,500 (1) 3,500 479,500 154,500 630,500 285,600 121,000 406,600 45,500 29,500 75,000 331,100 150,500 481,600 148,400 4,000 3,500 148,900 Parry Sent Eliminating Entries Consolidated Dr. Cr. Corp. Company Balances
76,000 148,400
76,000 19,500 (2) 19,500 4,000 3,500
148,900
(3,500) 20,000
(17,500) 0 207,400
(17,500) 206,900 84,400 76,000 49,500 140,000
(1) 23,000
3,500 3,500
29,000 56,500 36,500
113,400 132,500 86,000
(2) 140,000 (2) 20,500 (3) 20,500 4,000 12,000 (3) 20,500 353,900 134,000 27,000 14,000
36,500 368,400 41,000
120,000
120,000
100,000 (2) 100,000 206,900 20,000 23,000 353,900 134,000 164,000
4 - 28
3,500 164,000
207,400 368,400
Problem 4-2 (continued) (1) To eliminate intercompany dividends (2) To eliminate investment in Sent Company (3) To eliminate difference between implied and book value
Computation and Allocation of Difference between Implied and Book Value Acquired Parent Share Purchase price and implied value Less: Book value of equity acquired: Difference between implied and book value Undervalued land Balance
140,000 119,500 20,500 (20,500) -0-
4 - 29
NonControlling Share 0 0 0 (0) -0-
Entire Value 140,000 119,500 20,500 (20,500) -0-
Problem 4-3 Part A – Perkins Company uses the equity method. If the equity method is used, Perkins Company recognizes investment income from the investment based on the percentage owned times the investee net income. Part B Perkins Company and Subsidiary Consolidated Statements Workpaper Workpaper - Equity Method For the Year Ended December 31, 2012 Perkins Schultz Company Company Income Statement Sales Equity in Subsidiary Income Total Revenue Cost of Goods Sold Other Expenses Total Cost and Expense Net Income to Retained Earnings Retained Earnings Statement Retained Earnings 1/1 Perkins Company Schultz Company Net Income from Above Dividends Declared Perkins Company Schultz Company Retained Earnings 12/31 Balance Sheet Cash Inventory 12/31 Investment in Schultz
380,000 70,500 450,500 225,000 40,000 265,000 185,500
170,000
185,500
(1) 70,500 170,000 59,500 40,000 99,500 70,500
550,000 284,500 80,000 364,500 185,500
70,500
25,000 54,000 (3) 54,000 70,500 70,500
185,500
(15,000) 195,500 25,000 105,000 222,000
72,500
Consolidated Balances 550,000
25,000
Difference between Implied & Book Value Land 111,000 Goodwill Total 463,000 Accounts Payable Common Stock Perkins Company Schultz Company Other Contributed Capital Perkins Company Schultz Company Retained Earnings from above Total
Eliminating Entries Dr. Cr.
(15,000) (10,000) 114,500
(2) 10,000 124,500 10,000
30,000 97,500
195,500 55,000 202,500
(2) 10,000 (1) 70,500 (3) 161,500 (3) 15,000 (4) 15,000
97,000 224,500
208,000 15,000 480,500
17,500
90,000
(4) 15,000
160,000
160,000 75,000 (3) 75,000
35,000 195,500 463,000 4 - 30
35,000 17,500 (3) 17,500 114,500 124,500 224,500 257,000
10,000 257,000
195,500 480,500
Problem 4-3 (continued) (1) To eliminate intercompany dividends (2) To eliminate investment in Schultz Company (3) To eliminate difference between implied and book value
Computation and Allocation of Difference between Implied and Book Value Acquired Parent Share Purchase price and implied value Less: Book value of equity acquired: Difference between implied and book value Undervalued land Balance
161,500 146,500 15,000 (15,000) -0-
4 - 31
NonControlling Share 0 0 0 (0) -0-
Entire Value 161,500 146,500 15,000 (15,000) -0-
Problem 4-4 Workpaper - Cost Method Income Statement Sales Dividend Income ($22,000 .92) Total Revenue Cost of Goods Sold: Inventory, 1/1 Purchases Available for Sale Inventory, 12/31 Cost of Goods Sold Selling Expenses Other Expenses Total Cost and Expense Net/Consolidated Income Noncontrolling Interest in Consol. Inc. Net Income to Retained Earnings Retained Earnings Statement 1/1 Retained Earnings: Place Company Shaw Inc. Net Income from Above Dividends Declared Place Company Shaw Inc. 12/31/ Retained Earnings to Balance Sheet
Place Company
Shaw
Inc.
Eliminations Noncontrolling Consolidated Debit Credit Interest Balances
550,000 280,000 20,240 (1) 20,240 570,240 280,000
830,000
70,000 240,000 310,000 25,000 285,000 28,000 15,000 328,000 242,240
120,000 390,000 510,000 40,000 470,000 48,000 28,000 546,000 284,000 (4,960) 279,040
242,240
830,000
50,000 150,000 200,000 15,000 185,000 20,000 13,000 218,000 62,000 62,000
4,960 * 4,960
20,240
225,000
225,000
170,000 (2) 170,000 242,240 62,000 20,240
4,960
(35,000)
(35,000) (22,000)
432,240 210,000
190,240
(1) 20,240
(1,760)
20,240
3,200
Balance Sheet Cash 80,350 87,000 Accounts and Notes Receivable 200,000 210,000 (4) 15,000 Inventory 25,000 15,000 Investment in Shaw Inc.. 400,000 (2) 400,000 Difference b/w Implied & Book Value (2) 15,783 (3) 15,783 Plant Assets 300,000 200,000 (3) 15,783 Total 1,005,350 512,000 Accounts and Notes Payable Other Liabilities Common Stock: Place Company Shaw Inc. Other Contributed Capital Place Company Shaw Inc. Retained Earnings from above 1/1 Noncontrolling Interest 12/31 Noncontrolling Interest Total
99,110 45,000
279,040
469,040 167,350 395,000 40,000
515,783 1,118,133
38,000 (4) 15,000 15,000
122,110 60,000
150,000
150,000 100,000 (2) 100,000
279,000
279,000
149,000 (2) 149,000 432,240 210,000 190,240
1,005,350 512,000
*(.08 $62,000) = $4,960
4 - 32
485,806
20,240 (2) 34,783 485,806
3,200 34,783 37,983
469,040 37,983 1,118,133
Problem 4-4 (continued) (1) To eliminate intercompany dividends. (2) To eliminate Investment in Shaw and establish noncontrolling interest account. (3) To allocate the difference between implied and book value. (4) To eliminate intercompany receivables and payables.
Computation and Allocation of Difference between Implied and Book Value Acquired Parent Share Purchase price and implied value Less: Book value of equity acquired: Difference between implied and book value Undervalued land Balance
400,000 385,480 14,520 (14,520) -0 -
* $400,000/.92
4 - 33
NonControlling Share 34,783 33,520 1,263 (1,263) -0-
Entire Value 434,783 * 419,000 15,783 (15,783) -0-
Problem 4-5 Part A – Perez Company uses the cost method. If the cost method is used, Perez Company recognizes dividends received as income. Part B Workpaper – Cost Method
Perez Company and Subsidiary Consolidated Statements Workpaper For the Year Ended December 31, 2016 Perez Sanchez Company Company
Income Statement Sales 110,000 Dividend Income 10,800 Total Revenue 120,800 Cost of Goods Sold Inventory 1/1 14,000 Purchases 84,000 Available for Sale 98,000 Inventory 12/31 40,000 Cost of Goods Sold 58,000 Other Expenses 10,000 Total Cost and Expense 68,000 Net Income 52,800 Noncontrolling Interest Net Income to Retained Earnings 52,800 Retained Earnings Statement Retained Earnings 1/1 Perez Company Sanchez Company Net Income from above Dividends Declared Perez Company Sanchez Company Retained Earnings 12/31
Eliminating Entries Dr. Cr.
42,000
152,000 (3) 10,800
42,000
152,000
8,000 20,000 28,000 15,000 13,000 16,000 29,000 13,000
22,000 104,000 126,000 55,000 71,000 26,000 97,000 55,000 (1,300) 53,700
13,000
1,300 * 1,300
10,800
50,000 52,800
Noncontrolling Consolidated Interest Balance
(1) 16,200 30,000 (4) 30,000 13,000 10,800
66,200 1,300
(10,000) 92,800
53,700 (10,000)
(12,000) 31,000
(3) 10,800 40,800 27,000
* ($13,000 .10) = $1,300
4 - 34
(1,200) 100
109,900
Problem 4-5 (continued) Perez Sanchez Company Company Balance Sheet Cash Accounts Receivable Inventory 12/31 Advance to Sanchez Investment in Sanchez Difference b/w Implied & Book Value Plant and Equipment Land Goodwill Total Accounts Payable Other Liabilities Advances from Perez Common Stock: Perez Company Sanchez Company Retained Earnings from above Noncontrolling Interest 1/1 Noncontrolling Interest 12/31
13,000 22,000 40,000 8,000 85,000
14,000 36,000 15,000
50,000 17,800
44,000 6,000
Eliminating Entries Dr. Cr.
Noncontrol. Consolidated Interest Balance 27,000 58,000 55,000
(2) 8,000 16,200 (4) 101,200 12,444 (5) 12,444
(1) (4)
235,800 115,000
94,000 23,800 12,444 270,244
6,000 37,000
12,000 37,000
(5)
12,444
6,000 8,000 (2)
8,000
70,000 (4) 31,000
70,000 40,800
100,000 92,800
100,000
(4)
235,800 115,000 ** $9,444 + [($30,000 – $12,000) x .10] = $11,244
159,888
27,000 11,244 **
100 11,244 11,344
159,888
(1) To establish reciprocity/convert to the equity method (2) To eliminate intercompany advances (3) To eliminate intercompany dividends (4) To eliminate investment in Sanchez Company and establish noncontrolling interest account (5) To allocate the difference between implied and book value Computation and Allocation of Difference between Implied and Book Value Acquired Parent Share Purchase price and implied value Less: Book value of equity acquired: Difference between implied and book value Goodwill Balance
85,000 73,800 11,200 (11,200) -0-
*85,000/.90
4 - 35
NonControlling Share 9,444 8,200 1,244 (1,244) -0-
Entire Value 94,444 * 82,000 12,444 (12,444) -0-
109,900 11,344 270,244
ROE Circuit City
2007 2006 2005
-21.3% -0.5% 7.1%
ROA 2007 2006 2005
Leverage 2007 2.492 2006 2.237 2005 2.082
-8.5% -0.2% 3.4%
Profit Margin 2007 -2.7% 2006 -0.1% 2005 1.2%
Asset Turnover 2007 3.135 2006 3.102 2005 2.850
Asset/MV 2007 5.019 2006 1.236 2005 0.969
Profit Margin 2007 -2.7% 2006 -0.1% 2005 1.2%
NI/CFO 2007 7.011 2006 (0.026) 2005 0.383
MV/BV 2007 0.497 2006 1.811 2005 2.149
Asset turnover 2007 3.135 2006 3.102 2005 2.850
CFO/Sales 2007 -0.4% 2006 2.5% 2005 3.1%
Sales/WC 2007 14.081 2006 10.628 2005 9.577
10 - 7
WC/Assets 2007 22.3% 2006 29.2% 2005 29.8%
AFS10-2 Blockbuster versus Netflix The z-score is defined as: Z = 1.2x1 +1.4x2 + 3.3x3+ 0.6x4 + 0.999x5, where x1 = (current assets less current liabilities)/total assets x2 = retained earnings/total assets x3= earnings before interest and taxes/total assets x4 = market value of equity/total liabilities x5 = sales/total assets For Netflix and Blockbuster, the z-scores are plotted as follows from 2001 to 2009.
Netflix’s z-score, after a rather rocky start, has remained fairly constant since 2005. On the other hand, Blockbuster’s z-score, which had been fairly constant from 2001 to 2008, took a dramatic drop in 2009. The dramatic drop was caused primarily because retained earnings decreased by $500 million and total assets decreased by $600 million. This case also illustrates the dangers from using ratio analysis when a company’s financial performance is decreasing. Notice that Blockbusters ROE went from a negative 174.6% to a positive 177.6%. This change would indicate a significant improvement, but it is an artifact of the computations. Both earnings and equity turned negative in 2009, resulting in the ROE computation becoming positive. ROE should not be used as a performance measure in cases similar to this one. For Blockbuster, both ROA and the profit margin percentage are becoming increasingly negative. CFO is still positive but only at approximately 1% of sales. Despite the fact that the asset turnover has been increasing for Blockbuster, they have not been able to generate significant amounts of income or cash flows. The future of Blockbuster is not clear. The ratios for Netflix, on the other hand, indicate either improving or constant performance over time. ROE, ROA, and the profit margin percentage have increased over the last three years. The profit margin percentage in 2009 was almost 7%. Netflix is generating CFO equal to approximately 20% of sales (with sales increasing over time). 10 - 8
10 - 9
ROE Blockbuster
2009 2008 2007
177.6% -174.6% -11.3%
ROA 2009 2008 2007
Leverage 2009 -4.894 2008 10.054 2007 4.169
-36.3% -17.4% -2.7%
Profit Margin 2009 -13.7% 2008 -7.1% 2007 -1.3%
Asset Turnover 2009 2.641 2008 2.454 2007 2.018
Asset/MV 2009 12.357 2008 10.833 2007 3.795
Profit Margin 2009 -13.7% 2008 -7.1% 2007 -1.3%
NI/CFO 2009 (19.051) 2008 (7.335) 2007 1.313
MV/BV 2009 -0.396 2008 0.928 2007 1.099
Asset turnover 2009 2.641 2008 2.454 2007 2.018
CFO/Sales 2009 0.7% 2008 1.0% 2007 -1.0%
Sales/WC 2009 32.447 2008 1,016.904 2007 179.720
10 - 10
WC/Assets 2009 8.1% 2008 0.2% 2007 1.1%
ROE Netflix
2009 2008 2007
58.2% 23.9% 15.5%
ROA 2009 2008 2007
Leverage 2009 3.413 2008 1.780 2007 1.502
17.0% 13.4% 10.3%
Profit Margin 2009 6.9% 2008 6.1% 2007 5.6%
Asset Turnover 2009 2.457 2008 2.219 2007 1.863
Asset/MV 2009 0.231 2008 0.351 2007 0.374
Profit Margin 2009 6.9% 2008 6.1% 2007 5.6%
NI/CFO 2009 0.356 2008 0.292 2007 0.241
MV/BV 2009 14.783 2008 5.068 2007 4.012
Asset turnover 2009 2.457 2008 2.219 2007 1.863
CFO/Sales 2009 19.5% 2008 20.7% 2007 23.0%
Sales/WC 2009 9.046 2008 9.428 2007 5.910
10 - 11
WC/Assets 2009 27.2% 2008 23.5% 2007 31.5%
ANSWERS TO EXERCISES Exercise 10-1 1. a 2. b 3. a
4. c 5. b
10 - 12
Exercise 10-2 1. False
Insolvency is the inability to pay debts as they become due. Classification as to current and long-term is irrelevant.
2. True 3. True 4. False
Secured creditors are paid first from the proceeds of sale of specific assets. If there are proceeds remaining, unsecured creditors with priority will be paid before other unsecured creditors.
5. True 6. False
A gain on restructuring is measured by the excess of the carrying value of the payable settled over the fair value of the assets transferred.
7. False
Restructuring gains from troubled debt restructurings are reported by the debtor as a separate component of operating income.
8. False
The statement of affairs is a report that shows the estimated amount to be paid to each class of claim in the event of liquidation.
Exercise 10-3 Part A Copyright 50,000 Gain on Transfer of Assets 50,000 To revalue the copyright to its current fair value. [$95,000 – ($100,000 - $55,000)] Notes Payable Accrued Interest Payable Accumulated Amortization – Copyright Copyright ($100,000 + $50,000) Gain on Debt Restructuring
150,000 15,000 55,000 150,000 70,000
Part B The gain on transfer of assets ($50,000) should be reported as a separate component (assuming material in amount) of operating income; the gain on restructuring ($70,000) should also be reported as a separate component of operating income. Part C Loss on Transfer of Assets 15,000 Copyright 15,000 To revalue the copyright to its current fair value. [$30,000 – ($100,000 - $55,000)] Notes Payable Accrued Interest Payable Accumulated Amortization – Copyright Copyright ($100,000 - $15,000) Gain on Debt Restructuring ($165,000 - $30,000) 10 - 13
150,000 15,000 55,000 85,000 135,000
Exercise 10-4 Part A No gain should be recognized because the total future cash payments specified by the new terms of $1,144,250 ($995,000 carrying value plus 3 years’ interest at $49,750 per year) exceed the current carrying value of the debt, $995,000. Part B Note Payable Accrued Interest Payable Restructured Debt
900,000 95,000 995,000
Exercise 10-5 Part A A gain on restructuring should be recognized because the carrying value of the debt, $995,000, exceeds the total future cash payments specified by the new terms, $744,000 ($600,000 face value plus $144,000 interest). The gain of $251,000 should be reported as a separate component of operating income. Part B Notes Payable Accrued Interest Payable Restructured Debt Gain on Debt Restructuring
900,000 95,000
Part C Restructured Debt Cash
48,000
744,000 251,000
48,000
Exercise 10-6 Realizable Value of all Assets ($190,000 + $90,000 + $102,000) Allocated to: Fully secured creditors Partially secured creditors Unsecured creditors with priority Remainder available to general unsecured creditors Payment rate to general unsecured creditors (Including balance due to partially secured creditors) $171,000 / ($350,000 + ($120,000 - $90,000))
$382,000
(91,000) (90,000) (30,000) $171,000
45%
Realizable Value of Assets: Assets pledged to fully secured creditors Assets pledged to partially secured creditors Free assets Total realizable value
$190,000 90,000 102,000 $382,000
Amounts to be paid to: Fully secured creditors Partially secured creditors [$90,000 + .45($30,000)] Unsecured creditors with priority General unsecured creditors .45($350,000) Total
$ 91,000 103,500 30,000 157,500 $382,000
10 - 14
Exercise 10-7 BALL COMPANY Statement of Affairs June 30, 2015 Book Value
Realizable Value
Assets
Assets Pledged with Fully Secured Creditors: $180,000 Inventory $110,000 Note Payable 100,000
170,000
20,400 430,000
Assets Pledged with Partially Secured Creditors: Accounts Receivable 95,000 Note Payable 100,000 Free Assets Cash Property and Equipment Total Net Realizable Value Liabilities having Priority – Wages Net Free Assets
20,400 320,000 350,400 120,000 230,400
Estimated Deficiency to Unsecured Creditors $800,400
$120,000
Fully Secured Creditors: 100,000 Note Payable
$100,000
350,000
400,000 (269,600) $800,400
Partially Secured Creditors: Note Payable Accounts Receivable Unsecured Creditors: Accounts Payable
124,600 $355,000 Unsecured
Equities Liabilities Having Priority: $120,000 Accrued Wages
100,000
$ 10,000
$100,000 95,000
$
5,000
350,000
Stockholders’ Equity Common Stock Retained Earnings (deficit) $355,000
10 - 15
Exercise 10-7 (continued) BALL COMPANY Deficiency Account June 30, 2015 Estimated Losses: Accounts Receivable Inventory Property and Equipment
Estimated Gains: $ 75,000 Common Stock $ 400,000 70,000 Retained Earnings (269,600) 110,000 Estimated Deficiency to Unsecured Creditors 124,600 $255,000 $255,000
Exercise 10-8 Part A Retained Earnings Allowance for Uncollectibles ($48,700 - $40,000) Property and Equipment ($142,000 - $118,000) Goodwill To record the revaluation of assets
52,700 8,700 24,000 20,000
Common Stock - $20 par 200,000 Common Stock - $4 par ($4 10,000) 40,000 Reorganization Capital 160,000 To record the exchange of $20 par common stock for $4 par common stock. 10% Bonds Payable 130,000 Reorganization Capital 24,000 Common Stock (6,000 shares at $4 per share) 24,000 8% Bonds Payable 130,000 To record the exchange of 8% bonds and common stock for the 10% bonds. Reorganization Capital Retained Earnings ($81,300 + $52,700) To eliminate the deficit in retained earnings.
10 - 16
134,000 134,000
Exercise 10-8 (continued) Part B
CRANE COMPANY Balance Sheet December 31, 2015 Cash Accounts Receivable Less Allowance for Uncollectibles Inventory Property and Equipment ($142,000 - $24,000) Total Assets
$ 33,000 $ 52,500 12,500
40,000 71,000 118,000 $262,000
Accounts Payable 10% Bonds Payable, due 6/30/2018 Common Stock, $4 par, 16,000 shares Reorganization Capital ($160,000 – $24,000 - $134,000) Total Equities
$ 66,000 130,000 64,000 2,000 $262,000
Exercise 10-9 Cash Accounts Receivable (old) Inventory Property and Equipment Allowance for Uncollectibles (old) Accumulated Depreciation TRX Company – in Receivership ($939,400 – $16,000 - $211,500) To record the receipt of TRX Company assets.
26,700 130,400 191,900 590,400
Cash Accounts Receivable (new) Sales To record cash sales and sales on account.
31,500 264,500
Cash
319,000
16,000 211,500 711,900
296,000
Accounts Receivable (old) Accounts Receivable (new)
76,800 242,200
Purchases Accounts Payable (new) To record purchases on account.
127,500
TRX Company – in Receivership Accounts Payable (new) Operating Expenses Trustee Expenses Cash To record cash payments.
206,500 61,600 46,000 13,000
127,500
327,100
10 - 17
Exercise 10-9 (continued) Bad Debt Expense Depreciation Expense Allowance for Uncollectibles (old) Allowance for Uncollectibles (new) Accumulated Depreciation To record estimated bad debts and depreciation expense.
21,600 32,400
Allowance for Uncollectibles (old) Account Receivable (old) To write off uncollectible accounts.
21,000
Sales
296,000
13,000 8,600 32,400
21,000
Inventory ($191,900 - $149,700) Purchases Operating Expenses Trustee Expenses Bad Debt Expense Depreciation Expense Income Summary To close nominal accounts and to adjust inventory. Income Summary TRX Company – in Receivership To Close income summary account.
42,200 127,500 46,000 13,000 21,600 32,400 13,300
13,300 13,300
10 - 18
Exercise 10-10 TRX COMPANY – IN RECEVERSHIP Combining Workpaper December 31, 2015 Trial Balance TRX Trustee Company
Adjustments and Eliminations Dr. Cr.
Combined Income Statement
Balance Sheet
Debits Cash ($26,700 + $31,500 + $319,000 - $327,100) Accounts Receivable (old) Accounts Receivable (new) Inventory Property and Equipment Purchases Operating Expenses Trustee Expenses Bad Debt Expense Depreciation Expense Cost of Goods Sold ($191,900 + $127,500 - $149,700) Your Name, Trustee Total
50,100 53,600 22,300 191,900 590,400 127,500 46,000 13,000 21,600 32,400 (1) 1,148,800
(1)
42,200
(1)
127,500 46,000 13,000 21,600 32,400 169,700
169,700
505,400 505,400
50,100 53,600 22,300 149,700 590,400
(2)
505,400 282,700
866,100
Credits Allowance for Uncollectibles: (Old) (New) Accumulated Depreciation Accounts Payable: (Old) (New) Capital Stock Retained Earnings (Deficit) Sales TRX Company-in Receivership Total
29,000 8,600 243,900
29,000 8,600 243,900 101,900 65,900 800,000 (396,500)
101,900 65,900 800,000 (396,500) 296,000 505,400 1,148,800
296,000 (2) 505,400
505,400 675,100
675,100
296,000 (13,300) 282,700
Net Income (1) To adjust inventory and set up cost of goods sold. (2) To eliminate reciprocal accounts.
10 - 19
13,300 866,100
ANSWERS TO ASC (Accounting Standards Codification) EXERCISES ASC10-1 Presentation A sometimes-confusing aspect of the definition of current assets is the inclusion of prepaid items. Prepaid expenses are not usually converted into cash in the current period. How do GAAP rationalize this classification issue? Alternative 1: in the search menu, type ‘current assets.’ Narrow the search by clicking on presentation. Narrow the search again by clicking on balance sheet. Scroll through the results to find the answer. The third returned result provides the correct answer. Alternative 2: Step 1: Use the drop-down menus under the ‘Presentation’ general topic on the homepage and choose ‘210-Balance Sheet’; then under the second drop-down menu, choose ’10-overall’. Expand the table of contents. Step 2: Click on section 45 Other Presentation Matters. FASB ASC paragraph 210-10-45-2 states that prepaid expenses are not current assets in the sense that they will be converted into cash but in the sense that, if not paid in advance, they would require the use of current assets during the operating cycle. ASC10-2 Disclosure Must a firm separately disclose the cash flow pertaining to extraordinary items or discontinued items in operating activities? Step 1: Use the drop-down menus under the ‘Presentation’ general topic on the homepage and choose ‘230 Statement of Cash Flows’; then under the second drop-down menu, choose ’10-Overall.’ Step 2: There is no information to answer the question in the section 50 disclosure, so return to section 10 and expand the table of contents. Click on ‘Other Presentation Matters’ and scroll through the paragraphs FASB ASC paragraph 230-10-45-24 states that separate disclosure of cash flows pertaining to extraordinary items or discontinued operations reflected in those categories is not required. An entity that nevertheless chooses to report separately operating cash flows of discontinued operations shall do so consistently for all periods affected, which may include periods long after sale or liquidation of the operation. ASC10-3 Scope Must a defined pension plan that presents financial information in accordance with the provisions of topic 960 provide a statement of cash flows? Step 1: Use the drop-down menus under the ‘Industry’ general topic on the homepage and choose ‘96X-Plan Accounting’; then under the second drop-down menu, choose 960-Plan Accounting – Defined Benefit Pension Plan.’ In the third drop down menu choose ‘205 Presentation of Financial Statements.’ Step 2: The answer to the question cannot be found in section 15 Scope, so scroll through the ‘Other Presentation Matters’ paragraphs (960-205-45). FASB ASC paragraph 960-205-45-6 states that defined benefit pension plans that presents financial information in accordance with Topic 960 are not required to provide a statement of cash flows, but are encouraged to include a statement of cash flows if that statement would provide relevant information about the ability of the plan to meet future obligations. 10 - 20
ASC10-4 General List all the topics found in topic 400—Liabilities. (Hint: There are nine topics.) ASC 405-10 provides the overall guidance for liabilities. What is the overall objective of this section? Click on the general topic ‘Liabilities’. The nine topics are Topics 405 Liabilities, 410 Asset Retirement and Environmental Obligations, 420 Exit or Disposal Cost Obligations, 430 Deferred Revenue, 440 Commitments, 450 Contingencies, 460 Guarantees, 470 Debt, and 480 Distinguishing Liabilities from Equity. FASB ASC paragraph 405-10-05-2 states that this section does not contain any accounting guidance, but its purpose is to identify the locations in the Codification that provide guidance for liabilities. ASC10-5 Glossary What is a troubled debt restructuring? On the Codification homepage, click on ‘Master Glossary’ in the left-hand column. In the ‘glossary term quick find’ menu type ‘troubled debt restructuring’ and hit return.’ A troubled debt restructuring is a restructuring of a debt constitutes a troubled debt restructuring if the creditor for economic or legal reasons related to the debtor's financial difficulties grants a concession to the debtor that it would not otherwise consider.
ASC10-6 Presentation Describe fresh start accounting and the conditions under which it is acceptable under current GAAP. In the search box enter ‘fresh start accounting.’ The first returned result identifies the appropriate section in the Codification discussing fresh start accounting. Topic 852 discusses reorganization and the financial reporting requirements when entities emerge from Chapter 11 reorganization. FASB ASC 852-10-45-19 states that if the reorganization value of the assets of the emerging entity immediately before the date of confirmation is less than the total of all post-petition liabilities and allowed claims, and if holders of existing voting shares immediately before confirmation receive less than 50 percent of the voting shares of the emerging entity, the entity shall adopt fresh-start reporting upon its emergence from Chapter 11. If the above conditions are met, a new reporting entity is created and assets and liabilities should be recorded at their fair value.
10 - 21
ANSWERS TO PROBLEMS Problem 10-1 1.
2.
3.
4.
Accounts Payable Cash ($71,600 .42) Gain on Restructuring of Debt
71,600
Allowance for Uncollectible Accounts Loss on Transfer of Assets Accounts Receivable ($92,000 - $69,000)
19,450 3,550
Accounts Payable Accounts Receivable Gain on Restructuring of Debt ($132,400 - $69,000)
132,400
30,072 41,528
23,000
69,000 63,400
Accrued Expenses Cash
14,620
Notes Payable Accrued Interest Payable Cash Restructured Debt Gain on Restructuring of Debt ($327,000 - $309,000)
300,000 27,000
14,620
9,000 300,000 18,000
Problem 10-2 Part A 1. Allowance for Uncollectibles Loss on Transfer of Assets Accounts Receivable ($71,450 - $51,000)
2.
3.
16,750 3,700 20,450
Accounts Payable Accounts Receivable Gain on Restructuring of Debt
69,000
Patents Gain on Transfer of Asset ($50,000 - $42,000)
8,000
Accounts Payable Patents Gain on Restructuring of Debt
54,000
Accrued Wages Cash
11,900
Accounts Payable ($142,700 - $69,000 - $54,000) Cash ( .6 $19,700) Gain on Restructuring of Debt
19,700
51,000 18,000 8,000 50,000 4,000 11,900
10 - 22
11,820 7,880
Problem 10-2 (continued) 4.
Notes Payable Accrued Interest Payable Restructured Debt – due 1/2/14
57,000 6,000 63,000
Total future cash payments: Principal Interest (6% $63,000) 2 Total Carrying value No gain recognized 5.
$63,000 7,560 70,560 $63,000
Notes Payable Accrued Interest Payable Restructured Debt – due 1/2/15 Gain on Restructuring of Debt
54,400 11,900 52,000 14,300
Total future cash payments: Principal ($54,400 - $14,400) Interest (10% $40,000) 3 Total Carrying value ($54,400 + $11,900) Gain on Restructuring 6.
7,
Mortgage Note Payable Accrued Interest Payable Common Stock (100,000 $0.50) Paid-in Capital in Excess of Par Gain on Restructuring of Debt ($100,500 – (100,000 $.59)
80,000 20,500
Common Stock ($290,000 – (580,000 $.10) Retained Earnings Paid-in Capital in Excess of Par
232,000
Balance 1/2/15 Loss on transfer (1)
Balance
$40,000 12,000 52,000 66,300 $14,300
Retained Earnings 156,800 Gain on restructuring (1) 3,700 Gain on transfer (2) Gain on restructuring (2) Gain on restructuring (3) Gain on restructuring (5) Gain on restructuring (6) 66,820
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50,000 9,000 41,500 66,820 165,180
18,000 8,000 4,000 7,880 14,300 41,500
Problem 10-2 (continued) Part B
SRP COMPANY Balance Sheet January 2, 2015 Cash ($32,200 - $11,900 - $11,820) Inventories Plant and Equipment Less Accumulated Depreciation Land Patents ($92,000 - $8,000 - $50,000) Total
$ 8,480 126,600 $322,000 180,700
Restructured Debt – Due 2015 Due 2015 Common Stock, $ .10 par value, 580,000 shares outstanding Paid-in Capital in Excess of Par Retained Earnings since Reorganization on 1/2/15 Total Part C 12/31/15 Interest Expense Interest Payable ($63,000 .06)
141,300 20,800 50,000 $347,180 $ 63,000 52,000 58,000 174,180 - 0 $347,180
3,780 3,780
No interest is accrued on the debt due in 2015 because all cash payments are reductions of the carrying value of the debt. 1/2/16 Interest Payable Cash
3,780 3,780
Restructured Debt Cash ($52,000 .10)
5,200 5,200
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