tango_gs

A company reports an intercorporate investment using the acquistion method. Which of the following statements is most accurate?

A) The use of the acquistion method by a company will generally report the most favorable results.

B) The use of the proportionate consolidation method by a company will generally report the most favorable results.

C) The use of the acquistion method by a company will generally report the least favorable results.

---

The equity method will provide the most favorable results, while the acquistion method will provide the least favorable results.

tango_gs

Milburne Company purchased 1,000 shares of Marino Co. for $20 per share on January 1. By December 31, shares of Marino were trading at $15 per share in the open market. Marino Co. has 100,000 shares outstanding with a dividend yield of 2% at year end. Milburne plans to hold the shares of Marino for longer-term investment and liquidity purposes. The impact of the Marino holding on the Milburne income statement is:

A) -$4,700.

B) -$5,000.

C) $300.

---

These securities are to be classified as available for sale and hence, all unrealized gains and losses are posted to a securities valuation reserve on the balance sheet. Hence, the only income statement impact is the $300 dividend = 0.02 × $15 × 1,000.

tango_gs

Milburne Company purchased 1,000 shares of Marino Co. for $20 per share on January 1. By December 31, shares of Marino were trading at $15 per share in the open market. Marino Co. has 100,000 shares outstanding with a dividend yield of 2% at year end. Milburne plans to hold the shares of Marino for near-term trading purposes. The impact of the Marino holding on the Milburne income statement is:

A) -$4,700.

B) -$5,000.

C) $300.

---

Since these securities are to be classified as trading securities, both the dividend received and the unrealized loss are posted to the income statement. The dividend is computed as 0.02 × $15 × 1,000 = $300 whereas the unrealized loss is $5,000 = ($15 - $20) × 1,000. The net income statement impact is $300 - $5,000 = -$4,700.

tango_gs

On December 31, 2008 Company P invests $5,000 in Company S in exchange for 25% of the company. During 2009, Company S earns $2,000 and pays a dividend of $500. If Company P uses the equity method of accounting, what values will be reported on the balance sheet and income statement? How much cash will be recognized from the investment?

Balance Sheet

Income Statement

Cash

A) $5,500 $0 $0

B) $5,375 $125 $125

C) $5,375 $500 $125

---

The carrying value on the balance sheet is $5,375, the income statement will show $500 of income, and the cash recognized is equal to the dividend of $125.
Using the equity method, for 2008, Company P will:

• Recognize $500 ($2000 × 0.25) on its income statement as equity in the net income of Company S.
• Increase the investment in the Company S account on the balance sheet to $5,500, reflecting its share of the net assets of Company S.
• Receive $125 in cash dividends from Company S and reduce its investment in Company S by that amount to reflect the decline in the net assets of Company S due to the dividend payment.

At the end of 2008, the carrying value of Company S on Company P’s balance sheet will be ($5,000 original investment + $500 proportional share of Company S earnings – $125 dividend received = $5,375).

tango_gs

Fiduciary Investors held two portfolios of marketable equity securities:

• $50 million in Portfolio A was accounted for as available-for-sale.

• $50 million in Portfolio B was accounted for as trading securities.

Assume that Fiduciary reclassified securities ($10 million carrying value, $8 million market value) from Portfolio B into Portfolio A under U.S. GAAP. If no previous write downs were made, Fiduciary must:

A) charge $2 million to the equity section of its balance sheet.

B) do nothing to its income statement or equity section of its balance sheet.

C) charge $2 million to its income statement.

---

U.S. GAAP allows investment managers some latitude in reclassifying investment assets from “trading” to “available-for-sale.” Unrealized gains and losses are recognized on the income statement. IFRS severely restricts reclassification out of the held-for-trading category.

tango_gs

The Anderson Company acquired 100,000 shares of the Birschbach Company on January 1, 2000, at $25 per share. The market price of a share of Birschbach stock on December 31, 2000, was $35 per share. During 2000, Birschbach paid dividends of $1.50 per share and had earnings of $2.50 per share.If Anderson Company accounts for the Birschbach Company shares using the equity method, the carrying amount of these shares on Anderson's balance sheet at the end of 2000 is:

A) $2.6 million.

B) $2.5 million.

C) $3.5 million.

---

Under the equity method market value is ignored so the carrying value of the shares is the original investment + proportional share of earnings − dividend received.
[(100,000)($25)] + [(100,000)($2.50 − 1.50)] = $2,600,000

---

For the year 2000, the investment income that Anderson Company reports on its investment in Birschbach Company shares, assuming it accounts for the shares as an available-for-sale investment, is:

A) $150,000.

B) $250,000.

C) $100,000.

---

Under the available-for-sale accounting method unrealized gains and losses are not recognized on the income statement so the only impact on the income statement is the dividend received:
(100,000 shares)($1.50 per share) = $150,000

tango_gs

On December 15, 2009, the Zeisler Company faces a financial crisis. Zeisler’s industry has gone into recession and net income has declined to nearly zero. Jeremiah Welch, the company’s CFO, is extremely concerned that, when the final figures for 2009 come in, the poor operating results will throw the firm into violation of its debt covenants, which specify that it must meet a certain return on assets (ROA) and not exceed a certain debt-to-asset ratio. A violation of either covenant would trigger a provision in the lending agreement allowing lenders to put Zeisler’s debt back to the firm and likely force Zeisler into bankruptcy.
With only two weeks before the close of the firm’s fiscal year on December 31, there is no way to avoid bankruptcy through improved operations. Welch calls an emergency meeting with Olivia Dupree, the firm’s controller, to come up with a plan of action to keep Zeisler out of bankruptcy. He explains to Dupree that they need to increase Zeigler’s reported ROA and reduce its reported debt-to-assets ratio relative to the numbers that would otherwise be reported for 2009.
Dupree suggests that Zeisler’s equity investments might be useful in staving off bankruptcy. Zeisler acquired 100,000 shares of the Market Square Corporation on January 1, 2009, at $25 per share. Market Square paid dividends during 2009 of $1.50 per share and was expected to have earnings for 2009 of $2.50 per share. Zeisler also holds 250,000 shares of General Nuclear, purchased for $72 per share. General Nuclear has no dividends and is expected to report a loss for 2009. Both securities are classified on the financial statements as available-for-sale.
Dupree added that Zeisler also holds several million dollars of Market Square’s debt securities, classified as a held-to-maturity investment. The holding in Market Square represents a small fraction of Zeisler’s total fixed-income investments, all of which are also classified as held-to-maturity. The investment in Market Square’s debt differs significantly from Zeisler’s other investments in fixed-income securities in that Market Square’s debt is trading slightly above Zeisler’s cost while Zeisler’s other fixed-income investments are all trading significantly below Zeisler’s cost because of a general increase in market interest rates. Welch points out, however, that even if the firm were to sell all its marketable securities, the proceeds would not be sufficient to pay off the debt and avert bankruptcy.
Dupree left the meeting with Welch for a moment to check the stock market. She found that Market Square was trading at $35 per share and General Nuclear was at $43. This new information gave Dupree an idea.
Dupree suggested to Welch, “We could reclassify our equity investment in Market Square as trading before year-end. That will help raise our ROA for this year.” Welch pointed out that a reclassification of the equity investment from available-for-sale to trading would reduce Zeisler’s reported net income because the firm would be required to stop including the dividends it receives from Market Square in net income.
Welch suggested that, instead of reclassifying Market Square’s equity, they sell Market Square’s debt. That would reduce Zeisler’s debt-to-assets ratio because the unrealized gain in the market value of the Market Square debt would be realized when the security was sold. Dupree added that the firm could also liquidate the General Nuclear investment to raise cash without affecting the firm’s reported ROA for 2009. Welch and Dupree decided to liquidate the two assets to help improve the firm’s financial position.What is the investment income that Zeisler Company will report for the year 2009 on its investment in Market Square Corporation shares if it continues to account for the shares as an available-for-sale investment?

A) $200,000.

B) $150,000.

C) $250,000.

---

The investment income for available-for-sale securities includes dividends, interest, and realized gains. In this case, the investment income from Market Square Corporation would be the dividends it paid to the number of shares Zeisler owns:

100,000 shares × $1.50 per share = $150,000. (Study Session 6, LOS 22.c)

---

If Zeisler were to account for the Market Square Corporation shares as trading securities, assuming that the securities do not change in value between the December 15th meeting and the end of the year, the carrying amount of these shares on Zeisler's December 31, 2009 balance sheet would be:

A) $2.75 million.

B) $3.50 million.

C) $2.50 million.

---

Trading securities are carried at fair market value:
100,000 shares × $35 per share = $3,500,000. (Study Session 6, LOS 22.c)

---

If Zeisler reclassified the common stock of General Nuclear as a trading security, what effect would it have on Zeisler’s 2009 income statement?

A) Net income would increase.

B) Reclassifying the security would have no effect on the income statement because gains and losses would be recognized in equity.

C) Net income would decline.

---

Reclassifying a security from available-for-sale to trading requires unrealized gains and losses to be recognized in income. Since Zeisler’s investment in General Nuclear has an unrealized loss, net income would be reduced. (Study Session 6, LOS 22.c)

---

Regarding the statements made by Dupree and Welch about reclassifying Zeisler’s equity investment in Market Square to trading:

A) Welch’s statement is correct; Dupree’s statement is incorrect.

B) Welch’s statement is incorrect; Dupree’s statement is correct.

C) Welch’s statement is incorrect; Dupree’s statement is incorrect.

---

Welch’s statement is incorrect because dividends and interest are recognized as income both when the securities are classified as trading and when they are classified as available-for-sale.
Dupree’s statement is correct. Reclassifying the securities from available-for-sale to trading will significantly raise Zeisler’s near-zero net income by allowing Zeisler to recognize the unrealized gain in income when the security is reclassified. It will have no material effect on asset value because the shares will be carried at fair market value as trading securities and were already carried at fair market value (with the net unrealized gain in equity) as available-for-sale securities. Even though it may appear that equity would decline by the amount of the unrealized gain if the securities were reclassified, the unrealized gain will flow through income in 2009 and thus return to equity. Consequently, reclassifying the equity securities of Market Square would help increase Zeisler’s ROA by raising net income and having little effect on assets. (Study Session 6, LOS 22.c)

---

If Zeisler were to account for the Market Square Corporation shares using the equity method, assuming that the securities do not change in value between the December 15th meeting and the end of the year, the carrying amount of these shares on Zeisler's December 31, 2009 balance sheet would be:

A) $2.60 million.

B) $2.75 million.

C) $3.50 million.

---

Under the equity method the market value of the stock is ignored but the proportionate share of the earnings are added to the original investment and the proportionate share of the dividends are subtracted from the earnings. Hence, we have the original investment + (earnings − dividends) = total value of the investment.
[(100,000 shares)($25)] + [(100,000 shares)($2.50 earnings − 1.50 dividend)] = $2,600,000. (Study Session 6, LOS 22.c)

---

Regarding the statements made by Welch about reclassifying Zeisler’s debt investment in Market Square to trading, and Dupree's statement on General Nuclear:

A) Welch’s statement is correct; Dupree’s statement is incorrect.

B) Welch’s statement is correct; Dupree’s statement is correct.

C) Welch’s statement is incorrect; Dupree’s statement is incorrect.

---

Welch’s statement is incorrect because accounting standards require a firm that sells a held-to-maturity security before maturity to carry its remaining held-to-maturity securities at market value instead of cost. Since the Market Square debt is the only fixed-income investment trading above Zeisler’s cost, and it represents only a small part of Zeisler’s total fixed-income portfolio, the net effect of selling the Market Square debt would be to reduce assets (not raise them) because it would require Zeisler to mark down all its other fixed-income investments. A decline in assets would effectively increase the debt to assets ratio.
Dupree’s statement is also incorrect. The investment in General Nuclear would be carried on the books at fair market value, with the unrealized loss in equity. Selling the asset and converting it to cash would not materially affect total assets. However, selling the General Nuclear shares would reduce net income because the realized loss would have to be recognized in income. Thus, the sale would reduce reported ROA. (Study Session 6, LOS 22.c)

tango_gs

On January 9, 2006, Company X paid $2,000,000 for 100,000 shares of stock in Company S. Originally the company intended on holding the securities for the foreseeable future. As of December 31, the stocks were valued at $2,200,000. In 2006, Company S had earnings per share of $0.90 and paid dividends per share of $0.20. In late December 2006, the company decided to place the securities in their active marketable securities portfolio.What is the impact of this change in status on the value of the assets of Company X?

A) $200,000.

B) $70,000.

C) $0.

---

The stocks were classified as debt and equity securities available for sale, but now they will be classified as debt and equity trading securities. However, although it will affect net income, the change in status will not impact the reported value of the assets. According to SFAS 115, securities transferred from available-for-sale to trading securities are transferred at fair market value and unrealized gains or losses would be included in income.

---

What is the impact of this change in status on the income and the stockholders' equity of Company X?

A) Stockholders' equity will rise by $200,000, but income will not change.

B) Income will rise by $200,000, but stockholders' equity will not change.

C) Income and stockholder's equity will rise by $200,000.

---

The stocks were classified as debt and equity securities available for sale, but now they will be classified as debt and equity trading securities. The gain would have been reported in the securities valuation account in the equity section and not on the income statement, but now will be reported as income.

tango_gs

Which of the following statements about proportionate consolidation and the equity method is least accurate?

A) In a proportionate consolidation, the analyst adds the investor's pro-rata share of each of the affiliate's asset and liability accounts to the historical cost financial statements of the investor.

B) The equity balance under a proportionate consolidation will differ from that of the equity method because the investor records his pro-rata share of the equity of the affiliate firm in a proportionate consolidation.

C) Total assets under proportionate consolidation will most likely exceed the total assets reported under the equity method.

---

The equity balance of the investor will remain unchanged irrespective of whether or not the equity method or proportionate consolidation is employed.

dirk01

Joseph Haggs, CFA, is an analyst working for Garvess Jones, a large publicly traded investment-baking firm. Haggs covers the Internet sector. Recently, one of the more successful companies Haggs covers, Simpson Corporation, made an aggressive move to acquire another Internet company, Bailey Corporation (BC). BC is a company specializing in graphics and animation on the World Wide Web and has 1,000,000 shares outstanding. Simpson also holds minimal investments in other technology companies both public and private. In 1999 Simpson saw an opportunity to substantially increase its share in BC. Simpson feels that their sophisticated animation can greatly improve Simpson's market share and sees an acquisition as an opportunity to expand their business. The relevant financial data are in the following tables.

Bailey Corporation
Selected Financial Data, Years Ended December 31
(in Thousands)
Item	1998	1999	2000
Sales	$50,000	$60,000	$70,000
Less: cost of goods sold (COGS)	37,000	43,700	47,250
Earnings before interest & taxes (EBIT)	13,000	16,300	22,750
Less: Interest	10,000	13,000	19,000
EBT	3,000	3,300	3,750
Less: Taxes	1,000	1,100	1,250
Net Income	$2,000	$2,200	$2,500
Dividends Paid	$1,000	$1,200	$1,500
Total Shares Outstanding	1,000,000

Simpson’s Purchase Transactions in BC’s Stock
Date	January 1, 1998	January 1, 1999	January 1, 2000
Number of Shares	10,000	290,000	700,000
Price per Share	10	11	15

Because this is the largest acquisition in Simpson's history, Mr. Haggs' supervisor has asked him to prepare a report for Garvess Jones' clients detailing the affects of the acquisition on Simpson's financial statements.Haggs wonders which accounting method Simpson uses to calculate the book value of the BC investment for the year ending December 31, 1999. Which is the correct method?

A) Acquisition method.

B) Equity method.

C) Investment in Financial Assets method.

---

When a company owns an influential but non-controlling interest in another company, commonly 20-50%, it must account for it under the equity method.

---

Haggs wonders which accounting method Simpson uses to calculate the book value of the BC investment for the year ending December 31, 1998. Which is the correct method?

A) Equity method.

B) Acquisition method.

C) Investment in Financial Assets method.

---

When a company owns a non-influential and non-controlling interest in another company the investment must be carried at cost. Simpson must carry its BC investment at cost for 1998.

---

Haggs wonders which accounting method Simpson uses to calculate the book value of the BC investment for the year ending December 31, 2000. Which is the correct method?

A) Acquisition method.

B) Equity method.

C) Pooling-of-interests method.

---

When a company's interest in another exceeds 50% it is considered to have controlling interest and must consolidate the financial statements.

---

Haggs wants to make sure that he assumes the proper accounting method when he does his analysis. The acquisition of BC stock will lead to Simpson's total net cash flow equaling which of the following for the year ending December 31, 1999?

A) $−3,190,000.

B) $−2,830,000.

C) $360,000.

---

Simpson paid a total of $−3,190,000 (290,000 shares × $11) however, they also received a dividend from BC of $360,000. For 1999 Bailey Corporation is paying $1.20 in dividends per share (1,200,000 / 1,000,000). As of December 1999, Simpson has purchased 300,000 shares of BC (= 290,000 + 10,000). So dividends received is 300,000 × $1.20 = $360,000. This will make the total cash flow for the year $−2,830,000.