Reading 21:Intercorporate Investments LOS d ～ Q64-66

accounting, statements, following, black, about

Q64. Which of the following statements about accounting for joint ventures is least accurate?

A) The proportionate consolidation method to account for joint ventures provides financial analysts with better financial information.

B) When using the equity method to account for a joint venture, it results in less than complete information for analysts about assets, liabilities, revenues, and expenses.

C) With proportionate consolidation, the parent company includes its proportionate share of assets, liabilities, and equity in the joint venture.

Q65. Michael Smith is an analyst at Valley Securities following the automotive industry. Universal Motors (UM) is a

large U.S. based automotive company and Smith currently has the company rated as a strong buy and comments

that it is an industry leader. His conclusion is primarily based on comparing the company to three other very large

U.S. automakers: National, Gemeni and Crystal. Smith has used a number of financial measures based solely on

data taken directly from the financial statements of these companies. Susan Stone, CFA, is Smith's supervisor

and has called his analysis into question, because various underlying factors may prevent a direct comparison of

UM to National, Gemeni and Crystal. She believes that adjustments to the financial data are necessary before a

meaningful analysis can be completed.

UM provides credit to its customers through a partially owned finance company, which it accounts for under the equity method. Gemeni provides financing through a wholly owned, consolidated subsidiary. Finance companies typically carry a higher level of debt relative to most other industries. Over the last five years, Crystal has made several large acquisitions that it financed through the issuance of new common stock and accounted for the acquisitions using the purchase method. UM has made no acquisitions in the last 15 years.

Stone believes that Smith's analysis is not valid because he has not properly taken into consideration the impact of Gemeni's wholly owned financing subsidiary, Crystal's acquisition history, and a foreign subsidiary owned by National.

Due to the recent economic boom and interest rates that are at historic lows, the wholesale prices of durable goods have been rising over the last five years, specifically new automobile prices that have risen at a rate of about 6.5% per annum. All of the car manufactures account for their inventories using first in, first out (FIFO) methods. Present management at each firm believes this method most accurately reflects the actual flow of their inventories and claim that it will not change in the foreseeable future.

Smith is having difficulty understanding why the debt-to-equity (D/E) ratios of UM and Gemeni are not directly comparable. Stone explains that Gemeni's D/E ratio will be different under the consolidation method than if it used the equity method. Which of the following most accurately describes the difference in the D/E ratio under the two methods? Under the consolidation method Gemeni's D/E ratio will be:

A) higher because Gemeni must include all of the finance company's assets and liabilities on it's balance sheet.

B) higher because Gemeni's finance company has a higher debt-to-equity ratio than Universal Motors' finance company.

C) lower because the finance company has a larger profit margin than Gemeni's automotive business.

Q66. Stone is also critical of Smith's direct comparison of the return on assets of UM and Gemeni. She explains that

the effect the consolidation of Gemeni's finance company will cause its return on assets to be different than under

the equity method used by UM. Which of the following most accurately describes the difference on return on

assets under the two methods? Under the consolidation method Gemeni's return on assets will be:

A) lower because net income is no different under the two accounting methods, and Gemeni must include all assets of the subsidiary on the balance sheet.

B) higher because the finance company has a higher profit margin than Gemeni's core business.

C) lower because falling interest rates increase the value of the finance company's assets but do not improve returns.