Type:
Solution Manual
Resource:
Advanced Accounting
Edition:
8th Edition
Author(s):
Debra C. Jeter Paul K. Chaney
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., 2022 Subtract: Additional depreciation on building ($960,000 30%) Target’s adjusted earnings,2022
$1,200,000 (288,000)
Pretax income of Condominiums, Inc., 2023 Subtract: Additional depreciation on building Target’s adjusted earnings,2023
$1,500,000 (288,000)
912,000
1,212,000
Pretax income of Condominiums, Inc.,2024 Add: Extraordinary loss Subtract: Additional depreciation on building Target’s adjusted earnings,2024 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
Exercise 1-4 Parent versus Economic Entity Concepts LO 8 a. Under the economic entity assumption, consolidated income is the combined income to the entire economic entity (both controlling and non-controlling interests). Thus consolidated income is $7,768. b. Under the parent company concept, consolidated income would include income that the parent company has earned (the parent’s stand-alone income plus the controlling interest in income). Thus, consolidated income would be $7,747. c. Under the economic entity assumption, consolidated equity would be the combined equity of both the controlling and non-controlling interests. Thus consolidated equity would be $21,284. d. Under the parent company concept, consolidated equity would be the equity to the controlling interest which would include the parent’s standalone equity plus the controlling interest in equity of the subsidiaries. Thus consolidated equity would be $19,299.
ANSWERS TO ASC (Accounting Standards Codification) EXERCISES (These exercises are located in the instructor’s manual) ASC1-1 Cross-Reference The conditions determining whether a the acquisition date was prescribed in SFAS No. 141R, paragraph 10. 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 141R as the standard number. Click on ‘Generate Report.’ Paragraph 10 of SFAS No. 141R is included in the Codification; FASB ASC paragraphs 840-10-25 1,29,30,31, and 41. FASB ASC paragraph 805-10-25-6. The date of acquisition is the date on which it obtains control of the acquire. 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.’ Extraordinary items are no longer reported in the financial statements. Accounting standards update No. 2015-01 Simplifying Income Statement Presentation by Eliminating the concept of Extraordinary Items removed this topic. ASC1-3 Disclosure Suppose a firm entered into a capital lease (or a right-of-use asset), 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 1-15
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 as follows. In the first step, known as the qualitative test, the firm must evaluate relevant events or circumstances concerning the value of a reporting unit. If it is deemed more likely than not that the fair value of the reporting unit is less than its carrying value, the company proceeds to the quantitative test. Otherwise, goodwill is not impaired. If it is deemed more likely than not that the fair value of the reporting unit is less than its carrying value, the company must proceed to the quantitative test. In this test, 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 goodwill is considered impaired. The amount of goodwill impairment is the lesser of the carrying value of goodwill or the excess of the carrying value of the reporting unit over its fair value.
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). 2-1
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 Tesla Acquires SolarCity (2016). Questions: Part A: Assuming this were treated as an asset acquisition (business combination), prepare the journal entry on Tesla’s books to record the acquisition. Cash $213,523 Accounts Receivable 74,619 Inventory 191,878 Solar energy systems 5,781,496 Property, plant and equipment 1,056,312 Intangible assets 356,510 Prepaid expenses 199,864 Other assets 638,908 Accounts payable Accrued liabilities Debt Deferred revenues Other liabilities Noncontrolling interest on SolarCity’s books Bargain gain Common stock (11,124.497)($.001) Paid in capital
230,078 238,590 3,525,130 271,128 950,423 1,063,057 88,727 11 2,145,989
The noncontrolling interest on SolarCity’s books represents the amount of net assets on SolarCity’s books that they don’t own from prior acquisitions where they purchased less than 100% ownership. Part B: What was the reason Tesla was able to acquire SolarCity for a bargain? The primary factor contributing to the gain relates to the change in the overall price of our common stock from the time that the Merger Agreement was executed on July 31, 2016 to the acquisition date. During this time, our stock price decreased from $230.01 to $185.04, which in turn reduced the fair value of the consideration. Part C a. What is the journal entry to record the measurement period adjustment? Loss on acquisition* Other assets
57,746 11,571 2-2
Accrued liabilities * $88,727-30,981
46,175
b. How is the bargain gain reported in 2016 and 2017? In 2016, there was a bargain gain of $88,727 In 2017, there was a loss of $57,746 because of the measurement period adjustment which is recognized in the period estimates are finalized.
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
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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.
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