tango_gs

Proportionate consolidation is:

A) recommended under U.S GAAP for jointly controlled entities, but is not normally permitted under IFRS.

B) recommended under IFRS and U.S. GAAP for jointly controlled entities.

C) recommended under IFRS for jointly controlled entities, but is not normally permitted under U.S. GAAP.

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Recommended under IFRS for jointly controlled entities, but is not normally permitted under U.S. GAAP.

tango_gs

Which of the following methods is NOT considered U.S. GAAP?

A) Acquisition method.

B) Cost method.

C) Proportionate consolidation method.

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U.S. GAAP only recognizes the cost (as part of investmentes in financial assets), equity and acquisition methods. The proportionate consolidation is an analytical tool for analysts to evaluate joint venture entities properly, but it is not considered to be U.S. GAAP.

tango_gs

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

A) Under IFRS, one indication of control is when a sponsoring entity has a residual interest in the SPE.

B) According to U.S. GAAP, a variable interest entity (VIE) could be a SPE that has at-risk equity that is sufficient to finance its own activities without additional financial support.

C) According to U.S. GAAP, if a SPE is considered a VIE, it must be only consolidated by the entity that absorbs the majority of the risks.

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IFRS continues to use the term special purpose entity. The sponsoring entity must consolidate if it controls, “in substance,” the SPE. Indications of control include a sponsoring entity that:

• Benefits from the SPE’s activities.
• Has decision-making rights to receive benefits from the SPE.
• Absorbs the risks and rewards of the SPE.
• Has a residual interest in the SPE.

Under U.S. GAAP rules, a VIE could include a SPE that has at-risk equity that is insufficient to finance the entity’s activities without additional financial support.

If a SPE is considered a VIE, it must be consolidated by the primary beneficiary. The primary beneficiary is the entity that absorbs the majority of the risks OR receives the majority of the rewards.

tango_gs

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) $300,000.

B) −$200,000.

C) $600,000.

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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 6, LOS 22.b)

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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 acquisition method in its treatment of minority interest.

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A proportionate consolidation is not a provision of U.S. GAAP, although it has been adopted under IFRS. 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 6, LOS 22.b)

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If Flitenight were to account for its Rocky Mountain investment as an investment in financial assets 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) Only income of $200,000.

C) Nothing, since the cost of the acquisition is not adjusted until the asset is sold.

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If Flitenight accounted for its Rocky Mountain investment as an investment in financial assets, 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 6, LOS 22.b)

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Under the acquisition method, minority interest is considered:

A) equity under IFRS and US GAAP.

B) equity under IFRS and a liability under US GAAP.

C) a liability under IFRS and US GAAP.

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Under the acquisition method, minority interest is now considered equity under IFRS and US GAAP. Prior to SFAS 160 minority interest was considered either a liability or a mezzanine(hybrid) item under US GAAP. (Study Session 6, LOS 22.c)

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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 correct and Matthews’ statement is correct.

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

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

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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 6, LOS 22.b)

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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 incorrect and Glen’s statement is incorrect.

C) Basten’s statement is correct and Glen’s statement is correct.

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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 equity), 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 6, LOS 22.b)

tango_gs

When comparing companies that hold equity investments in other corporations, which of the following statements is most accurate? All else being equal, leverage measures for a firm using proportionate consolidation will appear:

A) less favorable than those for a comparable firm using consolidation, and less favorable than those for a comparable firm using the equity method.

B) more favorable than those for a comparable firm using consolidation, and less favorable than those for a comparable firm using the equity method.

C) less favorable than those for a comparable firm using consolidation, and more favorable than those for a comparable firm using the equity method.

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All else being equal, leverage measures for a firm using proportionate consolidation will appear more favorable than those for a comparable firm using consolidation, and less favorable than those for a comparable firm using the equity method. This is because the choice of accounting method will affect the value of the liabilities on the balance sheet, while the level of book equity remains the same.

tango_gs

When comparing companies that hold equity investments in other corporations, which of the following statements is most accurate? All else being equal, net profit margin measures for a firm using proportionate consolidation will appear:

A) less favorable than those for a comparable firm using consolidation, and less favorable than those for a comparable firm using the equity method.

B) more favorable than those for a comparable firm using consolidation, and less favorable than those for a comparable firm using the equity method.

C) less favorable than those for a comparable firm using consolidation, and more favorable than those for a comparable firm using the equity method.

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All else being equal, net profit margin measures for a firm using proportionate consolidation will appear more favorable than those for a comparable firm using consolidation, and less favorable than those for a comparable firm using the equity method. This is because the choice of accounting method will affect the level of sales, while the level of net income remains the same.

tango_gs

When comparing companies that hold equity investments in other corporations, which of the following statements is most accurate? All else being equal, return on asset measures for a firm using proportionate consolidation will appear:

A) more favorable than those for a comparable firm using consolidation, and less favorable than those for a comparable firm using the equity method.

B) less favorable than those for a comparable firm using consolidation, and less favorable than those for a comparable firm using the equity method.

C) less favorable than those for a comparable firm using consolidation, and more favorable than those for a comparable firm using the equity method.

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All else being equal, return on asset measures for a firm using proportionate consolidation will appear more favorable than those for a comparable firm using consolidation, and less favorable than those for a comparable firm using the equity method. This is because the choice of accounting method will affect the level of book assets, while the level of net income remains the same.

tango_gs

Which of the following methods of accounting for investments will reflect the highest assets and liabilities on a company’s balance sheet?

A) Acquisition method.

B) Equity method.

C) Both methods result in reporting the same balances for assets and liabilities.

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The consolidation method will reflect the highest assets and liabilities. The equity method would reflect the lowest.

tango_gs

Which of the following methods of accounting for investments will reflect the highest assets and liabilities on a company’s balance sheet?

A) Acquisition method.

B) Equity method.

C) Both methods result in reporting the same balances for assets and liabilities.

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The consolidation method will reflect the highest assets and liabilities. The equity method would reflect the lowest.

tango_gs

Which of the following methods of accounting for investments will reflect the highest net income on a company’s income statement?

A) Both methods report the same net income.

B) Acquisition method.

C) Equity method.

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Both methods will report the same net income