LOS d, (Part 2): Analyze and contrast the earnings effects of using the cost method, equity method, consolidation method, and proportionate consolidation method on a company's financial statements and financial ratios.

1.Prior to 2002, company X had never made any acquisitions of other companies. However, on January 2, 2002, it went on a buying spree, purchasing 10 percent of company A for $10,000; 30 percent of company B for $20,000; 40 percent of company C for $80,000; and 70 percent of company D for $168,000.

Below are the balance sheets for the five companies (in thousands) just prior to the purchase.

The company accounts for the acquisitions based on typical ownership proportion guidelines. After the acquisitions, the total cash balance reported by company X will be:

A)  $162,000.

B)  $150,000.

C)  $112,000.

D)  $192,000.

2.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.

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

A)  $300,000.

B)  $900,000.

C)  -$200,000.

D)  $600,000.

3.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?

A)  Both are provisions of U.S. GAAP.

B)  Both report all of the affiliate’s liabilities on the parent’s balance sheet.

C)  Both report the same level of assets on the parent’s balance sheet.

D)  The proportionate consolidation method differs from the consolidation method in its treatment of minority interest.

4.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?

A)  Only a loss of $160,000.

B)  Both dividends received by Flitenight from Rocky Mountain and Flitenight’s share of Rocky Mountain’s earnings.

C)  Nothing, since the cost of the acquisition is not adjusted until the asset is sold.

D)  Only income of $200,000.

5.Which of the following statements about the consolidation method and the equity method is FALSE?

A)  Only capital flows between parent and investee (such as dividends) appear in the cash flows of the parent.

B)  Both result in the same net income.

C)  Both result in the same net worth.

D)  Both result in the same ROE.

答案和详解如下：

LOS d, (Part 2): Analyze and contrast the earnings effects of using the cost method, equity method, consolidation method, and proportionate consolidation method on a company's financial statements and financial ratios.

1.Prior to 2002, company X had never made any acquisitions of other companies. However, on January 2, 2002, it went on a buying spree, purchasing 10 percent of company A for $10,000; 30 percent of company B for $20,000; 40 percent of company C for $80,000; and 70 percent of company D for $168,000.

Below are the balance sheets for the five companies (in thousands) just prior to the purchase.

Company	X	A	B	C	D
Cash	400	10	20	30	40
Other assets	1,600	90	180	270	360
Total assets	2,000	100	200	300	400
Liabilities	300	40	80	120	160
Equity	1,700	60	120	180	240
Total	2,000	100	200	300	400

The company accounts for the acquisitions based on typical ownership proportion guidelines. After the acquisitions, the total cash balance reported by company X will be:

A)  $162,000.

B)  $150,000.

C)  $112,000.

D)  $192,000.

The correct answer was A)

Company X will treat the acquisition of company A using the cost method, the acquisitions of companies B and C using the equity method, and the acquisition of company D using the consolidation method. The investments in companies A, B, and C, will be reported, while company D's financial statements will be consolidated with company X. The cash balance will be the starting balance less the amount paid for the four acquisitions plus the cash balance for company D, which is 400,000 − 278,000 + 40,000 = 162,000.

2.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.

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

A)  $300,000.

B)  $900,000.

C)  -$200,000.

D)  $600,000.

The correct answer was D)

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.

3.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?

A)  Both are provisions of U.S. GAAP.

B)  Both report all of the affiliate’s liabilities on the parent’s balance sheet.

C)  Both report the same level of assets on the parent’s balance sheet.

D)  The proportionate consolidation method differs from the consolidation method in its treatment of minority interest.

The correct answer was D)

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.

4.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?

A)  Only a loss of $160,000.

B)  Both dividends received by Flitenight from Rocky Mountain and Flitenight’s share of Rocky Mountain’s earnings.

C)  Nothing, since the cost of the acquisition is not adjusted until the asset is sold.

D)  Only income of $200,000.

The correct answer was D)

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.

5.Which of the following statements about the consolidation method and the equity method is FALSE?

A)  Only capital flows between parent and investee (such as dividends) appear in the cash flows of the parent.

B)  Both result in the same net income.

C)  Both result in the same net worth.

D)  Both result in the same ROE.

The correct answer was A)

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).