Financial Reporting and Analysis【 Reading 22】Sample following, 2012, account, interest

tango_gs

Under which of the following is a minority interest account most likely to appear on the consolidated balance sheet?

• The acquisition method.
• Proportionate consolidation.

A) II only.

B) I only.

C) Both I and II.

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Proportionate consolidation is similar to a business acquisition, except the investor only reports the proportionate share of the assets, liabilities, revenues, and expenses of the joint venture. Since only the proportionate share is reported, no minority owners’ interest is necessary.

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Luna Life Insurance is a publicly traded corporation with total assets in excess of $500 million. Joy Manning, CFA, has served as Luna’s chief investment officer for the past decade. Recent poor performance of Luna investment portfolio has led to the formation of a special task force to review Luna’s investment holdings as well as its operating policies. The task force is composed of two current Luna board members (who are not employees of Luna) and three independent investment professionals. Their assignment is to thoroughly review Luna’s financial statements for evidence of impropriety or mishandling of corporate assets. The task force is expected to complete their review within one month and report back to Luna’s board of directors shortly thereafter. Luna’s most recent financial statements reflect approximately $200 million in various equity holdings and $100 million in debt instruments. A broad classification of the portfolio (in millions of $) as of December 31, 2006 is as follows:

	Held-to-Maturity	Available-for-Sale	Trading
Equity	$0	$125	$75
Debt	$50	$25	$25

In the footnotes, there is a reference to $10 million of available-for-sale securities that were transferred to the held-to-maturity portfolio last year. The securities were transferred at fair market value, and an unrealized loss of $1 million was included in that period’s income. Several members of the task force believe the transaction deserves further analysis to determine if the securities’ transfer between portfolios was executed in accordance with SFAS 115, “Accounting for Certain Investments in Debt and Equity Securities” as Manning has represented. Also, in 2006, Luna transferred $5 million of shares in ABC Corp from the available-for-sale portfolio to the trading portfolio. In association with this transaction, $1 million in unrealized gains were included in the year’s income. The task force observes that after the transfer, there are $2.5 million of ABC Corp remaining in the available-for-sale portfolio. Manning has stated that the firm’s desire to reduce exposure to the equity market was the reason for selling only a portion of the position in ABC Corp. In addition, the group is performing its own analysis on the impact of last year’s acquisition of a 20% stake in Instate, a regional provider of commercial insurance. Instate reported $15 million in earnings for the year ending December 31, 2006, and paid approximately $1 million in dividends. Manning directed Luna’s accountants to record the purchase using the equity method, and thus has included a proportional share of Instate’s net income for the year. The acquisition was effective as of January 1st of 2006, and operating results for the investment stake in Instate are incorporated into Luna’s 2006 financial statements. The group will perform basic analysis both with and without the operating results of Instate in order to better evaluate what financial impact the inclusion of Luna’s results had on Instate’s overall performance. With regard to the $50 million of debt securities currently classified as held-to-maturity on Luna’s financial statements:

A) they are carried at their amortized cost and cannot be sold prior to maturity except under unusual circumstances.

B) unrealized gains and losses are excluded from income but reported as a separate component of shareholders’ equity.

C) the cost method of accounting should be used on the income statement while the market method should be used on the balance sheet.

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When debt securities are classified as held-to-maturity, the company has both the intent and ability to hold them until they reach their respective maturities. Only under unusual, isolated circumstances can a company liquidate prior to maturity. Note that only debt securities can be classified as held-to-maturity; equity securities cannot. (Study Session 6, LOS 22.a)

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Although the appropriate classification of investments is determined at the purchase date, management can reevaluate the classifications at the end of each financial period and adjust accordingly. When transferring debt securities from the available-for-sale portfolio to held-to-maturity, which of the following rules is most likely in accordance with SFAS 115? Available-for-sale securities transferred to held-to-maturity are transferred at:

A) fair market value, and any unrealized gains or losses remain in equity but are subsequently amortized over the remaining life of the security.

B) fair market value, and any unrealized gains or losses are included in income in the period of transfer.

C) their amortized cost, and any unrealized gains or losses remain in equity but are subsequently amortized over the remaining life of the security.

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When transferring debt securities between portfolios, available-for-sale securities transferred to held-to-maturity are transferred at fair market value, and any unrealized gains or losses remain in equity but are subsequently amortized over the remaining life of the security. Note that this only applies to debt securities because equity securities cannot be classified as held-to-maturity. (Study Session 6, LOS 22.a)

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Analysts should be wary of which of the following equity transactions a company may use to manipulate its reported earnings to reflect a higher net income? A company can move shares that have appreciated in value from:

A) held-to-maturity to the trading portfolio.

B) trading to the available-for-sale portfolio.

C) available-for-sale to the trading portfolio.

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Because shares of the same company can be classified as separate investments, a company could move those securities with unrealized gains to the trading portfolio, and thus recognize the gains, while leaving those securities with unrealized losses in the available-for-sale portfolio. Equity shares cannot be classified as held-to-maturity. (Study Session 6, LOS 22.a)

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An intercorporate investment must typically meet which of the following set of guidelines in order to be reported under the equity method?

% ownership

Degree of influence

A) 20% - 50% significant influence

B) 20% - 50% no significant influence

C) Less than 20% no significant influence

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The parent-company must have at least 20% ownership and/or significant influence over the management of the affiliate. Over 50% ownership would require the consolidation method. (Study Session 6, LOS 22.a)

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Luna has recorded its investment in Instate utilizing the equity method of accounting for intercorporate investments. According to FASB, which of the following statements most accurately reflects the impact on an investor’s financial statements by using the equity method?

A) The investing firm can include a proportionate share of the investee’s income in its earnings, regardless of whether or not there are actual cash flows (i.e. dividends).

B) The investing firm will not make any adjustments to its financial statements to reflect its proportionate share of the investee’s net assets, but will reference the investment in the footnotes.

C) Market values can be compared with the carrying amount for analysis purposes, but only market values may be used in the financial statements.

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The proportionate share of the investee’s income is included in the parent’s income statement. Changes in the market value of the investee are not reflected in the investing firm’s income statement so long as the decline in value is not considered to be permanent. (Study Session 6, LOS 22.b)

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Suppose Luna had accounted for the Instate acquisition using the passive method for investments in financial assets rather than the equity method of accounting for intercorporate investments. Explain how the different methods would most likely impact Luna’s financial statements? Under the equity method, Luna will report:

A) lower net income than under the passive method for investments in financial assets.

B) higher interest coverage ratios and return on investment than under the passive method for investments in financial assets.

C) improved debt coverage than under the passive method for investments in financial assets.

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In this scenario where the investee reported positive earnings and paid out less than 100% of its earnings as dividends, the parent will report higher income, thus resulting in higher interest coverage ratios and return on investment. (Study Session 6, LOS 22.c)

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Company A acquired a 50% stake in Company T on January 1, 2003 by paying T’s shareholders $100,000 in cash. Pre-acquisition balance sheets for the two firms are presented below:

Balance Sheet
	Company A	Company T
Current assets	$400,000	$60,000
Fixed assets	600,000	100,000
Total	$1,000,000	$160,000
Current liabilities	$50,000	$ 30,000
Common stock	350,000	60,000
Retained earnings	600,000	70,000
Total	$1,000,000	$160,000

What are the post-acquisition balance sheet values for total assets for Company A under the equity and acquisition methods of accounting respectively?

A) $1,000,000 and $1,060,000.

B) $1,060,000 and $1,000,000.

C) $1,060,000 and $1,060,000.

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Using the equity method will result in a decrease of the current asset account to $300,000 because of the cash outflow. However, a new non-current asset called "Investment in Company T" will be added to the balance sheet. This amount will be $100,000, so the total assets will remain unchanged. Under acquisition, total assets will be $1,060,000 (400,000 + 60,000 + 600,000 + 100,000 – 100,000).

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Mashburn Company acquired 25% of the 100,000 outstanding shares of Humm Co. on January 1 for $250,000 in cash. Humm Co. earned $1 per share and had a dividend payout ratio of 40%. As of December 31, Humm Co. shares were trading in the open market at $12 per share. Calculate the income statement treatment of the Humm Co. investment as of December 31.

A) $75,000.

B) $10,000.

C) $25,000.

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Under the equity method, the investor recognizes its pro-rata share of the affiliate's income on the income statement. Since Mashburn owns 25,000 shares of Humm and Humm earned $1, the income statement impact of the investment is $25,000.

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On January 9, 2006, Company X purchased $1,000,000 of government bonds and 100,000 shares of stock in Company S for $2,000,000. They are the first marketable securities purchased in the company's history. The company intends on holding the stock for the foreseeable future and holding the bonds to maturity. As of December 31, the bonds were valued at $900,000, and the stocks were valued at $2,200,000. The bonds paid $50,000 of interest and the stocks paid $20,000 of dividends. In 2006, Company S had earnings per share of $0.90.The marketable securities balance amount shown on the balance sheet is:

A) $3,000,000.

B) $3,200,000.

C) $3,100,000.

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The bonds are classified as debt securities held-to-maturity and are valued at cost. The stocks are classified as debt and equity securities available for sale and are valued at market value.

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The impact of the marketable securities on net income is:

A) $270,000.

B) $70,000.

C) $140,000.

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The bonds are classified as debt securities held-to-maturity, and the income generated from them is $50,000. The stocks are classified as debt and equity securities available for sale, and although the increased value is reported as an asset, the gain is reported in the securities valuation account in the equity section and not on the income statement. The effect of the stocks on income is the $20,000 of dividends.

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Which of the following statements regarding asset securitizations and special purpose entities (SPEs) is most accurate?

A) When receivables are securitized, the sponsor reports the cash inflow as an investing activity in the cash flow statement.

B) If the sponsor has no recourse, then the transaction is nothing more than a collateralized borrowing.

C) The SPE usually issues debt to purchase receivables from the sponsor.

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SPEs are often created to securitize assets, usually receivables of the sponsor. Typically, the SPE issues debt to purchase the receivables from the sponsor and the debt is repaid as the receivables are collected.

When the receivables are securitized, the sponsor removes the receivables from the balance sheet and reports the cash inflow as an operating activity in the cash flow statement. If the sponsor still has recourse, the transaction is nothing more than a collateralized borrowing.

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James White is preparing for the Level II CFA exam and is concerned about his knowledge of accounting for marketable equity securities. He has the following data from a previous take-home assignment from his MBA program:

Security	Cost	2005 Value	2006 Value
ABC	$80	$75	$85
HIJ	$20	$30	$35
XYZ	$40	$20	$45

The portfolio includes 100 shares of each firm; the securities are classified as either held-to-maturity, available-for-sale, or trading securities.Which of the following statements regarding the income statement and balance sheet treatment of securities classified as held-to-maturity is most accurate? They are carried at:

A) cost on the balance sheet and coupon receipts are considered income.

B) fair market value on the balance sheet with unrealized gains and losses excluded from income and reported as a separate component of shareholders' equity.

C) cost on the balance sheet with unrealized gains and losses reported in income.

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Accounting standards require a company to classify its securities into categories based upon the company's intent relative to the eventual disposition of the securities.
One of these categories, held-to-maturity securities, is composed of debt securities which a company has the positive intent and ability to hold to maturity. These securities are carried at the cost on the balance sheet and coupon receipts are considered income.

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Which of the following statements regarding the income statement and balance sheet treatment of securities classified as available-for-sale is most accurate? They are carried at:

A) cost on the balance sheet and coupon receipts are considered income.

B) fair market value on the balance sheet with unrealized gains and losses reported in income.

C) fair market value on the balance sheet with unrealized gains and losses excluded from income and reported as a separate component of shareholders' equity.

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Accounting standards require a company to classify its securities into categories based upon the company's intent relative to the eventual disposition of the securities.
One of these categories, available-for-sale securities, may be sold to address the liquidity and other needs of a company. Debt and equity securities classified as available-for-sale are carried at fair market value on the balance sheet with unrealized gains and losses excluded from income and reported as a separate component of shareholders' equity.

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Which of the following statements regarding the income statement and balance sheet treatment of securities classified as trading securities is most accurate? They are carried at:

A) fair market value on the balance sheet with unrealized gains and losses reported in income.

B) cost on the balance sheet with unrealized gains and losses reported in income.

C) fair market value on the balance sheet with unrealized gains and losses excluded from income and reported as separate component of shareholders' equity.

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Accounting standards require a company to classify its securities into categories based upon the company's intent relative to the eventual disposition of the securities.
One of these categories, trading securities, is for debt and equity securities acquired for the purpose of selling them in the near term. These securities are measured at fair market value and are listed as current assets on the balance sheet. Unrealized and realized gains and losses are reported in income.

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If the securities are classified as trading securities the balance sheet value for the portfolio at year-end 2005 is:

A) $12,500, and record no gains or losses.

B) $12,500, and record an unrealized loss of $1,500.

C) $14,000, and record no gains or losses.

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The original portfolio cost was: $8,000 + $2,000 + $4,000 = $14,000
In 2005: $7,500 + $3,000 + $2,000 = $12,500
Thus we write the portfolio down by $1,500 and take an unrealized loss.

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If the securities are classified as trading securities the balance sheet value for the portfolio at year-end 2006 is:

A) $16,500, and record an unrealized gain over the past year of $2,500.

B) $16,500, and record an unrealized gain over the past year of $4,000.

C) $14,000, and record an unrealized gain over the past year of $2,500.

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The original portfolio cost was: $8,000 + $2,000 + $4,000 = $14,000
In 2005 the value of the portfolio was: $7,500 + $3,000 + $2,000 = $12,500
In 2006 the value of the portfolio was: $8,500 + $3,500 + $4,500 = $16,500
We write the balance sheet value up to current value and recognize an unrealized gain of $4,000

tango_gs

Evergreen Brothers is a large producer of bedding plants and shrubs that are sold to various retail nurseries and home improvement stores located across the western coast of the United States with approximately $85 million in annual sales. Evergreen grows its products at two facilities, one in Northern California and the other in the Southern part of the state. Each production facility currently distributes its products within an approximate 150 mile radius of its location. All aspects of the shipping and delivery of products have historically been provided by an independent, third-party distribution company.
Because of impressive growth in the company's sales over the past several years, management has decided to pursue plans to bring "in-house" the distribution of the company's products. They believe that the projected decreased freight costs as well as the increased efficiencies in more actively managing the distribution of their production should immediately yield increased profit margins. As an initial step, Evergreen has negotiated the price for ten delivery trucks, which could provide all distribution capacity needed for the company's Northern production facility for the upcoming season. Current plans are to continue the use of the independent distribution company for the needs of the firm's Southern facility for at least the next several years.
Under advice from the company's CFO, Evergreen has created a new special purpose entity (SPE), QuickTime, Inc., which will serve as the entity that will purchase the trucks from the dealer. The purchase will be financed through a combination of debt and equity, with the dealer lending 75% of the total cost. The loan is collateralized by both the trucks and Evergreen's guarantee of the debt, as required by the dealer.
Evergreen has arranged for an outside investor to provide the remaining 25% of the upfront costs of the equipment in exchange for 100% of QuickTime's nonvoting stock. In addition, the outside investor is guaranteed an 8% annual return for the life of the financing term. At the end of seven years, QuickTime will be liquidated and Evergreen will have the option of purchasing the equipment for its fair value at that time. The proceeds of the liquidation will be used to repurchase the outside investor's stock at par value. In the event that the liquidation value is insufficient to buy back the outside investor's stock, Evergreen has committed to fund the shortfall.
Management has given its tentative approval of the project and the proposed structure. Questions remain, however, as to the effect of the creation of QuickTime on Evergreen's financial statements. With the relatively recent issuance of FASB Interpretation No. 46(R), "Consolidation of Variable Interest Entities" (FIN 46(R)), the management of Evergreen has not had prior experience with the new consolidation requirements for SPEs.Which of the following statements regarding special purpose entities (SPEs) is least accurate?

A) An SPE can be established as one of several legal forms, such as corporations, partnerships, or trusts, but must establish separate management from that of the sponsor.

B) An SPE can be formed to isolate specific assets from the sponsor, thus lowering the cost of capital by protecting the assets of the SPE in the event the sponsor experiences financial distress.

C) In general, the equity investors in an SPE can expect to receive a limited rate of return on their investment in exchange for limited risk exposure.

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An SPE can take on one of many legal forms, but does not necessarily have to have separate management or employees from that of the sponsor.

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In exchange for providing lower-cost financing to an SPE, lenders typically require additional financial support from a sponsor, which may be in the form of additional collateral or guarantees. In return, the sponsor will typically receive which of the following risk and return profiles?

A) Pro-rata share of the actual risk and a pre-determined fixed rate of return on the project.

B) Pro-rata share of the actual risks and returns on the project.

C) Pro-rata share of the actual returns on the project and a pre-determined fixed level of risk on the project.

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By transferring the variability in the risk of a project to a sponsor, a lender can provide a lower cost of financing to the company that creates the SPE. In return, the sponsor will receive pro-rata profits or other residual interests in the project.

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According to FIN 46(R), if an SPE is to be considered a variable interest entity (VIE), it must meet which of the following conditions?

A) The total at-risk equity of the SPE is not sufficient to finance the entity's activities without additional subordinated financial support.

B) The SPE must be consolidated by the primary beneficiary, whose status as primary beneficiary is defined by the level of the firm's percentage of voting control.

C) The equity investors in the VIE must bear all of the SPE's risk up to a pre-determined level as outlined in the governing documents.

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To qualify as a VIE under FIN 46(R), any one of four conditions must be met, one of which is the presence of an insufficient at-risk equity investment.

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In order to be considered a VIE under FIN 46(R), an entity must meet certain conditions. Which of the following statements about QuickTime is most accurate? Under FIN 46(R), QuickTime is:

A) not considered a VIE because the outside investor does not have any decision making rights.

B) considered a VIE because the outside investor's capital contribution is not sufficient to finance QuickTime's operations.

C) considered a VIE because outside investors share the residual gains and losses at liquidation with Evergreen.

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The outside investor contributed 25% of the necessary capital, but this was not sufficient because the dealer additionally required Evergreen's guarantee in order to close the deal. This condition satisfies the requirements established by FIN 46(R) in order to be classified as a VIE.

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As outlined in FIN 46(R), the primary beneficiary of a VIE is that entity which meets which of the following conditions?

A) Holds the majority voting control of the VIE and shares management with the VIE.

B) Holds the majority voting control of the VIE and has separate management from the VIE.

C) Has exposure to the majority of the loss risks or receives the majority of the residual benefits of the VIE.

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Unlike past accounting treatments of VIEs where consolidation was based upon voting control, FIN 46(R) recognizes the primary beneficiary of a VIE as that entity that absorbs the majority of the risks and enjoys the majority of the benefits of the VIE. The primary beneficiary is required to consolidate the VIE on their financial statements.

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Assuming that QuickTime is considered a VIE in accordance with FIN 46(R), which of the following statements regarding the consolidation of QuickTime on Evergreen's financial statements is most accurate?

A) The truck dealer is supplying the financing for the majority (75%) of QuickTime's debt, so Evergreen may not consolidate QuickTime on its financial statements.

B) Because the outside investor holds only nonvoting stock, Evergreen holds the majority controlling financial interest in QuickTime and must consolidate QuickTime on its financial statements.

C) Evergreen is exposed to the majority of QuickTime's risks and rewards, so Evergreen must consolidate QuickTime on its financial statements.

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Before the issuance of FIN 46(R), consolidation was based upon possession of voting control of an entity. FIN 46(R) uses a risk/reward approach when determining which firm must consolidate the VIE on its financial statements. Since Evergreen is the sole entity exposed to variability in QuickTime's net income, as well asset value, QuickTime should be consolidated on their financial statements.

tango_gs

Which of the following statements about special purpose entities (SPE) are correct or incorrect?

Statement #1:	The sponsor usually maintains the decision-making power and voting control over the SPE.
Statement #2:	The equity owners of an SPE usually receive a rate of return that is tied to the performance of the SPE.

A) Both are incorrect.

B) Both are correct.

C) Only one is correct.

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Both statements are incorrect. The sponsor does not usually have voting control over the SPE; the activities of an SPE are specifically detailed in governing documents created at the origination of the SPE. The structure of the SPE transfers the risks and rewards from the equity owners to the variable interest owners. In return, the equity owners usually receive a fixed rate of return.

tango_gs

Maverick Incorporated formed a special purpose entity (SPE) to purchase and lease a 50,000 acre ranch. The SPE financed 95% of the purchase price with debt. The remaining 5% was financed with equity capital received from two separate independent investors. The lender would not make the loan without Maverick’s guarantee. How should Maverick treat the SPE in its financial statements if Maverick is the lessee?

A) No firm must consolidate the SPE.

B) Each equity investor must proportionately consolidate the SPE.

C) Maverick must consolidate the SPE.

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The 5% at-risk equity investment is not sufficient to support the activities of the SPE without Maverick’s guarantee. Thus, the SPE is considered a variable interest entity (VIE). Since Maverick is responsible for the guarantee, Maverick is the primary beneficiary and must consolidate the SPE.