In comparing reported financial results between the equity method and the consolidation method, which of the methods generally produces the highest leverage measures and the lowest return on assets (ROA), respectively?
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Highest leverage |
Lowest ROA |
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The consolidation method results in the highest leverage measures – compared to the equity method, total liabilities are higher and net equity is the same.
The consolidated method results in the lowest ROA – compared to the equity method, net income is the same and total assets are higher.
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:
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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.
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:
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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.
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:
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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.
Which of the following methods of accounting for investments will reflect the highest assets and liabilities on a company’s balance sheet?
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The consolidation method will reflect the highest assets and liabilities. The equity method would reflect the lowest.
Which of the following methods of accounting for investments will reflect the highest net income on a company’s income statement?
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Both methods will report the same net income.
A company reports an intercorporate investment using the consolidation method. Which of the following statements is most accurate?
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The equity method will provide the most favorable results, while the consolidation method will provide the least favorable results.
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:
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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.
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:
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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.
Fiduciary Investors held two portfolios for 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 transferred $10 million in trading securities from Portfolio B into Portfolio A. It was determined that subsequent to the transfer these securities had a market value of $8 million. If no previous write downs were made, Fiduciary must:
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Reclassifications allow investment managers latitude in transferring investment assets from “trading” to “available-for-sale,” thus realizing losses from the income statement to the equity section of the balance sheet.
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:
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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
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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
On December 15, 2004, 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 2004 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 2004.
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, 2004, at $25 per share. Market Square paid dividends during 2004 of $1.50 per share and was expected to have earnings for 2004 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 2004. 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 2004. 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 2004 on its investment in Market Square Corporation shares if it continues to account for the shares as an available-for-sale investment?
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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:
(Study Session 5, LOS 21.b)100,000 shares × $1.50 per share = $150,000.
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Trading securities are carried at fair market value:
100,000 shares × $35 per share = $3,500,000
(Study Session 5, LOS 21.b)
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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 5, LOS 21.b)
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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 2004 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 5, LOS 21.b)
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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 5, LOS 21.b)
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Welch’s statement is incorrect because SFAS 115 requires 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 5, LOS 21.b)
Pamelan Portfolios purchased 100,000 shares in Delta Corporation at a price of $10 per share on January 2, 2000. Assume that Pamelan follows U.S. generally accepted accounting principles (GAAP) and initially accounts for its trading investments at lower of cost or market in 2000. Delta is a domestic U.S. Corporation with all if its operations and sales in the U.S. Delta had the following subsequent share prices:
12/31/00 $8 per share
12/31/01 $5 per share
12/31/02 $10 per share
Delta Corporation experienced a fire in August 2001 that destroyed virtually all of its operations in the U.S. Pamelan’s management believes that this has seriously impaired the value of its investment by $3 per share when Delta’s Stock had a market value of $8 per share prior to the fire. Delta’s stock had halted trading for the remainder of the year.
If Pamelan were to account for its investment in Delta at the end of 2001, Pamelan would:
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Write downs are considered part of the normal course of business so they must be classified as an ordinary loss.
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Permanent impairments are not restorable under U.S. GAAP.
The cost per shares of $10
Less: the permanent impairment of $3
= $7 (the maximum value of write up)
OR
The cost of shares of $10
Less: the unrealized loss in 2000 of $2
Less: the permanent impairment of $3
Plus: the maximum market adjustment of $2 on unrealized loss
= $7 (the carrying value at 2002)
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Sale price of $11 less $7 (carrying value from part #3) = $4.
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?
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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.
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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.
The California Wines owns 40% of a joint venture, Western Vineyards. Vineyard's income statement for this period is as follows:
Revenues $10,000 Less: cost of goods sold (COGS) 7,500 Gross profit $2,500 Less: selling and administrative expenses 500 Operating income $2,000 Less: interest expense 500 Earnings before taxes $1,500 Less tax 600 Net income $900
California Wines purchases 30% of the output of Vineyard. The amount of revenues, COGS, and net income of Vineyard to be included in the California Wine's income statement under proportionate consolidation are, respectively:
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[(0.4)($10,000)] ? [(0.4)(0.3)($10,000)] = $2,800; [(0.4)($7,500)] ? [(0.4)(0.3)($10,000)] = $1,800; (0.4)($900) = $360.
Which of the following statements about proportionate consolidation and the equity method is FALSE?
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The equity balance of the investor will remain unchanged irrespective of whether or not the equity method or proportionate consolidation is employed.
Which of the following statements about proportionate consolidation is TRUE?
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The proportionate consolidation method is most appropriate when two firms have entered into a joint venture relationship but the investor accounts for the investment under the equity method because it owns between 20 and 50% of the outstanding shares of the JV. The proportionate consolidation method is used by analysts to better reflect the true economic linkage between the JV and the investor firm. The equity method provides nothing more than a "one-line" consolidation.
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.
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Bailey Corporation | |||
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Selected Financial Data, Years Ended December 31 | |||
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(in Thousands) | |||
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Item |
1998 |
1999 |
2000 |
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Sales |
$50,000 |
$60,000 |
$70,000 |
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Less: cost of goods sold (COGS) |
37,000 |
43,700 |
47,250 |
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Earnings before interest & taxes (EBIT) |
13,000 |
16,300 |
22,750 |
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Less: Interest |
10,000 |
13,000 |
19,000 |
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EBT |
3,000 |
3,300 |
3,750 |
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Less: Taxes |
1,000 |
1,100 |
1,250 |
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Net Income |
$2,000 |
$2,200 |
$2,500 |
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Dividends Paid |
$1,000 |
$1,200 |
$1,500 |
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Total Shares Outstanding |
1,000,000 | ||
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Simpson’s Purchase Transactions in BC’s Stock | |||
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Date |
January 1, 1998 |
January 1, 1999 |
January 1, 2000 |
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Number of Shares |
10,000 |
290,000 |
700,000 |
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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?
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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.
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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.
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When a company's interest in another exceeds 50% it is considered to have controlling interest and must consolidate the financial statements.
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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.
Assume that on the balance sheet date shown below TME Corporation acquires 70% of Abcor, Inc. common stock for $25,000 in cash.
Pre-acquisition Balance Sheets
December 31, 2001
TME Corp.
Abcor, Inc.
Current assets
$80,000
$38,000
Other assets
28,000
15,000
Total assets
$108,000
$53,000
Current liabilities
$60,000
$32,000
Common stock
15,000
14,000
Retained earnings
33,000
7,000
Total liabilities and equity
$108,000
$53,000
What will be the post-acquisition current ratio, using both the consolidation method and the equity method, respectively, for TME? The choices below represent Consolidation and Equity, respectively.
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With the consolidation method: The current assets are ($80,000 + $38,000 - $25,000) = $93,000. The current liabilities are ($60,000 + $32,000) = $92,000. The current ratio is $93,000/$92,000 = 1.01. With the equity method: The current assets are ($80,000 - $25,000) = $55,000. The current liabilities are $60,000. The current ratio is $55,000/$60,000 = 0.92.
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Using the consolidated basis of accounting, the post-acquisition level of the current assets is the amount of the current assets prior to acquisition minus the amount of cash used for the acquisition. ($80,000 + 38,000 – 25,000) = $93,000.
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Since only 70% of Abcor was purchased by TME there is a minority interest that must be accounted for, equal to the percentage of Abcor not owned by TME times Abcor’s net worth. (0.30)($53,000 – 32,000) = $6,300.
Which of the following statements regarding a comparison of the equity method with the consolidation method is FALSE?
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Both net income and equity will be the same regardless of whether the equity method or consolidation is used to account for an intercorporate investment. Hence, ROE = net income / equity, will remain unchanged. Operating income tends to be higher under consolidation because minority interest is reported below the operating line in most cases on a consolidated income statement.
The proportionate consolidation method results in:
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The proportionate consolidation results in the SAME net income and equity as the equity method.
The proportionate consolidation method will least likely achieve the same results as the consolidation method because:
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Proportionate consolidations and regular consolidations are the same except for the exclusion of minority interests in proportionate consolidations.
Company A owns 40% of a joint venture, Jovent, Inc., and each company has reported the following information:
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Information Statement Information | ||
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Company A |
Jovent, Inc. |
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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 | ||
|
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Company A |
Jovent, Inc. |
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Cash |
$900 |
$300 |
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Inventory |
700 |
200 |
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Accounts receivable |
800 |
250 |
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Plant and equipment |
3,000 |
600 |
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Accounts payable |
1,300 |
200 |
|
Long-term debt |
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|
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?
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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.
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|
|
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) |
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Stockholder’s equity will be unaffected by use of the proportionate consolidation method to account for joint ventures.
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:
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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.
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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.
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|
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.
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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.
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:
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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 5, LOS 21.b)
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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)
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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)
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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)
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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 5, LOS 21.b)
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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 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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