[LEVEL II 模拟试题4] Mock Level II - Question 3

Question

Part 1)
Your answer: B was correct!

Under the equity method, Flitenight would record $600,000 = ($3 million × 0.2) on its 2003 income statement as its share of Rocky Mountain's earnings. The dividends received by Flitenight are already included as part of its share of Rocky Mountain’s net income in the equity method.

Part 2)
Your answer: B was incorrect. The correct answer was C) The proportionate consolidation method differs from the consolidation method in its treatment of minority interest.

A proportionate consolidation is not a provision of U.S. GAAP, although it has been adopted in IAS 31. An analyst would perform a proportionate consolidation on a firm that is currently accounted for using the equity method if a stronger link exists between the two firms than is implied by the ownership percentage. A joint venture is a typical example in which a proportionate consolidation would be used.

A proportionate consolidation will lead to the same results as a normal consolidation except that the consolidation method reports minority interest in the financial statements and the proportionate consolidation method does not. In a proportionate consolidation, the parent's proportionate share of asset and liability accounts (net of intercorporate transfers) is simply added to the parent’s financials. Note that the equity accounts are not added together.

Part 3)
Your answer: B was incorrect. The correct answer was D) Only income of $200,000.

If Flitenight accounted for its Rocky Mountain investment using the cost method, in 2004 it would record on its income statement ($1 million × 0.2) = $200,000 in dividends. That method would not be a permissible choice for Flitenight, however, since it controls more than 20 percent of Rocky Mountain.

Part 4)
Your answer: B was correct!

Under the consolidation method and the equity method, net income, net worth and ROE are all the same. The equity method includes only capital flows between parent and investee in the cash flows of the parent, but the consolidation method includes all cash flows of the subsidiary in the cash flow of the parent (with minority interest subtracted out).

Part 5)
Your answer: B was incorrect. The correct answer was C) Basten’s statement is correct and Matthews’ statement is correct.

If Flitenight accounted for its Rocky Mountain investment using the equity method, the value of the investment as of December 31, 2004, would be: 

Flitenight’s original $10 million investment + (Flitenight’s share of Rocky Mountain’s 2003 earnings less dividends Flitenight received in 2003) + (Flitenight’s share of Rocky Mountain’s 2004 earnings less dividends Flitenight received in 2004). 

Since we know that Flitenight owns 20 percent of Rocky Mountain and consequently receives 20 percent of the dividends that Rocky Mountain pays, we can calculate: 

Value of Rocky Mountain on Flitenight’s books at the end of 2004 = 

$10 million + (0.20 x $3 million in 2003 earnings - 0.20 x $1.5 million in 2003 dividends) + (0.20 x -$800,000 in 2004 earnings - 0.20 x $1 million in 2004 dividends) = 

$10 million + ($600,000 - $300,000) + (-$160,000 - $200,000) = 

$10,000,000 + $300,000 - $360,000 = $9,940,000 

Basten’s statement is correct. 

On a cash basis, Flitenight spent $10 million to acquire its stake in Rocky Mountain, and received ($300,000 in 2003 dividends + $200,000 in 2004 dividends) = $500,000 in dividends over the two years. $500,000 in cash return on a $10,000,000 cash investment equals 5 percent over the two years. Matthews’ statement is also correct.

Part 6)
Your answer: B was incorrect. The correct answer was D) Basten’s statement is incorrect and Matthews’ statement is incorrect.

The equity method of accounting is used when the parent has significant influence over the investee but does not exercise control. Consolidation is required when the parent controls, directly or indirectly, more than 50 percent of the voting stock.

Once Flitenight exercised its option to purchase the additional 40 percent of Rocky Mountain’s stock (for total ownership of 60 percent) on December 31, 2004, it could no longer use the equity method and had to switch to the consolidation method. In the consolidation method, Flitenight’s investment in Rocky Mountain is no longer listed as a separate asset on the balance sheet (all of Rocky Mountain’s assets and liabilities are combined with Flitenight’s, with the minority interest shown as a liability), so Basten’s statement is incorrect. In the consolidation method, parent company cash flows exclude those between parent and investee, so Glenn’s statement is also incorrect.