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The proportionate consolidation method results in:

A)
different net income from the equity method.
B)
same equity as the cost method.
C)
same net income as the equity method.



The proportionate consolidation results in the SAME net income and equity as the equity method.

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The proportionate consolidation method will least likely achieve the same results as the consolidation method because:

A)
of the use of the equity method on the income statement.
B)
there are no minority interests.
C)
no joint ventures are included.



Proportionate consolidations and regular consolidations are the same except for the exclusion of minority interests in proportionate consolidations.

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Company A owns 40% of a joint venture, Jovent, Inc., and each company has reported the following information:

Information Statement Information

 

 

Company A

Jovent, Inc.

Revenues

$8,000

$2,000

Cost of goods sold

  2,400

    800

Selling and administration expenses

  1,600

    200

Interest expense

  1,000

    100

Balance Sheet Information

 

 

Company A

Jovent, Inc.

Cash

 $900

$300

Inventory

   700

  200

Accounts receivable

   800

  250

Plant and equipment

3,000

  600

Accounts payable

1,300

  200

Long-term debt

 

 

Additional information:  Company A purchases 20% of Jovent’s annual production, Jovent has an account receivable from Company A for $100, and both companies have a 40% tax rate.

Using the equity method, what will be the before tax income for Company A, including its equity from Jovent?

A)
$3,216.
B)
$3,000.
C)
$2,650.



The net income for Jovent must be calculated first in order to determine the equity in Jovent that will be included on Company A’s income statement.

Company A

Jovent, Inc.

Revenues

$8,000

$2,000

Equity in Jovent

216

--

Cost of goods sold

2,400

800

Selling and administration expenses

1,600

200

Interest expense

1,000

100

Earnings before tax

$3,216

$900

Tax

360

Net income

$540

Multiply Jovent’s net income by the equity ownership by Company A to get Company A’s equity in Jovent. (0.40)($540) = $216.


Using the proportionate consolidation method, what will be the total assets for Company A?

A)
$6,750.
B)
$5,900.
C)
$5,400.



Cash

$1,020

$900 + 0.40($300)

Inventory

780

$700 + 0.40($200)

Accounts receivable

860

$800 + 0.40($250 ? 100)

Plant and equipment

$3,240

$3,000 + 0.40($600)


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.



Stockholder’s equity will be unaffected by use of the proportionate consolidation method to account for joint ventures.

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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's finance company has a higher debt-to-equity ratio than Universal Motors' finance company.
B)
higher because Gemeni must include all of the finance company's assets and liabilities on it's balance sheet.
C)
lower because the finance company has a larger profit margin than Gemeni's automotive business.



Under consolidation, the D/E ratio will be higher, because the parent company must include the high amount of debt that the finance company has on their balance sheet. In this case UM, using the equity method, does not carry their finance company's debt on their balance sheet and, therefore, will have a lower D/E ratio than if it used the consolidation method.


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.



Net income is the same under both methods, but total assets are higher under the consolidated method because all of the finance company's assets must be included on the balance sheet of the parent.


Smith is starting to understand Stone's point. He now turns his attention to the interest coverage ratio of UM and Gemeni. Which of the following most accurately describes the difference in the interest coverage ratio under the consolidation method compared to the equity method? Under the consolidation method, Gemeni's interest coverage ratio will be:

A)
lower because earnings before interest and taxes (EBIT) will decrease under consolidation.
B)
higher because EBIT will increase greatly under the consolidation of the finance company.
C)
lower because interest expense will increase under consolidation.



Because of the higher debt level characteristic of finance companies, they typically have a higher interest expense. EBIT is likely to increase under the consolidated method, but the substantially higher interest expense will reduce the interest coverage ratio under consolidation.


Stone now asks Smith how Gemeni's accounts receivable turnover is affected under the consolidation method when compared to the equity method. Which of the following most accurately describes the difference on accounts receivable turnover under the two methods? Under the consolidation method, Gemeni's accounts receivable turnover will be:

A)
higher because reported sales will increase under consolidation.
B)
lower because reported sales will decrease under consolidation.
C)
lower because accounts receivables will be higher under consolidation.



Under the consolidation method, sales would increase. Note that the accounts receivable account of the subsidiary will also increase, but not as much as sales. This will cause the accounts receivable turnover ratio to be higher.

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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% 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% stake in Rocky Mountain Air Cargo (with an option to purchase 40% 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% 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% 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)
$600,000.
B)
$300,000.
C)
?$200,000.



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. (Study Session 5, LOS 21.b)


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 acquisition method and the proportionate consolidation method is most accurate?

A)
Both are provisions of U.S. GAAP.
B)
Both report all of the affiliate’s liabilities on the parent’s balance sheet.
C)
The proportionate consolidation method differs from the consolidation method in its treatment of minority interest.



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 the acquisition method except that the acquisition 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. (Study Session 5, LOS 21.b)


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)
Nothing, since the cost of the acquisition is not adjusted until the asset is sold.
C)
Only income of $200,000.



If Flitenight accounted for its Rocky Mountain investment using the cost method, in 2004 it would record on its income statement $200,000 (= $1 million × 0.2) in dividends. That method would not be a permissible choice for Flitenight, however, since it controls more than 20% of Rocky Mountain. (Study Session 5, LOS 21.b)


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

A)
Both result in the same net worth.
B)
Only capital flows between parent and investee (such as dividends) appear in the cash flows of the parent.
C)
Both result in the same net income.



Under the acquistion 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 acquistion method includes all cash flows of the subsidiary in the cash flow of the parent (with minority interest subtracted out). (Study Session 5, LOS 21.d)


Regarding Basten’s and Matthews’ statements about the gain/loss that Flitenight had at the end of 2004 on its investment in Rocky Mountain, which is most accurate?

A)
Basten’s statement is incorrect and Matthews’ statement is correct.
B)
Basten’s statement is correct and Matthews’ statement is correct.
C)
Basten’s statement is correct and Matthews’ statement is incorrect.



If Flitenight accounted for its Rocky Mountain investment using the equity method, the value of the investment as of December 31, 2004, would be: 

Flitenight’s original $10 million investment + (Flitenight’s share of Rocky Mountain’s 2003 earnings less dividends Flitenight received in 2003) + (Flitenight’s share of Rocky Mountain’s 2004 earnings less dividends Flitenight received in 2004). 

Since we know that Flitenight owns 20% of Rocky Mountain and consequently receives 20% of the dividends that Rocky Mountain pays, we can calculate: 

Value of Rocky Mountain on Flitenight’s books at the end of 2004 = 

$10 million + (0.20 × $3 million in 2003 earnings ? 0.20 × $1.5 million in 2003 dividends) + (0.20 × ?$800,000 in 2004 earnings ? 0.20 × $1 million in 2004 dividends) = 

$10 million + ($600,000 ? $300,000) + (?$160,000 ? $200,000) = 

$10,000,000 + $300,000 ? $360,000 = $9,940,000 

Basten’s statement is correct. 

On a cash basis, Flitenight spent $10 million to acquire its stake in Rocky Mountain, and received $500,000 (= $300,000 in 2003 dividends + $200,000 in 2004 dividends) in dividends over the two years. $500,000 in cash return on a $10,000,000 cash investment equals 5% over the two years. Matthews’ statement is also correct. (Study Session 5, LOS 21.b)


Regarding Basten’s and Glenn’s statements about the impact of Rocky Mountain on Flitenight’s 2005 balance sheet and cash flow statement, which is most accurate?

A)
Basten’s statement is incorrect and Glen’s statement is correct.
B)
Basten’s statement is correct and Glen’s statement is correct.
C)
Basten’s statement is incorrect and Glen’s statement is incorrect.



The equity method of accounting is used when the parent has significant influence over the investee but does not exercise control. The acquistion method is required when the parent controls, directly or indirectly, more than 50% of the voting stock.

Once Flitenight exercised its option to purchase the additional 40% of Rocky Mountain’s stock (for total ownership of 60%) on December 31, 2004, it could no longer use the equity method and had to switch to the acquistion method. In the acquistion method, Flitenight’s investment in Rocky Mountain is no longer listed as a separate asset on the balance sheet (all of Rocky Mountain’s assets and liabilities are combined with Flitenight’s, with the minority interest shown as a liability), so Basten’s statement is incorrect. In the acquistion method, parent company cash flows exclude those between parent and investee, so Glenn’s statement is also incorrect. (Study Session 5, LOS 21.b)

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