tango_gs

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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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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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)