Question 3 - 8828

Rocky Mountain Air Cargo is a privately held commercial aviation company serving the western United States. It publishes financial statements in accordance with U.S. GAAP and uses a fiscal year that matches the calendar year.

Rocky Mountain was in good financial shape heading into 2003, with assets of $50 million at the beginning of the fiscal year. That year, it earned $3 million in net income and was easily able to maintain its traditional 50 percent dividend payout ratio. However, Rocky Mountain had a very difficult year in 2004, reporting a loss of $800,000. It managed to pay $1 million in dividends, but the decision to pay dividends in such a weak financial year further undermined the company’s fiscal stability.

Flitenight Air Lines, a publicly-traded aviation firm serving the central and Midwestern United States, wanted to expand its range of service by coordinating its flight schedule with airlines serving different geographic regions of North America. One of these airlines was Rocky Mountain Air Cargo.

To cement the relationship, Flitenight’s CEO, John “Bulldog” Basten, decided to make a significant investment in Rocky Mountain Air Cargo. He was easily able to convince both boards of the wisdom of the deal, and, in his usual brash style, personally negotiated the terms with his counterpart at Rocky Mountain, Buck Matthews. Flitenight Air Lines acquired a 20 percent stake in Rocky Mountain Air Cargo (with an option to purchase 40 percent more) for $10 million cash. The deal closed on January 1, 2003 and Flitenight accounted for the investment using the equity method.

Basten was not happy to find that he had invested right at the peak of Rocky Mountain’s profitability and wound up with a money-losing airline. He had a difficult conversation with Matthews in early 2005, complaining about the impact of the Rocky Mountain investment on Flitenight’s financials. Basten pointed out that he had a loss on his books: the original $10 million investment in Rocky Mountain was carried at only $9,940,000 on Flitenight’s December 31, 2004 balance sheet. Matthews countered that this was just an accounting entry: on a cash basis, Flitenight had a gain of 5 percent on its investment over the two years.

Matthews’ insistence that the investment had earned money for Flitenight did not sit well with Basten. Basten decided that Rocky Mountain was clearly being mismanaged and concluded it was time to gain control of the company.

Basten assured Neil Glenn, the Chairman of Flitenight’s board, that he could turn Rocky Mountain around. He promised Glenn that, in 2005, Rocky Mountain would once again achieve $3 million in earnings and a 50 percent payout ratio. “With those results,” Basten promised Glenn, “our asset accounts will value the Rocky Mountain investment at $10,240,000 on our December 31, 2005 balance sheet – so we’ll show a gain on our original investment.” Glenn was skeptical of anyone’s ability to turn the airline around so quickly. Even so, Glenn assured Basten, “If it takes you longer to turn it around, at least we’ll have the dividend income on our 2005 cash flow statements.”

Basten notified Matthews and Rocky Mountain’s board that Flitenight intended to exercise its option. At the direction of Basten and Glenn, Flitenight purchased the additional shares for cash and gained control of Rocky Mountain on December 31, 2004.

Part 1)
In 2003, Flitenight would reflect its investment in Rocky Mountain on its income statement by recording:

Part 2)
Since the coordination of flight schedules implies a stronger economic link between Rocky Mountain and Flitenight Air Lines than that implied merely by the ownership percentage, a proportionate consolidation is being considered. Which of the following statements regarding the consolidation method and the proportionate consolidation method is CORRECT?

Part 3)
If Flitenight were to account for its Rocky Mountain investment using the cost method instead of the equity method, Flitenight’s 2004 income statement would reflect its investment in Rocky Mountain by including which of the following?

Part 4)
Which of the following statements about the consolidation method and the equity method is FALSE?

Part 5)
Regarding Basten’s and Matthews’ statements about the gain/loss that Flitenight had at the end of 2004 on its investment in Rocky Mountain, which is CORRECT?

Part 6)
Regarding Basten’s and Glenn’s statements about the impact of Rocky Mountain on Flitenight’s 2005 balance sheet and cash flow statement, which is CORRECT?

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.