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LOS b. distinguish between IFRS and U.S. GAAP in the classification, measurement, and disclosure of investments in financial assets, investments in associates, joint ventures, business combinations, and special purpose and variable interest entities;
Investments in financial assets.
Investments in financial assets are those in which the investor has no significant influence. Depending on the nature of the investment relationship, investments in financial assets can be accounted for in different ways.
  • IFRS has three basic categories: 1) held-to-maturity, 2) fair value through profit or loss, and 3) available-for-sale.
  • GAAP has four categories: 1) held-to-maturity, 2) held for trading, 3) available-for-sale, and 4) investments designated at fair value.
Held-to-Maturity

Characteristics: The investor has both a positive intent to hold the securities, and the ability to hold them to maturity.

The cost method is used. The cost method reports investments at cost, not at market value, plus (minus) unamortized premium (discount).

Balance Sheet:

  • Initial value: fair value (IFRS) or cost (GAAP). In most cases they are identical.
  • The securities are accounted for at amortized cost, not fair value.
Income Statement:
  • Income is interest received -/+ amortization of premium (discount).
  • When the investment is sold, a gain or loss is recognized. The gain (or loss) on the sale is the difference between the sales price and the amortized cost.
This classification is available to debt only.

Both IAS 7 and SFAS 115 require that the market value be disclosed in a footnote even though the cost basis is the value that is actually reported.

Held for Trading

Characteristics: Trading securities are used to generate profits from short-term differences in prices. The holding period is usually less than 3 months. We would expect the portfolio turnover of companies with trading securities to be high.

The market method is used.

  • Balance Sheet: The securities are reported at fair market value. Any discount or premium is not amortized.
  • Income Statement: Unrealized gains and losses are reported as part of net income and affect stockholders' equity via retained earnings. Interest and dividends are also included in income.
This classification is available to both debt and equity securities.

Available-for-Sale

Characteristics: Investments not classified in another category are included here. The investor might sell these securities, but does not intend to trade on short-term price fluctuations. That is, it does not expect to sell and repurchase the same securities frequently.

The market method is used.

  • Balance Sheet: These investments are reported at fair value in the balance sheet.
  • Income Statement: Differences between the fair value and amortized cost are reported as unrealized holding gains and losses (net of deferred income tax) as a separate component (comprehensive income) in shareholder's equity. Income includes realized gains or losses, interest and dividends.
IFRS and U.S. GAAP differ on the treatment of foreign exchange gains/losses for debt (not equity) securities.
  • Under IFRS, foreign exchange gains/losses are recognized in the income statement (separate recognition of foreign exchange gains/losses).
  • Under GAAP, they are included in other comprehensive income, just like other changes in the carrying amount.
Designated Fair Value

These instruments can be financial assets or liabilities. They can be initially reported at fair value. Unrealized gains / losses on such instruments are reported in the income statement.

Example

Assume that the investment portfolio at the end of the year consists of three securities with cost and market values as follows:

Assuming that the securities were all purchased during the year, there is an unrealized gain on the portfolio of $3,000 at year-end. The adjusting entry to reflect this under the two mark-to-market classifications (available for sale and trading) is as follows:

In both cases, the security fair value adjustment (positive or negative) is added to the cost of the securities to arrive at the carrying amount on the balance sheet, $24,000 at year-end. The difference between the two classifications is this:

  • Available-for-sale: the unrealized gain is reported directly in stockholders' equity in other comprehensive income and does not affect current profitability.
  • Trading: the unrealized gain is reported as a component of net income and affects stockholders' equity via retained earnings.
Assume that the Company A security is sold subsequent to year-end for $4,500 (the security appreciated in value subsequent to year-end). The accounting entry is,

The original cost of the security is maintained in the general ledger and is used to compute the loss on sale. Had the security been sold for $6,000, a gain of $1,000 would have resulted.

Now assume that the portfolio at the end of the next year is as follows:

The unrealized gain on the portfolio has declined to $2,000. Since the current balance of the unrealized gain account is $3,000, it must be reduced by $1,000 as follows:

Again, the reduction in market value would be recognized as a reduction of stockholders' equity under the available-for-sale classification and a reduction of income under the trading classification. In either classification, the company reports a realized loss on the sale of company stock of $500 and may have also reported investment income on any dividends received during the year. The only difference between the two classifications is in how they treat unrealized gains and losses.

Reclassification of Investments

Although a company determines the classification of the security upon purchase, it does have the ability to change classifications subsequently.

Issues:

  • At what value is the security transferred?
  • How are gains and losses accounted for?
  • What is the effect of the gain/loss accounting on income and equity?
The security must be mark-to-market and all unrealized gains or losses recognized in income on the date the classification is changed.

IFRS generally allows reclassification between held-to-maturity securities and available-for-sale securities (the last 2 rows).

U.S. GAAP allows transfers of securities between all categories.

Although the classification rules are designed to curtail management's ability to manage earnings or smooth balance sheet volatility through reclassification, there are still some opportunities to accomplish exact that. One example is reclassifying securities that have had unrealized gains from available-for-sale to trading securities, so the company would report the unrealized gains as income.

For securities classified as available-for-sale, only realized gains and losses are recognized, so if the portfolio has securities with unrealized gains, management will have the ability to determine the amount and timing of gains, and this could have a distorting affect on the company's overall performance regardless of how the company's overall portfolio performed during the year.

Impairments

Occasionally, an investment's value will decline for reasons that are "other than temporary". This is called "impairment of value".

Under IFRS, if a security is deemed to be impaired:

  • For a held-to-maturity security, its carrying value is reduced. The impairment loss can be reversed for subsequent increases in fair value.
  • For an available-for-sale security its carrying value is reduced. The impairment loss on an equity security cannot be reversed, however.
Under U.S. GAAP, if the value is impaired, the recorded cost of the security is reduced to the impaired fair value, and the difference is included in the current period's income. The new cost basis (the impaired fair value) is not changed for subsequent recoveries in fair value.
Practice Question 1

Investment securities are reported on a balance sheet at fair value for:

A. Trading Securities = Yes, Securities Available-For-Sale = No.
B. Trading Securities = Yes, Securities Available-For-Sale = Yes.
C. Trading Securities = No, Held-to-Maturity Securities = Yes.

Check AnalystNotes for the correct answer and a detailed explanation.

Practice Question 2

Unrealized holding gains and losses for securities to be held-to-maturity are:

A. Reported as a separate component of the shareholders' equity section of the balance sheet.
B. Included in the determination of income from operations in the period of the change.
C. Neither reported in the income statement nor on the balance sheet.

Check AnalystNotes for the correct answer and a detailed explanation.

Practice Question 3

Unrealized holding gains and losses for trading securities are:

A. Reported as a separate component of the shareholders' equity section of the balance sheet.
B. Included in the determination of income from operations in the period of the change.
C. Neither reported in the income statement nor on the balance sheet.

Check AnalystNotes for the correct answer and a detailed explanation.

Practice Question 4

Debt securities that are bought and held primarily for sale in the near term are classified as

A. available-for-sale.
B. held-to-maturity.
C. trading.

Check AnalystNotes for the correct answer and a detailed explanation.

Practice Question 5

Trading securities are generally held for less than:

A. 1 month.
B. 3 months.
C. 12 months.

Check AnalystNotes for the correct answer and a detailed explanation.

Practice Question 6

XYZ Co. has marketable securities classified as trading securities according to SFAS No. 115. These are recorded as:

A. Assets reported at fair value and unrealized gains & losses included in earnings.
B. Assets reported at fair value and unrealized gains & losses reported in shareholders' equity.
C. Assets reported at fair value and unrealized gains & losses reported as extraordinary items.

Check AnalystNotes for the correct answer and a detailed explanation.

Practice Question 7

How are held-to-maturity securities reported on the balance sheet?

A. fair value with unrealized gains and losses included in earnings.
B. fair value with unrealized gains and losses reported as a separate component of stockholders' equity.
C. at amortized cost.

Check AnalystNotes for the correct answer and a detailed explanation.

Practice Question 8

Which of the following statements related to impairments of investments is not correct (under U.S. GAAP)?

A. A bankruptcy being experienced by an investee is an example of a permanent loss in value.
B. If the decline in value is considered temporary, the cost of the individual security is written down to a new cost basis.
C. The amount of any write-down in value is accounted for as a realized loss.
D. Subsequent increases/decreases in the fair value of impaired available-for-sale securities are included as other comprehensive income.

Check AnalystNotes for the correct answer and a detailed explanation.

Practice Question 9

Under U.S. GAAP, the unrealized gain (loss) at the date of transfer is recognized in income for transfers from:

I. available-for-sale to held-to-maturity.
II. held-to-maturity to available-for-sale.
III. available-for-sale to trading.

Check AnalystNotes for the correct answer and a detailed explanation.

Practice Question 10

Concerning changes to the classification of its investment portfolio from held-to-maturity to available-for-sale (under U.S. GAAP):

A. Companies cannot change the classification once it is selection.
B. The securities must be marked to market on the date of transfer.
C. Securities continue to be reported at cost as they were previously.

Check AnalystNotes for the correct answer and a detailed explanation.

Practice Question 11

When held-to-maturity securities are sold, the gain (loss) on sale is the difference between the selling price of the securities and their

A. fair value.
B. face value.
C. book value.

Check AnalystNotes for the correct answer and a detailed explanation.

Practice Question 12

When an available-for-sale equity security is sold, the gain (loss) on sale is the difference between the net proceeds from the sale and the security's

A. book value.
B. cost.
C. fair value.

Check AnalystNotes for the correct answer and a detailed explanation.

Practice Question 13

Held-to-maturity securities are reported at their:

A. Historical cost.
B. Amortized cost.
C. Fair value.

Check AnalystNotes for the correct answer and a detailed explanation.

Practice Question 14

Northern Company reports income unrealized gains (losses) on its short-term investment portfolio in Other Comprehensive Income (OCI). Its investment portfolio is classified as:

A. Trading.
B. Available for sale.
C. Held-to-maturity.

Check AnalystNotes for the correct answer and a detailed explanation.

Practice Question 15

One feature common to both the trading and available for sale classifications is:

A. Investments are reported at market value.
B. Unrealized gains (losses) are reported in current income.
C. Unrealized gains (losses) are reported in other comprehensive income.

Check AnalystNotes for the correct answer and a detailed explanation.

Practice Question 16

Southern Company holds a 10-year bond that it purchased 4 years ago at 1020 and records as held-to-maturity. It receives $40 in cash interest payments. The premium it recorded at acquisition is amortized on a straight-line basis. How much interest income will it report?

A. $40.
B. $42.
C. $38.

Check AnalystNotes for the correct answer and a detailed explanation.

Practice Question 17

The reporting of investment securities at market value is required for the following ownership percentage:

A. Less than 20% of the outstanding common stock.
B. Between 20% and 50% of the outstanding common stock.
C. More than 50% of the outstanding common stock.

Check AnalystNotes for the correct answer and a detailed explanation.

Practice Question 18

On May 1, 2009 Bluefish Co. bought 100 bonds (face value $1,000 and stated interest 10%) of Hawkeye Inc., interest payable semiannually on July 1, and January 1. The bond price was 920 excluding accrued interest. Due to short-term nature of the investment Bluefish put this in marketable debt securities section of its current assets. At the end of 2009 the interest revenue from this investment on income statement should be:

A. No interest revenue, since marketable securities are short-term in nature and only the difference between acquisition price and disposition price is calculated as gain or loss.
B. $10,000 since it received $5,000 on July as bond interest and another $5,000 would be due tomorrow (Jan. 1, 2010)
C. $6,667

Check AnalystNotes for the correct answer and a detailed explanation.

Practice Question 19

Pawnee Inc. bought 100 bonds of Omaha Corporation for $1,120 each (face value $1,000, stated interest rate 12%, semi-annul payment) on June 1, 2012. It's considered as a temporary investment. It would receive interest payment on July 1, 2012 and the price of $1,120 included all accrued interest already. At the date of purchase, Pawnee should credit cash for $112,000, and:

A. debit Marketable Debt Securities for $107,000 and debit Interest Receivable for $5,000.
B. debit Marketable Debt Securities for $118,000 and credit Interest Revenue for $6,000.
C. debit Marketable Debt Securities for $100,000 and debit Interest Receivable for $12,000.

Check AnalystNotes for the correct answer and a detailed explanation.

Practice Question 20

Pawnee Inc. bought 100 bonds of Omaha Corporation for $1,120 each (face value $1,000, stated interest rate 12%, semi-annul payment) on June 1, 2012. It would receive interest payment on July 1, 2012 so the price of $1,120 included all accrued interest already. It's considered as a temporary investment. At the date of purchase, Pawnee should credit cash for $112,000, and:

I. debit Marketable Debt Securities for $112,000.
II. debit Marketable Debt Securities for $107,000.
III. debit Marketable Debt Securities for $100,000.
IV. debit Bond Premium for $7,000.
V. debit Interest Revenue for $5,000.

A. III, IV and V only.
B. II and V only.
C. none is correct.

Check AnalystNotes for the correct answer and a detailed explanation.

Practice Question 21

An unrealized holding gain on a trading investment is recorded as

A. a direct credit to stockholders' equity.
B. extraordinary gains on the income statement.
C. other revenues and gains on the income statement.

Check AnalystNotes for the correct answer and a detailed explanation.

Practice Question 22

A company recognized an unrealized gain of $15,000 on a trading security. This would be reflected on the cash flow statement as:

A. an increase in investing cash flows.
B. a decrease in investing cash flows.
C. a deduction from operating cash flows.

Check AnalystNotes for the correct answer and a detailed explanation.

Practice Question 23

What does the FASB require regarding the disclosure of the fair value of financial instruments?

A. A company must not disclose the fair value of financial instruments because accounting emphasizes historical costs not fair values.
B. A company must disclose the fair value of financial instruments in the footnotes to the financial statements.
C. A company must disclose the fair value of financial instruments either on the face of the balance sheet or in the footnotes to the financial statements.

Check AnalystNotes for the correct answer and a detailed explanation.

Practice Question 24

Which of the following investments in debt securities would not normally be classified as long-term?

A. Available-for-sale securities.
B. Trading securities.
C. Held-to-maturity securities.

Check AnalystNotes for the correct answer and a detailed explanation.

Practice Question 25

Which of the following is/are true about trading securities?

I. They are current assets.
II. They are reported at fair market value.
III. Changes in their reported value are allocated directly to retained earnings.

A. I and III.
B. I, II and III.
C. I and II.

Check AnalystNotes for the correct answer and a detailed explanation.

Practice Question 26

Which of the following investments in debt securities would not normally be classified as long-term?

A. Trading securities.
B. Available-for-sale securities.
C. Held-to-maturity securities.

Check AnalystNotes for the correct answer and a detailed explanation.

Practice Question 27

Which of the following statements is (are) true with respect to the cost or market method of carrying an investment?

I. Cost method is primarily used for securities that are not publicly traded.
II. A company cannot carry an investment using the cost method if it exerts a significant influence on the company that it has an investment in.
III. Other than realized gains and losses, the market method only allows an unrealized gain to be recorded in the income statement.
IV. Under the lower of cost or market method, under no circumstances may unrealized gains be recorded in the income statement.

A. I and II.
B. II and IV.
C. I and III.

Check AnalystNotes for the correct answer and a detailed explanation.

Practice Question 28

Which of the following statements is (are) true with respect to the classification of securities for accounting purposes?

I. For held-to-maturity securities, unrealized gains and losses, in addition to interest income, may be recorded as part of income.
II. For trading securities, unrealized gains and losses, in addition to interest and dividend income, may be recorded as part of income.
III. Available-for-sale securities are carried in a balance sheet at their fair market values.
IV. Any unrealized gain or losses resulting from an available-for-sale security must be reported on an income statement as a separate item.

A. I and II.
B. II and III.
C. II and IV.

Check AnalystNotes for the correct answer and a detailed explanation.

Practice Question 29

Amex, Inc. reports a investment portfolio. Which of the following statements is true?

A. If the portfolio includes available-for-sale securities, the unrealized gains (losses) will be reported in current income.
B. The available for sale securities in its portfolio will be reported at cost.
C. The portfolio can contain both available-for-sale and held-to-maturity securities.

Check AnalystNotes for the correct answer and a detailed explanation.

Practice Question 30

Under U.S. GAAP, transfers between categories of investments are accounted for at:

A. Fair value.
B. Historical cost.
C. Amortized cost.

Check AnalystNotes for the correct answer and a detailed explanation.

Practice Question 31

Which of the following actions will reduce current net income?

A. Capitalizing rather than expensing, a purchase.
B. Changing from the LIFO method to the FIFO method in periods of rising prices.
C. Reclassification of a marketable security that has had a permanent decrease in value from current to noncurrent.

Check AnalystNotes for the correct answer and a detailed explanation.

Practice Question 32

How would securities held for the purpose of retiring long-term bonds be reported on a classified balance sheet?

A. They would be reported as current assets.
B. They would be reported as long-term investments.
C. They would be reported as a contra account to bonds payable.

Check AnalystNotes for the correct answer and a detailed explanation.

Practice Question 33

Unrealized holding gains and losses are included in an investor's earnings for:

A. Trading Securities = Yes, Securities Available-For-Sale = No.
B. Trading Securities = Yes, Securities Available-For-Sale = Yes.
C. Trading Securities = No, Securities Available-For-Sale = Yes.

Check AnalystNotes for the correct answer and a detailed explanation.

Investments in associates.
Investments in associates are those in which the investor has significant influence, but not control, over the investee's business activities.

Significant influence is presumed at ownership levels of at least 20%, but is determined based on the facts for each investment. For example, significant influence may be present for ownership levels of less than 20% if the investor licenses technology that is important to the investee company. Alternatively, lack of significant influence may be present for ownership levels above 20% if prohibited by contracts.

The FASB has provided examples of cases in which significant influence may NOT exist:

  • Investee opposes investor's acquisition of stock.
  • Investor surrenders significant shareholder rights.
  • Investor is unable to obtain needed financial information from investee.
  • Investor is unable to obtain representation on investee's board of directors.

The determining factor is the amount of influence. There are situations where 10% ownership has been enough to confer "significant influence" and others where more than 20% was not.

The equity method is generally employed when the investor has significant influence over the investee. Both the U.S. GAAP and IFRS require this method because it provides a more objective basis for reporting investment income. It is a method of accounting by which an equity investment is initially recorded at cost and subsequently adjusted to reflect the investor's share of the net assets of the associate (investee).

Equity Method: Basic Principles

For any company: ending retained earnings (RE) = beginning RE + Net Income - Dividends. Following the same logic:

  • In the year of acquisition, the investor company reports its investment in the investee at the acquisition cost.
  • The value that the investor company reports the investment in subsequent years will depend on both the dividends paid and the earnings of the investee.
    • If the investee in Year 2 has positive net income, the investor will increase its reported investment by % of ownership in the investee x the investee's net income.
    • If the investee has a loss, then the investor will reduce its investment by its ratable amount of the loss. If the balance is reduced to zero, equity method accounting is discontinued until the cumulative balance is positive.
    • Dividends received by the investor from the investee will not be included in the investor's net income. Instead, the dividends will be deducted from the investment in the investee, on the rationale that the investee's payment of dividends reduces its equity by the amount paid, and the investor will share ratably in that reduction. Therefore, dividends are treated as a return of investment.
The equity investment is reported as a single line item on the balance sheet and on the income statement.

Example

Rings & More acquired 45% of the equity securities of Diamonds Galore for $1,350,000. On the acquisition date, Diamonds Galore's net assets had a fair value of $3,000,000. During the year, Diamonds Galore paid dividends of $150,000 and net income of $1,750,000.

The journal entries are as follows:

To record the purchase of the investment:

To record percentage share of investee company earnings (45% of earnings of $1,750,000):

To record dividends received (45% of dividends of $150,000):

If the subsidiary had a loss, the investment account would have been reduced.

During the year, the investor will report $787,500 as equity income on investment in its income statement.

Equity Method: Other Issues

Implicit Goodwill

On acquisition of the investment in an associate, any difference between the cost of acquisition and the investor's share of the fair values of the net identifiable assets of the associate is accounted for like goodwill, which is part of the one-line item (the investment) on the investor's balance sheet.

  • The US. GAAP requires the use of net book values, not fair values, of net identifiable assets.
  • The IFRS allows the use of either net book values or fair values.
The goodwill is simply the residual excess not allocated to identifiable assets or liabilities.

Appropriate adjustments to the investor's share of the profits or losses after acquisition are made to account for additional depreciation or amortization of the associate's depreciable or amortizable assets based on the excess of their fair values over their carrying amounts at the time the investment was acquired.

Example

Purchase price: $500.
20% of shares.
Book value: $2,000.
Net identifiable assets of the investee: net book value $1,000, fair market value: $1,200.

The investor pays $500 for $400 ($2,000 x 20%) worth of assets. Assign $40 [(1,200 - 1,000) x 20%] to net identifiable assets, the goodwill is then $60. In subsequent accounting periods the $40 will be amortized and the $60 worth of goodwill is not amortized.

Impairment

If impairment is indicated, the amount is calculated. The entire carrying amount of the investment is tested for impairment as a single asset, that is, goodwill is not tested separately. The impairment loss is recognized on the income statement and the carrying amount of the investment on the balance sheet is reduced to its fair value.

The reversal of impairment losses is not allowed.

Transactions with Associates

Any inter-company transactions between the investor and investee (upstream or downstream) should be eliminated.

Effects on Financial Statements

Balance sheet effect. The investment account is reported on the balance sheet as a single amount. It is reported at cost, adjusted for dividends received and proportionate earnings, not at fair market value.

Income statement effect. The investor's share of the investee's earnings is reported as a single item on the investor's income statement. Compared with the previous subject, the equity method will result in the investor company reporting higher income than if it used classifications such as available-for-sale or trading securities.

Financial ratios. The equity method recognizes income in excess of dividends received.

  • Whenever the investee has earnings and a dividend payout ratio of less than 100%, use of the equity method will increase the earnings of the investor relative to those using the cost method.
  • When the investee has positive net income, the investor's ratios of interest coverage and return on investment will improve, but this is a two-edged sword, because the investor could find those ratios reduced if the investee starts to experience losses.
  • As only assets and equity are affected, without any recognition of the investee's debt, the investor's debt-to-equity and debt-to-total capital ratios improve under the equity method.
Issues for Analysts

  • The criteria of "significant influence" can be subjective. If the investee is profitable, the investor will want to purchase enough (i.e. 20%) to use the equity method. If the investee is not profitable, then the investor will purchase less than 20% so that it can avoid having to report its proportionate share of the losses.
  • The one-line consolidation can hide lots of details.
  • The premise of the equity method is that the investor has access to the investee's earnings. If the reality proves otherwise, then use of the equity method may not be indicated, and the investment should be considered as an investment in marketable securities and evaluated on a mark-to-market basis.
Practice Question 1

Examples of the ability to exercise significant influence over an investee include:

I. Material intercompany transactions.
II. Interchange of managerial personnel.
III. Technological dependency.

Check AnalystNotes for the correct answer and a detailed explanation.

Practice Question 2

The equity method is used when an investor can't control, but can exercise significant influence over the operating and financial policies of the investee. We presume, in the absence of evidence to the contrary, that this is so if:

A. The investor classifies the investment as available-for-sale or held-to-maturity.
B. The investor owns between 51% or more of the investee's voting shares.
C. The investor owns between 20% and 50% of the investee's voting shares.

Check AnalystNotes for the correct answer and a detailed explanation.

Practice Question 3

On January 2, 2011, Germane, Inc. bought 30% of the outstanding common stock of Quality, Inc. for $56 million cash. At the date of acquisition of the stock, Quality's net assets had a book value and fair value of $120 million. Quality's net income for the year ended December 31, 2011, was $30 million. During 2011, Quality declared and paid cash dividends of $10 million. On December 31, 2011, Germane should report investment revenue of:

A. $3 million.
B. $9 million.
C. $30 million.

Check AnalystNotes for the correct answer and a detailed explanation.

Practice Question 4

When applying the equity method, an investor should report dividends from the investee as:

A. Dividend revenue.
B. A reduction in the investment account.
C. An increase in the investment account.

Check AnalystNotes for the correct answer and a detailed explanation.

Practice Question 5

Western Manufacturing Company owns 40% of the outstanding common stock of Eastern Supply Company. During 2011, Western received a $50 million cash dividend from Eastern. What effect did this dividend have on Western's 2011 financial statements?

A. Total assets decreased.
B. Net income increased.
C. The investment account decreased.

Check AnalystNotes for the correct answer and a detailed explanation.

Practice Question 6

Which of the following is not a disclosure required under the equity method?

A. The accounting policies of the investor related to investments.
B. The difference between the amount in the investment account and the amount of underlying equity in the investee's net assets.
C. The name of the investor and the percentage of ownership.
D. The aggregate value of each identified investment based on quoted market price.

Check AnalystNotes for the correct answer and a detailed explanation.

Practice Question 7

Which of the following statements best describes why minority active investments are not marked-to-market?

A. The investor company consolidates minority active investments, and the investment amount is not shown on the balance sheet.
B. The investor company is generally not interested in selling the investment, and financial statement users are presumed to be less interested in the investment's fair value.
C. Minority active investments are less than 20%, and the mark-to-market procedure is not required under GAAP.

Check AnalystNotes for the correct answer and a detailed explanation.

Practice Question 8

Which statement is true?

I. In the equity method, if there is a difference between the cost of the acquisition and investor's share of the fair value of the net identifiable assets, the difference should be reported as goodwill as a separate item.
II. Equity method investments are subject to review for impairment.

Check AnalystNotes for the correct answer and a detailed explanation.

Practice Question 9

The equity investment is carried at:

A. cost + its share of posy-acquisition income - dividends received.
B. cost + its share of posy-acquisition income + dividends received.
C. cost - its share of posy-acquisition income + dividends received.

Check AnalystNotes for the correct answer and a detailed explanation.

Practice Question 10

Regarding impairment, which statement(s) is/are true?

I. The equity method requires the goodwill to be separately tested for impairment.
II. IFRS allows the reversal of impairment losses when the fair value later increases and there are some objective evidences.
III. Under U.S. GAAP, the impairment loss is recognized in the other comprehensive income of the stockholders' equity section.

Check AnalystNotes for the correct answer and a detailed explanation.

Practice Question 11

Marketable equity securities carried as long-term investments and representing less than 50 percent but more than 20 percent of the voting stock are:

A. treated the same as current marketable securities, but are valued and reported as a separate portfolio.
B. valued at lower-of-cost-or-market, with changes in value reflected in net income.
C. accounted for under the equity method, unless there is evidence of inability to exercise significant influence over the trustee.

Check AnalystNotes for the correct answer and a detailed explanation.

Practice Question 12

When an investor company owns 25% of an investee company's common stock, the investor is aid to have:

A. A controlling interest over the investee company.
B. A significant influence over the investee company.
C. A minor influence over the investee company.

Check AnalystNotes for the correct answer and a detailed explanation.

Practice Question 13

On January 2, 2011, Garner, Inc. bought 30% of the outstanding common stock of Moody, Inc. for $60 million cash. At the date of acquisition of the stock, Moody's net assets had a book value and fair value of $180 million. Moody's net income for the year ended December 31, 2011, was $30 million. During 2011, Moody declared and paid cash dividends of $6 million. On December 31, 2011, Garner's investment account should have a balance of:

A. $60.0 million.
B. $67.2 million.
C. $69.0 million.

Check AnalystNotes for the correct answer and a detailed explanation.

Practice Question 14

An ownership interest of 30% of the common stock of another corporation should be accounted for using the

A. consolidated method.
B. cost method.
C. equity method.

Check AnalystNotes for the correct answer and a detailed explanation.

Practice Question 15

Under the equity method, unrealized holding gains (losses) are

A. reported as a separate component of stockholders' equity.
B. part of net income.
C. not recognized.

Check AnalystNotes for the correct answer and a detailed explanation.

Practice Question 16

Under the equity method, the investment account is decreased by all of the following except the investor's proportionate share of

A. dividends paid by the investee.
B. declines in the fair value of the investment.
C. the losses of the investee.

Check AnalystNotes for the correct answer and a detailed explanation.

Practice Question 17

Under the equity method, if an investee company generates net income, the investor company:

A. Records its proportionate share of the net income as investment income.
B. Records its proportionate share of the net income as an increase in its investment account.
C. Records its proportionate share of the net income as an unrealized gain.

Check AnalystNotes for the correct answer and a detailed explanation.

Practice Question 18

Fairway Corporation owns 35% of the common stock of Tee Company. At the beginning of the year 2011, the balance of Fairway's "Investment in Tee" account was $100,000. During 2011, Tee Corp. earned $120,000 in net income and declared and paid $60,000 in total cash dividends. The market value of the Tee Company shares increased from $125,000 to $140,000 during the year.

How much income will Fairway Corporation record in 2011 related to its Investment in Tee Company?

A. $21,000.
B. $42,000.
C. $57,000.

Check AnalystNotes for the correct answer and a detailed explanation.

Practice Question 19

Fairway Corporation owns 35% of the common stock of Tee Company. At the beginning of the year 2011, the balance of Fairway's "Investment in Tee" account was $100,000. During 2011, Tee Corp. earned $120,000 in net income and declared and paid $60,000 in total cash dividends. The market value of the Tee Company shares increased from $125,000 to $140,000 during the year.

At what amount will the Investment in Tee Corporation account be reported on Fairway's 12/31/2011 balance sheet?

A. $142,000.
B. $140,000.
C. $121,000.

Check AnalystNotes for the correct answer and a detailed explanation.

Practice Question 20

Southern Corp. purchases an investment in Morton Inc. at a purchase price of $1million, representing 30% of the book value of Morton. During the year, Morton reports net income of $100,000 and pay dividends of $40,000. At the end of the year, the market value of Southern's investment is $1.2 million. The investment will be reported on Southern's balance sheet at:

A. $1 million.
B. $1.018 million.
C. $1.060 million.

Check AnalystNotes for the correct answer and a detailed explanation.

Practice Question 21

Southern Corp. purchases an investment in Morton Inc. at a purchase price of $1million, representing 30% of the value of Morton. During the year, Morton reports net income of $100,000 and pay dividends of $40,000. At the end of the year, the market value of Southern's investment is $1.2 million. Southern will report investment income of

A. $40,000.
B. $12,000.
C. $30,000.

Check AnalystNotes for the correct answer and a detailed explanation.

Practice Question 22

Southern Corp. purchases an investment in Morton Inc. at a purchase price of $1 million, representing 30% of the value of Morton. During the year, Morton reports net income of $100,000 and pay dividends of $40,000. At the end of the year, the market value of Southern's investment is $1.2 million. The unrealized gain of $200,000

A. Is not reflected on either the income statement or the balance sheet.
B. Is reported on the balance sheet only.
C. Is reported in other comprehensive income.

Check AnalystNotes for the correct answer and a detailed explanation.

Practice Question 23

If Investor Company acquires a 40% interest in Investee Company at book value, which of the following statements is true?

A. Investor Company will report the investment as an asset in the amount of $1,200.
B. Investor Company will report the investment account as an asset in the amount of $2,000.
C. Investor Company will report its investment at fair market value on the balance sheet date.

Check AnalystNotes for the correct answer and a detailed explanation.

Practice Question 24

Apex Corp. purchases an investment in Pinnacle, Inc. at a purchase price of $5 million, representing 40% of the book value of Pinnacle. During the year, Pinnacle reports net income of $600,000 and pay dividends of $200,000. At the end of the year, the market value of Apex's investment is $5.3 million. Apex will report the following income relating to this investment during the year:

A. $240,000.
B. $200,000.
C. $300,000.

Check AnalystNotes for the correct answer and a detailed explanation.

Practice Question 25

Merck's 2011 annual report contains the following note:

5. Affiliates Accounted for Using the Equity Method

Investments in affiliates accounted for using the equity method are included in other assets and were $2.0 billion on December 31, 2011. Dividends and distribution received from these affiliates were $572.2 million in 2011, $475.5 million in 2010 and $412.2 million in 2009.

Which of the following statements is true?

A. Merck reported $572.2 million of investment income during 2011.
B. The $2 billion refers to the market value of the investee companies.
C. The dividends received were accounted for as a reduction of the investment balance on Merck's balance sheet.

Check AnalystNotes for the correct answer and a detailed explanation.

Joint ventures.
Joint ventures are entities owned and operated by a small group of investors with shared common control. The definition of the joint venture is different under IFRS and U.S. GAAP.
  • IFRS defines three types of joint venture: jointly controlled operations, jointly controlled assets, and jointly controlled entities.
  • Under US. GAAP the term joint venture refers to a jointly controlled separate entity.
Both IFRS and U.S. GAAP require the equity method of accounting for joint ventures.

The proportionate consolidation method is an alternative to the equity method. It includes the proportional amount of each asset, liability, revenue and expense account of the subsidiary in the corresponding account of the parent. It better reflects the risk and return characteristics of proportionate ownership.

  • Balance sheet: Replace investment account with percentage owned of assets and liabilities of investee.
  • Income statement: Proportionate sales and expenses of investee reported.
Most financial ratios will change under this method because of the inclusion of additional reported amounts in the various numerators and denominators of the ratios.

Example

Assume the same pre-acquisition balance sheets for the investor and investee company. But instead of acquiring 100% of the outstanding common stock, assume that the investor only acquires 40% of the stock at its book value $1,200 ($3,000 book value of stockholders' equity x 40%). A comparison of the equity and proportionate consolidation methods is as follows:

* $7,000 + $1,200

Subsequent to purchase, the net income reported by the investor company will be the same under both methods. Under the equity method, the investor will report equity income equal to 40% of the net income of the investee company. Its sales and expenses will be unaffected. Under the proportionate consolidation method, the investor's sales and expenses will be increased by 40% of the investee company sales and expenses, yielding the same net income.

The effect on return on equity and its components is as follows:

The table presented above yields the following insights.

  • The equity method reports the same profit, but fewer sales, than the proportionate consolidation method. This results in a higher net profit margin. This will always be the case.
  • Since net income is the same under both methods and assets are higher under the proportionate consolidation method, ROA will be lower under the proportionate consolidation method as well.
  • Return on equity will be the same under both methods since income and equity are the same.
  • Leverage will be higher under proportionate consolidation since assets are higher and equity is the same.
  • Both the numerator and denominator change. As a result, the effect on total asset turnover is indeterminate.
Practice Question 1

Which statement is false for joint ventures accounting?

I. The U.S. GAAP does not permit the proportionate consolidation method.
II. IFRS recommends the proportionate consolidation method.

Check AnalystNotes for the correct answer and a detailed explanation.

Practice Question 2

Under both the equity method and the proportionate consolidation method:

I. The total sales and expenses are identical.
II. The total net assets are identical.
III. The total assets and liabilities are identical.
IV. The ratio analysis can be different.

Check AnalystNotes for the correct answer and a detailed explanation.

Practice Question 3

The proportionate consolidation method:

A. Results in lower net income than the equity method.
B. Results in recording minority interest for investment of less than 100% of the outstanding common stock.
C. Results in the same net income as the equity method.

Check AnalystNotes for the correct answer and a detailed explanation.

Practice Question 4

If Investor Company, by issuing new stocks, acquires a 30% interest in Investee Company at book value, under the proportionate consolidation method, Investor Company will report total assets of

A. $20,500.
B. $19,000.
C. $24,000.

Check AnalystNotes for the correct answer and a detailed explanation.

Practice Question 5

The proportionate consolidation method:

A. Results in higher reported net income than the equity method.
B. Results in lower net income than the equity method.
C. Results in the same net income as the equity method.

Check AnalystNotes for the correct answer and a detailed explanation.

Practice Question 6

If Investor company, by issuing new stocks, acquires a 30% interest in Investee company at book value, under the proportionate consolidation method, Investor Company will report total assets of

A. $20,500.
B. $19,000.
C. $24,000.

Check AnalystNotes for the correct answer and a detailed explanation.

Practice Question 7

The equity method

A. Results in a higher net profit margin than the proportionate consolidation method.
B. Results in a higher return on equity than the proportionate consolidation method.
C. Results in higher net income than the proportionate consolidation method.

Check AnalystNotes for the correct answer and a detailed explanation.

Practice Question 8

For the investor, which of the following is identical under the equity method and the proportionate consolidation method?

I. The total income.
II. The total assets recognized.
III. The net total assets recognized.

A. I and II.
B. I and III.
C. I, II and III.

Check AnalystNotes for the correct answer and a detailed explanation.

Business combinations.
A business combination is when separate entities or businesses are combined into one reporting entity. Under U.S. GAAP business combinations can be structured as mergers, acquisitions or consolidations.
  • In a merger, the acquirer takes 100% of the target company. Only one entity remains in existence.
  • An acquisition occurs when one entity acquires "control" over the net assets of another entity. Both entities continue as separate entities through a parent-subsidiary relationship.
  • A consolidation happens when two entities combine their resources and share the risk and rewards of co-ownership. Shareholders of two entities become shareholders of the combined entity.
IFRS makes no such distinction amongst business combinations.

The combined entity is required to publish consolidated financial statements. The two methods of accounting for a business combination are the acquisition method (which replaces the purchase method) and the pooling of interests method.

The fundamental difference between the two methods is the assumption made regarding whether there is a change in ownership as a result of the business combination.

  • The pooling of interests method is used when some business combination are assumed to merge the ownership interests of two entities, rather than transfer control from the stockholders of one entity to those of the surviving entity. The financial statements of the separate entities are added together at their historical book values.

  • The acquisition method accounts for a business combination as the acquisition of one company by another. As a result of the purchase, there is a change in the owners of the subsidiary. The change in ownership and the existence of a purchase price usually result in the revaluation of assets and liabilities at the acquisition date. That is, the assets and liabilities of the acquired company are received into the financial statements of the acquirer at their fair market values at the acquisition date.
Shareholders of the acquired company would recognize gain on the sale of the shares, so their preferences would be for the transaction to be treated as a pooling of interests, which was non-taxable to them.

In 2001 the FASB discontinued the acceptability of the pooling of interests method. A primary reason was the lack of comparability between the two methods. Keep in mind the combinations that were initiated before July 1, 2001 could still be accounted for using the pooling method.

The IFRS require that the acquisition (purchase) method should be used after March 2004.

Acquisition Method

Current IFRS and U.S. GAAP accounting standards require the use of the acquisition method to account for business combinations. The acquisition method treats the combinations as the purchase of one or more companies by another.

Balance Sheet:

  • Assets and liabilities acquired are recorded at their fair values.
  • Any excess of cost over fair value of net assets acquired is recorded as goodwill.

Income Statement:

  • The excess of cost over book value is depreciated or amortized to reduce future earnings.
  • Goodwill is not amortized but is tested annually for impairment.
  • The acquired company's earnings are included with the acquiring firm's only from the date of combination forward.
Other Issues

Goodwill

Goodwill is the excess purchase price after recognizing the fair market value of all identifiable net tangible and intangible assets acquired. Goodwill has an indefinite life and is not amortized but is evaluated at least annually for impairment. Impairment losses are reported on the income statement.

  • Initial recognition. If the acquisition is less than 100%, U.S. GAAP requires the noncontrolling interest to be measured at fair value (full goodwill), whereas IFRS provide the option for full or partial goodwill (measure the noncontrolling interest at the proportionate share of the acquiree's identifiable net assets).
  • Level of impairment testing for goodwill.
    • IFRS: Cash generating unit (CGU) - the lowest level to which goodwill can be allocated.
    • GAAP: Reporting unit - either a business segment or one organizational level below.
  • Calculating impairment of goodwill.
    • IFRS: One-step: compare recoverable amount of a CGU (higher of a) fair value less costs to sell and (b) value in use) to carrying amount.
    • GAAP: Two steps: 1. Compare FV of the reporting unit with its carrying amount including goodwill. If FV is greater than carrying amount, no impairment (skip step 2). 2. Compare implied FV of goodwill with carrying amount.
In-Process R & D

U.S. GAAP requires that in-process R&D (IPRD) of the target company should be expensed at the date of acquisition, which results in a large one-time charge. IFRS requires to identify IFRD as a separate asset with a finite life, or to include it as part of goodwill.

Minority Interests

If the acquiring company acquires less than 100%, minority (noncontrolling) shareholders' interests are reported on the consolidated financial statements (a separate line item in the equity section). However, IFRS and U.S. GAPP still differ on the measurement of noncontrolling interests.

Contingent Consideration

IFRS and U.S. GAAP classify contingent consideration as either a financial liability or equity.

Practice Question 1

Which of the following statements is/are true with respect to pronouncements related to business combinations?

I. Incomparability of financial statements under the old rules permitting two distinct methods of accounting for business combinations (acquisition and pooling) was corrected by making amortization of goodwill optional.
II. Under the new rules, impairment of goodwill is not accounted for because it does not affect the actual profit of the company.
III. Under GAAP, the use of the pooling method is prohibited for business combinations after June 30, 2001.
IV. Any goodwill acquired in previous acquisitions should continue to be amortized after the year 2001 for the continuity of the accounting practice.

Check AnalystNotes for the correct answer and a detailed explanation.

Practice Question 2

In accounting for a business combination, a bargain purchase exists when

A. purchase price > book value.
B. fair market value > purchase price.
C. fair market value < book value.
D. fair market value > book value.
E. fair market value < purchase price.

Check AnalystNotes for the correct answer and a detailed explanation.

Practice Question 3

On June 30th, 2009, Plum Corporation acquired the stock of Strawberry Company. Plum purchased for cash all 200,000 shares of Strawberry's common stock for $18 per share. On this date, the carrying value of Strawberry's net assets on their balance sheet was $2,500,000 and the fair market value of their plant assets exceeded its carrying value by $500,000. What amount of goodwill should Plum report on its 6/30/2009 balance sheet related to this transaction?

A. $0.
B. $500,000.
C. $600,000.

Check AnalystNotes for the correct answer and a detailed explanation.

Practice Question 4

Richardson, Inc. purchased 80 percent of Frankfort Enterprises at market value. At the acquisition date, Richardson's equipment had a market value of $380,000 and a book value of $250,000, while Frankfort's equipment had a market value of $82,000 and a book value of $60,000. What is the equipment account purchase differential included on the acquisition date consolidated balance sheet under the acquisition method?

A. $22,000.
B. $17,600.
C. $130,000.

Check AnalystNotes for the correct answer and a detailed explanation.

Practice Question 5

Able Manufacturing purchased 70 percent of Clark Enterprises. At the acquisition date, Able had common stock and retained earnings of $45,000 and $780,000, respectively. Clark had stock of $30,000 and retained earnings of $300,000. Under the acquisition method, what amount of stockholders' equity is eliminated when preparing the consolidated financial statements at the acquisition date?

A. $330,000.
B. $75,000.
C. $1,080,000.

Check AnalystNotes for the correct answer and a detailed explanation.

Practice Question 6

On September 1, 2009 Mountainview Company acquired all of the outstanding common stock of Ward Company in a business combination. Both companies have a December 31 year-end and have been operating for five years. Consolidated net income for the year ended December 31, 2009 should include:

A. 12 months of net income for Mountainview only.
B. 12 months of net income for Ward only.
C. no income for Mountainview or Ward.
D. 12 months of net income for both Mountainview and Ward.
E. 12 months of net income for Mountainview and 4 months of net income for Ward.

Check AnalystNotes for the correct answer and a detailed explanation.

Practice Question 7

Which of the following statements is false?

A. The acquisition method of accounting for business combinations is acceptable under both US and IASB GAAP.
B. The pooling method is acceptable under US GAAP in certain circumstances for new mergers and acquisitions.
C. The acquisition method records assets and liabilities of the acquired company at fair market value as of the date of acquisition.

Check AnalystNotes for the correct answer and a detailed explanation.

Practice Question 8

Which of the following statements comparing acquisition and pooling of interests methods is incorrect?

I. Acquisition method tends to report higher assets values than pooling because of the adjustment to market value and the recording of goodwill.
II. Acquisition method tends to report lower earnings than pooling because of the excess depreciation and amortization charges under purchase rules.
III. Depreciation charges will be greater under the acquisition method than under the pooling method over the remaining useful lives of the depreciable assets if the market values of depreciable assets exceed book values at the acquisition date.
IV. The future sale of any acquired company assets will normally produce a greater gain under the acquisition method since the assets are carried at lower pre-combination book value.

Check AnalystNotes for the correct answer and a detailed explanation.

Practice Question 9

Allocating too much value to depreciable / amortizable assets leads to:

I. higher assets.
II. higher future operating expense.
III. higher future cash flows.

Check AnalystNotes for the correct answer and a detailed explanation.

Practice Question 10

Under US GAAP, the ______ method should be used for acquisitions.

A. acquisition
B. pooling of interest
C. equity.

Check AnalystNotes for the correct answer and a detailed explanation.

Practice Question 11

Under IFRS, the pooling of interests method can be used to account for only:

I. mergers.
II. acquisitions.
III. statutory consolidation.

Check AnalystNotes for the correct answer and a detailed explanation.

Practice Question 12

The pooling method results in __________ than the acquisition method.

I. Greater depreciation expense.
II. Higher ROA.
III. Lower profit margin.
IV. Lower ROE.

Check AnalystNotes for the correct answer and a detailed explanation.

Practice Question 13

Which of the following statements is (are) true with respect to the effects of the various business combination accounting methods will have on the income statement?

I. The acquisition method, as per the U.S. GAAP version, distorts the growth in sales figure when comparing pre and post merger income statements.
II. Assuming that the fair market value of the acquired firm's net assets exceeds its book value, the acquisition method will result in higher future earnings than the pooling method.

Check AnalystNotes for the correct answer and a detailed explanation.

Practice Question 14

On March 31, Jumbo purchases 100% of Larz for $7,500,000 cash and 2,200,000 shares of Jumbo voting common stock (par value of $1). Jumbo's stock had a market value on March 31 of $40. Jumbo got 12,000,000 shares of Larz's voting common stock (par value $4) having a market value of $50 per share. Jumbo incurs $5,000,000 in direct combination costs and $3,500,000 in stock issuance costs. What is Jumbo's COST for this acquisition?

A. $95,500,000.
B. $99,000,000.
C. $104,000,000.

Check AnalystNotes for the correct answer and a detailed explanation.

Practice Question 15

Shaw Company has the following account balances:

Receivables: 100,000.
Inventory: 150,000.
Land: 100,000.
Building - net: 250,000.
Liabilities: 100,000.
Common stock: 100,000.
Additional paid-in capital: 150,000.
Retained earnings: 250,000.

Shaw's land has a fair market value of $200,000 while its building has a fair market value of $300,000. Shaw's liabilities have a fair market value of $75,000. Brooks Company obtains all of the outstanding shares of Shaw for $750,000 cash. In the financial statements prepared immediately after the business combination, what is the amount of goodwill?

A. $75,000.
B. $100,000.
C. $125,000.

Check AnalystNotes for the correct answer and a detailed explanation.

Practice Question 16

On December 31, 2008, Sam Company was merged into Paul Company. In carrying out the business combination, Paul Company issued 60,000 shares of its $10 par value common stock, with a fair market value of $15 per share, for all of Sam Company's outstanding common stock. The stockholders' equity section of the two companies immediately before the business combination was:

Assume that the transaction is accounted for as a purchase. On the December 31, 2009 consolidated balance sheet, the Additional Paid-In Capital account should be reported at

A. $400,000.
B. $300,000.
C. $500,000.

Check AnalystNotes for the correct answer and a detailed explanation.

Practice Question 17

Octopus has recently acquired Guppy. Octopus needs to consolidate the financial statements of the two companies that were released recently.

The following things are disclosed:

  • Octopus issued 20 million shares worth $250 million to pay for the acquisition.
  • Guppy's fixed assets are actually worth $350 million at market prices.
  • Guppy's current assets should be marked down by $10 million due to bad accounts which have not been fully covered, which the liabilities on Guppy's balance sheet are correctly valued.
  • Octopus uses a 10-year straight line depreciation with no salvage value, while Guppy uses a 15-year straight line depreciation with no salvage value.
Under the acquisition method, the asset turnover ratio of the combined entity will be ______ that under the pooling of interests method.

A. higher than.
B. lower than.
C. the same as.

Check AnalystNotes for the correct answer and a detailed explanation.

Practice Question 18

Lewis Corporation has owned 75% of the common stock of Clark Corporation throughout the year. What is the proper balance sheet presentation for Lewis' investment at year-end?

A. The investment account will be presented in the noncurrent asset section of the balance sheet as available-for-sale securities.
B. The investment account will be presented in the noncurrent asset section of the balance sheet according to the equity method.
C. The investment account will be eliminated, and consolidated financial statements will be presented.

Check AnalystNotes for the correct answer and a detailed explanation.

Practice Question 19

Stockholders' equity may contain all of the following components, except:

I. Minority interests in consolidated subsidiaries.
II. Employee Stock Option Plan accruals.
III. Minimum pension liability.
IV. Reinvested earnings.

Check AnalystNotes for the correct answer and a detailed explanation.

Practice Question 20

The acquisition method:

A. Reports higher stockholder's equity than the equity method.
B. Reports the same net income as the equity method.
C. Reports the assets relating to the investment at fair market value.

Check AnalystNotes for the correct answer and a detailed explanation.

Practice Question 21

Which of the following is NOT a condition that would be likely to prevent a U.S. parent company from exercising enough economic control over a foreign subsidiary's resources and financial operations to warrant consolidation?

A. Restrictions on transfers of property in the foreign country.
B. Restrictions on foreign exchange in the foreign country.
C. The U.S. company does not have the staff necessary to perform the consolidation.

Check AnalystNotes for the correct answer and a detailed explanation.

Practice Question 22

QuietKey acquired 100 percent of Lansing Corporation. At the acquisition date, QuietKey's machinery had a book and market value of $240,000 and $350,000, respectively, while Lansing's machinery had a book and market value of $100,000 and $125,000, respectively. Under the acquisition method, what amount is presented on the consolidated balance sheet for the machinery account at the acquisition date?

A. $475,000.
B. $240,000.
C. $365,000.

Check AnalystNotes for the correct answer and a detailed explanation.

Practice Question 23

Which of the following statements is false?

A. Goodwill is no longer amortized under both US GAAP and IFRS.
B. The pooling method results in greater depreciation expense than the acquisition method.
C. The pooling method fails to reflect the acquisition cost on-balance sheet.

Check AnalystNotes for the correct answer and a detailed explanation.

Practice Question 24

Assume Northern Communications acquires WorldTel in a stock transaction valued at $1,388 million. As of the acquisition date, the WorldTel reports the following balance sheet:

Current Assets: 318,000.
Land: 165,000.
Buildings (net): 419,000.
Equipment (net): 286,000.
Total assets: 1,188,000.

Northern is willing to pay the purchase price because it feels that land is undervalued by $90,000, equipment by $50,000, and it will realize synergies from the acquisition valued at $60,000.

Under the acquisition method, the investment will be recorded on Northern's balance sheet at

A. $1,328,000.
B. $1,248,000.
C. $1,388,000.

Check AnalystNotes for the correct answer and a detailed explanation.

Practice Question 25

Assume Northern Communications acquires WorldTel in a stock transaction valued at $1,388 million. As of the acquisition date, the WorldTel reports the following balance sheet:

Current Assets: 318,000.
Land: 165,000.
Buildings (net): 419,000.
Equipment (net): 286,000.
Total assets: 1,188,000.

Northern is willing to pay the purchase price because it feels that land is undervalued by $90,000, equipment by $50,000, and it will realize synergies from the acquisition valued at $60,000.

Which of the following statements is false under US GAAP?

I. WorldTel's land will initially be reported on the consolidated balance sheet at $255,000.
II. The excess of the purchase price over the book value of WorldTel's equipment ($50,000) will be depreciated in the consolidated income statement over its useful life.
III. The excess of the purchase price over the fair market value of the net assets acquired ($60,000) will initially be recorded as goodwill on the consolidated balance sheet.
IV. The recorded goodwill will be amortized on a straight-line basis over a period of up to 40 years.

A. II and IV.
B. I, III and IV.
C. IV only.

Check AnalystNotes for the correct answer and a detailed explanation.

Practice Question 26

Assume Northern Communications acquires WorldTel in a stock transaction valued at $1,388,000. As of the acquisition date (in 2008), the WorldTel reports the following balance sheet:

Current Assets: 318,000.
Land: 165,000.
Buildings (net): 419,000.
Equipment (net): 286,000.
Total assets: 1,188,000.

Northern is willing to pay the purchase price because it feels that land is undervalued by $90,000, equipment by $50,000, and it will realize synergies from the acquisition valued at $60,000.

Which of the following statements is false under US GAAP?

A. Consolidated expenses will be equal to the sum of the expenses of the individual companies plus the depreciation of the excess of the purchase price over the book value of the equipment only.
B. Consolidated expenses will be equal to the sum of the expenses of the individual companies plus the depreciation of the excess of the purchase price over the book value of the land and equipment.
C. Consolidated sales will be equal to the sum of the sales of both companies less any intercompany sales, and consolidated net income will equal the reported net income of the parent company only.

Check AnalystNotes for the correct answer and a detailed explanation.

Practice Question 27

Octopus Inc. acquires Target. Target has a book value of $25 million and a market value of $47.6 million. Octopus will pay $60 million in Octopus common stock to acquire all outstanding shares. Balance sheet information for Target includes:

If the acquisition method is used, goodwill will be recorded for:

A. $0.
B. $12.4 million.
C. $20.0 million.

Check AnalystNotes for the correct answer and a detailed explanation.

Practice Question 28

Under ______, the ______ method should be used for acquisitions.

I. IFRS, acquisition.
II. US GAAP, acquisition.
III. IFRS, pooling of interest.
IV. US GAAP, pooling of interest.
V. IFRS, acquisition / pooling of interest.
VI. US GAAP, acquisition / pooling of interest.

A. II and III.
B. I and II.
C. II and V.

Check AnalystNotes for the correct answer and a detailed explanation.

Practice Question 29

The acquisition method results in _______ than the pooling method.

I. Greater depreciation expense.
II. Higher ROA.
III. Lower profit margin.
IV. Lower ROE.

A. I and II.
B. I, III and IV.
C. III and IV.

Check AnalystNotes for the correct answer and a detailed explanation.

Practice Question 30

Assume that a U.S company properly accounted for an acquisition in 2011 using the pooling method. In general, the company's reported earnings in 2012:

I. Are unaffected by that accounting decision because pooling is not allowed.
II. Are higher than they would have been if acquisition method had been used.
III. Are lower than they would have been if acquisition method had been used.
IV. Are unaffected because that account decision impacts earnings only in the year of acquisition.

A. III and IV.
B. I and II.
C. II only.

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Practice Question 31

Which of the following statements is (are) true with respect to the effects of the various business combination accounting methods will have on the balance sheet?

I. If the acquiring company pays more than the fair market value of the acquired company, then the book value of the merged firm will be higher under the pooling method than it would be under the acquisition method.
II. U.S. GAAP allows the amortization of goodwill if the acquisition method is being used.
III. Only the pooling method requires that combined firm restate its pre-merger years' financial statements on a consolidated basis.

A. I and III.
B. III only.
C. II and III.

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Practice Question 32

Which of the following statements is (are) true with respect to the effects that the various acquisition methods will have on the various financial ratios?

I. During an inflationary period, the year in which the companies merge, the acquiring firm will see its profit margins decrease if it were to use the acquisition method as opposed to the pooling method.
II. If the acquired firm's financial leverage ratio is lower than that of the acquiring firm, then the interest coverage ratio on a post merger basis will be higher using the acquisition method as opposed to using the pooling method.
III. If the fair market value exceeds the book value of the acquired firm's net assets, then the asset turnover ratio of the consolidated firm will be lower under the acquisition method than it would be under the pooling method.
IV. If the fair market value exceeds the book value of the acquired firm's net assets, then the profitability ratios of the consolidated firm will be lower under the acquisition method than it would be under the pooling method.

A. I and IV.
B. III and IV.
C. I, III and IV.

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Practice Question 33

Which of the following statements is (are) true with respect to the acquisition method of accounting for business combinations?

I. The book value of the assets and liabilities of the acquired firm are combined with the book value of the acquiring firm.
II. The acquisition method is designed to maintain consistency in the reporting of financial statements by the acquirer both before and after a combination.
III. During the combination, if the acquired firm had some off-balance sheet items, they must now be explicitly recognized by the acquiring firm.
IV. During the combination, if the acquired firm had intangible assets such as in-process research and development, US GAAP mandates that this item be measured at fair value.

A. I and III.
B. III and IV.
C. II and III.

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Practice Question 34

Which of the following statements is (are) true with respect to the pooling method of consolidating businesses?

I. The pooling-of-interest method is no longer an option for companies reporting in accordance with U.S. GAAP.
II. When a merger of two businesses is involved, a clear distinction must be made as to which firm will be the acquirer and which will be the firm that's being acquired.
III. The market value of the assets and liabilities of the acquired firm is combined with the book value of the acquiring firm.
IV. After the business combination, the new entity must restate prior period financial statements as if it had always operated as combined entity.

A. I, II and III.
B. I, III and IV.
C. I and IV.

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Practice Question 35

Which of the following statements is (are) true with respect to constructing consolidated financial statements using the pooling method?

I. The equity of the target firm must be adjusted to reflect the purchase price paid by the acquiring company.
II. The acquiring company must record an amount for goodwill that's equal to what it paid for the acquiring company less the fair market value of the net assets of the acquired company.
III. Prior period results must be restated to reflect the financial situation as if the two firms had always been merged.
IV. If the acquired firm has any intangible assets, these items are first recognized in the consolidated balance sheet and then written off immediately.

A. III only.
B. I and III.
C. III and IV.

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Practice Question 36

Which of the following statements is (are) true with respect to constructing consolidated financial statements using the acquisition method?

I. There are no adjustments made to the acquiring company's asset and liability accounts during the consolidation.
II. The amount of goodwill is reported as part of the equity account of the acquiring company.
III. If the in-process research and development of the acquired firm has some value, the value would be recorded on the consolidated balance sheet and then simultaneously written off.
IV. The book value of the retained earnings of both firms is summed up without any adjustments.

A. I and III.
B. I and IV.
C. II and III.

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Practice Question 37

Lewis Corporation has owned 75% of the common stock of Clark Corporation throughout the year. What is the proper balance sheet presentation for Lewis' investment at year-end?

A. The investment account will be presented in the noncurrent asset section of the balance sheet as available-for-sale securities.
B. The investment account will be eliminated, and consolidated financial statements will be presented.
C. The investment account will be presented in the noncurrent asset section of the balance sheet according to the equity method.

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Practice Question 38

The acquisition method:

A. Reports the assets relating to the investment at fair market value.
B. Reports higher stockholder's equity than the equity method.
C. Reports the same net income as the equity method.

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Practice Question 39

Which of the following statements is (are) true with respect to the accounting treatment of intercorporate investments? Assume U.S. GAAP.

I. Minority interest would arise if less than 100% of a subsidiary is owned and the parent company uses the equity method of accounting.
II. If the parent owns less than 50% of a subsidiary, then the investment would be recorded in the parent's book using the lower of cost or market method.
III. The acquisition method is used if the parent owns more than 50% of the subsidiary.
IV. Regardless of the method of accounting method used, the parent's before tax cash flows should remain the same.

A. I, II and IV.
B. I, II and III.
C. III and IV.

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Variable interest and special purpose entities.
Thanks to Enron, special purpose entities (IFRS term) / variable interest entities (GAAP term) are household words. These entities aren't all bad though. They were originally (and still are) used to isolate financial risk.

Introduction

An SPE/VIE is an unique legal entity to be used for a specific purpose based on some set of financing or operating needs, such as leasing arrangements or project development activities. Structured financing is used to place assets and corresponding liabilities into this separate legal structure such as a trust, partnership, joint venture, or a corporation.

Examples:

  • General Motors created SPEs to redevelop closed factories with environmental problems.
  • Airlines created SPEs to hold airplane leases.
  • Mortgage companies used them to consolidate and sell mortgages to investors.
  • AOL Time Warner and Microsoft used SPEs to create synthetic leases (using sales-and-leasebacks through the SPEs).
  • GE used SPEs to resell credit card & trade receivables.
Rationales:
  • SPEs are created for specific tasks involving financial risks; for example, a SPE can have a higher credit rating (and lower interest rates) than the parent.
  • The financial risk of the sponsor may be limited to its investment or explicit recourse obligation in the SPE. In many instances, creditors of a bankrupt SPE cannot seek additional assets from the sponsor beyond what was invested or contracted for by that sponsor. In other words, the sponsor may not become the deep pockets for damages exceeding the assets of the SPE.
  • SPEs can be used for tax avoidance, such as synthetic leases.
  • Banks use SPEs to securitize pools of mortgages, credit card balances, accounts & other receivables - it generates cash & eliminates the receivables from the parent's books.
SPE Usage in the Past

To illustrate how an SPE was commonly used in the financial marketplace, consider the following example of a financial asset securitization. Typically, in these types of transactions the SPE was formed to facilitate the sale of specific financial assets belonging to the sponsor company. The assets were sold to the SPE and could include trade accounts receivable, equity securities, notes receivable, etc. A minimum 10% investment from an independent third-party investor was contributed, representing a legal equity ownership interest in the SPE.

In exchange for its investment, the third-party equity investor controlled the SPE activities and retained the substantial risks and rewards of its ownership in the SPE assets. For an SPE to be an arms length entity, not consolidated into the sponsor's financial statement, the third-party investor must bear the risk of its investment. If an investor contributed equity as a note payable to the SPE or secured the investment by a letter of credit, insurance or guarantee, the investment would not be considered "at risk". Once the 10% was established, the SPE then financed the remaining funds to acquire the financial assets from the sponsoring company by issuing debt and/or additional equity to institutional investors or public shareholders.

As long as the specific qualifications were met, the assets and the corresponding debt and equity of the SPE achieved off-balance sheet treatment with respect to the sponsor's financial statements. Further, if the SPE had no indebtedness other than the asset-secured loan and routine trade payables, the SPE was unlikely to become insolvent as a result of its activities being limited. Therefore, in financial asset securitizations, SPEs provided the sponsor the ability to legally isolate a group of assets from the sponsor's bankruptcy risk and to reflect the transfer of financial assets as a sale in its financial statements.

The New Rules

The key component of SPE analysis is determining when they have to be consolidated in the financial statements rather than off-balance-sheet and unreported.

  • IAS 27 now requires the consolidation if the SPE is controlled by the sponsor. However, there is no explicit guidance about the circumstance under which an SPE should be consolidated.

  • Under GAAP FIN 46R, the primary beneficiary of a VIE must consolidate it as its subsidiary regardless if how much of an equity investment it has in the VIE. In essence, companies that have the controlling financial interest of another entity through interests other than voting equity are required to consolidate the controlled entity, even though historically, voting equity interests have been the principal indicator of financial control.

    The U.S. GAAP used to allow for qualified SPEs (QSPEs) to avoid consolidation if the sponsor was not the primary beneficiary. QSPEs did not exist under IFRS.

Practice Question 1

In most cases, an equity qualifies as a VIE if equity at risk is less than ______ of total assets.

A. 5%.
B. 10%.
C. 20%.

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Practice Question 2

If the equity investors in an entity lack any of the characteristics below, the entity will be treated as a VIE. These characteristics are:

I. Decision making ability in the entity.
II. Voting rights.
III. The obligation to absorb the losses of the entity's assets and operations.
IV. The right to receive guaranteed rate of return.

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Practice Question 3

If variable interests predominate over voting interests,

A. The primary beneficiary should consolidate the controlled entity.
B. The equity investor should consolidate the controlled entity.
C. The financial statements of the entity should not be combined with those of other entities'.

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Practice Question 4

The party that has the voting rights in a VIE is usually called:

A. equity investor.
B. primary beneficiary.
C. variable interest investor.

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Practice Question 5

Which statement(s) is/are correct about the equity investor in a VIE?

I. They are typically provided a small rate of return by the entity.
II. They usually contribute substantial resources to enable the VIE to secure additional financing needed.
III. The equity at risk is usually less than 10 percent of total assets.

A. I and II.
B. I and III.
C. II and III.

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Practice Question 6

Which statement is correct?

I. A VIE's risk and rewards are distributed according to stock ownership.
II. The primary beneficiary, not the equity investor, is entitled to benefit from increases in the VIE's asset fair values.

A. I only.
B. II only.
C. Both I and II.

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