Professional Documents
Culture Documents
5-1
OUTLINE
Section 1: Intercompany Activities
Intercorporate Investments
Consolidated Financial Statements
Equity Method Accounting
Analysis Implications of Intercorporate Investments
Business Combinations
Accounting Mechanics of Business Combinations
Analysis Implications of Business Combinations
Comparison of Pooling versus Purchase Accounting for Business
Combinations
Section 2: International Activities
5-2
ANALYSIS OBJECTIVES
Analyze implications of both the purchase and pooling methods of accounting for
business combinations.
Distinguish between foreign currency translation and transaction gains and losses.
5-3
QUESTIONS
1. From a strict legal viewpoint, the statement is basically correct. Still, we must
remember that consolidated financial statements are not prepared as legal
documents. Consolidated financial statements disregard legal technicalities in favor
of economic substance to reflect the economic reality of a business entity under
centralized control. From the analysts' viewpoint, consolidated statements are often
more meaningful than separate financial statements in providing a fair presentation of
financial condition and the results of operations.
2. The consolidated balance sheet obscures rather than clarifies the margin of safety
enjoyed by specific creditors. To gain full comprehension of the financial position of
each part of the consolidated group, an analyst needs to examine the individual
financial statements of each subsidiary. Specifically, liabilities shown in the
consolidated financial statements do not operate as a lien upon a common pool of
assets. The creditors, secured and unsecured, have recourse in the event of default
only to assets owned by the individual corporation that incurred the liability. If, on the
other hand, a parent company guarantees a specific liability of a subsidiary, then the
creditor would have the guarantee as additional security.
3. Consolidated financial statements generally provide the most meaningful
presentation of the financial condition and the results of operations of the combined
entity. Still, they do have certain limitations, including:
The financial statements of the individual companies in the group may not be
prepared on a comparable basis. Accounting principles applied, valuation bases,
and amortization rates used can differ. This can impair homogeneity and the
validity of ratios, trends, and key relations.
Companies in relatively poor financial condition may be combined with sound
companies, obscuring information necessary for effective analysis.
The extent of intercompany transactions is unknown unless consolidating
financial statements (worksheets) are presented. The latter reveal the adjustments
involved in the consolidation process, but are rarely disclosed.
Unless disclosed, it is difficult to estimate how much of consolidated retained
earnings are actually available for payment of dividends.
The composition of the minority interest (such as between common and preferred
stock) cannot be determined because the minority interest is usually shown as a
combined amount in the consolidated balance sheet.
Consolidated financial statements do not reveal restrictions on use of cash for
individual companies nor the intercompany cash flows.
Consolidation of nonhomogeneous subsidiaries (such as finance or insurance
subsidiaries) can distort ratios and other relations.
4. a. This disclosure is necessaryit is a subsequent event required to be disclosed.
Also, the contingency conditions involving additional consideration are
adequately disclosed. Still, it would have been more informative had the note
disclosed the market value of net assets or stocks issued.
b. This must be accounted for by the purchase method. Since the more readily
determinable value in this case is the consideration given in the form of the Best
Company stock, the investment should be recorded at $1,057,386 (48,063 shares
x $22 market price at acquisition). In the consolidated statements, there may or
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j.
k. The goodwill of the acquired company is not carried forward to the acquiring
company's accounting records.
9. A crude way of adjusting for omitted values in a pooling combination is to estimate
the difference between the market value and the recorded book value of the net
assets acquired, and then to amortize this difference on some reasonable basis. The
result would be approximately comparable to the net income reported using purchase
accounting. Admittedly, the information available for making such adjustments is
limited.
10. Analysis should be alert to the appropriateness of the valuation of the net assets
acquired in the combination. In periods of high stock market price levels, purchase
accounting can introduce inflated values when net assets (particularly the
intangibles) of acquired companies are valued on the basis of the high market price
of the stock issued. Such values, while determined on the basis of temporarily
inflated stock prices, remain on a company's balance sheet and may require future
write-downs if impaired. This concern also extends to temporarily depressed stock
prices and its related implications.
11. a. An acquisition program aimed at purchasing companies with lower PE ratios can,
in effect, "buy" earnings for the acquiring company. To illustrate, say that
Company X has earnings of $1 million, or $1 per share on 1 million shares
outstanding, and that its PE is 50. Now, lets assume it purchases Company Y at
10 times it earnings of $5,000,000 ($50 million price) by issuing an additional
1,000,000 shares of X valued at $50 per share. Then:
Earnings of Combined Entity are: X earnings.....$1,000,000
Y earnings..... 5,000,000
$6,000,000
5-6
11
continued
5-7
13. All factors supporting the estimates of the benefit periods should be reexamined in
the light of current economic conditions. Some circumstances that can affect such
estimates are:
A new invention that renders a patented device obsolete.
Significant shifts in customer preferences.
Regulatory sanctions against a segment of the business.
Reduced market potential because of an increased number of competitors.
14. The analyst should realize that there are differences in accounting principles across
countries and, hence, should be familiar with international accounting practices. The
analyst should also verify the reputation of the independent auditors before relying
on them. Also, the analyst should be familiar with the provisions governing the
translation of foreign financial statements into dollars.
15. Problems in the accounting for and the analysis of foreign operations can be grouped
into two broad classifications:
(a) Problems related to differences in accounting principles, auditing standards, and
other reporting or economic practices that are peculiar to the foreign country
where the operations are conducted.
(b) Problems that arise from the translation of foreign assets, liabilities, equities, and
results of operations into U.S. dollars.
16. The major provisions of accounting for foreign currency translation (SFAS 52) are:
The translation process requires that the functional currency of the entity be
identified first. Ordinarily it will be the currency of the country where the entity is
located (or the U.S. dollar). All financial statement elements of the foreign entity
must then be measured in terms of the functional currency in conformity with
GAAP.
Under the current rate method (most commonly used), translation from the
functional currency into the reporting currency, if they are different, is to be at the
current exchange rate, except that revenues and expenses are to be translated at
the average exchange rates prevailing during the period. The current method
generally considers the effect of exchange rate changes to be on the net
investment in a foreign entity rather than on its individual assets and liabilities
(which was the focus of SFAS 8).
Translation adjustments are not included in net income but are disclosed and
accumulated as a separate component of stockholders' equity (Other
Comprehensive Income or Loss) until such time that the net investment in the
foreign entity is sold or liquidated. To the extent that the sale or liquidation
represents realization, the relevant amounts should be removed from the separate
equity component and included as a gain or loss in the determination of the net
income of the period during which the sale or liquidation occurs.
17. The accounting standards for foreign currency translation have as its major
objectives: (1) to provide information that is generally compatible with the expected
economic effects of a change in exchange rate on an enterprise's cash flows and
equity, and (2) to reflect in consolidated statements the financial results and relations
as measured in the primary currency of the economic environment in which the entity
operates, which is referred to as its functional currency. Moreover, in adopting the
functional currency approach, the FASB had the following goals of foreign currency
translation in mind: (1) to present the consolidated financial statements of an
enterprise in conformity with U.S. GAAP, and (2) to reflect in consolidated financial
5-8
statements the financial results and relations of the individual consolidated entities as
measured in their functional currencies. The Board's approach is to report the
adjustment resulting from translation of foreign financial statements not as a gain or
loss in the net income of the period but as a separate accumulation as part of equity
(in comprehensive income).
18. Following are some analysis implications of the accounting for foreign currency
translation:
(a) The accounting insulates net income from balance sheet translation gains and
losses, but not transaction gains and losses and income statement translation
effects.
(b) Under current GAAP, all balance sheet items, except equity, are translated at the
current rate; thus, the translation exposure is measured by the size of equity or
the net investment.
(c) While net income is not affected by balance sheet translation, the equity capital is.
This affects the debt-to-equity ratio (the level of which may be specified by certain
debt covenants) and book value per share of the translated balance sheet, but not
of the foreign currency balance sheet. Since the entire equity capital is the
measure of exposure to balance sheet translation gain or loss, that exposure may
be even more substantial, particularly with regard to a subsidiary financed with
low debt and high equity. The analyst can estimate the translation adjustment
impact by multiplying year-end equity by the estimated change in the period to
period rate of exchange.
(d) Under current GAAP, translated reported earnings will vary directly with changes
in exchange rates, and this makes estimation by the analyst of the "income
statement translation effect" less difficult.
(e) In addition to the above, income will also include the results of completed foreign
exchange transactions. Also, any gain or loss on the translation of a current
payable by the subsidiary to parent (which is not of a long-term capital nature) will
pass through consolidated net income.
19. The following two circumstances require use of the temporal method of translation.
(a) When by its nature, the foreign operation is merely an extension of the parent and
consequently the dollar is its functional currency.
(b) When hyperinflation (as defined) causes the translation of nonmonetary assets at
the current rate to result in unrealistically low carrying values. In such cases, in
effect, the foreign currency has lost its usefulness as a measure of performance
and a more stable unit (such as the dollar) is used.
5-9
EXERCISES
Exercise 5-1 (30 minutes)
a. Under purchase accounting, goodwill is reported if the purchase price
exceeds fair value of the acquired tangible and intangible net assets.
b. All identifiable tangible and intangible assets acquired, either individually or
by type, and liabilities assumed in a business combination, whether or not
shown in the financial statements of Moore, should be assigned a portion of
the cost of Moore, normally equal to the fair values at date of acquisition.
Then, the excess of the cost of Moore over the sum of the amounts assigned
to identifiable tangible and intangible assets acquired less the liabilities
assumed is recorded as goodwill.
c. Consolidated financial statements should be prepared to present financial
position and operating results in a manner more meaningful than in separate
statements. Such statements often are more useful for analysis purposes.
d. The first necessary condition for consolidation is control, as typically
evidenced by ownership of a majority voting interest. As a general rule,
ownership by one company, directly or indirectly, of over fifty percent of the
outstanding voting shares of another company is a condition necessary for
consolidation.
5-10
5-11
Exercise 5-2continued
g. 100 percent of C2's assets and liabilities are included in the consolidated
balance sheet. However, the stockholders' equity of C2 is split into two parts:
80 percent is added to the stockholders' equity of Co. X and 20 percent is
shown on a separate line (above Co. X's stockholders' equity) as "minority
ownership of C2" (frequently just simply called "minority interest"). The
portion of the 80 percent representing the past purchase by Co. X would be
eliminated (in consolidation) against the "investment in subsidiary."
h. Co. X must purchase enough additional common stock from the other
stockholders in C3 or purchase enough new shares issued by C3 to increase
its ownership to more than 50 percent of C3's common stock. (Alternatively,
C1 or C2 could purchase the additional shares.)
i. There would be no intercompany investment or intercompany dividends. But
any other intercompany transactions must be eliminated (such as
intercompany sales and intercompany receivables and payables).
j. No change. Instead, there would be a two-step consolidation (first C1 plus C2,
then Co. X plus C1 consolidated). Any gain or loss on the transaction would
be eliminated in consolidation.
k. No change. The additional investment by Co. X would be eliminated against
the additional invested capital for C1 in the consolidation.
5-12
5-13
Exercise 5-3continued
(3) Discretionary reserves highly depend on the convictions of management.
The usual impact of discretionary reserves on net income is to smooth the
net income, allowing management to "look better" in bad years (and not
as great in good years). The creation of a discretionary reserve, when
charged to income, lowers net income in that year. Absence of the charge
in a later year, or use of the reserve to cover expenses of that year,
increases net income in the later year. Discretionary reserves against fixed
assets (revaluation or impairment) will affect future depreciation charges
and, therefore, net income. "Excess" depreciation charges can also be
used to lower net income in a good year.
5-14
5-15
PROBLEMS
Problem 5-1 (40 minutes)
a.
Investment
$40,000
1,600 [1]
(800) [2]
(480) [3]
(640) [4]
$39,680
Notes ($000s):
[1] 80% of $2,000 net income
[2] 80% of $1,000 dividends
[3] 80% of $(600) net loss
[4] 80% of $800 dividends
b. The strengths associated with use of the equity method in this case include:
It reduces the balance in the investment account in Year 7 due to the net
loss. Note: Just recording dividend income would obscure the loss.
It recognizes goodwill on the balance sheet (via inclusion in the investment
balance) and, therefore, it reflects the full cost of the investment in
Bowman Co.
The possible weaknesses with use of the equity method in this case include:
Lack of detailed information (one-line consolidation).
Dollar earned by Bowman may not be equivalent to dollar earned by Burry.
5-16
5-17
$140
180
180
$500
*Goodwill computation:
Cash payment..........................................................................................................................
$180
Fair value of net assets acquired ($165 - $20)......................................................................
145
$ 35
b. The basic difference between pooling and purchase accounting for business
combinations is that in the pooling case there is a high likelihood of not
recording all assets acquired and paid for by the acquiring company. This
results in an understatement of assets and, consequently, an overstatement of
current and future net income. This is because pooling accounting is limited
to recording only book values of the acquired companys net assets, which do
not necessarily reflect current fair values of net assets. Given the inflationary
tendencies of most economies, pooling tends to understate asset values. The
understatement of assets under pooling leads to an understatement of
expenses (from lack of cost allocations) and to an overstatement of gains
realized on the disposition of these assets.
5-18
180.1
e. (1) The change in the cumulative translation adjustment accounts [101] for
Europe is most likely due to significant translation losses in Year 11.
(2) In the case of Australia, the decrease in the credit balance of the account
may be due to sales of businesses by Arnotts Ltd. [169A], which may have
involved the removal of a proportionate part of the account as well as
gains or losses on translation in Year 11. This is corroborated by item [93]
that shows a reduction in the cumulative translation account due to sales
of foreign operations.
5-19
5-20
CASES
Case 5-1 (45 minutes)
a. (1) Pooling Accounting:
Investment in Wheal ...........................................
Capital StockAxel ......................................
110,000
110,000
350,000
110,000
240,000
100,000
10,000
110,000
25,000
100,000
30,000
40,000
2,000
5,000
2,000
190,000
100,000
25,000
35,000
160,000
$150,000
35,000
$185,000
$150,000
$150,000
5-21
2,000,000A
10,000
80,000
20,000
100,000
190,000
________
2,400,000
.37
C
C.
C
H
[3]
740,000
.38
3,800
.38
30,400
.38
7,600
.30
30,000
[2]
61,000
25,900
898,700
Rate
$
Inventory, 1/1/Year 8
150,000
56,700 To Balance
Purchases
1,000,000
A
.37
370,000
Goods available for sale
1,150,000
426,700
Inventory, 12/31/Year 8
120,000
C
.38
45,600
Cost of goods sold
1,030,000
A
.37
381,100
[2] Dollar balance at Dec. 31, Year 7
[3] Amount to balance.
5-22
Case 5-2continued
b.
SWISSCO
Income Statement (In Dollars)
For the Year Ended Dec. 31, Year 8
Sales..................................................................
Beginning inventory......................................... $ 56,700 [1]
Purchases..........................................................
370,000
Goods available................................................
426,700
Ending inventory ( 120,000 = $0.36).............
(45,600) [1]
Cost of goods sold...........................................
Gross profit.......................................................
Depreciation expense......................................
37,000
Other expenses (including taxes)..................
74,000
Net income........................................................
$740,000
381,100
358,900
111,000
$247,900
SWISSCO
Balance Sheet (In Dollars)
At December 31, Year 8
ASSETS
Cash..........................................................................
Accounts receivable...............................................
Less: Allowances for doubtful accounts..............
Inventory...................................................................
Property, plant, and equipment, net......................
Total assets..............................................................
LIABILITIES AND EQUITY
Accounts payable....................................................
Note payable............................................................
Total liabilities.........................................................
Capital stock............................................................
Retained earnings: 1/1/Year 8................................
Add: Income for Year 8...........................................
Equity Adjustment from translation of
foreign currency statements.................................
Stockholders' equity...............................................
Total liabilities and equity......................................
$ 19,000
$38,000
3,800
34,200
45,600 [A]
304,000
$402,800
$30,400
7,600
38,000
30,000
61,000
247,900
308,900
25,900 [B]
364,800
$402,800
5-23
Case 5-2continued
c. Unisco Corp. Entry to Record its Share in SwissCo Year 8 Earnings:
Investment in SwissCo Corporation...........................
Equity in Subsidiary's Income...............................
185,925
185,925
Note: While not specifically required by the problem, the parent would also
pick up the translation adjustment as follows:
Investment in SwissCo Corporation...........................
Equity adjustment from translation of
foreign currency statements (75% x $25,900)....
19,425
19,425
ASSETS
Cash
...................................................................
Accounts receivable
...................................................................
Inventory
...................................................................
Fixed assets (net)
...................................................................
Total assets
...................................................................
LIABILITIES AND EQUITY
Accounts payable
...................................................................
Capital stock
...................................................................
Retained earnings
...................................................................
Translation adjustment
5-24
Exchange Rate
Ponts/$
Dollars
(millions)
82
4.0
20.50
700
4.0
175.00
455
4.0
113.75
360
4.0
90.00
1,597
399.25
532
4.0
133.00
600
3.0
200.00
465
132.86
(66.61)*
...................................................................
Total liabilities and equity
1,597
399.25
5-25
Case 5-3continued
FUNI, INC.
Income Statement
For Year Ended Dec. 31, Year 9
Ponts
(millions)
Sales
...................................................................
Cost of sales
...................................................................
Depreciation expense
...................................................................
Selling expense
...................................................................
Net income
b. (1) Dollar:
Pont:
(2) Dollar:
Pont:
(3) Dollar:
Pont:
5-26
Exchange Rate
Ponts/$
Dollars
(millions)
3,500
3.5
1,000.00
(2,345)
3.5
(60)
3.5
(670.00
)
(17.14)
(630)
3.5
465
(180.00
)
132.86
5-27
5-28
Case 5-5continued
f. Focusing on earnings before special items can be a useful tool when
attempting to measure earnings that is more reflective of the permanent
earnings stream and, consequently, more reflective of future earnings.
However, several companies record repeated special item charges. These
companies are essentially overstating earnings for several periods (not
including those with special charges) and then catching up by recording the
huge charge. Analysts must be careful to identify such companies so that they
are not relying on overstated earnings of the company in predicting future
performance. For such companies, it is prudent to assign a portion of the
charges to several periods to develop an approximation of the ongoing
earnings of the company.
5-29