SOLUTION'S MANUAL for Advanced Accounting 12e Joe Hoyle Thomas SchaeferTimothy Doupnik
Advanced Accounting 12e Joe Hoyle Thomas SchaeferTimothy Doupnik (Solutions Manual All Chapters, 100% Original Verified, A+ Grade) CHAPTER 1 THE EQUITY METHOD OF ACCOUNTING FOR INVESTMENTS Chapter Outline I.
Three methods are principally used to account for an investment in equity securities along with a fair value option. A. Fair value method: applied by an investor when only a small percentage of a company’s voting stock is held. 1. Income is recognized when the investee declares a dividend. 2. Portfolios are reported at fair value. If fair values are unavailable, investment is reported at cost. B. Consolidation: when one firm controls another (e.g., when a parent has a majority interest in the voting stock of a subsidiary or control through variable interests, their financial statements are consolidated and reported for the combined entity. C. Equity method: applied when the investor has the ability to exercise significant influence over operating and financial policies of the investee. 1. Ability to significantly influence investee is indicated by several factors including representation on the board of directors, participation in policy-making, etc. 2. GAAP guidelines presume the equity method is applicable if 20 to 50 percent of the outstanding voting stock of the investee is held by the investor. Current financial reporting standards allow firms to elect to use fair value for any new investment in equity shares including those where the equity method would otherwise apply. However, the option, once taken, is irrevocable. Investee dividends and changes in fair value over time are recognized as income. On February 14, 2013, the FASB issued a Proposed Accounting Standards Update (ASU) entitled, Recognition and Measurement of Financial Assets and Financial Liabilities. The proposed ASU would eliminate the fair-value option for investments that qualify for equity method treatment. Fair-value accounting, however, would be extended to “equity method” investments that meet the criteria for classification as held for sale.
II.
Accounting for an investment: the equity method A. The investment account is adjusted by the investor to reflect all changes in the equity of the investee company. B. Income is accrued by the investor as soon as it is earned by the investee. C. Dividends declared by the investee create a reduction in the carrying amount of the Investment account. The text assumes all investee dividends are declared and paid in the same reporting period.
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Chapter 01 - The Equity Method of Accounting for Investments
III.
Special accounting procedures used in the application of the equity method A. Reporting a change to the equity method when the ability to significantly influence an investee is achieved through a series of acquisitions. 1. Initial purchase(s) will be accounted for by means of the fair value method (or at cost) until the ability to significantly influence is attained. 2. At the point in time that the equity method becomes applicable, a retrospective adjustment is made by the investor to convert all previously reported figures to the equity method based on percentage of shares owned in those periods. 3. This restatement establishes financial statement comparability across years. B. Investee income from other than continuing operations 1. The investor recognizes its share of investee reported other comprehensive income (OCI) through the investment account and the investor’s own OCI. 2. Income items such as extraordinary gains and losses and discontinued operations that are reported separately by the investee should be shown in the same manner by the investor. The materiality of these other investee income elements (as it affects the investor) continues to be a criterion for separate disclosure. C. Investee losses 1. Losses reported by the investee create corresponding losses for the investor. 2. A permanent decline in the fair value of an investee’s stock should be recognized immediately by the investor as an impairment loss. 3. Investee losses can possibly reduce the carrying value of the investment account to a zero balance. At that point, the equity method ceases to be applicable and the fair-value method is subsequently used. D. Reporting the sale of an equity investment 1. The investor applies the equity method until the disposal date to establish a proper book value. 2. Following the sale, the equity method continues to be appropriate if enough shares are still held to maintain the investor’s ability to significantly influence the investee. If that ability has been lost, the fair-value method is subsequently used.
IV.
Excess investment cost over book value acquired A. The price an investor pays for equity securities often differs significantly from the investee’s underlying book value primarily because the historical cost based accounting model does not keep track of changes in a firm’s fair value. B. Payments made in excess of underlying book value can sometimes be identified with specific investee accounts such as inventory or equipment. C. An extra acquisition price can also be assigned to anticipated benefits that are expected to be derived from the investment. In accounting, these amounts are presumed to reflect an intangible asset referred to as goodwill. Goodwill is calculated as any excess payment that is not attributable to specific assets and liabilities of the investee. Because goodwill is an indefinite-lived asset, it is not amortized.
V.
Deferral of unrealized gross profit in inventory A. Profits derived from intra-entity transactions are not considered completely earned until the transferred goods are either consumed or resold to unrelated parties.
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B. Downstream sales of inventory 1. “Downstream” refers to transfers made by the investor to the investee. 2. Intra-entity gross profits from sales are initially deferred under the equity method and then recognized as income at the time of the inventory’s eventual disposal. 3. The amount of gross profit to be deferred is the investor’s ownership percentage multiplied by the markup on the merchandise remaining at the end of the year. C. Upstream sales of inventory 1. “Upstream” refers to transfers made by the investee to the investor. 2. Under the equity method, the deferral process for unrealized profits is identical for upstream and downstream transfers. The procedures are separately identified in Chapter One because the handling does vary within the consolidation process.
Answers to Discussion Questions The textbook includes discussion questions to stimulate student thought and discussion. These questions are also designed to allow students to consider relevant issues that might otherwise be overlooked. Some of these questions may be addressed by the instructor in class to motivate student discussion. Students should be encouraged to begin by defining the issue(s) in each case. Next, authoritative accounting literature (FASB ASC) or other relevant literature can be consulted as a preliminary step in arriving at logical actions. Frequently, the FASB Accounting Standards Codification will provide the necessary support. Unfortunately, in accounting, definitive resolutions to financial reporting questions are not always available. Students often seem to believe that all accounting issues have been resolved in the past so that accounting education is only a matter of learning to apply historically prescribed procedures. However, in actual practice, the only real answer is often the one that provides the fairest representation of the a firm’s transactions. If an authoritative solution is not available, students should be directed to list all of the issues involved and the consequences of possible alternative actions. The various factors presented can be weighed to produce a viable solution. The discussion questions are designed to help students develop research and critical thinking skills in addressing issues that go beyond the purely mechanical elements of accounting. Did the Cost Method Invite Manipulation? The cost method of accounting for investments often caused a lack of objectivity in reported income figures. With a large block of the investee’s voting shares, an investor could influence the amount and timing of the investee’s dividend declarations. Thus, when enjoying a good earnings year, an investor might influence the investee to withhold declaring a dividend until needed in a subsequent year. Alternatively, if the investor judged that its current year earnings “needed a boost,” it might influence the investee to declare a current year dividend. The equity method effectively removes managers’ ability to increase current income (or defer income to future periods) through their influence over the timing and amounts of investee dividend declarations. At first glance it may seem that the fair value method allows managers to manipulate income because investee dividends are recorded as income by the investor. However, dividends paid typically are accompanied by a decrease in fair value (also recognized in income), thus leaving reported net income unaffected.
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Does the Equity Method Really Apply Here? The discussion in the case between the two accountants is limited to the reason for the investment acquisition and the current percentage of ownership. Instead, they should be examining the actual interaction that currently exists between the two companies. Although the ability to exercise significant influence over operating and financial policies appears to be a rather vague criterion, ASC 323 "Investments—Equity Method and Joint Ventures," clearly specifies actual events that indicate this level of authority (paragraph 323-10-15-6): Ability to exercise that influence may be indicated in several ways, such as representation on the board of directors, participation in policy-making processes, material intra-entity transactions, interchange of managerial personnel, or technological dependency. Another important consideration is the extent of ownership by an investor in relation to the concentration of other shareholdings, but substantial or majority ownership of the voting stock of an investee company by another investor does not necessarily preclude the ability to exercise significant influence by the investor. In this case, the accountants would be wise to determine whether Dennis Bostitch or any other member of the Highland Laboratories administration is participating in the management of Abraham, Inc. If any individual from Highland's organization is on Abraham’s board of directors or is participating in management decisions, the equity method would seem to be appropriate. Likewise, if significant transactions have occurred between the companies (such as loans by Highland to Abraham), the ability to apply significant influence becomes much more evident. However, if James Abraham continues to operate Abraham, Inc., with little or no regard for Highland, the equity method should not be applied. This possibility seems especially likely in this case since one stockholder, James Abraham, continues to hold a majority (2/3) of the voting stock. Thus, evidence of the ability to apply significant influence must be present before the equity method is viewed as applicable. The mere holding of 1/3 of the stock is not conclusive.
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Answers to Questions 1. The equity method should be applied if the ability to exercise significant influence over the operating and financial policies of the investee has been achieved by the investor. However, if actual control has been established, consolidating the financial information of the two companies will normally be the appropriate method for reporting the investment. 2. According to FASB ASC paragraph 323-10-15-6 "Ability to exercise that influence may be indicated in several ways, such as representation on the board of directors, participation in policy-making processes, material intra-entity transactions, interchange of managerial personnel, or technological dependency. Another important consideration is the extent of ownership by an investor in relation to the extent of ownership of other shareholdings." The most objective of the criteria established by the Board is that holding (either directly or indirectly) 20 percent or more of the outstanding voting stock is presumed to constitute the ability to hold significant influence over the decision-making process of the investee. 3. The dividends are reported as a deduction from the investment account, not revenue, to avoid reporting the income from the investee twice. The equity method is appropriate when an investor has the ability to exercise significant influence over the operating and financing decisions of an investee. Because dividends represent financing decisions, the investor may have the ability to influence dividend timing. If dividends were recorded as income, managers could affect reported income in a way that does not reflect actual performance. Therefore, in reflecting the close relationship between the investor and investee, the equity method employs accrual accounting to record income as it is earned by the investee. The investment account is increased for the investee”s earned income and then decreased as the income is distributed, through dividends. From the investor’s view, the decrease in the investment asset (from investee dividends) is offset by an immediate increase in dividends receivable and an eventual increase in cash. 4. If Jones cannot significantly influence the operating and financial policies of Sandridge, the equity method should not be applied regardless of the ownership level. However, an owner of 25 percent of a company's outstanding voting stock is assumed to possess this ability. This presumption stands until overcome by predominant evidence to the contrary. Examples of indications that an investor may be unable to exercise significant influence over the operating and financial policies of an investee include (ASC 323-10-15-10): a. Opposition by the investee, such as litigation or complaints to governmental regulatory authorities, challenges the investor's ability to exercise significant influence. b. The investor and investee sign an agreement under which the investor surrenders significant rights as a shareholder. c. Majority ownership of the investee is concentrated among a small group of shareholders who operate the investee without regard to the views of the investor. d. The investor needs or wants more financial information to apply the equity method than is available to the investee's other shareholders (for example, the investor wants quarterly financial information from an investee that publicly reports only annually), tries to obtain that information, and fails. e. The investor tries and fails to obtain representation on the investee's board of directors. 5. The following events necessitate changes in this investment account. a. Net income earned by Watts would be reflected by an increase in the investment balance whereas a reported loss is shown as a reduction to that same account. 1-5 .
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b. Dividends declared by the investee decrease its book value, thus requiring a corresponding reduction to be recorded in the investment balance. c. If, in the initial acquisition price, Smith paid extra amounts because specific investee assets and liabilities had values differing from their book values, amortization of this portion of the investment account is subsequently required. As an exception, if the specific asset is land or goodwill, amortization is not appropriate. d. Intra-entity gross profits created by sales between the investor and the investee must be deferred until earned through usage or resale to outside parties. The initial deferral entry made by the investor reduces the investment balance while the eventual recognition of the gross profit increases this account. 6. The equity method has been criticized because it allows the investor to recognize income that may not be received in any usable form during the foreseeable future. Income is being accrued based on the investee's reported earnings, not on the investor’s share of investee dividends. Frequently, equity income will exceed the investor’s share of investee cash dividends with no assurance that the difference will ever be forthcoming. Many companies have contractual provisions (e.g., debt covenants, managerial compensation contracts) based on ratios in the main body of the financial statements. Relative to consolidation, a firm employing the equity method will report smaller values for assets and liabilities. Consequently, higher rates of return for its assets and sales, as well as lower debtto-equity ratios may result. Meeting such contractual provisions of may provide managers incentives to maintain technical eligibility for the equity method rather than full consolidation. 7. FASB ASC Topic 323 requires that a change to the equity method be reflected by a retrospective adjustment. Although a different method may have been appropriate for the original investment, comparable balances will not be readily apparent if the equity method is now applied. For this reason, financial figures from all previous years presented are restated as if the equity method had been applied consistently since the date of initial acquisition. 8. In reporting equity earnings for the current year, Riggins must separate its accrual into two components: (1) net income and (2) other comprehensive income or loss. This handling enables the reader of the investor's financial statements to assess the nature of the change to the investment account. 9. Under the equity method, losses are recognized by an investor at the time that they are reported by the investee. However, because of the conservatism inherent in accounting, any permanent losses in value should also be recorded immediately. Because the investee's stock has suffered a permanent impairment in this question, the investor recognizes the loss applicable to its investment. 10. Following the guidelines established by the ASC, Wilson would recognize an equity loss of $120,000 (40 percent) stemming from Andrews' reported loss. However, since the book value of this investment is only $100,000, Wilson's loss is limited to that amount with the remaining $20,000 being omitted. Subsequent income will be recorded by the investor based on investee dividends. If Andrews is ever able to generate sufficient future profits to offset the total unrecognized losses, the investor will revert to the equity method. 11. In accounting, goodwill is derived as a residual figure. It is the investor's cost in excess of its share of the fair value of the investee assets and liabilities. Although a portion of the acquisition price may represent either goodwill or valuation adjustments to specific investee 1-6 .
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assets and liabilities, the investor records the entire cost in a single investment account. No separate identification of the cost components is made in the reporting process. Subsequently, the cost figures attributed to specific accounts (having a limited life), besides goodwill and other indefinite life assets, are amortized based on their anticipated lives. This amortization reduces the investment and the accrued income in future years. 12. On June 19, Princeton removes the portion of this investment account that has been sold and recognizes the resulting gross profit or loss. For proper valuation purposes, the equity method is applied (based on the 40 percent ownership) from the beginning of Princeton's fiscal year until June 19. Princeton's method of accounting for any remaining shares after June 19 will depend upon the degree of influence that is retained. If Princeton still has the ability to significantly influence the operating and financial policies of Yale, the equity method continues to be appropriate based on the reduced percentage of ownership. Conversely, if Princeton no longer holds this ability, the fair-value method becomes applicable, based on the remaining equity value after the sale. 13. Downstream sales are made by the investor to the investee while upstream sales are from the investee to the investor. These titles have been derived from the traditional positions given to the two parties when presented on an organization-type chart. Under the equity method, no accounting distinction is actually drawn between downstream and upstream sales. Separate presentation is made in this chapter only because the distinction does become significant in the consolidation process as will be demonstrated in Chapter Five. 14. The unrealized portion of an intra-entity gross profit is computed based on the markup on any transferred inventory retained by the buyer at year's end. The markup percentage (based on sales price) multiplied by the intra-entity ending inventory gives the seller’s profit remaining in the buyer’s ending inventory. The product of the ownership percentage and this profit figure is the unrealized gross profit from the intra-entity transaction. This profit is deferred in the recognition of equity earnings until subsequently earned through use or resale to an unrelated party. 15. Intra-entity transfers do not affect the financial reporting of the investee except that the related party transactions must be appropriately disclosed and labeled. 16. Under fair value accounting, firms report the investment’s fair value as an asset and changes in fair value as earnings. Dividends from an investee are included in earnings under the fair value accounting. Dividends are not recognized in income but instead reduce the investment account under the equity method. Also, under the equity method, firms recognize their ownership share of investee profits adjusted for excess cost amortizations and intra-entity profits.
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Answers to Problems 1. D 2. B 3. C 4. B 5. D 6. A Acquisition price ............................................................................. $1,600,000 Equity income ($560,000 × 40%) .................................................... 224,000 Dividends (50,000 shares × $2.00).................................................. (100,000) Investment in Harrison Corporation as of December 31 .............. $1,724,000 7. A Acquisition price ............................................................................. Income accruals: 2014—$170,000 × 20%....................................... 2015—$210,000 × 20% ...................................... Amortization (see below): 2014 ...................................................... Amortization: 2015 .......................................................................... Dividends: 2014—$70,000 × 20% ................................................... 2015—$70,000 × 20% .................................................... Investment in Martes, December 31, 2015 .....................................
$700,000 34,000 42,000 (10,000) (10,000) (14,000) (14,000) $728,000
Acquisition price of Martes............................................................. Acquired net assets (book value) ($3,000,000 × 20%) ................. Excess cost over book value to patent ......................................... Annual amortization (10 year remaining life) ...............................
$700,000 (600,000) $100,000 $10,000
8. B Purchase price of Johnson stock .................. Book value of Johnson ($900,000 × 40%)...... Cost in excess of book value .................... Payment identified with undervalued ............ Building ($140,000 × 40%) ......................... Trademark ($210,000 × 40%) ..................... Total .................................................................
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$500,000 (360,000) $140,000 Remaining Annual life amortization
56,000 7 yrs. 84,000 10 yrs. $ -0-
$8,000 8,400 $16,400
Chapter 01 - The Equity Method of Accounting for Investments
Investment purchase price ............................................ Basic income accrual ($90,000 × 40%) .................... Amortization (above) ................................................. Dividends declared ($30,000 × 40%) ....................... Investment in Johnson ...................................................
$500,000 36,000 (16,400) (12,000) $507,600
9. D The 2014 purchase is reported using the equity method. Purchase price of Evan stock......................................................... $600,000 Book value of Evan stock ($1,200,000 × 40%) ............................... (480,000) Goodwill ........................................................................................... $120,000 Life of goodwill ................................................................................ indefinite Annual amortization ........................................................................ (-0-) Cost on January 1, 2014 ................................................................. 2014 Income accrued ($140,000 x 40%) ......................................... 2014 Dividend ($50,000 × 40%) ....................................................... 2015 Income accrued ($140,000 × 40%) ......................................... 2015 Dividend ($50,000 × 40%) ....................................................... 2016 Income accrued ($140,000 × 40%) ......................................... 2016 Dividend ($50,000 × 40%) ....................................................... Investment in Evan, 12/31/16.....................................................
$600,000 56,000 (20,000) 56,000 (20,000) 56,000 (20,000) $708,000
11. A Gross profit rate (GPR): $36,000 ÷ $90,000 = 40% Inventory remaining at year-end .................................................... GPR................................................................................................... Unrealized gross profit .............................................................. Ownership ........................................................................................ Intra-entity gross profit—deferred ............................................
$20,000 × 40% $8,000 × 30% $ 2,400
10. D
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12. B Purchase price of Steinbart shares ............................................... Book value of Steinbart shares ($1,200,000 × 40%)...................... Trade name ...................................................................................... Remaining life of trade name.......................................................... Annual amortization ........................................................................ 2014 Gross profit rate = $30,000 ÷ $100,000 = 30% 2015 Gross profit rate = $54,000 ÷ $150,000 = 36% 2015—Equity income in Steinbart: Income accrual ($110,000 × 40%) ................................................... Amortization (above) ....................................................................... Recognition of 2014 unrealized gross profit ($25,000 × 30% GPR × 40% ownership) .................................... Deferral of 2015 unrealized gross profit ($45,000 × 36% GPR × 40% ownership ..................................... Equity income in Steinbart—2015 ............................................
$530,000 (480,000) $ 50,000 20 years $ 2,500
$44,000 (2,500) 3,000 (6,480) $38,020
13. (6 minutes) (Investment account after one year) Purchase price ..................................................................................... $1,160,000 Basic 2015 equity accrual ($260,000 × 40%) ..................................... 104,000 Amortization of copyright: Excess payment ($1,160,000 – $820,000 = $340,000) to copyright allocated over 10 year remaining life .................. (34,000) Dividends (50,000 × 40%) .................................................................... (20,000) Investment account balance at year end ........................................... $1,210,000 14. (7 minutes) a. Purchase price ................................................................................. $ 2,290,000 Equity income accrual ($720,000 × 35%) ....................................... 252,000 Other comprehensive loss accrual ($100,000 × 35%)................... (35,000) Dividends (20,000 × 35%) ................................................................ (7,000) Investment in Steel at December 31, 2015 .................................... $2,500,000 b. Equity income of Steel = $252,000 (does not include OCI share which is reported separately).
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15. (15 minutes) (Investment account after 2 years) a. Acquisition price ................................................................................. $2,700,000 Book value acquired ($5,175,000 × 20%) ........................................... 1,035,000 Excess payment .................................................................................. $1,665,000 Excess fair value: Computing equipment ($700,000 × 20%) ........ 140,000 Excess fair value: Patented technology ($3,900,000 × 20%) ........ 780,000 Excess fair value: Trademark ($1,850,000 × 20%) ........................ 370,000 Goodwill ............................................................................................... $ 375,000 Amortization: Computing equipment ($140,000 ÷ 7) ....................................... $ 20,000 Patented technology ($780,000 ÷ 3) .......................................... 260,000 Trademark (indefinite)................................................................ -0Goodwill (indefinite) ................................................................... -0Annual amortization ........................................................................ $280,000 b. Basic equity accrual 2014 ($1,800,000 × 20%) .................................. Amortization—2014 (above) ............................................................... Equity in 2014 earnings of Sauk Trail ................................................
$360,000 (280,000) $ 80,000
Basic equity accrual 2015 ($1,985,000 × 20%) .................................. Amortization—2015 (above) ............................................................... Equity in 2015 earnings of Sauk Trail ................................................
$397,000 (280,000) $117,000
c.
Acquisition price ................................................................................. $2,700,000 Equity in 2014 earnings of Sauk Trail (above) .................................. 80,000 Dividends—2014 ($150,000 × 20%) .................................................... (30,000) Investment in Sauk Trail, 12/31/14 ..................................................... $2,750,000 Investment in Sauk Trail, 12/31/14 ..................................................... $2,750,000 Equity in 2015 earnings of Sauk Trail (above) .................................. $117,000 Dividends—2015 ($160,000 × 20%) .................................................... (32,000) Investment in Sauk Trail, 12/31/15 ..................................................... $2,835,000
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Chapter 01 - The Equity Method of Accounting for Investments
16. (10 minutes) (Investment account after 2 years with fair value accounting included) a. Acquisition price ................................................................................. $60,000 Book value—assets minus liabilities ($125,000 × 40%) ............... 50,000 Excess payment ......................................................................... $10,000 Value of patent in excess of book value ($15,000 × 40%) ............ 6,000 Goodwill ........................................................................................... $ 4,000
b.
Amortization: Patent ($6,000 ÷ 6) ...................................................................... Goodwill ...................................................................................... Annual amortization .............................................................
$1,000 -0$1,000
Acquisition price ............................................................................. Basic equity accrual 2014 ($30,000 × 40%) ................................... Dividends—2014 ($10,000 × 40%) .................................................. Amortization—2014 (above) ........................................................... Investment in Holister, 12/31/14 ..................................................... Basic equity accrual —2015 ($50,000 × 40%) ................................ Dividends—2015 .............................................................................. Amortization—2015 (above) ........................................................... Investment in Holister, 12/31/15 .....................................................
$60,000 12,000 (4,000) (1,000) $67,000 20,000 (6,000) (1,000) $80,000
Dividend income ($15,000 × 40%) .................................................. Increase in fair value ($75,000 – $68,000) ...................................... Investment income under fair value accounting—2015 ...............
$6,000 7,000 $13,000
17. (10 minutes) (Equity entries for one year, includes intra-entity transfers but no unearned gross profit) Purchase price of Burks stock ....................................................... $210,000 Book value of Burks stock ($360,000 × 40%) ................................ (144,000) Unidentified asset (goodwill) .......................................................... $ 66,000 Life .................................................................................................... indefinite Annual amortization ........................................................................ $ -0No unearned intra-entity profit exists at year’s end because all of the transferred merchandise was used during the period.
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17. (continued) Investment in Burks, Inc. .......................................... 210,000 Cash (or a Liability) .............................................. To record acquisition of a 40 percent interest in Burks.
210,000
Investment in Burks, Inc. .......................................... 32,000 Equity in Investee Income ................................... 32,000 To recognize 40 percent income earned during period by Burks, an equity method investment. Dividend Receivable .................................................. Investment in Burks, Inc. ..................................... To record investee dividend declaration.
10,000
Cash ............................................................................ Dividend Receivable. ........................................... To record collection of dividend from investee.
10,000
10,000
10,000
18. (20 Minutes) (Equity entries for one year, includes conversion to equity method) The 2014 purchase must be restated to the equity method. FIRST PURCHASE—JANUARY 1, 2014 Purchase price of McKenzie stock.................................................. Book value of McKenzie stock ($1,700,000 × 10%) ........................ Cost in excess of book value .......................................................... Excess cost assigned to undervalued land ($100,000 × 10%) ...... Trademark ......................................................................................... Remaining life of trademark ........................................................... Annual amortization .........................................................................
$210,000 (170,000) $40,000 (10,000) $30,000 10 years $ 3,000
BOOK VALUE—MCKENZIE—JANUARY 1, 2015 (before second purchase) January 1, 2014 book value (given) ................................................ $1,700,000 2014 Net income ............................................................................... 240,000 2014 Dividends ................................................................................. (90,000) January 1, 2015 book value ............................................................. $1,850,000
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18.
(continued) SECOND PURCHASE—JANUARY 1, 2015 Purchase price of McKenzie stock ............................................... Book value of McKenzie stock (above) ($1,850,000 × 30%) ....... Cost in excess of book value ....................................................... Excess cost assigned to undervalued land ($120,000 × 30%)....................................................................... Trademark ...................................................................................... Remaining life of Trademark ........................................................ Annual Amortization ..................................................................... Journal Entries: To record second acquisition of McKenzie stock. Investment in McKenzie ............................................ Cash ...................................................................... Investment in McKenzie ............................................ Retained Earnings—Prior Period Adjustment— 2014 Equity Income .......................................
$600,000 (555,000) $45,000 (36,000) $ 9,000 9 years $ 1,000
600,000 600,000 12,000 12,000
To restate reported figures for 2014 to the equity method. Reported income is $24,000 (10% of McKenzie’s income) less $3,000 (amortization on first purchase) = $21,000. Originally, Austin reported $9,000 (10% of the dividends). The adjustment increases the $9,000 to $21,000 for 2014. Investment in McKenzie ............................................ 120,000 Equity Income—Investment in McKenzie........... 120,000 To record income for the year: 40% of the $300,000 reported income. Dividend Receivable .................................................. 44,000 Investment in McKenzie....................................... To record dividend declaration from McKenzie (40% of $110,000).
44,000
Cash ............................................................................ Dividend Receivable. ........................................... To record collection of dividend from investee.
44,000
44,000
Equity Income—Investment in McKenzie ................ 4,000 Investment in McKenzie....................................... 4,000 To record 2015 amortization: $3,000 for first purchase, $1,000 for second.
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19. (7 minutes) (Deferral of unrealized gross profit) Ending inventory ($225,000 – $105,000) ............................................. Gross profit percentage (GP $75,000 ÷ Sales $225,000) ................... Unrealized gross profit ......................................................................... Ownership ............................................................................................. Intra-entity unrealized gross profit—deferred ....................................
$120,000 × 33⅓% $40,000 × 25% $10,000
Entry to Defer Unrealized Gross Profit: Equity Income from Schilling ....................................... Investment in Schilling ............................................
10,000 10,000
20. (10 minutes) (Reporting of equity income and transfers) a. Equity in investee income: Equity income accrual ($100,000 × 25%).................................. Less: deferral of intra-entity unrealized gross profit (below) Less: patent amortization (given) ............................................ Equity in investee income ....................................................
$25,000 (3,000) (10,000) $12,000
Deferral of intra-entity unrealized gross profit: Remaining inventory—end of year ...................................... Gross profit percentage (GP $30,000 ÷ Sales $80,000)...... Profit within remaining inventory ........................................ Ownership percentage ......................................................... Intra-entity unrealized gross profit ...............................................
$32,000 × 37½% $12,000 × 25% $ 3,000
b. In 2015, the deferral of $3,000 will likely become realized by BuyCo’s use or sale of this inventory. Thus, the equity accrual for 2015 will be increased by $3,000 in that year. Recognition of this amount is simply being delayed from 2014 until 2015, the year actually earned. c. The direction (upstream versus downstream) of the intra-entity transfer does not affect the above answers. However as discussed in Chapter Five, a controlling interest calls for a 100% gross profit deferral for downstream intra-entity transfers. In the presence of only signification influence, however, equity method accounting is identical regardless of whether an intra-entity transfer is upstream or downstream.
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Chapter 01 - The Equity Method of Accounting for Investments
21. (25 minutes) (Conversion from fair-value method to equity method with a subsequent sale of a portion of the investment) Equity method income accrual for 2015 30 percent of $644,000 for ½ year = ..................................... 24 percent of $644,000 for ½ year = ..................................... Total income accrual (no amort. or unearned gross profit) .......... Gain on sale (below) ....................................................................... Total income statement effect – 2015
$ 96,600 77,280 $173,880 31,000 $204,880
Gain on sale of 9,000 shares of Marion: Cost of initial acquisition—2013 .................................................... $435,000 10% income accrual (conversion made to equity method) .......... 35,900 10% of dividends ............................................................................. (10,700) Cost of second acquisition—2014 ................................................. 1,000,000 30% income accrual—2014 ............................................................. 150,300 30% of dividends—2014 .................................................................. (39,750) 30% income accrual for ½ year—2015 ........................................... 96,600 30% of dividends for ½ year—2015................................................ (22,350) Book value of 45,000 shares on July 1, 2015 .......................... $1,645,000 Cash proceeds from the sale: 9,000 shares × $40 ....................... Less: book value of shares sold: $1,645,000 × (9,000 ÷ 45,000) .. Gain on sale ................................................................................
$360,000 329,000 $ 31,000
22. (25 minutes) (Verbal overview of equity method, includes conversion to equity method) a. In 2014, the fair-value method (available-for-sale security) was appropriate. Thus, the only income recognized was the dividends declared. Collins should originally have reported dividend income equal to 10 percent of Merton’s dividends. b. The assumption is that Collins’ level of ownership now provides the company with the ability to exercise significant influence over the operating and financial policies of Merton. Factors that indicate such a level of influence are described in the textbook and include representation on the investee’s board of directors, material intra-entity transactions, and interchange of managerial personnel.
1-16 .
.
Chapter 01 - The Equity Method of Accounting for Investments
22.
(continued) c. Despite holding 25 percent of Merton’s outstanding stock, application of the equity method is inappropriate absent the ability to apply significant influence. Factors that indicate a lack of such influence include: an agreement whereby the owner surrenders significant rights, a concentration of the remaining ownership, and failure to gain representation on the board of directors. d. The equity method attempts to reflect the relationship between the investor and the investee in two ways. First, the investor recognizes investment income as soon as it is earned by the investee. Second, the Investment account reported by the investor is increased and decreased to indicate changes in the underlying book value of the investee. e. Criticisms of the equity method include ▪ its emphasis on the 20-50% of voting stock in determining significant influence vs. control ▪ allowing off-balance sheet financing ▪ potential biasing of performance ratios Relative to consolidation, the equity method will report smaller amounts for assets, liabilities, revenues and expenses. However, income is typically the same as reported under consolidation. Therefore, companies that use the equity method, and avoid consolidation, often show enhanced debt-to equity ratios, as well as ratios for returns on assets and sales. f. When an investor buys enough additional shares to gain the ability to exert significant influence, accounting for any shares previously owned must be adjusted to the equity method on a retrospective basis. Thus, in this case, the 10 percent interest held by Collins in 2014 must now be reported using the equity method. In this manner, the 2014 statements will be more comparable with those of 2015 and future years. g. The price paid for each purchase is first compared to the equivalent book value on the date of acquisition. Any excess payment is then assigned to specific assets and liabilities based on differences between book value and fair value. If any residual amount of the purchase price remains unexplained, it is assigned to goodwill.
1-17 .
.
Chapter 01 - The Equity Method of Accounting for Investments
22.
(continued) h. Investee dividends reduce its book value. Because the investor’s Investment account tracks the investee’s book value, Collins records the dividend as a reduction in its Investment account. This method of recording also avoids double-counting of the revenue since the investor has already recorded the amount when earned by the investee. Under the equity method, revenues are recognized when earned by the investee but not through dividends as a distribution of the same earnings. i. The Investment account will show the costs to obtain ownership of Merton. In addition, an equity accrual equal to 10 percent of the investee’s income for 2014 and 25 percent for 2015 is included. The investment balance will be reduced by 10 percent of any of Merton’s dividends during 2014 and 25 percent for 2015 dividends. Finally, the Investment account will be decreased by any amortization expense for both 2014 and 2015.
23. (20 minutes) (Verbal overview of intra-entity transfers and their impact on application of the equity method) a. An upstream transfer goes from investee to investor whereas a downstream transfer is made by the investor to the investee. b. The direction of an intra-entity transfer has no impact on reporting when the equity method is applied. The direction of the transfers was introduced in Chapter One because it does have an important impact on consolidation accounting as explained in Chapter Five. c. To determine the intra-entity unrealized gross profit when applying the equity method, the transferred inventory that remains at year’s end is multiplied by the gross profit percentage. This computation derives the unrealized gross profit. The intra-entity portion of this gross profit is found by multiplying it by the percentage of the investee that is owned by the investor. d. Parrot, as the investor, will accrue 42 percent of the income reported by Sunrise. However, this equity income will then be reduced by the amount of the unrealized intra-entity gross profit. These amounts can be combined and recorded as a single entry, increasing both the Investment account and an Equity Income account. As an alternative, separate entries can be made. The equity accrual is added to these two accounts while the deferral of the unrealized gross profit serves as a reduction.
1-18 .
.
Chapter 01 - The Equity Method of Accounting for Investments
23. (continued) e. In the second year, Parrot again records an equity accrual for 42 percent of the income reported by Sunrise. The intra-entity portion of the unrealized gross profit created by the transfers for that year are delayed in the same manner as for 2014 in (d) above. However, for 2015, the gross profit deferred from 2014 must now be recognized. This transferred merchandise was sold during this second year so that the earnings process has now been culminated. f.
If none of the transferred merchandise remains at year-end, the intra-entity transactions create no impact on the recording of the investment when applying the equity method. No gross profit remains unrealized.
g. The intra-entity transfers create no direct effects for Sunrise, the investee. However, as related party transactions, the amounts, as well as the relationship, must be properly disclosed and labeled. 24. (15 minutes) (Verbal overview of the sale of a portion of an investment being reported on the equity method and the accounting for any shares that remain) a. The equity method must be applied up to the date of the sale. Therefore, for the current year until August 1, Einstein records an equity accrual recognizing 40 percent of Brooks’ reported income for that period. In addition, Einstein records any dividends declared by Brooks as a reduction in the carrying amount of the investment account. Finally, amortization of acquisition-date excess fair over book values are recorded through August 1. These entries establish an appropriate book value as of the date of sale. Then, an amount of that book value equal to the portion of the shares sold is removed to compute a gain or loss on sale. b. Subsequent accounting for the remaining shares depends on the influence retained post-sale. If Einstein maintains the ability to apply significant influence to the operating and financial decisions of Brooks, the equity method is still applicable based on the smaller new ownership percentage. However, if significant influence has been lost, Einstein should report the remaining shares by means of the fair-value method. c. In this situation, three figures would be reported by Einstein. First, an equity income balance is recorded that includes both the accrual and amortization prior to August 1. Second, a gain or loss should be shown for the sale of the shares. Third, any investee dividends declared after August 1 must be included in Einstein’s income statement as dividend revenue.
1-19 .
.
Chapter 01 - The Equity Method of Accounting for Investments
24. (continued) d. No, the ability to apply significant influence to the investee was present prior to August 1 so that the equity method was appropriate. No change is made in those figures. However, after the sale, the remaining investment must be accounted for by means of the fair-value method. 25. (12 minutes) (Equity balances for one year includes intra-entity transfers) a. Equity income accrual—2015 ($90,000 × 30%) ......................... Amortization—2015 (given) ........................................................ Intra-entity profit recognized on 2014 transfer*........................ Intra-entity profit deferred on 2015 transfer** ........................... Equity income recognized by Matthew in 2015 ...................
$27,000 (9,000) 1,200 (2,640) $16,560
*Gross profit rate (GPR) on 2014 transfer ($16,000/$40,000) ... Unrealized gross profit: Remaining inventory (40,000 × 25%) .................................... GPR (above) ........................................................................... Ownership percentage .......................................................... Intra-entity profit deferred from 2014 until 2015 .................
40%
**GPR on 2015 transfer ($22,000/$50,000) ................................. Unrealized gross profit: Remaining inventory (50,000 × 40%) .................................... GPR (above) ........................................................................... Ownership percentage .......................................................... Intra-entity profit deferred from 2015 until 2016 .................
$20,000 × 44% × 30% $ 2,640
b. Investment in Lindman, 1/1/15 ................................................... Equity income—2015 (see [a] above) ........................................ Dividends—2015 ($30,000 × 30%) .............................................. Investment in Lindman, 12/31/15 ...............................................
$335,000 16,560 (9,000) $342,560
1-20 .
$10,000 × 40% × 30% $ 1,200
.
44%
Chapter 01 - The Equity Method of Accounting for Investments
26. (20 Minutes) (Equity method balances after conversion to equity method. Must determine investee’s book value) Part a 1. Allocation and annual amortization—first purchase 1/1/2014 Purchase price of 15 percent interest ....................................... $62,000 Net book value ($280,000 × 15%) ............................................... (42,000) Franchise agreements ................................................................ $20,000 Remaining life of franchise agreements ................................... ÷ 10 years Annual amortization .............................................................. $ 2,000 Allocation and annual amortization—second purchase 1/1/2015 Purchase price of 10 percent interest ....................................... Net book value $280,000 + $80,000 - $30,000 = $330,000. ($330,000 × 10%).......................................................................... Franchise agreements ................................................................ Remaining life of franchise agreements ................................... Annual amortization ..............................................................
(33,000) $10,800 ÷ 9 years $ 1,200
Investment in Bellevue account January 1, 2014 purchase........................................................... 2014 basic equity income accrual ($80,000 × 15%) .................. 2014 amortization on first purchase (above) ............................ 2014 dividends ($30,000 × 15%) ................................................. Equity method balance 12/31/2014 January 1, 2015 purchase........................................................... 2015 basic equity income accrual ($100,000 × 25%) ................ 2015 amortization on first purchase (above) ............................ 2015 amortization on second purchase (above) ...................... 2015 dividends ($40,000 × 25%) ................................................. Investment in Bellevue—December 31, 2015 ......................
$62,000 12,000 (2,000) (4,500) $67,500 43,800 25,000 (2,000) (1,200) (10,000) $123,100
2. Equity Income—2015 2015 basic equity income accrual ($100,000 × 25%) ................ 2015 amortization on first purchase (above) ............................ 2015 amortization on second purchase (above) ...................... Equity income—2015 .............................................................
$25,000 (2,000) (1,200) $21,800
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.
$43,800
Chapter 01 - The Equity Method of Accounting for Investments
26. (continued) 3. The January 1, 2015 retrospective adjustments to convert the Investment in Bellevue to the equity method is as follows: Unrealized Holding Gain—Shareholders’ Equity 3,700 Fair Value Adjustment (Available-for-Sale Securities)
3,700
To eliminate AFS fair value adjustment account balances for the investment in Bellevue (15% × $438,000 = $65,700 less $62,000 = $3,700) Investment in Bellevue Retained Earnings (January 1, 2015)
5,500 5,500
Retrospective adjustment to retained earnings to record 2014 equity method income for 15% investment (15% × $80,000 less $2,000 excess amortization less $4,500 dividend income recognized in 2014). [Alternative: Equity method balance of investment $67,500 less cost $62,000 = $5,500.] Part b 1.
Investment in Bellevue (25% × 468,000)
$117,000
2.
Dividend income (25% × 40,000) $10,000 Increase in fair value (25% × [$468,000 - $438,000]) 7,500 Reported income from Investment in Bellevue $17,500
27. (30 minutes) (Conversion to equity method, sale of investment, and unrealized gross profit) Part a Allocation and annual amortization—first purchase Purchase price of 10 percent interest ....................................... Net book value ($800,000 × 10%) ............................................... Copyright ..................................................................................... Remaining life of Copyright ............................................................. Annual Amortization ........................................................................
1-22 .
.
$92,000 (80,000) $12,000 ÷ 16 yrs $ 750
Chapter 01 - The Equity Method of Accounting for Investments
27. Part a (continued) Allocation and annual amortization—second purchase Purchase price of 20 percent interest ....................................... $210,000 Net book value ($800,000 is increased by $180,000 income but decreased by $80,000 in dividends) ($900,000 × 20%) ................................................................... (180,000) Copyright ..................................................................................... $30,000 Remaining life of copyright ............................................................. 15 years Annual amortization ......................................................................... $ 2,000 Equity income—2013 (after conversion to establish comparability) 2013 basic equity income accrual ($180,000 × 10%) ..................... $18,000 2013 amortization on first purchase (above).................................. (750) Equity income—2013 .................................................................. $17,250 Equity income 2014 2014 basic equity income accrual ($210,000 × 30%) ................ 2014 amortization on first purchase (above) ............................ 2014 amortization on second purchase (above) ...................... Equity income 2014 ..........................................................................
$63,000 (750) (2,000) $60,250
Part b Investment in Barringer Purchase price—January 1, 2013.................................................... 2013 equity income (above) ....................................................... 2013 dividends ($80,000 × 10%) ................................................. Purchase price January 1, 2014 ...................................................... 2014 equity income (above) ....................................................... 2014 dividends ($100,000 × 30%) ............................................... 2015 basic equity income accrual ($230,000 × 30%) ................ 2015 amortization on first purchase (above) ............................ 2015 amortization on second purchase (above) ...................... 2015 dividends ($100,000 × 30%) ............................................... Investment in Barringer—12/31/15 ..................................................
$92,000 17,250 (8,000) 210,000 60,250 (30,000) 69,000 (750) (2,000) (30,000) $377,750
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.
Chapter 01 - The Equity Method of Accounting for Investments
27. Part b (continued) Gain on sale of investment in Barringer Sales price (given) ...................................................................... Book value 1/1/16 (above) .......................................................... Gain on sale of investment ...................................................
$400,000 (377,750) $ 22,250
Part c Deferral of 2014 unrealized gross profit into 2015 Ending inventory ......................................................................... Gross profit percentage ($15,000 ÷ $50,000) ............................ Unrealized gross profit .......................................................... Anderson’s ownership................................................................ Unrealized intra-entity gross profit ......................................
$20,000 × 30% $6,000 × 30% $ 1,800
Deferral of 2015 unrealized gross profit into 2016 Ending inventory ......................................................................... Gross profit percentage ($27,000 ÷ $60,000) ............................ Unrealized gross profit .......................................................... Anderson’s ownership................................................................ Unrealized intra-entity gross profit ......................................
$40,000 × 45% $18,000 × 30% $ 5,400
Equity Income—2015 2015 equity income accrual ($230,000 × 30%) .......................... 2015 amortization on first purchase (above) ............................ 2015 amortization on second purchase (above) ...................... Realization of 2014 intra-entity profit (above)........................... Deferral of 2015 intra-entity profit (above) ................................ Equity Income—2015 .............................................................
$69,000 (750) (2,000) 1,800 (5,400) $62,650
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.
Chapter 01 - The Equity Method of Accounting for Investments
28. (40 Minutes) (Conversion to equity method and equity reporting after several years) a. Annual Amortization October 1, 2013 purchase Purchase price ............................................................................ Book value, 10/1/13: As of 1/1/13 ......................................................... $100,000 Equity increase 1/1/13 to 10/1/13 ($20,000 income less $8,000 dividends = $12,000) × ¾ year ......................................................... 9,000 Book value of Barker, first purchase date $109,000 Acquired percentage ............................................. × 5% Intangible assets .................................................... Remaining life......................................................... Annual amortization—first purchase.................... July 1, 2014 purchase Purchase price ....................................................... Book value, 7/1/14: As of 1/1/14 ($100,000 + $20,000 - $8,000) ........ $112,000 Equity increase 1/1/14 to 7/1/14 ($30,000 income less $16,000 dividends = $14,000) × ½ year ........................................................ 7,000 Book value of Barker, second purchase date $119,000 Acquired percentage ............................................. × 10% Intangible assets .................................................... Remaining life......................................................... Annual amortization—second purchase .............. December 31, 2015 purchase Purchase price ....................................................... Book value, 12/31/15: As of 1/1/15 ($112,000 + $30,000 - $16,000) ...... Equity increase 1/1/15 to 12/31/15 ($24,000 income less $9,000 dividends)........... Book value of Barker, third purchase Acquired percentage ............................................. 1-25 .
.
$7,475
5,450 $2,025 15 years $ 135
$14,900
11,900 $3,000 15 years $ 200
$34,200 $126,000 15,000 $141,000 × 20%
28,200
Chapter 01 - The Equity Method of Accounting for Investments
28. a (continued) Intangible assets .................................................... Remaining life......................................................... Annual amortization—third purchase ..................
$6,000 15 years $ 400
Equity Income Reported by Smith Reported for 2013 (3 months) after conversion to equity method: Accrual ($20,000 × ¼ year × 5%) ................ Amortization on first purchase ($135 × ¼ year) Equity income 2013................................
$250.00 (33.75) $216.25
Reported for 2014 (5% for entire year and an additional 10% for last 6 months) (after conversion to equity method): Accrual—first purchase ($30,000 entire year × 5%) ...... Accrual—second purchase ($30,000 × ½ year × 10%) .. Amortization on first purchase, entire year ................... Amortization on second purchase ($200 × ½ year) ....... Equity income—2014 ..................................................
1,500 1,500 (135) (100) $2,765
Reported for 2015 (15% for entire year; because final acquisition occurred at year end, neither income nor amortization is recognized): Basic equity accrual ($24,000 × 15%) ............................. Amortization on first purchase ....................................... Amortization on second purchase .................................. Equity income—2015 ..................................................
$3,600 (135) (200) $3,265
b. Investment in Barker Cost—first purchase ................................................................... $ 7,475.00 Cost—second purchase ............................................................. 14,900.00 Cost—third purchase .................................................................. 34,200.00 Equity Income (above) 2013 .......................................................................................... 216.25 2014 .......................................................................................... 2,765.00 2015 .......................................................................................... 3,265.00
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.
Chapter 01 - The Equity Method of Accounting for Investments
28. b (continued) Less: investee dividends 2013 ($8,000 × ¼ × 5%)............................................................ 2014 ($16,000 × 5% and $16,000 × 2/4 × 10%) ....................... 2015 ($9,000 × 15%)................................................................. Balance ........................................................................................
(100.00) (1,600.00) (1,350.00) $59,771.25
29. (25 Minutes) (Preparation of journal entries for two years, includes losses and intra-entity transfers of inventory) Journal Entries for Harper Co. 1/1/14
During 2014
12/31/14
12/31/14
Investment in Kinman Co. ............ Cash ......................................... (To record initial investment)
210,000
Dividends Receivable ................... 4,000 Investment in Kinman Co. ...... (To record dividend declaration: $10,000 x 40%)
4,000
Cash ............................................... Dividends Receivable ............. (To record receipt of dividend)
4,000
4,000
Equity in Kinman Income—Loss . 16,000 Other Comprehensive Loss of Kinman 8,000 Investment in Kinman Co. ...... (To record accrual of income and OCI from equity investee, 40% of reported balances) Equity in Kinman Income—Loss . 3,300 Investment in Kinman Co. ...... (To record amortization relating to acquisition of Kinman—see Schedule 1 below)
1-27 .
210,000
.
24,000
3,300
Chapter 01 - The Equity Method of Accounting for Investments
29. (continued) 12/31/14
During 2015
12/31/15
12/31/15
12/31/15
12/31/15
Equity in Kinman Income-Loss ... 2,000 Investment in Kinman Co. ...... (To defer unrealized gross profit on intra-entity sale see Schedule 2 below) Dividends Receivable ................... 4,800 Investment in Kinman Co. ...... (To record dividend declaration: $12,000 x 40%)
4,800
Cash ............................................... Dividends Receivable.............. (To record receipt of dividend)
4,800
4,800
Investment in Kinman Co. ............ 16,000 Equity in Kinman Income........ (To record 40% accrual of income as earned by equity investee) Equity in Kinman Income ............. 3,300 Investment in Kinman Co. ...... (To record amortization relating to acquisition of Kinman) Investment in Kinman Co. ............ 2,000 Equity in Kinman Income........ (To recognize income deferred from 2014) Equity in Kinman Income ............. 3,600 Investment in Kinman Co. ...... (To defer unrealized gross profit on intra-entity sale—see Schedule 3 below)
1-28 .
2,000
.
16,000
3,300
2,000
3,600
Chapter 01 - The Equity Method of Accounting for Investments
29. (continued) Schedule 1—Allocation of Purchase Price and Related Amortization Purchase price ........................................................ Percentage of book value acquired ($400,000 × 40%)..................................................... Payment in excess of book value ..............................
$210,000 (160,000) $50,000 Remaining Annual Life Amortization
Excess payment identified with specific assets: Building ($40,000 × 40%) $16,000 10 yrs. Royalty agreement ($85,000 × 40%) 34,000 20 yrs. Total annual amortization
$1,600 1,700 $3,300
Schedule 2—Deferral of Unrealized Gross Profit—2014 Inventory remaining at end of year ................................................. Gross profit percentage ($30,000 ÷ $90,000) .................................. Gross profit remaining in inventory .......................................... Ownership percentage ..................................................................... Unrealized gross profit to be deferred until 2015 .....................
$15,000 × 33⅓% $5,000 × 40% $ 2,000
Schedule 3—Deferral of Unrealized Gross Profit—2015 Inventory remaining at end of year (30%) ...................................... Gross profit percentage ($30,000 ÷ $80,000) .................................. Gross profit remaining in inventory .......................................... Ownership percentage ..................................................................... Unrealized gross profit to be deferred until 2016 .....................
1-29 .
.
$24,000 × 37½% $9,000 × 40% $ 3,600
Chapter 01 - The Equity Method of Accounting for Investments
30. (35 Minutes) (Investment sale with equity method applied both before and after. Includes other comprehensive loss and intra-entity inventory transfer) Income effects for year ending December 31, 2015 Equity income in Seacrest, Inc. (Schedule 1) ...........................
$116,000
Other comprehensive loss—Seacrest, Inc. 1/1/15 to 8/1/15 ($120,000 × 40% × 7/12 year) ............. . (28,000) 8/1/15 to 12/31/15 ($120,000 × 32% × 5/12 year) ......... (16,000)
$(44,000)
Gain on sale of 8,000 shares of Seacrest (Schedule 2) .................
$ 25,000
Schedule 1—Equity Income in Seacrest, Inc. Investee income accrual—operations $342,000 × 40% × 7/12 year.................................... $342,000 × 32% × 5/12 year.................................... Amortization $12,000 × 7/12 year ................................................. After 20 percent of stock is sold (8,000 ÷ 40,000 shares): $12,000 × 80% × 5/12 year ................. Recognition of unrealized gross profit Remaining inventory—12/31/14 ............................ Gross profit percentage on original sale ($20,000 ÷ $50,000)............................................ Gross profit remaining in inventory ..................... Ownership percentage .......................................... Intra-entity gross profit recognized in 2015 ......... Equity income in Seacrest, Inc. .......................
1-30 .
.
$79,800 45,600
$125,400
$7,000 4,000
(11,000)
$10,000 × 40% $4,000 × 40% 1,600 $116,000
Chapter 01 - The Equity Method of Accounting for Investments
30. (continued) Schedule 2—Gain on Sale of Investment in Seacrest, Inc. Book value—investment in Seacrest, Inc.—1/1/15 (given) ........ Investee income accrual—1/1/15 – 8/1/15 (Schedule 1) ............. Investee other comprehensive loss 1/1/15 – 8/1/15 .................... Amortization—1/1/15 – 8/1/15 (Schedule 1) ................................. Recognition of deferred profit (Schedule 1) ................................ Investment in Seacrest book value 8/1/15........................................ Percentage of investment sold (8,000 ÷ 40,000 shares) ............. Book value of shares being sold.................................................. Proceeds from sale of shares....................................................... Gain on sale of 8,000 shares of Seacrest. ..............................
$293,600 79,800 (28,000) (7,000) 1,600 $340,000 × 20% $ 68,000 93,000 $ 25,000
31. (30 Minutes) (Compute equity balances for three years. Includes intra-entity inventory transfer) Part a. Equity Income 2013 Basic equity accrual ($598,000 × ½ year × 25%) ....................... Amortization (½ year—see Schedule 1) .................................... Equity Income—2013 .............................................................
$74,750 (30,800) $43,950
Equity Income 2014 Basic equity accrual ($639,600 × 25%) ..................................... Amortization (see Schedule 1) .................................................. Deferral of unrealized profit (see Schedule 2) ......................... Equity Income—2014 ............................................................
$159,900 (61,600) (6,000) $92,300
Equity Income 2015 Basic equity accrual ($692,400 × 25%) ..................................... Amortization (see Schedule 1) .................................................. Recognition of deferred profit (see Schedule 2) ..................... Equity Income—2015 ............................................................
$173,100 (61,600) 6,000 $117,500
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Chapter 01 - The Equity Method of Accounting for Investments
31. (continued) Schedule 1—Acquisition Price Allocation and Amortization Acquisition price (88,000 shares × $13) $1,144,000 Book value acquired ($2,925,600 × 25%) 731,400 Payment in excess of book value $412,600 Excess payment identified with specific assets: Equipment ($364,000 × 25%) Copyright ($972,000 × 25%) Goodwill Total annual amortization (full year)
Remaining Annual Life Amortization
$91,000 7 yrs. 243,000 5 yrs. 78,600 indefinite
$13,000 48,600 -0$61,600
Schedule 2—Deferral of Unrealized Intra-entity Gross Profit Intra-entity Gross Profit Percentage: Sales $152,000 Cost of goods sold 91,200 Gross profit $ 60,800 Gross profit percentage: $60,800 ÷ $152,000 = 40% Inventory remaining at December 31, 2014 ................................. Gross profit percentage ............................................................... Total profit on intra-entity sale still held by affiliate ................... Investor ownership percentage.................................................... Unrealized intra-entity gross profit deferred from 2014 until 2015..........................................................................
$60,000 × 40% $24,000 × 25% $ 6,000
Part b. Investment in Shaun—December 31, 2015 balance Acquisition price ........................................................................... $1,144,000 2013 Equity income (above) ......................................................... 43,950 2013 Dividends declared during half year (88,000 shares × $1.00) (88,000) 2014 Equity income (above) ......................................................... 92,300 2014 Dividends declared (88,000 shares × $1.00 × 2) ................. (176,000) 2015 Equity income (above) ......................................................... 117,500 2015 Dividends declared (88,000 shares × $1.00 × 2) ................. (176,000) Investment in Shaun—12/31/15........................................... $957,750
1-32 .
.
Chapter 01 - The Equity Method of Accounting for Investments
32. (65 Minutes) (Journal entries for several years. Includes conversion to equity method and a sale of a portion of the investment) 1/1/13
Investment in Sumter ..................... 192,000 Cash ........................................... (To record cost of 16,000 shares of Sumter Company.)
9/15/13
Cash ................................................. 8,000 Dividend Income ........................ 8,000 (Annual dividends declared and received from Sumter Company. Because declaration and payment are on same day, a dividend receivable account is unnecessary.)
9/15/14
Cash ................................................. 8,000 Dividend Income ........................ 8,000 (Annual dividends declared and received from Sumter Company.)
1/1/15
Investment in Sumter ..................... 965,750 Cash ........................................... (To record cost of 64,000 additional shares of Sumter Company.)
1/1/15
Investment in Sumter ..................... 36,800 Retained Earnings—Prior Period Adjustment—Equity in Investee Income (Retrospective adjustment necessitated by change to equity method. Change in figures previously reported for 2013 and 2014 are calculated as follows.)
1-33 .
192,000
.
965,750
36,800
Chapter 01 - The Equity Method of Accounting for Investments
32. (continued) 2013 as reported
2013—equity method (as restated)
Income (dividends)..........$8,000
Income (8% of $300,000 reported income) .............................. $24,000 Change in investment balance (equity income less dividends) .................... $16,000
Change in investment Balance .................................. -02014 as reported Income (dividends)..........$8,000 Change in investment Balance .................................. -0-
2014—equity method (as restated) Income (8% of $360,000 reported income) .............................. $28,800 Change in investment balance (equity income less dividends) .................... $20,800
2013 increase in reported income ($24,000 – $8,000)................. 2014 increase in reported income ($28,800 – $8,000)................. Retrospective adjustment—income (above) ...............................
$16,000 20,800 $36,800
2013 increase in investment in Sumter balance—equity method 2014 increase in investment in Sumter balance—equity method Retrospective adjustment—Investment in Sumter (above) ..
$16,000 20,800 $36,800
9/15/15
12/31/15
12/31/15
Cash............................................................ 40,000 Investment in Sumter........................... (Annual dividend declared and received from Sumter [40% × $100,000]) Investment in Sumter ................................ Equity in Investee Income ................... (To accrue 2015 income based on 40% ownership of Sumter)
160,000
Equity in Investee Income ........................ Investment in Sumter........................... (Amortization of $50,550 patent [indicated in problem] over 15 years)
3,370
1-34 .
.
40,000
160,000
3,370
Chapter 01 - The Equity Method of Accounting for Investments
32. (continued) 7/1/16
7/1/16
7/1/16
Investment in Sumter ................................ Equity in Investee Income ................... (To accrue ½ year income of 40% ownership = $380,000 × ½ × 40%)
76,000
Equity in Investee Income ........................ Investment in Sumter........................... (To record ½ year amortization of patent to establish correct book value for investment as of 7/1/16)
1,685
Cash ........................................................... Investment in Sumter (rounded) ......... Gain on Sale of Investment ................. (20,000 shares of Sumter Company sold; investment basis computed below.)
425,000
76,000
1,685
Investment in Sumter and cost of shares sold: 1/1/13 Acquisition .................................................................... 1/1/15 Acquisition ..................................................................... 1/1/15 Retrospective adjustment ............................................ 9/15/15 Dividends ..................................................................... 12/31/15 Basic equity accrual.................................................. 12/31/15 Amortization .............................................................. 7/1/16 Basic equity accrual...................................................... 7/1/16 Amortization .................................................................. Investment in Sumter—7/1/16 balance.............................. Percentage of shares sold (20,000 ÷ 80,000) .................... Cost of shares sold (rounded) ...........................................
346,374 78,626
$
192,000 965,750 36,800 (40,000) 160,000 (3,370) 76,000 (1,685) $1,385,495 × 25% $ 346,374
Because 20,000 of 80,000, or ¼, of shares are sold, the percentage retained is ¾ of 40% = 30%. 9/15/16
Cash........................................................... 30,000 Investment in Sumter.......................... (To record annual dividend declared and received)
1-35 .
.
30,000
Chapter 01 - The Equity Method of Accounting for Investments
32. (continued) 12/31/16
12/31/16
Equity in Sumter ........................................ 57,000 Equity in Investee Income ................... (To record ½ year income based on remaining 30% ownership: $380,000 × 1/2 × 30%)
57,000
Equity in Investee Income ........................ 1,264 (rounded) Investment in Sumter........................... 1,264 (To record ½ year of patent amortization— computation presented below)
Annual patent amortization—original computation ................... Percentage of shares retained (60,000 ÷ 80,000) ........................ Annual patent amortization—current ......................................... Patent amortization for half year ..................................................
$3,370 × 75% $2,528.50 $1,263.75
33. (25 Minutes) (Equity income balances for two years, includes intra-entity transfers) Equity Income 2014 Basic equity accrual ($250,000 × 30%) ................................... Amortization (see Schedule 1) ................................................ Deferral of unrealized gross profit (see Schedule 2) ............ Equity Income—2014 ..........................................................
$75,000 (18,000) (9,000) $48,000
Equity Income (Loss—2015) Basic equity accrual ($100,000 [loss] × 30%) ........................ Amortization (see Schedule 1) ................................................ Realization of deferred gross profit (see Schedule 2) .......... Deferral of unrealized gross profit (see Schedule 3) ............ Equity Loss—2015 ..............................................................
$(30,000) (18,000) 9,000 (4,500) $(43,500)
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Chapter 01 - The Equity Method of Accounting for Investments
33. (continued) Schedule 1 Purchase price ................................................... $770,000 Book value acquired ($1,200,000 × 30%) ......... 360,000 Payment in excess of book value .................... $410,000 Remaining Annual
Excess payment identified with specific assets: Life Amortization Customer list ($300,000 × 30%) 90,000 5 yrs. $18,000 Excess not identified with specific accounts Goodwill $320,000 indefinite -0Total annual amortization $18,000 Schedule 2 Inventory remaining at December 31, 2014 ................................. Gross profit percentage ($60,000 ÷ $160,000) ............................. Total unrealized gross profit ........................................................ Investor ownership percentage.................................................... Unrealized intra-entity gross profit —12/31/14 (To be deferred until realized in 2015) .................................... Schedule 3 Inventory remaining at December 31, 2015 ................................. Gross profit percentage ($35,000 ÷ $175,000) ............................. Total unrealized gross profit ........................................................ Investor ownership percentage.................................................... Unrealized intra-entity gross profit —12/31/15 (To be deferred until realized in 2016) ....................................
1-37 .
.
$80,000 × 37½% $30,000 × 30% $ 9,000
$75,000 × 20% $15,000 × 30% $ 4,500
Chapter 01 - The Equity Method of Accounting for Investments
Solutions to Develop Your Skills Excel Assignment No. 1 (less difficult)—see textbook Website for the Excel file solution Parts 1, 2 and 3 Growth rate in income Dividends Cost Annual amortization 1st year PHC income Percentage owned
10% $30,000 $700,000 (given in problem) $15,000 $185,000 40%
PHC reported income Amortization Equity earnings
2015 $74,000 15,000 $59,000
2016 $81,400 15,000 $66,400
2017 $89,540 15,000 $74,540
2018 $98,494 15,000 $83,494
Beginning Balance Equity earnings Dividends Ending Balance
$700,000 59,000 (12,000) $747,000
$747,000 66,400 (12,000) $801,400
$801,400 74,540 (12,000) $863,940
$863,940 $935,434 83,494 93,343 (12,000) (12,000) $935,434 $1,016,777
8.43% 9.25%
8.89%
9.30%
ROI Average
9.66%
2019 $108,343 15,000 $93,343
9.98%
Part 3 Growth rate in income Dividends Cost
10% $30,000 $639,794
Annual amortization 1st year PHC income Percentage owned
$15,000 $185,000 40%
(Determined through Solver under Tools command)
PHC reported income Amortization Equity earnings
$74,000 15,000 $59,000
$81,400 15,000 $66,400
$89,540 15,000 $74,540
$98,494 15,000 $83,494
$108,343 15,000 $93,343
Beginning Balance Equity earnings Dividends Ending Balance
$639,794 59,000 (12,000) $686,794
$686,794 66,400 (12,000) $741,194
$741,194 74,540 (12,000) $803,734
$803,734 83,494 (12,000) $875,228
$875,228 93,343 (12,000) $956,571
9.22% 10.00%
9.67%
10.06%
10.39%
10.67%
ROI Average
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.
Chapter 01 - The Equity Method of Accounting for Investments
Excel Assignment No. 2 (more difficult)—see textbook Website for the Excel file solution Intergen’s ownership percentage of Ryan
40% Intra-entity Transfer Price = $1,025,000 Cell F4
Ryan's Income Statement Sales Beginning inventory Purchases from Intergen Inventory remaining Ending inventory Cost of goods sold Net income
$900,000 $ -0$1,025,000 25% $ 256,250 $768,750 $131,250
Income to Intergen—40% Income to two equity partners—60%
Intergen's Income Statement Sales Cost of goods sold Gross profit Equity in Ryan's earnings Net income *(52,500 – (40% × 256,250 × 175,000/1,025,000))
$ 52,500 $ 78,750
Rate of Return Analysis Investment Base $1,000,000 $300,000
Intergen Two outside equity partners Difference
$1,025,000 $ 850,000 $ 175,000 $ 35,000* $ 210,000
Rate of Return 21.00% 26.25% -5.25%
Use Goal Seek or Solver under the Tools command to set Cell D20 to zero by changing Cell F4
Intergen’s ownership percentage of Ryan = 40% Intra-entity Transfer Price = 1,050,000 Ryan's Income Statement Sales Beginning inventory Purchases from Intergen Inventory Ending inventory Cost of goods sold Net income
$900,000 $ -0$1,050,000 25% $ 262,500
Income to Intergen—40% Income to two equity partners—60%
$787,500 $112,500
Intergen's Income Statement Sales Cost of goods sold Gross profit Equity in Ryan's earnings Net income
*[45,000 – (40% ×262,500 × 200,000 ÷ 1,050,000)]
$ 45,000 $ 67,500
Rate of Return Analysis Intergen Two outside equity partners Difference
Investment Base $1,000,000 $300,000
1-39 .
.
$1,050,000 $ 850,000 $ 200,000 $ 25,000* $ 225,000
Rate of Return 22.50% 22.50% 0.00%
Chapter 01 - The Equity Method of Accounting for Investments
Solution to Coca-Cola Company Analysis Case 1. In its 2012 10-K, Coca-Cola lists the following companies as significant equity method investees: • • •
Coca-Cola Hellenic Bottling Company S.A. ("Coca-Cola Hellenic"). Coca-Cola FEMSA, S.A.B. de C.V. ("Coca-Cola FEMSA"). Coca-Cola Amatil Limited ("Coca-Cola Amatil").
As part of strategic business alliances, each of these companies bottle, market, and distribute Coca-Cola’s products in various designated geographic areas throughout the world, thus generating substantial revenues for the Coca-Cola Company. According to Coca-Cola’s 2012 annual report (page 10), We make equity investments in selected bottling operations with the intention of maximizing the strength and efficiency of the Coca-Cola system's production, distribution and marketing capabilities around the world. These investments are intended to result in increases in unit case volume, net revenues and profits at the bottler level, which in turn generate increased concentrate sales for our Company's concentrate and syrup business. When this occurs, both we and our bottling partners benefit from long-term growth in volume, improved cash flows and increased shareowner value.
2. From the Coca-Cola Company’s 2012 10-K report (page 85), We use the equity method to account for investments in companies, if our investment provides us with the ability to exercise significant influence over operating and financial policies of the investee. Our consolidated net income includes our Company’s proportionate share of the net income or loss of these companies.
3. 2012 equity income = $819 million. 4. In general, the equity method provides cost-based values while fair values provide exit-based values. The relevance of the equity method valuation derives from the investment’s nature as a productive asset for the investor. Because of their business relationship the investee represents an extension of the investor and frequently a key part of the investor’s business model. Coca-Cola, for example, has a high level of operational influence over its investees who, in turn receive exclusive rights to bottle and distribute Coca-Cola products in specific geographic areas. Because of its significance influence, investors may wish to judge the results of operations of CocaCola’s investees as it related to Coca-Cola’s ownership. Additionally, the equity method provides results consistent with accrual accounting recognizing the net effect of investee revenues and expenses as they are earned by the investor. When possible, fair values are measured using market prices for the investor’s shares of the investee. Although exit prices represent a “hypothetical” sale transaction, they indicate the market’s assessment of the investor’s position in the investee and thus may be relevant. However, if the investor has no plans to sell the shares, exit prices may be of limited relevance for investors’ decision making. 1-40 .
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Chapter 01 - The Equity Method of Accounting for Investments
RESEARCH AND ANALYSIS CASE—IMPAIRMENT 1. Paragraph 323-10-35-32 of the FASB ASC states that A loss in value of an investment which is other than a temporary decline shall be recognized. Evidence of a loss in value might include, but would not necessarily be limited to, absence of an ability to recover the carrying amount of the investment or inability of the investee to sustain an earnings capacity which would justify the carrying amount of the investment. A current fair value of an investment that is less than its carrying amount may indicate a loss in value of the investment. However, a decline in the quoted market price below the carrying amount or the existence of operating losses is not necessarily indicative of a loss in value that is other than temporary. All are factors to be evaluated. 2. Given the facts in the case, a very good case can be made that the decline in value appears permanent. The change in competitive environment, decline in revenues, drop in share value, and the lack of a responsive business plan all point to a loss that is other than temporary. 3. No, according to FASB ASC para. 350-20-35-59, the equity method investment as a whole is reviewed for impairment, not the underlying assets. The FASB concluded that because equity method goodwill is not separable from the related investment, that goodwill should not be separately tested for impairment.
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Chapter 01 - The Equity Method of Accounting for Investments
Research Case Solution -- Noncontrolling Shareholder Rights 1. Protective Rights (ASC Topic 810, Consolidation 810-10-25-10) Noncontrolling rights (whether granted by contract or by law) that would allow the noncontrolling shareholder to block corporate actions would be considered protective rights and would not overcome the presumption of consolidation by the investor with a majority voting interest in its investee. The following list is illustrative of the protective rights that often are provided to the noncontrolling shareholder but is not all-inclusive: a. Amendments to articles of incorporation of the investee b. Pricing on transactions between the owner of a majority voting interest and the investee and related self-dealing transactions c. Liquidation of the investee or a decision to cause the investee to enter bankruptcy or other receivership d. Acquisitions and dispositions of assets that are not expected to be undertaken in the ordinary course of business (noncontrolling rights relating to acquisitions and dispositions of assets that are expected to be made in the ordinary course of business are participating rights; determining whether such rights are substantive requires judgment in light of the relevant facts and circumstances [see paragraphs 810-10-25-13 and 810-10-55-1]) e. Issuance or repurchase of equity interests. 2. Substantive Participating Rights (ASC Topic 810, Consolidation 810-10-25-11) Noncontrolling rights (whether granted by contract or by law) that would allow the noncontrolling shareholder to participate in determining certain financial and operating decisions in the ordinary course of business shall be considered substantive participating rights and would overcome the presumption that the investor with a majority voting interest shall consolidate its investee. Example: In its 2012 10-K annual report, Sprint cited substantive participating rights of the noncontrolling interest as a reason for not consoldating its investment in Clearwire. 3. (FASB ASC Topic 810, Consolidation 810-10-25-11) Substantive participating rights would overcome the presumption that the investor with a majority voting interest shall consolidate its investee. The following list is illustrative of substantive participating rights, but is not necessarily all-inclusive: a. Selecting, terminating, and setting the compensation of management responsible for implementing the investee's policies and procedures
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Chapter 01 - The Equity Method of Accounting for Investments
b. Establishing operating and capital decisions of the investee, including budgets, in the ordinary course of business. 4. Assessing Individual Noncontrolling Rights (FASB ASC Topic 810, Consolidation 810-10-55-1 b and c) b. Existing facts and circumstances should be considered in assessing whether the rights of the noncontrolling shareholder relating to an investee's incurring additional indebtedness are protective or participating rights. For example, if it is reasonably possible or probable that the investee will need to incur the level of borrowings that requires noncontrolling shareholder approval in its ordinary course of business, the rights of the noncontrolling shareholder would be viewed as substantive participating rights. c. The rights of the noncontrolling shareholder relating to dividends or other distributions may be protective or participating and should be assessed in light of the available facts and circumstances. For example, rights to block customary or expected dividends or other distributions may be substantive participating rights, while rights to block extraordinary distributions would be protective rights.
1-43 .
.
Chapter 02 - Consolidation of Financial Information
CHAPTER 2 CONSOLIDATION OF FINANCIAL INFORMATION Accounting standards for business combination are found in FASB ASC Topic 805, “Business Combinations” and Topic 810, “Consolidation.” These standards require the acquisition method which emphasizes acquisition-date fair values for recording all combinations. In this chapter, we first provide coverage of expansion through corporate takeovers and an overview of the consolidation process. Then we present the acquisition method of accounting for business combinations followed by limited coverage of the purchase method and pooling of interests provided in the Appendix to this chapter.
Chapter Outline I.
Business combinations and the consolidation process A. A business combination is the formation of a single economic entity, an event that occurs whenever one company gains control over another B. Business combinations can be created in several different ways 1. Statutory merger—only one of the original companies remains in business as a legally incorporated enterprise. a. Assets and liabilities can be acquired with the seller then dissolving itself as a corporation. b. All of the capital stock of a company can be acquired with the assets and liabilities then transferred to the buyer followed by the seller’s dissolution. 2. Statutory consolidation—assets or capital stock of two or more companies are transferred to a newly formed corporation 3. Acquisition by one company of a controlling interest in the voting stock of a second. Dissolution does not take place; both parties retain their separate legal incorporation. C. Financial information from the members of a business combination must be consolidated into a single set of financial statements representing the entire economic entity. 1. If the acquired company is legally dissolved, a permanent consolidation is produced on the date of acquisition by entering all account balances into the financial records of the surviving company. 2. If separate incorporation is maintained, consolidation is periodically simulated whenever financial statements are to be prepared. This process is carried out through the use of worksheets and consolidation entries. Consolidation worksheet entries are used to adjust and eliminate subsidiary company accounts. Entry “S” eliminates the equity accounts of the subsidiary. Entry “A” allocates exess payment amounts to identifiable assets and liabilities based on the fair value of the subsidiary accounts. (Consolidation journal entries are never recorded in the books of either company, they are worksheet entries only.)
2-1 ..
Chapter 02 - Consolidation of Financial Information
II.
III.
The Acquisition Method A. The acquisition method replaced the purchase method. For combinations resulting in complete ownership, it is distinguished by four characteristics. 1. All assets acquired and liabilities assumed in the combination are recognized and measured at their individual fair values (with few exceptions). 2. The fair value of the consideration transferred provides a starting point for valuing and recording a business combination. a. The consideration transferred includes cash, securities, and contingent performance obligations. b. Direct combination costs are expensed as incurred. c. Stock issuance costs are recorded as a reduction in paid-in capital. d. The fair value of any noncontrolling interest also adds to the valuation of the acquired firm and is covered beginning in Chapter 4 of the text. 3. Any excess of the fair value of the consideration transferred over the net amount assigned to the individual assets acquired and liabilities assumed is recognized by the acquirer as goodwill. 4. Any excess of the net amount assigned to the individual assets acquired and liabilities assumed over the fair value of the consideration transferred is recognized by the acquirer as a “gain on bargain purchase.” B. In-process research and development acquired in a business combination is recognized as an asset at its acquisition-date fair value. Convergence between U.S. GAAP and IAS A. IFRS 3 – nearly identical to U.S. GAAP because of joint efforts B. IFRS 10 – Consolidated Finanical Statements and IFRS 12 – Disclosure of Interests in Other Entities both become effective in 2013. Some differences between these and GAAP
APPENDIX: The Purchase Method A. The purchase method was applicable for business combinations occurring for fiscal years beginning prior to December 15, 2008. It was distinguished by three characteristics. 1. One company was clearly in a dominant role as the purchasing party 2. A bargained exchange transaction took place to obtain control over the second company. 3. A historical cost figure was determined based on the acquisition price paid. a. The cost of the acquisition included any direct combination costs. b. Stock issuance costs were recorded as a reduction in paid-in capital and are not considered to be a component of the acquisition price. B. Purchase method procedures 1. The assets and liabilities acquired were measured by the buyer at fair value as of the date of acquisition. 2. Any portion of the payment made in excess of the fair value of these assets and liabilities was attributed to an intangible asset commonly referred to as goodwill.
2-2 ..
Chapter 02 - Consolidation of Financial Information
3. If the price paid was below the fair value of the assets and liabilities, the accounts of the acquired company were still measured at fair value except that the values of certain noncurrent assets were reduced in total by the excess cost. If these values were not great enough to absorb the entire reduction, an extraordinary gain was recognized. The Pooling of Interest Method (prohibited for combinations after June 2002) A. A pooling of interests was formed by the uniting of the ownership interests of two companies through the exchange of equity securities. The characteristics of a pooling are fundamentally different from either the purchase or acquisition methods. 1. Neither party was truly viewed as an acquiring company. 2. Precise cost figures stemming from the exchange of securities were difficult to ascertain. 3. The transaction affected the stockholders rather than the companies. B. Pooling of interests accounting 1. Because of the nature of a pooling, determination of an acquisition price was not relevant. a. Since no acquisition price was computed, all direct costs of creating the combination were expensed immediately. b. In addition, new goodwill arising from the combination was never recognized in a pooling of interests. Similarly, no valuation adjustments were recorded for any of the assets or liabilities combined. 2. The book values of the two companies were simply brought together to produce a set of consolidated financial records. A pooling was viewed as affecting the owners rather than the two companies. 3. The results of operations reported by both parties were combined on a retroactive basis as if the companies had always been together. 4. Controversy historically surrounded the pooling of interests method. a. Any cost figures indicated by the exchange transaction that created the combination were ignored. b. Income balances previously reported were altered since operations were combined on a retroactive basis. c. Reported net income was usually higher in subsequent years than in a purchase since no goodwill or valuation adjustments were recognized which require amortization.
2-3 ..
Chapter 02 - Consolidation of Financial Information
Answers to Questions 1.
2.
3.
4.
5.
6.
A business combination is the process of forming a single economic entity by the uniting of two or more organizations under common ownership. The term also refers to the entity that results from this process. (1) A statutory merger is created whenever two or more companies come together to form a business combination and only one remains in existence as an identifiable entity. This arrangement is often instituted by the acquisition of substantially all of an enterprise’s assets. (2) A statutory merger can also be produced by the acquisition of a company’s capital stock. This transaction is labeled a statutory merger if the acquired company transfers its assets and liabilities to the buyer and then legally dissolves as a corporation. (3) A statutory consolidation results when two or more companies transfer all of their assets or capital stock to a newly formed corporation. The original companies are being “consolidated” into the new entity. (4) A business combination is also formed whenever one company gains control over another through the acquisition of outstanding voting stock. Both companies retain their separate legal identities although the common ownership indicates that only a single economic entity exists. Consolidated financial statements represent accounting information gathered from two or more separate companies. This data, although accumulated individually by the organizations, is brought together (or consolidated) to describe the single economic entity created by the business combination. Companies that form a business combination will often retain their separate legal identities as well as their individual accounting systems. In such cases, internal financial data continues to be accumulated by each organization. Separate financial reports may be required for outside shareholders (a noncontrolling interest), the government, debt holders, etc. This information may also be utilized in corporate evaluations and other decision making. However, the business combination must periodically produce consolidated financial statements encompassing all of the companies within the single economic entity. The purpose of a worksheet is to organize and structure this process. The worksheet allows for a simulated consolidation to be carried out on a regular, periodic basis without affecting the financial records of the various component companies. Several situations can occur in which the fair value of the 50,000 shares being issued might be difficult to ascertain. These examples include: ▪ The shares may be newly issued (if Jones has just been created) so that no accurate value has yet been established; ▪ Jones may be a closely held corporation so that no fair value is available for its shares; ▪ The number of newly issued shares (especially if the amount is large in comparison to the quantity of previously outstanding shares) may cause the price of the stock to fluctuate widely so that no accurate fair value can be determined during a reasonable period of time; ▪ Jones’ stock may have historically experienced drastic swings in price. Thus, a quoted figure at any specific point in time may not be an adequate or representative value for long-term accounting purposes. For combinations resulting in complete ownership, the acquisition method allocates the fair value of the consideration transferred to the separately recognized assets acquired and liabilities assumed based on their individual fair values.
2-4 ..
Chapter 02 - Consolidation of Financial Information
7.
8.
9.
10.
11.
The revenues and expenses (both current and past) of the parent are included within reported figures. However, the revenues and expenses of the subsidiary are consolidated from the date of the acquisition forward within the worksheet consolidation process. The operations of the subsidiary are only applicable to the business combination if earned subsequent to its creation. Morgan’s additional acquisition value may be attributed to many factors: expected synergies between Morgan’s and Jennings’ assets, favorable earnings projections, competitive bidding to acquire Jennings, etc. In general however, any amount paid by the parent company in excess of the fair values of the subsidiary’s net assets acquired is reported as goodwill. In the vast majority of cases the assets acquired and liabilities assumed in a business combination are recorded at their fair values. If the fair value of the consideration transferred (including any contingent consideration) is less than the total net fair value assigned to the assets acquired and liabilities assumed, then an ordinary gain on bargain purchase is recognized for the difference. Shares issued are recorded at fair value as if the stock had been sold and the money obtained used to acquire the subsidiary. The Common Stock account is recorded at the par value of these shares with any excess amount attributed to additional paid-in capital. The direct combination costs of $98,000 are allocated to expense in the period in which they occur. Stock issue costs of $56,000 are treated as a reduction of APIC.
2-5 ..
Chapter 02 - Consolidation of Financial Information
Answers to Problems 1.
D
2.
B
3.
D
4.
A
5.
B
6.
A
7.
A
8.
B
9.
C
10. C 11. B Consideration transferred (fair value) Cash Accounts receivable Software Research and development asset Liabilities Fair value of net identifiable assets acquired Goodwill 12. C Legal and accounting fees accounts payable Contingent liabilility Donovan’s liabilities assumed Liabilities assumed or incurred 13. D Consideration transferred (fair value) Current assets Building and equipment Unpatented technology Research and development asset Liabilities Fair value of net identifiable assets acquired Goodwill Current assets Building and equipment Unpatented technology Research and development asset Goodwill Total assets
$150,000 140,000 320,000 200,000 (130,000) 680,000 $120,000 $15,000 20,000 60,000 $95,000 $420,000 $90,000 250,000 25,000 45,000 (60,000) 350,000 $ 70,000 $ 90,000 250,000 25,000 45,000 70,000 $480,000
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$800,000
Chapter 02 - Consolidation of Financial Information
14. C Value of shares issued (51,000 × $3) ...................................... $153,000 Par value of shares issued (51,000 × $1) ................................ 51,000 Additional paid-in capital (new shares) ................................. $102,000 Additional paid-in capital (existing shares) .......................... 90,000 Consolidated additional paid-in capital (fair value)............... $192,000 At the acquisition date, the parent makes no change to retained earnings. 15. B Consideration transferred (fair value) .......................... Book value of subsidiary (assets minus liabilities) .... Fair value in excess of book value ........................... Allocation of excess fair over book value identified with specific accounts: Inventory ..................................................................... Patented technology .................................................. Land ............................................................................ Long-term liabilities ................................................... Goodwill ......................................................................
$400,000 (300,000) 100,000
16. D TruData patented technology........................................ Webstat patented technology (fair value) .................... Acquisition-date consolidated balance sheet amount
$230,000 200,000 $430,000
17. C TruData common stock before acquisition.................. Common stock issued (par value) ................................ Acquisition-date consolidated balance sheet amount
$300,000 50,000 $350,000
18. B TruData’s 1/1 retained earnings .................................... TruData’s income (1/1 to 7/1) ........................................ Acquisition-date consolidated balance sheet amount
$130,000 80,000 $210,000
19.a.
30,000 20,000 25,000 10,000 $15,000
An intangible asset acquired in a business combination is recognized as an asset apart from goodwill if it arises from contractual or other legal rights (regardless of whether those rights are transferable or separable from the acquired enterprise or from other rights and obligations). If an intangible asset does not arise from contractual or other legal rights, it shall be recognized as an asset apart from goodwill only if it is separable, that is, it is capable of being separated or divided from the acquired enterprise and sold, transferred, licensed, rented, or exchanged (regardless of whether there is an intent to do so). An intangible asset that cannot be sold, transferred, licensed, rented, or exchanged individually is considered separable if it can be sold, transferred, licensed, rented, or exchanged with a related contract, asset, or liability.
b. ◼ Trademarks—usually meet both the separability and legal/contractual criteria. 2-7 ..
Chapter 02 - Consolidation of Financial Information ◼ ◼ ◼ ◼
Customer list—usually meets the separability criterion. Copyrights on artistic materials—usually meet both the separability and legal/contractual criteria. Agreements to receive royalties on leased intellectual property—usually meet the legal/contractual criterion. Unpatented technology—may meet the separability criterion if capable of being sold even if in conjunction with a related contract, asset, or liability.
20. (12 minutes) (Journal entries to record a merger—acquired company dissolved) Inventory Land Buildings Customer Relationships Goodwill Accounts Payable Common Stock Additional Paid-In Capital Cash
600,000 990,000 2,000,000 800,000 690,000
Professional Services Expense Cash
42,000
Additional Paid-In Capital Cash
25,000
80,000 40,000 960,000 4,000,000
42,000
25,000
21. (12 minutes) (Journal entries to record a bargain purchase—acquired company dissolved) Inventory Land Buildings Customer Relationships Accounts Payable Cash Gain on Bargain Purchase
600,000 990,000 2,000,000 800,000
Professional Services Expense Cash
42,000
80,000 4,200,000 110,000
42,000
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Chapter 02 - Consolidation of Financial Information
22. (15 Minutes) (Consolidated balances) In acquisitions, the fair values of the subsidiary's assets and liabilities are consolidated (there are a limited number of exceptions). Goodwill is reported at $80,000, the amount that the $760,000 consideration transferred exceeds the $680,000 fair value of Sol’s net assets acquired. ▪ Inventory = $670,000 (Padre's book value plus Sol's fair value) ▪ Land = $710,000 (Padre's book value plus Sol's fair value) ▪ Buildings and equipment = $930,000 (Padre's book value plus Sol's fair value) ▪ Franchise agreements = $440,000 (Padre's book value plus Sol's fair value) ▪ Goodwill = $80,000 (calculated above) ▪ Revenues = $960,000 (only parent company operational figures are reported at date of acquisition) ▪ Additional paid-in capital = $265,000 (Padre's book value adjusted for stock issue less stock issuance costs) ▪ Expenses = $940,000 (only parent company operational figures plus acquisition-related costs are reported at date of acquisition) ▪ Retained earnings, 1/1 = $390,000 (Padre's book value only) ▪ Retained earnings, 12/31 = $410,000 (beginning retained earnings plus revenues minus expenses, of Padre only)
2-9 ..
Chapter 02 - Consolidation of Financial Information
23. (20 minutes) Journal entries for a merger using alternative values. a. Acquisition date fair values: Cash paid Contingent performance liability Consideration transferred Fair values of net assets acquired Gain on bargain purchase
$700,000 35,000 $735,000 750,000 $ 15,000
Receivables 90,000 Inventory 75,000 Copyrights 480,000 Patented Technology 700,000 Research and Development Asset 200,000 Current liabilities 160,000 Long-Term Liabilities 635,000 Cash 700,000 Contingent Performance Liability 35,000 Gain on Bargain Purchase 15,000 Professional Services Expense Cash
100,000 100,000
b. Acquisition date fair values: Cash paid Contingent performance liability Consieration transferred Fair values of net assets acquired Goodwill
$800,000 35,000 $835,000 750,000 $ 85,000
Receivables 90,000 Inventory 75,000 Copyrights 480,000 Patented Technology 700,000 Research and Development Asset 200,000 Goodwill 85,000 Current Liabilities 160,000 Long-Term Liabilities 635,000 Cash 800,000 Contingent Performance Liability 35,000 Professional Services Expense Cash
100,000 100,000
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Chapter 02 - Consolidation of Financial Information
24. (20 Minutes) (Determine selected consolidated balances) Under the acquisition method, the shares issued by Wisconsin are recorded at fair value using the following journal entry: Investment in Badger (value of debt and shares issued) 900,000 Common Stock (par value) ............................................ 150,000 Additional Paid-In Capital (excess over par value) ..... 450,000 Liabilities......................................................................... 300,000 The payment to the broker is accounted for as an expense. The stock issue cost is a reduction in additional paid-in capital. Professional Services Expense.......................................... Additional Paid-In Capital ................................................... Cash ..............................................................................
30,000 40,000 70,000
Allocation of Acquisition-Date Excess Fair Value: Consideration transferred (fair value) for Badger Stock Book Value of Badger, 6/30 ................................................ Fair Value in Excess of Book Value .............................. Excess fair value (undervalued equipment) ...................... Excess fair value (overvalued patented technology) ....... Goodwill ..........................................................................
$900,000 770,000 $130,000 100,000 (20,000) $ 50,000
CONSOLIDATED BALANCES: ▪ Net income (adjusted for professional services expense. The figures earned by the subsidiary prior to the takeover are not included) ...................................................................... $ 210,000 ▪ Retained earnings, 1/1 (the figures earned by the subsidiary prior to the takeover are not included) ................................... 800,000 ▪ Patented technology (the parent's book value plus the fair value of the subsidiary) ........................................................... 1,180,000 ▪ Goodwill (computed above) .................................................... 50,000 ▪ Liabilities (the parent's book value plus the fair value of the subsidiary's debt plus the debt issued by the parent in acquiring the subsidiary) .................................................... 1,210,000 ▪ Common stock (the parent's book value after recording the newly-issued shares)......................................................... 510,000 ▪ Additional Paid-in Capital (the parent's book value after recording the two entries above) ................................... 680,000
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Chapter 02 - Consolidation of Financial Information
25. (20 minutes) (Preparation of a consolidated balance sheet)* CASEY COMPANY AND CONSOLIDATED SUBSIDIARY KENNEDY Worksheet for a Consolidated Balance Sheet January 1, 2015 Cash Accounts receivable Inventory Investment in Kennedy
Casey 457,000 1,655,000 1,310,000 3,300,000
Kennedy 172,500 347,000 263,500 -0-
Buildings (net) Licensing agreements Goodwill Total assets
6,315,000 -0347,000 13,384,000
2,090,000 3,070,000 -05,943,000
Accounts payable Long-term debt Common stock Additional paid-in cap. Retained earnings Total liab. & equities
(394,000) (3,990,000) (3,000,000) -0(6,000,000) (13,384,000)
(393,000) (2,950,000) (1,000,000) (500,000) (1,100,000) (5,943,000)
Adjust. & Elim.
(A) 382,000 (A) 426,000
(S) 1,000,000 (S) 500,000 (S) 1,100,000 3,408,000
Consolidated 629,500 2,002,000 1,573,500 (S) 2,600,000 (A) 700,000 -08,787,000 (A) 108,000 2,962,000 773,000 16,727,000 (787,000) (6,940,000) (3,000,000) -0(6,000,000) 3,408,000 (16,727,000)
*Although this solution uses a worksheet to compute the consolidated amounts, the problem does not require it.
26. (50 Minutes) (Determine consolidated balances for a bargain purchase.) a. Marshall’s acquisition of Tucker represents a bargain purchase because the fair value of the net assets acquired exceeds the fair value of the consideration transferred as follows: Fair value of net assets acquired $515,000 Fair value of consideration transferred 400,000 Gain on bargain purchase $115,000 In a bargain purchase, the acquisition is recorded at the fair value of the net assets acquired instead of the fair value of the consideration transferred (an exception to the general rule). Prior to preparing a consolidation worksheet, Marshall records the three transactions that occurred to create the business combination. Investment in Tucker ............................................... 515,000 Long-term Liabilities ............................................................... 200,000 Common Stock (par value) ..................................................... 20,000 Additional Paid-In Capital ....................................................... 180,000 Gain on Bargain Purchase ..................................................... 115,000 (To record liabilities and stock issued for Tucker acquisition fair value)
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Chapter 02 - Consolidation of Financial Information
26. (continued) Professional Services Expense.......................... Cash .............................................................. (to record payment of professional fees)
30,000
Additional Paid-In Capital ................................... Cash .............................................................. (To record payment of stock issuance costs)
12,000
30,000
12,000
Marshall's trial balance is adjusted for these transactions (as shown in the worksheet that follows). Next, the $400,000 fair value of the investment is allocated: Consideration transferred at fair value ................................... $400,000 Book value (assets minus liabilities or total stockholders' equity) .................................................. 460,000 Book value in excess of consideration transferred ........ (60,000) Allocation to specific accounts based on fair value: Inventory ................................................................... 5,000 Land ........................................................................ 20,000 Buildings ................................................................... 30,000 55,000 Gain on bargain purchase (excess net asset fair value over consideration transferred) ......................................... $(115,000) CONSOLIDATED TOTALS ▪ Cash = $38,000. Add the two book values less acquisition and stock issue costs ▪ Receivables = $360,000. Add the two book values. ▪ Inventory = $505,000. Add the two book values plus the fair value adjustment ▪ Land = $400,000. Add the two book values plus the fair value adjustment. ▪ Buildings = $670,000. Add the two book values plus the fair value adjustment. ▪ Equipment = $210,000. Add the two book values. ▪ Total assets = $2,183,000. Summation of the above individual figures. ▪ Accounts payable = $190,000. Add the two book values. ▪ Long-term liabilities = $830,000. Add the two book values plus the debt incurred by the parent in acquiring the subsidiary. ▪ Common stock = $130,000.The parent's book value after stock issue to acquire the subsidiary. ▪ Additional paid-in capital = $528,000.The parent's book value after the stock issue to acquire the subsidiary less the stock issue costs. ▪ Retained earnings = $505,000. Parent company balance less $30,000 in professional services expense plus $115,000 gain on bargain purchase. ▪ Total liabilities and equity = $2,183,000. Summation of the above figures.
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Chapter 02 - Consolidation of Financial Information
26. (continued) b.
MARSHALL COMPANY AND CONSOLIDATED SUBSIDIARY Worksheet January 1, 2015
Accounts Cash ............................................ Receivables ............................... Inventory ................................... Land ........................................... Buildings (net) .......................... Equipment (net) ........................ Investment in Tucker ................
Marshall Company* 18,000 270,000 360,000 200,000 420,000 160,000 515,000
Tucker Company 20,000 90,000 140,000 180,000 220,000 50,000
Total assets ...............................
1,943,000
700,000
Accounts payable ...................... Long-term liabilities ................. Common stock .......................... Additional paid-in capital ......... Retained earnings, 1/1/15 ......... Total liab. and owners’ equity ..
(150,000) (630,000) (130,000) (528,000) ( 505,000) (1,943,000)
(40,000) (200,000) (120,000) -0(340,000) (700,000)
Consolidation Entries Consolidated Debit Credit Totals 38,000 360,000 (A) 5,000 505,000 (A) 20,000 400,000 (A) 30,000 670,000 210,000 (S) 460,000 (A) 55,000 -02,183,000
(S) 120,000 (S) 340,000 515,000
Marshall's accounts have been adjusted for acquisition entries (see part a.).
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(190,000) (830,000) (130,000) (528,000) (505,000) 515,000 (2,183,000)
Chapter 02 - Consolidation of Financial Information
27. (Prepare a consolidated balance sheet) Consideration transferred at fair value .............. Book value ........................................................... Excess fair over book value ............................... Allocation of excess fair value to specific assets and liabilities: to computer software ..................................... to equipment................................................... to client contracts .......................................... to in-process research and development ... to notes payable ............................................. Goodwill ...............................................................
Cash Receivables Inventory Investment in Spider
Pratt
Spider
36,000 116,000 140,000 495,000
18,000 52,000 90,000 -0-
$495,000 265,000 230,000
$50,000 (10,000) 100,000 40,000 (5,000)
Debit
Credit
175,000 $ 55,000 Consolidated 54,000 168,000 230,000
(S) 265,000 (A) 230,000
-0280,000 725,000 338,000 100,000
Computer software 210,000 Buildings (net) 595,000 Equipment (net) 308,000 Client contracts -0Research and devlopment asset -0Goodwill -0Total assets 1,900,000
20,000 (A) 50,000 130,000 40,000 (A) 10,000 -0- (A) 100,000 -0- (A) 40,000 -0- (A) 55,000 350,000
40,000 55,000 1,990,000
Accounts payable Notes payable Common stock Additional paid-in capital Retained earnings Total liabilities and equities
(88,000) (510,000) (380,000)
(25,000) (60,000) (A) 5,000 (100,000) (S)100,000
(113,000) (575,000) (380,000)
(170,000) (752,000)
(25,000) (S) 25,000 (140,000) (S)140,000
(170,000) (752,000)
(1,900,000)
(350,000)
510,000
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510,000 (1,990,000)
Chapter 02 - Consolidation of Financial Information
27. (continued)
Pratt Company and Subsidiary Consolidated Balance Sheet December 31, 2015 Assets Liabilities and Owners’ Equity Cash $ 54,000 Accounts payable $ 113,000 Receivables 168,000 Notes payable 575,000 Inventory 230,000 Computer software 280,000 Buildings (net) 725,000 Equipment (net) 338,000 Client contracts 100,000 Research and Common stock 380,000 development asset 40,000 Additional paid in capital 170,000 Goodwill 55,000 Retained earnings 752,000 Total assets $1,990,000 Total liabilities and equities $1,990,000
28. (15 minutes) (Acquisition method entries for a merger) Case 1: Fair value of consideration transferred Fair value of net identifiable assets Excess to goodwill
$145,000 120,000 $25,000
Case 1 journal entry on Allerton’s books: Current Assets Building Land Trademark Goodwill Liabilities Cash
60,000 50,000 20,000 30,000 25,000 40,000 145,000
Case 2: Bargain Purchase under acquisition method Fair value of consideration transferred Fair value of net identifiable assets Gain on bargain purchase
$110,000 120,000 $ 10,000
Case 2 journal entry on Allerton’s books: Current Assets Building Land Trademark Gain on Bargain Purchase Liabilities Cash
60,000 50,000 20,000 30,000 10,000 40,000 110,000
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Chapter 02 - Consolidation of Financial Information
Problem 28. (continued) In a bargain purchase, the acquisition method employs the fair value of the net identifiable assets acquired as the basis for recording the acquisition. Because this basis exceeds the amount paid, Allerton recognizes a gain on bargain purchase. This is an exception to the general rule of using the fair value of the consideration transferred as the basis for recording the combination. 29. (25 minutes) (Combination entries—acquired entity dissolved) Cash consideration transferred Contingent performance obligation Consideration transferred (fair value) Fair value of net identifiable assets Goodwill
$310,800 17,900 328,700 294,700 $ 34,000
Journal entries: Receivables 83,900 Inventory 70,250 Buildings 122,000 Equipment 24,100 Customer List 25,200 Research and Development Asset 36,400 Goodwill 34,000 Current Liabilities Long-Term Liabilities Contingent Performance Liability Cash
12,900 54,250 17,900 310,800
Professional Services Expense Cash
15,100
15,100
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Chapter 02 - Consolidation of Financial Information
30. (30 Minutes) (Overview of the steps in applying the acquisition method when shares have been issued to create a combination. Part h. includes a bargain purchase.) a. The fair value of the consideration includes Fair value of stock issued Contingent performance obligation Fair value of consideration transferred
$1,500,000 30,000 $1,530,000
b. Stock issue costs reduce additional paid-in capital. c. In a business combination, direct acquisition costs (such as fees paid to investment banks for arranging the transaction) are recognized as expenses. d. The par value of the 20,000 shares issued is recorded as an increase of $20,000 in the Common Stock account. The $74 fair value in excess of par value ($75 – $1) is an increase to additional paid-in capital of $1,480,000 ($74 × 20,000 shares). e. Fair value of consideration transferred (above) Receivables $ 80,000 Patented technology 700,000 Customer relationships 500,000 In-process research and development 300,000 Liabilities (400,000) Goodwill
$1,530,000
1,180,000 $ 350,000
f. Revenues and expenses of the subsidiary from the period prior to the combination are omitted from the consolidated totals. Only the operational figures for the subsidiary after the purchase are applicable to the business combination. The previous owners earned any previous profits. g. The subsidiary’s Common Stock and Additional Paid-in Capital accounts have no impact on the consolidated totals. h. The fair value of the consideration transferred is now $1,030,000. This amount indicates a bargain purchase calculated as follows: Fair value of consideration transferred Receivables Patented technology Customer relationships Research and development asset Liabilities Gain on bargain purchase
$1,030,000 $ 80,000 700,000 500,000 300,000 (400,000)
1,180,000 $ 150,000
The values of SafeData’s assets and liabilities would be recorded at fair value, but there would be no goodwill recognized and a gain on bargain purchase would be reported. 2-18 ..
Chapter 02 - Consolidation of Financial Information
31. (50 Minutes) (Prepare balance sheet for a statutory merger using the acquisition method. Also, use worksheet to derive consolidated totals.) a. In accounting for the combination of NewTune and On-the-Go, the fair value of the acquisition is allocated to each identifiable asset and liability acquired with any remaining excess attributed to goodwill. Fair value of consideration transferred (shares issued) $750,000 Fair value of net assets acquired: Cash $ 29,000 Receivables 63,000 Trademarks 225,000 Record music catalog 180,000 In-process research and development 200,000 Equipment 105,000 Accounts payable (34,000) Notes payable (45,000) 723,000 Goodwill $ 27,000 Journal entries by NewTune to record combination with On-the-Go: Cash 29,000 Receivables 63,000 Trademarks 225,000 Record Music Catalog 180,000 Research and Development Asset 200,000 Equipment 105,000 Goodwill 27,000 Accounts Payable Notes Payable Common Stock (NewTune par value) Additional Paid-In Capital (To record merger with On-the-Go at fair value) Additional Paid-In Capital Cash (Stock issue costs incurred)
25,000 25,000
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34,000 45,000 60,000 690,000
Chapter 02 - Consolidation of Financial Information
Problem 31 (continued): Post-Combination Balance Sheet: Assets Cash Receivables Trademarks Record music catalog Research and development asset Equipment Goodwill Total
$
64,000 213,000 625,000 1,020,000
200,000 425,000 27,000 $2,574,000
Liabilities and Owners’ Equity Accounts payable $ 144,000 Notes payable 415,000
Common stock Additional paid-in capital Retained earnings Total
460,000 695,000 860,000 $2,574,000
b. Because On-the-Go continues as a separate legal entity, NewTune first records the acquisition as an investment in the shares of On-the-Go. Journal entries: Investment in On-the-Go Common Stock (NewTune, Inc., par value) Additional Paid-In Capital (To record acquisition of On-the-Go's shares)
750,000
Additional Paid-In Capital Cash (Stock issue costs incurred)
25,000
60,000 690,000
25,000
Next, NewTune’s accounts are adjusted for the two immediately preceding entries to facilitate the worksheet preparation of the consolidated financial statements.
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Chapter 02 - Consolidation of Financial Information
31. (continued) b.
NEWTUNE, INC., AND ON-THE-GO CO. Consolidation Worksheet January 1, 2015 Consolidation Entries Accounts NewTune, Inc. On-the-Go Co. Debit Credit Cash 35,000 29,000 Receivables 150,000 65,000 (A) 2,000 Investment in On-the-Go 750,000 -0(S) 270,000 (A) 480,000 Trademarks 400,000 95,000 (A) 130,000 Record music catalog 840,000 60,000 (A) 120,000 Research and development asset -0-0(A) 200,000 Equipment 320,000 105,000 Goodwill -0-0(A) 27,000 Totals 2,495,000 354,000 Accounts payable 110,000 34,000 Notes payable 370,000 50,000 (A) 5,000 Common stock 460,000 50,000 (S) 50,000 Additional paid-in capital 695,000 30,000 (S) 30,000 Retained earnings 860,000 190,000 (S) 190,000 Totals 2,495,000 354,000 752,000 752,000
Consolidated Totals 64,000 213,000 -0625,000 1,020,000 200,000 425,000 27,000 2,574,000 144,000 415,000 460,000 695,000 860,000 2,574,000
Note: The accounts of NewTune have already been adjusted for the first three journal entries indicated in the answer to Part b. to record the acquisition fair value and the stock issuance costs. The consolidation entries are designed to: ▪ Eliminate the stockholders’ equity accounts of the subsidiary (S) ▪ Record all subsidiary assets and liabilities at fair value (A) ▪ Recognize the goodwill indicated by the acquisition fair value (A) ▪ Eliminate the Investment in On-the-Go account (S, A) c. The consolidated balance sheets in parts a. and b. above are identical. The financial reporting consequences for a 100% stock acquisition vs. a merger are the same. The economic substances of the two forms of the transaction are identical and, therefore, so are the resulting financial statements. The difference is in the journal entry to record the acquisition in the parent company books.
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Chapter 02 - Consolidation of Financial Information
32. (40 minutes) (Prepare a consolidated balance sheet using the acquisition method). a. Journal entries to record the acquisition on Pacifica’s records. Investment in Seguros 1,062,500 Common Stock (50,000 × $5) 250,000 Additional Paid-In Capital (50,000 × $15) 750,000 Contingent Performance Obligation 62,500 The contingent consideration is computed as: $130,000 payment × 50% probability × 0.961538 present value factor Professional Services Expense Cash Additional Paid-In Capital Cash
15,000 15,000 9,000 9,000
b. and c.
Revenues Expenses Net income
(1,200,000) 890,000 (310,000)
Consolidated Balance Sheet (1,200,000) 890,000 (310,000)
Retained earnings, 1/1 Net income Dividends declared Retained earnings, 12/31
(950,000) (310,000) 90,000 (1,170,000)
(950,000) (310,000) 90,000 (1,170,000)
Cash Receivables and inventory Property, plant and equipment Investment in Seguros
86,000 750,000 1,400,000 1,062,500
Pacifica
Seguros
85,000 190,000 450,000
(A) 10,000 (A)150,000 (S) 705,000 (A) 357,500
Research and development asset Goodwill Trademarks Total assets
300,000 3,598,500
160,000 885,000
Liabilities Contingent performance obligation Common stock Additional paid-in capital Retained earnings Total liabilities and equities
(500,000) (62,500) (650,000) (1,216,000) (1,170,000) (3,598,500)
(180,000) (200,000) (70,000) (435,000) (885,000)
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Consolidation Entries
(A)100,000 (A) 77,500 (A) 40,000
(S) 200,000 (S) 70,000 (S) 435,000 1,072,500
171,000 930,000 2,000,000 0 100,000 77,500 500,000 3,778,500
1,072,500
(680,000) (62,500) (650,000) (1,216,000) (1,170,000) (3,778,500)
Chapter 02 - Consolidation of Financial Information
Answers to Appendix Problems 33. (25 minutes) Journal entries for a merger using legacy purchase method. Also compare to acquisition method. a. Purchase Method 1. Purchase price (including acquisition costs) Fair values of net assets acquired Goodwill
$635,000 525,000 $110,000
Journal entry: Current Assets Equipment Trademark Goodwill Liabilities Cash
80,000 180,000 320,000 110,000 55,000 635,000
2. Acquisition date fair values: Purchase price (including acquisition costs) $450,000 Fair values of net assets acquired 525,000 Bargain purchase ($ 75,000) Allocation of bargain purchase to long-term assets acquired:
Equipment Trademark
Fair value
Prop.
Total reduction
Asset reduction
$180,000 320,000 $500,000
36% x $75,000 = 64% x 75,000 =
$27,000 48,000 $75,000
Journal entry: Current Assets Equipment ($180,000 – $27,000) Trademark ($320,000 – $48,000) Liabilities Cash
80,000 153,000 272,000 55,000 450,000
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Chapter 02 - Consolidation of Financial Information
33. continued b. Acquisition Method 1. Consideration transferred Fair values of net assets acquired Goodwill
$ 610,000 525,000 $ 85,000
Journal entry: Current Assets Equipment Trademark Goodwill Liabilities Cash
80,000 180,000 320,000 85,000
Professional Services Expense Cash
25,000
55,000 610,000 25,000
2. Consideration transferred Fair values of net assets acquired Gain on bargain purchase
$425,000 525,000 ($100,000)
Journal entry: Current Assets Equipment Trademark Liabilities Gain on Bargain Purchase Cash
80,000 180,000 320,000
Professional Services Expense Cash
25,000
55,000 100,000 425,000 25,000
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Chapter 02 - Consolidation of Financial Information
34. (25 minutes) (Pooling vs. purchase involving an unrecorded intangible) a.
Purchase Inventory Land Buildings Unpatented technology Goodwill Total
Pooling
$ 650,000 $ 600,000 750,000 450,000 1,000,000 900,000 1,500,000 -0600,000 -0$4,500,000 $1,950,000
b. Pre-acquisition revenues and expenses were excluded from consolidated results under the purchase method, but were included under the pooling method. c. Poolings, in most cases, produce higher rates of return on assets than purchase accounting because the denominator typically is much lower. In the case of the Swimwear acquisition pooling produced an increment to total assets of $1,950,000 compared to $4,500,000 under purchase accounting. Future EPS under poolings were also higher because of lower future depreciation and amortization of the smaller asset base. Managers whose compensation contracts involved accounting performance measures clearly had incentives to use pooling of interest accounting whenever possible.
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Chapter 02 - Consolidation of Financial Information
Chapter 2 Develop Your Skills CONSIDERATION OR COMPENSATION CASE (estimated time 40 minutes) According to FASB ASC (805-10-55-25): If it is not clear whether an arrangement for payments to employees or selling shareholders is part of the exchange for the acquiree or is a transaction separate from the business combination, the acquirer should consider the following indicators: a. Continuing employment. The terms of continuing employment by the selling shareholders who become key employees may be an indicator of the substance of a contingent consideration arrangement. The relevant terms of continuing employment may be included in an employment agreement, acquisition agreement, or some other document. A contingent consideration arrangement in which the payments are automatically forfeited if employment terminates is compensation for postcombination services. Arrangements in which the contingent payments are not affected by employment termination may indicate that the contingent payments are additional consideration rather than compensation. b. Duration of continuing employment. If the period of required employment coincides with or is longer than the contingent payment period, that fact may indicate that the contingent payments are, in substance, compensation. c. Level of compensation. Situations in which employee compensation other than the contingent payments is at a reasonable level in comparison to that of other key employees in the combined entity may indicate that the contingent payments are additional consideration rather than compensation. d. Incremental payments to employees. If selling shareholders who do not become employees receive lower contingent payments on a per-share basis than the selling shareholders who become employees of the combined entity, that fact may indicate that the incremental amount of contingent payments to the selling shareholders who become employees is compensation. e. Number of shares owned. The relative number of shares owned by the selling shareholders who remain as key employees may be an indicator of the substance of the contingent consideration arrangement. For example, if the selling shareholders who owned substantially all of the shares in the acquiree continue as key employees, that fact may indicate that the arrangement is, in substance, a profit-sharing arrangement intended to provide compensation for postcombination services. Alternatively, if selling shareholders who continue as key employees owned only a small number of shares of the acquiree and all selling shareholders receive the same amount of contingent consideration on a per-share basis, that fact may indicate that the contingent payments are additional consideration. The preacquisition ownership interests held by parties related to selling shareholders who continue as key employees, such as family members, also should be considered. f. Linkage to the valuation. If the initial consideration transferred at the acquisition date is based on the low end of a range established in the valuation of the acquiree and the contingent formula relates to that valuation approach, that fact may suggest that the contingent payments are additional consideration. Alternatively, if the contingent payment formula is consistent with prior profitsharing arrangements, that fact may suggest that the substance of the arrangement is to provide compensation. 2-26 ..
Chapter 02 - Consolidation of Financial Information
g. Formula for determining consideration. The formula used to determine the contingent payment may be helpful in assessing the substance of the arrangement. For example, if a contingent payment is determined on the basis of a multiple of earnings, that might suggest that the obligation is contingent consideration in the business combination and that the formula is intended to establish or verify the fair value of the acquiree. In contrast, a contingent payment that is a specified percentage of earnings might suggest that the obligation to employees is a profit-sharing arrangement to compensate employees for services rendered. Suggested answer: Note: This case was designed to have conflicting indicators across the various criteria identified in the FASB ASC for determining the issue of compensation vs. consideration. Thus, the solution is subject to alternative explanations and student can be encouraged to use their own judgment and interpretations in supporting their answers. In the author’s judgment, the $8 million contingent payment (fair value = $4 million) is contingent consideration to be included in the overall fair value NaviNow records for its acquisition of TrafficEye. This contingency is not dependent on continuing employment (criteria a.), and uses a formula based on a component of earnings (criteria g.). Even though the four former owners of TrafficEye owned 100% of the shares (criteria e.), which suggests the $8 million is compensation, the overall fact pattern indicates consideration because no services are required for the payment. The profit-sharing component of the employment contract appears to be compensation. Criteria g. specifically identifies profit-sharing arrangements as indicative of compensation for services rendered. Criteria a. also applies given that the employees would be unable to participate in profit-sharing if they terminate employment. Although the employees receive non-profit sharing compensation similar to other employees (criteria c.), the overall pattern of evidence suggests that any payments made under the profit-sharing arrangement should be recognized as compensation expense when incurred and not contingent consideration for the acquisition.
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Chapter 02 - Consolidation of Financial Information
ASC RESEARCH CASE—DEFENSIVE INTANGIBLE ASSET (35 MINUTES) a. The ASC Glossary defines a defensive intangible asset as “An acquired intangible asset in a situation in which an entity does not intend to actively use the asset but intends to hold (lock up) the asset to prevent others from obtaining access to the asset.” ASC 820-10-35-10D also observes that To protect its competitive position, or for other reasons, a reporting entity may intend not to use an acquired nonfinancial asset actively, or it may intend not to use the asset according to its highest and best use. For example, that might be the case for an acquired intangible asset that the reporting entity plans to use defensively by preventing others from using it. Nevertheless, the reporting entity shall measure the fair value of a nonfinancial asset assuming its highest and best use by market participants. According to ASC 350-30-25-5 a defensive intangible asset should be accounted for as a separate unit of accounting (i.e., an asset separate from other assets of the acquirer). It should not be included as part of the cost of an entity's existing intangible asset(s) presumably because the defensive intangible asset is separately identifiable. b. The identifiable assets acquired in a business combination should be measured at their acquisition-date fair values (ASC 805-20-30-1). c. A fair value measurement assumes the highest and best use of an asset by market participants. Highest and best use is determined based on the use of the asset by market participants, even if the intended use of the asset by the reporting entity is different (ASC 820-10-35-10). Importantly, highest and best use provides maximum value to market participants. The highest and best use of the asset establishes the valuation premise used to measure the fair value of the asset—in this case an in-exchange premise maximizes the value of the asset at $2 million. d. A defensive intangible asset shall be assigned a useful life that reflects the entity's consumption of the expected benefits related to that asset. The benefit a reporting entity receives from holding a defensive intangible asset is the direct and indirect cash flows resulting from the entity preventing others from realizing any value from the intangible asset (defensively or otherwise). An entity shall determine a defensive intangible asset's useful life, that is, the period over which an entity consumes the expected benefits of the asset, by estimating the period over which the defensive intangible asset will diminish in fair value. The period over which a defensive intangible asset diminishes in fair value is a proxy for the period over which the reporting entity expects a defensive intangible asset to contribute directly or indirectly to the future cash flows of the entity. (ASC 350-30-35A) It would be rare for a defensive intangible asset to have an indefinite life because the fair value of the defensive intangible asset will generally diminish over time as a result of a lack of market exposure or as a result of competitive or other factors. Additionally, if an acquired intangible asset meets the definition of a defensive intangible asset, it shall not be considered immediately abandoned. (ASC 350-30-35B)
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Chapter 02 - Consolidation of Financial Information
RESEARCH CASE—CELGENE’S ACQUISITION OF AVILA THERAPEUTICS (25 Minutes) 1. From Celgene’s 2012 10-K report (Note 2), “We acquired Avila to enhance our portfolio of potential therapies for patients with life-threatening illnesses worldwide.” 2. Celgene accounted for its March 7, 2012 acquisition of Avila Therapeutics using the acquisition method. Accordingly, Celgene recorded the acquisition at $535 million. 3. From Celgene’s 12/31/12 10-K report (dollars in thousands) Cash consideration: Cash Contingent consideration Total fair value of consideration transferred Working capital (cash, A/R, A/P, etc.) Property, plant, and equipment Platform technology intangible asset In-process research and development product rights Net deferred tax liability Total fair value of net identifiable assets Goodwill
$363,405 171,654 $535,059 $ 11,987 2,559 330,800 198,400 (164,993) 378,753 $156,306
Celgene determined these allocations by estimating fair values for each of the assets acquired and the liabilities assumed. 4. As shown in the part 3. Schedule above, Celgene included $171.654 million of fair value contingent consideration in its consideration transferred. If all milestones are achieved, contingent consideration could reach a maximum of $595 million. 5. Acquired in-process research and development product rights are accounted for as an intangible asset with an indefinite life.
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Chapter 03 - Consolidations—Subsequent to the Date of Acquisition
CHAPTER 3 CONSOLIDATIONS—SUBSEQUENT TO THE DATE OF ACQUISITION I.
Several factors serve to complicate the consolidation process when it occurs subsequent to the date of acquisition. In all combinations within its own internal records the acquiring company will utilize a specific method to account for the investment in the acquired company. 1. Three alternatives are available a. Initial value method (also known as the cost method) b. Equity method c. Partial equity method 2. Depending upon the method applied, the acquiring company will record earnings from its ownership of the acquired company. This total must be eliminated on the consolidation worksheet and be replaced by the subsidiary’s revenues and expenses. 3. Under each of these three methods, the balance in the Investment account will also vary. It too must be removed in producing consolidated statements and be replaced by the subsidiary’s assets and liabilities.
II.
For combinations subsequent to the acquisition date, certain procedures are required. If the parent applies the equity method, the following process is appropriate. A. Assuming that the acquisition was made during the current fiscal period 1. The parent adjusts its own Investment account to reflect the subsidiary’s income and dividend declarations as well as any amortization expense relating to excess acquisition-date fair value over book value allocations and goodwill. 2. Worksheet entries are then used to establish consolidated figures for reporting purposes. a. Entry S offsets the subsidiary’s stockholders’ equity accounts against the book value component of the Investment account (as of the acquisition date). b. Entry A recognizes the excess fair over book value allocations made to specific subsidiary accounts and/or to goodwill. c. Entry I eliminates the investment income balance accrued by the parent. d. Entry D removes intra-entity dividend declarations e. Entry E recognizes the current excess amortization expenses on the excess fair over book value allocations. f. Entry P eliminates any intra-entity payable/receivable balances. B. Assuming that the acquisition was made during a previous fiscal period 1. Most of the consolidation entries described above remain applicable regardless of the time that has elapsed since the combination was formed. 2. The amount of the subsidiary’s stockholders’ equity to be removed in Entry S will differ each period to reflect the balance as of the beginning of the current year
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Chapter 03 - Consolidations—Subsequent to the Date of Acquisition
3. The allocations established by entry A will also change in each subsequent consolidation. Only the unamortized balances remaining as of the beginning of the current period are recognized in this entry. III.
For a combination where the parent has applied an accounting method other than the equity method, the consolidation procedures described above must be modified. A. If the initial value method is applied by the parent company, the intra-entity dividends eliminated in Entry I will only consist of the dividends transferred from the subsidiary. No separate Entry D is needed. B. If the partial equity method is in use, the intra-entity income to be removed in Entry I is the equity accrual only; no amortization expense is included. Intra-entity dividends are eliminated through Entry D. C. In any time period after the year of acquisition. 1. The initial value method recognizes neither income in excess of dividend declarations nor excess amortization expense. Thus, for all years prior to the current period, both of these figures must be entered directly into the consolidation. Entry*C is used for this purpose; it converts all prior amounts to equity method balances. 2. The partial equity method does not recognize excess amortization expenses. Therefore, Entry*C converts the appropriate account balances to the equity method by recognizing the expense that relates to all of the past years.
IV.
Bargain purchases A. As discussed in Chapter Two, bargain purchases occur when the parent company transfers consideration less than net fair values of the subsidiary’s assets acquired and liabilities assumed. B. The parent recognizes an excess of net asset fair value over the consideration transferred as a “gain on bargain purchase.”
V.
Goodwill Impairment A. When is goodwill impaired? 1. Goodwill is considered impaired when the fair value of its related reporting unit falls below its carrying value. Goodwill should not be amortized, but should be tested for impairment at the reporting unit level (operating segment or lower identifiable level). 2. Goodwill should be tested for impairment at least annually. 3. Interim impairment testing is necessary in the presence of negative indicators such as an adverse change in the business climate or market, legal factors, regulatory action, an introduction of competition, or a loss of key personnel. B. How is goodwill tested for impairment? 1. All acquired goodwill should be assigned to reporting units. It would not be unusual for the total amount of acquired goodwill to be divided among a number of reporting units. Goodwill may be assigned to reporting units of the acquiring entity that are expected to benefit from the synergies of the combination even though other assets or liabilities of the acquired entity may not be assigned to that reporting unit.
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Chapter 03 - Consolidations—Subsequent to the Date of Acquisition
2. Goodwill is tested for impairment through an optional assessment process followed by a two-step approach (if necessary). a. Entities are allowed the option of conducting a qualitative assessment of goodwill to assess whether the two-step testing procedure is required. Under the qualitative assessment, management evaluates relevant events or circumstances to determine whether it is more likely than not that the fair value of a reporting unit is less than its carrying amount. If it is more likely than not that the fair value of a reporting unit is less than its carrying amount, then the entity performs the two-step testing procedure. Otherwise, no further tests are required. b. The first step simply compares the fair value amount of a reporting unit to its carrying amount. If the fair value of the reporting unit exceeds its carrying amount, goodwill is not considered impaired and no further analysis is necessary. c. The second step is a comparison of goodwill to its carrying amount. If the implied value of a reporting unit’s goodwill is less than its carrying value, goodwill is considered impaired and a loss is recognized. The loss is equal to the amount by which goodwill exceeds its implied value. 3. The implied value of goodwill should be calculated in the same manner that goodwill is calculated in a business combination. That is, an entity should allocate the fair value of the reporting unit to all of the assets and liabilities of that unit (including any unrecognized intangible assets) as if the reporting unit had been acquired in a business combination and the fair value of the reporting unit was the value assigned at a subsidiary’s acquisition date. The excess “acquisition-date” fair value over the amounts assigned to assets and liabilities is the implied value of goodwill. This allocation is performed only for purposes of testing goodwill for impairment and does not require entities to record the “stepup” in net assets or any unrecognized intangible assets. C. How is the impairment recognized in financial statements?
1. The aggregate amount of goodwill impairment losses should be presented as a separate line item in the operating section of the income statement unless a goodwill impairment loss is associated with a discontinued operation.
2. A goodwill impairment loss associated with a discontinued operation should
VI.
be included (on a net-of-tax basis) within the results of discontinued operations. Contingent consideration A. The fair value of any contingent consideration is included as part of the consideration transferred. B. If the contingency results in a liability (typically a cash payment), changes in the fair value of the contingency are recognized in income as they occur. C. If the contingency calls for an additional equity issue at a later date, the acquisitiondate fair value of the contingency is not adjusted over time. Any subsequent shares issued as a consequence of the contingency are simply recorded at the original acquisition-date fair value. This treatment is similar to other equity issues (e.g., common stock, preferred stock, etc.) in the parent’s owners’ equity section.
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Chapter 03 - Consolidations—Subsequent to the Date of Acquisition
VII.
Push-down accounting A. A subsidiary may record any acquisition-date fair value allocations directly onto its own financial records rather than through the use of a worksheet. Subsequent amortization expense on these allocations could also be recorded by the subsidiary. B. Push-down accounting reports the assets and liabilities of the subsidiary at the amount the new owner paid. It also assists the new owner in evaluating the profitability that the subsidiary is adding to the business combination. C. Push-down accounting can also make the consolidation process easier since allocations and amortization need not be included as worksheet entries.
Answers to Discussion Questions How Does a Company Really Decide which Investment Method to Apply? Students can come up with dozens of factors that Pilgrim should consider in choosing its internal method of accounting for its subsidiary, Crestwood Corporation. The following is only a partial list of possible points to consider. ▪
Use of the information. If Pilgrim does not monitor its subsidiary’s income levels closely, applying the equity method may be not be fruitful. A company must plan to use the data before the task of accumulation becomes worthwhile. For example, Crestwood may use the information for evaluating the performance of the subsidiary’s managers.
▪
Size of the subsidiary. If the subsidiary is large in comparison to Pilgrim, the effort required of the equity method may be important. Income levels would probably be significant. However, if the subsidiary is actually quite small in relation to the parent, the impact might not be material enough to warrant the extra effort.
▪
Size of dividend declarations. If Crestwood distributes most of its income as dividends, that figure will approximate equity income. Little additional information would be accrued by applying the equity method. In contrast, if dividends are small or not declared on a regular basis, a Dividend Income balance might vastly understate the profits to be recognized by the business combination.
▪
Amount of excess amortizations. If Pilgrim has paid a significant amount in excess of book value, its annual amortization charges are high, and use of the equity method might be preferred to show the amortization effect each reporting period. In this case, waiting until year end and recognizing all of the expense at one time through a worksheet entry might not be the best way to reflect the impact of the expense.
▪
Amount of intra-entity transactions. As with amortization, the volume of transfers can be an important element in deciding which accounting method to use. If few intra-entity sales are made, monitoring the subsidiary through the application of the equity method is less essential. Conversely, if the amount of these transactions IS significant, the added data can be helpful to company administrators evaluating operations.
▪
Sophistication of accounting systems. If Pilgrim and Crestwood both have advanced accounting systems, application of the equity method may be relatively easy. Unfortunately, if these systems are primitive, the cost and effort necessary to apply the equity method may outweigh any potential benefits.
▪
The timeliness and accuracy of income figures generated by Crestwood. If the subsidiary reports operating results on a regular basis (such as weekly or monthly) and these figures prove to be reliable, equity totals recorded by Pilgrim may serve as valuable information to 3-4
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Chapter 03 - Consolidations—Subsequent to the Date of Acquisition
the parent. However, if Crestwood's reports are slow and often require later adjustment, Pilgrim's use of the equity method will provide only questionable results.
Answers to Questions 1.
a. CCES Corp., for its own recordkeeping, may apply the equity method to its Investment in Schmaling. Under this approach, the parent's records parallel the activities of the subsidiary. The parent accrues income as it is earned by the subsidiary. Dividends declared by Schmaling reduce its book value; therefore, CCES reduces the investment account. In addition, any excess amortization expense associated with CCES's acquisition-date fair value allocations is recognized through a periodic adjustment. By applying the equity method, both the parent’s income and investment balances accurately reflect consolidated totals. The equity method is especially helpful in monitoring the income of the business combination. This method can be, however, rather difficult to apply and a time consuming process. b. The initial value method. The initial value method can also be utilized by CCES Corporation. Any dividends declared are recognized as income but no other investment entries are made. Thus, the initial value method is easy to apply. However, the resulting account balances of the parent may not provide a reasonable representation of the totals that result from consolidating the two companies. c. The partial equity method combines the advantages of the previous two techniques. Income is accrued as earned by the subsidiary as under the equity method. Similarly, dividends reduce the investment account. However, no other entries are recorded; more specifically, amortization is not recognized by the parent. The method is, therefore, easier to apply than the equity method but the subsidiary's individual totals will still frequently approximate consolidated balances.
2.
a. The consolidated total for equipment is made up of the sum of Maguire’s book value, Williams’ book value, and any unamortized excess acquisition-date fair value over book value attributable to Williams’ equipment. b. Although an Investment in Williams account is appropriately maintained by the parent, from a consolidation perspective the balance is intra-entity in nature. Thus, the entire amount is eliminated in arriving at consolidated financial statements. c. Only dividends declared to outside parties are included in consolidated statements. Because Maguire owns 100 percent of Williams, all of the subsidiary's dividends are intra-entity. Consequently, only the dividends declared by the parent company will be reported in the financial statements for this business combination. d. Any acquisition-date goodwill must still be reported for consolidation purposes. Reductions to goodwill are made if goodwill is determined to be impaired. e. Unless intra-entity revenues have been recorded, consolidation is achieved in subsequent periods by adding the two book values together. f.
Consolidated expenses are determined by combining the parent's and subsidiary amounts including any amortization expense associated with the acquisition-date fair value allocations. As discussed in Chapter Five, intra-entity expenses can also require elimination in arriving at consolidated figures.
g. Only the parent’s common stock outstanding is included in consolidated totals.
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h. The net income for a business combination is calculated as the difference between consolidated revenues and consolidated expenses. 3.
Under the equity method, the parent accrues subsidiary earnings and amortization expense (associated with acquisition-date fair value allocations) in the same manner as in the consolidation process. The equity method parallels consolidation. Thus, the parent’s net income and retained earnings each year will equal the consolidated totals.
4.
In the consolidation process, excess amortizations must be recognized annually for any portion of the acquisition-date fair value allocations to specific assets or liabilities (other than indefinite-lived assets). Although this expense can be simulated in total on the parent's books by an equity method entry, the actual amortization of each allocated fair value adjustment is appropriate for consolidation. Hence, the effect of the parent's equity method amortization entry is removed as part of Entry I so that the amortization of specific accounts (e.g., depreciation) can be recognized (in consolidation Entry E).
5.
When a parent applies the initial value method, no accrual is recorded to reflect the subsidiary's change in book value subsequent to acquisition. Recognition of excess amortizations relating to the acquisition is also omitted by the parent. The partial equity method, in contrast, records the subsidiary’s book value increases and decreases but not amortizations. Consequently, for both of these methods, a technique must be employed in the consolidation process to recognize the omitted figures. Entry *C simply brings the parent's figures (more specifically, the beginning retained earnings balance and the investment account) up-to-date as of the first day of the current year. If the acquirer applies the initial value method, changes in the subsidiary's book value in previous years are recognized on the worksheet along with the appropriate amount of amortization expense. For the partial equity method, only the amortization relating to these prior years needs to be recognized. No similar entry to *C is needed when the parent applies the equity method. The parent will record changes in the subsidiary's book value as well as excess amortization each year. Thus, under the equity method, the parent's investment and beginning retained earnings balances are both correctly established and need no further adjustment.
6.
Lambert's loan payable and the receivable held by Jenkins are intra-entity accounts. The consolidation process offsets these reciprocal balances. The $100,000 is neither a debt to nor a receivable from an unrelated (or outside) party and is, therefore, not reported in consolidated financial statements. Any interest income/expense recognized on this loan is also intra-entity in nature and must likewise be eliminated.
7.
Because Benns applies the equity method, the $920,000 is composed of four balances: a. b. c. d.
The original consideration transferred by the parent; Benns’ annual accruals to recognize subsidiary net income as it is earned The reductions that are created by the subsidiary's declaration of dividends The periodic amortization recognized by Benns in connection with the allocations identified with its acquisition-date fair value allocations.
8.
The $100,000 attributed to goodwill is reported at its original amount unless a portion of goodwill is impaired or a unit of the business where goodwill resides is sold.
9.
A parent should consider recognizing an impairment loss for goodwill associated with an acquired subsidiary when, at the reporting unit level, the fair value is less than its carrying amount. Goodwill is reduced when its carrying value is less than its fair value. To compute fair value for goodwill, its implied value is calculated by subtracting the fair 3-6
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Chapter 03 - Consolidations—Subsequent to the Date of Acquisition
10.
11.
values of the reporting unit’s identifiable net assets from its total fair value. The impairment is recognized as a loss from continuing operations. The acquisition-date fair value of the contingent payment is part of the consideration transferred by Reimers to acquire Rollins and thus is part of the overall fair value assigned to the acquisition. If the contingency is a liability (to be settled in cash or other assets) then the liability is adjusted to fair value through time. If the contingency is a component of equity (e.g., to be settled by the parent issuing equity shares), then the equity instrument is not adjusted to fair value over time. At present, the Securities and Exchange Commission requires the use of push-down accounting for the separate financial statements of a subsidiary where no substantial outside ownership exists. Thus, if Company A owns all of Company B, the push-down method of accounting is appropriate for the separately issued statements of Company B. The SEC normally requires push-down accounting where 95 percent of a subsidiary is acquired and the company has no outstanding public debt or preferred stock. Push-down accounting may be required if 80-95 percent of the outstanding voting stock is acquired. Push-down accounting uses the consideration transferred as the valuation basis for the subsidiary in consolidated reports. For example, if a piece of land costs Company B $10,000 but Company A allocates a $13,000 fair value to the land in acquiring Company B, the land has a basis to the current owners of B of $13,000. If B's financial records had been united with A at the time of the acquisition, the land would have been reported at $13,000. Thus, keeping the $10,000 figure simply because separate incorporation is maintained is viewed, by proponents of push-down accounting, as unjustified.
12.
When push-down accounting is applied, the subsidiary adjusts the book value of its assets and liabilities based on the acquisition-date fair value allocations. The subsidiary then recognizes periodic amortization expense on those allocations with definite lives. Therefore, the subsidiary’s recorded income equals its impact on consolidated earnings. The parent uses no special procedures when push-down accounting is being applied. However, if the equity method is in use, amortization need not be recognized by the parent since that expense is included in the figure reported by the subsidiary.
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Chapter 03 - Consolidations—Subsequent to the Date of Acquisition
Answers to Problems 1. A 2. B 3. A 4. A Paar’s equipment book value—12/31/14 ............................ $294,000 Kimmel’s equipment book value—12/31/14 ....................... 190,400 Original acquisition-date allocation to Kimmel's equipment ($400,000 – $272,000) ........................................................... 128,000 Amortization of allocation ($128,000 ÷ 10 years for 3 years) ................................... (38,400) Consolidated equipment ...................................................... $574,000 5. A 6. B 7. D 8. B 9. B Phoenix revenues Phoenix expenses Net income before Sedona effect Equity income from Sedona Consolidated net income -orConsolidated revenues Consolidated expenses (includes $35K amortization) Consolidated net income
$498,000 350,000 148,000 55,000 $203,000 $783,000 580,000 $203,000
10. A (same as Phoenix because of equity method use). 11. C Consideration transferred at fair value Book value acquired Excess fair over book value to equipment to customer list (4-year remaining life)
$600,000 420,000 180,000 80,000 $100,000
Three years since acquisition, ¼ of acquisition-date value remains. 12. B 13. C
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Chapter 03 - Consolidations—Subsequent to the Date of Acquisition
14. D The $105,000 excess acquisition-date fair value allocation to equipment is "pushed-down" to the subsidiary and increases its balance to $441,500. The consolidated balance is $871,500 ($430,000 book value for Crawford plus fair value for Nashville $441,500). 15. (35 Minutes) (Determine consolidated retained earnings when parent uses various accounting methods. Determine Entry *C for each of these methods) a. CONSOLIDATED RETAINED EARNINGS--EQUITY METHOD Herbert (parent) balance—1/1/14 .................................. $400,000 Herbert income—2014 ................................................... 40,000 Herbert dividends—2014 (subsidiary dividends are intra-entity and, thus, eliminated) ............................ (10,000) Rambis income—2014 (not included in parent's income) 20,000 Amortization—2014 ........................................................ (12,000) Herbert income—2015 ................................................... 50,000 Herbert dividends—2015 ................................................ (10,000) Rambis income—2015 ................................................... 30,000 Amortization—2015 ....................................................... (12,000) Consolidated retained earnings, 12/31/15 ..................... $496,000 ▪
PARTIAL EQUITY METHOD AND INITIAL VALUE METHOD Consolidated RE are the same regardless of the method in use: the beginning balance plus the income less the dividends of the parent plus the income of the subsidiary less amortization expense. Thus, December 31, 2015 consolidated RE are $496,000 as computed above.
b. Investment in Rambis—equity method Rambis fair value 1/1/14............................................................. $574,000 Rambis income 2014 .................................................................. 20,000 Rambis dividends 2014.............................................................. (5,000) Herbert’s 2014 excess fair over book value amortization ...... (12,000) Investment account balance 1/1/15 .......................................... $577,000 Investment in Rambis—partial equity method Rambis fair value 1/1/14............................................................. $574,000 Rambis income 2014 .................................................................. 20,000 Rambis dividends 2014.............................................................. (5,000) Investment account balance 1/1/14 .......................................... $589,000 Investment in Rambis—Initial value method Rambis fair value 1/1/14............................................................. $574,000 Investment account balance 1/1/15 .......................................... $574,000
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Chapter 03 - Consolidations—Subsequent to the Date of Acquisition
15. (continued) c.
ENTRY *C
▪
EQUITY METHOD No entry is needed to convert the past figures to the equity method since that method has already been applied.
▪
PARTIAL EQUITY METHOD Amortization for the prior years (only 2014 in this case) has not been recorded and must be brought into the consolidation through worksheet entry *C: ENTRY *C Retained earnings, 1/1/15 (Parent) ..................... 12,000 Investment in Rambis .................................... 12,000 (To recognize 2014 amortization in consolidated figures. Expense was omitted because of application of partial equity method.)
▪
INITIAL VALUE METHOD Amortization for the prior years (only 2014 in this case) has not been recorded and must be brought into the consolidation through worksheet entry *C. In addition, only dividend income has been recorded by the parent ($5,000 in 2014). In this prior year, Rambis reported net income of $20,000. Thus, the parent has not recorded the $15,000 income in excess of dividends. That amount must also be included in the consolidation through entry *C: ENTRY *C Investment in Rambis ......................................... 3,000 Retained earnings, 1/1/15 (Parent) ............... 3,000 (To recognize 2014 unrecognized subsidiary earnings as part of the parent’s retained earnings. $15,000 net income of subsidiary was not recorded by parent (income in excess of dividends). Amortization expense of $12,000 was not recorded under the initial value method. Note that *C adjustments bring the parent’s January 1, 2015 Retained Earnings balance equal to that of the equity method.
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Chapter 03 - Consolidations—Subsequent to the Date of Acquisition
16. (30 Minutes) (A variety of questions on equity method, initial value method, and partial equity method.) a. An allocation of the acquisition price (based on the fair value of the shares issued) must be made first. Acquisition fair value (consideration paid by Haynes) Book value equivalency ................................................. Excess of Turner fair value over book value ............... Excess fair value assigned to specific accounts based on fair value Equipment ......................... $5,000 Customer List ...................... 30,000
$135,000 (100,000) $ 35,000
Remaining life
Annual excess amortizations
5 yrs. 10 yrs.
$1,000 3,000 $4,000
Acquisition-date fair value ............................................. 2014 Income accrual ...................................................... 2014 Dividends declared by Turner .............................. 2014 Amortizations (above) ........................................... 2015 Income accrual ...................................................... 2015 Dividends declared by Turner .............................. 2015 Amortizations ........................................................ Investment in Turner account balance .........................
$135,000 110,000 (50,000) (4,000) 130,000 (40,000) (4,000) $277,000
b. Net income of Haynes .................................................... Net Income of Turner ..................................................... Depreciation expense ..................................................... Amortization expense ..................................................... Consolidated net income 2015 ................................
$240,000 130,000 (1,000) (3,000) $366,000
c. Equipment balance Haynes ........................................... Equipment balance Turner ............................................ Allocation based on fair value (above) ......................... Depreciation for 2014-2015 ............................................ Consolidated equipment—December 31, 2015.............
$500,000 300,000 5,000 (2,000) $803,000
Parent's choice of an investment method has no impact on consolidated totals.
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Chapter 03 - Consolidations—Subsequent to the Date of Acquisition
16. (continued) d. If the initial value method was applied during 2014, the parent would have recorded dividend income of $50,000 rather than $110,000 (as equity income). Income is, therefore, understated by $60,000. In addition, amortization expense of $4,000 was not recorded. Thus, the January 1, 2015, retained earnings is understated by $56,000 ($60,000 – $4,000). Worksheet Entry *C thus serves to adjust the parent’s beginning retained earning to a full accrual basis: Investment in Turner ........................................... Retained earnings, 1/1/15 (Haynes) ..............
56,000 56,000
If the partial equity method was applied during 2014, the parent would have failed to record amortization expense of $4,000. Retained earnings are overstated by $4,000 and are corrected through Entry *C: Retained earnings, 1/1/15 (Haynes) ................... Investment in Turner .....................................
4,000 4,000
If the equity method was applied during 2014, consolidated retained earnings would equal the parent's retained earnings. Thus, no adjustment would be necessary.
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Chapter 03 - Consolidations—Subsequent to the Date of Acquisition
17. (20 minutes) (Record a merger combination with subsequent testing for goodwill impairment). a. In accounting for the combination, the total fair value of Beltran (consideration transferred) is allocated to each identifiable asset acquired and liability assumed with any remaining excess as goodwill. Cash paid Fair value of shares issued Consideration transferred
$ 450,000 1,248,000 $1,698,000
Consideration transferred (above) Fair value of net assets acquired and liabilities assumed Goodwill recognized in the combination
$1,698,000 1,298,000 $ 400,000
Entry by Francisco to record assets acquired and liabilities assumed in the combination with Beltran: Cash 75,000 Receivables 193,000 Inventory 281,000 Patents 525,000 Customer relationships 500,000 Equipment 295,000 Goodwill 400,000 Accounts payable Long-term liabilities Cash Common stock (Francisco Co., par value) Additional paid-in capital b. Step one in goodwill impairment test: Fair value of reporting unit as a whole Book value of reporting unit's net assets
121,000 450,000 450,000 104,000 1,144,000
1,425,000 1,585,000
Because the total fair value of the reporting unit is less than its carrying value, a potential goodwill impairment loss exists, step two is performed: Fair value of reporting unit as a whole $1,425,000 Fair values of reporting unit's net assets (excluding goodwill) 1,325,000 Implied fair value of goodwill 100,000 Book value of goodwill 400,000 Goodwill impairment loss $ 300,000
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Chapter 03 - Consolidations—Subsequent to the Date of Acquisition
18. (20 minutes) (Goodwill impairment testing.) a. Goodwill Impairment Step 1 Fair value of reporting unit = Carrying value of reporting unit =
$1,028 1,094
Because fair value < carrying value, there is a potential goodwill impairment loss. Step 2 Fair value of reporting unit $1,028 Fair value of net assets excluding goodwill Tangible assets $137 Recognized intangibles 326 Unrecognized intangibles 255 718 Implied value of goodwill 310 Carrying value of goodwill 755 Goodwill impairment loss $445 b. Tangible assets, net Goodwill Patent Customer list
$84 310 -0-0-
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Chapter 03 - Consolidations—Subsequent to the Date of Acquisition
19. (30 minutes) (Goodwill impairment and intangible assets.) Part a: Goodwill Impairment Test—Step 1
Sand Dollar Salty Dog Baytowne
Total fair value $510,000 580,000 560,000
< < >
Carrying Potential goodwill value impairment? $530,000 yes 610,000 yes 280,000 no
Part b: Goodwill Impairment Test—Step 2 (Sand Dollar and Salty Dog only) Sand Dollar—total fair value Fair values of identifiable net assets Tangible assets Trademark Customer list Liabilities Implied value of goodwill Carrying value of goodwill Impairment loss
$510,000 $190,000 150,000 100,000 (30,000)
Salty Dog—total fair value Fair values of identifiable net assets Tangible assets $200,000 Unpatented technology 125,000 Licenses 100,000 Implied value of goodwill Carrying value of goodwill No impairment—implied value > carry value
410,000 100,000 120,000 $20,000 $580,000
425,000 155,000 150,000 -0-
Part c: No changes in tangible assets or identifiable intangibles are reported based on goodwill impairment testing. The sole purpose of the valuation exercise is to estimate an implied value for goodwill. Destin will report a goodwill impairment loss of $20,000, which will reduce the amount of goodwill allocated to Sand Dollar. However, because the fair value of Sand Dollar’s trademark is less than its carrying amount, the account should be subjected to a separate impairment testing procedure to see if the carrying value is “recoverable” in future estimated cash flows.
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Chapter 03 - Consolidations—Subsequent to the Date of Acquisition
20.
(30 Minutes) (Consolidation entries for two years. Parent uses equity method.) Fair Value Allocation and Annual Amortization: Acquisition fair value (consideration transferred) . $490,000 Book value (assets minus liabilities or total stockholders' equity) .................................................................. (400,000) Excess fair value over book value .......................... $ 90,000 Excess fair value assigned to specific accounts based on individual fair values Remaining Annual excess life
amortizations
Land .................................... Buildings ............................. Equipment ...........................
$10,000 40,000 (20,000)
-4 yrs. 5 yrs.
-$10,000 (4,000)
Total assigned to specific accounts ........................ Goodwill .............................. Total ....................................
30,000 60,000 $90,000
indefinite
-0$6,000
Consolidation Entries as of December 31, 2014 Entry S Common stock—Abernethy ................................ 250,000 Additional paid-in capital .................................... 50,000 Retained earnings—1/1/14 .................................. 100,000 Investment in Abernethy ............................... (To eliminate stockholders' equity accounts of subsidiary)
400,000
Entry A Land ..................................................................... 10,000 Buildings .............................................................. 40,000 Goodwill ............................................................... 60,000 Equipment ...................................................... 20,000 Investment in Abernethy ............................... 90,000 (To recognize allocations attributed to fair value of specific accounts at acquisition date with residual fair value recognized as goodwill). Entry I Equity in subsidiary earnings ............................ 74,000 Investment in Abernethy ............................... 74,000 (To eliminate $80,000 income accrual for 2014 less $6,000 amortization recorded by parent using equity method)
3-16 .
.
Chapter 03 - Consolidations—Subsequent to the Date of Acquisition
20. (continued) Entry D Investment in Abernethy .................................... Dividends declared ........................................ (To eliminate intra-entity dividend transfers)
10,000 10,000
Entry E Depreciation expense .......................................... 6,000 Equipment............................................................. 4,000 Buildings ......................................................... (To recognize current year amortization expense)
10,000
Consolidation Entries as of December 31, 2015 Entry S Common stock—Abernethy ............................... 250,000 Additional paid-in capital .................................... 50,000 Retained earnings—1/1/15................................... 170,000 Investment in Abernethy ............................... 470,000 (To eliminate beginning stockholders' equity of subsidiary—the Retained Earnings account has been adjusted for 2014 income and dividends. Entry *C is not needed because equity method was applied.) Entry A Land ..................................................................... 10,000 Buildings .............................................................. 30,000 Goodwill ............................................................... 60,000 Equipment ...................................................... 16,000 Investment in Abernethy ............................... 84,000 (To recognize allocations relating to investment—balances shown here are as of beginning of current year [original allocation less excess amortizations for the prior period]) Entry I Equity in subsidiary earnings ............................ 104,000 Investment in Abernethy ............................... 104,000 (To eliminate $110,000 income accrual less $6,000 amortization recorded by parent during 2015 using equity method) Entry D Investment in Abernethy .................................... Dividends declared ........................................ (To eliminate intra-entity dividend transfers) Entry E Same as Entry E for 2014
3-17 .
.
30,000 30,000
Chapter 03 - Consolidations—Subsequent to the Date of Acquisition
21.
(35 Minutes) (Consolidation entries for two years. Parent uses initial value method.) Acquisition-date allocation and annual excess fair value amortizations: Acquisition date value (consideration paid) ..... $500,000 Book value ........................................................... (400,000) Excess price paid over book value .................... $100,000 Excess price paid assigned to specific accounts based on fair values Equipment Long-term liabilities Goodwill Total
$ 20,000 30,000 50,000 $100,000
Remaining life
Annual excess amortizations
5 yrs. 4 yrs. indefinite
$4,000 7,500 -0$11,500
Consolidation entries as of December 31, 2014 Entry S Common stock—Abernethy .............................. 250,000 Additional paid-in capital ................................... 50,000 Retained earnings—1/1/14 ................................. 100,000 Investment in Abernethy ............................... (To eliminate stockholders' equity accounts of subsidiary)
400,000
Entry A Equipment ........................................................... 20,000 Long-term liabilities ........................................... 30,000 Goodwill .............................................................. 50,000 Investment in Abernethy .............................. 100,000 (To recognize allocations determined above in connection with acquisition-date fair values) Entry I Dividend income ................................................ 10,000 Dividends declared ....................................... 10,000 (To eliminate intra-entity dividend declarations recorded by parent as income) Entry E Depreciation expense ........................................ Interest expense .................................................. Equipment ...................................................... Long-term liabilities ....................................... (To recognize 2014 amortization expense)
3-18 .
.
4,000 7,500 4,000 7,500
Chapter 03 - Consolidations—Subsequent to the Date of Acquisition
21. (continued) Consolidation Entries as of December 31, 2015 Entry *C Investment in Abernethy ................................... 58,500 Retained earnings—1/1/15 (Chapman) ........ 58,500 (To convert parent company figures to equity method by recognizing subsidiary's increase in book value for prior year [$80,000 net income less $10,000 dividend declaration] and excess amortizations for that period [$11,500]) Entry S Common stock—Abernethy .............................. 250,000 Additional paid-in capital ................................... 50,000 Retained earnings—1/1/15 ................................. 170,000 Investment in Abernethy .............................. 470,000 (To eliminate beginning of year stockholders' equity accounts of subsidiary. The retained earnings balance has been adjusted for 2014 net income and dividends) Entry A Equipment ........................................................... 16,000 Long-term liabilities ........................................... 22,500 Goodwill .............................................................. 50,000 Investment in Abernethy .............................. 88,500 (To recognize allocations relating to investment—balances shown here are as of the beginning of the current year [original allocation less excess amortizations for the prior period]) Entry I Dividend income ................................................ 30,000 Dividends declared .................................. 30,000 (To eliminate intra-entity dividend declarations recorded by parent as income) Entry E Same as Entry E for 2014
3-19 .
.
Chapter 03 - Consolidations—Subsequent to the Date of Acquisition
22.
(20 Minutes) (Consolidation entries for two years. Parent uses partial equity method.) Fair value allocation and annual excess amortizations: Abernethy fair value (consideration paid) .................... Book value ...................................................................... Excess fair value over book value (all goodwill) .........
$520,000 (400,000) $120,000
Excess amortization (indefinite life for goodwill) ........
-0-
Consolidation Entries as of December 31, 2014 Entry S Common stock—Abernethy ............................... 250,000 Additional paid-in capital .................................... 50,000 Retained earnings—Abernethy—1/1/14 ............ 100,000 Investment in Abernethy ............................... (To eliminate stockholders' equity accounts of subsidiary)
400,000
Entry A Goodwill ............................................................... 120,000 Investment in Abernethy ............................... 120,000 (To recognize goodwill portion of the original acquisition fair value) Entry I Equity in earnings of subsidiary ......................... 80,000 Investment in Abernethy ............................... 80,000 (To eliminate intra-entity income accrual for the current year based on the parent's usage of the partial equity method) Entry D Investment in Abernethy .................................... Dividends declared ........................................ (To eliminate intra-entity dividend transfers)
10,000 10,000
Entry E—Not needed. Goodwill is not amortized. Consolidation Entries as of December 31, 2015 Entry *C—Not needed. Goodwill is not amortized. Entry S Common stock—Abernethy ................................ Additional paid-in capital—Abernethy .............. Retained earnings—Abernethy—1/1/15 ............ Investment in Abernethy ...............................
3-20 .
.
250,000 50,000 170,000 470,000
Chapter 03 - Consolidations—Subsequent to the Date of Acquisition
22. (continued) (To eliminate beginning of year stockholders' equity accounts of subsidiary—the retained earnings balance has been adjusted for 2014 income and dividends.) Entry A Goodwill ............................................................... Investment in Abernethy ............................... (To recognize original goodwill balance.)
120,000 120,000
Entry I Equity in earnings of subsidiary ......................... 110,000 Investment in Abernethy ............................... 110,000 (To eliminate Intra-entity Income accrual for the current year.) Entry D Investment in Abernethy .................................... Dividends declared ........................................ (To eliminate Intra-entity dividend transfers.)
30,000 30,000
Equity E—not needed
23.
(45 Minutes) (Variety of questions about the three methods of recording an Investment in a subsidiary for internal reporting purposes.) a. Acquisition-Date Fair-Value Allocation and Annual Amortization: Clay’s acquisition-date fair value ...... $510,000 Book value (assets minus liabilities or stockholders' equity) ................ 450,000 Fair value in excess of book value .... 60,000 Allocation to equipment based on ...... fair and book value difference ............ Goodwill ............................................... Total ....................................................
Remaining Annual excess life amortizations
50,000 5 yrs. $10,000 indefinite
EQUITY METHOD Investment Income—2015: Equity accrual (based on Clay's net income) .............. Amortization (above) ..................................................... Investment income for 2015 ................................................
3-21 .
.
$10,000 -0$10,000
$60,000 (10,000) $50,000
Chapter 03 - Consolidations—Subsequent to the Date of Acquisition
23. (continued) Investment in Clay—December 31, 2015: Consideration transferred for Clay ............................... 2014: Equity accrual (based on Clay's net Income) ......... Excess amortizations (above) ................................. Dividends ...................................................................
$510,000 55,000 (10,000) (5,000)
2015: Equity accrual (based on Clay's net Income).......... Excess amortizations ............................................... Dividends ................................................................... Total ................................................................................
60,000 (10,000) (8,000) $592,000
INITIAL VALUE METHOD Investment Income—2015: Dividend income ...........................................................
$8,000
Investment in Clay—December 31, 2015: Consideration transferred for Clay ...............................
$510,000
b. The reported consolidated balances are not affected by the parent’s investment accounting method. Thus, consolidated expenses ($480,000 or $290,000 + $180,000 + amortizations of $10,000) are the same regardless of whether the equity method, the partial equity method, or the initial value method is applied by Adams. c. The reported consolidated balances are not affected by the parent’s investment accounting method. Thus, consolidated equipment ($970,000 or $520,000 + $420,000 + allocation of $50,000 – two years of excess depreciation totaling $20,000) is the same regardless of whether the equity method or the initial value method is applied by Adams. d. Adams retained earnings—Equity method Adams retained earnings—1/1/14 ....................................... Adams income 2014 ............................................................. 2014 equity accrual for Clay income .................................. 2014 excess amortization .................................................... Adams retained earnings—1/1/15 .......................................
$860,000 125,000 55,000 (10,000) $1,030,000
Adams retained earnings—Initial value method Adams retained earnings—1/1/14 ....................................... Adams income 2014 ............................................................. 2014 dividend income from Clay ........................................ Adams retained earnings—1/1/15 .......................................
$860,000 125,000 5,000 $990,000
3-22 .
.
Chapter 03 - Consolidations—Subsequent to the Date of Acquisition
23. (continued) e. EQUITY METHOD—Entry *C is not utilized since parent's retained earnings balance is correct. INITIAL VALUE METHOD—Entry *C is needed to recognize increase in subsidiary's book value ($55,000 income less 5,000 dividends) and amortization ($10,000) for prior year. Investment in Clay .............................................. Retained earnings, 1/1/15 (parent) ................
40,000 40,000
f. Consolidated worksheet entry S for 2015: Common stock (Clay) .................................... Retained earnings, 1/1/15 (Clay) .................... Investment in Clay ....................................
150,000 350,000 500,000
g. Consolidated revenues (combined) .................. Consolidated expenses (combined plus excess amortization) ..................................... Consolidated net income .................................... 24.
$640,000 (480,000) $160,000
(15 Minutes) (Consolidated accounts one year after acquisition) Stanza acquisition fair value ($10,000 in stock issue costs reduce additional paid-in capital) .................... $680,000 Book value of subsidiary (1/1/15 stockholders' equity balances) ..... (480,000) Fair value in excess of book value .......... $200,000 Remaining life Amortization
Excess fair value allocated to copyrights based on fair value .............................. 120,000 6 yrs. Goodwill ..................................................... $ 80,000 indefinite Total ...................................................... a. Consolidated copyrights Penske (book value) ...................................... $900,000 Stanza (book value) ....................................... 400,000 Allocation (above) .......................................... 120,000 Excess amortization, 2015 ............................ (20,000) Total ........................................................... $1,400,000
3-23 .
.
$20,000 -0$20,000
Chapter 03 - Consolidations—Subsequent to the Date of Acquisition
24. (continued) b. Consolidated net income, 2015 Revenues (add book values) ........................ Expenses: Add book values ....................................... Excess amortizations ............................... Consolidated net income ............................... c. Consolidated retained earnings, 12/31/15 Retained earnings 1/1/15 (Penske) ............... Net income 2015 (above) ............................... Dividends declared 2015 (Penske) ............... Total ...........................................................
$1,100,000 $700,000 20,000
720,000 $380,000
$600,000 380,000 (80,000) $900,000
Stanza's retained earnings balance as of January 1, 2015, is not included because these operations occurred prior to the acquisition. Stanza's dividends were attributable to Penske and therefore are excluded because they are intra-entity in nature. d. Consolidated goodwill, 12/31/15 Allocation (above) .......................................... 25.
$80,000
(30 Minutes) (Consolidated balances three years after the date of acquisition. Includes questions about parent's method of recording investment for internal reporting purposes.) a. Acquisition-Date Fair Value Allocation and Amortization: Consideration transferred 1/1/13 ............. $600,000 Book value (given) .................................... (470,000) Fair value in excess of book value ..... 130,000 Allocation to equipment based on fair and book value difference Goodwill ..................................................... Total ......................................................
Annual Remaining excess Life amortizations 90,000 10 yrs. $9,000 $40,000 indefinite -0-
$9,000
CONSOLIDATED BALANCES ▪
Depreciation expense = $659,000 (book values plus $9,000 excess depreciation)
▪
Dividends declared = $120,000 (parent balance only. Subsidiary's dividends are eliminated as intra-entity transfer)
▪
Revenues = $1,400,000 (add book values)
▪
Equipment = $1,563,000 (add book values plus $90,000 allocation less three years of excess depreciation [$27,000])
3-24 .
.
Chapter 03 - Consolidations—Subsequent to the Date of Acquisition
25. (continued) ▪
Buildings = $1,200,000 (add book values)
▪
Goodwill = $40,000 (original residual allocation)
▪
Common Stock = $900,000 (parent balance only)
b. The parent's choice of an investment method has no impact on the consolidated totals. The choice of an investment method only affects the internal reporting of the parent. c. The initial value method is used. The parent's Investment in Subsidiary account still retains the original consideration transferred of $600,000. In addition, the Investment Income account equals the amount of dividends declared by the subsidiary. d. If the partial equity method had been utilized, the investment income account would have shown an equity accrual of $100,000. If the equity method had been applied, the Investment Income account would have included both the equity accrual of $100,000 and excess amortizations of $9,000 for a balance of $91,000. e. Initial value method—Foxx’s retained earnings—1/1/15 Foxx’s 1/1/15 balance (initial value method was employed) $1,100,000 Partial equity method—Foxx’s retained earnings—1/1/15 Foxx’s 1/1/15 balance (initial value method) ...................... $1,100,000 2013 net equity accrual for Greenburg ($90,000 – $20,000) 70,000 2014 net equity accrual for Greenburg ($100,000 – $20,000) 80,000 Foxx’s 1/1/15 retained earnings .......................................... $1,250,000 Equity method—Foxx’s retained earnings—1/1/15 Foxx’s 1/1/15 balance (initial value method) ...................... $1,100,000 2013 net equity accrual for Greenburg ($90,000 – $20,000) 70,000 2013 excess fair over book value amortization ................. (9,000) 2014 net equity accrual for Greenburg ($100,000 – $20,000) 80,000 2014 excess fair over book value amortization ................. (9,000) Foxx’s 1/1/15 retained earnings .......................................... $1,232,000
3-25 .
.
Chapter 03 - Consolidations—Subsequent to the Date of Acquisition
26.
(50 Minutes) (Consolidated totals for an acquisition where parent employs the equity method. Worksheet is produced as a separate requirement.) a. Sea Cliff acquisition-date fair value ................... Sea Cliff book value ............................................ Fair value in excess of book value .................... Excess assigned to specific accounts based on fair value Computer software ................ $1,200,000 Patented technology ............ 2,100,000 Goodwill ................................ 200,000 Total ....................................... $3,500,000
$6,000,000 (2,500,000) $3,500,000 Annual Remaining excess life amortization
12 yrs. $100,000 7 yrs. 300,000 indefinite -0$400,000
b. Equity earnings in Sea Cliff: Because Persoff uses the equity method, the $575,000 "Equity earnings in Sea Cliff" reflects a $975,000 equity accrual (100% of Sea Cliff’s reported earnings) less $400,000 in excess amortization expense computed above. c. Investment in Sea Cliff: Fair value at 1/1/13 ................................................................. $6,000,000 Persoff's equity in Sea Cliff earnings (net of amortization): 2013 .................................................................. $500,000 2014 .................................................................. 540,000 2015 .................................................................. 575,000 Post-acquisition earnings net of amortization .................... 1,615,000 Sea Cliff dividends since acquisition ................................... (450,000) Investment balance at 12/31/15 ............................................. $7,165,000
3-26 .
.
Chapter 03 - Consolidations—Subsequent to the Date of Acquisition
26. continued (part d.) PERSOFF COMPANY AND CONSOLIDATED SUBSIDIARY Consolidation Worksheet For Year Ending December 31, 2015 Income Statement Revenues Cost of goods sold Depreciation Amortization Equity earnings in Sea Cliff Net income
Persoff (2,720,000) 1,350,000 275,000 370,000 (575,000) (1,300,000)
Sea Cliff (2,250,000) 870,000 380,000 25,000
Statement of Retained Earnings Retained earnings 1/1 Net income (above) Dividends declared Retained earnings 12/31
(7,470,000) (1,300,000) 600,000 (8,170,000)
(3,240,000) (975,000) 150,000 (4,065,000)
Balance Sheet Current assets Investment in Sea Cliff
490,000 7,165,000
375,000
E I
400,000 575,000
(975,000)
S 3,240,000 150,000 D
300,000 800,000 100,000 1,835,000 10,690,000
45,000 80,000 0 4,500,000 5,000,000
Liabilities Common stock Retained earnings 12/31 Total liabilities and equity
(520,000) (2,000,000) (8,170,000) (10,690,000)
(135,000) (800,000) (4,065,000) (5,000,000)
3-27
Consolidated (4,970,000) 2,220,000 655,000 795,000 0 (1,300,000)
(7,470,000) (1,300,000) 600,000 (8,170,000)
865,000 D
Computer software Patented technology Goodwill Equipment Total assets
..
Adjustments & Eliminations
150,000
A 1,000,000 A 1,500,000 A 200,000
S
575,000 I 4,040,000 S 2,700,000 A 100,000 E 300,000 E
800,000 7,865,000
7,865,000
-01,245,000 2,080,000 300,000 6,335,000 10,825,000 (655,000) (2,000,000) (8,170,000) (10,825,000)
Chapter 03 - Consolidations—Subsequent to the Date of Acquisition
27.
(50 Minutes) (Consolidated totals for an acquisition where parent employs the equity method. Worksheet is produced as a separate requirement.) a. Osprey acquisition-date fair value ..................... Osprey book value ............................................... Fair value in excess of book value ..................... Excess assigned to specific accounts based on fair value
$2,017,000 (1,550,000) $467,000
Equipment............................... Customer list ......................... Trademark ............................... Goodwill ................................. Total .......................................
8 yrs. 4 yrs. indefinite indefinite
$120,000 160,000 50,000 137,000 $467,000
Annual Remaining excess life amortization
$15,000 40,000 -0-0-
$55,000
b. Investment in Osprey: Fair value at 1/1/14 ................................................................. $2,017,000 Peregrine's equity in Osprey earnings: 2014: ($175,000 – $55,000) ............................. $120,000 2015: ($378,000 – $55,000) ............................. 323,000 Post-acquisition earnings less excess amortization .......... 443,000 Osprey dividends since acquisition ..................................... (70,000) Investment balance at 12/31/15 ............................................ $2,390,000
3-28 .
.
Chapter 03 - Consolidations—Subsequent to the Date of Acquisition
P 27 (continued) part d.
PEREGRINE COMPANY AND CONSOLIDATED SUBSIDIARY Consolidation Worksheet For Year Ending December 31, 2015
Income Statement Sales Cost of goods sold Depreciation expense Amortization expense Equity earnings in Osprey Net income Statement of Retained Earnings Retained earnings 1/1 Net income Dividends declared Retained earnings 12/31 Balance Sheet Cash Accounts receivable Inventory Investment in Osprey
Peregrine (4,200,000) 2,300,000 493,000 105,000 (323,000) (1,625,000)
Osprey (2,200,000) 1,550,000 272,000 -0-0(378,000)
(2,900,000) (1,625,000) 150,000 (4,375,000)
(900,000) (378,000) 45,000 (1,233,000)
430,000 690,000 890,000 2,390,000
88,000 75,000 420,000 -0-
Equipment (net) Customer lists Trademarks Goodwill Total assets
6,000,000 115,000 2,500,000 185,000 13,200,000
1,400,000 -0850,000 -02,833,000
Accounts payable Long-term debt Common stock - Peregrine Common stock - Osprey Retained earnings 12/31 Total liabilities and SE
(500,000) (1,325,000) (7,000,000)
(75,000) (725,000)
(4,375,000) (13,200,000)
Adjustments & Eliminations
15,000 40,000 323,000
S
900,000 45,000 D
D
A A A A
45,000 1,700,000 S 412,000 A 323,000 I 105,000 15,000 E 120,000 40,000 E 50,000 137,000
(2,900,000) (1,625,000) 150,000 (4,375,000) 518,000 765,000 1,310,000 -0-
7,490,000 195,000 3,400,000 322,000 14,000,000 (575,000) (2,050,000) (7,000,000)
(800,000) (1,233,000) (2,833,000)
S 800,000 2,535,000
3-29 ..
E E I
Consolidated (6,400,000) 3,850,000 780,000 145,000 -0(1,625,000)
(4,375,000) 2,535,000 (14,000,000)
Chapter 03 - Consolidations—Subsequent to the Date of Acquisition
28.
(50 Minutes) (Consolidated totals for an acquisition. Worksheet is produced as a separate requirement.) a. O’Brien acquisition-date fair value .................... O’Brien book value ............................................. Fair value in excess of book value .................... Excess assigned to specific accounts based on fair value
$550,000 (350,000) $200,000 Annual Remaining excess life amortizations
Trademarks .............................. $100,000 indefinite Customer relationships ........... 75,000 5 yrs. Equipment ................................ (30,000) 10 yrs. 55,000 indefinite Goodwill ................................... Total .......................................... $200,000
-0$15,000 (3,000) -0-
$12,000
If the partial equity method were in use, the Income of O’Brien account would have had a balance of $222,000 (100% of O’Brien's reported income for the period). If the initial value method were in use, the Income of O’Brien account would have had a balance of $80,000 (100% of the dividends declared by O’Brien). The Income of O’Brien balance is an equity accrual of $222,000 (100% of O’Brien’s reported income) less excess amortizations of $12,000 (as computed above). Thus, the equity method must be in use. b. Students can develop consolidated figures conceptually, without relying on a worksheet or consolidation entries. Thus, part b. asks students to determine independently each balance to be reported by the business combination. ▪ Revenues = $1,645,000 (the accounts of both companies combined) ▪
Cost of goods sold = 528,000 (the accounts of both companies combined)
▪
Amortization expense = $40,000 (the accounts of both companies and the acquisition-related adjustment of $15,000)
▪ Depreciation expense = $142,000 (the accounts for both companies and the acquisition-related depreciation adjustment of $3,000) ▪
Income from O’Brien = $0 (the balance reported by the parent is removed and replaced with the subsidiary’s individual revenue and expense accounts)
▪
Net Income = 935,000 (consolidated revenues less expenses)
▪
Retained earnings, 1/1 = $700,000 (only the parent's retained earnings figure is included)
▪ Dividends declared = $142,000 (the subsidiary's dividends were attributable to the parent and, thus, as an intra-entity transfer are eliminated) ▪
Retained earnings, 12/31 = $1,493,000 (the beginning balance for the parent plus consolidated net income less consolidated [parent] dividends) 3-30
.
.
Chapter 03 - Consolidations—Subsequent to the Date of Acquisition
28. (continued) ▪
Cash = $290,000 (the accounts of both companies are added together)
▪
Receivables = $281,000 (the accounts of both companies are combined)
▪
Inventory = $310,000 (the accounts of both companies are combined)
▪
Investment in O’Brien = $0 (the parent’s balance is removed and replaced with the subsidiary’s individual asset and liability accounts)
▪
Trademarks = $634,000 (the accounts of both companies are added together plus the 100,000 fair value adjustment)
▪
Customer relationships = $60,000 (the initial $75,000 fair value adjustment less $15,000 amortization expense)
▪
Equipment = $1,170,000 (both company’s balances less the $30,000 fair value adjustment net of $3,000 in depreciation expense reduction)
▪
Goodwill = $55,000 (the original allocation)
▪
Total assets = $2,800,000 (summation of consolidated balances)
▪
Liabilities = $907,000 (the accounts of both companies are combined)
▪
Common stock = $400,000 (parent balance only)
▪
Retained earnings, 12/31 = $1,493,000 (computed above)
▪
Total liabilities and equities = 2,800,000 (summation of consolidated balances)
3-31 .
.
Chapter 03 - Consolidations—Subsequent to the Date of Acquisition
28. (Continued) c.
Accounts Revenues Cost of goods sold Depreciation expense Amortization expense Income from O’Brien Net income
PATRICK COMPANY AND CONSOLIDATED SUBSIDIARY Consolidation Worksheet For Year Ending December 31 Consolidation Entries Patrick O’Brien Debit Credit (1,125,000) (520,000) 300,000 228,000 75,000 70,000 (E) 3,000 25,000 -0(E) 15,000 (210,000) -0(I) 210,000 (935,000) (222,000)
Retained earnings, 1/1 Net income (above) Dividends declared Retained earnings, 12/31
(700,000) (935,000) 142,000 (1,493,000)
(250,000) (222,000) 80,000 (392,000)
Cash Receivables Inventory Investment in O’Brien
185,000 225,000 175,000 680,000
105,000 56,000 135,000
(D) 80,000
474,000 -0925,000 -02,664,000
60,000 -0272,000 -0628,000
Liabilities Common stock Retained earnings (above) Total liabilities and equity
(771,000) (400,000) (1,493,000) (2,664,000)
(136,000) (100,000) (392,000) (628,000)
3-32
(700,000) (935,000) 142,000 (1,493,000) 290,000 281,000 310,000
(D) 80,000
Trademarks Customer relationships Equipment (net) Goodwill Total assets
..
(S)250,000
Consolidated Totals (1,645,000) 528,000 142,000 40,000 -0(935,000)
(A) 100,000 (A) 75,000 (E) 3,000 (A) 55,000
(S) 350,000 (A) 200,000 (I) 210,000 (E) 15,000 (A) 30,000
(S)100,000 888,000
888,000
-0634,000 60,000 1,170,000 55,000 2,800,000 (907,000) (400,000) (1,493,000) (2,800,000)
Chapter 03 - Consolidations—Subsequent to the Date of Acquisition
29.
(60 Minutes) (Consolidation worksheet five years after acquisition with parent using initial value method. Effects of using equity method also included) Acquisition-date fair value allocation and annual amortization: a. Aaron fair value (stock exchanged at fair value) ....................................... Book value of subsidiary ....................... Excess fair value over book value ........ Excess assigned to specific accounts based on fair values Royalty agreements Trademark Total
$470,000 (360,000) $110,000 Remaining Annual excess life amortizations
$ 60,000 6 yrs. 50,000 10 yrs. $110,000
$10,000 5,000 $15,000
The parent company is apparently applying the initial value method: only dividend income is recognized during the current year and the investment account retains its original $470,000 balance. Therefore, both the subsidiary's change in retained earnings during 2011–2014 as well as the amortization for that period must be brought into the consolidation. Aaron's retained earnings January 1, 2015 ....................... Retained earnings at acquisition-date ............................... Increase since acquisition-date ......................................... Excess amortization expenses ($15,000 x 4 years) .......... Conversion to equity method for years prior to 2015 (Entry *C) ...................................................................
$490,000 (230,000) $260,000 (60,000) $200,000
Explanations of consolidation worksheet entries Entry*C: Converts 1/1/15 figures from initial value method to equity method as per computation above. Entry S: Eliminates stockholders' equity accounts of subsidiary as of the beginning of current year. Entry A: Recognizes allocations to royalty agreements and trademark. This entry establishes unamortized balances as of the beginning of the current year. Entry I:
Eliminates intra-entity dividends.
Entry E: Recognizes excess amortization expenses for the current year. See next page for worksheet.
3-33 .
.
Chapter 03 - Consolidations—Subsequent to the Date of Acquisition
29. a. (continued)
Accounts Revenues Cost of goods sold Amortization expense Dividend income Net income
MICHAEL COMPANY AND CONSOLIDATED SUBSIDIARY Consolidation Worksheet For Year Ending December 31, 2015 Consolidation Entries Michael Aaron Debit Credit (610,000) (370,000) 270,000 140,000 115,000 80,000 (E) 15,000 (5,000) -0(I) 5,000 (230,000) (150,000)
Retained earnings 1/1
(880,000)
(*C) 200,000
Net income (above) Dividends declared Retained earnings 12/31
(230,000) 90,000 (1,020,000)
(490,000) (150,000) 5,000 (635,000)
Cash Receivables Inventory Investment in Aaron Co.
$110,000 380,000 560,000 470,000
$15,000 220,000 280,000 -0-
Copyrights Royalty agreements Trademark Total assets
460,000 920,000 -02,900,000
340,000 380,000 -01,235,000
Liabilities Preferred stock Common stock Additional paid-in capital Retained earnings 12/31 Total liabilities and equity
(780,000) (300,000) (500,000) (300,000) (1,020,000) (2,900,000)
(470,000) -0(100,000) (30,000) (635,000) (1,235,000)
Parentheses indicate a credit balance.
3-34 ..
(S) 490,000 (I)
5,000
(*C) 200,000
(S) 620,000 (A) 50,000
(A) (A)
(E) 10,000 (E) 5,000
20,000 30,000
(S) 100,000 (S) 30,000 890,000
890,000
Consolidated Totals (980,000) 410,000 210,000 -0(360,000) (1,080,000) -0(360,000) 90,000 (1,350,000) $125,000 600,000 840,000 -0800,000 1,310,000 25,000 3,700,000 (1,250,000) (300,000) (500,000) (300,000) (1,350,000) (3,700,000)
Chapter 03 - Consolidations—Subsequent to the Date of Acquisition
29. (continued) b. If the equity method had been applied by Michael, three figures on that company's financial records would be different: Equity in Earnings of Aaron, Retained Earnings—1/1/15, and Investment in Aaron Co. Equity in earnings of Aaron: $135,000 (the parent would accrue 100% of Aaron's $150,000 income but must also recognize $15,000 in amortization expense.) Retained earnings, 1/1/15: $1,080,000 (increases by $200,000—the parent would have recognized the $260,000 increment in the subsidiary's book value during previous years as well as $60,000 in excess amortization expenses for these same four years [see Part a.]) Investment in Aaron: $800,000 (increases by $330,000—the parent would have recognized the $260,000 increment in the subsidiary's book value during previous years as well as $60,000 in excess amortization expenses for these same four years [see Part a.]. In the current year, net income of $135,000 would have been recognized [see above] along with a reduction of $5,000 for subsidiary dividends declared). c. No Entry *C is needed on the worksheet if the equity method is applied. Both the investment account as well as beginning retained earnings would be stated appropriately. Entry I would have been used to eliminate the $135,000 Equity in Earnings of Aaron from the parent's income statement and from the Investment in Aaron Co. account. Entry D would eliminate the $5,000 current year dividend from Dividends Declared and the Investment in Aaron account balances. d. Consolidated figures are not affected by the investment method used by the parent. The parent company balances would differ and changes would be required in the worksheet entries. However, the figures to be reported do not depend on the parent's selection of a method.
3-35 .
.
Chapter 03 - Consolidations—Subsequent to the Date of Acquisition
30.
(65 Minutes) (Consolidated totals and worksheet five years after acquisition. Parent uses equity method. Includes goodwill impairment.) a. Acquisition-date fair value allocations (given) Remaining Annual excess Land Equipment Goodwill Total
$90,000 50,000 60,000 $200,000
life
amortizations
-10 yrs. indefinite
-$5,000 -0$5,000
Because Giant uses the equity method, the $135,000 "Equity in Income of Small" reflects a $140,000 equity accrual (100% of Small’s reported earnings) less $5,000 in amortization expense computed above. b. ▪ Revenues = $1,535,000 (both balances are added together) ▪ Cost of goods sold = $640,000 (both balances are added) ▪ Depreciation expense = $307,000 (both balances are added along with excess equipment depreciation) ▪ Equity in income of Small = $0 (the parent's Equity in Income of Small balance is removed and replaced with Small's individual revenue and expense accounts) ▪ Net income = $588,000 (consolidated expenses are subtracted from consolidated revenues) ▪ Retained earnings, 1/1/15 = $1,417,000 (the parent’s balance) ▪ Dividends declared = $310,000 (the parent number alone because the subsidiary's dividends are intra-entity) ▪ Retained earnings, 12/31/15 = $1,695,000 (the parent’s balance at beginning of the year plus consolidated net income less consolidated dividends declared) ▪ Current assets = $706,000 (both book balances are added together while the $10,000 intra-entity receivable is eliminated) ▪ Investment in Small = $0 (the parent's asset is removed so that Small's individual asset and liability accounts can be brought into the consolidation) ▪ Land = $695,000 (both book balances are added together along with the acquisition-date fair value allocation of $90,000) ▪ Buildings = $723,000 (both book balances are added together) ▪ Equipment = $959,000 (both book balances are added plus the unamortized portion of the acquisition-date fair value allocation [$50,000 less $25,000 after 5 years of excess depreciation]) 3-36 .
.
Chapter 03 - Consolidations—Subsequent to the Date of Acquisition
30. b. (continued) ▪ Goodwill = $60,000 (represents the original acquisition-date allocation) ▪ Total assets = $3,143,000 (summation of all consolidated assets) ▪ Liabilities = $1,198,000 (both balances are added together while the $10,000 intra-entity payable is eliminated) ▪ Common stock = $250,000 (parent balance only) ▪ Retained earnings, 12/31/15 = $1,695,000 (see above) ▪ Total liabilities and equity = $3,143,000 (summation of all consolidated liabilities and equity) d. Worksheet is presented on following page. e. If all goodwill from the Small investment was determined to be impaired, Giant would make the following journal entry on its books: Goodwill impairment loss Investment in Small
60,000 60,000
After this entry, the worksheet process would no longer require an adjustment in Entry (A) to recognize goodwill. The impairment loss would simply carry over to the consolidated income column. The impairment loss would be reported as a separate line item in the operating section of the consolidated income statement.
3-37 .
.
Chapter 03 - Consolidations—Subsequent to the Date of Acquisition
30. c. (continued) GIANT COMPANY AND SMALL COMPANY Consolidation Worksheet For Year Ending December 31, 2015 Consolidation Entries Debit Credit
Accounts Revenues ............................................................ Cost of goods sold............................................. Depreciation expense ........................................ Equity income of Small ...................................... Net income ....................................................
Giant (1,175,000) 550,000 172,000 (135,000) (588,000)
Small (360,000) 90,000 130,000 -0(140,000)
Retained earnings 1/1 ........................................ Net income (above) ............................................ Dividends declared ............................................ Retained earnings 12/31 ..............................
(1,417,000) (588,000) 310,000 (1,695,000)
(620,000) (140,000) 110,000 (650,000)
Current assets .................................................... Investment in Small ...........................................
398,000 995,000
318,000 -0-
Land ................................................................. Buildings (net) .................................................... Equipment (net).................................................. Goodwill.............................................................. Total assets ..................................................
440,000 304,000 648,000 -02,785,000
165,000 419,000 286,000 -01,188,000
(A) 90,000
Liabilities ............................................................ Common stock ................................................... Retained earnings (above) ................................ Total liabilities and equity............................
(840,000) (250,000) (1,695,000) (2,785,000)
(368,000) (170,000) (650,000) (1,188,000)
(P) 10,000 (S)170,000
Parentheses indicate a credit balance.
3-38 ..
(E) 5,000 (I) 135,000
(S) 620,000 (D) 110,000
(D) 110,000
(A) 30,000 (A) 60,000
1,230,000
(P) 10,000 (S) 790,000 (A) 180,000 (I) 135,000
(E)
5,000
1,230,000
Consolidated Totals (1,535,000) 640,000 307,000 -0(588,000) (1,417,000) (588,000) 310,000 (1,695,000) 706,000 -0-
695,000 723,000 959,000 60,000 3,143,000 (1,198,000) (250,000) (1,695,000) (3,143,000)
Chapter 03 - Consolidations—Subsequent to the Date of Acquisition
31. (45 Minutes) (Consolidated totals and worksheet two years after acquisition. Parent uses initial value method. Includes question comparing initial value and equity methods). a. 12/31/2015 Sales Cost of goods sold Interest expense Depreciation expense Amortization expense Dividend income Net Income
Pinnacle (7,000,000) 4,650,000 255,000 585,000 (50,000) (1,560,000)
(190,000)
Retained earnings 1/1/15 Net income Dividends declared Retained earnings 12/31/15
(5,000,000) (1,560,000) 560,000 (6,000,000)
(1,350,000) (190,000) 50,000 (1,490,000)
Cash Accounts receivable Inventory Investment in Strata
433,000 1,210,000 1,235,000 3,200,000
165,000 200,000 1,500,000
Buildings (net) Licensing agreements Goodwill Total Assets
5,572,000
2,040,000 1,800,000
Accounts payable Long-term debt Common stock - Pinnacle Common stock - Strata Retained earnings 12/31/15 Total Liabilities and OE
350,000 12,000,000 (300,000) (2,700,000) (3,000,000) (6,000,000) (12,000,000)
Strata (3,000,000) 1,700,000 160,000 350,000 600,000
Adjustments and Eliminations
E
30,000
D
50,000
S 1,350,000
E
20,000
*C
240,000
D
50,000
P
85,000
*C
240,000
S 2,850,000 A 590,000
A E A
270,000 20,000 400,000
E A
(715,000) (2,000,000)
P
85,000
(1,500,000) (1,490,000) (5,705,000)
S 1,500,000
30,000 80,000
5,705,000
3,945,000
3,945,000
Consolidated (10,000,000) 6,350,000 415,000 965,000 580,000 0 (1,690,000) (5,240,000) (1,690,000) 560,000 (6,370,000) 598,000 1,325,000 2,735,000 0
7,852,000 1,740,000 750,000 15,000,000 (930,000) (4,700,000) (3,000,000) 0 (6,370,000) (15,000,000)
b. Subsidiary income (190,000 – 10,000) ...................................... $180,000 1/1/15 retained earnings (5,000,000 + 240,000) .................... $5,240,000 Investment in Strata: Initial value basis ............................................................ $3,200,000 Conversion to equity as of 1/1/15.................. 240,000 Net income for 2015 ....................................... 180,000 Dividends for 2015 .......................................... (50,000) 370,000 Equity method balance 12/31/15 ..................................... $3,570,000 c. The internal method choice for investment accounting has no effect on consolidated financial statements. 3-39 .
.
Chapter 03 - Consolidations—Subsequent to the Date of Acquisition
32. (30 Minutes) (Determine consolidated accounts and consolidation entries five years after acquisition. Parent applies equity method.) a. Fair value allocation and annual amortization Allocation
Land .......................................... Buildings ........................................ Equipment ...................................... Customer List ................................. Total ..........................................
$20,000 (30,000) 60,000 100,000
Remaining Annual excess life amortizations
10 yrs. 5 yrs. 20 yrs.
$(3,000) 12,000 5,000 $14,000
CONSOLIDATED TOTALS ▪ Revenues = $850,000 (add the two book values) ▪ Cost of goods sold = $380,000 (the accounts of both companies are added together) ▪ Depreciation expense = $179,000 (the accounts are added and include the excess depreciation net adjustment of $9,000) ▪ Amortization expense = $5,000 (current amortization for customer list recognized in acquisition) ▪ Buildings (net) = $625,000 (add the two book values less the acquisitiondate fair value allocation [a $30,000 reduction] after removing 5 years of amortization totaling $15,000) ▪ Equipment (net) = $450,000 (add the two book values. The acquisition-date fair value allocation is completely amortized at end of current year) ▪ Customer list = $75,000 ($100,000 original allocation less $25,000 [5 years of amortization]) ▪ Common stock = $300,000 (parent company balance only) ▪ Additional paid-in capital = $50,000 (parent company balance only) b. The method used by the parent is only important in determining the parent's separate account balances (which are given here or are not needed) or consolidation worksheet entries (which are not required in a.)
3-40 .
.
Chapter 03 - Consolidations—Subsequent to the Date of Acquisition
32. (continued) c. Consolidation entry S Common stock (Hill) ............................ 40,000 Additional paid-in capital (Hill) ........... 160,000 Retained earnings 1/1 .......................... 600,000 Investment in Hill ............................ 800,000 (To eliminate beginning stockholders' equity of subsidiary) Consolidation entry A Land ...................................................... 20,000 Equipment (net) ................................... 12,000 Customer list (net) ............................... 80,000 Buildings (net) ................................ 18,000 Investment in Hill ............................ 94,000 (To recognize unamortized allocation balances as of beginning of current year) Consolidation entry I Investment income .............................. 86,000 Investment in Hill ............................ 86,000 (To remove equity income recognized during year—equity method accrual of $100,000 [based on subsidiary's income] less amortization of $14,000 for the year) Consolidation entry D Investment in Hill ................................. 40,000 Dividends declared ......................... (To remove Intra-entity dividend declarations)
40,000
Consolidation entry E Amortization expense........................... 5,000 Depreciation expense ........................... 9,000 Buildings .............................................. 3,000 Equipment ........................................ 12,000 Customer list ................................... 5,000 (To recognize excess acquisition-date fair-value amortizations for the period)
3-41 .
.
Chapter 03 - Consolidations—Subsequent to the Date of Acquisition
33.
(30 Minutes) (Determine parent company and consolidated account balances for a bargain purchase combination. Parent applies equity method)
a.
Acquisition-date fair value allocation and annual excess amortization Consideration transferred ............. $1,183,000 Chandler book value (given) .......... $1,105,000 Technology undervaluation (6 yr. life) 204,000 Acquisition-date fair value of net assets 1,309,000 Gain on bargain purchase .............. $(126,000) Chandler net income ....................... Technology amortization ................ Equity earnings in Chandler ...........
$(233,000) 34,000 $(199,000)
Fair value of net assets at acquisition-date Equity earnings from Chandler ...... Dividends declared.......................... Investment in Chandler 12/31/15 ....
$1,309,000 199,000 (40,000) $1,468,000
Because a bargain purchase occurred, Chandler’s net asset fair value replaces the fair value of the consideration transferred as the initial value assigned to the subsidiary on the books of the parent, Brooks.
3-42 .
.
Chapter 03 - Consolidations—Subsequent to the Date of Acquisition
33 continued (part b.) Income Statement Revenues Cost of goods sold Gain on bargain purchase Depreciation and amortization Equity earnings in Chandler Net income
Brooks (640,000) 255,000 (126,000)
Chandler (587,000) 203,000 -0-
Adj. &
150,000
151,000
(E) 34,000
335,000
(199,000) (560,000)
-0(233,000)
(I) 199,000
-0(560,000)
Statement of Retained Earnings Retained earnings, 1/1 Net income (above) Dividends declared Retained earnings, 12/31
(1,835,000) (560,000) 100,000 (2,295,000)
(805,000) (233,000) 40,000 (998,000)
(S) 805,000
(1,835,000) (560,000) 100,000 (2,295,000)
Balance Sheet Current assets Investment in Chandler
343,000 1,468,000
432,000 -0-
Trademarks Patented technology Equipment Total assets
134,000 395,000 693,000 3,033,000
221,000 410,000 341,000 1,404,000
Liabilities Common stock Retained earnings, 12/31 Total liabilities and equity
(203,000) (535,000) (2,295,000) (3,033,000)
(106,000) (300,000) (998,000) (1,404,000)
3-43 .
.
Elim.
(D)
Consolidated (1,227,000) 458,000 (126,000)
40,000
775,000 (D) 40,000
(A) 204,000
(I) 199,000 (S)1,105,000 (A) 204,000 (E)
34,000
(S) 300,000 1,582,000
1,582,000
-0355,000 975,000 1,034,000 3,139,000 (309,000) (535,000) (2,295,000) (3,139,000)
Chapter 03 - Consolidations—Subsequent to the Date of Acquisition
34. (35 minutes) (Contingent performance obligation and worksheet adjustments for equity and initial value methods.) a.
Investment in Wolfpack, Inc. Contingent performance obligation Cash
500,000 35,000 465,000
b. 12/31/14 Loss from increase in contingent performance obligation Contingent performance obligation
5,000 5,000
12/31/15 Loss from increase in contingent performance obligation 10,000 Contingent performance obligation 10,000 12/31/15 Contingent performance obligation Cash
50,000 50,000
c. Equity Method Common stock- Wolfpack Retained earnings-Wolfpack Investment in Wolfpack
200,000 180,000
Royalty agreements Goodwill Investment in Wolfpack
90,000 60,000
Equity earnings of Wolfpack Investment in Wolfpack
65,000
Investment in Wolfpack Dividends declared
35,000
Amortization expense Royalty agreements
10,000
380,000
150,000
65,000
35,000
10,000
d. Initial Value Method Investment in Wolfpack Retained earnings-Branson
30,000
Common stock Retained earnings-Wolfpack Investment in Wolfpack
200,000 180,000
30,000
380,000
3-44 .
.
Chapter 03 - Consolidations—Subsequent to the Date of Acquisition
34. (continued) Royalty agreements Goodwill Investment in Wolfpack
90,000 60,000
Dividend income Dividends declared
35,000
Amortization expense Royalty agreements
10,000
150,000
35,000
10,000
35. (45 Minutes) (Prepare consolidation worksheet five years after acquisition. Parent applies equity method. Includes question on push-down accounting.) a. Allocation of Acquisition-Date Fair Value and Determination of Amortization: Storm’s acquisition-date fair value .................... Book value of Storm (acquisition date) ............. Fair value in excess of book value .................... Excess assigned to specific accounts: Land ........................................... Equipment ................................. Formula ...................................... Total ................................................
$140,000 (105,000) $ 35,000 Remaining Annual excess life amortizations
$10,000 5,000 20,000 $35,000
– 5 yrs. 20 yrs.
– $1,000 1,000 $2,000
The equity in subsidiary earnings reflects the equity method. The initial value method would have recorded $40,000 (100% of dividend declared) as income while the partial equity method would have shown $68,000 (100% of the subsidiary's income). Under the equity method, a $66,000 income accrual is recognized (100% of reported income less the $2,000 in excess amortization expenses computed above). b. Explanation of Consolidation Entries Found on Worksheet Entry S—Eliminates stockholders' equity accounts of the subsidiary as of the beginning of the current year. Entry A—Recognizes remaining unamortized allocation from acquisition-date fair value adjustments. As of the beginning of the current year, equipment and formula have undergone four years of amortization. Entry I—Eliminates intra-entity income accrual for the current year. Entry D—Eliminates intra-entity dividend transfers. Entry E—Recognizes excess amortization expenses for current year. 3-45 .
.
Chapter 03 - Consolidations—Subsequent to the Date of Acquisition
35. (continued) Palm and Subsidiary Consolidated Worksheet for year ended December 31, 2015 Accounts Income Statement Revenues .......................................................... Cost of goods sold........................................... Depreciation expense ...................................... Amortization expense ...................................... Equity in subsidiary earnings ......................... Net income ..................................................
Consolidation Entries Debit Credit
Consolidated Totals
Palm Co.
Storm Co.
(485,000) 160,000 130,000 -0(66,000) (261,000)
(190,000) 70,000 52,000 (E) 1,000 -0- (E) 1,000 -0- (I) 66,000 (68,000)
(675,000) 230,000 183,000 1,000 -0(261,000)
Statement of Retained Earnings Retained earnings 1/1 ...................................... Net income (above) .......................................... Dividends declared .......................................... Retained earnings 12/31 ............................
(659,000) (261,000) 175,500 (744,500)
(98,000) (S) 98,000 (68,000) 40,000 (126,000)
(659,000) (261,000) 175,500 (744,500)
Balance Sheet Current assets .................................................. Investment in Storm Co. ..................................
268,000 216,000
75,000 -0-
Land ............................................................... Buildings and equipment (net) ........................ Formula............................................................. Total assets ................................................
427,500 713,000 -01,624,500
58,000 161,000 -0294,000
Current liabilities.............................................. Long-term liabilities ......................................... Common stock ................................................. Additional paid-in capital................................. Retained earnings 12/31 .................................. Total liabilities and equity..........................
(110,000) (80,000) (600,000) (90,000) (744,500) (1,624,500)
(19,000) (84,000) (60,000) (S) 60,000 (5,000) (S) 5,000 (126,000) (294,000) 298,000
Parentheses indicate a credit balance. 3-46 ..
(D) 40,000
(A) 10,000 (A) 1,000 (A) 16,000
(D)
40,000
(S) 163,000 (A) 27,000 (I) 66,000 (E) (E)
1,000 1,000
298,000
343,000 -0-
495,500 874,000 15,000 1,727,500 (129,000) (164,000) (600,000) (90,000) (744,500) (1,727,500)
Chapter 03 - Consolidations—Subsequent to the Date of Acquisition
35. (continued) c. If push-down accounting had been applied, the acquisition-date fair value allocations to land ($10,000), equipment ($5,000), and formula ($20,000) would have been entered into the subsidiary's balances with an offsetting $35,000 increase in additional paid-in capital. The equipment and the formula would then have been amortized by the subsidiary as annual expenses of $1,000 each. For 2015, the subsidiary's expenses would have been $2,000 higher leaving reported net income at $66,000. At the end of 2015, land would still have been $10,000 higher because no amortization is recorded on that asset. Equipment would be no higher at this time since the $5,000 allocation is fully depreciated at the end of this fifth year. However, the secret formula would be recorded by the subsidiary as $15,000, the $20,000 allocation less five years of amortization at $1,000 per year. 36.
(20 Minutes) (Consolidated balances three years after acquisition. Parent has applied the equity method.) a. Schedule 1—Acquisition-Date Fair Value Allocation and Amortization Jasmine’s acquisition-date fair value $206,000 Book value of Jasmine .................. (140,000) Fair value in excess of book value 66,000 Excess fair value assigned to specific accounts based on individual fair values Equipment .............................. Buildings (overvalued) .......... Goodwill .................................. Total ...........................................
Remaining life
$54,400 8 yrs. (10,000) 20 yrs. $21,600 indefinite
Annual excess amortization
$6,800 (500) -0$6,300
Investment in Jasmine Company—12/31/15: Jasmine’s acquisition-date fair value ............................ 2013 Increase in book value of subsidiary ................... 2013 Excess amortizations (Schedule 1) ..................... 2014 Increase in book value of subsidiary ................... 2014 Excess amortizations (Schedule 1) ..................... 2015 Increase in book value of subsidiary ................... 2015 Excess amortizations (Schedule 1) ..................... Investment in Jasmine Company 12/31/15 ..............
3-47 .
.
$206,000 40,000 (6,300) 20,000 (6,300) 10,000 (6,300) $257,100
Chapter 03 - Consolidations—Subsequent to the Date of Acquisition
36. (continued) b. Equity in subsidiary earnings: Income accrual ................................................................ Excess amortizations (Schedule 1) .............................. Equity in subsidiary earnings ..................................
$30,000 (6,300) $23,700
c. Consolidated net income: Consolidated revenues (add book values) .................. Consolidated expenses (add book values) .................. Excess amortization expenses (Schedule 1) ............... Consolidated net income ...............................................
$414,000 (272,000) (6,300) $135,700
d. Consolidated equipment: Book values added together ......................................... Acquisition-date fair value allocation ........................... Excess depreciation ($6,800 × 3) .................................. Consolidated equipment ..........................................
$370,000 54,400 (20,400) $404,000
e. Consolidated buildings: Book values added together ......................................... Acquisition-date fair value allocation ............................ Excess depreciation ($500 × 3) ..................................... Consolidated buildings .............................................
$288,000 (10,000) 1,500 $279,500
f. Allocation of excess fair value to goodwill ...................
$21,600
g. Consolidated common stock .........................................
$290,000
The parent's $290,000 balance appropriately shows the parent company stockholders’ contributed capital (the acquired company's common stock will be eliminated each year on the consolidation worksheet). h. Consolidated retained earnings.....................................
$410,000
Tyler's balance of $410,000 is equal to the consolidated total because the equity method has been applied. 37.
(35 minutes) (Consolidation with IPR&D, equity method)
a.
Consideration transferred 1/1/14 Increase in Salsa’s retained earnings to 1/1/15 In-process R&D write-off in 2014 Amortizations 2014 Income 2015 Dividends declared 2015 Amortization 2015 Investment balance 12/31/15
3-48 .
.
$1,765,000 150,000 (44,000) (7,000) 210,000 (25,000) (7,000) $2,042,000
Chapter 03 - Consolidations—Subsequent to the Date of Acquisition
37. (continued) b. The IPR&D was abandoned in 2014 and the original asset was written off to expense to reflect the absence of future economic benefits. Because the parent applies the equity method, the investment account was reduced by $44,000.
c.
Picante and Subsidiary Salsa Consolidated Worksheet for the year ended December 31, 2015
Accounts Sales Cost of goods sold Depreciation expense Subsidiary income Net Income
12/31/15 Picante (3,500,000) 1,600,000 540,000 (203,000) (1,563,000)
12/31/15 Salsa (1,000,000) 630,000 160,000
Retained earnings 1/1/15 Net Income Dividends declared Retained earnings 12/31/15
(3,000,000) (1,563,000) 200,000 (4,363,000)
(800,000) (210,000) 25,000 (985,000)
Cash Accounts receivable Inventory Investment in Salsa
228,000 840,000 900,000 2,042,000
50,000 155,000 580,000
Land Equipment (net) Goodwill Total assets
3,500,000 5,000,000 290,000 12,800,000
700,000 1,700,000 -03,185,000
Accounts payable Long-term debt Common stock—Picante Common stock—Salsa Retained earnings 12/31/15
(193,000) (3,094,000) (5,150,000)
(400,000) (800,000)
(4,363,000) (12,800,000)
Consolidated (4,500,000) 2,230,000 707,000 -0(1,563,000)
(E) 7,000 (I) 203,000
(210,000) (S) 800,000 (D)
(D) 25,000
(1,000,000) (985,000) (3,185,000)
3-49 .
Adjustments
.
(A) 49,000 (A) 15,000
25,000
(S)1,800,000 (A) 64,000 (I) 203,000 (E)
7,000
(3,000,000) (1,563,000) 200,000 (4,363,000) 278,000 995,000 1,480,000 -0-
4,200,000 6,742,000 305,000 14,000,000 (593,000) (3,894,000) (5,150,000)
(S)1,000,000 2,099,000
2,099,000
(4,363,000) (14,000,000)
Chapter 03 - Consolidations—Subsequent to the Date of Acquisition
38.
(55 minutes) (Goodwill impairment, consolidated balances, and worksheet) a. Prine compares Lydia’s total fair value to its carrying value, as follows: 12/31 Carrying value (equity method balance) $120,070,000 12/31 Fair value 110,000,000 Excess carrying value over fair value $10,070,000 Because fair value is less than carrying value, Prine is required to further test whether goodwill is impaired. b. 12/31 Fair value for Lydia Fair values of assets and liabilities Cash Receivables (net) Movie library Broadcast licenses Equipment Current liabilities Long-term debt Total net fair value Implied fair value for goodwill Carrying value for goodwill Impairment loss Journal Entry by Prine: Goodwill impairment loss Investment in Lydia Co.
$110,000,000 $109,000 897,000 60,000,000 20,000,000 19,000,000 (650,000) (6,250,000) 93,106,000 16,894,000 50,000,000 $33,106,000
33,106,000 33,106,000
c. Combined revenues $30,000,000 Combined expenses (including excess amortization) 22,200,000 Income before impairment loss 7,800,000 Goodwill impairment loss—Lydia (33,106,000) Consolidated net loss $(25,306,000) d. Consolidated goodwill = $50,000,000 – $33,106,000 = $16,894,000 e. Consolidated broadcast licenses = $350,000 + $14,014,000 = $14,364,000 The consolidated balance is the parent’s book value plus the fair value of the subsidiary acquisition-date value adjusted for changes since acquisition. Because the subsidiary’s book value equaled fair value at acquisition date, there is no fair value adjustment. Because the broadcast licenses have indefinite lives, they are not amortized. Note that the 12/31 fair value, assessed for purposes of computing implied value for goodwill, is not used for financial reporting purposes.
3-50 .
.
Chapter 03 - Consolidations—Subsequent to the Date of Acquisition
38. f. (continued)
Prine and Lydia Consolidated Worksheet December 31 Adjusting Entries Debit Credit
Accounts Revenues Expenses Equity in Lydia earnings Impairment loss Net loss (income)
Prine, Inc. (18,000,000) 10,350,000 (150,000) 33,106,000 25,306,000
Lydia Co. (12,000,000) 11,800,000 (E) -0- (I) -0(200,000)
Retained earnings 1/1 Dividends declared Net loss (income) Retained earnings 12/31
(52,000,000) 300,000 25,306,000 (26,394,000)
(2,000,000) (S) 2,000,000 80,000 (200,000) (2,120,000)
Cash Receivables (net) Investment in Lydia, Co.
260,000 210,000 86,964,000
Broadcast licenses Movie library Equipment (net) Goodwill Total assets
350,000 365,000 136,000,000 -0224,149,000
14,014,000 45,000,000 17,500,000 (A) 500,000 -0- (A)16,894,000 77,520,000
Current liabilities Long-term debt Common stock Retained earnings 12/31 Total liabilities and equity
(755,000) (22,000,000) (175,000,000) (26,394,000) (224,149,000)
(650,000) (7,250,000) (67,500,000) (S)67,500,000 (2,120,000) (77,520,000) 87,114,000
109,000 897,000 -0- (D)
3-51 ..
50,000 150,000
80,000
(D)
80,000
(S)69,500,000 (A)17,394,000 (I) 150,000
(E)
Consolidated Totals (30,000,000) 22,200,000 -033,106,000 25,306,000 (52,000,000) 300,000 25,306,000 (26,394,000) 369,000 1,107,000 -0-
14,364,000 45,365,000 50,000 153,950,000 16,894,000 232,049,000
87,114,000
(1,405,000) (29,250,000) (175,000,000) (26,394,000) (232,049,000)
Chapter 03 - Consolidations—Subsequent to the Date of Acquisition
RESEARCH CASE SOLUTION Jonas recognized several identifiable intangibles from its acquisition of Innovation Plus. Jonas expresses the desire to expense these intangible assets in the acquisition period. 1. Advise Jonas on the acceptability of its suggested immediate write-off. An intangible asset should not be written down or off in the period of acquisition unless it becomes impaired during that period. 2. Indicate the relevant factors to consider in allocating the values assigned to identifiable intangibles acquired in a business combination. The accounting for a recognized intangible asset is based on its useful life to the reporting entity. An intangible asset with a finite useful life is amortized; an intangible asset with an indefinite useful life is not amortized. The useful life of an intangible asset to an entity is the period over which the asset is expected to contribute directly or indirectly to the future cash flows of that entity. Other factors to be considered are legal, regulatory, or contractual provisions, effects of obsolescence, demand, competition, and other economic factors, and the level of maintenance expenditures required to obtain the expected future cash flows from the asset (ASC 350-30-35-3). The price paid by Jonas for Innovation Plus indicates a large amount was paid for goodwill. However, Jonas worries that any goodwill impairment may send the wrong signal to its investors about the wisdom of the acquisition. Jonas thus wishes to allocate all the goodwill to one account called “enterprise goodwill.” In this way, Jonas hopes to minimize the possibility of goodwill impairment because a decline in goodwill in one business unit may be offset by an increase in the value of goodwill in another business unit. 3. Jonas’ suggested treatment of goodwill is inappropriate. To ensure that goodwill increases in one reporting unit do not offset decreases in others, goodwill acquired in a business combination is allocated across business units that benefit from the goodwill. 4. Per the FASB ASC (350-20-35-41): For the purpose of testing goodwill for impairment, all goodwill acquired in a business combination shall be assigned to one or more reporting units as of the acquisition date. Goodwill shall be assigned to reporting units of the acquiring entity that are expected to benefit from the synergies of the combination even though other assets or liabilities of the acquired entity may not be assigned to that reporting unit. The total amount of acquired goodwill may be divided among a number of reporting units. The methodology used to determine the amount of goodwill to assign to a reporting unit shall be reasonable and supportable and shall be applied in a consistent manner.
3-52 .
.
Chapter 03 - Consolidations—Subsequent to the Date of Acquisition
Therefore, Jonas’ desire to minimize the possibility of goodwill impairment should not be a factor in allocating goodwill to reporting units. MICROSOFT IMPAIRMENT ANALYSIS CASE SOLUTION The following all can be found in Microsoft Corporation’s 2012 10-K annual report. 1. Microsoft’s OnOnline Services Division incurred a $6.193 billion goodwill impairment loss assess on May 1, 2012 Online Services Division (“OSD”) develops and markets information and content designed to help people simplify tasks and make more informed decisions online, and help advertisers connect with audiences. OSD offerings include Bing, MSN, adCenter, and advertiser tools. Bing and MSN generate revenue through the sale of search and display advertising, accounting for nearly all of OSD’s annual revenue. (page 6) 2. Goodwill impairment appeared on the 2012 income statement and cash flow statement as follows: • •
Goodwill impairment $6,193 million operating expense in the Income Statement. Goodwill impairment $6,193 addition to net income to arrive at net cash from operations in the Cash Flows Statement.
3. The impairment was the result of the OSD unit experiencing slower than projected growth in search queries and search advertising revenue per query, slower growth in display revenue, and changes in the timing and implementation of certain initiatives designed to drive search and display revenue growth in the future. Although revenues increased compared to the prior year, the industry is highly competitive and certain operational challenges have affected our expectations such that future growth and profitability are lower than previous estimates. In addition, in the current year, we added a business-specific risk factor to the weighted average cost of capital used to calculate the discounted cash flows of OSD in estimating the fair value of the business. This business-specific risk factor reflects the increased uncertainty in forecasting the future performance of OSD. (page 64) 4. Microsoft’s Note 10 - Goodwill (page 64) states the following: We tested goodwill for impairment as of May 1, 2012 at the reporting unit level using a discounted cash flow methodology with a peer-based, risk-adjusted
3-53 .
.
Chapter 03 - Consolidations—Subsequent to the Date of Acquisition
weighted average cost of capital. We believe use of a discounted cash flow approach is the most reliable indicator of the fair values of the businesses. Upon completion of the annual test, OSD goodwill was determined to be impaired. The impairment was the result of the OSD unit experiencing slower than projected growth in search queries and search advertising revenue per query, slower growth in display revenue, and changes in the timing and implementation of certain initiatives designed to drive search and display revenue growth in the future. Although revenues increased compared to the prior year, the industry is highly competitive and certain operational challenges have affected our expectations such that future growth and profitability are lower than previous estimates. In addition, in the current year, we added a business-specific risk factor to the weighted average cost of capital used to calculate the discounted cash flows of OSD in estimating the fair value of the business. This business-specific risk factor reflects the increased uncertainty in forecasting the future performance of OSD. Because our annual test indicated that OSD’s carrying value exceeded its estimated fair value, a second phase of the goodwill impairment test (“Step 2”) was performed specific to OSD. Under Step 2, the fair value of all OSD assets and liabilities were estimated, including tangible assets, existing technology, trade names, and partner relationships for the purpose of deriving an estimate of the implied fair value of goodwill. The implied fair value of the goodwill was then compared to the recorded goodwill to determine the amount of the impairment. Assumptions used in measuring the value of these assets and liabilities included the discount rates, royalty rates, and obsolescence rates used in valuing the intangible assets, and pricing of comparable transactions in the market in valuing the tangible assets. (page 64)
3-54 .
.
Chapter 03 - Consolidations—Subsequent to the Date of Acquisition
FASB ASC AND IASB RESEARCH CASE 1. GAAP prohibits reversal of impairment losses for goodwill. prohibits reversal of impairment losses for goodwill
IFRS also
2. Requirements for goodwill impairment differ under IFRS. Under IFRS, goodwill impairment testing uses a one-step approach: The recoverable amount of the CGU (cash-generating unit) or group of CGUs (i.e., the higher of its fair value minus costs to sell and its value in use) is compared with its carrying amount. An impairment loss is recognized in operating results as the excess of carrying over the recoverable amount. The impairment loss is allocated first to goodwill and then pro rata to the other assets of the CGU or group of CGUs to the extent that the impairment exceeds goodwill’s book value. IAS 36 Impairment of Assets: 88. When, as described in paragraph 81, goodwill relates to a cash-generating unit but has not been allocated to that unit, the unit shall be tested for impairment, whenever there is an indication that the unit may be impaired, by comparing the unit’s carrying amount, excluding any goodwill, with its recoverable amount. Any impairment loss shall be recognised in accordance with paragraph 104. 90. A cash-generating unit to which goodwill has been allocated shall be tested for impairment annually, and whenever there is an indication that the unit may be impaired, by comparing the carrying amount of the unit, including the goodwill, with the recoverable amount of the unit. If the recoverable amount of the unit exceeds the carrying amount of the unit, the unit and the goodwill allocated to that unit shall be regarded as not impaired. If the carrying amount of the unit exceeds the recoverable amount of the unit, the entity shall recognise the impairment loss in accordance with paragraph 104. 104. An impairment loss shall be recognised for a cash-generating unit (the smallest group of cash-generating units to which goodwill or a corporate asset has been allocated) if, and only if, the recoverable amount of the unit (group of units) is less than the carrying amount of the unit (group of units). The impairment loss shall be allocated to reduce the carrying amount of the assets of the unit (group of units) in the following order: (a) first, to reduce the carrying amount of any goodwill allocated to the cash-generating unit (group of units); and (b) then, to the other assets of the unit (group of units) pro rata on the basis of the carrying amount of each asset in the unit (group of units). These reductions in carrying amounts shall be treated as impairment losses on individual assets and recognised in accordance with paragraph 60.
3-55 .
.
Chapter 03 - Consolidations—Subsequent to the Date of Acquisition
Excel Case 1 Solution a. Innovus employs initial value method to account for ChipTech.
Revenues Cost of good sold Depreciation expense Amortization expense Dividend income Net Income
Innovus (990,000) 500,000 100,000 55,000 (40,000) (375,000)
ChipTech (210,000) 90,000 5,000 18,000 -0(97,000)
Retained earnings 1/1 Net income Dividends declared Retained earnings 12/31
(1,555,000) (375,000) 250,000 (1,680,000)
(450,000) (97,000) 40,000 (507,000)
Current assets Investment in Chiptech
960,000 670,000
355,000
Adjustments
(E) 20,000 (I) 40,000
(S)450,000
(*C) 60,000 (I) 40,000
(1,615,000) (412,000) 250,000 (1,777,000) 1,315,000
(*C) 60,000 (S) 580,000 (A) 150,000
Equipment (net) Trademark Existing technology Goodwill Total assets
765,000 235,000 0 450,000 3,080,000
225,000 100,000 45,000 -0725,000
Liabilities Common stock Additional paid-in capital Retained earnings 12/31 Total liabilities and equity
(780,000) (500,000) (120,000) (1,680,000) (3,080,000)
(88,000) (100,000) (30,000) (507,000) (725,000)
3-56 .
Consolidated (1,200,000) 590,000 105,000 93,000 -0(412,000)
.
(A) 36,000 (A) 64,000 (A) 50,000
(E) 4,000 (E) 16,000
(S)100,000 (S) 30,000 850,000
850,000
-0990,000 367,000 93,000 500,000 3,265,000 (868,000) (500,000) (120,000) (1,777,000) (3,265,000)
Chapter 03 - Consolidations—Subsequent to the Date of Acquisition
Excel Case 1 Solution (continued) b. Innovus employs initial value method to account for ChipTech and goodwill is impaired.
Revenues Cost of good sold Depreciation expense Amortization expense Impairment loss Dividend income Net Income
Innovus (990,000) 500,000 100,000 55,000 50,000 (40,000) (325,000)
ChipTech (210,000) 90,000 5,000 18,000 -0(97,000)
(I) 40,000
Retained earnings 1/1 Net income Dividends declared Retained earnings 12/31
(1,555,000) (325,000) 250,000 (1,630,000)
(450,000) (97,000) 40,000 (507,000)
(S)450,000
Current assets Investment in Chiptech
960,000 620,000
355,000
Consolidated (1,200,000) 590,000 105,000 93,000 50,000 -0(362,000)
(E) 20,000
(*C) 60,000 (I) 40,000
(1,615,000) (362,000) 250,000 (1,727,000) 1,315,000
(*C) 60,000 (S)580,000 (A)100,000
Equipment (net) Trademark Existing technology Goodwill Total assets
765,000 235,000 -0450,000 3,030,000
225,000 100,000 45,000 -0725,000
Liabilities Common stock Additional paid-in capital Retained earnings 12/31 Total liabilities and equity
(780,000) (500,000)
(88,000) (100,000)
(120,000) (1,630,000)
(30,000) (507,000)
(S) 30,000
(3,030,000)
(725,000)
800,000
(A) 36,000 (A )64,000
-0990,000 367,000 93,000 450,000 3,215,000
(E) 4,000 (E) 16,000
(868,000) (500,000)
(S)100,000
(120,000) (1,727,000) 800,000
(3,215,000)
Alternatively, the goodwill impairment loss could have been recognized as an adjustment on the worksheet.
3-57 .
.
Chapter 03 - Consolidations—Subsequent to the Date of Acquisition
Excel Case 2 Solution Part a: Investment in Wi-Free account balance 12/31/15 Wi-Free’s acquisition-date fair value Change in Wi-Free’s retained earnings for 2014 2014 amortization 2014 in-process R&D write-off 2015 reported Wi-Free income 2015 Wi-Free dividend 2015 amortization Balance 12/31/15 Part b:
$730,000 80,000 (4,500) (75,000) 180,000 (50,000) (4,500) $856,000 Consolidation Entries Debit Credit
Consolidated Totals (1,425,000) 747,000 152,000 (E) 7,500 65,500
Hi-Speed (1,100,000) 625,000 140,000 50,000
Wi-Free (325,000) 122,000 12,000 11,000
(175,500) (460,500)
-0(180,000)
(I)175,500
-0(460,500)
Retained earnings 1/1 Net income Dividends declared Retained earnings 12/31
(1,552,500) (460,500) 250,000 (1,763,000)
(450,000) (180,000) 50,000 (580,000)
(S)450,000
(1,552,500) (460,500) 250,000 (1,763,000)
Current assets Investment in Wi-Free
1,034,000 856,000
345,000
Equipment (net) Computer software Internet domain name Goodwill Total assets
713,000 650,000 0 -03,253,000
305,000 130,000 100,000 -0880,000
Liabilities Common stock Additional paid-in capital Retained earnings 12/31 Total liab. and equity
(870,000) (500,000) (120,000) (1,763,000) (3,253,000)
(170,000) (110,000) (20,000) (580,000) (880,000)
Revenues Cost of goods sold Depreciation expense Amortization expense Equity in subsidiary earnings Net Income
(D) 50,000
(D) 50,000
3-58 .
(E) 12,000
.
(E) 7,500 (A)108,000 (A) 65,000
(P) 30,000 (I) 175,500 (S)580,000 (A)150,500 (A) 22,500 (E) 12,000
(P) 30,000 (S)110,000 (S) 20,000 1,028,000
1,028,000
1,349,000
0 1,018,000 765,000 196,000 65,000 3,393,000 (1,010,000) (500,000) (120,000) (1,763,000) (3,393,000)
Chapter 03 - Consolidations—Subsequent to the Date of Acquisition
Chapter 3 - Computer Project PECOS COMPANY AND SUARO COMPANY Consolidated Information Worksheet
Revenues Operating expenses Amortization of intangibles Goodwill impairment loss Income of Suaro
Pecos (1,052,000) 821,000
Net income Retained earnings—Pecos, 1/1 Retained earnings—Suaro, 1/1 Net income (above) Dividends declared
(165,000)
0 0 200,000
Retained earnings, 12/31 Cash Receivables Inventory Investment in Suaro Land Equipment (net) Software Other intangibles Goodwill
195,000 247,000 415,000 341,000 240,100 0 145,000 0
95,000 143,000 197,000 0 85,000 100,000 312,000 0 0 932,000
(1,537,100) (500,000)
Total liabilities and equity
(251,000) (350,000) (331,000) (932,000)
3-59 .
(201,000) (165,000) 35,000 (331,000)
Total assets Liabilities Common stock Retained earnings (above)
Suaro (427,000) 262,000 0 0 0
.
Chapter 03 - Consolidations—Subsequent to the Date of Acquisition
Consolidated Information Worksheet (continued) Fair Value Allocation Schedule Acquisition-date fair value 1,450,000 Book value 476,000 Excess fair value over book value
974,000 Amortizations and Write-off 2014
Land Brand Name Software IPR&D Goodwill Total
2015
(10,000) 60,000 100,000 300,000 524,000
0 0 50,000 300,000 0
0 0 50,000 0 0
974,000
350,000
50,000
Suaro's Retained Earnings Changes Income Dividends
3-60 .
.
2014 75,000 0
2015 165,000 35,000
Chapter 03 - Consolidations—Subsequent to the Date of Acquisition
Chapter 3 - Computer Project Solution PECOS COMPANY AND SUARO COMPANY Consolidated Worksheet For the Year Ended December 31, 2015 EQUITY METHOD Consolidation Entries
Consolidated
Debit
Totals (1,479,000) 1,083,000 50,000 0 0
Pecos (1,052,000) 821,000 0 0 (115,000)
Suaro (427,000) 262,000 0 0 0
Net income
(346,000)
(165,000)
(346,000)
Retained earnings—Pecos, 1/1 Retained earnings—Suaro, 1/1 Net income (above) Dividends declared
(655,000) 0 (346,000) 200,000
0 (201,000) (165,000) 35,000
(655,000) 0 (346,000) 200,000
Retained earnings, 12/31
(801,000)
(331,000)
(801,000)
Cash Receivables Inventory Investment in Suaro
195,000 247,000 415,000 1,255,000
95,000 143,000 197,000 0
290,000 390,000 612,000 0
Revenues Operating expenses Amortization of intangibles Goodwill impairment loss Income of Suaro
3-61 ..
(E)
50,000
(I)
115,000
(S)
Credit
201,000 (D)
(D)
35,000 (S) (A)
35,000
551,000 624,000
Chapter 03 - Consolidations—Subsequent to the Date of Acquisition
(I)
115,000
Consolidated Worksheet (continued) Land Equipment (net) Software Other intangibles Brand name Goodwill
341,000 240,100 0 145,000 0 0
85,000 100,000 312,000 0 0 0
Total assets
2,838,100
932,000
3,089,100
Liabilities Common stock Retained earnings (above)
(1,537,100) (500,000) (801,000)
(251,000) (350,000) (331,000)
350,000
(1,788,100) (500,000) (801,000)
Total liabilities and equity
(2,838,100)
(932,000)
1,385,000
1,385,000 (3,089,100)
Shaded items were provided on the Consolidated Information Worksheet
3-62 ..
(A)
10,000
(A)
50,000 (E)
50,000
(A) (A)
60,000 524,000
(S)
416,000 340,100 312,000 145,000 60,000 524,000
Chapter 03 - Consolidations—Subsequent to the Date of Acquisition
Chapter 3 – Computer Project Solution PECOS COMPANY AND SUARO COMPANY Consolidated Worksheet For the Year Ended December 31, 2015 PARTIAL EQUITY METHOD Consolidation Entries Pecos (1,052,000) 821,000 0 0 (165,000)
Suaro (427,000) 262,000 0 0 0
(396,000)
(165,000)
Retained earnings—Pecos, 1/1 Retained earnings—Suaro, 1/1 Net income (above) Dividends declared
(1,005,000) 0 (396,000) 200,000
0 (201,000) (165,000) 35,000
Retained earnings, 12/31
(1,201,000)
(331,000)
(801,000)
Cash Receivables Inventory Investment in Suaro
195,000 247,000 415,000 1,655,000
95,000 143,000 197,000 0
290,000 390,000 612,000 0
Revenues Operating expenses Amortization of intangibles Goodwill impairment loss Income of Suaro Net income
3-63 ..
Debit
Consolidated
(E)
50,000
(I)
165,000
Credit
Totals (1,479,000) 1,083,000 50,000 0 0 (346,000)
(*C) (S)
350,000 201,000 (D)
(D)
35,000 (S) (A) (I) (*C)
35,000
551,000 624,000 165,000 350,000
(655,000) 0 (346,000) 200,000
Chapter 03 - Consolidations—Subsequent to the Date of Acquisition
Consolidated Worksheet (continued) Land Equipment (net) Software Other intangibles Brand name Goodwill
341,000 240,100 0 145,000 0 0
85,000 100,000 312,000 0 0 0
Total assets
3,238,100
932,000
3,089,100
Liabilities Common stock Retained earnings (above)
(1,537,100) (500,000) (1,201,000)
(251,000) (350,000) (331,000)
350,000
(1,788,100) (500,000) (801,000)
Total liabilities and equity
(3,238,100)
(932,000)
1,785,000
1,785,000 (3,089,100)
Shaded items were provided on the Consolidated Information Worksheet
3-64 ..
(A)
10,000
(A)
50,000 (E)
50,000
(A) (A)
60,000 524,000
(S)
416,000 340,100 312,000 145,000 60,000 524,000
Chapter 03 - Consolidations—Subsequent to the Date of Acquisition
Chapter 3 – Computer Project Solution PECOS COMPANY AND SUARO COMPANY Consolidated Worksheet For the Year Ended December 31, 2015 INITIAL VALUE METHOD Consolidation Entries Pecos (1,052,000) 821,000 0 0 (35,000)
Suaro (427,000) 262,000 0 0 0
Net income
(266,000)
(165,000)
Retained earnings—Pecos, 1/1 Retained earnings—Suaro, 1/1 Net income (above) Dividends declared
(930,000) 0 (266,000) 200,000
0 (201,000) (165,000) 35,000
Retained earnings, 12/31
(996,000)
(331,000)
(801,000)
Cash Receivables Inventory Investment in Suaro
195,000 247,000 415,000 1,450,000
95,000 143,000 197,000 0
290,000 390,000 612,000 0
Revenues Operating expenses Amortization of intangibles Goodwill impairment loss Income of Suaro
3-65 ..
Debit
Consolidated
(E)
50,000
(I)
35,000
Credit
Totals (1,479,000) 1,083,000 50,000 0 0 (346,000)
(*C) (S)
275,000 201,000 (I)
(S) (A) (*C)
35,000
551,000 624,000 275,000
(655,000) 0 (346,000) 200,000
Chapter 03 - Consolidations—Subsequent to the Date of Acquisition
Consolidated Worksheet (continued) Land Equipment (net) Software Other intangibles Brand name Goodwill
341,000 240,100 0 145,000 0 0
85,000 100,000 312,000 0 0 0
Total assets
3,033,100
932,000
3,089,100
Liabilities Common stock Retained earnings (above)
(1,537,100) (500,000) (996,000)
(251,000) (350,000) (331,000)
350,000
(1,788,100) (500,000) (801,000)
Total liabilities and equity
(3,033,100)
(932,000)
1,545,000
1,545,000 (3,089,100)
Shaded items were provided on the Consolidated Information Worksheet
3-66 ..
(A)
10,000
(A)
50,000 (E)
50,000
(A) (A)
60,000 524,000
(S)
416,000 340,100 312,000 145,000 60,000 524,000
Chapter 03 - Consolidations—Subsequent to the Date of Acquisition
Chapter 3 – Computer Project PECOS COMPANY AND SUARO COMPANY Goodwill Impairment Loss Effects
Without
With
Impairment
Impairment
Common shares outstanding
500,000
500,000
Consolidated net income/(loss)
346,000
(178,000)
Consolidated assets, 1/1/15
2,943,100
2,943,100
Consolidated assets, 12/31/15
3,089,100
2,565,100
Consolidated equity, 1/1/15
1,155,000
1,155,000
Consolidated equity, 12/31/15
1,301,000
777,000
Consolidated liabilities
1,788,100
1,788,100
0.69
-0.36
Return on assets
11.47%
-6.46%
Return on equity
28.18%
-18.43%
1.37
2.30
Earnings-per-share
Debt-to-equity
3-67 .
.
Chapter 03 - Consolidations—Subsequent to the Date of Acquisition
Chapter 3 – Computer Project Solution PECOS COMPANY AND SUARO COMPANY Consolidated Worksheet For the Year Ended December 31, 2015 EQUITY METHOD – GOODWILL IMPAIRMENT LOSS Consolidation Entries Pecos (1,052,000) 821,000 0 524,000 (115,000)
Suaro (427,000) 262,000 0 0 0
Net income
178,000
(165,000)
178,000
Retained earnings—Pecos, 1/1 Retained earnings—Suaro, 1/1 Net income (above) Dividends declared
(655,000) 0 178,000 200,000
0 (201,000) (165,000) 35,000
(655,000) 0 178,000 200,000
Retained earnings, 12/31
(277,000)
(331,000)
(277,000)
Cash Receivables Inventory Investment in Suaro
195,000 247,000 415,000 731,000
95,000 143,000 197,000 0
290,000 390,000 612,000 0
Revenues Operating expenses Amortization of intangibles Goodwill impairment loss Income of Suaro
3-68 ..
Debit
Consolidated
(E)
50,000
(I)
115,000
(S)
Credit
201,000 (D)
(D)
35,000 (S) (A) (I)
35,000
551,000 100,000 115,000
Totals (1,479,000) 1,083,000 50,000 524,000 0
Chapter 03 - Consolidations—Subsequent to the Date of Acquisition
Consolidated Worksheet (continued) Land Equipment (net) Software Other intangibles Brand name Goodwill
341,000 240,100 0 145,000 0 0
85,000 100,000 312,000 0 0 0
Total assets
2,314,100
932,000
2,565,100
Liabilities Common stock Retained earnings (above)
(1,537,100) (500,000) (277,000)
(251,000) (350,000) (331,000)
350,000
(1,788,100) (500,000) (277,000)
Total liabilities and equity
(2,314,100)
(932,000)
861,000
861,000 (2,565,100)
Shaded items were provided on the Consolidated Information Worksheet
3-69 ..
(A)
10,000
(A)
50,000 (E)
50,000
(A)
60,000
(S)
416,000 340,100 312,000 145,000 60,000 0
Chapter 04 - Consolidated Financial Statements and Outside Ownership
CHAPTER 4 CONSOLIDATED FINANCIAL STATEMENTS AND OUTSIDE OWNERSHIP Chapter Outline I.
Outside ownership may be present within any business combination. A. Complete ownership of a subsidiary is not a prerequisite for consolidation—only enough voting shares need be owned so that the acquiring company has the ability to control the decision-making process of the acquired company. B. Any ownership interest in a subsidiary company by a party unrelated to the acquiring company is termed a noncontrolling interest.
II.
Valuation of subsidiary assets and liabilities poses a challenge when a noncontrolling interest is present. A. The accounting emphasis is placed on the entire entity that results from the business combination when control has been obtained. The parent company that controls its subsidiary must consolidate 100% of subsidiary assets, liabilities, revenues, and expense are consolidated even when its ownership is less than 100%. B. The consolidated valuation basis for a newly acquired subsidiary is the acquisition-date fair value of the company (most frequently determined by the consideration transferred and the fair value of the noncontrolling interest); specific subsidiary assets and liabilities are measured at their acquisition-date fair values. C. The noncontrolling interest balance is reported in the parent’s consolidated financial statements as a component of stockholders' equity.
III.
Consolidations involving a noncontrolling interest—subsequent to the date of acquisition A. Four noncontrolling interest figures are determined for reporting purposes 1. Beginning of year balance sheet amount 2. Net income attributable to noncontrolling interest 3. Dividends declared by subsidiary during the period attributable to the noncontrolling interest 4. End of year balance sheet amount B. Noncontrolling interest balances are accumulated in a separate column in the consolidation worksheet 1. The beginning of year figure is entered on the worksheet as a component of Entries S and A 2. The net income attributable to the noncontrolling interest is established by a columnar entry that simultaneously reports the balance in both the consolidated income statement and the noncontrolling interest column 3. Dividends declared to these outside owners are reflected by extending the subsidiary's Dividends declared balance (after eliminating intra-entity transfers) into the noncontrolling interest column as a reduction 4. The end of year noncontrolling interest total is the summation of the three items above and is reported in stockholders' equity.
4-1 .
.
Chapter 04 - Consolidated Financial Statements and Outside Ownership
IV. Step acquisitions A. An acquiring company may make several different purchases of a subsidiary's stock in order to gain control B. Upon attaining control, all of the parent’s previous investments in the subsidiary are adjusted to fair value and a gain or loss recognized as appropriate C. Upon attaining control, the valuation basis for the subsidiary is established at its total fair value (the sum of the fair values of the controlling and noncontrolling interests) D. Post-control subsidiary stock acquisitions by the parent are considered transactions with current owners of the consolidated entity. Thus such post-control stock acquisitions neither result in gains or losses nor provide a basis for subsidiary asset remeasurement to fair value. The difference between the sale proceeds and the carrying value of the shares sold (equity method) is recorded as an adjustment to the parent’s additional paid in capital. V. Sales of subsidiary stock A. The proper book value must be established within the parent's Investment account so that the sales transaction can be correctly recorded B. The investment balance is adjusted as if the equity method had been applied during the entire period of ownership C. If only a portion of the shares are being sold, the book value of the investment account is reduced using either a FIFO or a weighted-average cost flow assumption D. If the parent maintains control, any difference between the proceeds of the sale and the equity-adjusted book value of the share sold is recognized as an adjustment to additional paid-in capital. E. If the parent loses control with the sale of the subsidiary shares, the difference between the proceeds of the sale and the equity-adjusted book value of the share sold is recognized as a gain or loss. F. Any interest retained by the parent company should be accounted for by either consolidation, the equity method, or the fair value method depending on the influence remaining after the sale.
Answer to Discussion Question: Do you think the FASB made the correct decision in requiring consolidated financial statements to recognize all subsidiary’s assets and liabilities at fair value regardless of the percentage ownership acquired by the parent? As the quotes from the five accounting professionals illustrate, the decision to require the revaluation of 100% of a newly controlled subsidiary’s assets and liabilities—regardless of percentage ownership—was not without some controversy. Students can use the quotes to discuss cost-benefit issues, relevance of capturing the underlying economics, use of hypothetical transactions in financial reporting, potential for abuse, etc. The requirement to value all acquisition date subsidiary assets at 100% fair value thus provides a useful vehicle for the class to discuss the many issues surrounding standard setters’ decisions.
4-2 .
.
Chapter 04 - Consolidated Financial Statements and Outside Ownership
Answer to Discussion Question: DOES GAAP UNDERVALUE POST-CONTROL STOCK ACQUISITIONS? From the Berkshire Hathaway 2012 annual 10-K report: We have owned a controlling interest in Marmon Holdings, Inc. (“Marmon”) since 2008. In the fourth quarter of 2012, pursuant to the terms of the 2008 Marmon acquisition agreement, we acquired an additional 10% of the outstanding shares of Marmon held by noncontrolling interests for aggregate consideration of approximately $1.4 billion. Approximately $800 million of the consideration was paid in the fourth quarter of 2012, and the remainder is payable in March 2013. In the fourth quarter of 2010, we acquired 16.6% of Marmon’s outstanding common stock for approximately $1.5 billion. As a result of these acquisitions, our ownership interest in Marmon has increased to approximately 90%. These purchases were accounted for as acquisitions of noncontrolling interests. The differences between the consideration paid or payable and the carrying amounts of the noncontrolling interests acquired were recorded as reductions in Berkshire’s shareholders equity of approximately $700 million in 2012 and $614 million in 2010. We are contractually required to acquire substantially all of the remaining noncontrolling interests of Marmon no later than March 31, 2014, for an amount that will be based on Marmon’s future operating results.
On the date control is established, the new subsidiary’s valuation basis is established. Subsequent acquisitions of any remaining portions of the noncontrolling interests do not establish a new valuation basis for the subsidiary. In the Berkshire case, the new valuation basis for Marmon was established in 2008 when its 64% control was acquired. Berkshire then increases Marmon’s consolidated carrying amount as Marmon earns income, not by subsequent purchases of Marmon’s noncontrolling shares. Berkshire’s payments for its post-control equity acquisitions (16% and 10%) were in excess of Marmon’s proportionate carrying amounts. Because these transactions were with owners (not outside parties), no gain or loss is recorded. Berkshire reduces its paid-in capital the for excess of the purchase price over the carrying amount. The accounting is similar to retirement of stock for a payment in excess of the company’s proportionate carrying amount. Mr.Buffett may be correct that the current market value of Marmon is $4.6 bilion more that its carrying amount. However, GAAP does not, in general, record unrealized increases in a firm’s market value as increases in reported asset amounts.
4-3 .
.
Chapter 04 - Consolidated Financial Statements and Outside Ownership
Answers to Questions 1.
"Noncontrolling interest" refers to an equity interest that is held in a member of a business combination by an unrelated (outside) party.
2.
Acquisition method = $220,000 (fair value)
3.
A control premium is the portion of an acquisition price (above currently traded market values) paid by a parent company to induce shareholders to sell a sufficient number of shares to obtain control. The extra payment typically becomes part of the goodwill acquired in the acquisition attributable to the parent company.
4.
Current accounting standards require the noncontrolling interest to appear in the stockholders' equity section. The noncontrolling interest's share of the subsidiary’s net income is shown as an allocated component of consolidated net income.
5.
The ending noncontrolling interest is determined on a consolidation worksheet by adding the four components found in the noncontrolling interest column: (1) the beginning balance of the subsidiary’s book value, (2) the noncontrolling interest share of the adusted acquisition-date excess fair over book value allocation, (3) its share of current year net income, (4) less dividends declared to these outside owners.
6.
Allsports should remove the pre-acquisition revenues and expenses from the consolidated totals. These amounts were earned (incurred) prior to ownership by Allsports and therefore should are not earnings for the current parent company owners.
7.
Following the second acquisition, consolidation is appropriate. Once Tree gains control, the 10% previous ownership is included at fair value as part of the total consideration transferred by Tree in the acquisition.
8.
When a company sells a portion of an investment, it must remove the carrying value of that portion from its investment account. The carrying value is based upon application of the equity method. Thus, if either the initial value method or the partial equity method has been used, Duke must first restate the account to the equity method before recording the sales transaction. The same method is applied to the operations of the current period occurring prior to the time of sale.
9.
Unless control is surrendered, the acquisition method views the sale of subsidiary's stock as a transaction with its owners. Thus, no gain or loss is recognized. The difference between the sale proceeds and the carrying value of the shares sold (equity method) is accounted for as an adjustment to the parent’s additional paid in capital.
10.
The accounting method choice for the remaining shares depends upon the current relationship between the two firms. If Duke retains control, consolidation is still required. However, if the parent now can only significantly influence the decision-making process, the equity method is applied. A third possibility is Duke may have lost the power to exercise even significant influence. The fair value method then is appropriate.
4-4 .
.
Chapter 04 - Consolidated Financial Statements and Outside Ownership
Answers to Problems 1. C 2.A
At the date control is obtained, the parent consolidates subsidiary assets at fair value ($549,000 in this case) regardless of the parent’s percentage ownership.
3.D
In consolidating the subsidiary's figures, all intra-entity balances must be eliminated in their entirety for external reporting purposes. Even though the subsidiary is less than fully owned, the parent nonetheless controls it.
4. C An asset acquired in a business combination is initially valued at 100% acquisition-date fair value and subsequently amortized its useful life. Patent fair value at January 1, 2014 ............................................... Amortization for 2 years (10 year remaining life).......................... Patent reported amount December 31, 2015 .................................
$45,000 (9,000) $36,000
5. C 6. B Combined revenues ........................................................................ $1,100,000 Combined expenses........................................................................ (700,000) Excess acquisition-date fair value amortization........................... (15,000) Consolidated net income ................................................................ $385,000 (34,000) Less: noncontrolling interest share ($85,000 × 40%) ................... Consolidated net income to Chamberlain Corporation................ $351,000 7. C Consideration transferred by Pride ............................................... Noncontrolling interest fair value .................................................. Star acquisition-date fair value ...................................................... Star book value................................................................................ Excess fair over book value ...........................................................
to equipment (8 year remaining life) ........................... to customer list (4 year remaining life) .......................
$ 80,000 100,000
Combined revenues ........................................................................ Combined expenses..................................................... $545,000 35,000 Excess fair value amortization .................................... Consolidated net income ................................................................ 8. A Under the equity method, consolidated RE = parent’s RE. 9. B 4-5 .
.
$540,000 60,000 $600,000 420,000 $180,000 Amort. $10,000 25,000 $35,000 $783,000 580,000 $203,000
Chapter 04 - Consolidated Financial Statements and Outside Ownership
10. A Amie, Inc. fair value at July 1, 2015: 30% previously owned fair value (30,000 shares × $5) ................ 60% new shares acquired (60,000 shares × $6) ............................ 10% NCI fair value (10,000 shares × $5) ......................................... Acquisition-date fair value .............................................................. Net assets' fair value ....................................................................... Goodwill ..........................................................................................
$150,000 360,000 50,000 $560,000 500,000 $60,000
12. B Fair value of 30% noncontrolling interest on April 1 .................... 30% of net income for remainder of year ($240,000 × 30%) ......... Noncontrolling interest December 31 ............................................
$165,000 72,000 $237,000
11. C
13. C Proceeds of $80,000 less $64,000 (⅓ × $192,000) book value = $16,000 Control is maintained so excess proceeds go to APIC. 14. B Combined revenues ........................................................................ $1,300,000 Combined expenses ........................................................................ (800,000) Trademark amortization .................................................................. (6,000) Patented technology amortization ................................................. (8,000) Consolidated net income ............................................................... $486,000 15. C Subsidiary net income ($100,000 – $14,000 excess amortizations) .............................. Noncontrolling interest percentage ............................................... Net income attributable to noncontrolling interest ......................
$86,000 40% $34,400
Fair value of noncontrolling interest at acquisition date ............. 40% change in previous year Solar book value ............................ ($530,000 – $400,000) × 40% ..................................................... 40% of excess fair value amortization—year one ......................... Net income attributable to noncontrolling interest (above) ......... Noncontrolling interest at end of year ...........................................
$200,000
16. A West trademark balance ................................................................. Solar trademark balance ................................................................. Acquisition-date fair value allocation ............................................ Excess fair value amortization for two years ................................ Consolidated trademarks ...............................................................
$260,000 200,000 60,000 (12,000) $508,000
4-6 .
.
52,000 (5,600) 34,400 $280,800
Chapter 04 - Consolidated Financial Statements and Outside Ownership
17. A Acquisition-date fair value ($60,000 ÷ 80%) .................................. Strand's book value ........................................................................ Fair value in excess of book value ................................................
$75,000 (50,000) $25,000
Excess assigned to inventory (60%) ................................ $15,000 Excess assigned to goodwill (40%) ................................. $10,000 Park current assets ......................................................................... Strand current assets ...................................................................... Excess inventory fair value ............................................................ Consolidated current assets ..........................................................
$70,000 20,000 15,000 $105,000
18. D Park noncurrent assets ................................................................... Strand noncurrent assets ............................................................... Excess fair value to goodwill.......................................................... Consolidated noncurrent assets ....................................................
$90,000 40,000 10,000 $140,000
19. B Add the two book values and include 10% (the $6,000 current portion) of the loan taken out by Park to acquire Strand. 20. B Add the two book values and include 90% (the $54,000 noncurrent portion) of the loan taken out by Park to acquire Strand. 21. C Park stockholders' equity ............................................................... Noncontrolling interest at fair value (20% × $75,000) ................... Total stockholders' equity .............................................................. 22.
$80,000 15,000 $95,000
(15 minutes) (Compute consolidated net income and noncontrolling interest) 2014 2015 a. Harrison net income ...................................................... $220,000 $260,000 Starr net income ............................................................ 70,000 90,000 Acquisition-date excess fair value amortization......... (8,000) (8,000) Consolidated net income .............................................. $282,000 $342,000 b. Starr fair value ................................................................................. $1,200,000 Fair value of consideration transferred ......................................... 1,125,000 Noncontrolling interest fair value .................................................. $75,000 Noncontrolling interest fair value January 1, 2014 (above) .......... 2014 income to NCI ([$70,000 – $8,000] × 10%) ................................ 2014 dividends to NCI .................................................................... Noncontrolling interest reported value December 31, 2014 .... 2015 net income attributable to NCI ([$90,000 – $8,000] × 10%)...... 2015 dividends to NCI .................................................................... Noncontrolling interest reported value December 31, 2015
4-7 .
.
$75,000 6,200 (3,000) 78,200 8,200 (3,000) $83,400
Chapter 04 - Consolidated Financial Statements and Outside Ownership
23. (30 minutes) (Consolidated balances, allocation of consolidated net income to controlling and noncontrolling interest, calculation of noncontrolling interest). a. Stayer’s technology processes: Acquisition-date fair value (20 year remaining life) 2015 amortization Technology processes 12/31/15
$1,000,000 (50,000) $ 950,000
b. Stayer’s building: Acquisition-date fair value (10 year remaining life) 2015 depreciation Building 12/31/15 -or$175,500 + $150,000 – $15,000 = $310,500
$345,000 (34,500) $310,500
c. Controlling interest in consolidated net income: Net income–Johnsonville Net income–Stayer adjusted for excess fair value amortization (see part d below) Consolidated net income Less: net income attributable to noncontrolling interest (see part d below) Net income attributable to Johnsonville Co.
$650,000 285,000 935,000 (57,000) $878,000
-ORJohnsonville’s separate net income Stayer’s reported net income Excess fair value amortization: Technology processes Building ($345,000 – $195,000) ÷ 10 years Stayer’s adjusted net income Johnsonville’s ownership percentage Net income attributable to Johnsonville Co. d. Net income attributable to noncontrolling interest: Stayer’s reported net income Excess fair value amortization: Technology processes Building ($345,000 – $195,000) ÷ 10 years Stayer’s adjusted net income Noncontrolling interest percentage Net income attributable to noncontrolling interest
4-8 .
.
$650,000 350,000 (50,000) (15,000) 285,000 80%
228,000 $878,000
350,000 (50,000) (15,000) 285,000 20% $57,000
Chapter 04 - Consolidated Financial Statements and Outside Ownership
23. (continued) e. Noncontrolling interest: Acquisition-date balance 1/1/15 Total Stayer fair value ($3,000,000 ÷ 80%) $3,750,000 Noncontrolling interest percentage 20% Noncontrolling interest acquisition-date fair value $750,000 Net income attributable to noncontrolling interest 57,000 Noncontrolling interest share of Stayer dividends (20% × $50,000) (10,000) Noncontrolling interest 12/31/15 $ 797,000 24. (40 minutes) (Several valuation and income determination questions for a business combination involving a noncontrolling interest.) a.B usiness combinations are recorded generally at the fair value of the consideration transferred by the acquiring firm plus the acquisition-date fair value of the noncontrolling interest. Patterson’s consideration transferred ($31.25 × 80,000 shares).......... $2,500,000 Noncontrolling interest fair value ($30.00 × 20,000 shares) ................. 600,000 Soriano’s total fair value January 1..................................................... $3,100,000 b. Each identifiable asset acquired and liability assumed in a business combination is initially reported at its acquisition-date fair value. c.I n periods subsequent to acquisition, the subsidiary’s assets and liabilities are reported at their book values adjusted for acquisition-date fair value allocations and for subsequent amortization and depreciation on those allocations. Except for certain financial items, the subsidiary’s assets and liabilities are not continually adjusted for changing fair values. d. Soriano’s total fair value January 1..................................................... $3,100,000 Soriano’s net assets book value ......................................................... 1,290,000 Excess acquisition-date fair value over book value .......................... $1,810,000 Adjustments from book to fair values................................................. Buildings and equipment......................................... (250,000) 200,000 Trademarks ............................................................... Patented technology ................................................ 1,060,000 Unpatented technology............................................ 600,000 1,610,000 Goodwill .......................................................................................... $ 200,000 e. Combined revenues.............................................................................. $4,400,000 Combined expenses ............................................................................. (2,350,000) Building and equipment excess depreciation .................................... 50,000 Trademark excess amortization .......................................................... (20,000) Patented technology amortization ...................................................... (265,000) Unpatented technology amortization.................................................. (200,000) Consolidated net income ..................................................................... $1,615,000 4-9 .
.
Chapter 04 - Consolidated Financial Statements and Outside Ownership
24. (continued) To noncontrolling interest: Soriano’s revenues ......................................................................... $1,400,000 Soriano’s expenses ......................................................................... (600,000) Total excess amortization expenses (above) ................................ (435,000) Soriano’s adjusted net income....................................................... $ 365,000 Noncontrolling interest percentage ownership ............................ 20% Net income attributable to noncontrolling interest ...................... $ 73,000 To controlling interest: Consolidated net income ................................................................ $1,615,000 Net income attributable to noncontrolling interest ...................... (73,000) Net income attributable to Patterson ............................................. $1,542,000 -ORPatterson’s revenues ...................................................................... $3,000,000 Patterson’s expenses ...................................................................... 1,750,000 Patterson’s separate net income ................................................... $1,250,000 Patterson’s share of Soriano’s adjusted net income (80% × $365,000) ................................................................... 292,000 Consolidated net income attributable to Patterson ...................... $1,542,000 f. Fair value of noncontrolling interest January 1 ................................. $ 600,000 Net income attributable to noncontrolling interest ............................ 73,000 Dividends (20% × $30,000) ................................................................... (6,000) Noncontrolling interest December 31 ................................................. $ 667,000 g. If Soriano’s acquisition-date total fair value was $2,250,000, then a bargain purchase has occurred. Collective fair values of Soriano’s net assets .................................... $2,900,000 Soriano’s total fair value January 1..................................................... $2,250,000 Bargain purchase.................................................................................. $ 650,000 The acquisition method requires that the subsidiary assets acquired and liabilities assumed be recognized at their acquisition date fair values regardless of the assessed fair value. Therefore, none of Soriano’s identifiable assets and liabilities would change as a result of the assessed fair value. When a bargain purchase occurs, however, no goodwill is recognized.
4-10 .
.
Chapter 04 - Consolidated Financial Statements and Outside Ownership
25. (30 minutes) Step acquisition. a. Investment in Sellinger Cash Additional paid-in capital
445,000 415,000 30,000
Acquisition-date fair value ($1,141,000 ÷ .7) Sellinger net income 2014 Excess fair value amortization 2014 Sellinger dividends 2014 Acquisition-date adjusted subsidiary value 12/31/14 Percent acquired 1/1/15 Acquisition-date based value of newly acquired shares Acquisition price for 25% interest Credit to Palka’s APIC b. Initial value for 70% acquisition 70% of adjusted 2014 subsidiary net income ($340,000 – $40,000) 70% of subsidiary dividends 2014 Adjusted fair value of newly acquired shares 95% of adjusted subsidiary 2015 net income ($440,000 – $40,000) 95% of subsidiary dividends 2015 Investment in Sellinger 12/31/15
4-11 .
.
$1,630,000 340,000 (40,000) (150,000) 1,780,000 0.25 $ 445,000 415,000 $ 30,000 $1,141,000 210,000 (105,000) 445,000 380,000 (171,000) $1,900,000
Chapter 04 - Consolidated Financial Statements and Outside Ownership
26. (20 Minutes) (Determine consolidated income balances, includes a mid-year acquisition) a.
Acquisition-date total fair value .......................... $594,000 Book value of net assets ...................................... (400,000) Fair value in excess of book value ..................... $194,000 Excess fair value assigned to specific Remaining Annual excess accounts based on fair value life amortizations Patent .......................................................... 140,000 5 years $28,000 Land .......................................................... 10,000 Buildings ......................................................... 30,000 10 years 3,000 Goodwill .......................................................... 14,000 Total .......................................................... -0$31,000 Consolidated figures following January 1 acquisition date: Combined revenues ............................................................................. $1,500,000 Combined expenses ............................................................................. (1,031,000) Consolidated net income ..................................................................... 469,000 Net income to noncontrolling interest ([200,000 – 31,000] × 30%) ....... (50,700) Net income attributable to Parker, Inc. ............................................... $ 418,300
b. Consolidated figures following April 1 acquisition date: Combined revenues (1)......................................................................... $1,350,000 Combined expenses (2) ........................................................................ (923,250) Consolidated net income .................................................................... $ 426,750 Net income attributable to noncontrolling interest (3) ....................... (38,025) Net income attributable to Parker, Inc ................................................ $ 388,725 (1) $900,000 Parker revenues plus $450,000 of post-acquisition Sawyer revenues (2) $600,000 Parker expenses plus $300,000 of post-acquisition Sawyer expenses plus $23,250 amortization expenses for 9 months (3) ($200,000 – 31,000) adjusted subsidiary net income × 30% × ¾ year
4-12 .
.
Chapter 04 - Consolidated Financial Statements and Outside Ownership
27.
(15 minutes) Consolidated figures with noncontrolling interest Fair value of company (given) Book value Fair value in excess of book value to machine ($50,000 – $10,000) to process trade secret
$60,000 (10,000) 50,000 40,000 ÷ 10 = $4,000 per year $10,000 ÷ 4 = 2,500 per year $6,500 per year
Consolidated figures: •
Net income attributable to noncontrolling interest = 40% ($50,000 revenues less $26,500 expenses) = $9,400
•
End-of-year noncontrolling interest: Beginning balance (40% $60,000) Net income allocation (from above) Dividend reduction (40% $5,000) End-of-year noncontrolling interest
•
Machine (net) = $45,000 ($9,000 book value plus $40,000 excess allocation less $4,000 excess depreciation for one year).
•
Process trade secret (net) = $10,000 – $2,500 = $7,500
4-13 .
$24,000 9,400 (2,000) $31,400
.
Chapter 04 - Consolidated Financial Statements and Outside Ownership
28. (45 minutes) Noncontrolling interest in the presence of a control premium. a.
Goodwill allocation: Parflex Acquisition-date fair value $344,000 Share of identifiable net assets ($324,000 + $18,000) 307,800 Goodwill allocation $36,200
b. Investment in Eagle Initial value Change in Eagle’s RE × 90% ($341,000 – $174,000) × 90% Excess amortization (3 years) × 90% Investment in Eagle 12/31/15
$344,000 150,300 (5,400) $488,900
-ORInvestment in Eagle Initial value 2013-2014 change in Eagle’s RE × 90% ($278,000 – $174,000) × 90% Excess fair value amortization Equity income 2015 (below) Eagle 2015 dividends × 90% Investment in Eagle 12/31/15 Equity in Eagle’s earnings: Eagles reported 2015 net income Excess equipment amortization Adjusted net income Parflex ownership share Equity in Eagle’s earnings
4-14 .
.
$344,000 93,600 (3,600) 79,200 (24,300) $488,900
$90,000 (2,000) $88,000 90% $79,200
NCI $36,000 34,200 $1,800
Chapter 04 - Consolidated Financial Statements and Outside Ownership
28. continued c. December 31, 2015
Parflex
Eagle
Adjustments
NCI
Sales
(862,000)
(366,000)
(1,228,000)
Cost of goods sold
515,000
209,000
724,000
Depreciation expense
191,200
67,000
E
2,000
260,200
Equity in Eagle's earnings Separate company net income
(79,200)
0
I
79,200
0
(235,000)
(90,000)
Consolidated net income
Consolidated
(243,800)
to noncontrolling interest
(8,800)
to Parflex Corporation
8,800 (235,000)
Retained earnings, 1/1
(500,000)
(278,000)
Net income (above)
(235,000)
(90,000)
Dividends declared
130,000
27,000
Retained earnings, 12/31
(605,000)
(341,000)
(605,000)
Cash and receivables
135,000
82,000
217,000
Inventory
255,000
136,000
391,000
Investment in Eagle
488,900
0
Property & equipment (net)
964,000
328,000
Goodwill
S 278,000
(500,000) (235,000) 24,300
D
24,300
A1
14,000
A2
38,000
D
385,200
S
12,600
A1
36,200
A2
79,200
I
2,000
E
2,700
130,000
-0-
1,304,000 38,000
Total assets
1,842,900
546,000
1,950,000
Liabilities
(722,900)
(55,000)
(777,900)
Common stock
(515,000)
(150,000)
S 150,000
NCI 1/1
(515,000) 42,800
S
1,400
A1
1,800
A2
NCI 12/31
(52,100)
Retained earnings, 12/31
(605,000)
(341,000)
Total liabilities and equities
(1,842,900)
(546,000)
4-15 .
(46,000)
.
(52,100) (605,000)
585,500
585,500
(1,950,000)
Chapter 04 - Consolidated Financial Statements and Outside Ownership
29. (25 Minutes) (Determine consolidated balances for a step acquisition). a. Amsterdam fair value implied by price paid by Morey $560,000 ÷ 70% =
$800,000
b. Revaluation gain: 1/1 equity investment in Amsterdam (book value) 25% net income for 1st 6 months Investment book value at 6/30 Fair value of investment at 6/30 (25% × $800,000) Gain on revaluation to fair value
$178,000 8,750 186,750 200,000 $ 13,250
c. Goodwill at 12/31: Fair value of Amsterdam at 6/30 Book value at 6/30 (700,000 + [70,000 ÷ 2]) Excess fair value Allocation to goodwill (no impairment)
$800,000 735,000 $ 65,000 $ 65,000
d. Noncontrolling interest: 5% fair value balance at 6/30 5% subsidiary net income from 6/30 to 12/31 5% subsidiary dividends Noncontrolling interest 12/31
$40,000 1,750 (1,000) $40,750
4-16 .
.
Chapter 04 - Consolidated Financial Statements and Outside Ownership
30. (30 Minutes) (Reporting the sale of a portion of an investment in a subsidiary.) a. Posada records an accrual of $7,950 (see computation below) as "Equity Income from Sold Shares of Sabathia" for the January 1, 2015 to October 1, 2015 period which will appear in the 2015 consolidated income statement. The consolidation will continue to include all of Sabathia's accounts but now recognizing a 40% noncontrolling interest. Sabathia fair value 1/1/13 .......................................... Sabathia book value ................................................. Patent ......................................................................... Remaining life of patent ............................................ Annual amortization ..................................................
$1,200,000 (1,130,000) $70,000 5 years $14,000
Posada’s share of Sabathia’s net income accruing to shares sold: Sabathia's net income ............................................... $120,000 Excess patent fair value amortization ...................... (14,000) Sabathia's adjusted net income ................................ 106,000 Fraction of year held .................................................. 9/12 Sabathia’s adjusted net income for 9 months ......... 79,500 Percentage owned by Posada................................... 70% Posada’s share of Sabathia’s 9 month net income 55,650 Shares sold—1,000 out of 7,000 .............................. 1/7 Posada’s income for shares sold ............................ $7,950 b. As long as control is maintained, the acquisition method considers transactions in the stock of a subsidiary, whether purchases or sales, as transactions in the equity of the consolidated entity. Posada’s investment book value 10/1/15 1/1/15 balance (given—equity method) ................... Recognition of 1/1/15–10/1/15 period: Income accrual ($120,000 × 70% × ¾) ................ Dividends ($40,000 × 70% × ¾) ........................... Amortization ($14,000 × 70% × ¾) ...................... Pre-sale investment book value—10/1/15 ................ Computation of income effect—sale transaction 10/1/15 book value (above) ....................................... Portion of investment sold (1,000/7,000 shares) .... Book value of investment sold ................................ Proceeds .................................................................... Credit to Posada’s additional paid-in capital ..........
$1,085,000 63,000 (21,000) (7,350) $1,119,650 $1,119,650 1/7 $ 159,950 191,000 $ 31,050
c. Because Posada continues to hold 6,000 shares of Sabathia, control is still maintained and consolidated financial statements would be appropriate with a noncontrolling interest of 40 percent.
4-17 .
.
Chapter 04 - Consolidated Financial Statements and Outside Ownership
31.
(35 Minutes) (Consolidation entries and the effect of different investment methods) a. From the original fair value allocation, $30,000 is assigned based on the fair value of the patent. With a 5-year remaining life, excess amortization will be $6,000 per year. Because the equity method is in use, no Entry *C is required. Entry S Common stock (Bandmor) ............................ 300,000 Retained earnings, 1/1/15 (Bandmor) ........... 268,000 Investment in Bandmor (70%) ................. 397,600 Noncontrolling interest in Bandmor, 1/1/15 170,400 (To eliminate stockholders' equity accounts of subsidiary and recognize outside ownership. Retained earnings figure includes 2013 and 2014 net income and dividends.) Entry A Patent .............................................................. 18,000 Goodwill .......................................................... 190,000 Investment in Bandmor ............................ 145,600 Noncontrolling interest in Bandmor (30%) 62,400 (To recognize unamortized portions of acquisition-date fair value allocations. No control premium, so goodwill is allocated proportionately. Patent has undergone two years amortization) Entry I Equity in Bandmor earnings ......................... 72,800 Investment in Bandmor ............................ 72,800 (To eliminate intra-entity income balance. Equity accrual of $72,800 [70% × ($110,000 – 6,000 amortization)] has been recorded) Entry D Investment in Bandmor ................................. 42,000 Dividends declared ................................... 42,000 (To eliminate current intra-entity dividend transfers—70% of $60,000) Entry E Amortization expense..................................... Patent ......................................................... (To recognize amortization for current year)
6,000
Entry P Accounts payable .......................................... 22,000 Accounts receivable ................................. (To eliminate intra-entity payable/receivable balance)
4-18 .
.
6,000
22,000
Chapter 04 - Consolidated Financial Statements and Outside Ownership
31. (continued) b. If the initial value method had been applied, the parent would have recorded only the subsidiary dividends declared as income rather than an equity accrual. Therefore, Entry *C is needed to adjust the parent's beginning retained earnings for 2015 to the equity method. During 2013 and 2014, the subsidiary earned a total net income of $171,000 but declared dividends of only $83,000. The parent's share of the difference is $61,600 (70% of $88,000 [$171,000 - $83,000]). In addition, the parent’s 70% share of excess amortization expense for two years must also be included ($8,400 = 2 years × $6,000 per year × 70%). The net amount to be recognized is $53,200 ($61,600 - $8,400). ENTRY *C Investment in Bandmor ................................. Retained earnings, 1/1/15 ........................
53,200 53,200
c. If the partial equity method had been applied, only the excess amortization expenses for the previous two years would have been omitted from the parent's retained earnings. As shown above, that figure is $8,400 (2 years × $6,000 per year × 70%). ENTRY *C Retained earnings, 1/1/15 .............................. Investment in Bandmor ............................
8,400 8,400
d. Net income attributable to noncontrolling interest—2015 [($110,000 – 6,000) × 30%] .............................
$31,200
Noncontrolling interest (NCI) fair value January 1, 2013 $210,000 Adjustments to original basis: 2013 NI to noncontrolling interest..................... $20,700 Dividends to NCI ........................................ (11,700) 9,000 2014 NI to noncontrolling interest..................... Dividends to NCI ........................................
$27,000 (13,200)
2015 Net income to noncontrolling interest ..... Dividends to NCI ........................................ Noncontrolling interest in Bandmor 12/31/15 ....
$31,200 (18,000)
13,800
13,200 $246,000
–OR– Worksheet adjustment S ........................................................ Worksheet adjustment A ........................................................ 2015 net income attributable to noncontrolling interest...... 2015 dividends to noncontrolling interest ........................... Noncontrolling interest in Bandmor 12/31/15 .......................
4-19 .
.
$170,400 62,400 31,200 (18,000) $246,000
Chapter 04 - Consolidated Financial Statements and Outside Ownership
32.
(45 Minutes) (Asks about several consolidated balances and consolidation process. Includes the different accounting methods to record investment.) a. Schedule 1—Fair Value Allocation and Excess Amortizations Consideration transferred by Miller ......... $664,000 Noncontrolling interest fair value ............. 166,000 Taylor’s fair value ....................................... $830,000 Taylor’s book value .................................... (600,000) Fair value in excess of book value .......... 230,000 Excess fair value assigned to specific accounts based on fair value Excess fair value assigned to buildings
Remaining life
Annual excess amortizations
80,000
20 years Goodwill ..................................................... $150,000 indefinite Total .......................................................
$4,000 -0$4,000
b. $150,000 (see schedule 1 above) c. Entry (S) Common stock (Taylor) ...................................... Additional paid-in capital (Taylor) ..................... Retained earnings (Taylor) ................................. Investment in Taylor Company (80%) .......... Noncontrolling interest in Taylor (20%) .......
300,000 90,000 210,000 480,000 120,000
Entry (A)—no control premium Buildings .............................................................. Goodwill ............................................................... Investment in Taylor Company (80%) .......... Noncontrolling interest in Taylor (20%) .......
80,000 150,000 184,000 46,000
d. (1) Equity method Income accrual (80%) ........................................... Excess amortization expense .............................. Investment income ..........................................
$56,000 (3,200) $52,800
(2) Partial equity method Income accrual (80%) ...........................................
$56,000
(3) Initial value method Dividends received (80%) .....................................
4-20 .
.
$8,000
Chapter 04 - Consolidated Financial Statements and Outside Ownership
32. (continued) e. (1) Equity method Initial fair value paid .............................................. $664,000 Income accrual 2013–2015 ($260,000 × 80%) ..... 208,000 Dividends 2013–2015 ($45,000 × 80%) ................ (36,000) Excess amortizations 2013–2015 ($3,200 × 3) .... (9,600) Investment in Taylor—12/31/15 ...................... $826,400 (2) Partial Equity Method Investment in Taylor—12/31/15 = $836,000 (initial value paid plus income accrual of $208,000 less dividends of $36,000 [no excess amortizations]) (3) Initial Value Method Investment in Taylor—12/31/15 = $664,000 (original value paid) f. Using the acquisition method, the allocation will be the total difference ($80,000) between the buildings' book value and fair value. Based on a 20 year remaining life, annual excess amortization is $4,000. Miller book value—buildings ......................................... Taylor book value—buildings ....................................... Allocation ........................................................................ Excess amortizations for 2013–2014 ($4,000 × 2) ........ Consolidated buildings account .............................
$800,000 300,000 80,000 (8,000) $1,172,000
g. Acquisition-date fair value allocated to goodwill (see schedule 1 above) ............................................
$150,000
h. If the parent has been applying the equity method, the stockholders' equity accounts on its books will already represent consolidated totals. The common stock and additional paid-in capital figures to be reported are the parent balances only. As to retained earnings, the equity method will properly record all subsidiary net income and amortization so that the parent balance is also a reflection of the consolidated total.
4-21 .
.
Chapter 04 - Consolidated Financial Statements and Outside Ownership
33.
(20 Minutes) (A variety of consolidated balances-midyear acquisition) Consideration transferred by Karson (cash and contingent consideration) ......... $1,360,000 Noncontrolling interest fair value ................. 340,000 Reilly’ fair value (given) .................................. $1,700,000 Book value of Reilly ........................................ (1,450,000)* Fair value in excess of book value................. $250,000 Excess fair value assigned to specific accounts based on fair value Trademarks .................................................. Goodwill ....................................................... Total ..........................................................
Remaining life
Annual excess amortizations
150,000 5 years $30,000 $100,000 indefinite -0$30,000
*Reilly book value, January 1 (Common stock + APIC + RE) ...................... Increase in book value: Net income (revenues less cost of goods sold and expenses) ................... Dividends .................................................. Change during year ................................. Change during first 6 months of year ..... Reilly book value, July 1 (acquisition date)......
$1,400,000
$120,000 (20,000) $100,000
CONSOLIDATION TOTALS: ▪ Sales (1)
50,000 $1,450,000 $1,050,000
▪
Cost of goods sold (2)
540,000
▪
Operating expenses (3)
265,000
▪
Consolidated net income
$245,000
▪
Net income attributable to noncontrolling interest (4)
$9,000
(1) $800,000 Karson revenues plus $250,000 (post-acquisition subsidiary revenue) (2) $400,000 Karson COGS plus $140,000 (post-acquisition subsidiary COGS) (3) $200,000 Karson operating expenses plus $50,000 (post-acquisition subsidiary operating expenses) plus ½ year excess amortization of $15,000 (4) 20% of post-acquisition subsidiary net income less excess fair value amortization [20% × ½ year × (120,000 – 30,000)] = $9,000
▪
Retained earnings, 1/1 = $1,400,000 (the parent’s balance because the subsidiary was acquired during the current year)
▪
Trademarks = $935,000 (add the two book values and the excess fair value allocation after taking one-half year excess amortization)
▪
Goodwill = $100,000 (the original allocation) 4-22
.
.
Chapter 04 - Consolidated Financial Statements and Outside Ownership
34.
(25 Minutes) (A variety of consolidated questions and balances) a. Nascent applies the initial value method because the original price of $414,000 is still in the Investment in Sea-Breeze account. In addition, the Investment Income account is equal to 60 percent of the dividends declared by the subsidiary during the year. b. Consideration transferred in acquisition . $414,000 Noncontrolling interest fair value ............. 276,000 Sea-Breeze fair value 1/1/12 ...................... $690,000 Sea-Breeze book value 1/1/12 550,000 Excess fair value over book value $140,000 Excess fair value assigned to specific Remaining Annual excess accounts based on fair value life amortizations Buildings ............................................... 60,000 6 years $10,000 Equipment ............................................. (20,000) 4 years (5,000) Patent ..................................................... 100,000 10 years 10,000 Total ..................................................... -0$15,000 c. If the equity method had been applied, the Investment Income account would show the basic equity accrual less amortization: 60% of (the subsidiary's net income of $90,000 less $15,000 excess fair value amortization) = $45,000. d. The initial value method recognizes neither the increase in the subsidiary's book value nor the excess amortization expenses for prior years. At the acquisition date, the subsidiary’s book value was $550,000 as indicated by the assets less liabilities. At the beginning of the current year, the book value of the subsidiary is $780,000 as indicated by beginning stockholders' equity balances. Increase in book value during prior years ($780,000 – $550,000)........................................................... Less excess amortization ......................................................... Net increase in book value ........................................................ Ownership .................................................................................. Increase required in parent's retained earnings, 1/1/15 ......... Parent's retained earnings, 1/1/15 as reported ....................... Parent’s share of consolidated retained earnings, 1/1/15 ...... e. Consolidated net income and allocation ▪ Revenues (add book values) ▪ Expenses (add book values and excess amortization) ▪ Consolidated net Income ▪ Net income attributable to noncontrolling interest ($90,000 – 15,000) × 40% ▪ Net income attributable to Nascent, Inc.
4-23 .
.
$230,000 (45,000) $185,000 60% $111,000 700,000 $811,000 $900,000 (635,000) $265,000 30,000 $235,000
Chapter 04 - Consolidated Financial Statements and Outside Ownership
34. (continued) f. Consolidated buildings, 1/1/12 (subsidiary): Book value............................................................................. Acquisition-date fair-value allocation ................................ Consolidation figure ............................................................
$300,000 60,000 $360,000
g. Consolidated buildings, 12/31/15: Parent's book value ............................................................. Subsidiary's book value ...................................................... Original allocation ................................................................ Amortization ($10,000 × 4 years) ........................................ Consolidated balance ..........................................................
$700,000 200,000 60,000 (40,000) $920,000
4-24 .
.
Chapter 04 - Consolidated Financial Statements and Outside Ownership
35. (Acquisition Method Consolidated Balances) December 31, 2015 Revenues Cost of goods sold Depreciation expense Amortization expense Interest expense Equity in San Marco Income Separate company net income
Paloma (1,843,000) 1,100,000 125,000 275,000 27,500 (121,500)
San Marco (675,000) 322,000 120,000 11,000 7,000
(437,000)
(215,000)
Adjustments & Eliminations
(E) 80,000 (I)121,500
Consolidated net income To noncontrolling interest To Paloma Company
(13,500)
Retained Earnings 1/1 Net Income Dividends declared Retained Earnings 12/31
(2,625,000) (437,000) 350,000 (2,712,000)
(395,000) (215,000) 25,000 (585,000)
Current Assets Investment in San Marco
1,204,000 1,854,000
430,000
Customer base Buildings and Equipment Copyrights Goodwill Total Assets Accounts Payable Notes Payable NCI in San Marco
Common Stock Additional Paid-In Capital Retained Earnings 12/31 Total Liab. and SE
-0931,000 950,000
(S)395,000 (D) 22,500
-0863,000 107,000
2,500
Consolidated (2,518,000) 1,422,000 245,000 366,000 34,500 -0-
(450,500) (13,500) (437,000) (2,625,000) (437,000) 350,000 (2,712,000) 1,634,000
(D) 22,500
(A)720,000
(S)769,500 (A)985,500 (I) 121,500 (E) 80,000
-0-
4,939,000
1,400,000
640,000 1,794,000 1,057,000 375,000 5,500,000
(485,000) (542,000)
(200,000) (155,000)
(685,000) (697,000)
(A)375,000
(S) 85,500 (A)109,500 (900,000) (300,000) (2,712,000) (4,939,000)
(400,000) (60,000) (585,000) (1,400,000)
4-25 .
NCI
.
(S)400,000 (S) 60,000 2,174,000
2,174,000
(195,000) (206,000)
(206,000) (900,000) (300,000) (2,712,000) (5,500,000)
Chapter 04 - Consolidated Financial Statements and Outside Ownership
35. (Continued)
Fair value at acquisition date Relative fair values of identifiable net assets 90% and 10% of $1,525,000 (acquisition date recorded fair value plus customer base) Goodwill
Controlling Noncontrolling Interest Interest $1,710,000 $190,000
1,372,500 $337,500
152,500 $37,500
b. If the acquisition-date fair value of the noncontrolling interest was $167,500, both goodwill (NCI portion) and the noncontrolling interest balance would be reduced equally by $22,500 as follows: Fair value of San Marco Company (1,710,000 + 167,500) Carrying amount acquired Excess fair value to customer base to goodwill
$1,877,500 725,000 1,152,500 800,000 $352,500
Noncontrolling interest balance beginning of year* Net income attributable to noncontrolling interest Dividends declared to noncontrolling interest Noncontrolling interest end of year
$(172,500) (13,500) 2,500 $(183,500)
* NCI at beginning of year Common stock-subsidiary APIC-subsidiary Retained earnings-subsidiary 1/1 Total Noncontrolling interest percentage Noncontrolling share of subsidiary book value Noncontrolling share of 1/1 customer base excess Noncontrolling share of goodwill (below) Noncontrolling interest 1/1
Fair value at acquisition date Relative fair values of identifiable net assets 90% and 10% of $1,525,000 (acquisition date recorded fair value plus customer base) Goodwill
4-26 .
.
$400,000 60,000 395,000 $855,000 10% 85,500 72,000 15,000 $172,500
Controlling Noncontrolling Interest Interest $1,710,000 $167,500
1,372,500 $ 337,500
152,500 $15,000
Chapter 04 - Consolidated Financial Statements and Outside Ownership
36.
(60 Minutes) (Consolidation worksheet and income statement with parent using initial value method. Also consolidated balances with a control premium paid by parent.)
a.
Fair Value Allocation and Amortization Consideration transferred by Holtz................ $576,000 Noncontrolling interest fair value .................. 144,000 Devine total fair value 1/1/14........................... $720,000 Devine book value 1/1/14 ................................ (326,500) Fair value in excess of book value ................ $393,500 Excess fair value assigned to specific Remaining Annual excess accounts based on fair value: life amortizations Building ....................................................... 85,500 5 years $17,100 Trademark ................................................. 64,000 10 years 6,400 Goodwill ...................................................... $244,000 indefinite -0$23,500 Explanation of Consolidation Entries Found on Worksheet Entry *C: Convert the parent’s 1/1/15 retained earnings balance from the initial value method to the accrual basis. Change in subsidiary RE from 1/1/14 to 1/1/15 ........ Excess amortization for 2014 .................................... Adjusted subsidiary RE increase ............................. Percentage ownership by parent .............................. *C conversion entry ...................................................
$70,000 23,500 $46,500 80% $37,200
Entry S: Eliminates stockholders' equity accounts of subsidiary while recognizing noncontrolling interest balance (20%) as of the beginning of the current year. Entry A: Recognizes acquisition-date fair value allocations less one year of amortization for building and trademark and increases beginning balance of the noncontrolling interest for its share. Entry I: Eliminates Intra-entity dividends declared by subsidiary and recorded as income by parent. Entry E: Recognizes amortization expense for current year. Columnar entry—Recognizes net income attributable to noncontrolling interest [($97,000 – $23,500) × 20%].
4-27 .
.
Chapter 04 - Consolidated Financial Statements and Outside Ownership
36. a. (continued)
HOLTZ CORPORATION AND DEVINE, INC. Consolidation Worksheet For Year Ending December 31, 2015 Holtz Corporation
Devine Inc.
Sales Cost of goods sold Operating expenses Dividend income Separate company net income Consolidated net income NI attributable to noncontrolling interest NI attributable to Holtz Corp.
(641,000) 198,000 273,000 (16,000) (186,000)
(399,000) 176,000 126,000 ___ _-0(97,000)
Retained earnings, 1/1 Net income (above) Dividends declared Retained earnings, 12/31
(762,000) (186,000) 70,000 (878,000)
(296,500) (97,000) 20,000 (373,500)
Current assets Investment in Devine
121,000 576,000
120,500 -0-
Buildings and equipment (net) Trademarks Goodwill Total assets
887,000 149,000 -01,733,000
335,000 236,000 -0691,500
Liabilities Common stock Retained earnings, 12/31 (above) NCI in Devine, 1/1
(535,000) (320,000) (878,000)
(218,000) (100,000) (373,500)
Accounts
NCI in Devine, 12/31 Total liabilities and equities
Noncontrolling Consolidated Interest Totals
(1,040,000) 374,000 422,500 -0-
(E) 23,500 (I) 16,000
(14,700)
(S) 296,500 (*C) 37,200 (I)
(*C) 37,200 (A) 68,400 (A) 57,600 (A)244,000
16,000
(1,733,000)
(691,500)
4,000
(799,200) (228,800) 70,000 (958,000)
1,273,300 436,200 244,000 2,195,000 (753,000) (320,000) (958,000)
(S)100,000
843,200
(243,500) 14,700 (228,800)
241,500 -0-
(S)317,200 (A)296,000 (E) 17,100 (E) 6,400
(S) 79,300 (A) 74,000
4-28 ..
Consolidation Entries Debit Credit
843,200
(153,300) (164,000)
(164,000) (2,195,000)
Chapter 04 - Consolidated Financial Statements and Outside Ownership
36. (continued) b.
HOLTZ CORPORATION AND DEVINE, INC. Consolidated Income Statement For Year Ending December 31, 2015
Sales Cost of goods sold Operating expenses Total expenses Consolidated net income
$1,040,000 $374,000 422,500 796,500 $243,500
To 20% noncontrolling interest To Holtz Corporation
$14,700 $228,800
c. Consideration transferred by Holtz for 80% of Devine Noncontrolling interest fair value ($4.76 × 20,000 shares) Devine fair value Fair value of Devine’s underlying net assets Goodwill
$576,000 95,200 $671,200 476,000 $195,200
If the noncontrolling interest fair value was $4.76 per share at the acquisition date, then goodwill declines to $195,200. The noncontrolling interest total would also decline from $164,000 to $115,200. Worksheet entries (S), (A1) and (A2) assuming a $4.76 noncontrolling interest acquisition-date fair value: (S)
Common stock-Devine Retained earnings- Devine 1/1 Investment in Devine Noncontrolling interest
100,000 296,500
(A1) Buildings and equipment (net) Trademarks Investment in Devine Noncontrolling interest
68,400 57,600
(A2) Goodwill Investment in Devine
195,200
317,200 79,300
100,800 25,200 195,200
Fair value at acquisition date Relative fair values of identifiable net assets 80% and 20% of $476,000 (acquisition date fair value of net identifiable assets) Goodwill
4-29 .
.
Controlling Noncontrolling Interest Interest $576,000 $95,200
380,800 $195,200
95,200 -0-
Chapter 04 - Consolidated Financial Statements and Outside Ownership
37.
(40 Minutes) (Determine consolidated balances.) Acquisition-date subsidiary fair value (given) ... $1,003,400 Book value of subsidiary (given) ....................... (690,000) Fair value in excess of book value ..................... $313,400 Allocations to specific accounts based on difference between fair value and book value Land ................................................................ $225,000 Buildings and equipment .............................. (24,000) Copyright ........................................................ 94,000 Notes payable ................................................. 18,400 313,400 Total ....................................................... -0Annual excess amortizations: Buildings and equipment [$(24,000) ÷ 10 years] Copyright ($94,000 ÷ 20 years) Notes payable ($18,400 ÷ 8 years) Total
$(2,400) 4,700 2,300 $4,600
Consolidated Totals: ▪
Revenues = $2,079,880 (add the two book values)
▪
Cost of goods sold = $1,206,000 (add the two book values)
▪
Depreciation expense = $283,200 (add the two book values less $2,400 excess adjustment)
▪
Amortization expense = $10,800 (add the two book values plus $4,700 excess adjustment)
▪
Interest expense = $63,600 (add the two book values plus $2,300 excess adjustment)
▪
Equity in income of Sierra = -0- (eliminated so that the individual revenues and expenses of the subsidiary can be included in the consolidated figures)
▪
Consolidated net income = $516,280 (revenues less expenses)
▪
Net income attributable to noncontrolling interest = $44,280 ($226,000 reported subsidiary net income less $4,600 net excess amortization expense multiplied by 20 percent outside ownership)
▪
Net income to Padre Company = $472,000 ($516,280 consolidated net income less noncontrolling interest share of $44,280)
▪
Retained earnings, 1/1 = $1,275,000 (parent company balance only)
▪
Dividends declared = $260,000 (parent company balance; subsidiary's declarations to parent are intra-entity, declarations to outside owners decrease noncontrolling interest balance) 4-30
.
.
Chapter 04 - Consolidated Financial Statements and Outside Ownership
37. (continued) ▪
Retained earnings, 12/31 = $1,487,000 (consolidated balance on 1/1 plus net income to Padre Co. less Padre’s dividends declared) or simply the parent’s RE because parent employs the equity method.
▪
Current assets = $1,620,860 (add the two book values)
▪
Investment in Sierra = -0- (eliminated so that the individual assets and liabilities of the subsidiary can be included in the consolidated figures)
▪
Land = $650,000 (add the book values plus the $225,000 excess allocation)
▪
Buildings and equipment (net) = $1,162,800 (add the book values less the $24,000 allocation [asset was overvalued] plus the excess amortization)
▪
Copyright = $205,200 (book value plus $94,000 excess allocation less amortization for the year)
▪
Total assets = $3,638,860
▪
Accounts payable = $469,000 (add book values)
▪
Notes payable = $700,900 (add the book values less $18,400 excess allocation plus amortization)
▪
Noncontrolling interest in subsidiary = $231,960 (20% of fair value as of 1/1 [$200,680] plus net income attributable to noncontrolling interest [$44,280] less dividends declared to outside owners [$13,000])
▪
Common stock = $300,000 (parent company balance)
▪
Additional paid-in capital = 450,000 (parent company balance)
▪
Retained earnings, 12/31 = $1,487,000 (computed above)
▪
Total liabilities and equities = $3,638,860
4-31 .
.
Chapter 04 - Consolidated Financial Statements and Outside Ownership
37. (continued) Acquisition Method Accounts
Padre
Sierra
Revenues ............................................ Cost of goods sold ............................. Depreciation expense ........................ Amortization expense ........................ Interest expense ................................. Equity in income of Sierra ................ Separate company net income .......... Consolidated net income ................... NI to noncontrolling interest ............ NI to Padre Company ...................... Retained earnings 1/1 ....................... Net income (above) ........................... Dividends declared ............................ Retained earnings 12/31 .............. Current assets ................................... Investment in Sierra .......................... ....................................................... ....................................................... Land .................................................... Buildings and equipment (net) .......... Copyright ........................................... Total assets .................................. Accounts payable .............................. Notes payable .................................... NCI in Sierra 1/1 .................................. NCI in Sierra 12/31 .............................. ....................................................... Common stock .................................. Additional paid-in capital ................... Retained earnings 12/31.... (above) … Total liab. and stockholders' equity
(1,394,980) 774,000 274,000 -052,100 (177,120) (472,000)
(684,900) 432,000 11,600 6,100 9,200 -0(226,000)
(E)
Noncontrolling Consolidated Interest Totals
(2,079,880) 1,206,000 283,200 10,800 63,600 -0-
2,400
(E) 4,700 (E) 2,300 (I) 177,120
(44,280) (1,275,000) (472,000) 260,000 (1,487,000) 856,160 927,840
(530,000) (226,000) 65,000 (691,000) 764,700
360,000 909,000 -03,053,000 (275,000) (541,000)
65,000 275,400 115,900 1,221,000 (194,000) (176,000)
(300,000) (450,000) (1,487,000) (3,053,000)
(100,000) (60,000) (691,000) (1,221,000)
4-32 ..
Consolidation Entries Debit Credit
(S) 530,000 (D) 52,000
13,000
(D) 52,000 (S) 552,000 (I) 177,120 (A) 250,720 (A) 225,000 (E) 2,400 (A) 24,000 (A) 94,000 (E) 4,700
(A) 18,400 (E) 2,300 (S) 138,000 (A) 62,680 (S) 100,000 (S) 60,000 1,265,920
1,265,920
(516,280) 44,280 (472,000) (1,275,000) (472,000) 260,000 (1,487,000) 1,620,860
-0650,000 1,162,800 205,200 3,638,860 (469,000) (700,900) (200,680) (231,960)
(231,960) (300,000) (450,000) (1,487,000) (3,638,860)
Chapter 04 - Consolidated Financial Statements and Outside Ownership
38. a.
b.
(55 Minutes) (Consolidated worksheet) Consideration transferred by Adams $603,000 Noncontrolling interest fair value 67,000 Acquisition-date total fair value $670,000 Book value of Barstow (CS + RE 12/31/13) (460,000) Excess fair value over book value 210,000 Excess fair value assigned to specific Remaining Annual excess accounts based on fair value life amortizations Land $30,000 — — Buildings (20,000) 10 years ($2,000) Equipment 40,000 5 years 8,000 Patents 50,000 10 years 5,000 Notes payable 20,000 5 years 4,000 120,000 Goodwill $90,000 indefinite -0Total $15,000 Because investment income is exactly 90 percent of Barstow's reported earnings, Adams apparently is applying the partial equity method.
c. d. Explanation of Consolidation Entries Found on Worksheet Entry *C—Converts Adams's financial records from the partial equity method to the equity method by recognizing amortization for 2014. Total expense was $15,000 but only 90 percent (or $13,500) applied to the parent. Entry S—Eliminates subsidiary's stockholders' equity while recording noncontrolling interest balance as of January 1, 2015. Entry A—Records unamortized allocation balances as of January 1, 2015. The acquisition method attributes 10 percent of these amounts to the noncontrolling interest. Entry I—Eliminates intra-entity income accrual for 2015. Entry D—Eliminates intra-entity dividend transfers. Entry E—Records amortization expense for current year. Columnar Entry—Recognizes noncontrolling interest's share of consolidated net income as follows: Net income attributable to noncontrolling interest (Columnar Entry) Barstow reported net income ........................................................ $120,000 Excess amortization expenses 2015.............................................. (15,000) Adjusted net income of Barstow ............................................. $105,000 Noncontrolling interest ownership ............................................... 10% Net income attributable to noncontrolling interest ................. $ 10,500
4-33 .
.
Chapter 04 - Consolidated Financial Statements and Outside Ownership
38. c. and d. (continued)
Revenues Cost of goods sold Depreciation expense Amortization expense Interest expense Investment income Separate company net income Consolidated net income NI to noncontrolling interest NI to Adams Corporation
ADAMS CORPORATION AND BARSTOW, INC. Consolidation Worksheet-Acquisition Method For Year Ending December 31, 2015 Adams Corp.
Barstow Inc.
(940,000) 480,000 100,000
(280,000) 90,000 55,000
40,000 (108,000) (428,000)
15,000 -0(120,000)
Debit
(340,000)
Net income Dividends declared Retained earnings, 12/31
(428,000) 110,000 (1,685,000)
(120,000) 70,000 (390,000)
Current assets Investment in Barstow
610,000 702,000
250,000
(C*) 13,500 (S) 340,000
Land Buildings Equipment Patents Goodwill Total assets
380,000 490,000 873,000 -0-03,055,000
150,000 250,000 150,000 -0-0800,000
(A) (E) (A) (A) (A)
Notes payable Common stock Retained earnings, 12/31
(860,000) (510,000) (1,685,000)
(230,000) (180,000) (390,000)
(A) 16,000 (S) 180,000
30,000 2,000 32,000 45,000 90,000
(3,055,000)
(800,000)
4-34
934,500
7,000
(425,000) 10,500 (414,500)
560,000 724,000 1,047,000 40,000 90,000 3,321,000
(A) 18,000 (E) 8,000 (E) 5,000
(E)
4,000
934,500
(414,500) 110,000 (1,658,000) 860,000 -0-
(*C) 13,500 (S) 468,000 (A) 175,500 (I) 108,000
(S) 52,000 (A) 19,500
Noncontrolling interest
Totals
(1,353,500)
(D) 63,000
(D) 63,000
Consolidated
(1,220,000) 570,000 161,000 5,000 59,000 -0-
(10,500)
(1,367,000)
..
Interest
(E) 6,000 (E) 5,000 (E) 4,000 (I) 108,000
Retained earnings, 1/1
Total liabilities and stockholders' equity
Noncontrolling
Credit
(1,078,000) (510,000) (1,658,000) (71,500) (75,000)
(75,000) (3,321,000)
Chapter 04 - Consolidated Financial Statements and Outside Ownership
39. (25 minutes) (Consolidated balances after a mid-year acquisition) a. Investment account balance indicates the initial value method. Consideration transferred by Gibson ....... $528,000 Noncontrolling interest fair value ............ 352,000 Davis acquisition-date fair value ............. 880,000 Book value of Davis (see below) ............... (765,000) Fair value in excess of book value .......... $115,000 Excess fair value assigned to specific Remaining Annual excess accounts based on fair value: life amortizations Equipment (overvalued).................. (30,000) 5 years $(6,000) Goodwill .......................................... $145,000 indefinite -0Total ...................................................... $(6,000) Amortization for 9 months .................. $(4,500) Acquisition-date subsidiary book value: Book value of Davis, 1/1/15 (CS + 1/1 RE) ............... $740,000 Increase in book value-net income (dividends were declared after acquisition) ......................... $100,000 Time prior to purchase (3 months) .......................... × ¼ year 25,000 Book value of Davis, 4/1/15 (acquisition date) ........ $765,000 Consolidated income statement: Revenues (1) Cost of goods sold (2) $405,000 Operating expenses (3) 214,500 Consolidated net income Net income attributable to noncontrolling interest (4) Net income to Gibson Company
$825,000 619,500 205,500 28,200 $177,300
(1) $900,000 combined revenues less $75,000 (preacquisition subsidiary revenue) (2) $440,000 combined COGS less $35,000 (preacquisition subsidiary COGS) (3) $234,000 combined operating expenses less $15,000 (preacquisition subsidiary operating expenses) less nine month excess overvalued equipment depreciation reduction of $4,500 (4) 40% of post-acquisition subsidiary net income less excess amortization
b.
Goodwill = $145,000 (original allocation) Equipment = $774,500 (add the two book values less $30,000 reduction to fair value plus $4,500 nine months excess amortization) Common stock = $630,000 (parent company balance only) Buildings = $1,124,000 (add the two book values) Dividends declared = $80,000 (parent company balance only)
4-35 .
.
Chapter 04 - Consolidated Financial Statements and Outside Ownership
40. (40 minutes) Determine consolidated balance for a mid-year acquisition. a.
Consideration transferred by Truman .......... $720,000 Noncontrolling interest fair value ................. 290,000 Atlanta’s acquisition-date total fair value ...... $1,010,000 Book value of Atlanta ...................................... (840,000) Fair value in excess of book value................. $ 170,000 Excess fair value assigned to specific accounts based on fair value Patent ......................................................... Goodwill ....................................................... Total ..........................................................
b.
Remaining life
100,000 5 years $20,000 $ 70,000 indefinite -0$20,000
Goodwill allocation with control premium Fair values at acquisition date Relative fair values of identifiable net assets 70% and 30% of $940,000 (acquisition date book value plus patent = net asset fair value) Goodwill
c.
Controlling Noncontrolling Interest Interest $720,000 $290,000
Initial value at acquisition date Truman’s share of Atlanta’s net income for half year ([$120,000 – 20,000 amortization × ½ year] × 70%) Dividends 2015 ($80,000 × ½ year × 70%) Investment account balance 12/31/15
4-36 .
.
Annual excess amortizations
658,000 $ 62,000 $720,000 35,000 (28,000) $727,000
282,000 $ 8,000
Chapter 04 - Consolidated Financial Statements and Outside Ownership 40. (continued) d. Consolidated Worksheet TRUMAN COMPANY AND SUBSIDIARY ATLANTA COMPANY Consolidation Worksheet For Year Ending December 31, 2015 Truman Revenues (670,000) Operating Expenses 402,000 Net income of subsidiary (35,000) Separate company net income (303,000) Consolidated net income Net income attributable to NCI Net income attributable to Truman
Atlanta (400,000) 280,000
Retained earnings, 1/1 Net income (above) Dividends declared
(500,000) (120,000) 80,000
(823,000) (303,000) 145,000
(540,000)
Current assets Investment in Atlanta
481,000 727,000
390,000
Land Buildings Patent Goodwill Total assets
388,000 701,000
200,000 630,000
Cons. (870,000) 552,000 -0-
2,297,000
1,220,000
(816,000) (95,000) (405,000) (981,000)
(360,000) (300,000) (20,000) (540,000)
.
12,000 145,000 (981,000) 871,000 -0-
(S)588,000 (I) 35,000 (A1) 70,000 (A2) 62,000
588,000 1,331,000 90,000 70,000 2,950,000
(E) 10,000
(1,176,000) (95,000) (405,000) (981,000)
(S) 300,000 (S) 20,000 (A1) 30,000 (A2) 8,000 (S) 252,000
(1,220,000)
1,263,000
(318,000) 15,000 (303,000) (823,000) (303,000)
(S) 40,000 (D) 28,000
(D) 28,000
4-37 .
(S)140,000
(S) 500,000
(A1)100,000 (A2) 70,000
(2,297,000)
NCI
(15,000)
(981,000)
Noncontrolling interest 12/31 Total liab. and equity
(S)200,000 (E) 10,000 (I) 35,000
(120,000)
Retained earnings 12/31
Liabilities Common stock Additional paid-in capital Retained earnings 12/31 Noncontrolling interest 7/1
Adjustments & Eliminations
1,263,000
(290,000) (293,000)
(293,000) (2,950,000)
Chapter 04 - Consolidated Financial Statements and Outside Ownership
41. (60 minutes) (Consolidated statements for a step acquisition) a.
Fair value of Sysinger 1/1/15 (given) Book value of Sysinger 1/1/15 (CS + APIC + RE) Excess fair value over book value To customer contract (4 year remaining life) To goodwill
b.
Equity in earnings of Sysinger 2015 net income (150,000 × 95%) Amortization (100,000 × 95%) Equity in earnings of Sysinger
$142,500 (95,000) $47,500
Revaluation of 15% block to fair value Consideration transferred 2014 net income (100,000 × 15%) 2014 dividends (30,000 × 15%) Book value at 1/1/15 Fair value at 1/1/15 Gain on revaluation
$184,500 15,000 (4,500) 195,000 262,500 $67,500
Investment account balance Fair value at 1/1/15 (15% block) Consideration transferred 1/1/15 (80% block) Equity earnings 2015 Net income (95% × 150,000) Customer contract amortization Dividends (40,000 × 95%) Investment in Sysinger 12/31/15
4-38 .
.
$1,750,000 1,300,000 450,000 400,000 $50,000
$262,500 1,400,000 142,500 (95,000)
47,500 (38,000) $1,672,000
Chapter 04 - Consolidated Financial Statements and Outside Ownership
41. (Continued) c.
Accounts Revenues Operating expenses Equity earnings of Sysinger Gain on revaluation Separate company net income Consolidated net income NI attributable to noncontrolling interest NI attributable to Allan Company
Allan and Sysinger Consolidation Worksheet For Year Ending December 31, 2015 Allan Sysinger Consolidation Entries Company Company Debit Credit (931,000) (380,000) 615,000 230,000 (E)100,000 (47,500) -0(I) 47,500 (67,500) -0(431,000) (150,000)
(2,500)
Retained earnings, 1/1 Net income Dividends declared Retained earnings 12/31
(965,000) (431,000) 140,000 (1,256,000)
(600,000) (150,000) 40,000 (710,000)
Current assets Investment in Sysinger
288,000 1,672,000
540,000 -0-
826,000 850,000 -0-
Property, plant, and equipment Patented technology Customer contract Goodwill Total assets
3,636,000
590,000 370,000 -0-01,500,000
Liabilities Common stock Additional paid-in capital Retained earnings 12/31 NCI in Sysinger, 1/1
(1,300,000) (900,000) (180,000) (1,256,000) -0-
(90,000) (500,000) (200,000) (710,000) -0-
NCI in Sysinger, 12/31 Total liab. and stockholders' equity
-0(3,636,000)
-0(1,500,000)
4-39 ..
Noncontrolling Consolidated Interest Totals (1,311,000) 945,000 -0(67,500)
(S) 600,000 (D)
(D) 38,000
(A) 400,000 (A) 50,000
38,000
2,000
(965,000) (431,000) 140,000 (1,256,000) 828,000 -0-
(S)1,235,000 (I) 47,500 (A) 427,500
1,416,000 1,220,000 300,000 50,000 3,814,000
(E) 100,000
(1,390,000) (900,000) (180,000) (1,256,000)
(S) 500,000 (S) 200,000 (S) 65,000 (A) 22,500 1,935,500
(433,500) 2,500 (431,000)
1,935,500
(87,500) (88,000)
(88,000) (3,814,000)
Chapter 04 - Consolidated Financial Statements and Outside Ownership
42. (60 minutes) (Step acquisition—control previously acquired.) a. According to the acquisition method, the valuation basis for a subsidiary is established on the date control is obtained, in this case January 1, 2014. Subsequent acquisitions are valued consistent with this initial value after adjusting the investment for subsidiary net income and other changes. Because subsequent acquisitions are considered as transactions in the parent’s own equity, no gains or losses are recorded. Differences in cash paid and the underlying value are recorded as adjustments to APIC. Fair value of Keane Company 1/1/14 ($573,000 ÷ 60%) Keane net income 2014 Excess fair value amortization for copyright Keane dividends 2014 Initial fair value adjusted to 1/1/15 Percent acquired in step acquisition Value assigned to 30% acquisition Cash paid for the 30% acquisition Credit to APIC from 30% step acquisition
$955,000 150,000 (20,000)* (80,000) $1,005,000 30% 301,500 300,000 $ 1,500
*Fair value of Keane Company 1/1/14 ($573,000 ÷ 60%) Book value of Keane Company 1/1/14 (given) Excess fair value over book value To copyright (6 year remaining life) To goodwill
$955,000 810,000 145,000 120,000 $25,000
Entry to record 30% additional investment in Keane: 1/1/15
Investment in Keane Cash APIC from step acquisition
301,500
b. Investment in Keane Company 1/1/14 2014 Equity earnings [60% × (150,000 – 20,000)] 2014 Dividends from Keane (60% × $80,000) Additional acquisition of 30% interest 2015 Equity earnings [90% × (180,000 – 20,000)] 2015 Dividends from Keane (90% × $60,000) Investment in Keane Company 12/31/15
4-40 .
.
300,000 1,500 $573,000 78,000 (48,000) 301,500 144,000 (54,000) $994,500
Chapter 04 - Consolidated Financial Statements and Outside Ownership
42. (continued) part c.
BRETZ, INC. AND KEANE COMPANY Consolidation Worksheet Year Ending December 31, 2015
Accounts Revenues Operating expenses Equity in Keane’s income Separate company net income Consolidated net income NI attributable to noncontrolling interest NI attributable to Bretz, Inc.
Bretz, Inc. (402,000) 200,000 (144,000) (346,000)
Retained earnings, 1/1 Net income (above) Dividends declared Retained earnings, 12/31
(797,000) (346,000) 143,000 (1,000,000)
(500,000) (180,000) 60,000 (620,000)
224,000 994,500
190,000
Current assets Investment in Keane Company
Trademarks Copyrights Equipment (net) Goodwill Total assets Liabilities Common stock Additional paid-in capital APIC-step acquisition Retained earnings,12/31 Non-controlling interest 1/1 Non-controlling interest 12/31 Total liabilities and equities
Keane Co. (300,000) 120,000 (180,000)
(16,000)
106,000 210,000 380,000
600,000 300,000 110,000
1,914,500
1,200,000
(453,000) (400,000) (60,000) (1,500) (1,000,000)
(200,000) (300,000) (80,000)
(S) 500,000 (D) 54,000
(D)54,000
(S) 792,000 (A) 112,500 (I) 144,000
(A)100,000
(E) 20,000
6,000
(653,000) (400,000) (60,000) (1,500) (1,000,000)
(620,000)
(1,200,000)
1,223,000
(797,000) (346,000) 143,000 (1,000,000)
706,000 590,000 490,000 25,000 2,225,000
(S)300,000 (S) 80,000
(A) 12,500 (S) 88,000 (1,914,500)
(362,000) 16,000 (346,000)
414,000 0
(A) 25,000
4-41 ..
Consolidation Entries Noncontrolling Consolidated Debit Credit Interest Totals (702,000) (E) 20,000 340,000 (I) 144,000
1,223,000
(100,500) (110,500)
(110,500) (2,225,000)
Chapter 04 - Consolidated Financial Statements and Outside Ownership
ACCOUNTING THEORY RESEARCH CASE: NONCONTROLLING INTEREST In deliberations prior to the issuance of SFAS 160, “Noncontrolling Interests in Consolidated Financial Statements,” the FASB considered three alternatives for displaying the noncontrolling interest in the consolidated balance sheet What were these three alternatives? 1. As a liability 2. As equity 3. In the “mezzanine” area between liabilities and owners’ equity What criteria did the FASB use to evaluate the desirability of each alternative? The FASB evaluated whether the classifications conformed to current definitions of financial statement elements (assets, liabilities, or equity) as articulated in FASB Concept Statement No. 6. In what specific ways did FASB Concept Statement 6 affect the FASB’s evaluation of these alternatives? From SFAS 160 paragraphs 32-34 If it required that the noncontrolling interest be reported in the mezzanine, the Board would have had to create a new element— noncontrolling interest in subsidiaries—specifically for consolidated financial statements. The Board concluded that no compelling reason exists to create a new element specifically for consolidated financial statements to report the interests in a subsidiary held by owners other than the parent. The Board believes that using the existing elements of financial statements along with appropriate labeling and disclosure provides financial information in the consolidated financial statements that is representationally faithful, understandable, and relevant to the entity’s owners, creditors, and other resource providers. The Board concluded that a noncontrolling interest in a subsidiary does not meet the definition of a liability in the Board’s conceptual framework. Paragraph 35 of Concepts Statement 6 defines liabilities as “probable future sacrifices of economic benefits arising from present obligations of a particular entity to transfer assets or provide services to other entities in the future as a result of past transactions or events” The Board concluded that a noncontrolling interest represents the residual interest in the net assets of a subsidiary within the consolidated group held by owners other than the parent. The noncontrolling interest, therefore, meets the definition of equity in Concepts Statement 6. Paragraph 49 of Concepts Statement 6 defines equity (or net assets) as “the residual interest in the assets of an entity that remains after deducting its liabilities.”
4-42 .
.
Chapter 04 - Consolidated Financial Statements and Outside Ownership
RESEARCH CASE: COCA-COLA’S ACQUISITION OF COCA-COLA ENTERPRISES 1. How did Coca-Cola allocate the acquisition-date fair value of CCE among the assets acquired and liabilities assumed? Note 2 (Acquisitions and Divestitures) of Coca-Cola’s 2010 10-K shows the following allocation for the CCE acquisition: Cash and cash equivalents Marketable securities Trade accounts receivable Inventories Other current assets Property, plant and equipment Bottlers' franchise rights with indefinite lives Other intangible assets Other noncurrent assets Total identifiable assets acquired
$ 49 7 1,194 696 744 5,385 5,100 1,032 261 14,468
Accounts payable and accrued expenses Loans and notes payable Long-term debt Pension and other postretirement liabilities Other noncurrent liabilities Total liabilities assumed
1,826 266 9,345 1,313 2,603 15,353
Net liabilities assumed Goodwill Less: Noncontrolling interests
(885) 7,746 13
Net assets acquired
$ 6,848
2. What are employee replacement awards? How did Coca-Cola account for the replacement award value provided to the former employees of CCE? Employee replacement award represent various share-based payments to employees that the acquiring firm replaces with new awards based on its shares. The ASC requires that if replacement awards are based on past service, their fair value is included in consideration transferred. If the replacement award are for future service, their value is expensed as incurred. Coca-Cola followed the ASC for its replacement awards (10-K Note 2). 3. How did Coca-Cola account for its 33 percent interest in CCE prior to the acquisition of the 67 percent not already owned by Coca-Cola? Coca-Cola used the equity method to account for its previous 33 percent investment in CCE (10-K page 53). 4. Upon acquisition of the additional 67 percent interest, how did Coca-Cola account for the change in fair value of its original 33 percent ownership interest? “We remeasured our equity interest in CCE to fair value upon the close of the transaction. As a result, we recognized a gain of approximately $4,978 million, which was classified in the line item other income (loss) — net in our consolidated statement of income.” (10-K Note 2).
4-43 .
.
Chapter 04 - Consolidated Financial Statements and Outside Ownership
INSTAPOWER: FASB ASC AND IFRS RESEARCH CASE 1. What is the total consideration transferred by Q-Car to acquire its 90 percent controlling interest in InstaPower? Cash Shares of Q-Car stock Contingency Total consideration transferred
$60,000,000 27,000,000 10,000,000 $97,000,000
The shares of Q-Car stock and the contingency are both measured at their acquisition-date fair values (ASC 805-30-30-7, ASC 805-30-25-5).
2. What values should Q-Car assign to identifiable assets and liabilities as part of the acquisition accounting? Cash Accounts receivable Land Building Machinery Trademark Research and development asset Accounts payable Total identifiable net asset fair value
$ 270,000 800,000 2,930,000 19,000,000 46,000,000 8,000,000 14,000,000 (1,000,000) $90,000,000 (ASC 805-20-30-1)
3. What is the acquisition-date value assigned to the 10 percent noncontrolling interest? What are the noncontrolling interest valuation alternatives available under IFRS? Under U.S. GAAP, the acquisition-date noncontrolling interest is measured at its fair value. In this case, there are no readily available market values for the noncontrolling shares so Q-Car has relied on other valuation techniques to arrive at an estimated fair value of $11,000,000. IFRS allows two alternative measures for the noncontrolling interest. The first is identical to the U.S. measure. The second alternative uses the noncontrolling interest percentage of the fair value of the subsidiary’s identifiable net assets. In this case, the second alternative provides a value of $9,000,000 ($90,000,000 x 10%). 4. Under U.S. GAAP, what amount should Q-Car recognize as goodwill from the acquisition? What alternative valuations are available for goodwill under IFRS? Goodwill under U.S. GAAP (ASC 805-30-30-1) and IFRS alternative 1 (IFRS 3 IN 8): Consideration transferred (above) Acquisition-date noncontrolling interest fair value Acquisition-date value assigned to subsidiary Net assets acquired fair value (above) Goodwill
$ 97,000,000 11,000,000 $108,000,000 90,000,000 $ 18,000,000
Goodwill under IFRS alternative 2: Consideration transferred (above) Acquisition-date NCI value assigned (above) Acquisition-date value assigned to subsidiary Net assets acquired fair value (above) Goodwill
4-44 .
.
$ 97,000,000 9,000,000 $106,000,000 90,000,000 $ 16,000,000
Chapter 05 - Consolidated Financial Statements—Intra-Entity Asset Transactions
CHAPTER 5 CONSOLIDATED FINANCIAL STATEMENTS— INTRA-ENTITY ASSET TRANSACTIONS Chapter Outline I.
II.
III.
The transfer of assets between the companies forming a business combination is a common practice. The opportunity for such direct acquisition (especially of inventory) is often the underlying motive for the creation of the combination. Intra-entity inventory transfers A. The individual accounting systems of the two companies will record the transfer as a sale by one party and as a purchase by the other B. Because the transaction was not made with an outside, unrelated party, the sales and purchases balances created by the transfer are eliminated in consolidation (Entry Tl) C. Any transferred inventory retained at the end of the year is recorded at its transfer price which in (many cases) will include an unrealized gross profit 1. For consolidation purposes, this intra-entity gross profit must be deferred by eliminating the amount from the inventory account on the balance sheet and from the ending inventory figure within cost of goods sold (Entry G). 2. Because transfer effects carry over to the subsequent fiscal period, the unrealized gross profit must also be removed a second time: from the beginning inventory component of cost of goods sold and from the beginning retained earnings balance (Entry *G). a. The retained earnings figure being adjusted is that of the original seller. b. If the equity method has been applied and the transfer was made downstream (by the parent), the beginning retained earnings account will be correct; therefore, in this one case, the adjustment is to the Investment in Subsidiary account. 3. The consolidation process is designed to shift the profit from the period of transfer into the time period in which the goods are actually sold to unrelated parties or consumed D. Effect of deferral process on the valuation of a noncontrolling interest 1. Official accounting pronouncements permit but do not require deferral of unrealized profits on the valuation of noncontrolling interest balances 2. This textbook adjusts the noncontrolling interest balances but only if the sale was made upstream from subsidiary to parent. Downstream sales are made by the parent and, thus, are viewed as having no effect on the outside interest. Intra-entity land transfers A. Any gain created by intra-entity land transfers is unrealized and will remain so until the land is sold to an outside party B. For each subsequent consolidation, the recorded value of the land account is reduced to original cost. The unrealized gain recorded by the seller must also be removed and deferred until the land is sold to an outsider. 1. In the year of transfer, an actual gain account exists within the accounting records of the seller and must be removed. 2. In all later time periods, since the unrealized gain has become an element of the seller's beginning retained earnings balance, the reduction is made to this equity account. 3. If the land is ever sold to an outside party, the intra-entity gain is realized and has to be recognized within that time period. 5-1
..
Chapter 05 - Consolidated Financial Statements—Intra-Entity Asset Transactions
IV.
Intra-entity transfer of depreciable assets A. As with other intra-entity transfers, any unrealized gross profit must be deferred for consolidation purposes to establish appropriate historical cost balances. B. However, the difference between the transfer-based accounting value and the historical cost of the asset will change each year because of the effects of depreciation. The amount of unrealized gain within retained earnings will also be reduced annually since excess depreciation expense is recognized (and closed into retained earnings) based on the inflated transfer price. C. Consequently, elimination of the unrealized gain (within retained earnings) and the reduction of the asset value to historical cost will differ from year to year. D. Also within the consolidation process, the recorded depreciation expense must be decreased every period to an amount appropriately based on the asset's original acquisition price.
Answers to Discussion Questions Earnings Management: By selling goods to special purpose entities that it controlled but did not consolidate, did Enron overstate its earnings? According to the Power’s Report (Report of Investigation by the Special Investigative Committee of the Board of Directors of Enron Corp.—February 1, 2004) These partnerships—Chewco, LJM1, and LJM2—were used by Enron Management to enter into transactions that it could not, or would not, do with unrelated commercial entities. Many of the most significant transactions apparently were designed to accomplish favorable financial statement results, not to achieve bona fide economic objectives or to transfer risk. (page 4) Assuming Enron controlled LJM2, the transactions that produced the $67 million gain and the $20.3 million agency fee were not arm’s length and thus did not provide a proper basis for recognizing income. What effect does consolidation have on the financial reporting for transactions with controlled entities? In consolidation, all intra-entity profit would have been deferred until the goods were sold to an outside party. Also the intra-entity note receivable and payable would have been eliminated in consolidation. As noted by Bala Dahran in his February 6, Congressional Testimony Despite their potential for economic and business benefits, the use of SPEs has always raised the question of whether the sponsoring company has some other accounting motivations, such as hiding of debt, hiding of poor-performing assets, or earnings management. Additionally, explosive growth in the use of SPEs led to debates among managers, auditors and accounting standard setters as to whether and when SPEs should be consolidated. This is because the intended accounting effects of SPEs can only be achieved if the SPEs are reported as unconsolidated entities separate from the sponsoring entity. FASB Activity on Variable Interest Entities (VIEs) Fortunately the FASB’s ASC Topic 810 explains how to identify an SPE (a type of entity that is often a VIE) that is not subject to control through voting ownership interests, but is nonetheless controlled by another enterprise and therefore subject to consolidation. The entity that controls the SPE is then required to include the assets, liabilities, and results of the activities of the SPE in its consolidated financial statements. 5-2 ..
Chapter 05 - Consolidated Financial Statements—Intra-Entity Asset Transactions
What Price Should We Charge Ourselves? Transfer pricing is actually a topic for a managerial accounting discussion. Students, though, need to be aware that managerial and financial accounting do overlap at times. In this illustration, the price set by company officials for this component will affect the specific consolidation procedures needed in the preparation of financial statements for external reporting purposes. Since Slagle owns 100 percent of Harrison's common stock, consolidated net income will not be altered by the transfer pricing decision. All intra-entity transactions as well as unrealized profits will be removed entirely. However, because the sales are upstream, if a noncontrolling interest had been present, the portion of the subsidiary's net income attributed to these outside owners would be influenced by the markup. Both the noncontrolling interest figure on the balance sheet and on the income statement are impacted by the amount of profits that remain unrealized when transactions are from subsidiary to parent. To the accountant, the easiest approach is to set the transfer price at the seller's cost ($70.00 in this case). No intra-entity profits are created and the consolidation process is less complicated. However, as indicated in the narrative, that price may penalize the seller since no profits are recognized by that profit center. In addition, the buyer will then show artificially inflated income. Thus, some amount of profit is usually built into transfer pricing decisions. Those students who have already completed cost/managerial accounting can be asked to describe the various factors that should influence the establishment of this price. Interaction between accounting courses is beneficial to the students.
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Chapter 05 - Consolidated Financial Statements—Intra-Entity Asset Transactions
Answers to Questions 1.
2.
3.
4.
5.
6.
7.
One reason for the significant volume and frequency of intra-entity transfers is that many business combinations are specifically organized so that the companies can provide products for each other. This design is intended to benefit the business combination as a whole because of the economies provided by vertical integration. In effect, more profit can often be generated by the combination if one member is able to buy from another rather than from an outside party. The sales between Barker and Walden totaled $100,000. Regardless of the ownership percentage or the gross profit rate, the $100,000 was simply an intra-entity asset transfer. Thus, within the consolidation process, the entire $100,000 should be eliminated from both the Sales and the Purchases (Inventory) accounts. Sales price per unit ($900,000 ÷ 3,000 units) $ 300 Number of units in Safeco’s ending inventory × 500 Intra-entity inventory at transfer price $150,000 Gross profit rate (0.6 ÷ 1.6) .375 Intra-entity profit in ending inventory $ 56,250 In intra-entity transactions, a transfer price is often established that exceeds the cost of the inventory. Hence, the seller is recording a gross profit on its books that, from the perspective of the business combination as a whole, remains unrealized until the asset is consumed or sold to an outside party. Any unrealized gross profit on merchandise still held by the buyer must be deferred whenever consolidated financial statements are prepared. For the year of transfer, this consolidation procedure is carried out by removing the unrealized gross profit from the inventory account on the balance sheet and from the ending inventory balance within cost of goods sold. In the year following the transfer (if the goods are resold or consumed), the realized gross profit must be recognized within the consolidation process. Reductions are made on the worksheet to the beginning inventory component of cost of goods sold and to the beginning retained earnings balance of the original seller. The gross profit is thus taken out of last year’s earnings (retained earnings) and recognized in the current year through the reduction of cost of goods sold. If the transfer was downstream in direction and the parent company has applied the equity method, the adjustment in the subsequent year is made to the Investment in Subsidiary account rather than to retained earnings. On the individual financial records of James, Inc., a gross profit is recorded in the year of transfer. From the viewpoint of the business combination, this gross profit is actually earned in the period in which the products are sold or consumed by Matthews Co. An initial consolidation entry must be made in the year of transfer to defer any gross profit that remains unrealized. A second entry must be made in the following time period to allow the gross profit to be recognized in the year of its ultimate realization. Currently accounting pronouncement allow discretion regarding the effect of unrealized intraentity profits and noncontrolling interest values. This textbook reasons that unrealized profits relate to the seller and to the computation of the seller's income. Therefore, any unrealized profits created by upstream transfers (from subsidiary to parent) are attributed to the subsidiary. The effects resulting from the deferral and eventual recognition of these intra-entity profits are considered in the calculation of noncontrolling interest balances. In contrast, unrealized profits from downstream transfers are viewed as relating solely to the parent (as the seller) and, thus, have no effect on the noncontrolling interest. Consolidated financial statements are largely unchanged across downstream versus upstream transfers. Sales and purchases (Inventory) balances created by the transactions are eliminated in total. Any unrealized gross profits remaining at the end of a fiscal period get deferred until ultimately earned through sale or consumption of the assets.
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Chapter 05 - Consolidated Financial Statements—Intra-Entity Asset Transactions
8.
9.
10.
11.
The direction of intra-entity transfers (upstream versus downstream) does have one effect on consolidated financial statements. In computing noncontrolling interest balances (if present), the deferral of unrealized gross profits on upstream sales is taken into account. Downstream sales, however, are attributed to the parent and are viewed as having no impact on the outside interest. The computation of this noncontrolling interest balance depends on the direction of the intraentity transfers which is not indicated in the question. If the unrealized gross profits were created by downstream sales from King to Pawn, they relate only to King. The net income attributable to the noncontrolling interest is not affected and would be $11,000 ($110,000 × 10%). In contrast, if the transfers were upstream from Pawn to King, the deferral and recognition of the profits are attributed to Pawn. Pawn's "realized" net income would be $80,000 and the noncontrolling interest's share of consolidated net income is reported as $8,000: Pawn's reported net income ......................................... $110,000 Recognition of prior year unrealized gross profit .......... 30,000 Deferral of current year unrealized gross profit ............ (60,000) Pawn's realized net income .......................................... $ 80,000 Outside ownership percentage ..................................... 10% Net income attributable to noncontrolling interest .......... $ 8,000 The deferral and subsequent recognition of intra-entity profits are allocated to the noncontrolling interest in the same periods as the parent. When one affiliate sells to another affiliate, ownership does not change and therefore the underlying profit is deferred. When the purchasing affiliate subsequently sells the inventory to an entity outside the affiliated group, ownership changes, and the profit may be recognized. Intra-entity profits are not really eliminated, but simply deferred until a sale to an outsider takes place. Several differences can be cited that exist between the consolidated process applicable to inventory transfers and that which is appropriate for land transfers. The total intra-entity Sales balance is offset against Purchases (Inventory) when inventory is transferred but no corresponding entry is needed when land is involved. Furthermore, in the year of the sale, ending unrealized inventory gross profits are deferred through an adjustment to cost of goods sold, but a specific gross profit account exists (and must be removed) when land has been sold. Finally, unrealized inventory gross profits are usually expected to be realized in the year following the transfer. This effect is mirrored in that period by reduction of the beginning inventory figure (within cost of goods sold). For land transfers, however, the unrealized gain must be repeatedly deferred in each fiscal period for as long as the land continues to be held within the business combination. As long as the land is held by the parent, its recorded value must be reduced to historical cost within each consolidated set of financial statements. In the year of the original transfer, the asset reduction is offset against the subsidiary's recorded gain. For all subsequent years in which the property is held, the credit to the Land account is made against the beginning retained earnings balance of the subsidiary (since the unrealized gain will have been closed into that account). According to this question, the land is eventually sold to an outside party. The intra-entity gain (which has been deferred in each of the previous years) is realized by the sale and should be recognized in the consolidated statements of this later period. Because the transfer was upstream from subsidiary to parent, the above consolidated entries will also affect any noncontrolling interest balances being reported. Because of the deferral of the intra-entity gross profit, the realized net income balances applicable to the subsidiary will be less than the reported values. In the year of resale, however, the realized net income for consolidation purposes is higher than reported. All noncontrolling interest totals are computed on the realized balances rather than the reported figures.
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Chapter 05 - Consolidated Financial Statements—Intra-Entity Asset Transactions
12.
13.
Depreciable assets are often transferred between the members of a business combination at amounts in excess of book value. The buyer will then compute depreciation expense based on this inflated transfer price rather than on an historical cost basis. From the perspective of the business combination, depreciation should be calculated solely on historical cost figures. Thus, within the consolidation process for each period, adjustment of the depreciation (that is recorded by the buyer) is necessary to reduce the expense to a cost-based figure. From the viewpoint of the business combination, an unrealized gain has been created by the intra-entity transfer and must be deferred in the preparation of consolidated financial statements. This unrealized gain is closed by the seller into retained earnings necessitating subsequent reductions to that account. In the individual financial records, however, another income effect is created which gradually reduces the overstatement of retained earnings each period. The asset will be depreciated by the buyer based on the inflated transfer price. The resulting expense will be higher than the amount appropriate to the historical cost of the item. Because this excess depreciation is closed into retained earnings annually, the overstatement of the equity account is gradually reduced to a zero balance over the remaining life of the asset.
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Chapter 05 - Consolidated Financial Statements—Intra-Entity Asset Transactions
Answers to Problems 1. D 2. B Merchandise remaining in James’s inventory $250,000 × 40% = $100,000. Unrealized gross profit (based on subsidiary's gross profit rate as the seller) $100,000 × 30% = $30,000. James’s ownership percentage of Carl has no impact on this computation. 3. A 4. D UNREALIZED GROSS PROFIT, 12/31/14 Intra-entity gross profit ($200,000 – $160,000) ............................. Inventory remaining at year's end ................................................ Unrealized intra-entity gross profit, 12/31/14 ...............................
$40,000 18% $ 7,200
UNREALIZED GROSS PROFIT, 12/31/15 Intra-entity gross profit ($350,000 – $297,500) ............................. Inventory remaining at year's end ................................................ Unrealized intra-entity gross profit, 12/31/15 ...............................
$52,500 30% $15,750
CONSOLIDATED COST OF GOODS SOLD Parent balance .......................................................................... Subsidiary balance ................................................................... Remove intra-entity transfer .................................................... Recognize 2014 deferred gross profit ..................................... Defer 2015 unrealized gross profit .......................................... Cost of goods sold .........................................................................
$607,500 450,000 (350,000) (7,200) 15,750 $716,050
5. A Intra-entity sales and purchases of $100,000 must be eliminated. Additionally, an unrealized gross profit of $10,000 must be removed from ending inventory based on a gross profit rate of 25 percent ($200,000 gross profit ÷ $800,000 sales) which is multiplied by the $40,000 ending balance. This deferral increases cost of goods sold because ending inventory is a negative component of that computation. Thus, cost of goods sold for consolidation purposes is $690,000 ($600,000 + $180,000 – $100,000 + $10,000). 6. C The only change here from Problem 5 is the gross profit rate which would now be 40 percent ($120,000 gross profit $300,000 sales). Thus, the unrealized gross profit to be deferred is $16,000 ($40,000 × 40%). Consequently, consolidated cost of goods sold is $696,000 ($600,000 + $180,000 – $100,000 + $16,000).
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Chapter 05 - Consolidated Financial Statements—Intra-Entity Asset Transactions
7. B UNREALIZED GROSS PROFIT, 12/31/14 Ending inventory ....................................................................... Gross profit rate ($33,000 ÷ $110,000) ..................................... Unrealized intra-entity gross profit, 12/31/14 .........................
$40,000 30% $12,000
UNREALIZED GROSS PROFIT, 12/31/15 Ending inventory ....................................................................... Gross profit rate ($48,000 ÷ $120,000) ..................................... Unrealized intra-entity gross profit, 12/31/15 .........................
$50,000 40% $20,000
NET INCOME ATTRIBUTABLE TO NONCONTROLLING INTEREST Reported net income for 2015 .................................................. Realized gross profit deferred in 2014 .................................... Deferral of 2015 unrealized gross profit ................................. Realized net income of subsidiary .......................................... Outside ownership .................................................................... Noncontrolling interest ............................................................
$90,000 12,000 (20,000) $82,000 10% $ 8,200
8. A Individual records after transfer: 12/31/14 Machinery = $40,000 Gain = $10,000 Depreciation expense $8,000 ($40,000 ÷ 5 years) Net effect on income = $2,000 ($10,000 – $8,000) 12/31/15 Depreciation expense = $8,000 Consolidated figures—historical cost: 12/31/14 Machinery = $30,000 Depreciation expense = $6,000 ($30,000 ÷ 5 years) 12/31/15 Depreciation expense = $6,000 Adjustments for consolidation purposes: 2014: $2,000 income is reduced to a $6,000 expense (net income is reduced by $8,000) 2015: $8,000 expense is reduced to a $6,000 expense (net income is increased by $2,000)
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Chapter 05 - Consolidated Financial Statements—Intra-Entity Asset Transactions
9. D UNREALIZED GAIN Transfer price ............................................................................ Book value (original cost less two years depreciation) ........ Unrealized gain .......................................................................... EXCESS DEPRECIATION Annual depreciation based on cost ($460,000 ÷ 10 years) ..... Annual depreciation based on transfer price ($430,400 ÷ 8 years) ............................................................. Excess depreciation ................................................................. ADJUSTMENTS TO CONSOLIDATED NET INCOME Defer unrealized gain ................................................................ Remove excess depreciation ................................................... Net reduction in consolidated net income ..............................
$430,400 368,000 $ 62,400
$46,000 53,800 $ 7,800
$(62,400) 7,800 $(54,600)
10. D Add the two book values and remove $100,000 intra-entity transfers. 11. C Intra-entity gross profit ($100,000 - $80,000) ............................... Inventory remaining at year's end ................................................ Unrealized intra-entity gross profit ...............................................
$20,000 60% $12,000
CONSOLIDATED COST OF GOODS SOLD Parent balance .......................................................................... Subsidiary balance ................................................................... Remove intra-entity transfer .................................................... Defer unrealized gross profit (above) ..................................... Cost of goods sold .........................................................................
$140,000 80,000 (100,000) 12,000 $132,000
12. C Consideration transferred ............................ Noncontrolling interest fair value .................. Suarez total fair value ..................................... Book value of net assets ................................ Excess fair over book value Excess fair value to undervalued assets: Equipment .................................................. Secret Formulas ........................................ Total ...............................................................
$260,000 65,000 $325,000 (250,000) $ 75,000 Remaining Annual Excess Life Amortizations
$25,000 5 years 50,000 20 years -0-
$5,000 2,500 $7,500
Consolidated expenses = $37,500 (add the two book values and include current year amortization expense)
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Chapter 05 - Consolidated Financial Statements—Intra-Entity Asset Transactions
13. A 20% of the beginning book value Excess fair value allocation (20%× $75,000) 20% share of Suarez net income adjusted for amortization (20% × [110,000 – 7,500]) Ending noncontrolling interest balance
$50,000 15,000 20,500 $85,500
14. C Add the two book values plus the $25,000 original allocation less one year of excess amortization expense ($5,000). 15. B Add the two book values less the ending unrealized gross profit of $12,000. Combined pre-consolidation inventory balances ........................ $260,000 Intra-entity gross profit ($100,000 – $80,000) ................... $20,000 Inventory remaining at year's end .................................... 60% Unrealized intra-entity gross profit, 12/31 .................................... 12,000 Consolidated total for inventory .................................................... $248,000 16.
(15 Minutes) (Determine selected consolidated balances; includes inventory transfers and an outside ownership.) Customer list amortization = $78,000 ÷ 4 years = $19,500 per year Intra-entity gross profit ($180,000 – $130,000) ............................. Inventory remaining at year end .................................................... Unrealized intra-entity gross profit, 12/31 ....................................
$50,000 10% $ 5,000
CONSOLIDATED TOTALS ▪
Inventory = $795,000 (add the two book values and subtract the ending unrealized gross profit of $5,000)
▪
Sales = $1,620,000 (add the two book values and subtract the $180,000 intraentity transfer)
▪
Cost of goods sold = $725,000 (add the two book values and subtract the intraentity transfer and add [to defer] ending unrealized gross profit)
▪
Operating expenses = $549,500 (add the two book values and the amortization expense for the period)
▪
Barone’s net income........................................................... $100,000 Intra-entity gross profit deferral ........................................ (5,000) Excess fair value amortization .......................................... (19,500) Adjusted subsidiary net income ........................................ $75,500 Noncontrolling interest percentage .................................. 10% Net income attributable to noncontrolling interest ....... $ 7,550 Gross profit deferral is allocated to the noncontrolling interest because the transfer was upstream from Barone to Allister.
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Chapter 05 - Consolidated Financial Statements—Intra-Entity Asset Transactions
17.
(60 minutes) (Downstream intra-entity profit adjustments when parent uses equity method and a noncontrolling interest is present) Consideration transferred by Corgan Noncontrolling interest fair value Smashing’s acquisition-date fair value Book value of subsidiary Excess fair over book value Excess assigned to covenants Remaining useful life in years Annual amortization
$980,000 245,000 1,225,000 950,000 275,000 275,000 ÷ 20 $13,750
2014 Ending Inventory Profit Deferral ▪ ▪ ▪
Cost = $100,000 ÷ 1.6 = $62,500 Intra-entity gross profit = $100,000 – $62,500 = $37,500 Ending inventory gross profit = $37,500 × 40% = $15,000
2015 Ending Inventory Profit Deferral ▪ ▪ ▪
Cost = $120,000 ÷ 1.6 = $75,000 Intra-entity gross profit = $120,000 – $75,000 = $45,000 Ending inventory gross profit = $45,000 40% = $18,000
a. Investment account: Consideration transferred, January 1, 2014 Smashing’s 2014 net income × 80% Covenant amortization (13,750 × 80%) Ending inventory profit deferral (100%) Equity in Smashing’s earnings 2014 dividends Investment balance 12/31/14 Smashing’s 2015 net income × 80% Covenants amortization (13,750 × 80%) Beginning inventory profit recognition Ending inventory profit deferral (100%) Equity in Smashing’s earnings 2015 dividends Investment balance 12/31/15
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$980,000 $120,000 (11,000) (15,000) 94,000 (28,000) $1,046,000 $104,000 (11,000) 15,000 (18,000) 90,000 (36,000) $1,100,000
Chapter 05 - Consolidated Financial Statements—Intra-Entity Asset Transactions
17. (continued) b. 12/31/15 Worksheet Adjustments *G Investment in Smashing Cost of goods sold
15,000
S Common stock—Smashing Retained earnings—Smashing Investment in Smashing Noncontrolling interest
700,000 365,000
A Covenants Investment in Smashing Noncontrolling interest
261,250
I
90,000
15,000
209,000 52,250
Equity in earnings of Smashing Investment in Smashing
90,000
D Investment in Smashing Dividends declared
36,000
E Amortization expense Covenants
13,750
TI Sales Cost of goods sold
120,000
G Cost of goods sold Inventory
18,000
36,000
13,750
120,000
18,000
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852,000 213,000
Chapter 05 - Consolidated Financial Statements—Intra-Entity Asset Transactions
18.
(40 Minutes) (Series of independent questions concerning various aspects of the consolidation process when intra-entity transfers have occurred) a. Placid Lake's 2015 net income before effect from Scenic...... Scenic's reported net income 2015 ......................................... Amortization expense (given) ................................................. Realization of 2014 intra-entity gross profit (see below) ...... Deferral of 2015 intra-entity gross profit (see below) ............ Consolidated net income ..........................................................
$300,000 110,000 (5,000) 7,200 (16,200) $396,000
2014 Unrealized gross profit to be recognized in 2015: Intra-entity gross profit on transfers ($90,000 – $54,000) ...... Inventory retained at end of 2014 ............................................ Unrealized gross profit—12/31/14 ......................................
$36,000 20% $ 7,200
2015 Unrealized gross profit deferred: Intra-entity gross profit on transfers ($120,000 – $66,000) .... Inventory retained at end of 2015 ............................................ Unrealized gross profit—12/31/15 .......................................
$54,000 30% $16,200
b. Noncontrolling interest's share of consolidated net income (upstream sales): Scenic's reported net income 2015 .......................................... Amortization of excess fair value to intangibles ..................... 2014 gross profit realized in 2015 (upstream sales) .............. 2015 gross profit deferred (upstream sales) .......................... Scenic's realized net income ................................................... Noncontrolling interest ownership .......................................... Noncontrolling interest share of consolidated net income ....
$110,000 (5,000) 7,200 (16,200) $96,000 20% $19,200
Placid Lake’s net income from own operations ...................... Placid Lake’s share of Scenic’s adjusted NI (80%× $96,000) ... Placid Lake’s share of consolidated net income ...................
$300,000 76,800 $376,800
c. Noncontrolling interest's share of consolidated net income (downstream sales): Downstream transfers do not affect the noncontrolling interest. Scenic's reported net income 2015 after amortization ........... Noncontrolling interest ownership .......................................... Noncontrolling interest share of consolidated net income ...
$105,000 20% $21,000
Placid Lake’s net income from own operations ...................... Placid Lake’s share of Scenic’s adjusted NI (80% × $105,000) Realization of 2014 intra-entity gross profit (see part a.) ..... Deferral of 2015 intra-entity gross profit (see part a.) ............ Placid Lake’s share of consolidated net income ...................
$300,000 84,000 7,200 (16,200) $375,000
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Chapter 05 - Consolidated Financial Statements—Intra-Entity Asset Transactions
18. (continued) d. Inventory—Placid Lake book value ......................................... Inventory—Scenic book value ................................................. Unrealized gross profit, 12/31/15 (see part a) ......................... Consolidated inventory ............................................................ (Direction of transfer has no impact here)
$140,000 90,000 (16,200) $213,800
e. Land—Placid Lake’s book value ............................................. Land—Scenic's book value ...................................................... Elimination of unrealized intra-entity gain on land ................ Consolidated land balance ......................................................
$600,000 200,000 (20,000) $780,000
f. The intra-entity transfer was upstream from Scenic to Placid Lake. Because the transfer occurred in 2014, beginning retained earnings of the seller for 2015 contains the remaining portion of the unrealized gain. Transfer pricing figures: 2014
Equipment Gain Depreciation expense Income effect Accumulated depreciation
= = = = =
$80,000 $20,000 ($80,000 – $60,000) $16,000 ($80,000 ÷ 5) $4,000 ($20,000 – $16,000) $16,000
2015
Depreciation expense Accumulated depreciation
= =
$16,000 $32,000
Historical cost figures: 2014
Equipment Depreciation expense Accumulated depreciation
= = =
$100,000 $12,000 ($60,000 ÷ 5 years) $52,000 ($40,000 + $12,000)
2015
Depreciation expense Accumulated depreciation
= =
$12,000 $64,000
CONSOLIDATION ENTRIES FOR TRANSFERRED EQUIPMENT ENTRY *TA Retained earnings, 1/1/15 (Scenic) .......................... Equipment ($100,000 – $80,000) .............................. Accumulated depreciation ($52,000 – $16,000) ..
16,000 20,000 36,000
To change beginning of year figures to historical cost by removing impact of 2014 transactions. Retained earnings reduction removes $4,000 income effect (above) and replaces it with $12,000 depreciation expense for 2014.
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Chapter 05 - Consolidated Financial Statements—Intra-Entity Asset Transactions
18. (continued) ENTRY ED Accumulated depreciation ....................................... 4,000 Depreciation expense .......................................... 4,000 To reduce depreciation from transfer price ($16,000) to historical cost of $12,000. This intra-entity transfer was upstream from Scenic to Placid Lake. Thus, income effects are assumed to relate to the original seller (Scenic). Because the sale occurred in 2014, the only effect in 2015 relates to depreciation expense. The expense based on the transfer price is $4,000 higher than the amount based on the historical cost. As an upstream transfer, this adjustment affects Scenic and the noncontrolling interest computations. Transfer price depreciation: $80,000 ÷ 5 yrs. = $16,000 Historical cost depreciation (based on book value): $60,000 ÷ 5 yrs. = $12,000 Net income attributable to noncontrolling interest Scenic's reported net income less excess amortization ........ Reduction of depreciation expense to historical cost figure .. Scenic's realized net income ..................................................... Outside ownership percentage ................................................. Net income attributable to noncontrolling interest ............
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$105,000 4,000 $109,000 20% $ 21,800
Chapter 05 - Consolidated Financial Statements—Intra-Entity Asset Transactions
19.
(20 Minutes) (Consolidation entries and noncontrolling interest balances affected by inventory transfers.) a. Conversion from Markup on Cost to Gross Profit Rate Markup (given as a percentage of cost) ..................................
25%
Convert to gross profit rate [.25 (1.00 + 0.25)] ......................
20%
Noncontrolling Interest's Share of Consolidated Net Income Reported net income of subsidiary—2015 .............................. $160,000 2014 intra-entity gross profit realized in 2015 ($250,000 × 30% × 20%) ........................................................ 15,000 2015 intra-entity gross profit deferred ($300,000 × 30% × 20%) ........................................................ (18,000) Realized net income of subsidiary—2015 ......................... $157,000 Outside ownership .................................................................... 40% Noncontrolling interest's share of consolidated net income $ 62,800 b. Entry *G Retained earnings, Jan. 1 (subsidiary) ......... 15,000 Cost of goods sold .................................... 15,000 To remove intra-entity gross profit from previous year so that it can be recognized in current year. Entry Tl Sales ................................................................. 300,000 Cost of goods sold .................................... To eliminate intra-entity inventory sale and purchase. Entry G Cost of goods sold ......................................... 18,000 Inventory .................................................... To remove effects of current year unrealized gross profit.
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300,000
18,000
Chapter 05 - Consolidated Financial Statements—Intra-Entity Asset Transactions
20.
(30 Minutes) (Compute selected balances based on three different intra-entity asset transfer scenarios) a. Consolidated Cost of Goods Sold Protrade’s cost of goods sold ................................................. Seacraft’s cost of goods sold .................................................. Elimination of 2015 intra-entity transfers ............................... Realized gross profit deferred in 2014 (2015 beginning inventory) $52,000 transfer price ÷ 1.6 = $32,500 cost $52,000 – $32,500 = $19,500 unrealized gross profit ...... Deferral of 2015 unrealized gross profit in ending inventory: $66,000 transfer price ÷ 1.6 = $41,250 cost $66,000 – $41,250 = $24,750 unrealized gross profit ...... Consolidated cost of goods sold ............................................ Consolidated Inventory Protrade book value ............................................................ Seacraft book value ............................................................. Defer ending unrealized gross profit (see above) ............ Consolidated Inventory .......................................................
$410,000 317,000 (134,000)
(19,500)
24,750 $598,250
$370,000 144,000 (24,750) $489,250
Net income attributable to noncontrolling interest: Because all intra-entity sales were downstream, the deferrals do not affect Seacraft. Thus, the noncontrolling interest share is 20% of the $154,000 reported net income (revenues minus cost of goods sold and expenses) or $30,800. b. Consolidated Cost of Goods Sold Protrade book value ................................................................. Seacraft book value .................................................................. Elimination of 2015 intra-entity transfers ............................... Realized gross profit deferred in 2014 (2015 beginning inventory) $45,000 transfer price ÷ 1.6 = $28,125 cost $45,000 – $28,125 = $16,875 unrealized gross profit ........ Deferral of 2015 unrealized gross profit in ending inventory: $59,000 transfer price ÷ 1.6 = $36,875 cost $59,000 – $36,875 = $22,125 unrealized gross profit ........ Consolidated cost of goods sold ............................................
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$410,000 317,000 (104,000)
(16,875)
22,125 $628,250
Chapter 05 - Consolidated Financial Statements—Intra-Entity Asset Transactions
20. b. (continued) Consolidated inventory Protrade book value ................................................................. Seacraft book value .................................................................. Defer ending unrealized gross profit (see above) .................. Consolidated inventory ............................................................
$370,000 144,000 (22,125) $491,875
Net income attributable to noncontrolling interest Since all intra-entity sales are upstream, the effect on Seacraft's net income must be reflected in the noncontrolling interest computation: Seacraft reported net income .................................................. 2014 unrealized gross profit realized in 2015 (above) ........... 2015 unrealized gross profit deferred until 2016 (above) ...... Seacraft realized net income ................................................... Outside ownership percentage ................................................ Net income attributable to noncontrolling interest .................
$154,000 16,875 (22,125) $148,750 20% $ 29,750
c. Consolidated buildings (net): Protrade’s buildings .............................................. Seacraft's buildings ............................................... Remove write-up created by transfer ($128,000 – $74,000) ......................................... Remove excess depreciation created by transfer ($54,000 unrealized gain ÷ 5-year remaining life × 2 years) .................................. Consolidated buildings (net) ................................
$382,000 181,000 $(54,000)
21,600
(32,400) $530,600
Consolidated expenses: Protrade’s book value ........................................... Seacraft's book value ............................................ Remove excess depreciation on transferred building ($54,000 unrealized gain ÷ 5 year remaining life) Consolidated expenses .........................................
$174,000 129,000 (10,800) $292,200
Net income attributable to noncontrolling interest: Because the transfer was made downstream, it has no effect on the noncontrolling interest. Thus, Seacraft's reported net income ($154,000 computed as revenues minus cost of goods sold and expenses) is used for this computation. The 20 percent outside ownership will be allotted consolidated net income of $30,800 (20% × $154,000).
5-18 ..
Chapter 05 - Consolidated Financial Statements—Intra-Entity Asset Transactions
21.
(15 Minutes) (Prepare consolidated income statement with a wholly-owned subsidiary, includes transfers) a. In this business combination, the direction of the intra-entity transfers (either upstream or downstream) is not important to the consolidated totals. Because Akron controls all of Toledo's outstanding stock, no noncontrolling interest figures are computed. If present, noncontrolling interest balances are affected by upstream sales but not by downstream. For purposes of a 2015 consolidation, the following worksheet entries would affect income statement balances: Entry *G Retained earnings, 1/1/15 (seller) ....... 17,500 Cost of goods sold ......................... 17,500 To remove 2014 unrealized gross profit from beginning account balances. Gross profit is the 25% gross profit rate ($80,000 ÷ $320,000) multiplied by remaining inventory ($70,000). Entry E Amortization expense .......................... 15,000 Patented technology ...................... 15,000 To recognize excess amortization expense for the current period. Entry Tl Sales ...................................................... 320,000 Cost of goods sold ......................... 320,000 To eliminate intra-entity transfers of inventory during 2015. Entry G Cost of goods sold .............................. 12,500 Inventory ......................................... 12,500 To remove 2015 unrealized gross profit from ending account balances. Gross profit is the 25% gross profit rate ($80,000 ÷ $320,000) multiplied by remaining inventory ($50,000). b. By including the impact of each of these four consolidation entries, the following income statement can be created from the individual account balances: AKRON, INC. AND CONSOLIDATED SUBSIDIARY Income Statement Year Ending December 31, 2015 Sales ..................................................................................... $1,380,000 Cost of goods sold .............................................................. 575,000 Gross profit ..................................................................... 805,000 Operating expenses ............................................................ 635,000 Consolidated net income ............................................... $170,000
5-19 ..
Chapter 05 - Consolidated Financial Statements—Intra-Entity Asset Transactions
22.
(60 minutes) (Downstream intra-entity asset transfer when parent uses equity method and when a noncontrolling interest is present) a. Investment account: Consideration paid (fair value) 1/1/14 $810,000 Netspeed’s reported net income for 2014 $80,000 Database amortization (12,000) Netspeed’s adjusted net income $68,000 Quickport's ownership percentage 90% Quickport's share of Netspeed’s net income $61,200 Gain on equipment transfer deferral (3,000) Depreciation adjustment (6 months) 500 Equity in earnings of Netspeed Company, $58,700 Quickport’s share of Netspeed’s dividends (90%) (7,200) Balance 12/31/14 $861,500 Netspeed’s reported net income for 2015 $115,000 Database amortization (12,000) Netspeed’s adjusted 2015 net income $103,000 Quickport's ownership percentage 90% Quickport's share of Netspeed net income $ 92,700 Depreciation adjustment 1,000 Equity in earnings of Netspeed Company, 2015 $93,700 Quickport’s share of Netspeed’s dividends, 2015 (90%) (7,200) Balance 12/31/15 $948,000 b. 12/31/15 Worksheet Adjustments *TA
Equipment 6,000 Investment in Netspeed 2,500 Accumulated depreciation 8,500 To transfer the unrealized intra-entity equipment reduction (as of Jan. 1, 2015) from the Investment account to the equipment and A.D. accounts. S
A
I D
Common stock—Netspeed Retained earnings—Netspeed Investment in Netspeed Noncontrolling interest
800,000 112,000
Database Investment in Netspeed Noncontrolling interest
48,000
Equity in earnings of Netspeed Investment in Netspeed
93,700
Investment in Netspeed Dividends declared
7,200
43,200 4,800 93,700 7,200
5-20 ..
820,800 91,200
Chapter 05 - Consolidated Financial Statements—Intra-Entity Asset Transactions
22. (continued) E
Amortization expense Database
12,000
ED Accumulated depreciation Depreciation expense
1,000
12,000 1,000
23. (20 Minutes) (Consolidation entries for intra-entity equipment transfer.) INDIVIDUAL RECORDS BASED ON TRANSFER PRICE 12/31/13 Equipment = $95,000 Gain on transfer = $45,000 ($95,000 – $50,000) Depreciation expense = $19,000 ($95,000 ÷ 5 years) Accumulated depreciation = $19,000 12/31/14 Depreciation expense $19,000 Accumulated depreciation = $38,000 (2 years) 12/31/15 Effect on retained earnings, 1/1/15 = $7,000 credit balance (gain less two years depreciation) Depreciation expense = $19,000 Accumulated depreciation = $57,000 (3 years) CONSOLIDATED REPORTING BASED ON HISTORICAL COST 12/31/13 Equipment = $130,000 Depreciation expense = $10,000 ($50,000 ÷ 5 years) Accumulated depreciation = $90,000 ($80,000 + $10,000) 12/31/14 Depreciation expense = $10,000 Accumulated depreciation = $100,000 ($90,000 + $10,000) 12/31/15 Effect on retained earnings, 1/1/15 = ($20,000) (two years depreciation) Depreciation expense = $10,000 Accumulated depreciation = $110,000 ($100,000 + $10,000) Entry *TA Retained earnings, 1/1/15 (Padre) ....................................... Equipment ($130,000 – $95,000) .................................... Accumulated depreciation ($100,000 – $38,000) ..........
27,000 35,000 62,000
To adjust to beginning-of-year balances for consolidated entity. Retained earnings adjustment reduces $7,000 credit balance to $20,000 debit balance as computed above. Entry ED Accumulated depreciation .................................................... Depreciation expense ................................................
9,000 9,000
To remove excess depreciation for current year to reflect an allocation of the historical cost ($10,000) rather than the transfer price ($19,000).
5-21 ..
Chapter 05 - Consolidated Financial Statements—Intra-Entity Asset Transactions
24.
(20 Minutes) (Determine consolidated net income when an intra-entity transfer of equipment occurs. Includes an outside ownership) a. Net income—Ackerman ............................................................ Net income—Brannigan ............................................................ Excess amortization for unpatented technology .................... Remove unrealized gain on equipment .................................. ($200,000 – $110,000) Remove excess depreciation created by inflated transfer price ($90,000 ÷ 5) .................................... Consolidated net income .........................................................
$300,000 98,000 (4,000) (90,000)
18,000 $322,000
b. Net income calculated in (part a.) ............................................ $322,000 Net income attributable to noncontrolling interest: Net income—Brannigan ......................................... $98,000 Excess amortization .............................................. (4,000) Adjusted net income .............................................. $94,000 NI attributable to the noncontrolling interest ...................... 10% (9,400) Consolidated net income to parent company ......................... $312,600 c. Net income calculated in (part a.) ............................................ NI attributable to noncontrolling interest (see Schedule 1) ... Consolidated net income to parent company .........................
$322,000 (2,200) $319,800
Schedule 1: Net income attributable to noncontrolling interest (includes upstream transfer) Reported subsidiary net income .............................................. Excess amortization .................................................................. Defer unrealized gain on equipment transfer ......................... Eliminate excess depreciation ($90,000 ÷ 5) .......................... Brannigan's realized net income ............................................. Outside ownership .................................................................... Net income attributable to noncontrolling interest ..........
$98,000 (4,000) (90,000) 18,000 $22,000 10% $ 2,200
d. Net income 2016—Ackerman ................................................... Net income 2016—Brannigan .................................................. Excess amortization .................................................................. Eliminate excess depreciation stemming from transfer ($90,000 ÷ 5) (year after transfer) ....................................... Consolidated net income ................................................
320,000 108,000 (4,000)
5-22 ..
18,000 $442,000
Chapter 05 - Consolidated Financial Statements—Intra-Entity Asset Transactions
25.
(35 minutes) (Compute consolidated totals with transfers of both inventory and a building.) Excess Amortization Expenses Equipment $60,000 ÷ 10 years = $ 6,000 per year Franchises $80,000 ÷ 20 years = 4,000 per year Annual excess amortizations $10,000 Unrealized Gross Profit—Inventory, 1/1/15: Gross profit ($70,000 – $49,000) .............................................. Gross profit rate ($21,000 ÷ $70,000) .......................................
$21,000 30%
Remaining inventory ................................................................ Gross profit rate ........................................................................ Unrealized gross profit, 1/1/15 ..................................................
$30,000 30% $ 9,000
Unrealized Gross Profit—Inventory, 12/31/15: Gross profit ($100,000 – $50,000) ............................................ Gross profit rate ($50,000 ÷ $100,000) .....................................
$50,000 50%
Remaining inventory ................................................................ Gross profit rate ......................................................................... Unrealized gross profit, 12/31/15 .............................................
$40,000 50% $20,000
Impact of Intra-Entity Building Transfer: 12/31/14—Transfer price figures Transfer price ....................................................................... Gain on transfer ($50,000 – $30,000) .................................. Depreciation expense ($50,000 ÷ 5 years) ......................... Accumulated depreciation .................................................. 12/31/15—Transfer price figures Depreciation expense ......................................................... Accumulated depreciation .................................................. 12/31/14—Historical cost figures Historical cost ...................................................................... Depreciation expense ($30,000 book value ÷ 5 years) ..... Accumulated depreciation ($40,000 + $6,000) .................. 12/31/15—Historical cost figures Depreciation expense ......................................................... Accumulated depreciation ..................................................
5-23 ..
$50,000 20,000 10,000 10,000 10,000 20,000 $70,000 6,000 46,000 6,000 52,000
Chapter 05 - Consolidated Financial Statements—Intra-Entity Asset Transactions
25. (continued) CONSOLIDATED BALANCES ▪
Sales = $1,000,000 (add the two book values and subtract $100,000 in intra-entity transfers)
▪
Cost of Goods Sold = $571,000 (add the two book values and subtract $100,000 in intra-entity purchases. Subtract $9,000 because of the previous year unrealized gross profit and add $20,000 to defer the current year unrealized gross profit.)
▪
Operating Expenses = $206,000 (add the two book values and include the $10,000 excess amortization expenses but remove the $4,000 in excess depreciation expense [$10,000 – $6,000] created by building transfer)
▪
Investment Income = $0 (the intra-entity balance is removed so that the individual revenue and expense accounts of the subsidiary can be shown)
▪
Inventory = $280,000 (add the two book values and subtract the $20,000 ending unrealized gross profit)
▪
Equipment (net) = $292,000 (add the two book values and include the $60,000 allocation from the acquisition-date fair value less three years of excess amortizations)
▪
Buildings (net) = $528,000 (add the two book values and subtract the $20,000 unrealized gain on the transfer after two years of excess depreciation [$4,000 per year])
5-24 ..
Chapter 05 - Consolidated Financial Statements—Intra-Entity Asset Transactions
26.
(35 Minutes) (Prepare consolidation entries for a business combination with intraentity inventory and equipment transfers; includes an outside ownership.) a. Entry *G Retained earnings, 1/1/15 (Sledge) ............... 2,000 Cost of goods sold .................................... 2,000 To remove unrealized gross profit from beginning account balances. This is the 40% gross profit rate ($6,000 ÷ $15,000) multiplied by remaining inventory ($5,000). Entry *TA Equipment ........................................................ 4,000 Investment in Sledge ...................................... 2,400 Accumulated depreciation ....................... 6,400 To adjust the equipment balance to original cost ($16,000) and to adjust accumulated depreciation to the correct consolidated January 1, 2015 balance ($7,000 less $600 extra depreciation in 2014). The net reduction to the reported equipment balance (cost less A.D. = $2,400) equals the amount of unrealized gain at January 1, 2015. The $2,400 debit to the Investment account appropriately transfers the reduction in the net book value of the transferred equipment to the subsidiary’s accounts. The Investment account was reduced by $3,000 in 2014 for the original intra-entity gain and increased by $600 in 2014 for the extra depreciation ($3,000 gain ÷ 5 years) through application of the equity method. Entry ED (below) completes the adjustment of A.D. and depreciation expense to their correct December 31, 2015 balances. Entry S Common stock (Sledge) .......................................... 120,000 Retained earnings, 1/1/15 (adjusted) (Sledge) ........ 258,000 Investment in Sledge (80%) ................................ 302,400 Noncontrolling interest in Sledge, 1/1/15 (20%) 75,600 To eliminate subsidiary's stockholders' equity accounts (after adjustment for Entry *G) and recognize noncontrolling interest balance as of January 1, 2015. Entry A Contracts ($60,000 – $3,000 for 2 years) ................ 54,000 Buildings ($20,000 – $2,000 for 2 years) ................. 16,000 Investment in Sledge (80%) ................................. 56,000 Noncontrolling interest in Sledge, 1/1/15 (20%) 14,000 To recognize acquisition-date fair value allocations adjusted for 2 years of amortization (2013 and 2014).
5-25 ..
Chapter 05 - Consolidated Financial Statements—Intra-Entity Asset Transactions
26. (continued) Entry I Equity in income of Sledge ...................................... 10,600 Investment in Sledge .......................................... 10,600 To remove parent’s recognized intra-entity income using equity method. Subsidiary reported net income .................................................................... Realized upstream intra-entity gross profit in beginning inventory ...... Deferred upstream intra-entity gross profit in ending inventory ............ Excess amortization .................................................................................... 2015 realized subsidiary net income ............................................................. Parent’s ownership percentage ..................................................................... Parent’s share of subsidiary realized net income ....................................... Depreciation adjustment from 2014 downstream fixed asset sale ......... Parent’s recorded 2015 equity income from subsidiary .............................
Entry E Depreciation expense ............................................... Amortization expense ............................................... Contracts ($60,000 ÷ 20 years) ........................... Buildings ($20,000 ÷ 10 years) ........................... To recognize 2015 excess amortizations.
$20,000 2,000 (4,500) (5,000) $12,500 80% $10,000 600 $10,600
2,000 3,000
Entry TI Sales ........................................................................... 20,000 Cost of goods sold .............................................. To eliminate intra-entity inventory transfers during 2015.
3,000 2,000
20,000
Entry G Cost of goods sold ................................................... 4,500 Inventory .............................................................. 4,500 To remove unrealized gross profit from ending account balances. The gross profit is the 45% gross profit rate ($9,000 ÷ $20,000) multiplied by remaining inventory ($10,000). Entry ED Accumulated depreciation ....................................... 600 Depreciation expense ......................................... 600 To eliminate excess depreciation on equipment recorded at transfer price. Expense is being reduced from the recorded amount ($2,400 or $12,000 ÷ 5) to historical cost figure ($1,800 or $9,000 ÷ 5).
5-26 ..
Chapter 05 - Consolidated Financial Statements—Intra-Entity Asset Transactions
26. (continued) b. Net income attributable to noncontrolling interest (2015) Revenues .................................................................................... Cost of goods sold ................................................................... Other expenses ......................................................................... Excess acquisition-date fair value amortization ..................... Net income adjusted for amortization ............................... Gross profit on 2014 upstream inventory transfer realized in 2015 (Entry *G) ................................................. Gross profit on 2015 upstream inventory transfer deferred until 2016 (Entry G) .............................................. Realized net income of subsidiary—2015................................ Outside ownership .................................................................... Net income attributable to noncontrolling interest .......... 27.
$130,000 (70,000) (40,000) (5,000) $15,000 2,000 (4,500) $12,500 20% $ 2,500
(65 Minutes) (Determine consolidation totals after answering a series of questions about combination and intra-entity inventory transfers) a. Consideration transferred ....................... $342,000 Noncontrolling interest fair value ............. 38,000 Subsidiary fair value at acquisition-date 380,000 Book value.................................................. (326,000) Fair value in excess of book value .......... $54,000 Remaining Annual Excess Excess fair value assignments Life Amortizations To building ........................................... 18,000 9 yrs. $2,000 To patented technology ...................... 36,000 6 yrs. 6,000 Totals ..................................................... -0$8,000 b. Because Brey sold inventory to Pitino, the transfers are upstream. c. Gross profit on 2014 transfers ($135,000 – $81,000) .............. Gross profit percentage ($54,000 ÷ $135,000) ........................
$54,000 40%
Inventory remaining, 12/31/14 ................................................. Gross profit percentage ........................................................... Unrealized gross profit, January 1, 2015 ...............................
$37,500 40% $15,000
d. Gross profit on 2015 transfers ($160,000 – $92,800) ............. Gross profit percentage ($67,200 ÷ $160,000) ........................
$67,200 42%
Inventory remaining, 12/31/15 ................................................. Gross profit percentage ........................................................... Unrealized gross profit, December 31, 2015 ...........................
$50,000 42% $21,000
5-27 ..
Chapter 05 - Consolidated Financial Statements—Intra-Entity Asset Transactions
27. (continued) e. Pitino is applying the equity method because the $68,400 equals neither 90% of Brey's reported net income nor 90% of the dividends declared by Brey. Brey’s reported net income ..................................................... Excess fair value amortization ................................................. Realized gross profit ............................................................... Deferred gross profit ................................................................. Adjusted subsidiary net income ............................................... Ownership ................................................................................. Equity in earnings of Brey .......................................................
$90,000 (8,000) 15,000 (21,000) $76,000 90% $68,400
f. Brey’s adjusted net income (see e.) ........................................ Outside ownership .................................................................... Net income attributable to noncontrolling interest ................
$76,000 10% $ 7,600
g. Investment in Brey (consideration transferred) ..................... Net income of Brey Reported 2013 ....................................... $64,000 2014 ................................................. 80,000 2015 ................................................ 90,000 Total ................................................ 234,000 Unrealized gross profit, 12/31/15(see d.) (21,000) Realized net income 2013-2015 ......... 213,000 Pitino’s ownership ............................... 90% Excess amortizations ($8,000 × 3 years × 90%)
$342,000
Dividends declared by Brey 2013 ................................................. 2014 ................................................. 2015 ................................................ Total ................................................ Pitino's ownership ............................... Investment in Brey, 12/31/15 ................... h. Entry S Common stock (Brey) ............................... Retained earnings, 1/1/15 (Brey) (reduced by 1/1/15 unrealized gross profit) ................. Investment in Brey (90%) .................... Noncontrolling interest in Brey (10%)
5-28 ..
$19,000 23,000 27,000 69,000 90%
191,700 (21,600)
(62,100) $450,000
150,000 263,000 371,700 41,300
Chapter 05 - Consolidated Financial Statements—Intra-Entity Asset Transactions
27. (continued) part i. ▪
Sales Revenues = $1,068,000 (total less $160,000 intra-entity sales)
▪
Cost of Goods Sold = $570,000 (add book values less $160,000 in intra-entity purchases. Also, adjust for 2014 unrealized gross profit [subtract $15,000] and 2015 unrealized gross profit [add $21,000])
▪
Expenses = $260,400 (add book values with $8,000 amortization for excess fair value allocations)
▪
Equity in Earnings of Brey = $0 (intra-entity balance is eliminated to include individual revenue and expense accounts of the subsidiary)
▪
Consolidated Net Income = $237,600 (consolidated revenues less COGS and expenses)
▪
Net Income Attributable to Noncontrolling Interest = $7,600 (see f.)
▪
Net Income to Pitino (parent) = $230,000 (consolidated revenues less consolidated cost of goods sold, expenses, and the noncontrolling interest's share of the subsidiary's net income)
▪
Retained Earnings, 1/1 = $488,000 (parent equity method balance)
▪
Dividends Declared = $136,000 (parent balance only)
▪
Retained Earnings, 12/31 = $582,000 (consolidated beginning balance plus net income less dividends declared)
▪
Cash and Receivables = $228,000 (total less $16,000 intra-entity balance)
▪
Inventory = $370,000 (total less ending unrealized gross profit)
▪
Investment in Brey = $0 (intra-entity balance is eliminated so that the individual assets and liabilities of the subsidiary can be reported)
▪
Land, Buildings, and Equipment = $1,304,000 (add book values and include a $12,000 net allocation after 3 years of amortization)
▪
Patented Technology = $18,000 (original allocation after 3 years of amortization [$6,000 per year])
▪
Total Assets = $1,920,000 (add consolidated figures)
▪
Liabilities = $773,000 (add book values less $16,000 intra-entity balance)
▪
Noncontrolling Interest in Brey, 12/31 = $50,000 ([10% of subsidiary's book value at beginning of period plus unamortized excess less beginning unrealized gross profit] plus 10% of the subsidiary's realized net income less 10% of subsidiary dividends).
▪
Common Stock = $515,000 (parent balance only)
▪
Retained Earnings, 12/31 = $582,000 (see above)
▪
Total Liabilities and Stockholders' Equity = $1,920,000 (summation)
5-29 ..
Chapter 05 - Consolidated Financial Statements—Intra-Entity Asset Transactions
28.
(20 Minutes) (Computation of selected consolidation balances as affected by downstream inventory transfers) UNREALIZED GROSS PROFIT, 12/31/14: (downstream transfer) Intra-entity gross profit ($120,000 – $72,000) ......................... Inventory remaining at year's end ........................................... Unrealized intra-entity gross profit, 12/31/14 ...............................
$48,000 30% $14,400
UNREALIZED GROSS PROFIT, 12/31/15: (downstream transfer) Intra-entity gross profit ($250,000 – $200,000) ....................... Inventory remaining at year's end ........................................... Unrealized intra-entity gross profit, 12/31/15 ...............................
$50,000 20% $10,000
CONSOLIDATED TOTALS ▪ Sales = $1,150,000 (combine amounts and eliminate intra-entity sales of $250,000) ▪
Cost of goods sold: Brannigan's book value ............................................................ Zeigler's book value .................................................................. Eliminate intra-entity transfers ................................................ Realized gross profit deferred in 2014 .................................... Deferral of 2015 unrealized gross profit ................................. Cost of goods sold ..............................................................
▪
Operating expenses = $210,000 (add the two book values and include intangible amortization for current year)
▪
Dividend income = -0- (intra-entity transfer eliminated in consolidation)
▪
Net income attributable to noncontrolling interest: (impact of transfers is not included because they were downstream) Zeigler reported net income for 2015 ................................. $(100,000) Intangible amortization ........................................................ 10,000 Zeigler adjusted net income ................................................ (90,000) Outside ownership .............................................................. 30% Net income attributable to noncontrolling interest ...... $(27,000)
▪
Inventory = $980,000 (combine amounts less the $10,000 ending unrealized gross profit)
▪
Noncontrolling interest in subsidiary 30% beginning $950,000 book value...................................... $(285,000) Excess January 1 intangible allocation (30% × $395,000) ... (118,500) Net income attributable to noncontrolling interest .............. (27,000) Dividends (30% × $50,000) ...................................................... 15,000 Total noncontrolling interest at 12/31/15 ............................... $(415,500)
5-30 ..
$535,000 400,000 (250,000) (14,400) 10,000 $680,600
Chapter 05 - Consolidated Financial Statements—Intra-Entity Asset Transactions
29.
(25 Minutes) (Computation of selected consolidation balances as affected by upstream inventory transfers) UNREALIZED GROSS PROFIT, 12/31/14: (upstream transfer) Intra-entity gross profit ($120,000 – $72,000) ......................... Inventory remaining at year's end ........................................... Unrealized intra-entity gross profit, 12/31/14 ...............................
$48,000 30% $14,400
UNREALIZED GROSS PROFIT, 12/31/15: (upstream transfer) Intra-entity gross profit ($250,000 – $200,000) ....................... Inventory remaining at year's end ........................................... Unrealized intra-entity gross profit, 12/31/15 ...............................
$50,000 20% $10,000
CONSOLIDATED TOTALS ▪ Sales = $1,150,000 (combine amounts and eliminate intra-entity transfer) ▪ Cost of goods sold: Brannigan's COGS book value ................................................ $535,000 Zeigler's COGS book value ...................................................... 400,000 Eliminate intra-entity transfers ................................................ (250,000) Realized gross profit deferred in 2014 .................................... (14,400) Deferral of 2015 unrealized gross profit ................................. 10,000 Consolidated cost of goods sold ....................................... $680,600 ▪ Operating expenses = $210,000 (combine amounts and include intangible amortization for current year) ▪ Dividend income = -0- (intra-entity transfer eliminated in consolidation) ▪ Net income attributable to noncontrolling interest: (impact of transfers is included because they were upstream) Zeigler reported net income for 2015 ...................................... $100,000 Intangible amortization ........................................................ (10,000) 2014 gross profit recognized in 2015 ................................. 14,400 2015 gross profit deferred .................................................. (10,000) Zeigler realized net income for 2015 ................................... $94,400 Outside ownership .............................................................. 30% Net income attributable to noncontrolling interest ................ $28,320 ▪ Inventory = $980,000 (combine amounts and defer the $10,000 ending unrealized gross profit) ▪ Noncontrolling interest in subsidiary, 12/31/15 30% beginning book value less $14,400 unrealized gross profit (30% × $935,600) ........................ $(280,680) Excess intangible allocation (30% × $395,000) .................. (118,500) Net income attributable to noncontrolling interest ........... (28,320) Dividends (30% × $50,000) ................................................... 15,000 Total noncontrolling interest at 12/31/15 ............................ $(412,500)
5-31 ..
Chapter 05 - Consolidated Financial Statements—Intra-Entity Asset Transactions
30.
(75 Minutes) (Determine consolidated balances after impact of upstream Inventory transfers and downstream transfer of building. Parent uses initial value method.) PRELIMINARY COMPUTATIONS a. Consideration transferred ....................... $657,000 Noncontrolling interest fair value ............. 73,000 Subsidiary fair value at acquisition-date 730,000 Book value.................................................. (620,000) Fair value in excess of book value .......... $110,000 Remaining Annual Excess Excess fair value assignments Life Amortizations to equipment ......................................... 20,000 4 yrs. $5,000 to liabilities ........................................... 40,000 5 yrs. 8,000 to brand names .................................... 50,000 10 yrs. 5,000 Totals ..................................................... -0$18,000 Determination of subsidiary book value on 1/1/14 Book value, 1/1/15 (based on stockholders' equity accounts) Eliminate net income – 2014 .................................................... Eliminate dividends – 2014 ...................................................... Book value, 1/1/14 ...............................................................
$700,000 (80,000) -0$620,000
Beginning inventory unrealized gross profit, 12/31/14 (Upstream) Ending Inventory ($145,000 × 30%) ......................................... Gross profit rate (given) ........................................................... Unrealized intra-entity gross profit, 12/31/14 .........................
$43,500 20% $ 8,700
Ending inventory unrealized gross profit, 12/31/15 (Upstream) Ending Inventory ($160,000 × 40%) ......................................... Gross profit rate (given) ........................................................... Unrealized intra-entity gross profit, 12/31/15 .........................
$64,000 20% $12,800
Building unrealized gross profit, 1/2/14 (Downstream) Transfer price ............................................................................ Book value ................................................................................. Unrealized gross profit .............................................................
$25,000 10,000 $15,000
Annual excess depreciation Annual depreciation based on book value ($10,000 ÷ 5 years) Annual depreciation based on transfer price ($25,000 ÷ 5 years) ............................................................... Excess annual depreciation .....................................................
5-32 ..
$2,000 5,000 $3,000
Chapter 05 - Consolidated Financial Statements—Intra-Entity Asset Transactions
30. (continued) Adjustment to buildings to return to historical cost at 1/1/15 Transfer Price Historical Cost $25,000 $100,000
Buildings Accumulated depreciation (1/1/15 balance after 1 more year of depreciation)
5,000
92,000
Consolidation Adjustment $75,000
87,000
Consolidated Totals ▪
Sales and other Income = $1,240,000 (add the two book values and eliminate the intra-entity transfers)
▪
Cost of goods sold: Moore's book value ................................................................... Kirby's book value .................................................................... Eliminate intra-entity transfers ................................................ Realized gross profit deferred in 2014 ..................................... Deferral of 2015 unrealized gross profit ................................. Cost of goods sold ...................................................................
▪
Operating and interest expenses = $275,000 (add the two book values and include $18,000 amortization for current year but eliminate $3,000 excess depreciation from asset transfer)
▪
Net income attributable to noncontrolling interest = $1,790 (impact of inventory transfers is included because they were upstream but building transfer is omitted because it was downstream)
Reported net income for 2015 ....................................................... Realized gross profit deferred in 2014 .................................... Deferral of 2015 unrealized gross profit ................................. Realized net income of subsidiary .......................................... Excess fair value amortization ................................................. Adjusted subsidiary net income ............................................... Outside ownership ......................................................................... Net income attributable to noncontrolling interest ................. ▪
$40,000 8,700 (12,800) $35,900 (18,000) 17,900 10% $ 1,790
Consolidated net income = $220,900 (consolidated sales less consolidated cost of goods sold, expenses, and noncontrolling interest) ➢ To noncontrolling interest = $1,790 (above) ➢ To controlling interest = $219,110
5-33 ..
$500,000 400,000 (160,000) (8,700) 12,800 $744,100
Chapter 05 - Consolidated Financial Statements—Intra-Entity Asset Transactions
30. (continued) ▪
Retained earnings, 1/1/15 = $1,025,970 (because the parent uses the initial value method, worksheet entries adjust its retained earnings for changes in subsidiary's book value, excess amortizations, and the impact of unrealized gross profits in previous years)
Moore's reported balance, 1/1/15 ................................. Impact of building transfer (parent's income was overstated by the $15,000 gain but has been reduced by one prior year of excess depreciation) .................... Adjustments to convert initial value to equity method: Increase in subsidiary's book value during prior years .................................................................... Excess fair value amortization ................................. Deferral of 12/31/14 unrealized gross profit (subsidiary's prior income was overstated) ...... Realized increase in book value ......................... Ownership................................................................... Equity accrual ............................................................ Retained Earnings, 1/1/15 ...................................
$990,000
(12,000)
$80,000 (18,000) (8,700) 53,300 90% 47,970 $1,025,970
Dividends declared = $130,000 (parent balance only) Retained Earnings, 12/31/15 = $1,115,080 (the beginning balance plus controlling interest share of consolidated net income less dividends declared) Cash and Receivables = $397,000 (add the two book values) Inventory = $371,200 (add the two book values and defer the $12,800 ending unrealized gross profit) Investment in Kirby = -0- (eliminated for consolidation purposes) Equipment (Net) = $1,030,000 (add the two book values adjusted for excess allocation and amortization) Buildings = $1,725,000 (add the two book values and add the $75,000 impact to return to historical cost as computed above for transfer) Accumulated Depreciation = $384,000 (add the two book values plus adjustment to historical cost ($87,000 at beginning of year less $3,000 excess depreciation for current year) Other Assets = $300,000 (add the two book values) Brand Names = $40,000 (the original $50,000 allocation less two years of amortization at $5,000 per year) Total Assets = $3,479,200 (summation of the consolidated totals) Liabilities = $1,684,000 (add the two book values and subtract the original allocation [$40,000] after two years of amortization [$8,000 per year])
5-34 ..
Chapter 05 - Consolidated Financial Statements—Intra-Entity Asset Transactions
30. (continued) Noncontrolling interest 12/31/15 = $80,120 (10 percent of $691,300 adjusted beginning book value [$700,000 less $8,700 deferral of unrealized gross profit] plus $9,200 share of beginning unamortized excess fair value allocations plus $1,790 net income share) Common Stock = $600,000 (parent balance only) Retained Earnings, 12/31/15 = $1,115,080 (computed above) Total Liabilities and Equities = $3,479,200 (summation of consolidated balances). The same consolidation balances can be derived using a worksheet and the following adjusting and eliminating entries: CONSOLIDATION ENTRIES Entry *G Retained earnings, 1/1/15 (Kirby) ....................... 8,700 Cost of goods sold ......................................... (To recognize 2014 deferred gross profit as income in 2015) Entry *TA Building ................................................................. Retained earnings, 1/1/15 (Moore) ...................... Accumulated depreciation ............................. (To adjust 1/1/15 balance to historical cost figures)
8,700
75,000 12,000
Entry *C Investment in Kirby .............................................. 47,970 Retained earnings, 1/1/15 (Moore) ................ (To convert from initial value to equity method as follows:) Increase in subsidiary's book value during prior years (income of $80,000) ........................................................... Excess amortization for 2014 ................................................. Deferral of 12/31/14 unrealized gross profit .......................... Realized increase in subsidiary's book value ....................... Ownership .............................................................................. Conversion to equity method (full accrual) adjustment .......
87,000
47,970
$80,000 (18,000) (8,700) $53,300 90% $47,970
S Common stock (Kirby) ........................................ 150,000 Retained earnings, 1/1/15 as adjusted (Kirby) .... 541,300 Investment in Kirby (90%) .............................. 622,170 Noncontrolling interest in Kirby (10%) ......... 69,130 (To eliminate subsidiary's beginning stockholders' equity accounts and recognize beginning noncontrolling interest balance)
5-35 ..
Chapter 05 - Consolidated Financial Statements—Intra-Entity Asset Transactions
30. (continued) A Liabilities .............................................................. 32,000 Equipment ............................................................ 15,000 Brand names ........................................................ 45,000 Investment in Kirby ........................................ 82,800 Noncontrolling interest in Kirby (10%) ......... 9,200 (To recognize unamortized balance of excess allocations as of 1/1/15. Figures have been reduced by one year of amortization) Entry I (the subsidiary declared no dividends so no adjustment needed) E Operating and interest expense .......................... 18,000 Liabilities ......................................................... Equipment ........................................................ Brand names ................................................... (To recognize excess amortization expenses for current year) Tl Sales ..................................................................... Cost of goods sold ......................................... (To eliminate intra-entity transfers for 2015)
160,000
G Cost of goods sold .............................................. Inventory ......................................................... (To defer ending unrealized inventory gross profit)
12,800
8,000 5,000 5,000
160,000
12,800
ED Accumulated depreciation .................................. 3,000 Depreciation expense .................................... 3,000 (To adjust depreciation for current year created by transfer of building)
5-36 ..
Chapter 05 - Consolidated Financial Statements—Intra-Entity Asset Transactions
30. continued: Worksheet (not part of requirements) Moore Company and Subsidiary Consolidated Worksheet December 31, 2015 Moore
Kirby
NCI
Sales and other income
(800,000)
(600,000)
(TI) 160,000
Cost of goods sold
500,000
400,000
(G) 12,800
Consolidated (1,240,000)
(G*)
8,700
744,100
(TI)160,000 Op. and interest expenses
100,000
160,000
Separate company income
(200,000)
(40,000)
(E) 18,000
(ED)
3,000
275,000
Consolidated net income
(220,900)
to noncontrolling interest
(1,790)
to Moore Company Retained earnings, 1/1
1,790 (219,110)
(990,000)
(TA*) 12,000 (550,000)
(*C) 47,970
(1,025,970)
(S) 541,300 (G*)
8,700
Net income
(200,000)
(40,000)
(219,110)
Dividends declared
130,000
0
130,000
(1,060,000)
(590,000)
(1,115,080)
Cash and receivables
217,000
180,000
397,000
Inventory
224,000
160,000
Investment in Kirby
657,000
0
Retained earnings, 12/31
(*C) 47,970
(G) 12,800
371,200
(S) 622,170
0
(A) 82,800
Equipment (net)
600,000
420,000
(A) 15,000
Buildings
1,000,000
650,000
(TA*) 75,000
Acc. depreciation—buildings
(100,000)
(200,000)
(ED) 3,000
(TA*) 87,000
(384,000)
Brand names
0
0
(A) 45,000
(E) 5,000
40,000
Other assets
200,000
100,000
300,000
Total assets
2,798,000
1,310,000
3,479,200
Liabilities
(1,138,000)
(570,000)
(A) 32,000
(600,000)
(150,000)
(S)150,000
Common stock Noncontrolling interest , 1/1
(E) 5,000
1,725,000
(E) 8,000
(1,684,000) (600,000)
(S) 69,130 (A) 9,200
Noncontrolling interest,12/31
(78,330) (80,120)
Retained earnings, 12/31
(1,060,000)
(590,000)
Total liabilities and equity
(2,798,000)
(1,310,000)
(80,120) (1,115,080)
1,120,770
5-37 ..
1,030,000
1,120,770
(3,479,200)
Chapter 05 - Consolidated Financial Statements—Intra-Entity Asset Transactions
31.
(55 Minutes) (Investment account balance and consolidated worksheet with downstream inventory transfers when parent uses equity method) Acquisition-date fair value allocation and excess amortizations a. Consideration transferred .......................... $372,000 Noncontrolling interest fair value ................ 248,000 Subsidiary fair value at acquisition-date ... $620,000 Acquisition-date book value ........................ (320,000) Fair value in excess of book value ............. $300,000 Remaining Annual Excess Excess fair value assignments............... Life Amortizations to patents ................................................. 70,000 10 yrs. $7,000 to customer list ....................................... 45,000 15 yrs. 3,000 to goodwill ............................................... $185,000 indefinite -0$10,000
Determination of Investment in Stinson account balance Consideration transferred ................................................... Increase in Stinson’s retained earnings 1/1/14 to 1/1/15 [(280,000 – 220,000) × 60%] .......................................... Excess fair value amortization × 60% ............................ 2014 ending inventory profit deferral (100%) ................
$372,000 $36,000 (6,000) (10,000)
McIlroy’s equity in earnings of Stinson for 2015* ........ Stinson 2015 dividends declared to McIlroy ................. Investment account balance 12/31/15 ................................. * Stinson’s 2015 net income ............................................. Excess fair value amortization ....................................... Adjusted net income ....................................................... McIlroy’s percentage ownership .................................... McIlroy’s share of Stinson’s adjusted net income ....... 2014 intra-entity inventory profit recognized ................ 2015 intra-entity inventory profit deferred .................... McIlroy’s equity in earnings of Stinson.........................
Intra-entity profits (downstream) Intra-entity transfers remaining in inventory Gross profit rate**
**(150,000 – 120,000) ÷ 150,000 = 20% (160,000 – 112,000) ÷ 160,000 = 30%
5-38 ..
2014 $50,000 20% $10,000
20,000 28,000 (9,000) $411,000
$60,000 (10,000) $50,000 60% $30,000 10,000 (12,000) $28,000
2015 $40,000 30% $12,000
Chapter 05 - Consolidated Financial Statements—Intra-Entity Asset Transactions
31. (continued) b. Sales Cost of goods sold
McIlroy (700,000) 460,000
Stinson (335,000) 205,000
Operating expenses 188,000 Equity in earnings of Stinson (28,000) Separate company net income (80,000) Consolidated net income to noncontrolling interest to McIlroy, Inc.
70,000
(280,000) (60,000) 15,000 (325,000)
Cash and receivables Inventory Investment in Stinson
248,000 233,000 411,000
148,000 129,000 -0-
Buildings (net) Equipment (net) Patents (net) Customer list Goodwill Total assets
308,000 220,000 -0-
202,000 86,000 20,000
1,420,000
585,000
(390,000) (300,000)
(160,000) (100,000)
(S) 280,000 (D) 9,000
(D) 9,000 (*G) 10,000
(A) 63,000 (A) 42,000 (A)185,000
6,000
899,000
(695,000) (80,000) 45,000 (730,000)
510,000 306,000 76,000 39,000 185,000 1,862,000
(E) 7,000 (E) 3,000
(550,000) (300,000) (S) 152,000 (A)116,000
(325,000) (585,000)
(100,000) 20,000 (80,000)
396,000 350,000 -0-
(G) 12,000 (S) 228,000 (A)174,000 (I) 28,000
(S) 100,000
5-39 ..
268,000 -0-
(20,000)
(695,000) (80,000) 45,000 (730,000)
Noncontrolling interest 12/31 Retained earnings, 12/31 (730,000) Total liabilities and equities (1,420,000)
NCI Consolidated (875,000) 507,000
(60,000)
Retained earnings, 1/1 Net income (above) Dividends declared Retained earnings, 12/31
Liabilities Common stock Noncontrolling interest 1/1
Adj. & Elim. (TI)160,000 (G) 12,000 (*G) 10,000 (TI) 160,000 (E) 10,000 (I) 28,000
899,000
(268,000) (282,000)
(282,000) (730,000) (1,862,000)
Chapter 05 - Consolidated Financial Statements—Intra-Entity Asset Transactions
32. Investment balance and worksheet preparation—upstream sales, equity method a. 2015 net income reported by Sander Excess patent fair value amortization ($350,000 ÷ 5 years) Deferred gross profit for 12/31/15 intra-entity inventory (160,000 × 25%) Recognized gross profit for 1/1/15 intra-entity inventory (125,000 × 28%) Sander’s net income adjusted To controlling interest (80%) To noncontrolling interest (20%) Adjustments b. Plymouth Sander & Eliminations Revenues (1,740,000) (950,000) (TI) 300,000 Cost of goods sold 820,000 500,000 (G) 40,000 (TI)300,000 (*G) 35,000 Depreciation expense 104,000 85,000 Amortization expense 220,000 120,000 (E) 70,000 Interest expense 20,000 15,000 Equity in earnings of Sander (124,000) (I) 124,000 Separate company net income (700,000) (230,000) Consolidated net income to noncontrolling interest to Plymouth Corp.
NCI
Consolidated
(2,390,000) 1,025,000 189,000 410,000 35,000 0
(731,000) (31,000)
Retained earnings 1/1
(2,800,000)
(345,000)
Net income Dividends declared Retained earnings 12/31
(700,000) 200,000 (3,300,000)
(230,000) 25,000 (550,000)
Cash Accounts receivable Inventory Investment in Sander
535,000 575,000 990,000 1,420,000
115,000 215,000 800,000
(S) 310,000 (*G) 35,000
(2,800,000)
(D) 20,000
(D) 20,000
31,000 (700,000)
5,000
(700,000) 200,000 (3,300,000) 650,000 790,000 1,750,000
(G) 40,000 (S)968,000 (A)348,000 (I) 124,000
0
Buildings and equipment Patents Goodwill Total Assets
1,025,000 950,000
863,000 107,000
5,495,000
2,100,000
1,888,000 1,197,000 225,000 6,500,000
Accounts payable Notes payable Noncontrolling interest 1/1
(450,000) (545,000)
(200,000) (450,000)
(650,000) (995,000)
Noncontrolling interest 12/31 Common stock APIC Retained earnings 12/31 Total liab. and SE
(A) 210,000 (A) 225,000
(E) 70,000
(S)242,000 (A) 87,000 (900,000) (300,000) (3,300,000) (5,495,000)
(800,000) (100,000) (550,000) (2,100,000)
5-40 ..
$230,000 (70,000) (40,000) 35,000 $155,000 $124,000 $31,000
(S) 800,000 (S) 100,000 2,234,000
2,234,000
(329,000) (355,000)
(355,000) (900,000) (300,000) (3,300,000) (6,500,000)
Chapter 05 - Consolidated Financial Statements—Intra-Entity Asset Transactions
33. (50 Minutes) (Prepare consolidation entries for a combination where upstream inventory transfers have occurred as well as downstream equipment transfers. Parent has applied initial value method) Consideration transferred ............................... $665,000 Noncontrolling interest fair value ..................... 285,000 Subsidiary fair value at acquisition-date ......... $950,000 Book value .......................................................... (800,000) Fair value in excess of book value .................. $150,000 Remaining Annual Excess Excess fair value assignments .................... Life Amortizations to building ..................................................... 50,000 5 yrs. $10,000 to franchise agreements ............................. 100,000 10 yrs. 10,000 -0$20,000 Inventory Transfers (Upstream) 2014 gross profit deferred until 2015 ($12,000 × 30%) .................
$3,600
2015 gross profit deferred until 2016 ($18,000 × 30%) .................
$5,400
Equipment Transfer (Downstream) Unrealized gain as of January 1, 2015: Unrealized gain on transfer (1/1/14) ........................................ 2014 excess depreciation ($36,000 ÷ 6 yrs.) ........................... Unrealized gain January 1, 2015 ....................................................
$36,000 (6,000) $30,000
Excess depreciation—2015 ($36,000 ÷ 6 yrs.) .............................
$6,000
Entry *G Retained earnings, 1/1/15 (Young) ..................... Cost of goods sold .........................................
3,600
3,600
To recognize upstream intra-entity inventory gross profit deferred from previous year. Entry *TA Retained earnings, 1/1/15 (Monica) ................... Equipment ($50,000 – $36,000) ........................... Accumulated depreciation ($50,000 – $6,000)
30,000 14,000 44,000
To return equipment accounts to beginning book value based on historical cost and to remove unrealized gain from beginning retained earnings.
5-41 ..
Chapter 05 - Consolidated Financial Statements—Intra-Entity Asset Transactions
33. (continued) Entry *C Investment in Young ...................................... Retained earnings, 1/1/15 (Monica) .........
123,480 123,480
Because the parent uses the initial value method, its retained earnings must be adjusted for the subsidiary's increase in book value less excess amortizations and upstream profits during 2013–2014 as follows. Retained earnings of Young, December 31, 2015 (given) $740,000 Eliminate income and dividends of Young ($160,000 – $50,000) ............................................ (110,000) Retained earnings of Young, December 31, 2014 .. 630,000 Removal of unrealized gross profit (Entry *G) ....... (3,600) Realized retained earnings of Young, December 31, 2014 ............................................... 626,400 Retained earnings at date of acquisition ................ (410,000) Increase in retained earnings during 2013–2014 .... 216,400 Ownership percentage ............................................. 70% Income accrual to be recognized ............................ 151,480 Excess amortization for 2013–2014 ($20,000 × 70%× 2 yrs.) (28,000) ENTRY *C ADJUSTMENT (above) ........................... $123,480 Entry S Common stock (Young) ...................................... 300,000 Additional paid-in capital (Young) ...................... 90,000 Retained earnings, 1/1/15 (Young) (adjusted for *G) ............................... 626,400 Investment in Young (70%) ...................... 711,480 Noncontrolling interest in Young (30%) .. 304,920 To eliminate stockholders' equity accounts of subsidiary and recognize noncontrolling interest; amount of retained earnings was previously reduced to realized balance by Entry *G. The $626,400 figure is computed above. Entry A Franchise agreement ............................................ 80,000 Buildings .............................................................. 30,000 Investment in Young ...................................... 77,000 Noncontrolling interest in Young (30%) ....... 33,000 To recognize amount paid within acquisition price for buildings and the franchise agreement. Balances have been reduced by two years of excess amortizations.
5-42 ..
Chapter 05 - Consolidated Financial Statements—Intra-Entity Asset Transactions
33. (continued) Entry I Dividend income .................................................. 35,000 Dividends declared ......................................... 35,000 To eliminate Intra-entity dividend declarations recorded by parent as income under the initial value method. Entry E Depreciation expense ........................................... 10,000 Amortization expense .......................................... 10,000 Franchise agreement ..................................... Buildings .......................................................... To recognize current year excess amortization expense.
10,000 10,000
Entry Tl Sales ..................................................................... 90,000 Cost of goods sold ......................................... 90,000 To remove intra-entity inventory transfers made during the current year. Entry G Cost of goods sold .............................................. 5,400 Inventory .......................................................... 5,400 To defer unrealized gross profit on 2015 intra-entity inventory transfers (computed above). Entry ED Accumulated depreciation .................................. 6,000 Depreciation expense .................................... 6,000 To remove current year depreciation on transferred item since its historical cost has been fully depreciated. Noncontrolling Interest's Share of Consolidated Net Income Reported net income of Young (given) ............................. Excess fair value amortization ........................................... Recognition of 2014 unrealized gross profit (Entry *G) ... Deferral of 2015 unrealized gross profit (Entry G) (upstream) Realized net income of Young ........................................... Outside ownership percentage .......................................... Net income attributable to noncontrolling interest ..........
5-43 ..
$160,000 (20,000) 3,600 (5,400) $138,200 30% $ 41,460
Chapter 05 - Consolidated Financial Statements—Intra-Entity Asset Transactions
34.
(35 Minutes) (Consolidation entries with upstream Inventory transfers and downstream equipment transfers. Parent uses equity method) Entry *G (Same as Entry *G in Problem 33.) Entry *TA Investment in Young ............................................ 30,000 Equipment ............................................................ 14,000 Accumulated depreciation ............................. 44,000 To return equipment account to its book value based on historical cost. Because the parent uses the equity method and the transfer is downstream, the unrealized gain has already been removed from the parent's retained earnings. Thus, the remaining gain is eliminated here from the Investment account rather than from retained earnings. Entry *C (No Entry *C is needed because equity method has been applied.) Entry S (Same as Entry S in Problem 33.) Entry A (Same as Entry A in Problem 33.) Entry I Investment income .............................................. Investment in Young ...................................... To eliminate intra-entity income accrual.
102,740 102,740
Reported net income of Young (given) ...................................... $160,000 Excess fair value amortization ................................................... (20,000) Recognition of 2014 unrealized gross profit (Entry *G) ............ 3,600 Deferral of 2015 unrealized gross profit (Entry G) (upstream) . (5,400) Realized net income of Young .................................................... $138,200 Outside ownership percentage ................................................... 70% Monica’s share of Young’s realized net income ........................ $ 96,740 Depreciation adjustment for asset transfer gain ....................... 6,000 Equity accrual for 2015 ........................................................... $102,740 Entry D Investment in Young ............................................ Dividends declared ......................................... To eliminate intra-entity dividend transfers.
35,000 35,000
Entry E (Same as Entry E in Problem 33.) Entry TI (Same as Entry Tl in Problem 33.) Entry G (Same as Entry G in Problem 33.) Entry ED (Same as Entry ED in Problem 33.) Net income attributable to noncontrolling interest (Same as in Problem 33.)
5-44 ..
Chapter 05 - Consolidated Financial Statements—Intra-Entity Asset Transactions
35.
(60 Minutes) (Consolidation worksheet for combination with upstream inventory transfers and downstream transfer of land. Also asks about transfer of a building. Parent uses partial equity method.) Consideration transferred ............................... $570,000 Noncontrolling interest fair value ..................... 380,000 Subsidiary fair value at acquisition-date ......... $950,000 Book value .......................................................... (850,000) Fair value in excess of book value .................. $100,000 Remaining Annual Excess Excess fair value assignment ..................... Life Amortization to customer list ............................................. 100,000 20 yrs. $5,000 -0a. CONSOLIDATION ENTRIES Entry *TL Retained earnings, 1/1/15 (Gibson) ............... 40,000 Land ........................................................... 40,000 To remove unrealized gain on Intra-entity downstream transfer of land made in 2014. Entry *G Retained earnings, 1/1/15 (Keller) ................. 10,000 Cost of goods sold .................................... 10,000 To defer unrealized upstream Inventory gross profit from 2014 until 2015 computed as the 2014 ending inventory balance of $30,000 (20% × $150,000) multiplied by 33-1/3% gross profit rate ($50,000 ÷ $150,000). Entry *C Retained earnings, 1/1/15 (Gibson) ............... Investment in Keller ..................................
9,000 9,000
Parent is applying the partial equity method as can be seen by the amount in the Equity in earnings of Keller Company account (60 percent of the reported balance). Thus, the parent’s share of amortization of $3,000 ($100,000 divided by 20 years × 60%) must be recognized for the previous year 2014. In addition, the equity accrual recorded by the parent has been based on Keller's reported net income. As shown in Entry *G, $10,000 of that reported net income has not actually been realized as of January 1, 2015. Thus, the previous accrual must be reduced by $6,000 to mirror the parent's 60% ownership. The total of the two adjustments being made here is $9,000.
5-45 ..
Chapter 05 - Consolidated Financial Statements—Intra-Entity Asset Transactions
35. (continued) Entry S Common stock (Keller) .................................. 320,000 Additional paid-in capital ............................... 90,000 Retained earnings, 1/1/15 (Keller) (adjusted for Entry *G) ............................................... 610,000 Investment in Keller (60%) .................. 612,000 Noncontrolling interest in Keller, 1/1/15 (40%) 408,000 To remove stockholders' equity accounts of Keller and recognize beginning noncontrolling interest. Retained earnings balance has been adjusted in Entry *G. Entry A Customer list.................................................... 95,000 Investment in Keller .................................. Noncontrolling interest in Keller, 1/1/15 (40%)
57,000 38,000
To recognize amount paid within acquisition price for the customer list. Original balance is adjusted for previous year’s amortization. Entry I Equity in earnings of Keller ........................... Investment in Keller .................................. To eliminate intra-entity income accrual.
84,000 84,000
Entry D Investment in Keller ....................................... 36,000 Dividends declared ................................... To eliminate intra-entity (60%) dividend transfers. Entry E Amortization expense ..................................... 5,000 Customer list ............................................. To recognize current period excess amortization expense. Entry P Liabilities .......................................................... Accounts receivable ................................. To eliminate intra-entity debt.
5-46
5,000
40,000
Entry Tl Sales ................................................................. 200,000 Cost of goods sold .................................... To eliminate current year intra-entity inventory transfer.
..
36,000
40,000
200,000
Chapter 05 - Consolidated Financial Statements—Intra-Entity Asset Transactions
35. (continued) Entry G Cost of goods sold ......................................... 12,000 Inventory ..................................................... 12,000 To defer 2015 unrealized inventory gross profit. Unrealized gain is the ending inventory of $40,000 (20% of $200,000) multiplied by 30% gross profit rate ($60,000 ÷ $200,000). Net income attributable to noncontrolling interest Keller reported net income ....................................................... Excess fair value amortization ................................................. 2014 Intra-entity gross profit realized in 2015 (inventory)....... 2015 Intra-entity gross profit deferred (inventory) .................. Keller realized net income 2015 ................................................. Outside ownership percentage ................................................. Net income attributable to noncontrolling interest ...........
5-47 ..
$140,000 (5,000) 10,000 (12,000) $133,000 40% $ 53,200
Chapter 05 - Consolidated Financial Statements—Intra-Entity Asset Transactions
35. a. (continued)
Accounts Sales Cost of goods sold
GIBSON AND KELLER Consolidation Worksheet Year Ending December 31, 2015 Gibson (800,000) 500,000
Operating expenses 100,000 Equity in earnings of Keller (84,000) Separate company net net income (284,000) Consolidated net income To noncontrolling interest To Gibson Company RE, 1/1—Gibson (1,116,000) RE, 1/1—Keller Net income (above) Dividends declared Retained earnings, 12/31 Cash Accounts receivable Inventory Investment in Keller
(284,000) 115,000 (1,285,000) 177,000 356,000 440,000 726,000
Land Buildings and equipment (net) Customer list Total assets Liabilities Common stock Additional paid-in capital Retained earnings, 12/31 NCI in Keller, 1/1
180,000 496,000 -02,375,000 (480,000) (610,000)
NCI In Keller, 12/31 Total liabilities and equity
(1,285,000)
Consolidation Entries Noncontrolling Keller Debit Credit Interest (500,000) (TI) 200,000 300,000 (G) 12,000 (*G) 10,000 (TI) 200,000 60,000 (E) 5,000 -0(I) 84,000 (140,000) (53,200) (*TL) 40,000 (*C) 9,000 (620,000) (*G) 10,000 (S) 610,000 (140,000) 60,000 (700,000) 90,000 410,000 320,000 (D) 36,000
390,000 300,000 -01,510,000 (400,000) (320,000) (90,000) (700,000)
(A)
95,000
36,000
(P) 40,000 (G) 12,000 (*C) 9,000 (S) 612,000 (I) 84,000 (A) 57,000 (*TL) 40,000 (E)
(1,510,000)
165,000 -0(333,000) 53,200 (279,800) (1,067,000)
(279,800) 115,000 (1,231,800) 267,000 726,000 748,000 -0-
530,000 796,000 90,000 3,157,000 (840,000) (610,000)
5,000
(1,231,800) (S) 408,000 (A) 38,000
(2,375,000)
24,000
(P) 40,000 (S) 320,000 (S) 90,000
1,551,000
5-48 ..
(D)
Consolidated Totals (1,100,000) 602,000
1,551,000
(408,000) (38,000) (475,200)
(475,200) (3,157,000)
Chapter 05 - Consolidated Financial Statements—Intra-Entity Asset Transactions
35. (continued) b. If the intra-entity transfer had been a building rather than land, two adjustments to the consolidation entries would be needed. Entry *TL would be changed and relabeled as Entry *TA and an Entry ED would be added to eliminate the overstatement of depreciation expense for 2015. All other consolidation entries would be the same as shown in Part a. As a downstream transfer, entries *C and S are not affected. Entry *TA Retained earnings, 1/1/15 (Gibson) .............. 36,000 Buildings ........................................................ 40,000 Accumulated depreciation ....................... 76,000 To defer unrealized gain ($40,000 original amount less one year of excess depreciation at $4,000 per year) as of beginning of year. Entry also returns Buildings account to historical cost (from $100,000 to $140,000) and Accumulated Depreciation account to historical cost (original $80,000 less one year of excess depreciation at $4,000). Because the Buildings account is shown at net value in the information given in this problem, the above entry would probably be made as follows: Entry *TA (Alternative) Retained earnings, 1/1/15 (Gibson) .............. Buildings (net) ..........................................
36,000 36,000
Entry ED Accumulated depreciation ............................ 4,000 Operating (or depreciation) expense ...... 4,000 To remove excess depreciation for current year created by transfer price. Excess depreciation for each year would be $4,000 based on allocating the $60,000 historical cost book value over 10 years ($6,000 per year) rather than the $100,000 transfer price ($10,000 per year).
5-49 .
.
Chapter 05 - Consolidated Financial Statements—Intra-Entity Asset Transactions
36.
(40 Minutes) (Prepare consolidation worksheet with intra-entity transfer of inventory and land. No outside ownership exists) a. Skyline reported net income ..................................................... Patented technology amortization ............................................ Beginning inventory gross profit recognized .......................... Ending inventory gross profit deferred .................................... Deferral of land gain on sale ..................................................... Equity in Skyline’s earnings...................................................... b. Acquisition-Date Fair Value Allocation Consideration transferred (fair value of shares issued) ........ Book value of subsidiary .......................................................... Fair value in excess of book value .......................................... Excess fair over book value assigned to: Trademarks (indefinite life) ................................................... Patented technology .............................................................. Remaining life of patented technology ................................ Annual amortization ..................................................................
$(88,000) 15,000 (14,400) 14,000 18,000 $(55,400)
$450,000 300,000 $150,000 30,000 $120,000 8 years $ 15,000
Unrealized Upstream Inventory Gross Profit, 1/1 Inventory being held ($50,000 × 72%) ...................................... Gross profit rate ($20,000 ÷ $50,000) ....................................... Unrealized gross profit, 1/1 ......................................................
$36,000 40% $14,400
Unrealized Upstream Inventory Gross Profit, 12/31 Inventory being held (given) .................................................... Gross profit rate ($40,000 ÷ $80,000) ....................................... Unrealized gross profit, 12/31 ...................................................
$28,000 50% $14,000
CONSOLIDATION ENTRIES Entry *G Retained earnings 1/1 (Skyline) ......................... 14,400 Cost of goods sold ........................................ 14,400 To remove impact of beginning unrealized gross profit. Amount computed above. Entry S Common stock (Skyline) .................................... 120,000 Additional paid-in capital (Skyline) .................... 30,000 Retained earnings 1/1 (Skyline, adjusted) ......... 277,600 Investment in Skyline ..................................... 427,600 To remove stockholders' equity accounts of subsidiary. Retained earnings is adjusted for elimination of beginning unrealized gross profit in Entry *G.
5-50 .
.
Chapter 05 - Consolidated Financial Statements—Intra-Entity Asset Transactions
36. (continued) Entry A Trademarks .......................................................... 30,000 Patented technology ........................................... 105,000 Investment in Skyline .................................... 135,000 To recognize excess fair value allocations as of 1/1. Patented technology is adjusted for one prior year of amortization at $15,000 per year. Entry I Investment income .............................................. 55,400 Investment in Skyline .................................... 55,400 To remove intra-entity income accrued by parent using the equity method. Entry D Investment in Skyline ......................................... Dividends declared ........................................ To eliminate Intra-entity dividends.
20,000 20,000
Entry E Other operating expenses ................................... 15,000 Patented technology ...................................... 15,000 To recognize current year amortization expense on patented technology Entry Tl Revenues ............................................................. 80,000 Cost of goods sold ........................................ To eliminate intra-entity inventory transfer for current year.
80,000
Entry G Cost of goods sold .............................................. 14,000 Inventory.......................................................... 14,000 To defer unrealized inventory gross profit. Amount is computed above. Entry TL Gain on sale of land ............................................ 18,000 Land ................................................................ 18,000 To remove gain from intra-entity transfer of land during current year. Entry P Accounts payable ............................................... Accounts receivable ....................................... To remove intra-entity payable and receivable.
5-51 .
.
65,000 65,000
Chapter 05 - Consolidated Financial Statements—Intra-Entity Asset Transactions
36. (continued)
Accounts Revenues Cost of goods sold
PARKWAY AND SKYLINE Consolidation Worksheet Year Ending December 31, 2015 Parkway (627,000) 289,000
Skyline (358,000) 195,000
Other operating expenses Gain on sale of land Investment income Net income
170,000 (18,000) (55,400) (241,400)
(88,000)
Retained earnings 1/1
(314,600)
(292,000)
Net income (above) Dividends declared Retained earnings 12/31
(241,400) 70,000 (486,000)
(88,000) 20,000 (360,000)
Cash and receivables Inventory Investment in Skyline
134,000 281,000 598,000
150,000 112,000
Trademarks Patented technology Land, buildings, and equipment (net) Total assets Liabilities Common stock Additional paid-in capital Retained earnings (above) Total liabilities & stockholders’ equity
75,000
(*G) 14,400 (S) 277,600 (D) 20,000
(D)
20,000
(A) 30,000 (A) 105,000
637,000 1,650,000
50,000 130,000 283,000 725,000
(463,000) (410,000) (291,000) (486,000) (1,650,000)
(215,000) (120,000) (30,000) (360,000) (725,000)
(P) 65,000 (S) 120,000 (S) 30,000
5-52 ..
Consolidation Entries Debit Credit (TI) 80,000 (G) 14,000 (TI) 80,000 (*G) 14,400 (E) 15,000 (TL) 18,000 (I) 55,400
844,400
(P) 65,000 (G) 14,000 (S) 427,600 (A) 135,000 (I) 55,400 (E) 15,000 (TL) 18,000
844,400
Consolidated Totals (905,000) 403,600 260,000 -0-0(241,400) (314,600) -0(241,400) 70,000 (486,000) 219,000 379,000 -080,000 220,000 902,000 1,800,000 (613,000) (410,000) (291,000) (486,000) (1,800,000)
Chapter 05 - Consolidated Financial Statements—Intra-Entity Asset Transactions
Chapter 5 Excel Case Solution Excel Case Fair Value Allocation Schedule 1/1/2014El profit Consideration transferred 1,000,000 C.S. 500,000 R.E. 185,000 685,000 Life Amort. Tradename 315,000 25 12,600 Inventory Shawn sells GPR remaining to Patrick 60% 30% Intra-entity Inventory Transfers (upstream) Sales Inventory Intra. profit 2014 190,000 57,000 34,200 2015 210,000 63,000 37,800
Investment account Cost 2014 Equity earnings dividends 12/31/14 2015 12/31/15
Equity earnings dividends
1,000,000 31,200 (25,000) 1,006,200 68,800 (27,000) 1,048,000
Equity in Shawn Co. Earnings 2014 78,000 (34,200) Amortization (12,600) Equity earnings 31,200 2015 BI profit El profit Amortization Equity earnings
Shawn Co. dividends 2014 25,000 2015 27,000
Consolidation Adjustments *G RE-Shawn 34,200 COGS 34,200 S Common stock-Shawn RE-Shawn Investment in Shawn
500,000 203,800 703,800
A Tradename Investment in Shawn
302,400 302,400
I
Equity in earnings of Shawn 68,800 Investment in Shawn 68,800
D Investment in Shawn Dividends declared
27,000
E Amortization expense Tradename
12,600
IT Sales COGS
210,000 210,000
G COGS Inventory
37,800
Investment account goes to zero? 0
5-53 .
.
85,000 34,200 (37,800) (12,600) 68,800
27,000
12,600
37,800
Chapter 05 - Consolidated Financial Statements—Intra-Entity Asset Transactions
Analysis and Research—Accounting Information and Salary Negotiations a. With common control over related enterprises, a consolidated income statement better portrays economic reality. For example, it is likely that the Stadium’s concession and parking revenues would have been less if the team did not play there. Additionally, the $1,400,000 rent expense does not represent an arm’s length transaction—given that the $1,400,000 is the only rent revenue, it appears that the stadium is used exclusively for baseball with its fortunes intertwined with the team. Searching the FASB ASC for “separate statements” and then “intra-entity” yields the following relevant support: There is a presumption that consolidated financial statements are more meaningful than separate financial statements and that they are usually necessary for a fair presentation when one of the entities in the consolidated group directly or indirectly has a controlling financial interest in the other entities. FASB ASC (para. 810-10-10-1). As consolidated financial statements are based on the assumption that they represent the financial position and operating results of a single economic entity, such statements should not include gain or loss on transactions among the entities in the consolidated group. FASB ASC (para. 810-10-45-1). Granger Eagles Team and Stadium Consolidated Income Statement Ticket revenues Concession revenue Parking revenue
$2,000,000 800,000 100,000
Ticket expense Promotion COGS Depreciation Player salaries Staff salaries Consolidated net income
25,000 35,000 250,000 80,000 400,000 350,000
$2,900,000
1,140,000 $1,760,000
b. Other pertinent factors include ▪ Any available comparisons for the market values for the players ▪ The market value of any alternative uses for the stadium ▪ The amount the owners have invested in the team ▪ The amount the owners have invested in the stadium ▪ Fair rates of return for the owners’ investments in the team and the stadium
5-54 .
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Chapter 06 - Variable Interest Entities, Intra-Entity Debt, Consolidated Cash Flows, and Other Issues
CHAPTER 6 VARIABLE INTEREST ENTITIES, INTRA-ENTITY DEBT, CONSOLIDATED CASH FLOWS, AND OTHER ISSUES Chapter Outline I.
Variable interest entities (VIEs) A. VIEs typically take the form of a trust, partnership, joint venture, or corporation. In most cases a sponsoring firm creates these entities to engage in a limited and well-defined set of business activities. For example, a business may create a VIE to finance the acquisition of a large asset. The VIE purchases the asset using debt and equity financing, and then leases the asset back to the sponsoring firm. If their activities are strictly limited and the asset is pledged as collateral, VIEs are often viewed by lenders as less risky than their sponsoring firms. As a result, such arrangements can allow financing at lower interest rates than would otherwise be available to the sponsor. B. Control of VIEs, by design, sometimes does not rest with its equity holders. Instead, control is exercised through contractual arrangements with the sponsoring firm who becomes the "primary beneficiary" of the entity. These contracts can take the form of leases, participation rights, guarantees, or other residual interests. Through contracting, the primary beneficiary bears a majority of the risks and receives a majority of the rewards of the entity, often without owning any voting shares. C. An entity whose control rests with a primary beneficiary is addressed by FASB ASC subtopic 810-10 Variable Interest Entities. The following characteristics indicate a controlling financial interest in a variable interest entity. 1. The power, through voting rights or similar rights, to direct the activities of an entity that most significantly impact the entity’s economic performance. 2. The obligation to absorb the expected losses of the entity if they occur,or 3. The right to receive the expected residual returns of the entity if they occur The primary beneficiary bears the risks and receives the rewards of a variable interest entity and is considered to have a controlling financial interest. D. If a reporting entity has a controlling financial interest in a variable interest entity, it should include the assets, liabilities, and results of the activities of the variable interest entity its consolidated financial statements.
Proposed Accounting Standards Update on Variable Interest Entities In November 2011 (updated January 2013), the FASB issued a proposed change for evaluating whether an entity must consolidate a VIE. The proposed accounting standard update, entitled Principal versus Agent Analysis, would introduce a separate qualitative analysis to determine whether a reporting entity with the authority to make economic decisions for a VIE uses its power in a principal or agent capacity. If the decision making party is a principal (rather than an agent of another party) then it is the controlling party. Alternatively, if the party that exercises decision-making power acts in the capacity of an agent, under the proposed guidance that party would not consolidate the VIE. As this latest FASB proposal demonstrates, the manner in which control is assessed continues to evolve over time.
6-1 .
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Chapter 06 - Variable Interest Entities, Intra-Entity Debt, Consolidated Cash Flows, and Other Issues
II. Intra-entity debt transactions A.N o special difficulty is created when one member of a business combination loans money to another. The resulting receivable/payable accounts as well as the interest income expense balances are identical and can be directly offset in the consolidation process. B.T he acquisition of an affiliate's debt instrument from an outside party does require special handling so that consolidated financial statements can be produced. 1. Because the acquisition price will usually differ from the book value of the liability, a gain or loss has been created by an effective retirement which is not recorded within the individual records of either company. 2. Because of the amortization of any associated discounts and/or premiums, the interest income reported by the buyer will not equal the interest expense of the debtor. C.I n the year of acquisition, the consolidation process eliminates intra-entity accounts (the liability, the receivable, interest income, and interest expense) while the gain or loss (which produced all of the discrepancies because of the initial difference) is recognized. 1. Although several alternatives exist, this textbook assigns all income effects resulting from the retirement to the parent company, the party ultimately responsible for the decision to reacquire the debt. 2. Any noncontrolling interest is, therefore, not affected by the adjustments utilized to consolidate intra-entity debt. D.A fter the year of effective retirement, all intra-entity accounts must be eliminated again in each subsequent consolidation. However, when the parent uses the equity method, the parent’s Investment in Subsidiary account is adjusted in consolidation rather than a gain or loss account. If the parent employs an accounting method other than the equity method, then the parent’s Retained Earnings are adjusted for the prior years’ income net effects of the effective gain/loss on retirement. 1. The change in retained earnings is needed because a gain or loss was created in a prior year by the effective retirement of the debt, but only interest income and interest expense were recognized by the two parties. 2. The adjustment to retained earnings at any point in time is the original gain or loss adjusted for the subsequent amortization of discounts or premiums. III. Subsidiary preferred stock A. Subsidiary preferred shares not owned by the parent are a part of noncontrolling interest. B. The fair value of any subsidiary preferred shares not acquired by the parent is added to the consideration transferred along with the fair value of the noncontrolling interest in common shares to compute the acquisition-date fair value of the subsidiary. IV. Consolidated statement of cash flows A.S tatement is produced from consolidated balance sheet and income statement and not from the separate cash flow statements of the component companies. B.C onsolidated net income is the starting point for the cash flow from operating section— including both the parent and noncontrolling interest share. C.I ntra-entity cash transfers are omitted from this statement because they do not occur with an outside unrelated party. D.D ividends paid by the subsidiary to the noncontrolling interest are reported as a financing activity. 6-2 .
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Chapter 06 - Variable Interest Entities, Intra-Entity Debt, Consolidated Cash Flows, and Other Issues
V. Consolidated earnings per share A.T his computation normally follows the pattern described in intermediate accounting textbooks. For basic EPS, consolidated net income is divided by the weighted-average number of parent shares outstanding. If convertibles (such as bonds or warrants) exist for the parent shares, their weight must be included in computing diluted EPS but only if earnings per share is reduced. 1. The subsidiary's diluted earnings per share are computed first to arrive at (1) an earnings figure and (2) a shares figure. 2. The portion of the shares figure belonging to the parent is computed. That percentage of the subsidiary's diluted earnings is then added to the parent's net income in order to complete the earnings per share computation. VI. Subsidiary stock transactions A.I f the subsidiary issues new shares of stock or reacquires its own shares as treasury stock, a change is created in the book value underlying the parent's investment account. The increase or decrease should be reflected by the parent as an adjustment to this balance. B.T he book value of the subsidiary that corresponds to the parent's ownership is measured before and after the transaction with any alteration recorded directly to the investment account. The parent's additional paid-in capital (or retained earnings) account is normally adjusted although the recognition of a gain or loss is an alternate accounting treatment. C.T reasury stock acquired by the subsidiary may also necessitate a similar adjustment to the parent's investment account. In addition, any subsidiary treasury stock is eliminated within the consolidation process.
Answer to Discussion Question: Who Lost this $300,000? This case is designed to give life to a theoretical accounting issue: If a subsidiary's debt is retired, should the resulting gain or loss be assigned to the parent or to the subsidiary? The case illustrates that there is no clear-cut solution. This lack of an absolute answer makes financial accounting both intriguing and frustrating. The assignment decision is only necessary in the presence of a noncontrolling interest. Regardless of the ownership level all intra-entity balances are eliminated on the worksheet with a gain or loss recognized. Not until the consolidated net income is allocated across the controlling interest and the noncontrolling interest does the assignment decision have an impact. We assume that financial and operating decisions are made in the best interest of the business entity as a whole. This debt would not have been retired unless corporate officials believed that Penston/Swansan would benefit from the decision. Thus, an argument can be made against any assignment to either separate party. Students should choose and justify one method. Discussion often centers on the following: ▪
▪
Parent company officials made the actual choice that created the book loss. Therefore, assigning the $300,000 to the subsidiary directs the impact of their decision to the wrong party. In effect, the subsidiary had nothing to do with this transaction (as indicated in the case) so that its share of consolidated net income should not be affected by the $300,000 loss. The debt was that of the subsidiary. Because the subsidiary's debt is being retired, all of the $300,000 should be attributed to that party. Financial records measure the results of 6-3
.
.
Chapter 06 - Variable Interest Entities, Intra-Entity Debt, Consolidated Cash Flows, and Other Issues
▪
transactions and the retirement simply culminates an earlier transaction made by the subsidiary. The parent is doing no more than acting as an agent for the subsidiary (as indicated in the case). If the subsidiary had acquired its own debt, for example, no question as to the assignment would have existed. Thus, changing that assignment simply because the parent agreed to be the acquirer is not justified. Both parties were involved in the transaction so that some allocation of the loss is required. If, at the time of repurchase, a discount existed within the subsidiary's accounts, this figure would have been amortized to interest expense (if the debt had not been retired). Thus, the $300,000 loss was accepted now in place of the later amortization. This reasoning then assigns this portion of the loss to the subsidiary. Because the parent agreed to pay more than face value, that remaining portion is assigned to the buyer.
Answers to Questions 1. A variable interest entity (VIE) is a business structure that is designed to accomplish a specific purpose. A VIE can take the form of a trust, partnership, joint venture, or corporation although typically it has neither independent management nor employees. The entity is frequently sponsored by another firm to achieve favorable financing rates. 2. Variable interests are contractual, ownership, or other pecuniary interests in an entity that change with changes in the entity's net asset value. Variable interests will absorb portions of a variable interest entity's expected losses if they occur or receive portions of the entity's expected residual returns if they occur. Variable interests typically are accompanied by contractual arrangements that provide decision making power to the owner of the variable interests. Examples of variable interests include debt guarantees, lease residual value guarantees, participation rights, and other financial interests. 3. The following characteristics are indicative of an enterprise qualifying as a primary beneficiary with a controlling financial interest in a VIE. ▪ The power, through voting rights or similar rights, to direct the activities of an entity that most significantly impact the entity’s economic performance. ▪ The obligation to absorb the expected losses of the entity if they occur, or ▪ The right to receive the expected residual returns of the entity if they occur 4. Because the bonds were purchased from an outside party, the acquisition price is likely to differ from the book value of the debt in the subsidiary's records. This difference creates accounting challenges in handling the intra-entity transaction. From a consolidated perspective, the debt is retired; a gain or loss is reported with no further interest being recorded. In reality, each company continues to maintain these bonds on their individual financial records. Also, because discounts and/or premiums are likely to be present, these account balances as well as the interest income/expense will change from period to period because of amortization. For reporting purposes, all individual accounts must be eliminated with the gain or loss being reported so that the events are shown from the vantage point of the consolidated entity. 5. If the bonds are acquired directly from the affiliate company, all reciprocal accounts will be equal in amount. The debt and the receivable will be in agreement so that no gain or loss is created. Interest income and interest expense should also reflect identical amounts. 6-4 .
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Chapter 06 - Variable Interest Entities, Intra-Entity Debt, Consolidated Cash Flows, and Other Issues
Therefore, the consolidation process for this type of intra-entity debt requires no more than the offsetting of the various reciprocal balances. 6. The gain or loss to be reported is the difference between the price paid and the book value of the debt on the date of acquisition. For consolidation purposes, this gain or loss should be recognized immediately on the date of acquisition. 7. Because the bonds are still legally outstanding, they will continue to be found on both sets of financial records. Thus, each account (Bonds Payable, Investment in Bonds, Interest Expense, and Interest Income) must be eliminated within the consolidation process. Any gain or loss on the effective retirement as well as later effects on interest caused by amortization are also included to arrive at an adjustment to the beginning retained earnings (or the Investment account if the equity method is used) of the parent company. 8. The original gain is never recognized within the financial records of either company. Thus, within the consolidation process for the year of acquisition, the gain is directly recorded whereas (for each subsequent year) it is entered as an adjustment to beginning retained earnings (or the Investment account if the equity method is used). In addition, because the book value of the debt and the investment are not in agreement, the interest expense and interest income balances being recorded by the two companies will differ each year because of the amortization process. This amortization effectively reduces the difference between the individual retained earnings balances and the total that is appropriate for the consolidated entity. Consequently, a smaller change is needed each period to arrive at the balance to be reported. For this reason, the annual adjustment to beginning retained earnings (or the Investment account if the equity method is used) gradually decreases over the life of the bond. 9. No set rule exists for assigning the income effects from intra-entity debt transactions although several different theories exist and include: (1) assignment of the entire amount to the debtor, (2) assignment of the entire amount to the buyer, and (3) allocation of the gain or loss between the two parties in some manner. This textbook attributes the entire income effect (the $45,000 gain in this case) to the parent company. Assignment to the parent is justified because that party is ultimately responsible for the decision to retire the debt from the public market. The answer to the discussion question included in this chapter analyzes this question in more detail. 10. Subsidiary outstanding preferred shares are part of the noncontrolling interest and are included in the consolidated financial statements at acquisition-date fair value and subsequently adjusted for their share of subsidiary income and dividends. 11. The consolidated cash flow statement is developed from consolidated balance sheet and income statement figures. Thus, the cash flows generated by operating, investing, and financing activities are identified only after the consolidation of these other statements. 12. The noncontrolling interest share of the subsidiary’s net income is a component of consolidated net income. Consolidated net income then is adjusted for noncash and other items to arrive at consolidated cash flows from operations. Any dividends paid by the subsidiary to these outside owners are listed as a financing activity because an actual cash outflow occurs.
6-5 .
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Chapter 06 - Variable Interest Entities, Intra-Entity Debt, Consolidated Cash Flows, and Other Issues
13. An alternative to the normal diluted earnings per share calculation is required whenever the subsidiary has dilutive convertible securities such as bonds or warrants. In this case, the potential impact of the conversion of subsidiary shares must be factored into the overall diluted earnings per share computation. 14. Basic Earnings per Share. The existence of subsidiary convertible securities does not affect basic EPS. The parent’s basic earnings per share is computed by dividing the parent’s share of consolidated net income by the weighted average number of parent shares outstanding. Diluted Earnings per Share. The subsidiary's diluted earnings per share is computed by including both convertible items. The portion of the parent's controlled shares to the total shares used in this calculation is then determined. Only this percentage (of the income figure used in the subsidiary's computation) is added to the parent's income in arriving at the parent company’s diluted earnings per share. 15. Several reasons could exist for a subsidiary to issue new shares of stock to outside parties. First, additional financing is brought into the company by any such sale. Also, stock issuance may be used to entice new individuals to join the organization. Additional management personnel, as an example, might be attracted to the company in this manner. The company could also be forced to sell shares because of government regulation. Many countries require some degree of local ownership as a prerequisite for operating within that country. 16. Because the new stock was issued at a price above the subsidiary’s assigned consolidation value, the overall valuation for Metcalf's stock has been increased. Consequently, the Washburn's investment is increased to reflect this change. To measure the effect, the value of Washburn's investment is calculated both before and after the new issue. Because the increment is the result of a stock transaction, an increase is made to additional paid-in capital. Although the subsidiary's shares (both new and old) are eliminated in the consolidation process, the increase in the parent's APIC (or gain or loss) carries into the consolidated figures. Also, the noncontrolling interest percentage of the subsidiary increases. 17. A stock dividend does not alter the assigned consolidated subsidiary value and, thus, creates no effect on Washburn's investment account or on the consolidated figures. Hence, no entry is recorded by the parent company in connection with the subsidiary's stock dividend.
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Chapter 06 - Variable Interest Entities, Intra-Entity Debt, Consolidated Cash Flows, and Other Issues
Answers to Problems 1.C 2.B 3.D 4. A 5. D 6. D Cash flow from operations: Net income ................................................................. Depreciation............................................................... Trademark amortization ............................................ Increase in accounts receivable............................... Increase in inventory................................................. Increase in accounts payable................................... Cash flow from operations ....................................... 7. C
$45,000 10,000 15,000 (17,000) (40,000) 12,000
Cash flow from financing activities: Dividends to parent’s interest .................................. Dividends to noncontrolling interest (20% $5,000) Reduction in long-term notes payable .................... Cash flow from financing activities .........................
(20,000) $25,000
($12,000) (1,000) (25,000) ($38,000)
8. C 9. C Post-issue subsidiary valuation ($800,000 + $250,000) Arcola’s new ownership percentage (40,000 ÷ 50,000) Arcola’s share of post-issue subsidiary valuation Arcola’s pre-issue equity balance Increase to Arcola’s investment account
$1,050,000 80% $ 840,000 800,000 $ 40,000
10. C Dane’s income from own operations....................... Carlton’s income ...................................................... Eliminate intra-entity interest income...................... Eliminate intra-entity interest expense .................... Recognize retirement gain on debt ($209,000 – $196,000) Consolidated net income ....................................
$185,000 105,000 (19,000) 18,000 13,000 $302,000
11. B Mattoon’s share of consolidated net income .......... Number of Mattoon common shares outstanding ..
$465,000 100,000
Mattoon’s EPS = ($465,000 ÷ 100,000 shares).........
$4.65
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Chapter 06 - Variable Interest Entities, Intra-Entity Debt, Consolidated Cash Flows, and Other Issues
12. B Aaron net income ..................................................... Less intra-entity dividends (initial value method) .. Zeese reported net income ...................................... Gain on extinguishment of debt ($60,200 – $56,000) Eliminate interest expense on "retired" debt ($60,200 × 10%) .................................................... Eliminate interest income on "retired" debt ($56,000 × 12%) .................................................... Consolidated net income .........................................
$430,000 (8,050) $421,950 164,000 4,200 6,020 (6,720) $589,450
13. B 30% of $147,000 subsidiary net income; the intra-entity debt effects are attributed solely to the parent company. 30% x $147,000 = $44,100 14. A For 2014, the adjustment to beginning retained earnings should recognize the gain on the retirement of the debt, the elimination of the 2013 interest expense, and the elimination of the 2013 interest income. Gain on Retirement of Bond: Original book value ............................................................. 2010–2012 amortization ($600,000 ÷ 20 yrs. × 3 yrs.) ....... Book value, January 1, 2013 ............................................... Percentage of bonds retired ............................................... Book value of retired bonds ............................................... Cash received ($4,000,000 × 96.6%) ................................... Gain on retirement of bonds ...............................................
$10,600,000 (90,000) $10,510,000 40% $4,204,000 3,864,000 $ 340,000
Interest Expense on Intra-Entity Debt—2013 Cash interest expense (9% × $4,000,000) .......................... Premium amortization ($30,000 per year total × 40% retired portion of bonds) ............................................... Interest expense on intra-entity debt .................................
(12,000) $348,000
Interest Income on Intra-Entity Debt—2013 Cash interest income (9% × $4,000,000) ............................ Discount amortization (.034 × $4,000,000 ÷ 17 years) ....... Interest income on intra-entity debt ...................................
$360,000 8,000 $368,000
Adjustment to 1/1/14 Retained Earnings Recognition of 2013 gain on extinguishment of debt (above) ..... Elimination of 2013 intra-entity interest expense (above)............ Elimination of 2013 intra-entity interest income (above) ............. Increase in retained earnings, 1/1/14 .......................................
$340,000 348,000 (368,000) $320,000
6-8 .
$360,000
.
Chapter 06 - Variable Interest Entities, Intra-Entity Debt, Consolidated Cash Flows, and Other Issues
15. D Consideration transferred for preferred stock ............................. $ 424,000 Consideration transferred for common stock .............................. 3,960,000 Noncontrolling interest fair value for preferred ........................... 1,696,000 Noncontrolling interest fair value for common ............................ 440,000 Acquisition-date fair value ............................................................. 6,520,000 Acquisition-date identified net asset fair value ........................... (6,000,000) Goodwill .......................................................................................... $ 520,000 16. B Consideration transferred for preferred stock ............................. $214,000 Consideration transferred for common stock .............................. 1,253,280 Noncontrolling interest fair value for common ............................ 835,520 Acquisition-date fair value ............................................................. $2,302,800 Acquisition-date book value .......................................................... (2,174,000) Excess fair over book value ........................................................... $ 128,800 to building .................................................................................. 63,600 to goodwill .................................................................................. $ 65,200 17. B Parent’s reported sales ............................................ Subsidiary's reported sales ..................................... Less: intra-entity transfers ...................................... Sales to outsiders ............................................... Less: increase in receivables ................................... Cash generated by sales ....................................
$480,000 264,000 (57,600) $686,400 (37,300) $649,100
18. B Subsidiary’s unamortized fair value of prior to new share issue (12,000 × $49) ....................................................... Parent's ownership ................................................... Unamortized subsidiary fair value .........................
$588,000 100% $588,000
Subsidiary unamortized fair value after issuing new shares (above value plus 3,000 shares at $50 each) Parent's ownership 12,000 ÷ 15,000 shares) .......... Unamortized subsidiary fair value after stock issue
$738,000 80% $590,400
Investment in Veritable increases by $2,400 ($590,400 less $588,000). 19. A Because the parent acquired 80 percent of the new shares, its proportional ownership remains the same. Because the amount the parent pays will necessarily equal 80 percent of the increase in the subsidiary's book value, no separate adjustment by the parent is required.
6-9 .
.
Chapter 06 - Variable Interest Entities, Intra-Entity Debt, Consolidated Cash Flows, and Other Issues
20. C Adjusted acquisition-date sub. fair value at 1/1/14 Consideration transferred ........................................................ Noncontrolling interest acquisition-date fair value ................ Increase in Stamford book value .............................................. Stock issue proceeds ................................................................ Subsidiary valuation basis 1/1/14 .................................................. New parent ownership (32,000 shs. ÷ 50,000 shs.) ...................... Parent’s post-stock issue ownership balance .............................. Parent's investment account ($592,000 + [80% × 80,000]) .......... Required adjustment —decrease ............................................
$592,000 148,000 80,000 150,000 970,000 64% $620,800 656,000 $(35,200)
21. D Adjusted acquisition-date fair value ($820,000 – $192,000) ........ New parent ownership (32,000 shs. ÷ 32,000 shs.) ...................... Fair value equivalency of parent's ownership ........................ Parent's investment account ($592,000 + [80% × 80,000]) .......... Required adjustment—decrease ..............................................
$628,000 100% $628,000 656,000 $ (28,000)
22. (10 minutes) (Qualification of Primary Beneficiary of a VIE) Consolidation of a variable interest entity is required if a firm has a variable interest that gives the firm ▪
The power, through voting rights or similar rights, to direct the activities of an entity that most significantly impact the entity’s economic performance.
▪
The obligation to absorb a majority of the entity's expected losses if they occur and/or the right to receive a majority of the entity's expected residual returns if they occur
Because (1) HCO Media’s losses are limited by contract, and (2) Hillsborough has the right to receive the residual benefits of the sales generated on the HCO Media internet site above $500,000, Hillsborough should consolidate HCO Media. 23.(3
0 minutes) (VIE Qualifications for Consolidation)
a.T he purpose of consolidated financial statements is to present the financial position and results of operations of a group of businesses as if they were a single entity. They are designed to provide information useful for making business and economic decisions—especially assessing amounts, timing, and uncertainty of prospective cash flows. Consolidated statements also provide more complete information about the resources, obligations, risks, and opportunities of an enterprise than separate statements. b. An entity qualifies as a VIE and is subject to consolidation if either of the following conditions exist. 6-10 .
.
Chapter 06 - Variable Interest Entities, Intra-Entity Debt, Consolidated Cash Flows, and Other Issues
23. (continued) ▪
The total equity at risk is not sufficient to permit the entity to finance its activities without additional subordinated financial support from other parties. In most cases, if equity at risk is less than 10% of total assets, the risk is deemed insufficient.
▪
The equity investors in the VIE lack any one of the following three characteristics of a controlling financial interest. 1. The power, through voting rights or similar rights, to direct the activities of an entity that most significantly impact the entity’s economic performance. 2. The obligation to absorb the expected losses of the entity if they occur (e.g., another firm may guarantee a return to the equity investors) 3. The right to receive the expected residual returns of the entity (e.g., the investors' return may be capped by the entity's governing documents or other arrangements with variable interest holders).
Consolidation of a variable interest entity is required if a firm has a variable interest that gives the firm ▪
The power, through voting rights or similar rights, to direct the activities of an entity that most significantly impact the entity’s economic performance.
▪
The obligation to absorb a majority of the entity's expected losses if they occur and/or the right to receive a majority of the entity's expected residual returns if they occur
c. Risks of the construction project that has TecPC has effectively shifted to the owners of the VIE: At the end of the 1st five-year lease term, if the parent opts to sell the facility, and the proceeds are insufficient to repay the VIE investors, TecPC may be required to pay up to 85% of the project's cost. Thus, a potential 15% risk. Risks that remain with TecPC ▪
Guarantees of return to VIE investors at market rate, if facility does not perform as expected TecPC is still obligated to pay market rates.
▪
If lease is not renewed, TecPC must either purchase the facility or sell it on behalf of the VIE with a guarantee of Investors' (debt and equity) balances representing a risk of decline in market value of asset
▪
Debt guarantees
6-11 .
.
Chapter 06 - Variable Interest Entities, Intra-Entity Debt, Consolidated Cash Flows, and Other Issues
23. (continued) d. TecPC possesses the following characteristics of a primary beneficiary: ▪ Direct decision-making ability (end of five-year lease term). ▪
Absorb a majority of the entity's expected losses if they occur (via debt guarantees and guaranteed lease payments and residual value).
▪
Receive a majority of the entity's expected residual returns if they occur (via use of the facility and potential increase in its market value).
24. (10 minutes) (Consolidation of variable interest entity.) a. Implied valuation and excess allocation for Softplus. Noncontrolling interest fair value Consideration transferred by Pantech Total business fair value Fair value of VIE net assets Excess net asset value fair value
$ 60,000 20,000 80,000 100,000 $20,000
PanTech recognizes the $20,000 excess net asset fair value as a bargain purchase and records all of SoftPlus’ assets and liabilities at their individual fair values. Cash $20,000 Marketing software 160,000 Computer equipment 40,000 Long-term debt (120,000) Noncontrolling interest (60,000) Pantech equity interest (20,000) Gain on bargain purchase (20,000) -0b. Implied valuation and excess allocation for Softplus. Noncontrolling interest fair value 60,000 Consideration transferred by Pantech 20,000 Total business fair value 80,000 Fair value of VIE net identifiable assets 60,000 Goodwill $20,000 When the fair value of a VIE (that is a business) is greater than assessed asset values, all identifiable assets and liabilities are reported at fair values (unless a previously held interest) and the difference is treated as goodwill. Cash Marketing software Computer equipment Goodwill (excess business fair value) Long-term debt Noncontrolling interest Pantech equity interest
6-12 .
.
$20,000 120,000 40,000 20,000 (120,000) (60,000) (20,000) -0-
Chapter 06 - Variable Interest Entities, Intra-Entity Debt, Consolidated Cash Flows, and Other Issues
25. (40 minutes) (Acquisition-date consolidated worksheet for a parent and a variable interest entity) Access IT 61,000 1,000,000
Net Connect 41,000
Capitalized software Computer equipment Communications equipment Research and development asset Patent Goodwill Total assets
981,000 1,066,000
156,000 56,000
1,137,000 1,122,000
916,000
336,000
1,252,000
4,024,000
780,000
Long-term debt Common stock-Access IT Common stockNetConnect Retained earnings Noncontrolling interest Total liabilities and equity
(941,000) (2,660,000)
(616,000)
Cash Investment in NetConnect
Adjust. & Elim.
NCI
S 65,600 A 934,400
A1,960,000
1,960,000 191,000 376,000 6,140,000
191,000 A 376,000
(423,000) (4,024,000)
Consolidated Balances 102,000
(41,000) (123,000) (780,000)
(1,557,000) (2,660,000) S S
2,401,600
Consideration transferred Noncontrolling interest fair value Acquisition-date fair value Book value Excess fair over book value Research and development asset Goodwill
$1,000,000 1,500,000 $2,500,000 (164,000) $2,336,000 1,960,000 $ 376,000
.
.
6-13
16,400 49,200 A 1,401,600 2,401,600
(24,600) (73,800) (1,401,600)
(423,000) (1,500,000) (6,140,000)
Chapter 06 - Variable Interest Entities, Intra-Entity Debt, Consolidated Cash Flows, and Other Issues
26. (25 Minutes) (Consolidation entry for three consecutive years to report effects of intra-entity bond acquisition. Straight-line method used. Parent uses equity method) a. Book Value of Bonds Payable, January 1, 2013 Book value, January 1, 2011 ................................................. Amortization—2011–2012 ($5,000 per year [$50,000 premium ÷ 10 years] for two years) .................. Book value of bonds payable, January 1, 2013 .................... Book value of 40% of bonds payable (intra-entity portion), January 1, 2013 ............................. Gain on Retirement of Bonds, January 1, 2013 Purchase price ($400,000 × 96%) .......................................... Book value of liability (computed above) ............................. Gain on retirement of bonds ................................................. Book Value of Bonds Payable, December 31, 2013 Book value, January 1, 2013 (computed above) .................. Amortization for 2013.............................................................. Book value of bonds payable, December 31, 2013 .............. Book value of 40% of bonds payable (intra-entity portion), December 31, 2013 ............................................................ Book Value of Investment, December 31, 2013 Book value of investment, January 1, 2013 (purchase price) Amortization for 2013 ($16,000 discount ÷ 8-yr. rem. life) .. Book value of investment, December 31, 2013 .................... Intra-entity Interest Balances for 2013 Interest expense: Cash payment ($400,000 × 9%) ........................................ Amortization of premium for 2013 ($5,000 per year × 40% intra-entity portion) .......................................... Intra-entity interest expense ............................................ Interest income: Cash collection ($400,000 × 9%) ...................................... Amortization of discount for 2013 (above) ..................... Intra-entity interest income ..............................................
6-14 .
.
$1,050,000 10,000 $1,040,000 $416,000
$384,000 416,000 $ 32,000
$1,040,000 5,000 $1,035,000 $414,000
$384,000 2,000 $386,000
$36,000 2,000 $34,000
$36,000 2,000 $38,000
Chapter 06 - Variable Interest Entities, Intra-Entity Debt, Consolidated Cash Flows, and Other Issues
26. (continued) CONSOLIDATION ENTRY B (2013) Bonds Payable .......................................................... 400,000 Premium on Bonds Payable ..................................... 14,000 Interest Income .......................................................... 38,000 Investment in Bonds.............................................. 386,000 Interest Expense ................................................... 34,000 Gain on Retirement of Bonds .............................. 32,000 (To eliminate accounts stemming from intra-entity bonds [balances computed above] and to recognize gain on the effective retirement of this debt.) b. In 2014, because straight-line amortization is used, the interest accounts remain unchanged at $38,000 and $34,000. However, the premium associated with the bond payable as well as the discount on the investment are affected by the $2,000 per year amortization. In addition, the gain now has to be removed from the Investment in Hamilton account. Concurrently, the two interest balances recorded by the individual companies in 2013 are removed from the Investment in Hamilton because they occurred after the intra-entity retirement. Gain of $32,000 plus $34,000 expense removal less $38,000 income elimination yields a $28,000 credit to the investment account. CONSOLIDATION ENTRY *B (2014) Bonds Payable .............................................................. 400,000 Premium on Bonds Payable (net of $2,000 amort.) ........ 12,000 Interest Income .............................................................. 38,000 Investment in Bonds (net of $2,000 amorti.) ............... 388,000 Interest Expense ....................................................... 34,000 Investment in Hamilton ............................................. 28,000 (To remove intra-entity bond accounts that remain on the individual records of both companies. Both debt and bond investment balances have been adjusted for 2013–13 amortization. Entry to Investment in Hamilton brings the totals reported by the individual companies [interest income and expense] to the balance of the original gain.) c. As with part b, new premium and discount balances must be determined and then removed. The adjustment made to the Investment in Hamilton takes into account that another year of interest expense ($34,000) and income ($38,000) have been incorporated into the investment account through application of the equity method.
6-15 .
.
Chapter 06 - Variable Interest Entities, Intra-Entity Debt, Consolidated Cash Flows, and Other Issues
26. (continued) CONSOLIDATION ENTRY *B (2015) Bonds Payable .................................................... Premium on Bonds Payable ............................... Interest Income .................................................... Investment in Bonds ...................................... Interest Expense ............................................ Investment in Hamilton ..................................
400,000 10,000 38,000 390,000 34,000 24,000
(To remove intra-entity bond accounts that remain on the individual records of both companies. Both debt and bond investment balances have been adjusted for 2013–2015 amortization. Credit to Investment in Hamilton brings the totals reported by the individual companies to the balance of the original gain.) 27.
(12 Minutes) (Determine consolidated income statement accounts after acquisition of intra-entity bonds.) ▪
Interest Expense To Be Eliminated = $84,000 × 11% = $9,240
▪
Interest Income To Be Eliminated = $108,000 × 8% = $8,640
▪
Loss To Be Recognized = $108,000 – $84,000 = $24,000
CONSOLIDATED TOTALS ▪
Revenues and Interest Income = $1,051,360 (add the two book values and eliminate interest income on intra-entity bond)
▪
Operating and Interest Expense = $751,760 (add the two book values and eliminate interest expense on intra-entity bond)
▪
Other Gains and Losses = $152,000 (add the two book values)
▪
Loss on Retirement of Debt = $24,000 (computed above)
▪
Net Income = $427,600 (consolidated revenues, interest income, and gains less consolidated operating and interest expense and losses)
6-16 .
.
Chapter 06 - Variable Interest Entities, Intra-Entity Debt, Consolidated Cash Flows, and Other Issues
28.
(30 Minutes) (Consolidation entry for two years to report effects of intraentity bond acquisition. Effective rate method applied.) a. Loss on Repurchase of Bond Cost of acquisition ......................................... Book value ($760,000 × 1/5) .......................... Loss on repurchase .......................................
$201,000 152,000 $ 49,000
Interest Balances for 2013 Interest income: $201,000 × 7% ...........................................
$14,070
Interest expense: $152,000 (book value [above]) × 12% .....
$18,240
Investment in Bonds Balance, December 31, 2013 Original cost, 1/1/13 ........................................ Amortization of premium: Cash interest ($180,000 × 9%) ................. $16,200 Effective interest income (above) ........... 14,070 Investment in Bonds, 12/31/13 ....................... Bonds Payable Balance, December 31, 2013 Book value, 1/1/13 (above) ............................ Amortization of discount: Cash interest ($180,000 × 9%) ................. Effective interest expense (above) .......... Bonds payable, 12/31/13 ................................
$201,000
2,130 $198,870
$152,000 $16,200 18,240
2,040 $154,040
Entry B—12/31/13 Bonds Payable ............................................... 154,040 Interest Income .............................................. 14,070 Loss on Retirement of Debt .......................... 49,000 Investment in Bonds ................................ 198,870 Interest Expense ....................................... 18,240 (To eliminate intra-entity debt holdings and recognize loss on retirement.) b. Interest Balances for 2014 followed by 2015 Interest income: $198,870 (Investment in Bonds balance for the year) × 7% (rounded).......................
$13,921
Interest expense: $154,040 (liability balance for the year) × 12% (rounded) ...................................
$18,485
6-17 .
.
Chapter 06 - Variable Interest Entities, Intra-Entity Debt, Consolidated Cash Flows, and Other Issues
28. (continued) Investment in Bonds Balance, December 31, 2014 Book value, January 1, 2014 (part a) ....................... Amortization of premium: Cash interest ($180,000 × 9%) ............................ Effective interest income (above) ...................... Investment in Bonds balance, December 31, 2014 . Bonds Payable Balance, December 31, 2014 Book value, January 1, 2014 (part a) ....................... Amortization of discount: Cash interest ($180,000 × 9%) ............................ Effective interest expense (above) .................... Bonds payable balance, December 31, 2014 ..........
$198,870 $16,200 13,921
$154,040 $16,200 18,485
Interest Balances for 2015 Interest income: $196,591 (Investment in Bonds.... balance for the year [above]) × 7% (rounded)
Bonds Payable Balance, December 31, 2015 Book value, January 1, 2015 (above) ...................... Amortization of discount: Cash interest ($180,000 × 9%) ............................ Effective interest expense (above) .................... Bonds payable balance, December 31, 2015 ..........
6-18 .
.
2,285 $156,325
$13,761
Interest expense: $156,325 (liability balance for the year [above]) × 12% ................................ Investment in Bonds Balance, December 31, 2015 Book value, January 1, 2015 (above) ...................... Amortization of premium: Cash interest ($180,000 × 9%) ............................ Effective interest income (above) ...................... Investment in Bonds balance, December 31, 2015 .
2,279 $196,591
$18,759
$196,591 $16,200 13,761
2,439 $194,152
$156,325 $16,200 18,759
2,559 $158,884
Chapter 06 - Variable Interest Entities, Intra-Entity Debt, Consolidated Cash Flows, and Other Issues
28. (continued) Adjustment Needed to Investment in Zack for Bond Retirement Loss: Loss on retirement of debt (part a) ............................................ Amounts recognized in previous years: Interest income: 2013 $(14,070) 2014 (13,921) $(27,991) 2013 $18,240 2014 18,485 36,725 Adjustment needed to Investment in Zack to arrive at consolidated total ..................................
$49,000
Interest expense:
8,734 $40,266
Entry *B—12/31/15 Bonds Payable .......................................................... Interest Income ......................................................... Investment in Zack ................................................... Investment in Bonds ........................................... Interest Expense .................................................
158,884 13,761 40,266 194,152 18,759
(To eliminate intra-entity bond holdings and adjust the Investment in Zack for the unrecognized loss on retirement. Amounts computed above.) Many of the above amounts can also be determined using amortization tables as shown below. Investment in Bonds Amortization Table:
Cash 2013 2014 2015
16,200 16,200 16,200
Interest Revenue Amortization 14,070 13,921 13,761
2,130 2,279 2,439
Carrying Value 201,000 198,870 196,591 194,152
Intra-Entity Portion of Bonds Payable Amortization Table:
2013 2014 2015
Cash
Interest Expense
Amortization
16,200 16,200 16,200
18,240 18,485 18,759
(2,040) (2,285) (2,559)
Carrying Value 152,000 154,040 156,325 158,884
6-19 .
.
Chapter 06 - Variable Interest Entities, Intra-Entity Debt, Consolidated Cash Flows, and Other Issues
29. (35 Minutes) (Consolidation procedures and balances related to intra-entity bonds. Both straight-line and effective interest rate methods are used.) a. Acquisition price of bonds ............................................................... Book value of bonds payable (see Schedule 1) ($443,497 × 50%) .......................................................................... Loss on retirement ............................................................................
$283,550 (221,749) $61,801
SCHEDULE 1—Book Value of Bonds Payable
Date 2011 2012 2013
Book Value $435,763 $438,055 $440,622
Effective Interest (12% Rate) $52,292 $52,567 $52,875
Cash Interest $50,000 $50,000 $50,000
Amortization $2,292 $2,567 $2,875
b. Investment in Bloom Bonds Purchase price—12/31/13 ......................................... Cash interest ($250,000 × 10%) ............................... Effective interest income ($283,550 × 8%) .............. Amortization ........................................................ Investment in Bloom bonds, 12/31/14 ..................... Bonds Payable Book value—12/31/13 (computed above) ............... Cash interest ($500,000 × 10%) ............................... Effective interest expense ($443,497 × 12%) .......... Amortization ........................................................ Bonds payable, 12/31/14 ..........................................
Year-End Book Value $438,055 $440,622 $443,497
$283,550 $25,000 22,684 2,316 $281,234
$443,497 $50,000 53,220 3,220 $446,717
Although not required, the consolidation entry as of 12/31/14 is as follows. The reduction in retained earnings represents the loss only; no intra-entity interest was recognized in the previous year because the purchase was made on December 31. Entry *B (2014) Bonds Payable ($446,717 × 50%) ............................ Interest Income ......................................................... Retained Earnings, 1/1/14 ........................................ Interest Expense ($53,220 × 50%) ...................... Investment in Bloom Bonds ...............................
6-20 .
.
223,359 22,684 61,801 26,610 281,234
Chapter 06 - Variable Interest Entities, Intra-Entity Debt, Consolidated Cash Flows, and Other Issues
29.(continued) c.L oss on Retirement of Bond Because Bloom uses the straight-line method of amortization, the loss on retirement must be computed again. Original issue price—1/1/11......................................................... Discount amortization (2011–2013) ([$64,237 ÷ 11] × 3 years).. Book value 12/31/13 ....................................................................
$435,763 17,519 $453,282
Intra-entity portion of bonds payable (50%) .............................. Purchase price ............................................................................. Loss on retirement ......................................................................
$226,641 283,550 $ 56,909
Investment in Bloom Bonds Purchase price—12/31/13 ........................................................... Premium amortization (2014) ($33,550 ÷ 8) ............................... Book value 12/31/14 ...............................................................
$283,550 (4,194) $279,356
Interest Income Cash interest ($250,000 × 10%) .................................................. Premium amortization (above) ................................................... Intra-entity interest income—2014 ........................................
$25,000 (4,194) $20,806
Bonds Payable Original issue price 1/1/11 ........................................................... Discount amortization (2011–2014) [($64,237 ÷ 11) × 4 years] . Book value 12/31/14 ............................................................... Opus ownership ..................................................................... Intra-entity portion—12/31/14 ..........................................
$435,763 23,359 $459,122 50% $229,561
Interest Expense Cash interest ($250,000 × 10%) .................................................. Discount amortization ([$64,237 ÷ 11] × 1/2) ............................. Intra-entity interest expense—2014 ......................................
$25,000 2,920 $27,920
The reduction in retained earnings represents the loss only; no intra-entity interest was recognized in the previous year because the purchase was made on December 31. Entry *B (2014) Bonds Payable .......................................................... Interest Income ......................................................... Retained Earnings, 1/1/14 ....................................... Interest Expense ................................................ Investment in Bloom Bonds ............................... 6-21 .
.
229,561 20,806 56,909 27,920 279,356
Chapter 06 - Variable Interest Entities, Intra-Entity Debt, Consolidated Cash Flows, and Other Issues
30. (8 Minutes) (Determine goodwill for an acquisition in which subsidiary has both common stock and preferred stock) Consideration transferred for common stock Consideration transferred for preferred stock Noncontrolling interest in common stock Noncontrolling interest in preferred stock Hepner’s acquisition-date fair value Book value of Hepner Goodwill
$1,600,000 630,000 400,000 270,000 $2,900,000 2,500,000 $400,000
31. (30 Minutes) (Consolidation entries with subsidiary cumulative preferred stock.) a. The preferred shares are entitled to the specified cumulative dividend. Thus, the noncontrolling interest's share of the subsidiary's income equals $160,000 or 8 percent of the preferred stock's par value. b. Acquisition-Date Fair Value Allocation and Amortization Consideration transferred ........................................................... $14,040,000 Noncontrolling interest fair value (preferred shares) ................ 2,000,000 Acquisition-date fair value of Smith ........................................... 16,040,000 Book value ................................................................................... (16,000,000) Franchises .................................................................................... $ 40,000 Period of amortization ................................................................. 40 years Annual amortization .................................................................... $1,000 Investment in Smith Account, December 31, 2014 Consideration transferred, January 1, 2014 .............................. $14,040,000 Equity accrual (income remaining for common stock after preferred stock dividend) ............................................. 290,000 Dividends collected ($360,000 total less $160,000 paid to preferred shareholders) ............................................ (200,000) Amortization for 2014 (above) .................................................... (1,000) Investment in Smith account, December 31, 2014..................... $14,129,000 c. Consolidation Entries Entry S and A combined Preferred Stock (Smith) ........................................... 2,000,000 Common Stock (Smith) ............................................ 4,000,000 Retained Earnings, 1/1/14 (Smith) ........................... 10,000,000 Franchises ................................................................. 40,000 Investment in Smith ........................................ 14,040,000 Noncontrolling Interest in Smith, Inc ............ 2,000,000 (To eliminate subsidiary stockholders’ equity, record excess fair values, and record outside ownership of subsidiary's preferred stock at fair value)
6-22 .
.
Chapter 06 - Variable Interest Entities, Intra-Entity Debt, Consolidated Cash Flows, and Other Issues
31. c. (continued) Entry I
Equity Income of Subsidiary .............................. 289,000 Investment in Smith ....................................... 289,000 (To eliminate equity accrual made in connection with common stock [$290,000] along with excess amortization recorded by parent.)
Entry D Investment in Smith ............................................ 200,000 Dividends Declared ........................................ 200,000 (To remove intra-entity dividend declarations made on common stock [see computation above].) Entry E Amortization Expense ......................................... 1,000 Franchises ...................................................... 1,000 (To recognize amortization of franchises for current year [see computation above].) 32. (30 Minutes) (Prepare consolidation entries for an acquisition where subsidiary has outstanding preferred stock) Consideration transferred for common stock $ 7,368,000 Consideration transferred for preferred stock 3,100,000 Noncontrolling interest in common stock 4,912,000 Acquisition-date fair value for Young $15,380,000 Young’s book value 15,000,000 Excess fair over book value 380,000 to building (5-year life) $200,000 to equipment (10-year life) (100,000) 100,000 to brand name (20-year life) $280,000 CONSOLIDATION ENTRIES Entries S and A combined Preferred Stock (Young) .......................................... 1,000,000 Common Stock (Young) ........................................... 4,000,000 Retained Earnings (Young) ...................................... 10,000,000 Brand Name ............................................................... 280,000 Building .................................................................... 200,000 Equipment ............................................................ Investment in Young's preferred stock (100%) . Investment in Young's common stock (60%) ... Noncontrolling Interest .......................................
100,000 3,100,000 7,368,000 4,912,000
(To eliminate subsidiary stockholders’ equity, record excess acquisition-date fair values, and record outside ownership of subsidiary's preferred stock at acquisition-date fair value) 6-23 .
.
Chapter 06 - Variable Interest Entities, Intra-Entity Debt, Consolidated Cash Flows, and Other Issues
32. (continued) Entry I1 Dividend Income ....................................................... 80,000 Dividends Declared ............................................. 80,000 (To offset intra-entity preferred stock dividends recognized as income by parent— $1,000,000 par value × 8% dividend rate.) Entry I2 Dividend Income ....................................................... 192,000 Dividends Declared ............................................. 192,000 (To eliminate intra-entity dividends [60% of $320,000] on common stock. Because the $320,000 in dividends remaining after Entry I1 equals exactly 8 percent of the common stock par value, the participation factor does not affect the distribution.) Entry E Amortization Expense .............................................. 44,000 Equipment ................................................................. 10,000 Building ................................................................ Brand Name ......................................................... (To record 2014 amortization of specific accounts recognized within acquisition price of preferred stock.)
6-24 .
.
40,000 14,000
Chapter 06 - Variable Interest Entities, Intra-Entity Debt, Consolidated Cash Flows, and Other Issues
33. (15 Minutes) (The effect that various events have on a consolidated statement of cash flows.) ▪
Sale of building. The $44,000 in cash received from the sale is listed as a cash inflow within the company's investing activities. If the company is using the direct method in presenting cash flows from operating activities, the $12,000 gain is not presented. However, if the indirect method is used, the gain (a positive) must be eliminated from net income by a subtraction.
▪
Intra-entity inventory transfers. Because these transactions do not occur with any parties outside of the business combination, they are not reflected in the consolidated statement of cash flows.
▪
Dividend paid by the subsidiary. The $27,000 payment to the parent is eliminated in consolidated statements and is not a cash outflow from the consolidated entity. The remaining $3,000 payment to the noncontrolling interest is reported as a cash outflow from a financing activity.
▪
Amortization of intangible asset. This $16,000 noncash expense appears in the consolidated income statement. If the combined companies are using the direct method to present cash flows from operating activities, this expense not presented. If the indirect method is used, the expense must be removed by adding it back to consolidated net income.
▪
Decrease in accounts payable. Cash payments have reduced this liability balance during the period. If the direct method is used to present cash flows from operating activities, the change is added to cost of goods sold as one step in deriving the cash paid during the period for inventory (an outflow). If the indirect method is applied, the decrease is subtracted from net income in arriving at the net cash generated from operating activities during the period.
6-25 .
.
Chapter 06 - Variable Interest Entities, Intra-Entity Debt, Consolidated Cash Flows, and Other Issues
34. (20 Minutes) (Determine cash flows from operations for a consolidated entity.) DIRECT METHOD Cash revenues (add book values, eliminate intra-entity transfers, and add decrease in accounts receivable) ................................... $648,000 Cash inventory purchases (add book values, eliminate intra-entity transfers, eliminate unrealized gains, add increase in inventory, and add decrease in accounts payable) ...................... (370,000) Depreciation and amortization (omit as noncash expenses) ............ -0Other expenses (add book values) ..................................................... (40,000) Gain on sale of equipment (omit because this is an investing activity) -0Equity in earnings of Knight (intra-entity so not included) .............. -0Net cash flow from operating activities ................................... $238,000 INDIRECT METHOD Consolidated net income (computed below) ..................................... Adjustments: Depreciation and amortization ................................................. Gain on sale of equipment ....................................................... Increase in inventory ................................................................ Decrease in accounts receivable ............................................. Decrease in accounts payable ................................................. Net cash flow from operating activities .............................
$216,000 61,000 (30,000) (11,000) 8,000 (6,000) $238,000
Consolidated Net Income = $206,200 + 9,800 = $216,000 or computation below: Revenues (add book values and subtract intra-entity transfers) $640,000 Cost of goods sold (add book values, less intra-entity transfers and beginning unrealized gain, plus ending unrealized gain) ......................................................................... (353,000) Depreciation and amortization (add book values plus amortization from excess fair value allocations) ................... (61,000) Other expenses (add book value) ................................................. (40,000) Gain on sale of equipment ............................................................. 30,000 Consolidated net income .......................................................... $216,000
6-26 .
.
Chapter 06 - Variable Interest Entities, Intra-Entity Debt, Consolidated Cash Flows, and Other Issues
35. (30 Minutes) (Compute basic and diluted earnings per share for a parent and its 100 percent owned subsidiary, both with convertible bonds.) Basic EPS—Porter Company: Porter's reported net income ................................... Street's reported net income ................................... Amortization expense .............................................. Consolidated net income (all to Porter) ............. Porter shares outstanding .................................. Basic earnings per share ($270,000 ÷ 60,000) ........ Diluted EPS—Street Company Street earnings after amortization ........................... Shares outstanding .................................................. Basic earnings per share (120,000 ÷ 30,000) .......... Street's earnings assuming conversion of its bonds ($120,000 + $24,000 interest saved net of tax) .. Street's shares assuming conversion of its bonds (30,000 + 10,000) .................................................. Diluted earnings per share (144,000 ÷ 40,000) .......
$150,000 130,000 (10,000) $270,000 60,000 $4.50
$120,000 30,000 $4.00 $144,000 40,000 $3.60
Because diluted earnings per share is less than basic earnings per share, the convertible bonds are dilutive and should be included. Porter’s share of Street’s diluted earnings: Total shares assuming Street bond conversion .... Shares owned by Porter ........................................... Porter's ownership percentage (30,000 ÷ 40,000) .. Street's earnings for diluted EPS (above) .............. Porter's ownership percentage ................................ Earnings attributed to Porter company .................. Porter’s earnings and shares for diluted EPS: Porter's separate net income .................................. Street’s income applicable to Porter (above).......... Interest saved (net of tax) on assumed conversion of Porter's bonds ............................. Diluted earnings to Porter......................................... Porter shares outstanding ....................................... Additional shares from assumed bond conversion Diluted shares ...........................................................
40,000 30,000 75% $144,000 75% $108,000
$150,000 108,000 32,000 $290,000 60,000 8,000 68,000
Consolidated income statement EPS amounts for Porter Company: Basic earnings per share (above) ............................ $4.50 Diluted earnings per share ($290,000 ÷ 68,000) ..... 6-27 .
.
$4.26
Chapter 06 - Variable Interest Entities, Intra-Entity Debt, Consolidated Cash Flows, and Other Issues
36. (15 Minutes) (Compute diluted EPS. Subsidiary has stock warrants outstanding) Figures For Sonston's Diluted EPS Net Income .................................................................... Shares outstanding ....................................................... Assumed conversion of stock warrants ...................... Repurchase of treasury stock with proceeds of stock Warrants (10,000 × $10 = $100,000 ÷ $20) .................... Shares for diluted earnings per share computation ....
$200,000 40,000 10,000 (5,000)
5,000 45,000
Shares controlled by Primus: 40,000 + (20% of 5,000) = 41,000 Percentage of total held by Primus: 41,000 ÷ 45,000 = 91% (rounded) Income to be included in parent’s diluted EPS = $200,000 × 91% = $182,000 Parent’s Diluted Earnings Per Share: Net income – Primus ..................................................... Net income included from Sonston .............................. Earnings for diluted EPS .......................................... Outstanding shares of Primus ................................
$600,000 182,000 $782,000 100,000
PARENT’S DILUTED EARNINGS PER SHARE = $782,000 ÷ 100,000 = $7.82 37. (15 Minutes) (Compute diluted EPS. Subsidiary has convertible bonds.) Figures for Simon's diluted EPS: Net income ....................................................................................... Interest (net of tax) saved from assumed conversion ................... Earnings for diluted earnings per share .........................................
$290,000 56,000 $346,000
Shares outstanding .......................................................................... Assumed conversion of bonds ........................................................ Subsidiary shares for parent’s share of diluted earnings ..............
80,000 30,000 110,000
Shares controlled by Garfun = 80,000 ÷ 110,000 = 73% (rounded) Income to be included in parent’s diluted EPS = $346,000 × 73% = $252,580 Earnings for parent’s diluted earnings per share: Net income—Garfun ............................................................. $480,000 Dividends to Garfun's preferred stock ................................. (15,000) Net Income included from Simon (above) ........................... 252,580 Earnings for diluted EPS.................................................. $717,580 PARENT’S DILUTED EARNINGS PER SHARE = $717,580 ÷ 80,000 = $8.97 (rounded)
6-28 .
.
Chapter 06 - Variable Interest Entities, Intra-Entity Debt, Consolidated Cash Flows, and Other Issues
38. (35 Minutes) (Compute basic and diluted earnings per share for parent company. Subsidiary has stock warrants and convertible bonds.) Basic EPS—Parent Company (Burks): Reported net income (separate)—Burks ........................ Foreman net income: 80% × ($120,000 – $40,000 amort.)........ Preferred stock dividends (8,000 × $4) ............................. Burks’ earnings applicable to basic EPS .......................
$150,000 64,000 (32,000) $182,000
Burks' outstanding shares .............................................. Basic earnings per share ($182,000 ÷ 65,000) ...................
65,000 $ 2.80
Diluted EPS—Parent Company (Burks) Subsidiary income for Burks’ EPS: Net income after amortization ($120,000 – 40,000) ............ Interest (net of tax) saved assuming bond conversion .. Income applicable to diluted EPS ..............................
$80,000 45,000 $125,000
Shares outstanding .......................................................... Assumed conversion of warrants ................................... Assumed acquisition of treasury stock with proceeds of conversion [(20,000 × $15) ÷ $20] ............ Assumed conversion of bonds ....................................... Shares applicable to diluted EPS ..............................
(15,000) 10,000 55,000
Shares controlled by parent: (40,000 × 80%) plus (10% × 10,000) ............................
33,000
Income used in diluted EPS computation ...................... Portion owned by parent (33,000 ÷ 55,000) ....................... Subsidiary income applicable to parent—diluted EPS .
$125,000 60% $ 75,000
Earnings applicable to Burks’ diluted EPS: Reported net income (separate)— Burks ........................ Less: 10% intra-entity interest revenue (net of tax) ........ Burks’ income for diluted EPS ......................................... Burks’ share of Foreman income (above) ...................... Because of assumed conversion, preferred stock dividends would not be paid ...................................... Earnings applicable to diluted EPS ................................
$150,000 (4,500) $145,500 $ 75,000 -0$220,500
Burks' outstanding shares .............................................. Assumed conversion of preferred stock (8,000 × 4) ....... Shares applicable to diluted EPS ....................................
65,000 32,000 97,000
Diluted earnings per share ($220,500 ÷ 97,000)(rounded) =
$ 2.27
6-29 .
40,000 20,000
.
Chapter 06 - Variable Interest Entities, Intra-Entity Debt, Consolidated Cash Flows, and Other Issues
38. (continued) Alternative derivation of Burks’ diluted EPS: Consolidated net income $150,000 + ($120,000 - $40,000) $(230,000) Consolidated interest saved (net of 10% intra-entity interest) (40,500) Consolidated net income assuming bond conversion (270,500) Subsidiary net income $(120,000) Excess fair value amortization 40,000 Subsidiary interest saved (100%) (45,000) Income applicable to diluted EPS $(125,000) Noncontrolling interest share (22,000 ÷ 55,000) 40% (50,000) Parent's net income applicable to diluted EPS $(220,500) Shares for diluted EPS
97,000
Diluted EPS ($220,500 ÷ 97,000 shares)
$ 2.27
39. (8 Minutes) (Effect of subsidiary stock issuance to public at a price above reported value per share) Equity method investment prior to Ricardo share issue Parent's ownership percentage ..................................... Fair value ownership equivalency ................................. Adjusted subsidiary fair value after new share issue (above value plus 10,000 shares at $15.75 each) ... Parent's ownership (40,000 ÷ 50,000 shares) .............. New ownership adjusted fair value ...............................
$490,000 100% $490,000 $647,500 80% $518,000
Investment in Ricardo should be increased by $28,000 ($518,000 less $490,000)
40. (20 Minutes) (Effects of two different stock issuances by subsidiary.) a. Prior to the issuance of the new shares, Albuquerque owns an 80% interest in Marmon (16,000 shares out of 20,000 shares). The adjusted acquisition-date fair value is $840,000 ($600,000 + $150,000 + $90,000). After the stock issue, the adjusted acquisition-date fair value of the subsidiary will increase by $235,000 (the price of the stock) to $1,075,000. Albuquerque' ownership, however, will only be 64% (16,000 ÷ 25,000). The investment’s equity method balance before stock issue is $672,000 (600,000 + [$90,000 × 80%]). The book value underlying Albuquerque' investment is now $688,000 (64% of $1,075,000) so that a $16,000 increase is recorded by the parent. Investment in Marmon ............................................. Additional Paid-In Capital ................................... 6-30 .
.
16,000 16,000
Chapter 06 - Variable Interest Entities, Intra-Entity Debt, Consolidated Cash Flows, and Other Issues
40.(continued) b. Albuquerque's adjusted acquisition-date fair value is $840,000 (see above) prior to the issuance of the new shares. The 4,000 additional shares increase subsidiary's total value by $132,000 (the price of the stock) to $972,000. Albuquerque' ownership decreases to 2/3 (16,000 shares out of a total of 24,000) for a fair value equivalency of $648,000. Reducing the $672,000 (see a.) to $648,000 requires a $24,000 decrease to the parent’s APIC. Additional Paid-In Capital ........................................ Investment in Marmon ........................................
24,000 24,000
41. (55 Minutes) (Prepare consolidation entries following a subsidiary stock issue to outside parties.) Initially, Aronsen owns 18,000 shares (or 90%) of Siedel's outstanding shares (the total number of shares can be determined by dividing the subsidiary's common stock account by the $10 per share par value). After issuing 4,000 additional shares, the parent must prepare an adjustment to reflect the change in its share of the subsidiary’s unamortized acquisition-date fair value. Because that entry has not been recorded, it is included on the consolidation worksheet as Entry C1 (labeled in this manner as a correction). Other consolidation procedures follow as described in previous chapters. Excess Acquisition-Date Fair Value Allocation and Amortization Fair value (consideration transferred plus NCI fair value) .......... Acquisition-date book value ........................................................... Fair value in excess of book value ................................................ Allocated to land based on fair value ............................................ Allocated to copyrights based on fair value ................................. Life of copyrights ........................................................................... Annual amortization .......................................................................
$649,000 (480,000) $169,000 89,000 $ 80,000 16 yrs $ 5,000
Adjustment for Stock Transaction Adjusted acquisition-date fair value of subsidiary on new issue date ($649,000 + $90,000 + $152,000) ............... $891,000 Adjusted parent ownership (18,000 shares ÷ 24,000 shares) ..... 75% Parent’s post-issue equity method value at 1/1/14 ................ $668,250 Equity method balance before new subsidiary stock issue Consideration transferred .......................................... 584,100 Increase in book value (90% × $100,000) .................. 90,000 Copyright amortization ($5,000 × 2 years × 90%) ..... (9,000) 665,100 Required increase (Entry C1) ........................................................ $ 3,150
6-31 .
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Chapter 06 - Variable Interest Entities, Intra-Entity Debt, Consolidated Cash Flows, and Other Issues
41. (continued) Consolidation worksheet entries: Entry *C Investment in Siedel ................................................. Retained Earnings, 1/1/14 (Aronsen) .................
81,000 81,000
(To convert 1/1/14 balance to full accrual [$100,000 less two year’s amortization expense $5,000 × 2] × 90%) Entry C1 Investment in Siedel ................................................. Additional Paid-In Capital (Aronsen) .................
3,150 3,150
(To record adjustment for subsidiary stock transaction; computation shown above.) Entry S Common Stock (Siedel) ........................................... Additional Paid-In Capital (Siedel) .......................... Retained Earnings, 1/1/14 (Siedel) .......................... Investment in Siedel (75%) ................................. Noncontrolling Interest in Siedel, 1/1/14 (25%)..
240,000 112,000 380,000 549,000 183,000
(To eliminate subsidiary stockholders' equity accounts against Investment account and to recognize noncontrolling interest. Stockholders’equity balances have been adjusted for increase in book value during 2012–2013 and the issuance by the subsidiary of 4,000 shares of stock on 1/1/14.) Entry A Land .......................................................................... Copyrights ................................................................. Investment in Siedel (75%) .................................. Noncontrolling Interest (25%) ............................
89,000 70,000 119,250 39,750
(To recognize acquisition price allocated to land and copyrights. Copyrights balance has been reduced for 2012–2013 amortization to arrive at 1/1/14 balance. NCI now reflects 25% of the unamortized 1/1/14 balance.) Entry I Dividend Income ....................................................... Dividends Declared .............................................
15,000 15,000
(To eliminate intra-entity dividends recorded by parent as income [75% × $20,000].) Entry E Amortization Expense .............................................. Copyrights ............................................................ (To recognize current year amortization.) 6-32 .
.
5,000 5,000
Chapter 06 - Variable Interest Entities, Intra-Entity Debt, Consolidated Cash Flows, and Other Issues
42. (50 Minutes) (Prepare consolidation worksheet for business combination. Intraentity bond acquisition is made during the current year.) Acquisition-date fair-value allocation and amortization: Equipment Trademarks
$30,000 $40,000
10-year life 20-year life
$3,000 annual amortization $2,000 annual amortization
As indicated in the problem, the parent is applying the partial equity method. Hence an Entry *C must be recorded on the worksheet to convert the recorded figures (amortization is needed for the three years prior to 2015) to equity balances: Amortization expense ($5,000 × 3 years) = ............ $15,000 (Entry *C) Unrealized gain in ending inventory (downstream): Ending balance ......................................................... Markup ($20,000 ÷ $100,000) .................................... Unrealized gain to be eliminated .............................
$10,000 20% $ 2,000
(Entry G)
Loss on extinguishment of bonds: Book value at date of repurchase ................................. Percentage repurchased ............................................... Equivalent book value ................................................... Amount paid ................................................................... Loss on extinguishment of bonds ................................
$282,000 50% $141,000 145,500 $ 4,500
(Entry B)
Amortization during 2015 changed the carrying value of the bond payable from $282,000 to $288,000 (found in the balance sheet) and the investment from $145,500 to $147,000. This amortization also affects interest income and expense accounts. Entry A reflects remaining values after three years of amortizations.
6-33 .
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Chapter 06 - Variable Interest Entities, Intra-Entity Debt, Consolidated Cash Flows, and Other Issues
42.(continued)
Pavin and Stabler Consolidation Worksheet Year Ending December 31, 2015
Accounts Revenues ............................................... Cost of goods sold ................................ Expenses................................................ Interest expense—bonds .................... Interest income—bond investment ..... Loss on extinguishment of bonds ...... Equity in income of Stabler .................. Net income ..........................................
Pavin (740,000) 455,000 125,000 36,000 -0-0(123,000) (247,000)
Stabler (505,000) 240,000 158,500 -0(16,500) -0-0(123,000)
Retained earnings, 1/1/15 ..................... Retained earnings, 1/1/15 ..................... Net income (above) ............................... Dividends declared ............................... Retained earnings, 12/31/15 .................
(345,000) (247,000) 155,000 (437,000)
(361,000) (123,000) 61,000 (423,000)
Cash and receivables ........................... Inventory ................................................ Investment in Stabler ............................
217,000 175,000 613,000
35,000 87,000 -0-
Investment in Pavin ............................. Land, buildings, and equipment (net) . Trademarks ............................................ Total assets ........................................
-0245,000 -01,250,000
147,000 541,000 -0810,000
Accounts payable ................................. Bonds payable ....................................... Discount on bonds ................................ Common stock ...................................... Retained earnings (above) ................... Total liabilities and stockholders’ equity
(225,000) (300,000) 12,000 (300,000) (437,000) (1,250,000)
(167,000) (100,000) -0(120,000) (423,000) (810,000)
6-34 ..
Consolidation Entries Debit Credit (TI)100,000 (G) 2,000 (TI) 100,000 (E) 5,000 (B) 18,000 (B) 16,500 (B) 4,500 (I) 123,000
(*C) 15,000 (S) 361,000 (D)
(D) 61,000
(A) 21,000 (A) 34,000
61,000
(P) 33,000 (G) 2,000 (*C) 15,000 (S) 481,000 (A) 55,000 (I) 123,000 (B) 147,000 (E) 3,000 (E) 2,000
(P) 33,000 (B) 150,000 (B)
6,000
(S) 120,000 1,046,000
1,046,000
Consolidated Totals (1,145,000) 597,000 288,500 18,000 -04,500 -0(237,000) (330,000) -0(237,000) 155,000 (412,000) 219,000 260,000
-0-0804,000 32,000 1,315,000 (359,000) (250,000) 6,000 (300,000) (412,000) (1,315,000)
Chapter 06 - Variable Interest Entities, Intra-Entity Debt, Consolidated Cash Flows, and Other Issues
43. (45 Minutes) (Prepare consolidation entries after intra-entity bond acquisition.) a. Allocation of Acquisition-date Excess Fair Value Consideration transferred $312,000 Noncontrolling interest fair value 208,000 Acquisition-date fair value $520,000 Book value acquired 300,000 Fair value in excess of book value $220,000 Annual Excess Excess allocated to patents based Life Amortizations on fair value 90,000 12 years $7,500 Customer list $130,000 10 years 13,000 Total $20,500 CONSOLIDATION ENTRIES Entry *TL Investment in Herman .............................................. 7,000 Land .................................................................... 7,000 (To eliminate unrealized gain created by previous intra-entity transfer. Investment is adjusted here because transfer was downstream and equity method has been applied by parent. Thus, retained earnings have already been corrected.) Entry *G Retained Earnings 1/1/14 (Herman) ........................ 8,000 Cost of Goods Sold ............................................. 8,000 (To remove unrealized inventory gain from prior year so that it can be properly realized in current year. Amount is computed as shown below.) Intra-entity profit—2013 ........................................... Transfer price—2013 ................................................ Markup ($25,000 ÷ $125,000) .................................... Unrealized gain in 1/1/14 inventory ($40,000 × 20%) ....................................................
$25,000 $125,000 20% $8,000
Entry S Common Stock (Herman) ......................................... 100,000 Retained Earnings, 1/1/14 (Herman) (adjusted for Entry *G) ........................................ 292,000 Investment in Herman (60%) ......................... 235,200 Noncontrolling Interest in Herman (40%) .... 156,800 (To eliminate Herman's stockholders' equity accounts and to record beginning of year balance for noncontrolling interest.)
6-35 .
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Chapter 06 - Variable Interest Entities, Intra-Entity Debt, Consolidated Cash Flows, and Other Issues
43. a. (continued) Entry A Patents .................................................................... 75,000 Customer List ............................................................ 104,000 Investment in Herman ......................................... 107,400 Noncontrolling Interest ....................................... 71,600 (To recognize unamortized balances as of 1/1/14 of amounts allocated within original acquisition price. Allocations have been reduced by two years of amortizations.) Entry I Equity income of Herman ......................................... 3,000 Investment in Herman .................................... (To eliminate intra-entity equity income accrual) Herman’s income ............................................................ $25,000 Excess amortizations ..................................................... (20,500) 2013 intra-entity inventory gross profit ......................... 8,000 2014 intra-entity inventory gross profit ......................... (7,500) Accrual-based income .................................................... $5,000 Fred’s ownership percentage ........................................ 60% Equity in earnings of Herman ........................................ $3,000 Entry D Investment in Herman .............................................. Dividends Declared ............................................. (To eliminate intra-entity dividend declaration.) Entry E Amortization Expense .............................................. Patents .................................................................. Customer List ....................................................... (To recognize current year amortization expense.)
2,400 2,400
20,500
Entry P Accounts Payable ..................................................... 60,000 Accounts Receivable .......................................... (To remove intra-entity debt created by inventory transfers.)
6-36 .
.
3,000
7,500 13,000
60,000
Chapter 06 - Variable Interest Entities, Intra-Entity Debt, Consolidated Cash Flows, and Other Issues
43. a. (continued) Entry B Bonds Payable .......................................................... Premium on Bonds Payable .................................... Interest Income ......................................................... Investment in Parent Bonds ............................... Interest Expense ................................................. Gain on Retirement of Bonds ..............................
20,000 1,069 1,873 19,005 1,283 2,654
(To eliminate effect created by bond acquisition and recognize the related retirement gain [$21,386 – $18,732]. Amounts are calculated below.)
Investment Liability
Book Value (given)
Effective Interest
Cash Interest (8%)
Excess Amortizations
Year-End Book Value
$18,732 21,386
$1,873 (10%) 1,283 (6%)
$1,600 1,600
$273 317
$19,005 21,069
Entry Tl Sales .......................................................................... 120,000 Cost of Goods Sold (or purchases) ................... (To eliminate intra-entity transfers made during current year.)
120,000
Entry G Cost of Goods Sold .................................................. 7,500 Inventory ............................................................... 7,500 (To defer intra-entity inventory profits until 2014 as calculated below): Intra-entity profit ....................................................................... Transfer price 2014 ................................................................... Markup ($30,000 ÷ $120,000) .................................................... Unrealized gain in ending inventory ($30,000 × 25%) ............
$30,000 $120,000 25% $7,500
b. Herman's reported net income for 2014 .................................. Excess fair value amortization ................................................. 2013 unrealized gain recognized in 2014 (Entry *G) .............. 2014 unrealized gain (Entry G) ................................................. Herman's realized net income for 2014 .................................... NCI ownership ........................................................................... NCI’s share of the subsidiary's net income .............................
$25,000 (20,500) 8,000 (7,500) $5,000 40% $2,000
Noncontrolling interest, 1/1/14 (Entries S and A) ................... NCI’s share of Herman's net income (above) ......................... NCI’s share of Herman's dividends ($4,000 × 40%) ................ Noncontrolling interest, 12/31/14 ..............................................
$228,400 2,000 (1,600) $228,800
6-37 .
.
Chapter 06 - Variable Interest Entities, Intra-Entity Debt, Consolidated Cash Flows, and Other Issues
43. (continued) c. The balances in the individual records as of December 31, 2015 pertaining to the Intra-entity bonds are as follows:
Investment Liability
Beginning Book Value (see part a.)
Effective Interest
Cash Interest (8%)
Excess Amortizations
Year-End Book Value
$19,005 21,069
$1,901 (10%) 1,264 (6%)
$1,600 1,600
$301 336
$19,306 20,733
The adjustment to recognize the original gain by the parent can be computed as follows: Original gain on retirement (see part a) ....................... Interest income recorded on investment in 2014 (see part a) ................................................................ Interest expense recorded on liability in 2014 (see part a) ............................................................... Required increase as of January 1, 2015 ..................... Entry *B (as of December 31, 2015) Bonds Payable ........................................................... Premium on Bonds Payable .................................... Interest Income ......................................................... Investment in Herman ......................................... Investment in Fred’s bonds ................................ Interest Expense .................................................
$2,654 $1,873 1,283
590 $2,064
20,000 733 1,901 2,064 19,306 1,264
(To remove accounts pertaining to intra-entity bonds. "Investment in Herman" is adjusted here rather than retained earnings because equity method is being applied and gain is attributed to the parent.)
6-38 .
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Chapter 06 - Variable Interest Entities, Intra-Entity Debt, Consolidated Cash Flows, and Other Issues
44. (50 Minutes) (Prepare consolidation entries for intra-entity preferred stock and bonds. Determine specified account balances. Preferred stock is a debt instrument.) a. Consideration transferred for common stock .................. Consideration transferred for preferred stock ................. Noncontrolling interest in common stock ........................ Noncontrolling interest in preferred stock ....................... Lisa’s acquisition-date fair value....................................... Book value of Lisa .............................................................. Excess assigned to franchises ..........................................
$552,800 65,000 138,200 34,000 $790,000 750,000 $ 40,000
CONSOLIDATION ENTRIES 1/1/13 Entry S and A combined: Preferred Stock (Lisa) .............................................. Common Stock (Lisa) ............................................... Retained Earnings, 1/1/13 (Lisa) .............................. Franchises ................................................................. Investment in Lisa-Common Stock ............... Investment in Lisa-Preferred Stock ............... Noncontrolling Interest in Lisa, Inc ...............
100,000 200,000 450,000 40,000 552,800 65,000 172,200
(To eliminate subsidiary stockholders’ equity, record excess acquisition-date fair values, and record outside ownership of subsidiary's preferred and common stock at acquisition-date fair values.) b. Acquisition price of bonds, 1/2/13 .......................... Book value of bonds payable (one-half acquired) . Loss on extinguishment of debt ........................ Interest income—Mona ($53,310 × 8%) ................... Interest expense—Lisa ($44,175 × 14%) ................. Investment in bonds of Lisa (book value): Book value—date of acquisition, 1/2/13 ............ Cash interest ($50,000 × 10%) ............................ Effective interest (above) .................................... Investment in Bonds of Lisa (book value as of 12/31/13) ...........................
6-39 .
.
(rounded) (rounded)
$53,310 (44,175) $9,135 $4,265 $6,185 $53,310
$5,000 4,265
735 $52,575
Chapter 06 - Variable Interest Entities, Intra-Entity Debt, Consolidated Cash Flows, and Other Issues
44. b. (continued) Bonds payable (book value) Book value—date of acquisition, 1/2/13 ............ Cash interest ($50,000 × 10%) ............................ Effective interest (above) .................................... Bonds payable (book value as of 12/31/13) .. CONSOLIDATION ENTRY B—December 31, 2013 (all figures computed above) Bonds Payable .......................................................... Interest Income (or other revenues) ....................... Loss on Retirement of Bonds .................................. Discount on Bonds Payable ($50,000 – $45,360) Interest Expense .................................................. Investment in Bonds of Lisa ..............................
$44,175 $5,000 6,185
1,185 $45,360
50,000 4,265 9,135 4,640 6,185 52,575
c. December 31, 2013 book values based on historical cost figures: Cost of fixed assets .................................................. $100,000 Depreciation expense ($40,000 book value over a 10-year life) ....................................................... 4,000 Accumulated depreciation (including current expense) ............................................................... 64,000 December 31, 2013 book values based on transfer price: Cost of fixed assets .................................................. $120,000 Depreciation expense (10-year life) ........................ 12,000 Accumulated depreciation ....................................... 12,000 Gain on transfer of fixed assets ($120,000 – $40,000) book value ........................ 80,000 CONSOLIDATION ENTRY TA—December 31, 2013 Gain on Transfer of Fixed Assets (to remove) ....... Accumulated Depreciation ($64,000 – $12,000) . Depreciation Expense ($12,000 – $4,000) ......... Fixed Assets ($120,000 – $100,000) ...................
6-40 .
.
80,000 52,000 8,000 20,000
Chapter 06 - Variable Interest Entities, Intra-Entity Debt, Consolidated Cash Flows, and Other Issues
44. (continued) d. Original allocation to franchises (given) ...................... Amortization at $1,000/year (2013–2014) ................ Consolidated franchises—12/31/14 ........................ Fixed assets (book values): Mona, Inc. .................................................................. Lisa Co. .................................................................... Reduction necessitated by intra-entity sale ($120,000 transfer price reduced to $100,000 original cost) (see part c) .................................... Consolidated fixed assets—12/31/14 ...................... Accumulated depreciation (book values): Mona, Inc .................................................................... Lisa Co. .................................................................... Increase needed to eliminate intra-entity sale ($60,000 accumulated depreciation at time of transfer less excess depreciation expense [$12,000 - $4,000] for 2013 and 2014) ...................... Consolidated Acc. Depr.—12/31/14.......................... Expenses (book values): Mona, Inc............................................................... Lisa Co. ................................................................ Recognition of amortization on franchises ............ Elimination of interest expense on intercompany debt ($45,360 [see part b] × 14%) (rounded) Elimination of excess depreciation from intra-entity transfer of fixed assets ($12,000– $4,000) ................................................. Consolidated expenses ...........................................
6-41 .
.
$40,000 (2,000) $38,000
$1,100,000 800,000
(20,000) $1,880,000
$300,000 200,000
44,000 $544,000
$220,000 120,000 1,000 (6,350)
(8,000) $326,650
Chapter 06 - Variable Interest Entities, Intra-Entity Debt, Consolidated Cash Flows, and Other Issues
45. (35 Minutes) (Prepare statement of cash flows for a business combination.) (Note: before working this problem, students may wish to review the statement of cash flows in an intermediate accounting textbook.) BOLERO COMPANY AND CONSOLIDATED SUBSIDIARY RIVERA Consolidated Statement of Cash Flows Year Ending December 31, 2015 CASH FROM OPERATING ACTIVTIES Consolidated net income .......................................... Adjustment from accrual to cash: Depreciation and amortization ........................... Gain on sale of building ...................................... Decrease in accounts receivable ....................... Increase in inventory .......................................... Decrease in accounts payable ........................... Net cash flow from operating activities ..................
$250,000 120,000 (30,000) 20,000 (150,000) (50,000) $160,000
CASH FLOWS FROM INVESTING ACTIVITIES Sale of building ......................................................... Purchase of equipment (given) ................................ Net cash flow from investing activities ..............
$70,000 (205,000)
CASH FLOWS FROM FINANCING ACTIVITIES Dividends paid .......................................................... Issuance of bonds .................................................... Issuance of common stock ...................................... Net cash flow from financing activities .............
$(112,000) 110,000 67,000
Net increase in cash during 2015 ................................. Cash, January 1, 2015 ................................................... Cash, December 31, 2015 ..............................................
(135,000)
65,000 90,000 90,000 $180,000
The above statement uses the indirect method for computing cash flows from operations.
6-42 .
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Chapter 06 - Variable Interest Entities, Intra-Entity Debt, Consolidated Cash Flows, and Other Issues
45. (continued) Development of Cash Flow Balances via Direct Method OPERATING ACTIVITIES Cash collected from customers (consolidated revenues plus the decrease in accounts receivable) ................................... $1,050,000 Cash Purchases (consolidated COGS plus increase in inventory plus decrease in accounts payable) ...................................................... (850,000) Interest expense (the consolidated balance) ..................................... (40,000) Cash flows from operating activities .................................................. $ 160,000 INVESTING ACTIVITIES Sale of building ($40,000 book value sold at a $30,000 gain)............ $ 70,000 Purchase of equipment (given in problem) ........................................ (205,000) Cash flows from investing activities ................................................... $(135,000) FINANCING ACTIVITIES Dividends paid by parent (the consolidated balance) ...................... $(110,000) Dividends paid by subsidiary (amount paid to noncontrolling interest—20%) ....................................................... (2,000) Issuance of bonds ............................................................................... 110,000 Issuance of common stock by the parent (increase in common stock and additional paid-in capital) ............................. 67,000 Cash flows from financing activities ................................................... $ 65,000
6-43 .
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Chapter 06 - Variable Interest Entities, Intra-Entity Debt, Consolidated Cash Flows, and Other Issues
46. (40 Minutes) (Compute basic and diluted earnings per share. Subsidiary has stock warrants outstanding and convertible debt.) Basic EPS—Austin, Inc. Consolidated net income to parent ............................... Austin’s preferred dividends ........................................ Earnings applicable to Austin’s basic EPS ............
$284,000 (40,000) $244,000
Austin's outstanding common shares .........................
50,000
Basic earnings per share ($244,000 ÷ 50,000) ..................
$4.88
Diluted EPS—Austin, Inc. Subsidiary earnings and shares for Austin’s diluted EPS calculation: $105,000 Rio Grande net income after amortization.................... Interest saved assuming conversion of bonds (net of tax) ................................................................. 22,000 Net income applicable to diluted EPS .......................... $127,000 Shares outstanding ....................................................... Assumed conversion of warrants ................................ Assumed treasury stock acquisition using proceeds from warrant conversion ([5,000 × $10] ÷ $20) ....... Assumed conversion of bonds ..................................... Subsidiary shares applicable to diluted EPS ..............
30,000 5,000 (2,500) 10,000 42,500
Shares controlled by parent (24,000 plus 50% of increment created by warrants [or 1,250]) ......................
25,250
Portion owned by parent (25,250 ÷ 42,500) ..................
59.4%
Net income applicable to parent—diluted EPS (59.4% × $127,000) ....................................................
$75,438
Austin’s income and shares for diluted EPS calculation: Austin’s separate net income ........................................ $200,000 Net income of Rio Grande to parent (computed above) -0Preferred dividends (assumed converted) .................. Earnings applicable to diluted EPS .............................. $275,438 Austin's outstanding common shares ......................... Assumed conversion of preferred stock (10,000 × 2 shares) .................................................... Shares applicable to diluted EPS .................................
50,000
Diluted earnings per share ($275,438 ÷ 70,000) ................
$3.93
6-44 .
.
(rounded)
75,438
20,000 70,000 (rounded)
Chapter 06 - Variable Interest Entities, Intra-Entity Debt, Consolidated Cash Flows, and Other Issues
47. (50 Minutes) (Determine consolidated totals. Subsidiary has preferred shares outstanding that are equity instruments.) Consideration transferred for common and preferred stock Skyler’s book value Excess fair value assigned to intangible asset (10-year life)
$560,000 450,000 $110,000
Annual amortization
$11,000
Ending Unrealized Gain Ending inventory (at transfer price) ............................. Markup ($30,000 ÷ $90,000) ...................................... Ending unrealized gain (increase made to cost of goods sold to defer gain) ...............................
$18,000 33⅓% $6,000
Effect of Intra-Entity Equipment Transfer: Transfer price: Recorded value ................................................................................ Depreciation expense ($20,000 ÷ 4) ............................................... Accumulated depreciation .............................................................. Gain on sale ($20,000 – $12,000) ....................................................
$20,000 $5,000 $5,000 $8,000
Historical cost: Recorded value ................................................................................ Depreciation expense ($12,000 ÷ 4) ............................................... Accumulated depreciation ($18,000 + $3,000) ..............................
$30,000 $3,000 $21,000
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Chapter 06 - Variable Interest Entities, Intra-Entity Debt, Consolidated Cash Flows, and Other Issues
47. (continued)
Accounts Sales ............................................... Cost of goods sold......................... Expenses ........................................ Gain on sale of equipment ............ Net income...................................
Paisley, Inc. and Skyler Corp. Consolidation Worksheet Year Ending December 31, 2014 Consolidation Entries Paisley, Inc. Skyler Corp. Debit Credit (800,000) (400,000) (TI) 90,000 528,000 260,000 (G) 6,000 (TI) 90,000 180,000 130,000 (E) 11,000 (ED) 2,000 (8,000) -0(TA) 8,000 (100,000) (10,000)
Retained earnings, 1/1 ................... Net income ..................................... Dividends declared ........................ Retained earnings, 12/31 ............
(400,000) (100,000) 60,000 (440,000)
(150,000) (10,000) -0(160,000)
Cash ................................................ Accounts receivable ...................... Inventory......................................... Investment in Skyler Corp. ............
30,000 300,000 260,000 560,000
40,000 100,000 180,000 -0-
Land, buildings, and equipment ... Accumulated depreciation ............ Intangible Asset ............................. Total assets .................................
680,000 (180,000) -01,650,000
500,000 (90,000) -0730,000
(TA) 10,000 (ED) 2,000 (A) 110,000
Accounts payable .......................... Long-term liabilities ....................... Preferred stock............................... Common stock ............................... Additional paid-in capital............... Retained earnings, 12/31 ............... Total liab. and stockholders’ equity
(140,000) (240,000) -0(620,000) (210,000) (440,000) (1,650,000)
(90,000) (180,000) (100,000) (200,000) -0(160,000) (730,000)
(P)
6-46 ..
(S) 150,000
(400,000) (87,000) 60,000 (427,000) (P) 28,000 (G) 6,000 (S) 450,000 (A) 110,000 (TA) 18,000 (E) 11,000
28,000
(S) 100,000 (S) 200,000
715,000
Consolidated Totals (1,110,000) 704,000 319,000 -0(87,000)
715,000
70,000 372,000 434,000 -01,190,000 (286,000) 99,000 1,879,000 (202,000) (420,000) -0(620,000) (210,000) (427,000) (1,879,000)
Chapter 06 - Variable Interest Entities, Intra-Entity Debt, Consolidated Cash Flows, and Other Issues
47. (continued) CONSOLIDATED TOTALS ▪ ▪ ▪ ▪ ▪ ▪ ▪ ▪ ▪ ▪ ▪ ▪ ▪ ▪ ▪ ▪ ▪ ▪ ▪ ▪ ▪ ▪ ▪
Sales = $1,110,000 (add book values and eliminate intra-entity transfers) Cost of Goods Sold = $704,000 (add book values, eliminate intra-entity transfers, and eliminate ending unrealized gain [computed above]) Expenses = $319,000 (add book values and include amortization of intangibles and eliminate $2,000 excess equipment depreciation) Gain on Sale of Equipment = $0 (intra-entity balance is eliminated) Net Income = $87,000 (consolidated revenues less consolidated expenses) Retained Earnings, 1/1 = $400,000 (parent company figure only because subsidiary was not acquired until current year) Dividends Declared = $60,000 (parent balance only) Retained Earnings, 12/31 = $427,000 (consolidated beginning retained earnings plus net income less dividends declared) Cash = $70,000 (add book values) Accounts Receivable = $372,000 (add book values after eliminating intraentity balance) Inventory = $434,000 (add book values after eliminating unrealized gain) Investment in Skyler Corporation = 0 (intra-entity account is eliminated because individual asset and liability accounts of subsidiary are included) Land, Buildings, and Equipment = $1,190,000 (add book values and increase transferred asset from transfer price to historical cost [see above]) Accumulated Depreciation = $286,000 (add book values and adjust balance for transferred asset from transfer price figure to historical cost (see above]) Intangible Asset = $99,000 (original allocations less one year amortization) Total Assets = $1,879,000 (summation of consolidated accounts) Accounts Payable = $202,000 (add book values and remove intra-entity balance) Long-Term Liabilities = $420,000 (add book values) Preferred Stock = $0 (subsidiary outstanding shares are eliminated) Common Stock = $620,000 (parent balance only) Additional Paid-in Capital = $210,000 (parent balance only) Retained Earnings, 12/31 = $427,000 (computed above) Total Liabilities and Equities = $1,879,000 (summation of consolidated accounts)
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Chapter 06 - Variable Interest Entities, Intra-Entity Debt, Consolidated Cash Flows, and Other Issues
47. (continued): Consolidation entries and explanations: Entry S Preferred Stock (Skyler) ................................................... Common Stock (Skyler) ................................................... Retained Earnings, 1/1 ..................................................... Investment in Skyler Corp. ......................................... (To eliminate subsidiary stockholder’s equity accounts.)
100,000 200,000 150,000 450,000
Entry A Intangible Asset ............................................................... 110,000 Investment in Skyler Corp. ......................................... (To recognize excess fair value attributed to intangible asset.) Entry E Amortization Expense ...................................................... Intangible Asset .......................................................... (To record current year’s amortization of intangible asset.) Entry P Accounts Payable............................................................. Accounts Receivable .................................................. (To eliminate intra-entity debt.)
110,000
11,000 11,000
28,000 28,000
Entry TA Equipment ......................................................................... 10,000 Gain on Sale of Equipment .............................................. 8,000 Accumulated Depreciation......................................... 18,000 (To eliminate effects as of 1/1 created by intra-entity transfer of equipment.) Entry TI Sales ............................................................................... 90,000 Cost of Goods Sold .................................................... (To eliminate intra-entity inventory transfers for the current year.)
90,000
Entry G Cost of Goods Sold .......................................................... 6,000 Inventory ..................................................................... 6,000 (To defer unrealized intra-entity gain remaining at the end of the current year. Markup is 33⅓% [30,000 gross profit ÷ 90,000 transfer price] indicating that the ending inventory of 18,000 contains an unrealized profit of 6,000 [18,000 × 33⅓%].) Entry ED Accumulated Depreciation .............................................. 2,000 Depreciation Expense ................................................ 2,000 (To eliminate excess depreciation resulting from intra-entity gain of 8,000 on transfer of equipment [see Entry TA]. Equipment is being depreciated over a remaining life of four years.)
6-48 .
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Chapter 06 - Variable Interest Entities, Intra-Entity Debt, Consolidated Cash Flows, and Other Issues
48. (30 minutes) (Consolidated Cash Flow Statement with current year business combination) Plaster Inc. and Subsidiary Stucco Company Consolidated Statement of Cash Flows For the year ended 12/31/14 CASH FLOW FROM OPERATING ACTIVITIES Consolidated net income Depreciation expense Amortization expense Decrease in accounts receivable (net of acquisition) Increase in inventory (net of acquisition) Decrease in accounts payable (net of acquisition) Net cash flow provided by operating activities
$274,000 187,500 8,750 3,600 (102,000) (8,000)
89,850 $363,850
CASH FLOW FROM INVESTING ACTIVITIES Purchase of Stucco Company assets (net of cash acquired) Net cash flow used in investing activities
(856,000)
CASH FLOW FROM FINANCING ACTIVITIES Issue long-term debt Dividends Net cash flow provided by financing activities
$692,000
800,000 (108,000)
Increase in cash 1/1/14 to 12/31/14
$199,850
Beginning cash, 1/1/14 Ending cash, 12/31/14
43,000 $242,850
6-49 .
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Chapter 06 - Variable Interest Entities, Intra-Entity Debt, Consolidated Cash Flows, and Other Issues
Excel Case–Intra-entity Bonds Bonds with a stated rate of 11% sold to yield 12% Eff. Yield 12%
2012 2013 2014 2015 2016 2017 2018 2019 2020 2021
1,000,000.00 110,000.00
943,497.77 946,717.50 950,323.60 954,362.43 958,885.93 963,952.24 969,626.51 975,981.69 983,099.49 991,071.43 1,000,000.00
0.32197 5.65022
321,973.24 621,524.53 943,497.77
113,219.73 113,606.10 114,038.83 114,523.49 115,066.31 115,674.27 116,355.18 117,117.80 117,971.94 118,928.57
110,000.00 110,000.00 110,000.00 110,000.00 110,000.00 110,000.00 110,000.00 110,000.00 110,000.00 110,000.00
Consolidated Worksheet Entry 12/31/14 Bonds Payable 954,362.43 Interest Income 117,523.20 Loss on Retirement 0.00 Gain on Retirement Investment in Bonds Interest Expense
46,299.01 911,547.79 114,038.83
Bonds retired by affiliate on 1/1/14 at Eff. Yield 13% 1,000,000.00 0.37616 110,000.00 4.79877
2014 2015 2016 2017 2018 2019 2020 2021
904,024.59 911,547.79 920,049.00 929,655.37 940,510.57 952,776.95 966,637.95 982,300.88 1,000,000.00
117,523.20 118,501.21 119,606.37 120,855.20 122,266.37 123,861.00 125,662.93 127,699.12
6-50 .
.
56,502.23 3,219.73 3,606.10 4,038.83 4,523.49 5,066.31 5,674.27 6,355.18 7,117.80 7,971.94 8,928.57 56,502.23
904,024.59 376,159.86 527,864.73 904,024.59 110,000.00 110,000.00 110,000.00 110,000.00 110,000.00 110,000.00 110,000.00 110,000.00
95,975.41 7,523.20 8,501.21 9,606.37 10,855.20 12,266.37 13,861.00 15,662.93 17,699.12 95,975.41
Chapter 06 - Variable Interest Entities, Intra-Entity Debt, Consolidated Cash Flows, and Other Issues
Financial Reporting Research and Analysis Case The number of potential solutions is large. Searches in Lexis-Nexis, Edgar, etc. will produce numerous examples of consolidations of VIEs. For example, Walt Disney Company prepares a before and after disclosure of its consolidated VIEs Euro Disney, Hong Kong Disneyland, and Shanghai Disney Resort as follows (9-29-12):
Cash and cash equivalents Other current assets Total current assets
Before International International Theme Parks Theme Parks Consolidation and Adjustments $2,839 $548 10,066 256 12,905 804
Total $ 3,387 10,322 13,709
Investments/Advances Fixed assets Other assets Total assets
6,065 17,005 36,949 $72,924
(3,342) 4,507 5 $1,974
2,723 21,512 36,954 $74,898
Current portion of borrowings Other current liabilities Total current liabilities
3,614 8,742 12,356
-0457 457
3,614 9,199 12,813
Borrowings Deferred income tax and other liabilities Equity Total liabilities and equity
10,430 9,325 40,813 $72,924
267 105 1,145 $1,974
10,697 9,430 41,958 $74,898
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Chapter 07 - Consolidated Financial Statements—Ownership Patterns and Income Taxes
CHAPTER 7 CONSOLIDATED FINANCIAL STATEMENTS—OWNERSHIP PATTERNS AND INCOME TAXES Chapter Outline I.
Indirect subsidiary control A. Control of subsidiary companies within a business combination is often of an indirect nature; one subsidiary possesses the stock of another rather than the parent having direct ownership. 1. These ownership patterns may be developed specifically to enhance control or for organizational purposes. 2. Such ownership patterns may also result from the parent company's acquisition of a company that already possesses subsidiaries. B. One of the most common corporate structures is the father-son-grandson configuration where each subsidiary in turn owns one or more subsidiaries. C. The consolidation process is altered somewhat when indirect control is present. 1. The worksheet entries are effectively doubled by each corporate ownership layer but the concepts underlying the consolidation process are not changed. 2. Calculation of the accrual-based income of a subsidiary recognizing the consolidated relationships is an important step in an indirect ownership structure. a. The determination of accrual-based income figures is needed for equity income accruals as well as for the computation of noncontrolling interest balances. b. Any company within the business combination that is in both a parent and a subsidiary position must recognize the equity income accruing from its subsidiary before computing its own income.
II. Indirect subsidiary control-connecting affiliation A. A connecting affiliation exists whenever two or more companies within a business combination hold an equity interest in another member of that organization. B. Despite this variation in the standard ownership pattern, the consolidation process is essentially the same for a connecting affiliation as for a father-son-grandson organization. C. Once again, any company in both a parent and a subsidiary position must recognize an appropriate equity accrual in computing its own income. III. Mutual ownership A. A mutual affiliation exists whenever a subsidiary owns shares of its parent company. B. Parent shares being held by a subsidiary are accounted for by the treasury stock approach. 1. The cost paid to acquire the parent's stock is reclassified within the consolidation process to a treasury stock account and no income is accrued. 2. The treasury stock approach is popular in practice because of its simplicity and is now required by the FASB Codification.
7-1 .
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Chapter 07 - Consolidated Financial Statements—Ownership Patterns and Income Taxes
IV. Income tax accounting for a business combination—consolidated tax returns A. A consolidated tax return can be prepared for all companies comprising an affiliated group. Any other companies within the business combination file separate tax returns. B. A domestic corporation may be included in an affiliated group if the parent company (either directly or indirectly) owns at least 80 percent of the voting stock of the subsidiary as well as 80 percent of each class of its nonvoting stock. C. The filing of a consolidated tax return provides several potential advantages to the members of an affiliated group. 1. Intra-entity profits are not taxed until realized. 2. Intra-entity dividends are not taxed (although these distributions are nontaxable for all members of an affiliated group whether a consolidated return or a separate return is filed). 3. Losses of one affiliate can be used to reduce the taxable income earned by other members of the group. D. Income tax expense—effect on noncontrolling interest valuation 1. If a consolidated tax return is filed, an allocation of the total expense must be made to each of the component companies to arrive at the realized income figures that serve as a basis for noncontrolling interest computations. 2. Income tax expense is frequently assigned to each subsidiary based on the amounts that would have been paid on separate returns. V. Income tax accounting for a business combination—separate tax returns A. Members of a business combination that are foreign companies or that do not meet the 80 percent ownership rule (as described above) must file separate income tax returns. B. Companies in an affiliated group can elect to file separate tax returns. Deferred income taxes are often recognized when separate returns are filed due to temporary differences stemming from unrealized gains and losses as well as intra-entity dividends. VI. Temporary tax differences can stem from the creation of a business combination A. The tax basis of a subsidiary's assets and liabilities may differ from their consolidated values (which is based on the fair value on the date the combination is created). B. If additional taxes will result in future years (for example, it the tax basis of an asset is lower than its consolidated value so that future depreciation expense for tax purposes will be less), a deferred tax liability is created by a combination. C. The deferred tax liability is then written off (creating a reduction in tax expense) in future years so that the net expense recognized (a lower number) matches the combination's book income (a lower number due to the extra depreciation of the consolidated value). Vll. Operating loss carryforwards A. Net operating losses recognized by a company can be used to reduce taxable income from the previous two years (a carryback) or for the future 20 years (a carryforward). B. If one company in a newly created combination has a tax carryforward, the future tax benefits are recognized as a deferred income tax asset. C. However, a valuation allowance must also be recorded to reduce the deferred tax asset to the amount that is more likely than not to be realized. 7-2 .
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Chapter 07 - Consolidated Financial Statements—Ownership Patterns and Income Taxes
Answers to Questions 1. A father-son-grandson relationship is a specific type of ownership configuration often encountered in business combinations. The parent possesses the stock of one or more companies. At least one of these subsidiaries holds a majority of the voting stock of its own subsidiary. Each subsidiary controls other subsidiaries with the chain of ownership going on indefinitely. The parent actually holds control over all of the companies within the business combination despite having direct ownership in only its own subsidiaries. 2. In a business combination having an indirect ownership pattern, at least one company is in both a parent and a subsidiary position. To calculate the accrual-based income earned by that company, a proper recognition of the equity income accruing from its own subsidiary must initially be made. Structuring the income calculation in this manner is necessary to ensure that all earnings are properly included by each company. 3. Able—100% of income accrues to the consolidated entity (as parent company). Baker—70% (percentage of stock owned by Able). Carter—56% (80% of stock owned by Baker multiplied by the 70% of Baker controlled by Able). Dexter—33.6% (60% of stock owned by Carter multiplied by the 80% of Carter controlled by Baker multiplied by the 70% of Baker owned by Able). 4. When an indirect ownership is present, the quantity of consolidation entries will increase, perhaps significantly. An additional set of entries is included on the worksheet for each separate investment. Furthermore, the determination of realized income figures for each subsidiary must be computed in a precise manner. For any company in both a parent and a subsidiary position, equity income accruals are recognized prior to the calculation of that company's realized income. This realized income total is significant because it serves as the basis for noncontrolling interest calculations as well as the equity accruals to be recognized by that company's parent. 5. In a connecting affiliation, two (or more) companies within a business combination own shares in a third member. A mutual ownership, in contrast, exists whenever a subsidiary possesses an equity interest in its own parent. 6. In accounting for a mutual ownership, U.S. GAAP requires the treasury stock approach. The treasury stock approach presumes that the cost of the parent shares should be reclassified as treasury stock within the consolidation process. The subsidiary is being viewed, under this method, as an agent of the parent. Thus, the shares are accounted for as if the parent had actually made the acquisition. 7. According to present tax laws, an affiliated group can be comprised of all domestic corporations in which a parent holds 80 percent ownership. More specifically, the parent must own (directly or indirectly) 80 percent of the voting stock of the corporation as well as at least 80 percent of each class of nonvoting stock. 8. Several basic advantages are available to combinations that file a consolidated tax return. First, intra-entity profits are not taxed until realized. For companies with large amounts of intraentity transactions, the deferral of unrealized gains causes a delay in the making of significant tax payments. Second, losses incurred by one company can be used to reduce or offset 7-3 .
.
Chapter 07 - Consolidated Financial Statements—Ownership Patterns and Income Taxes
taxable income earned by other members of the affiliated group. In addition, intra-entity dividends are not taxable but that exclusion applies to the members of an affiliated group regardless of whether a consolidated or separate tax return is filed. Members of a business combination may be forced to file separate tax returns. Foreign corporations, for example, must always file separately. Domestic companies that do not meet the 80 percent ownership rule are also required to file in this manner. Furthermore, companies that are in an affiliated group may still elect to file separately. If all companies within the combination are profitable and few intra-entity transactions are carried out, little advantage may accrue from preparing a consolidated return. With a separate filing, a subsidiary has more flexibility as to accounting methods as well as its choice of a fiscal year-end. 9. The allocation of income tax expense among the component companies of a business combination has a direct bearing on realized income totals and, therefore, noncontrolling interest calculations. Obviously, the more expense that is assigned to a particular company the less realized income is attributed to that concern. Income tax expense can be allocated based on the income totals that would have been reported by various companies if separate tax returns had been filed or on the portion of taxable income derived from each company. 10. In filing a separate tax return (assuming that the two companies do not qualify as members of an affiliated group), the parent must include as income the dividends received from the subsidiary. For financial reporting purposes, however, income is accrued based on the ownership percentage of the realized income of the subsidiary. Because income is frequently recognized by the parent prior to being received in the form of dividends (when it is subject to taxation), deferred income taxes must be recognized. Either the parent or the subsidiary might also have to record deferred income taxes in connection with any unrealized intra-entity gain. On a separate tax return, such gains are reported at the time of transfer while for financial reporting purposes they are appropriately deferred until realized. Once again, a temporary difference is created which necessitates the recognition of deferred income taxes. 11. If the consolidated value of a subsidiary’s assets exceeds their tax basis, depreciation expense in the future will be less on the tax return than is shown for external reporting purposes. The reduced expense creates higher taxable income and, thus, increases taxes. Therefore, the difference in values dictates an anticipated increase in future tax payments. This deferred liability is recognized at the time the combination is created. Subsequently, when actual tax payments do arise, the deferred liability is written off rather than recognizing expense based solely on the current liability. In this manner, the expense is shown at a lower figure, one that is matched with reported income (which is also a lower balance because of the extra depreciation). Recognition of this deferred liability at date of acquisition also reduces the net amount attributed to the subsidiary's assets and liabilities in the initial allocation process. Therefore, the residual asset (goodwill) is increased by the amount of any liability that must be recognized. 12. A net operating loss carryforward allows the company to reduce taxable income for up to 20 years into the future. Thus, a benefit may possibly be derived from the carryforward but that benefit is based on Wilson (the subsidiary) being able to generate taxable income to be decreased by the carryforward. To reflect the potential tax reduction, a deferred income tax 7-4 .
.
Chapter 07 - Consolidated Financial Statements—Ownership Patterns and Income Taxes
asset is recorded for the total amount of anticipated benefit. However, because of the uncertainty, unless the receipt of this benefit is more likely than not to be received, a valuation allowance must also be recorded as a contra account to the asset. The valuation allowance may be for the entire amount or just for a portion of the asset. 13. At the date of acquisition, the valuation allowance was $150,000. As a contra asset account, recognition of this amount reduced the net assets attributed to the subsidiary and, hence, increased the recording of goodwill (assuming that the price did not indicate a bargain purchase). If the valuation allowance is subsequently reduced to $110,000, the net assets have increased by $40,000. This change is reflected by a decrease in income tax expense.
7-5 .
.
Chapter 07 - Consolidated Financial Statements—Ownership Patterns and Income Taxes
Answers to Problems 1. D 2. B 3. D 4. C 5. C 6. C 7. D Sapphire's accrual-based income: Operating income ...................................................................... Defer unrealized gain ................................................................ Sapphire's accrual-based income ......................................
$210,000 (50,000) $160,000
Emerald's accrual-based income: Operating income ...................................................................... Investment Income (90% of Sapphire’s accrual income) ....... Emerald's accrual-based income .......................................
$228,000 144,000 $372,000
Diamond's accrual-based income: Operating income ...................................................................... Investment income (80% of Emerald's accrual income) ........ Diamond's accrual-based income ......................................
$348,000 297,600 $645,600
8. C Cherry's accrual-based income: Operating income ...................................................................... Defer unrealized gain ................................................................ Cherry's accrual-based income .......................................... Outside ownership .................................................................... Net income attributable to noncontrolling interest............
$280,000 (50,000) $230,000 20% $ 46,000
Beech's accrual-based income: Operating income ...................................................................... Defer unrealized gain ................................................................ Investment income (80% of Cherry's accrual-based income) ..... Beech's accrual-based income ........................................... Outside ownership .................................................................... Net income attributable to noncontrolling interest ...........
$315,000 (19,000) 184,000 $480,000 20% $ 96,000
Total net income attributable to noncontrolling interest = ($46,000 + $96,000) = $142,000 7-6 .
.
Chapter 07 - Consolidated Financial Statements—Ownership Patterns and Income Taxes
9. A Stark's operating income................................................................ Dividend income from Arryn .......................................................... Stark 's income ............................................................................... Outside ownership ......................................................................... Noncontrolling interest ..................................................................
$78,000 18,000 $96,000 5% $ 4,800
10. B Equity income (75% of $415,000) .................................................. Dividend income (75% of $110,000) .............................................. Tax difference ............................................................................ Dividends received deduction upon eventual distribution (80%) Temporary portion of tax difference ........................................ Tax rate .......................................................................................... Deferred income tax liability ....................................................
$311,250 82,500 $228,750 (183,000) $ 45,750 40% $ 18,300
11. C Unrealized Gross Profit: Total gross profit ........................................................................ Portion still held .......................................................................... Unrealized gross profit ............................................................. Tax rate .......................................................................................... Deferred tax asset .......................................................................
$30,000 20% $ 6,000 25% $ 1,500
12. A Recognition of this gross profit is not required on a consolidated tax return. 13. A Because fair value of the subsidiary's assets exceeds the tax basis by $144,000, a deferred tax liability of $57,600 (40%) must be recorded. Goodwill is then computed as follows: Consideration transferred ....................................... Fair value ............................................................... Deferred tax liability ................................................. Goodwill ....................................................................
$450,000 $454,000 (57,600)
396,400 $ 53,600
14. (30 Minutes) (Series of reporting and consolidation questions pertaining to a father-son-grandson combination. Includes unrealized inventory gains) a. Consideration transferred (by Aspen) ......................... Noncontrolling interest fair value ................................. Birch’s business fair value ............................................ Book value ............................................................... Trade name ...................................................................... Life .................................................................................. Annual amortization ......................................................
7-7 .
.
$288,000 72,000 360,000 (300,000) $ 60,000 30 years $ 2,000
Chapter 07 - Consolidated Financial Statements—Ownership Patterns and Income Taxes
14. (continued) Consideration transferred for Cedar (by Birch) .......... Noncontrolling interest fair value ................................. Cedar’s business fair value .......................................... Book value ............................................................... Trade name ...................................................................... Life .................................................................................. Annual amortization ......................................................
$104,000 26,000 $130,000 (100,000) $30,000 30 years $ 1,000
Investment in Birch Birch's reported income-2012 Amortization expense Accrual-based income Birch’s percentage ownership Equity accrual-2012 Dividends received 2012 Birch's reported income-2013 Amortization expense Income from Cedar [80% x ($10,000 - $1,000)] Accrual-based income Birch’s percentage ownership Equity accrual-2013 Dividends received from Birch 2013 Investment in Birch 12-31-13
$288,000 $40,000 (2,000) $38,000 80% $30,400 (8,000) $60,000 (2,000) 7,200 $65,200 80% $52,160 (16,000) $346,560
Note: Dividends declared by Cedar to Birch do not affect Aspen’s Investment account. b. Consolidated sales (total for the companies) Consolidated expenses (total for the companies) Total amortization expense (see a.) Consolidated net income for 2014 c. Noncontrolling interest in income of Cedar Revenues less expenses $30,000 Excess amortization (1,000) Accrual-based income $29,000 Noncontrolling interest percentage 20% Noncontrolling interest in income of Cedar Noncontrolling interest in income of Birch: Revenues less expenses $65,000 Excess amortization (2,000) Equity in Cedar income [(30,000-1,000) × 80%] 23,200 Realized income of Birch—2014 $86,200 Outside ownership 20% NCI share of 2014 consolidated income 7-8 .
.
$1,298,000 (1,025,000) (3,000) $ 270,000
$5,800
$17,240 $23,040
Chapter 07 - Consolidated Financial Statements—Ownership Patterns and Income Taxes
14. (continued) d. 2013 Realized net income of Birch (prior to accounting for unrealized gross profit) (see a) 2012 Transfer-gross profit recognized in 2013 2013 Transfer-gross profit to be recognized in 2014 2013 Realized net income - Birch
$65,200 10,000 (16,000) $59,200
2014 Realized net income of Birch (prior to accounting for unrealized gross profit) (see c.) 2013 Transfer-gross profit recognized in 2014 2014 Transfer-gross profit to be recognized in 2015 2014 Realized net income—Birch
$86,200 16,000 (25,000) $77,200
15. (15 minutes) (Income and noncontrolling interest with mutual ownership.) a. Consideration transferred by Uncle ............................. Noncontrolling interest fair value ................................. Nephew’s business fair value ....................................... Book value ...................................................................... Intangible assets ............................................................ Life .................................................................................. Amortization expense (annual) .....................................
$500,000 125,000 $625,000 600,000 $25,000 10 years $2,500
Net income reported by Nephew—2014 ........................ Amortization expense (above) ...................................... Accrual-based income.................................................... Uncle's ownership percentage ..................................... Net income of subsidiary recognized by Uncle ...........
$50,000 (2,500) 47,500 80% $38,000
b. To the outside owners, the $6,000 intra-entity dividends ($20,000 × 30%) declared by Uncle are viewed as income because the book value of Nephew increases. Thus, the noncontrolling interest's share of income is computed as follows: Nephew’s accrual-based income (above) Dividends declared by Uncle to Nephew Income to outside owners Noncontrolling interest percentage Noncontrolling interest share of Nephew’s net income
7-9 .
.
$47,500 6,000 $53,500 20% $10,700
Chapter 07 - Consolidated Financial Statements—Ownership Patterns and Income Taxes
16. (35 Minutes) (Consolidated net income for a father-son-grandson combination.) a. Mesa's operating income Butte's operating income Valley's operating income Amortization expense–Mesa's investment in Butte Amortization expense–Butte's investment in Valley Consolidated net income b. Valley's operating income $140,000 Amortization expense (on Butte's investment) (8,000) Valley's accrual-based net income $132,000 Outside ownership 45% Noncontrolling interest in Valley's income Butte's operating income $ 98,000 Amortization expense (on Mesa's investment) (22,500) Equity accrual from ownership of Valley ($132,000 × 55%) 72,600 Butte's accrual-based net income $148,100 Outside ownership 20% Noncontrolling interest in Butte's net income Total net income attributable to noncontrolling interests
$250,000 98,000 140,000 (22,500) (8,000) $457,500
$59,400
$29,620 $89,020
Reconciliation: Mesa’s operating income $250,000 Mesa’s share of Butte’s operating income (80% × $98,000) 78,400 Mesa’s share of Valley’s operating income (80% × 55% × $140,000) 61,600 Mesa’s share of Butte’s excess amortization (80% × $22,500) (18,000) Mesa’s share of Valley’s excess amortization (80% × 55% × $8,000) (3,520) Controlling interest in consolidated net income $368,480 Net income attributable to noncontrolling interest 89,020 Consolidated net income $457,500
7-10 .
.
Chapter 07 - Consolidated Financial Statements—Ownership Patterns and Income Taxes
17. (30 Minutes) (Consolidated net income figures for a connecting affiliation) UNREALIZED GROSS PROFIT: Cleveland ($12,000 remaining inventory × 25% markup) = $3,000 Wisconsin ($40,000 remaining inventory × 30% markup) = $12,000 NONCONTROLLING INTERESTS: CLEVELAND: Operating income (sales minus cost of goods sold and expenses) ........................................................................ Defer unrealized gross profit (above) ................................ Realized income—Cleveland ......................................... Outside ownership ............................................................... Noncontrolling interest in Cleveland's net income ..... WISCONSIN: Operating income (sales minus cost of goods sold and expenses) ...................................................................... Defer unrealized gross profit (above) .............................. Investment income (60% of Cleveland's realized income of $57,000) ........................................................................ Realized income—Wisconsin ...................................... Outside ownership ............................................................. Noncontrolling interest in Wisconsin's net income ..
$60,000 (3,000) $57,000 20% $11,400
$110,000 (12,000) 34,200 $132,200 10% $ 13,220
TOTAL NONCONTROLLING INTERESTS: $24,620 ($11,400 + $13,220) CONSOLIDATION TOTALS ▪
Sales = $1,590,000 (add the three book values and eliminate intra-entity transfers of $40,000 and $100,000)
▪
Cost of goods sold = $1,015,000 (add the three book values, eliminate intraentity transfers of $40,000 and $100,000, and defer [add] unrealized gains of $3,000 and $12,000)
▪
Expenses = $200,000 (add the three book values)
▪
Dividend income = -0- (eliminated for consolidation purposes)
▪
Consolidated net income = $375,000 (consolidated revenues less consolidated cost of goods sold and expenses)
▪
Net income attributable to noncontrolling interest = $24,620 (above)
▪
Net income attributable to Baxter Company = $350,380 (consolidated net income less noncontrolling interest share)
7-11 .
.
Chapter 07 - Consolidated Financial Statements—Ownership Patterns and Income Taxes
18. (12 Minutes) (Acquisition accounting for a subsidiary’s operating loss carryforward) a. Consideration transferred 1/1/14 $1,080,000 Fair value of identifiable assets acquired: Software licensing agreements $830,000 Deferred tax asset from NOL (.35 × $155,000) 54,250 Fair value of net identifiable assets acquired 884,250 Goodwill $195,750 b. Consideration transferred 1/1/14 $1,080,000 Fair value of identifiable assets acquired: Software licensing agreements $830,000 Deferred tax asset from NOL (.35 × $155,000) 54,250 Valuation allowance for NOL (54,250) Fair value of net identifiable assets acquired 830,000 Goodwill $250,000 19. (25 Minutes) (Tax expense with separate tax returns for a combination.) a. CONSOLIDATED TOTALS ▪ Sales = $790,000 (add the two book values and eliminate the $110,000 intraentity transfer) ▪ Cost of goods sold = $340,000 (add the book values, eliminate intra-entity transfers of $110,000, recognize [subtract] $30,000 deferred gain from 2014, and defer [add] $40,000 intra-entity gain into 2015) ▪ Operating expenses = $234,000 (add the two book values) ▪ Dividend income = -0- (eliminated for consolidation purposes) ▪ Consolidated net income = $216,000 (Revenues less expenses) ▪ Net income attributable to noncontrolling interest = $18,000 (20 percent of reported Income of $100,000 plus $30,000 gain deferred from 2014 less $40,000 gain deferred into 2015) ▪ Net income attributable to Up Company = $198,000 b. On separate returns, the unrealized gains are reported as taxable income. Because Up owns 80 percent of Down's stock, the dividends are tax- free and no deferred tax liability is necessary on the undistributed income. DUE TO GOVERNMENT: (separate returns) UP: Income (without dividend income) ............................... Tax rate .......................................................................... Currently payable to government ...........................
7-12 .
.
$126,000 30% $ 37,800
Chapter 07 - Consolidated Financial Statements—Ownership Patterns and Income Taxes
19. (continued) DOWN: Reported income ............................................................ Tax rate .......................................................................... Currently payable to government ...........................
$100,000 30% $ 30,000
Total income tax payable: Current = $67,800 ($37,800 + $30,000) Taxable income is not reduced by the unrealized gain. Therefore, the gain is recognized for tax purposes but not for book purposes and this temporary difference results in a deferred tax asset of $3,000 ($10,000 x 30%). CONSOLIDATED INCOME TAX EXPENSE: Income tax liability ($37,800 + $30,000 = $67,800) less deferred tax asset ($3,000) = income tax expense $64,800. Otherwise stated as: Up has a tax expense of $37,800 and Down has a tax expense of $27,000 ($30,000 payable - $3,000 deferred tax asset). Income tax expense on the consolidated income statement is $64,800. 20. (45 Minutes) (Computation of income tax expense and the related payable balances) a. $260,000 ($650,000 × 40%) The affiliated group is taxed on its operating income of $650,000 ($500,000 $90,000 + $240,000: the net unrealized gross profit is deferred on a consolidated return). The intra-entity income and dividends are not relevant since a consolidated return is filed. b. $260,000 ($650,000 × 40%) The affiliated group is taxed on its operating income of $650,000 (the net unrealized gross profit is deferred on a consolidated return). The intra-entity income and dividends are not relevant if a consolidated return is filed. The percentage ownership does not affect the figures on a consolidated return. c. $296,000 ($96,000 + $200,000) Rogers would pay $96,000 or 40% of its $240,000 operating income. Clarke would pay $200,000 or 40% of its $500,000 operating income. The unrealized gross profit is not deferred when separate returns are filed. Intra-entity dividends are not taxable because the parties qualify as an affiliated group even though separate returns are being filed. Answer (c.) differs from (a.) and (b.) because tax on the $90,000 unrealized gross profit (40% or $36,000) is paid immediately.
7-13 .
.
Chapter 07 - Consolidated Financial Statements—Ownership Patterns and Income Taxes
20. (continued) d. Clarke’s operating income Dividends received net of 80% deduction ($80,000 x 70% x 20%) Taxable income Tax rate Clarke’s income tax payable
$500,000 11,200 $511,200 40% $204,480
Clarke’s deferred taxes: Unrealized gain Tax rate Clarke’s deferred tax asset
$90,000 40% $36,000
Rogers’ income before income tax Less: income tax (40%) Rogers net income Less: dividends paid Undistributed income Clarke’s ownership percentage Clarke’s share of undistributed income Less: dividends-received deduction (80%) Income eventually taxable to Clarke Tax rate Clarke’s deferred tax liability
$240,000 96,000 $144,000 80,000 $ 64,000 70% $ 44,800 35,840 $ 8,960 40% $ 3,584
Entry on Clarke’s books: Deferred Tax Asset Income Tax Expense Deferred Tax Liability Tax Payable
36,000 172,064
Entry on Rogers’ books: Income Tax Expense (40% x $240,000) Tax Payable
96,000
3,584 204,480
96,000
Consolidated tax expense = $172,064 + $96,000 = $268,064 e. $204,480 (see part d. above) Clarke owes $200,000 on its operating income ($500,000 × 40%) because the unrealized gain cannot be deferred. Clarke also owes $4,480 from the dividends received ($56,000 × 20% × 40%). The difference between the Clarke’s $204,480 payment and the $172,064 tax expense in (d.) is created by the premature payment of the tax (a deferred tax asset) on the unrealized gain ($90,000) less the deferred tax liability on the parent's equity accrual ($100,800) in excess of dividends received ($56,000).
7-14 .
.
Chapter 07 - Consolidated Financial Statements—Ownership Patterns and Income Taxes
21. (20 Minutes) (Comparison of income tax expense and payable on separate and consolidated tax returns.) a. Consolidated Return—2014 Piranto income 2014 (sales less expenses) ...................................... Slinton income 2014 (sales less expenses) ....................................... 2013 gain realized in 2014 .................................................................... 2014 deferred gain ................................................................................ Taxable income ............................................................................... Tax rate ................................................................................................ Income tax payable—current .........................................................
$300,000 100,000 120,000 (150,000) $370,000 40% $148,000
Because no temporary differences exist in this problem, the income tax expense would also be $148,000. The unrealized gain is not taxed until realized. Dividend income is not important because a consolidated return is being filed. b. Separate Returns—2014 On its separate tax return, Piranto will report taxable income of $300,000—the unrealized gains cannot be deferred. The dividends would not be taxable because Slinton still meets the criteria to be a member of an affiliated group. A consolidated return is not a requirement for these dividends to be excluded. Thus, income taxes payable by Piranto would be $120,000 ($300,000 × 40%). To determine the income tax expense for Piranto, the two temporary differences must be taken into account: Taxable income .............................................................. Gain taxed in 2013 although realized in 2014 ....................................................................... Gain taxed in 2014 although not yet realized ............... 2014 realized income subject to taxation .................... Tax rate ........................................................................... Income tax expense .......................................................
$300,000 120,000 (150,000) $270,000 40% $108,000
The $12,000 difference between the expense and the payable is the tax effect on the net unrealized gain ($30,000 × 40%). Slinton will have an expense and payable of $40,000 ($100,000 × 40%). Consolidated income tax expense is $148,000 ($108,000 + $40,000). Consolidated income tax payable is $160,000 ($120,000 + $40,000).
7-15 .
.
Chapter 07 - Consolidated Financial Statements—Ownership Patterns and Income Taxes
22. (45 Minutes) (Comparison of income tax expense and payable on separate and consolidated tax returns. Includes question on mutual ownership and the conventional approach.) a. Total income tax expense is $156,877. Because of the level of ownership, separate returns must be filed. Unrealized gross profits are taxed immediately as are intra-entity dividends. Because the unrealized gross profits are deferred on the consolidated financial statements, Boxwood's expense would be $34,400 or 40% of $86,000 in realized income ($100,000 + $18,000 – $32,000). Lake's income subject to taxation includes its $300,000 in operating income plus $30,960 in income accruing from its investment in Boxwood (60% of the after-tax income of $51,600 [$86,000 – $34,400]). Income tax expense for Lake is computed as follows: Operating income .......................................................... Equity income ................................................................ Taxable portion .............................................................. Income eventually subject to taxation ......................... Tax rate ............................................................................ Income tax expense Lake (rounded) ............................. Income tax expense Boxwood (above) ......................... Total income tax expense ............................................. -ORLake’s operating income ................................................ Dividends received net of 80% deduction ($10,000 x 60% x 20%) .................................................. Taxable income ............................................................... Tax rate Lake’s income tax payable ........................................ Boxwood’s income before income tax .......................... Less: income tax (40%) .................................................. Boxwood’s net income ................................................... Less: dividends paid ...................................................... Undistributed income ..................................................... Lake’s ownership percentage ........................................ Lake’s share of undistributed income .......................... Less: dividends-received deduction (80%) .................. Income eventually taxable to Lake ................................ Tax rate ............................................................................ Lake’s deferred tax liability (rounded) ..................... Income tax expense Lake ......................................... Income tax expense Boxwood (above) .................... Total income tax expense .............................................
7-16 .
.
$300,000 $30,960 20%
6,192 $306,192 40% $122,477 34,400 $156,877
$300,000 1,200 $301,200 40% $120,480 $ 86,000 34,400 $ 51,600 10,000 $ 41,600 60% $ 24,960 19,998 $ 4,992 40% $ 1,997 $122,477 34,400 $156,877
Chapter 07 - Consolidated Financial Statements—Ownership Patterns and Income Taxes
22. (continued) Entry on Lake’s books: Income Tax Expense Deferred Tax Liability Tax Payable
122,477 1,997 120,480
Entry on Boxwood’s books: Income Tax Expense Deferred Tax Asset Tax Payable
34,400 5,600 40,000
b. Boxwood will pay $40,000 ($100,000 × 40%) because separate returns are filed. Lake, however, will pay its taxes based on dividends received rather than on the equity accrual. A deferred income tax liability would be established for the difference. Lake's payment for the current year is computed as follows: Operating income ........................................................... Dividend income (60% × $10,000) ................................. $6,000 Taxable portion (net of 80% dividends received deduction) 20% Income currently taxable ............................................... Tax rate .......................................................................... Income tax payable—Lake ............................................ Income tax payable—Boxwood (above) ...................... Total income tax payable current .................................
$300,000 1,200 $301,200 40% $120,480 40,000 $160,480
The $3,603 difference between the expense in a. and the payable in b. is created by the following two effects: Deferred income tax liability on equity income accrual not yet taxed ($30,960 – $6,000 = $24,960 × 20% × 40%) .................................. Deferred income tax asset on net unrealized gross profit ($32,000 – $18,000 = $14,000 × 40%) ........................................... Net decrease in expense ...................................................................
$1,997 5,600 $3,603
c. Because a consolidated tax return is filed, unrealized gross profits are deferred as for external reporting purposes. Dividend income is not taxable. Lake's operating income ............................................... Boxwood's operating income ....................................... Prior year unrealized gross profit ................................. Current year unrealized gross profit ............................ Income subject to taxation (and currently taxable) ..... Tax rate ........................................................................... Income tax expense .......................................................
7-17 .
.
$300,000 100,000 18,000 (32,000)
86,000 $386,000 40% $154,400
Chapter 07 - Consolidated Financial Statements—Ownership Patterns and Income Taxes
23. (30 Minutes) (Computation of income tax expense and income tax payable on consolidated and separate tax returns.) a. Operating income .......................................................... Tax rate .......................................................................... Taxes to be paid .............................................................
$450,000 40% $180,000
The affiliated group would be taxed on its operating income of $450,000 (the $50,000 unrealized gain is deferred). Intra-entity income and dividends are not relevant because a consolidated return is filed. b. Total taxes to be paid are $200,000. Robertson would have to pay $80,000 or 40% of its $200,000 operating income. Garrison would pay $120,000 or 40% of its $300,000 operating income. The unrealized gain is not deferred because separate returns are being filed. Intra-entity dividends are not taxable because the parties still qualify as an affiliated group even though separate returns are being filed. c. Robertson must report an income tax expense of $80,000 or 40% of its $200,000 operating income. Garrison records its expense based on the revenue recognized during the period. Thus, the expense is computed on an operating income of $250,000 (the net unrealized gain is not recognized in this period) along with equity income from Robertson of $84,000 (70% of that company's $120,000 after-tax income). Garrison will record an income tax expense of $100,000 in connection with the operating income ($250,000 × 40%) and $6,720 resulting from its equity income ($84,000 × 20% × 40%). Total expense to be reported amounts to $186,720 for Garrison and Robertson ($80,000 + $100,000 + $6,720). d. Garrison will pay $120,000 in connection with its operating income ($300,000 × 40%) and $2,400 because of the dividends received from Robertson. Garrison will receive $30,000 in dividends based on its 60% ownership. Of this total, only $6,000 (20%) is taxable. Thus, at a 40% rate, the tax on the dividends would amount to $2,400 ($6,000 × 40%). The total income taxes payable by Garrison is $122,400 ($120,000 + $2,400).
7-18 .
.
Chapter 07 - Consolidated Financial Statements—Ownership Patterns and Income Taxes
24. (10 Minutes) (Impact on goodwill of assets with a different tax vs. book value.) a. The assets and liabilities of Oxford (the subsidiary) will be consolidated at their individual net fair values ($558,000). However, both the buildings and equipment have a tax basis that is lower than fair value. Thus, for tax purposes, future depreciation expense will be lower on the tax return so that taxable income will exceed book income. The higher taxable income (anticipated in the future) creates a deferred tax liability at the time the combination is created. Tax Basis $221,000 160,000
Buildings ................................... Equipment ................................. Total temporary difference ...... Tax rate ...................................... Deferred tax liability .................
Fair Value $276,000 233,000
Temporary Difference $ 55,000 73,000 $128,000 40% $ 51,200
b. Consequently, Oxford's accounts will be consolidated as follows: (parentheses indicate a credit balance) Accounts receivable ................................................. Inventory ................................................................... Land ........................................................................... Buildings ................................................................... Equipment .................................................................. Liabilities .................................................................... Deferred tax liability ................................................. Assigned to specific accounts ................................ Acquisition consideration ........................................
$153,000 141,000 136,000 276,000 233,000 (281,000) (51,200) 606,800 850,000
c. Excess assigned to goodwill ...................................
$243,200
7-19 .
.
Chapter 07 - Consolidated Financial Statements—Ownership Patterns and Income Taxes
25. (55 Minutes) (Consolidation worksheet for a father-son-grandson combination. Includes intra-entity inventory transfers.) The following computations are needed before the consolidation worksheet is prepared: calculation of the deferred gross profits in beginning and ending inventory. Beginning Unrealized Gross Profit (Wilson) (January 1, 2014 Inventory Transfer Price (goods remaining) = Balance) Cost + .25 Cost $60,000 = 1.25 Cost $48,000 = Cost $12,000 is Unrealized gross profit Ending Unrealized Gross Profit (Wilson) (December 31, 2014 Inventory Transfer Price (goods remaining) = Balance) Cost + .25 Cost $90,000 = 1.25 Cost $72,000 = Cost $18,000 is Unrealized gross profit CONSOLIDATION ENTRIES Entry *G Retained Earnings, 1/1/14 (Wilson) ......................... 12,000 Cost of Goods Sold .............................................. 12,000 (To recognize income on intra-entity inventory transfers made in previous year but not resold until current year as per above computation.) Entry *C Retained Earnings, 1/1/14 (House) ............................... 11,200 Investment in Wilson .......................................... 11,200 (To convert investment account from partial equity method to equity method. Unrealized gross profit shown in Entry *G is not properly reflected by parent under partial equity method [12,000 × 70% = $8,400 income decrease] nor would be the $2,800 in amortization expense for 2012–2013. Thus, a reduction of $11,200 is required. Because Cuddy is a current year acquisition, no prior conversion to equity method is required for the investment.) Entry S1 Common Stock (Cuddy) ................................................ 150,000 Retained Earnings, 1/1/14 (Cuddy) ............................... 150,000 Investment in Cuddy (80%) ....................................... 240,000 Noncontrolling Interest in Cuddy Common Stock (20%) 60,000 (To eliminate Cuddy's stockholders' equity against the corresponding investment balance and to recognize noncontrolling interest in common stock.)
7-20 .
.
Chapter 07 - Consolidated Financial Statements—Ownership Patterns and Income Taxes
25. (continued) Entry S2 Common Stock (Wilson) ............................................... 310,000 Retained Earnings, 1/1/14 (Wilson) (adjusted by Entry *G) .............................................. 578,000 Investment in Wilson (70%) ................................ 621,600 Noncontrolling Interest in Wilson (30%) ........... 266,400 (To eliminate Wilson's stockholders' equity against corresponding investment balance and to recognize noncontrolling interest.) Entry A Buildings ......................................................................... 54,000 Franchise Contracts ...................................................... 32,000 Goodwill ........................................................................... 140,000 Equipment ................................................................. 10,000 Investment in Wilson ................................................ 151,200 Noncontrolling Interest in Wilson ............................ 64,800 (To allocate excess payment made in connection with purchase of Wilson shown above. Amortization for 2012 and 2013 has been taken into account in determining the January 1, 2014 value for each account.) Entry I1 Income of Cuddy ...................................................... 56,000 Investment in Cuddy ........................................... 56,000 (To eliminate intra-entity income accrued by both House and Wilson during the year.) Entry I2 Income of Wilson ...................................................... 91,000 Investment in Wilson .......................................... 91,000 (To eliminate intra-entity income accrued by House during the year.) Entry D1 Investment in Cuddy ............................................... 40,000 Dividends declared (80%) (Cuddy) .................... (To eliminate effects of intra-entity dividend payments.) Entry D2 Investment in Wilson ............................................... 67,200 Dividends declared (70%) (Wilson) .................... (To eliminate effects of intra-entity dividend payments.)
7-21 .
.
40,000
67,200
Chapter 07 - Consolidated Financial Statements—Ownership Patterns and Income Taxes
25. (continued) Entry E Operating Expenses ................................................. 2,000 Equipment ............................................................... 5,000 Franchise Contracts ........................................... 4,000 Buildings ............................................................... 3,000 (To record 2014 amortization on excess payment made in connection with acquisition of Wilson Company.) Entry TI Sales and Other Revenues ...................................... 200,000 Cost of Goods Sold .............................................. (To eliminate intra-entity inventory sales for the current year.) Entry G Cost of Goods Sold ................................................... Inventory ............................................................... 18,000 (To defer unrealized gross profit in ending inventory.)
200,000
18,000
Noncontrolling Interest in Net Income of Cuddy: Reported net income Outside ownership Noncontrolling interest in Cuddy net income—common .........
$70,000 20% $14,000
Noncontrolling Interest in Net Income of Wilson: Reported operating income Equity income of Cuddy ($70,000 × 40%) ................................... Excess amortization ..................................................................... Recognition of 2013 gross profit (Entry *G) Deferral of 2014 unrealized gross profit (Entry G) Realized net income Outside ownership Noncontrolling interest in net income of Wilson
7-22 .
.
$130,000 28,000 (2,000) 12,000 (18,000) $150,000 30% $ 45,000
Chapter 07 - Consolidated Financial Statements—Ownership Patterns and Income Taxes
25. (continued) HOUSE CORPORATION AND CONSOLIDATED SUBSIDIARIES Consolidation Worksheet December 31, 2014 Accounts
House Corp.
Sales and other revenue
(900,000)
(700,000)
(300,000) (TI) 200,000
Cost of goods sold
551,000
300,000
140,000 (G) 18,000
Operating expenses 219,000 Income of Wilson Company (91,000) Income of Cuddy Company (28,000) Net income (249,000) Consolidated net income Net income attributable to noncontrolling interest (Wilson) Net income attributable to noncontrolling interest (Cuddy) Net income attributable to House Corporation Retained earnings, 1/1/14: —House Corporation (820,000) —Wilson Company
270,000
90,000 (E) 2,000 (I2) 91,000 (I1) 56,000 (70,000)
—Cuddy Company Net Income Dividends declared —House Corporation —Wilson Company —Cuddy Company Retained earnings, 12/31/14
(249,000)
Wilson Company
(28,000) (158,000)
Consolidation EntriesNoncontrollingConsolidated Debit Credit Interest Balance (1,700,000) (*G) 12,000 (TI) 200,000
797,000 581,000 -0-0(322,000)
(590,000)
(158,000)
(45,000)
45,000
(14,000)
14,000 (263,000)
(*C) 11,200 (*G) 12,000 (S2)578,000 (150,000) (S1)150,000 (70,000)
(808,800) -0-0(263,000)
100,000 96,000 (969,000)
(652,000)
7-23 ..
Cuddy Company
50,000 (170,000)
(D2) 67,200 (D1) 40,000
28,800 10,000
100,000 -0-0(971,800)
Chapter 07 - Consolidated Financial Statements—Ownership Patterns and Income Taxes
25. (continued) Accounts
House Corp.
Wilson Company
Cuddy Company
Cash and receivables Inventory Investment in Wilson Company
220,000 390,200 807,800
334,000 320,000
67,000 103,000
Investment in Cuddy Company
128,000
128,000
(D1) 40,000
Buildings Equipment Land Goodwill Franchise Contracts Total assets
385,000 310,000 180,000
320,000 130,000 300,000
2,421,000
1,532,000
144,000 (A) 54,000 88,000 (E) 5,000 16,000 (A) 140,000 (A) 32,000 418,000
(632,000)
(570,000)
(98,000)
Liabilities Noncontrolling interest in Cuddy Noncontrolling interest in Wilson Noncontrolling interest in subsidiary companies Common stock Retained earnings (above) Total liabilities and equities
(D2) 67,200
(820,000)
(310,000)
(969,000) (2,421,000)
(652,000) (1,532,000)
7-24
(150,000) (S1) 150,000 (S2) 310,000 (170,000) (418,000) 1,916,400
621,000 795,200 -0-
(G) 18,000 (*C) 11,200 (S2) 621,600 (I2) 91,000 (A) 151,200 (S1) 240,000 (I1) 56,000 (E) 3,000 (A) 10,000
(E)
-0900,000 523,000 496,000 140,000 28,000 3,503,200
4,000
(1,300,000) (S1) 60,000 (S2) 266,400 (A) 64,800
Parentheses indicate a credit balance.
..
Consolidation EntriesNoncontrollingConsolidated Debit Credit Interest Balance
1,916,400
(60,000) (331,200) (411,400)
(411,400) (820,000) (971,800) (3,503,200)
Chapter 07 - Consolidated Financial Statements—Ownership Patterns and Income Taxes
26. (20 Minutes) (Consolidation entries for a mutual holding business combination) a. Acquisition Allocation and Amortization Consideration transferred ............................................ Noncontrolling interest fair value ................................. Lowly’s business fair value ........................................... Book value acquired ....................................................... Trademarks ..................................................................... Annual amortization (20-year life) .................................
$420,000 280,000 700,000 (600,000) $100,000 $ 5,000
CONSOLIDATION ENTRIES Entry *C Investment in Lowly ................................................. 117,000 Retained Earnings, 1/1/14 (Mighty) .................... 117,000 (To accrue income to parent during the previous years as measured by increase in book value [$200,000 × 60%] and amortization expense of $3,000 [$5,000 × 60%] for the previous year.) Entry S1 Common Stock (Lowly) ............................................ 300,000 Retained Earnings, 1/1/14 (Lowly) ........................... 500,000 Investment in Lowly (60%) ................................. 480,000 Noncontrolling Interest in Lowly 1/1/14 (40%) .. 320,000 (To eliminate subsidiary stockholders' equity accounts against investment account and to recognize noncontrolling interest ownership.) Entry S2 Treasury Stock .......................................................... 240,000 Investment in Mighty ........................................... (To reclassify cost of parent shares as treasury stock.)
240,000
Entry A Trademarks ............................................................... 95,000 Investment in Lowly ............................................ 57,000 Noncontrolling Interest in Lowly 1/1/14 (40%) .. 38,000 (To recognize unamortized portion of acquisition-date excess fair value.) Entry E Amortization Expense .............................................. Trademarks .......................................................... (To record trademarks amortization expense for 2014.) Net income attributable to noncontrolling interest = $14,000 [40% × ($40,000 - $5,000)]
7-25 .
.
5,000 5,000
Chapter 07 - Consolidated Financial Statements—Ownership Patterns and Income Taxes
27. (80 Minutes) (Prepare consolidation worksheet for a father-son-grandson combination. Also asks about income taxes paid on both a separate and a consolidated return) a. Acquisition-Date Allocation and Amortization The January 1, 2013 book values are determined by removing the 2013 income from the January 1, 2014 book values (based on equity accounts). Consideration transferred for Stookey ......................... Noncontrolling interest fair value ................................. Stookey business fair value .......................................... Stookey book value ....................................................... Customer List .................................................................. Life .................................................................................. Annual amortization ......................................................
$344,000 86,000 $430,000 (380,000) $ 50,000 10 Years $ 5,000
Consideration transferred for Yarrow ........................... Noncontrolling interest fair value ................................. Yarrow business fair value ........................................... Yarrow book value .......................................................... Copyright ........................................................................ Life .................................................................................. Annual amortization ......................................................
$720,000 80,000 $800,000 740,000 $ 60,000 15 Years $ 4,000
CONSOLIDATION ENTRIES Entry *G Retained Earnings, 1/1/14 (Stookey) ....................... 7,680 Cost of Goods Sold .............................................. 7,680 (To give effect to unrealized gross profit from 2013. Amount is calculated based on normal 48% markup [found from Income Statement] multiplied by $16,000 retained inventory [20% of $80,000]) Entry *C1 Investment in Stookey ............................................. 85,856 Retained Earnings, 1/1/14 (Yarrow) ................... 85,856 (To recognize equity income accruing from Yarrow's investment in Stookey during 2013. Because the initial value method is applied and no dividends declared, no income has been recognized in connection with the 2013 ownership of Stookey. Reported income of $120,000 [2013] less unrealized gain of $7,680 deferred above indicates income of $112,320. Based on 80% ownership, an $89,856 accrual is needed, which is reduced by the $4,000 amortization (80% × $5,000) for that year.
7-26 .
.
Chapter 07 - Consolidated Financial Statements—Ownership Patterns and Income Taxes
27. (continued) Entry *C2 Investment in Yarrow ............................................... 217,670 Retained Earnings, 1/1/14 (Travers) .................. 217,670 (To recognize equity income accruing from Travers' investment in Yarrow during 2013. Because the initial method is applied and no dividends declared, income has not been recognized in connection with the 2013 ownership of Yarrow. Income of $245,856 is calculated based on reported income of $160,000 [2013] plus the $85,856 accrual recognized in Entry *C1. Ownership of 90% dictates a $221,270 accrual that is then reduced to $217,670 by the $3,600 [90% × $4,000] amortization applicable to 2013.) Entry S1 Common Stock (Stookey) ........................................ 200,000 Retained Earnings, 1/1/14 (Stookey, as adjusted by Entry *G) ......................................................... 292,320 Investment in Stookey (80%) ........................ 393,856 Noncontrolling Interest in Stookey (20%) .... 98,464 (To eliminate stockholders' equity accounts of subsidiary [Stookey] against corresponding balance in investment account and to recognize noncontrolling interest ownership.) Entry S2 Common Stock (Yarrow) .......................................... 300,000 Retained Earnings, 1/1/14 (Yarrow, as adjusted by Entry *C1) ........................................................ 685,856 Investment in Yarrow (90%) .......................... 887,270 Noncontrolling Interest in Yarrow (10%) ...... 98,586 (To eliminate stockholders’ equity accounts of subsidiary Yarrow against corresponding balance in investment account and to recognize noncontrolling interest ownership.) Entry A1 Customer List ............................................................ Investment in Stookey ........................................ Noncontrolling Interest in Stookey (20%) .........
45,000 36,000 9,000
(To recognize January 1, 2014 unamortized portion of acquisition price assigned to Stookey’s customer list.)
7-27 .
.
Chapter 07 - Consolidated Financial Statements—Ownership Patterns and Income Taxes
27. (continued) Entry A2 Copyright ................................................................... 56,000 Investment in Yarrow . ......................................... 50,400 Noncontrolling Interest in Yarrow ...................... 5,600 (To recognize January 1, 2014 unamortized portion of acquisition price assigned to copyright.) Entry E Operating Expenses ................................................. 9,000 Customer List ....................................................... 5,000 Copyright .............................................................. 4,000 (To recognize amortization expense for 2014—$5,000 in connection with Travers' investment and $3,000 in connection with Yarrow's investment.) Entry Tl Sales .......................................................................... 100,000 Cost of Goods Sold .............................................. (To eliminate intra-entity inventory transfers made during 2014.)
100,000
Entry G Cost of Goods Sold ................................................... 9,600 Inventory (current assets) .................................. 9,600 (To defer unrealized gross profit on ending inventory—$20,000 × 48% markup.) Noncontrolling Interest in Stookey's Net Income 2014 Reported net income ............................................ Customer list amortization ............................................ Realization of 2013 deferred gross profit (*G) ............. Deferral of 2014 unrealized gross profit (G) ................ Realized income 2014 .................................................... Outside ownership ......................................................... Noncontrolling interest in Stookey's net income ........ Noncontrolling Interest in Yarrow's Net Income 2014 Reported net income ............................................ Copyright amortization .................................................. Accrual of Stookey's income (80% of $93,080 realized income [computed above]) ........................ Realized income—2014 ................................................. Outside ownership ......................................................... Noncontrolling interest in Yarrow's net income ..........
7-28 .
.
$100,000 (5,000) 7,680 (9,600) $93,080 20% $18,616
$200,000 (4,000) 74,464 $270,464 10% $ 27,046
Chapter 07 - Consolidated Financial Statements—Ownership Patterns and Income Taxes
27. (continued)
Accounts
TRAVERS COMPANY AND CONSOLIDATED SUBSIDIARIES Consolidation Worksheet December 31, 2014 Travers Yarrow Stookey Consolidation EntriesNoncontrollingConsolidated Company Company Company Debit Credit Interest Balances
Sales and other revenues Cost of goods sold
(900,000) 480,000
(600,000) 320,000
(500,000) 260,000
(Tl) (G)
Operating expenses Separate company net income Consolidated net income Net income attributable to NCI (Yarrow) Net income attributable to NCI (Stookey) Net income attributable to Travers Company Retained earnings, 1/1/14: Travers Company Yarrow Company Stookey Company
100,000 (320,000)
80,000 (200,000)
140,000 (100,000)
(E)
Net Income (above) Dividends declared Retained earnings, 12/31/14
(320,000) 128,000 (892,000)
(200,000) (800,000)
(400,000)
Current assets Investment in Yarrow Company
444,000 720,000
380,000
280,000
(700,000) (600,000) (300,000)
329,000
217,670 85,856
(G) 217,670 (S2) (A2) 85,856 (S1) (A1)
9,600 887,270 50,400 393,856 36,000
(A1) (A2)
45,000 (E) 56,000 (E)
5,000 4,000
(S1) (S2)
200,000 300,000
(*C1)
2,113,000
1,560,000
800,000
Liabilities Common stock
(721,000) (500,000)
(460,000) (300,000)
(200,000) (200,000)
Retained earnings, 12/31/14 (above) NCI interest in Stookey, 1/1/14
(892,000)
(800,000)
(400,000)
(2,113,000)
836,000
(*C2) 685,856 (*C1) 7,680 292,320
(917,670) -0-0-
1,094,400 -0-0-
520,000
(1,560,000)
(800,000)
7-29
(609,080) 27,046 18,616 (563,418)
(563,418) 128,000 (1,353,088)
(*C2) 344,000
949,000
(S2) (*G) (S1)
(100,000)
Land, buildings, & equipment (net) Customer list Copyright Total assets
..
(1,900,000) 961,920
7,680 100,000
(27,046) (18,616)
Investment in Stookey Company
Noncontrolling interest in Yarrow, 1/1/14 Noncontrolling interests in subsidiaries Total liabilities and equities
100,000 9,600 (*G) (TI) 9,000
2,305,000 40,000 52,000 3,491,400 (1,381,000)
(S1) (A1) (S2) (A2) 2,008,982
98,464 9,000 98,586 5,600 2,008,982
(500,000) (1,353,088) (107,464) (104,186) (257,312)
(257,312) (3,491,400)
Chapter 07 - Consolidated Financial Statements—Ownership Patterns and Income Taxes
27. (continued) b. Travers' reported pre-tax income ....................................................... Yarrow's reported pre-tax income ...................................................... Dividend income (none collected) ...................................................... Intra-entity gains (no transfers) .......................................................... Amortization expense .......................................................................... Taxable income .................................................................................... Tax rate ................................................................................................. Income tax payable ..............................................................................
$320,000 200,000 -0-0(9,000) $511,000 45% $229,950
c. Stookey's reported pre-tax income .................................................... (Unrealized gains are not deferred on a separate tax return.) Tax rate ................................................................................................. Income tax payable ..............................................................................
$100,000
45% $45,000
d. (1) Because Yarrow owns 80% of Stookey's stock, intra-entity dividends are nontaxable. Thus, no temporary difference is created by Stookey's failure to pay a dividend. (2) Stookey's unrealized gains are recognized in one time period for financial reporting purposes and in a different time period for tax purposes. This temporary increases taxable income by $1,920 over reported income: 2014 Unrealized gross profit taxed in 2014 ........................................ 2013 Unrealized gross profit taxed previously in 2013...................... Increase in taxable income ................................................................. Tax rate ................................................................................................. Deterred income tax asset ..................................................................
$9,600 (7,680) $1,920 45% $ 864
Income Tax Expense: Travers and Yarrow—payable (part b) .......................................... Stookey—payable (part c) .............................................................. Total taxes to be paid—2014 .......................................................... Prepayment (asset) (above) ........................................................... Income tax expense 2014................................................................
$229,950 45,000 $274,950 (864) $274,086
Because a single rate is used, income tax expense can also be computed by taking consolidated net income (prior to noncontrolling interest reduction) of $609,080 (part a.) and multiplying by the 45% tax rate to obtain $274,086. Income tax expense—current ....................................... Deferred income tax—asset .......................................... Income tax payable ..................................................
7-30 .
.
274,086 864 274,950
Chapter 07 - Consolidated Financial Statements—Ownership Patterns and Income Taxes
28. (40 Minutes) (Series of questions about a business combination and its income tax reporting) a. Partial equity method. "Income of Soludan" is 80% of Soludan's reported total. b. $12,000. Reduction is evidenced by a $338,000 figure reported for consolidated inventory rather than the $350,000 total for the two companies. c. $37,500. Consolidated operating expenses have increased by $2,500, evidently the annual amortization. Because a 15-year life is assumed by the combination, the amount originally allocated to trademarks must have been $37,500. d. $120,000. Decrease shown in consolidated sales account. e. Upstream. " Net income attributable to the noncontrolling interest" is $18,700. Because this amount is not equal to 20% of Soludan's reported net income less excess amortization ($100,000 – $2,500), realized net income must have been adjusted for unrealized gross profits. Subsidiary net income is only adjusted to show the effects of upstream transfers. f. $20,000. For both receivables and liabilities, the consolidated total is $20,000 less than the sum of the two companies. g. $8,000. Consolidated cost of goods sold is decreased by $120,000 (to $780,000) in eliminating intra-entity sales. The increase of $12,000 created by the ending unrealized gross profit (see part b.) would then leave a $792,000 balance. Because $784,000 is the ending balance reported for consolidated cost of goods sold, an $8,000 unrealized gross profit must have been deferred from the previous year.
7-31 .
.
Chapter 07 - Consolidated Financial Statements—Ownership Patterns and Income Taxes
28. (continued) h. Because the trademarks balance now stands at $32,500, amortization expense of $2,500 has been recognized, $2,500 in the previous year. In addition, an $8,000 unrealized gross profit from the prior year (see part g.) is recognized. Amortization expense—prior year × 80% ..................... Unrealized gross profit—upstream effect on parent's retained earnings is $8,000 × 80% ............. Adjustment to parent’s beginning retained earnings ..
$2,000 6,400 $8,400
i. This figure is computed as follows: Book value of subsidiary—1/1 ...................................... $370,000 Unrealized gross profit in beginning inventory (see above) Realized book value .................................................... $362,000 Excess allocation at 1/1.................................................. 35,000 Subsidiary valuation basis 1/1 ...................................... 397,000 Noncontrolling interest percentage .............................. 20% Noncontrolling interest 1/1 ........................................... Noncontrolling interest in Soludan's income (as reported) .............................................................. Noncontrolling interest in Soludan's dividends ($20,000 × 20%) ......................................................... Ending noncontrolling interest .....................................
(8,000)
$79,400 18,700 (4,000) $94,100
j. For a consolidated return, unrealized gross profit are deferred as in the consolidated statements. At a 40% rate, both the expense and payable would be $117,400. Income tax expense ....................................................... Income tax payable ..................................................
117,400 117,400
Consolidated Taxable Income: Sales .............................................................................................. $1,280,000 Cost of Goods Sold ....................................................................... (784,000) Operating expenses ..................................................................... (202,500) Taxable income ....................................................................... $ 293,500 k. On a separate return, Politan would report its operating income of $200,000 leading to a tax expense and payable of $80,000. Because of the level of ownership, intra-entity dividend (or investment) income is omitted. Income Tax Expense ..................................................... Income Tax Payable .................................................
7-32 .
.
80,000 80,000
Chapter 07 - Consolidated Financial Statements—Ownership Patterns and Income Taxes
28. k. (continued) On a separate return, Soludan would report $100,000 operating income for a payable of $40,000. The unrealized gross profits are accounted for in different time periods in the financial statements, thus, a temporary difference is created. The beginning inventory gross profit of $8,000 was taxed in the previous year rather than currently. The current unrealized gross profit of $12,000 is taxed now rather than next year; the tax paid this year on the net $4,000 ($1,600) is a prepayment. Income Tax Expense ..................................................... Deferred Income Tax Asset ............................................ Income Tax Payable .................................................
38,400 1,600
Soludan's entry can also be computed as follows: Reported income ............................................................................ Unrealized gross profit from previous period realized currently Deferral of current unrealized gross profit ................................... Realized income ............................................................................. Tax rate ..................................................................................... Income tax expense ....................................................................... Taxes payable .................................................................................. Deferred tax asset ................................................................................
40,000
$100,000 8,000 (12,000) $96,000 40% $38,400 40,000 $ 1,600
29. (45 Minutes) Develop worksheet entries that were used to consolidate the financial statements of a father-son-grandson combination. Entry *G Retained Earnings, 1/1/14 (Delta) ............................ 15,000 Cost of Goods Sold .............................................. 15,000 (To recognize gross profit that was unrealized in 2013 [amount provided].) Entry *C1 Retained Earnings, 1/1/14 (Delta) ............................ 7,000 Investment in Omega Company ......................... 7,000 (To recognize amortization expense from Delta’s acquisition for 2013.)
7-33 .
.
Chapter 07 - Consolidated Financial Statements—Ownership Patterns and Income Taxes
29. (continued) Entry *C2 Retained Earnings, 1/1/14 (Alpha) ........................... 27,600 Investment in Delta Company ............................ 27,600 To recognize accrual adjustments for excess amortization and inventory deferral as follows: Excess amortization from Delta acquisition (80% × $6,250 × 2 years)........................................ $10,000 Deltas’ share of excess amortization from Omega acquisition (80% × [70% × $10,000] × 1 year) .......................... 5,600 Inventory profit deferral at 1/1/14 (80% × $15,000) . 12,000 *C2 adjustment .......................................................... $27,600 Entry S1 Common Stock (Omega) .......................................... 100,000 Retained Earnings, 1/1/14 (Omega) ......................... 100,000 Investment in Omega (70%) ................................ 140,000 Noncontrolling Interest in Omega (30%) ........... 60,000 (To eliminate stockholders' equity accounts of Omega against parent's Investment account and to recognize outside ownership.) Entry S2 Common Stock (Delta) ............................................. 120,000 Retained Earnings, 1/1/14 (Delta, as adjusted) ...... 378,000 Investment in Delta (80%) ................................... 398,400 Noncontrolling Interest in Delta (20%) .............. 99,600 (To eliminate stockholders' equity accounts of Delta [as adjusted as Entry *G and Entry *C1] against corresponding balance in Investment account and to recognize outside ownership.) Entry A Copyrights ................................................................. 222,500 Investment in Delta ............................................. 90,000 Investment in Omega .......................................... 77,000 Noncontrolling Interest in Delta .......................... 22,500 Noncontrolling Interest in Omega ...................... 33,000 (To recognize January 1, 2014 unamortized copyrights, 2 years amortization recorded on first investment but only one year for second.) Entry I1 Income of Subsidiary ............................................... 144,000 Investment in Delta ............................................. 144,000 (To eliminate intra-entity income accrual found on Alpha's records.)
7-34 .
.
Chapter 07 - Consolidated Financial Statements—Ownership Patterns and Income Taxes
29. (continued) Entry I2 Income of Subsidiary ............................................... 49,000 Investment in Omega .......................................... 49,000 (To eliminate intra-entity income accrual found on Delta's records.) Entry D1 Investment in Delta ................................................... Dividends Declared (Delta) ................................. (To eliminate intra-entity dividends.) Entry D2 Investment in Omega ............................................... Dividends Declared (Omega) ............................. (To eliminate intra-entity dividends.)
32,000 32,000
35,000 35,000
Entry E Operating Expenses ................................................. 16,250 Copyrights ........................................................... 16,250 (Current year amortization, $6,250 on first acquisition and $10,000 on second.) Entry Tl Sales .......................................................................... Cost of Goods Sold .............................................. (To eliminate intra-entity inventory transfer.)
200,000 200,000
Entry G Cost of Goods Sold ................................................... 22,000 Inventory ............................................................... (To defer ending unrealized gross profit on intra-entity transfers.) Noncontrolling Interest in Omega's Income: Reported income ............................................................ Excess fair value amortization ...................................... Accrual-based income.................................................... Outside ownership ......................................................... Net income attributable to noncontrolling interest .....
7-35 .
.
22,000
$70,000 (10,000) 60,000 30% $18,000
Chapter 07 - Consolidated Financial Statements—Ownership Patterns and Income Taxes
29. (continued) Noncontrolling Interest in Delta's Net Income: Reported operating income .......................................... Equity income investment in Omega (70% × $60,000) Amortization expense .................................................... 2013 Unrealized income realized in 2014 ...................... 2014 Unrealized income realized in 2014 ..................... Accrual-based income—Delta (2014) ........................... Outside ownership ......................................................... Net income attributable to noncontrolling interest ...... Noncontrolling interest in Delta Company ................... Noncontrolling interest, 1/01/14 (Entry S2) ............. Noncontrolling interest, 1/01/14 (Entry A) ............... Noncontrolling interest in Delta’s income (above) . Dividends declared to noncontrolling interest ($40,000 × 20%) ....................................................... Noncontrolling interest in Delta, 12/31/14 ..........
$131,000 42,000 (6,250) 15,000 (22,000) $159,750 20% $ 31,950
$99,600 22,500 31,950 (8,000) $146,050
Noncontrolling interest in Omega Company ................ Noncontrolling interest, 1/01/14 (Entry S1) ............. $60,000 Noncontrolling interest in Omega’s income (above) 18,000 Noncontrolling interest, 1/01/14 (Entry A) ............... 33,000 Dividends declared to noncontrolling interest ($50,000 × 30%) (15,000) Noncontrolling interest in Omega, 12/31/14....... $96,000
7-36 .
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Chapter 07 - Consolidated Financial Statements—Ownership Patterns and Income Taxes
Chapter 7 Excel Case Solution
Summit Treeline Basecamp
Operating income $345,000 $280,000 $175,000
Ownership percentages Summit-->Treeline Treeline-->Basecamp
Dividends declared $150,000 $100,000 $40,000
Excess amortizations $20,000 $25,000
90% 70%
Treeline's share of Basecamp net income: Basecamp operating income Excess amortization Accrual based income Treeline ownership percentage Equity income from Basecamp
$175,000 (25,000) $150,000 70% $105,000
Summit's share of Treeline income: Treeline operating income Equity income from Basecamp Excess amortization Treeline adjusted income Summit ownership percentage Summit's share of reported net income
$280,000 105,000 (20,000) $365,000 90% $328,500
Controlling interest in net income Summit's operating income Equity earnings in Treeline and Basecamp Summit’s net income
$345,000 328,500 $673,500
Comparison Consolidated net income (operating incomes less amortizations) Net income attributable to noncontrolling interests (30% × $150,000 plus 10% × $365,000) Net income attributable to Summit Company
$755,000 81,500 $673,500
Difference between Summit’s net income and controlling interest in consolidated net income = -0-
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Chapter 07 - Consolidated Financial Statements—Ownership Patterns and Income Taxes
RESEARCH CASE: CONSOLIDATED TAX EXPENSE At www.thecoca-colacompany.com the annual 10-K Note 14 provides detailed footnote disclosures for consolidated income tax. The excerpt below shows a portion of the footnote relating to deferred tax assets, liabilities, and carryforwards. From Note 14: Income Taxes The tax effects of temporary differences and carryforwards that give rise to deferred tax assets and liabilities consist of the following (in millions): December 31, 2012 2011 Deferred tax assets: Property, plant and equipment $ 89 $ 224 Trademarks and other intangible assets 77 68 Equity method investments (including translation adjustment) 209 278 Derivative financial instruments 116 43 Other liabilities 1,178 1,257 Benefit plans 1,808 2,022 Net operating/capital loss carryforwards 782 818 Other 320 418 Gross deferred tax assets 4,579 5,128 Valuation allowances (487) (859) 1,2 Total deferred tax assets $ 4,092 $ 4,269 Deferred tax liabilities: Property, plant and equipment $ (2,204) $ (2,039) Trademarks and other intangible assets (4,133) (4,201) Equity method investments (including translation adjustment) (712) (816) Derivative financial instruments (140) (129) Other liabilities (144) (129) Benefit plans (495) (445) Other (929)4 (753) Total deferred tax liabilities3 $ (8,757) $ (8,512) Net deferred tax liabilities $ (4,665) $ (4,243) 1 Noncurrent deferred tax assets of $ 403 million and $243 million were included in the line item
other assets in our consolidated balance sheets as of December 31, 2012 and 2011, respectively. 2 Current deferred tax assets of $244 million and $227 million were included in the line item
prepaid expenses and other assets in our consolidated balance sheets as of December 31, 2012 and 2011, respectively. 3 Current deferred tax liabilities of $ 331 million and $19 million were included in the line item
accounts payable and accrued expenses in our consolidated balance sheets as of December 31, 2012 and 2011, respectively.
As of December 31, 2012 and 2011, we had $70 million of net deferred tax assets and $491 million of net deferred tax liabilities located in countries outside the United States. As of December 31, 2012, we had $6,494 million of loss carryforwards available to reduce future taxable income. Loss carryforwards of $ 279 million must be utilized within the next five years, and the remainder can be utilized over a period greater than five years..
7-38 .
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Chapter 08 - Segment and Interim Reporting
CHAPTER 8 SEGMENT AND INTERIM REPORTING Chapter Outline I.
FASB Accounting Standards Codification Topic 280, Segment Reporting (FASB ASC 280), provides current guidance on segment reporting. A. ASC 280 follows a management approach in which segments are based on the way that management disaggregates the enterprise for making operating decisions; these are referred to as operating segments. B. Operating segments are components of an enterprise which meet three criteria. 1. Engage in business activities and earn revenues and incur expenses. 2. Operating results are regularly reviewed by the chief operating decision-maker to assess performance and make resource allocation decisions. 3. Discrete financial information is available from the internal reporting system. C. Once operating segments have been identified, three quantitative threshold tests are then applied to identify segments of sufficient size to warrant separate disclosure. Any segment meeting even one of these tests is separately reportable. 1. Revenue test—segment revenues, both external and intersegment, are 10 percent or more of the combined revenue, external and intersegment, of all reported operating segments. 2. Profit or loss test—segment profit or loss is 10 percent or more of the greater (in absolute terms) of the combined reported profit of all profitable segments or the combined reported loss of all segments incurring a loss. 3. Asset test—segment assets are 10 percent or more of the combined assets of all operating segments. D. Several general restrictions on the presentation of operating segments exist. 1. Separately reported operating segments must generate at least 75 percent of total (consolidated) sales made by the company to outside parties. 2. Ten is suggested as the maximum number of operating segments that should be separately disclosed. If more than ten are reportable, the company should consider combining some operating segments. E. Information to be disclosed by operating segment. 1. General information about the operating segment including factors used to identify operating segments and the types of products and services from which each segment derives its revenues. 2. Segment profit or loss and the following components of profit or loss. a. Revenues from external customers. b. Revenues from transactions with other operating segments. c. Interest revenue and interest expense (reported separately). d. Depreciation, depletion, and amortization expense. e. Other significant noncash items included in segment profit or loss. f. Unusual items and extraordinary items. g. Income tax expense or benefit. 3. Total segment assets and the following related items. a. Investment in equity method affiliates. b. Expenditures for additions to long-lived assets. 8-1
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Chapter 08 - Segment and Interim Reporting
II.
Enterprise-wide disclosures. A. Information about products and services. 1. Additional information must be provided if operating segments have not been determined based on differences in products and services, or if the enterprise has only one operating segment. 2. In those situations, revenues derived from transactions with external customers must be disclosed by product or service. B. Information about geographic areas. 1. Revenues from external customers and long-lived assets must be reported for (a) the domestic country, (b) all foreign countries in which the enterprise has assets or derives revenues, and (c) each individual foreign country in which the enterprise has material revenues or material long-lived assets. 2. U.S. GAAP does not provide any specific guidance with regard to determining materiality of revenues or long-lived assets; this is left to management’s judgment. C. Information about major customers. 1. The volume of sales to a single customer must be disclosed if it constitutes 10 percent or more of total sales to unaffiliated customers. 2. The identity of the major customer need not be disclosed.
III. International Financial Reporting Standards (IFRS) also provide guidance with respect to segment reporting. A. IFRS 8, “Operating Segments,” is based on U.S. GAAP. Major differences between IFRS 8 and U.S. GAAP are: 1. IFRS 8 requires disclosure of total assets and total liabilities by operating segment if these are regularly reported to the chief operating decision maker. U.S. GAAP requires disclosure of segment assets but does not require disclosure of segment liabilities. 2. IFRS 8 specifically includes intangibles in the scope of “non-current assets” to be disclosed by geographic area. Authoritative accounting literature (FASB ASC) indicates that “long-lived assets” to be disclosed by geographic area excludes intangibles. 3. U.S. GAAP requires an entity with a matrix form of organization to determine operating segments based on products and services. IFRS 8 allows such an entity to determine operating segments based on either products and services or geographic areas. IV. To provide investors and creditors with more timely information than is provided by an annual report, the U.S. Securities and Exchange Commission (SEC) requires publicly traded companies to provide financial statements on an interim (quarterly) basis. A. Quarterly statements need not be audited. V.
FASB Accounting Standards Codification Topic 270, Interim Reporting (FASB ASC 270) requires companies to treat interim periods as integral parts of an annual period rather than as discrete accounting periods in their own right. A. Generally, interim statements should be prepared following the same accounting principles and practices used in the annual statements. B. However, several items require special treatment for the interim statements to better reflect the expected annual amounts. 1. Revenues are recognized for interim periods in the same way as they are on an annual basis. 8-2 .
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Chapter 08 - Segment and Interim Reporting
2. Interim statements should not reflect the effect of a LIFO liquidation if the units of beginning inventory sold are expected to be replaced by year-end; inventory should not be written down to a lower market value if the market value is expected to recover above the inventory's cost by year-end; and planned variances under a standard cost system should not be reflected in interim statements if they are expected to be absorbed by year-end. 3. Costs incurred in one interim period but associated with activities or benefits of multiple interim periods (such as advertising and executive bonuses) should be allocated across interim periods on a reasonable basis through accruals and deferrals. 4. The materiality of an extraordinary item should be assessed by comparing its amount against the expected income for the full year. 5. Income tax related to ordinary income should be computed at an estimated annual effective tax rate; income tax related to an extraordinary item should be calculated at the margin. VI. FASB ASC 270 provides guidance for reporting changes in accounting principles made in interim periods. A. Unless impracticable to do so, an accounting change is applied retrospectively, that is, prior period financial statements are restated as if the new accounting principle had always been used. B. When an accounting change is made in other than the first interim period, information for the interim periods prior to the change should be reported by retrospectively applying the new accounting principle to these pre-change interim periods. C. If retrospective application of the new accounting principle to interim periods prior to the change of change is impracticable, the accounting change is not allowed to be made in an interim period but may be made only at the beginning of the next fiscal year.
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Chapter 08 - Segment and Interim Reporting
VII. Many companies provide summary financial statements and notes in their interim reports. A. U.S. GAAP imposes minimum disclosure requirements for interim reports. 1. Sales, income tax, extraordinary items, cumulative effect of accounting change, and net income. 2. Earnings per share. 3. Seasonal revenues and expenses. 4. Significant changes in estimates or provisions for income taxes. 5. Disposal of a business segment and unusual items. 6. Contingent items. 7. Changes in accounting principles or estimates. 8. Significant changes in financial position. B. Disclosure of balance sheet and cash flow information is encouraged but not required. If not included in the interim report, significant changes in the following must be disclosed: 1. Cash and cash equivalents. 2. Net working capital. 3. Long-term liabilities. 4. Stockholders' equity. VIII. Four items of information must also be disclosed by operating segment in interim financial statements: revenues from external customers, intersegment revenues, segment profit or loss, and, if there has been a material change since the annual report, total assets. IX. IAS 34, “Interim Financial Reporting,” provides guidance in IFRS with respect to interim financial statements. A. Unlike U.S. GAAP, IAS 34 requires each interim period to be treated as a discrete accounting period in terms of the amounts to be recognized. As a result, expenses that are incurred in one quarter are expensed in that quarter even though the expenditure benefits the entire year. And there is no accrual in earlier quarters for expenses expected to be incurred later in the year.
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Chapter 08 - Segment and Interim Reporting
Answer to Discussion Question: How Does a Company Determine Whether a Foreign Country is Material? In his well-publicized “The Numbers Game” speech delivered in September 1998, former SEC chairman Arthur Levitt cited “materiality” as one of five gimmicks used by companies to manage earnings. Although his remarks were not specifically directed toward the issue of geographic segment reporting, the intent was to warn corporate America that materiality should not be used as an excuse for inappropriate accounting. To make the point even more salient, ASC 250-10-S99 (SAB Topic 1.M, Assessing Materiality, originally issued by the SEC as Staff Accounting Bulletin (SAB) 99, “Materiality”), warns financial statement preparers that reliance on a simple numerical rule of thumb, such as 5% of net income, is not sufficient. And in paragraph QC 11 of Statement of Financial Accounting Concepts (SFAC) 8, the FASB stated the essence of the materiality aspect of relevance as follows: “Information is material if omitting it or misstating it could influence decisions that users make on the basis of the financial information of a specific reporting entity….Consequently, the Board cannot specify a uniform quantitative threshold for materiality or predetermine what could be material in a particular situation.” Further, ASC 250-10-S99 reminds companies that both quantitative and qualitative factors should be considered in determining materiality. With respect to segment reporting, ASC 250-10-S99 states: “The materiality of a misstatement may turn on where it appears in the financial statements. For example, a misstatement may involve a segment of the registrant's operations. In that instance, in assessing materiality of a misstatement to the financial statements taken as a whole, registrants and their auditors should consider not only the size of the misstatement but also the significance of the segment information to the financial statements taken as a whole. “A misstatement of the revenue and operating profit of a relatively small segment that is represented by management to be important to the future profitability of the entity" is more likely to be material to investors than a misstatement in a segment that management has not identified as especially important. In assessing the materiality of misstatements in segment information as with materiality generally - situations may arise in practice where the auditor will conclude that a matter relating to segment information is qualitatively material even though, in his or her judgment, it is quantitatively immaterial to the financial statements taken as a whole. Thus, in addition to quantitative factors, such as the relative percentage of total revenues generated in an individual foreign country, companies should consider qualitative factors as well. Qualitative factors that might be relevant in assessing the materiality of a specific foreign country include: the growth prospects in that country and the level of risk associated with doing business in that country. There are competing arguments for the FASB establishing a significance test for determining material foreign countries. On one hand, such a quantitative materiality test flies in the face of the warning provided in ASC 250-10-S99 and SFAC 8. For example, a “10% of total revenue or longlived asset test” might give companies an excuse to avoid reporting individual countries that would be material for qualitative reasons. Assume that from one year to the next a company increases its revenues in China from 2% of total revenues to 6% of total revenues. Although 6% of total revenues would not meet a 10% test, the relatively large increase in total revenues generated in China could be material in that it could affect an investor’s assessment of the company’s future prospects. This company might be reluctant to disclose information about its revenues in China because of potential 8-5 .
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Chapter 08 - Segment and Interim Reporting
competitive harm. On the other hand, one could argue that if the FASB were to establish a relatively low disclosure threshold of, say, “5% of total revenues,” that many countries that financial statement users would deem to be of significance would be disclosed regardless of whether they are deemed material for quantitative or for qualitative reasons. However, it could also result in disclosures being provided that are not material, i.e., capable of influencing decisions made by financial statement users. In any event, establishing a materiality threshold would be inconsistent with the FASB’s conclusion in SFAC 8 that it “cannot predetermine what could be material in a particular situation.”
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Chapter 08 - Segment and Interim Reporting
Answers to Questions 1.
Consolidation presents the account balances of a business combination without regard for the individual component units that comprise the organization. Thus, no distinction can be drawn as to the financial position or operations of the separate enterprises that form the corporate structure. Without a method by which to identify the various individual operations, financial analysis cannot be well refined.
2.
The word disaggregated refers to a whole that has been broken apart. Thus, disaggregated financial information is the data of a reporting unit that has been broken down into components so that the separate parts can be identified and studied.
3.
According to the FASB, the objective of segment reporting is to provide information to help users of financial statements: a. better understand the enterprise’s performance, b. better assess its prospects for future net cash flows, and c. make more informed judgments about the enterprise as a whole.
4.
Defining segments on the basis of a company’s organizational structure removes much of the flexibility and subjectivity associated with defining industry segments under prior standards. In addition, the incremental cost of providing segment information externally should be minimal because that information is already generated for internal use. Analysts should benefit from this approach because it reflects the risks and opportunities considered important by management and allows the analyst to see the company the way it is viewed by management. This should enhance the analyst’s ability to predict management actions that can significantly affect future cash flows.
5.
An operating segment is defined as a component of an enterprise: a. that engages in business activities from which it earns revenues and incurs expenses, b. whose operating results are regularly reviewed by the chief operating decision maker to assess performance and make resource allocation decisions, and c. for which discrete financial information is available.
6.
Two criteria must be considered in this situation to determine an enterprise’s operating segment. If more than one set of organizational units exists, but there is only one set for which segment managers are held responsible, that set constitutes the operating segments. If segment managers exist for two or more overlapping sets of organizational units, the organizational units based on products and services are defined as the operating segments.
7.
The Revenue Test. An operating segment is separately reportable if its total revenues amount to 10 percent or more of the combined total revenues of all operating segments. The Profit or Loss Test. An operating segment is separately reportable if its profit or loss is 10 percent or more of the greater (in absolute terms) of the combined profits of all profitable segments or the combined losses of all segments reporting a loss. The Asset Test. An operating segment is separately reportable if its assets comprise 10 percent or more of combined assets of all operating segments.
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Chapter 08 - Segment and Interim Reporting
8.
For reportable operating segments, the following information must be disclosed: a. Revenues from sales to unaffiliated customers. b. Revenues from intercompany transfers. c. Profit or loss. d. Interest revenue. e. Interest expense. f. Depreciation, depletion, and amortization expense. g. Other significant noncash items included in profit or loss. h. Unusual items included in profit or loss. i. Income tax expense or benefit. j. Total assets. k. Equity method investments. l. Expenditures for long-lived assets. m. Description of the types of products or services from which the segment derives its revenues.
9.
If operating segments are not based upon products or services, or a company has only one operating segment, then revenues from sales to unaffiliated customers must be disclosed for each of the company’s products and services.
10. Information must be provided for the domestic country, for all foreign countries in which the company generates revenue or holds assets, and for each foreign country in which the company generates a material amount of revenues or has a material amount of assets. 11. Two items of information must be reported for the domestic country, for all foreign countries in total, and for each foreign country in which the company has material operations: (1) revenues from external customers, and (2) long-lived assets. 12. The minimum number of countries to be reported separately is one: the domestic country. If no single foreign country is material, then all foreign countries would be combined and two lines of information would be reported; one for the United States and one for all foreign countries. U.S. GAAP does not provide any guidelines related to the maximum number of countries to be reported. 13. The existence of a major customer and the related amount of revenues must be disclosed when sales to a single customer are 10 percent or more of consolidated sales. 14. U.S. GAAP requires disclosure of a measure of segment assets, but does not require disclosure of a measure of segment liabilities. IFRS 8 requires disclosure of total assets and total liabilities by segment if such a measure is regularly provided to the chief operating decision maker 15. U.S. publicly traded companies are required to prepare quarterly financial reports to provide investors and creditors with relevant information on a more timely basis than is provided by an annual report. 16. Companies are required to follow an "integral" approach in which each interim period is considered to be an integral part of an annual accounting period, rather than a "discrete" accounting period in its own right. For several items, the integral approach requires deviation from the general rule that the same accounting principles used in preparing annual statements should also be used in preparing interim statements.
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Chapter 08 - Segment and Interim Reporting
17. Cost-of-goods-sold should be adjusted in the interim period to reflect the cost at which the liquidated inventory is expected to be replaced, thus avoiding the effect of the LIFO liquidation on interim period income. 18. Income tax expense related to interim period income is determined by estimating the effective tax rate for the entire year. That rate is then applied to the cumulative pre-tax income earned to date to determine the cumulative income tax to be recognized to date. The amount of income tax recognized in the current interim period is the difference between the cumulative income tax to be recognized to date and the income tax recognized in prior interim periods. 19. When an accounting change occurs in other than the first interim period, information for the prechange interim periods should be reported based on retrospective application of the new accounting principle. If retrospective application of the new accounting principle to pre-change interim periods is not practicable, the accounting change may be made only at the beginning of the next fiscal year. 20. The following minimum information must be disclosed in an interim report: a. Sales, income tax, extraordinary items, cumulative effect of accounting change, and net income. b. Earnings per share. c. Seasonal revenues and expenses. d. Significant changes in estimates or provisions for income taxes. e. Disposal of a business segment and unusual items. f. Contingent items. g. Changes in accounting principles or estimates. h. Significant changes in the following items of financial position: 1. Cash and cash equivalents. 2. Net working capital. 3. Long-term liabilities. 4. Stockholders' equity. 21. Four items of segment information are required to be included in interim reports: revenues from external customers, intersegment revenues, segment profit or loss, and total assets if there has been a material change in assets from the last annual report. 22. Under IAS 34, an annual bonus paid in the fourth quarter of the year would be recognized fully in that quarter. There would be no accrual of an estimated bonus expense in the first three quarters of the year. Under U.S. GAAP, the annual bonus would be estimated at the beginning of the year and a portion of the estimated bonus would be accrued as expense in each of the first three quarters.
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Chapter 08 - Segment and Interim Reporting
Answers to Problems 1. D 2. C 3. A 4. C 5. B 6. D 7. C 8. A 9. B 10. B 11. A 12. C 13. C With regard to major customers, U.S. GAAP (FASB ASC 280) only requires disclosure of the total amount of revenues from each such customer and the identity of the segment or segments reporting the revenues. 14. D 15. D 16. A 17. C 18. D 19. C If there has been a material change from the last annual report, total assets, but not individual assets, for each operating segment must be disclosed. 20. B
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Chapter 08 - Segment and Interim Reporting
21. C (Determine quantitative threshold under revenue test for reportable segments) Sales to outsiders Intersegment transfers Combined segment revenues 10% criterion Minimum
$20,500 3,800 $24,300 x 10% $ 2,430
22. A (Determine quantitative threshold for disclosure of a major customer) Revenues from a single customer must be disclosed if the amount is 10 percent or more of consolidated sales. Consolidated sales only includes sales to outsiders; intersegment sales are eliminated. Consolidated sales (combined sales to outsiders) 10% criterion Minimum
$376,000 x 10% $ 37,600
23. D (Determine reportable segments under the profit or loss test) Total operating losses of $1,020,000 (K and M) are larger than total operating profits of $770,000. Thus, based on the 10 percent criterion, any segment with a profit or loss of $102,000 or more must be separately disclosed. K, O, and P do not meet that standard while L, M, and N do. 24. C (Determine reportable segments under three tests) Revenue Test Combined segment revenues 10% criterion Minimum
$32,750,000 x 10% $ 3,275,000
Segments meeting test—A, B, C, E Profit or Loss Test Since there are no segments with a loss, this test is applied based on total combined segment profit. Combined segment profit 10% criterion Minimum
$5,800,000 x 10% $ 580,000
Segments meeting test—A, B, C, E
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Chapter 08 - Segment and Interim Reporting
24. (continued) Asset Test Combined segment assets 10% criterion Minimum
$67,500,000 x 10% $ 6,750,000
Segments meeting test—A, B, C, D, E Five segments are separately reportable. 25. D 26. B (Determine minimum number of reportable segments under 75% rule) The test to verify that a sufficient number of industry segments is being disclosed is based on revenues generated from unaffiliated customers. The four segments that are to be separately disclosed show outside sales of $520,000 out of a total for the company of $710,000. Since this portion is only 73.2 percent of the company’s total, the 75 percent criterion established by the U.S. GAAP has not been met. 27. C (Determine expense amounts to be recognized in interim period) Depreciation Bonus
$70,000 x 1/4 $140,000 x 1/4
= =
$17,500 35,000 $52,500
28. C (Determine net income to be reported in interim period) Income as reported Less: Extraordinary loss (recognized in full in the interim period in which it occurs) Add: Cumulative effect loss (handled through adjustment of retained earnings balance at the beginning of the year)
$100,000 (20,000)
16,000 $ 96,000
29. C (Determine bonus expense to be recognized in interim period) Bonus
$1,000,000 x 1/4 = $250,000
30. C (Determine property tax expense to be recognized in interim period) Property taxes
$480,000 x 1/4 = $120,000 8-12
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Chapter 08 - Segment and Interim Reporting
31. C (Journal entry for property tax expense recognized in interim period) Dr. Property tax expense Prepaid property taxes Cr. Cash
$120,000 360,000 $480,000
32. A (Determine COGS in interim period under LIFO with LIFO liquidation) 5,000 units x $80 = $400,000 300 units x $50 = 15,000 5,300 units $415,000 33. C 5,000 units x $80 = $400,000 300 units x $82 = 24,600 5,300 units $424,600
34. (10 minutes) (Apply the Profit or Loss Test to Determine Reportable Operating Segments) Calculation of profit or loss. Revenues Intersegment Operating from Outsiders Transfers Expenses – $900,000 – 1,350,000 – 700,000 – 770,000
Cards $1,200,000 + $ 100,000 Calendars 900,000 + 200,000 Clothing 1,000,000 Books 800,000 + 50,000 Total
Profit = $400,000 = = 300,000 = 80,000 $ 780,000
Loss
$250,000
$250,000
Any segment with an absolute amount of profit or loss greater than or equal to $78,000 (10% x $780,000) is separately reportable. Based on this test, each of the four segments must be reported separately.
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Chapter 08 - Segment and Interim Reporting
35. (25 minutes) (Apply the Three Tests Necessary to Determine Reportable Operating Segments) Revenue Test (numbers in thousands) Segment Plastics Metals Lumber Paper Finance Total
Revenues $ 6,842 2,561 870 572 243 $11,088
Percentage 61.6% (reportable) 23.1% (reportable) 7.9% 5.2% 2.2% 100.0%
Profit or Loss Test (numbers in thousands) Segment Plastics Metals Lumber Paper Finance Total
Revenues $ 6,842 2,561 870 572 243
Expenses $ 4,290 1,793 1,132 682 133
Profit $2,552 768
110 $3,430
Loss $ (reportable) (reportable) 262 110 $372
Since $3,430 is larger in absolute terms than $372, it will serve as the basis for testing. Each of the profit or loss figures will be compared to $343 (10% x $3,430). Asset Test (numbers in thousands) Segment Plastics Metals Lumber Paper Finance Total
Assets $1,588 3,599 524 834 885 $7,430
Percentage 21.4% (reportable) 48.4% (reportable) 7.1% 11.2% (reportable) 11.9% (reportable) 100.0%
The plastics, metals, paper, and finance segments meet at least one of the three tests and therefore are reportable.
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Chapter 08 - Segment and Interim Reporting
36. (20 minutes) (A Variety of Computational Questions about Operating Segment and Major Customer Testing) a. Total revenues for Fairfield (including intersegment revenues) amount to $4,200,000. Minimum revenues for required disclosure are 10% or $420,000. b. Disclosure of operating segments is considered adequate only if the separately reported segments have sales to unaffiliated customers that comprise 75% or more of total consolidated sales. In this situation that requirement is met. Red, Blue, and Green have total sales to outsiders of $3,137,000 (or 86%) of total consolidated sales of $3,666,000. Thus, disclosure of these three segments would be adequate. c. Major customer disclosure is based on a level of sales to unaffiliated customers of at least 10% or, for Fairfield, $366,600 ($3,666,000 x 10%). d. This test is based on the greater (in absolute terms) of profits or losses. In this problem, the total profit of Red, Blue, Green, and White ($1,971,000) is greater than the total loss of Pink and Black ($316,000). Therefore, any segment with a profit or loss of $197,100 or more (10% x $1,971,000) is reportable. Using this standard, Red, Blue, Black, and White are of significant size.
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Chapter 08 - Segment and Interim Reporting
37. (25 minutes) (Apply the three tests necessary to determine reportable operating segments and determine whether a sufficient number of segments is reported)
Revenue Test (numbers in thousands) Segment Books Computers Maps Travel Finance Total
Revenues Percentage $ 205 9.3% 936 42.3% (reportable) 455 20.6% (reportable) 432 19.5% (reportable) 184 8.3% $2,212 100.0%
Profit or Loss Test (numbers in thousands) Segment Revenues Books $ 205 Computers 936 Maps 455 Travel 432 Finance 184 Total $2,212
Expenses $ 218 899 400 284 132 $1,933
Profit Loss $ 13 $ 37 (reportable) 55 (reportable) 148 (reportable 52 (reportable) $292 $ 13
This test is based on the greater (in absolute amount) of total profit from profitable segments or total loss from segments with a loss. In this case, any segment with profit or loss greater than or equal to $29,200 (10% x $292,000) is separately reportable. Asset Test (numbers in thousands) Segment Books Computers Maps Travel Finance Total
Assets $ 206 1,378 248 326 1,240 $3,398
Percentage 6.1% 40.5% (reportable) 7.3% 9.6% 36.5% (reportable) 100.0%
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Chapter 08 - Segment and Interim Reporting
37. (continued) Test for Sufficient Number of Segments Being Reported Four of Mason’s segments (computers, maps, travel, and finance) meet at least one of the tests carried out above. To determine whether a sufficient number of segments is being reported, revenues from unaffiliated parties for these four segments must comprise at least 75% of total consolidated revenues. Consolidated revenues (sales to outside parties and interest income-external) for the company amount to $1,644. These four segments do make up over 75% (actually $1,463 or 89%) of this total. Therefore, this company is presenting disaggregated information for enough of its segments. Segment
Sales to Outsiders
Computers Maps Travel Finance Total
$ 696 416 314 37 $1,463
38. (15 minutes) (Apply materiality tests adopted by a company to determine countries to be reported separately) Revenue Test (sales to unaffiliated parties) United States Spain Italy Greece Total
$4,610,000 80.3% 395,000 6.9% 272,000 4.7% 463,000 8.1% $5,740,000 100.0%
Long-lived Asset Test United States Spain Italy Greece Total
$1,894,000 83.7% 191,000 8.4% 106,000 4.7% 72,000 3.2% $2,263,000 100.0%
None of the individual foreign countries meets either the revenue or long-lived asset materiality test, so no foreign country must be reported separately. However, information must be presented for the United States separately and for all foreign countries combined.
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Chapter 08 - Segment and Interim Reporting
39. (20 minutes) (Allocate costs incurred in one quarter that benefit the entire year and determine income tax expense
a. Determination of Net Income by Quarter -- Estimated Annual Tax Rate 40%
Sales Cost of goods sold Administrative costs Advertising costs Executive bonuses Provision for bad debts Annual maintenance costs
1st Quarter 2nd Quarter 3rd Quarter 4th Quarter $ 1,300,000 $ 1,560,000 $ 1,820,000 $ 2,080,000 (430,000) (510,000) (580,000) (630,000) (190,000) (225,000) (230,000) (240,000) (25,000) (25,000) (25,000) (25,000) (19,000) (19,000) (19,000) (19,000) (16,000) (16,000) (16,000) (16,000) (18,000) (18,000) (18,000) (18,000)
Pre-tax income Income tax*
$
602,000 $ 747,000 $ 932,000 $ 1,132,000 (240,800) (298,800) (372,800) (452,800)
Net income
$
361,200
$
448,200
$
559,200
$
679,200
* Calculation of income tax by quarter: 1st Quarter 2nd Quarter 3rd Quarter 4th Quarter Pre-tax income this quarter $ 602,000 $ 747,000 $ 932,000 $ 1,132,000 Cumulative pre-tax income $ Estimated income tax rate Cumulative income tax to be recognized to date $ Cumulative income tax recognized in earlier periods $ Income tax this quarter
602,000 $ 1,349,000 $ 2,281,000 $ 3,413,000 40% 40% 40% 40% 240,800
$
-
$
240,800
240,800
$
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539,600
.
298,800
$
912,400
$ 1,365,200
539,600
912,400
372,800
$
452,800
Chapter 08 - Segment and Interim Reporting
39. (continued)
b. Determination of Net Income by Quarter -- Change in Estimated Annual Tax Rate
Pre-tax income Income tax*
1st Quarter 2nd Quarter 3rd Quarter 4th Quarter $ 602,000 $ 747,000 $ 932,000 $ 1,132,000 (240,800) (298,800) (327,180) (430,160)
Net income
$
361,200
$
448,200
$
604,820
$
701,840
* Calculation of income tax by quarter: 1st Quarter 2nd Quarter 3rd Quarter 4th Quarter Pre-tax income this quarter $ 602,000 $ 747,000 $ 932,000 $ 1,132,000 Cumulative pre-tax income $ 602,000 $ 1,349,000 $ 2,281,000 $ 3,413,000 Estimated income tax rate 40% 40% 38% 38% Cumulative income tax to be recognized to date $ 240,800 $ 539,600 $ 866,780 $ 1,296,940 Cumulative income tax 240,800 539,600 866,780 recognized in earlier periods $ 240,800 $ 298,800 $ 327,180 $ 430,160 Income tax this quarter
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Chapter 08 - Segment and Interim Reporting
40. (15 minutes) (Treatment of accounting change made in other than first interim period) Retrospective application of the FIFO method results in the following restatements of income for 2014 and the first quarter of 2015: 2014 1st Q.
2nd Q.
3rd Q.
2015 4th Q.
1st Q.
Sales
$10,000 $12,000 $14,000 $16,000 $18,000
Cost of goods sold (FIFO) Operating expenses Income before income taxes Income taxes (40%) Net income
3,800 2,000 4,200 1,680 $2,520
4,600 2,200 5,200 2,080 $3,120
5,200 2,600 6,200 2,480 $3,720
6,000 3,000 7,000 2,800 $4,200
7,400 3,200 7,400 2,960 $4,440
Net income in the second quarter of 2015 is $4,560 [$20,000 – 9,000 – 3,400 = $7,600 – 3,040 (40%) = $4,560]. The accounting change is reflected in the second quarter of 2015, with year-todate information, and comparative information for similar periods in 2014 as follows:
Net income Net income per common share
Three Months Ended June 30 2014 2015 $3,120 $4,560 $3.12 $4.56
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Six Months Ended June 30 2014 2015 $5,640 $9,000 $5.64 $9.00
Chapter 08 - Segment and Interim Reporting
41. (10 minutes) (LIFO liquidation in interim report) Determination of Cost-of-Goods-Sold and Gross Profit Sales (110,000 units @ $20) Cost-of-goods-sold 100,000 units @ $14 10,000 units @ $15 (replacement cost) Gross profit
$2,200,000 $1,400,000 150,000
1,550,000 $650,000
Journal Entries to Record Sales and Cost-of-Goods-Sold Dr. Cash or Accounts Receivable Cr. Sales Revenue Dr. Cost-of-goods-sold Cr. Inventory Excess of Replacement Cost over Historical Cost of LIFO Liquidation
$2,200,000 $2,200,000 $1,550,000 $1,520,000 30,000
To record cost-of-goods-sold with a historical cost of $1,520,000 and an excess of replacement cost over historical cost for beginning inventory liquidated of $30,000 (($15 – $12) x 10,000 units).
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Chapter 08 - Segment and Interim Reporting
Develop Your Skills Research Case 1—Segment Reporting (60 minutes) This assignment requires the student to select a company and find the note on operating segments in that company’s annual report. The responses to this assignment will depend upon the company selected by the student for analysis. Research Case 2—Interim Reporting (60 minutes) This assignment requires students to select a company, find the most recent quarterly report for that company, and then determine whether the company provides the minimum disclosure required as listed in the text. The responses to this assignment will depend upon the company selected by the student for analysis. Research Case 3—Operating Segments (60 minutes) This assignment requires students to find the note on operating segments in each company's annual report, determine three items of information (answer three questions) from those notes, and prepare a written summary of their findings. The primary objective of this requirement is to help students develop their ability to present such findings in a written format. In answering these questions, students will become familiar with the different formats and terminology used by companies in providing operating segment information. The answers to these questions will change depending upon the most recent annual report available on the company’s website. The following general observations indicate how these questions might be answered. 1.
The two most important operating segments in terms of percentage of total revenues. The answer to this question is determined by calculating the ratio “segment revenues/total segment revenues” for each segment of each company. Companies might use different terms to describe revenues including net sales and net sales to external customers. Companies are required to disclose both revenues from sales to external customers and revenues from intersegment sales. This question should be answered using revenues from sales to external customers if reported separately. In 2012, each of the four companies defined operating segments on the basis of products/services.
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Chapter 08 - Segment and Interim Reporting
2.
The two operating segments with the largest growth in revenues. This question is answered by calculating the ratio “(current year segment revenues – previous year segment revenues)/previous year segment revenues” for each segment of each company.
3.
The two most profitable operating segments in terms of profit margin. This question is answered by calculating the ratio “segment profit/segment revenues” for each segment of each company (again using revenues from sales to external customers if separately reported). Segment profit goes under a variety of names including operating earnings, income from continuing operations, standard margin, and operating profit. Some companies might provide information for more than one measure of profit, e.g., income before income taxes and operating income, in which case the instructor might wish to indicate which measure of profit to consider in answering this question. There is no right or wrong measure of profit to use. General Electric does not include segment profit in its operating segment note, but instead (in 2012) refers the reader to a “Summary of Operating Segments” table (on page 44 of the annual report), which is part of Management's Discussion and Analysis.
After reviewing the information provided by each of these companies in its segment note, instructors might wish to add additional questions to this assignment. For example, do these companies use generally accepted accounting principles in preparing segment information? Does each company provide a reconciliation to consolidated totals?
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Chapter 08 - Segment and Interim Reporting
Research Case 4—Comparability of Geographic Area Information (60 minutes) This assignment requires students to find the note on geographic areas in each company's annual report and then prepare a report describing the comparability of this information. In preparing this assignment, students will see the different formats used by companies in providing this information, and the different levels of detail on geographic areas provided. The comparability of this information will change depending upon the most recent annual report available on the company’s website. The following comparison based upon the 2011 annual reports represents the type of analysis students might perform in solving this assignment. Geographic Areas Reported by Four Pharmaceutical Companies Bristol-Myers Squibb Eli Lilly Merck Pfizer U.S. Europe Japan, Asia Pacific, and Canada Latin America, Middle East, and Africa Emerging Markets Other
U.S. Europe -
U.S. E/ME/A -
U.S. Developed Europe
Japan
Japan
-
Other
Other
Emerging Markets Developed Rest of World -
The only geographic area that can be directly compared across these four pharmaceutical companies is the United States. Bristol-Myers Squibb provides somewhat more detailed information than the other companies. Only Eli Lilly and Merck report an individual country (Japan) other than the U.S. Issues that could be discussed include different quantitative thresholds used by companies in determining what is a material country, and the fact that disclosure of geographic areas aggregated above the individual country level (e.g., E/ME/A, Emerging Markets) is not required. One can assume that Bristol-Myers Squibb does not have a material amount of revenues or assets in any single country and voluntarily provides information on a more aggregated, regional basis. The same appears to be true for Pfizer. Eli Lilly and Merck provide information for a combination of both individual countries (Japan) and aggregated regional area (Europe, E/ME/A). Pfizer has perhaps the most different basis for determining geographic areas, focusing on developed vs. emerging markets.
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Chapter 08 - Segment and Interim Reporting
Evaluation Case—Operating Segment Disclosures (60 minutes) 1. Two questions must be considered in evaluating CHIC’s operating segment disclosures: (a) have reportable operating segments been appropriately determined, e.g., is it appropriate to combine the Helicopters and Ships divisions into one segment designated as Other, and (b) are the disclosures provided for each segment in compliance with FASB ASC Topic 280, Segment Reporting? With respect to question (a), ASC 280 allows (but does not require) segments to be combined if they have essentially the same business activities in essentially the same economic environments. In determining whether business activities and environments are similar, management must consider these aggregation criteria: 1. The nature of the products and services provided by each operating segment. 2. The nature of the production process. 3. The type or class of customer. 4. The distribution methods. 5. If applicable, the nature of the regulatory environment. Segments must be similar in each and every one of these areas to be combined. The facts of this case indicate that the types of customers and method used to distribute products differ across the four divisions, and each division must comply with industry-specific regulations. Thus, the Helicopters and Ships divisions may not be combined into one reportable segment on the basis of having essentially the same business activities in essentially the same economic environments. The Helicopters and Ships divisions still could be combined into a single Other category if neither division meets any of the quantitative thresholds for disclosure as a separate segment. Revenue test: Total segment revenues are $11,171,005; thus, any segment with more than $1,117,100 in sales is separately reportable. • Automobiles, Trucks, and Helicopters meet this threshold. Profit (loss) test: Total segment profits of $ 1,686,700 ($881,292 + $456,530 + $348,878) exceed total segment losses of $58,879, thus any segment with profit or loss greater than $168,670 is separately reportable. • Automobiles, Trucks, and Helicopters meet this threshold.
Asset test: Total segment assets are $9,993,830, thus any segment with assets greater than $999,383 is separately reportable. • All four segments, including Ships, meet this threshold.
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Chapter 08 - Segment and Interim Reporting
As a result of applying these tests, each division must be reported as a separate segment; combining Helicopters and Ships into one segment does not comply with ASC 280. With respect to question (b), Note X. Operating Segments prepared by CHIC’s accountant fails to disclose information for the Helicopters and Ships segments separately. Note X. also fails to separately disclose revenues from sales to outside parties and revenues from intersegment sales, as well expenditures for additions to long-lived assets and depreciation and amortization. Interest expense and income taxes need not be disclosed by segment because these items are not reported by segment to the chief operating decision maker. CHIC’s accountant also has neglected to provide a reconciliation of segment amounts to consolidated totals.
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Chapter 08 - Segment and Interim Reporting
2. The disclosures required under ASC 280 could be provided in the following manner: Operating Segments Segment profit (loss)* Sales to outside parties Intersegment sales Depreciation and amortization Segment assets Expenditures for additions to long-lived assets
Automobiles Trucks Helicopters Ships $ 881,292 $ 456,530 $ 348,878 $ (58,879) 4,007,304 3,796,432 1,411,235 1,003,809 644,243 180,345 3,987,776 349,776
307,982 170,976 3,209,078 365,543
-097,638 1,587,006 276,655
Reconciliation of Segment Results to Consolidated Totals Revenues: Total segment revenues Elimination of intersegment revenues Total consolidated revenues
$ 11,171,005 952,225 $ 10,218,780
Profit or loss: Total segment operating profit before depreciaton and amortization Unallocated amounts: Depreciation and amortization Interest expense Total consolidated income before income taxes Assets: Total segment assets Unallocated corporate headquarters assets Total consolidated assets
1,627,821
$
(507,576) (130,655) 989,590
$
9,993,830 1,008,988 $ 11,002,818
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.
-058,617 1,209,970 23,695
Chapter 08 - Segment and Interim Reporting
Accounting Standards Case 1 —Segment Reporting (15 minutes) Source of guidance: FASB ASC 280-10-55-2: Segment Reporting; Overall; Implementation Guidance and Illustrations; Operating Segments - Equity Method Investees ASC 280-10-55-2 states “An equity method investee could be considered an operating segment, if, under the specific facts and circumstances being considered, it meets the definition of an operating segment, even though the investor has no control over the performance of the investee.” Thus, in response to the questions asked in the case: (a) an equity method investment can be treated as an operating segment for financial reporting purposes, (b) under the conditions that it meets the definition of an operating segment, that is, (1) it engages in business activities from which it earns revenues and incurs expenses, (2) the chief operating decision maker regularly reviews its operating results to assess performance and make resource allocation decision, and (3) its discrete financial information is available. Accounting Standards Case 2—Interim Reporting (15 minutes) Source of guidance: FASB ASC 270-10-50-6: Interim Reporting; Overall; Disclosure; Contingencies Contingencies that could be expected to affect the fairness of presentation of financial data at an interim date must be disclosed in interim reports in the same manner required for annual reports. The materiality of a contingency should be judged in relation to annual financial statements.
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Chapter 08 - Segment and Interim Reporting
Analysis Case—Walmart Interim and Segment Reporting (60 minutes) 1. Assess the seasonal nature of Walmart’s sales and income for the company as a whole and by operating segment. The excerpt from Note 17 Quarterly Financial Data shows that Walmart experienced a significant increase in net sales and income in the quarter ended January 31 over the previous three quarters of the year. This is not surprising given that this quarter includes the holiday season. Operating income for the quarter ended January 31 can be determined for each segment by subtracting the amounts reported in the three quarterly reports from the amounts reported in Note 15 Segments.
Operating Income Fiscal Year Ended January 31, 2012 Quarter Ended April 30, 2011 Quarter Ended July 31, 2011 Quarter Ended October 31, 2011 Quarter Ended January 31, 2012
Walmart Walmart U.S. International 20,367 $ 6,214 $ 4,650 1,096 4,985 1,415 4,627 1,397 6,105 $ 2,306 $
$
$
SAM's Club 1,865 459 492 390 524
These results show the seasonal nature of the company’s two largest segments (Walmart U.S. and Walmart International), with a significantly larger amount of operating income generated in the quarter ended January 31 than in the other quarters. 2. Assess Walmart’s profitability by quarter and by segment. Note 17 can be used to assess profitability in terms of profit margin (Income from continuing operations/Net sales) by quarter.
Amounts in millions Income from continuing operations Net sales Income from continuing operations/Net sales
Fiscal Year Ended January 31, 2012 Q1 Q2 Q3 Q4 $ 3,578 $ 3,937 $ 3,501 $ 5,438 103,415 108,638 109,516 122,285 3.46%
3.62%
3.20%
4.45%
These results indicate that profit margins are highest in the fourth quarter of the year, the quarter with the largest percentage of total sales. 8-29 .
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Chapter 08 - Segment and Interim Reporting
Note 15 can be used to assess profitability in terms of operating profit margin (Operating income/Net sales) and return on assets (Operating income/Total assets of continuing operations) by segment. Walmart Walmart U.S. International $20,367 $6,214 264,186 125,873 7.71% 4.94%
Fiscal year ended January 31, 2012 Operating income (loss) Net sales Operating income/Net Sales Operating income (loss) Total assets of continuing operations Operating income/Total assets
$20,367 93,050 21.89%
$6,214 81,364 7.64%
SAM’S CLUB $1,865 53,795 3.47% $1,865 12,823 14.54%
These results indicate that Walmart U.S. by far is the most profitable segment for Walmart Stores, Inc. Although the Walmart International segment has a reasonable Operating Profit Margin (4.94%), that segment’s Return on Assets is very low (7.64%). Return on Assets must be interpreted with caution, however, because the ending balance in Total Assets of Continuing Operations is used in the denominator of the ratio rather than the average amount of Total Assets for the year. The Walmart International segment’s Return on Assets (7.64%) is understated, for example, if a significant portion of Total Assets was acquired late in the year.
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Chapter 08 - Segment and Interim Reporting
Excel Case—Coca-Cola Geographic Segment Information (60 minutes) 1. The ratios required to be calculated for the Coca-Cola Company are as follows: Percentage of total net revenues Eurasia & Africa Europe Latin America North America Pacific Total
2011 % 2,841 7.21% 5,474 13.89% 4,690 11.90% 20,571 52.19% 5,838 14.81% 39,414 100.00%
Percentage growth in total net revenues Eurasia & Africa Europe Latin America North America Pacific
2010 % 2,556 9.00% 5,249 18.48% 4,121 14.51% 11,205 39.45% 5,271 18.56% 28,402 100.00%
2010 to 2011 11.15% 4.29% 13.81% 83.59% 10.76%
2009 to 2010 16.34% 0.88% 6.16% 35.47% 8.12%
2011 38.40% 56.45% 60.02% 11.27% 36.84%
2010 38.34% 56.70% 58.36% 13.57% 38.85%
Operating income as a percentage of total net revenues (profit margin) Eurasia & Africa Europe Latin America North America Pacific
2. There is no right or wrong answer to this question. Students could argue that Latin America and Europe would be the areas of the world in which to expand because profit margin is highest in these areas. There would seem to be more room to expand in Latin America given that this area has a slightly smaller percentage of total net revenues than Europe. In addition, revenue growth in Europe has been small in the most recent two years, so expansion might not be feasible in this region. Eurasia & Africa and Pacific also have relatively high profit margins. The company generates the smallest percentage of total revenues in Eurasia & Africa, so perhaps there is an opportunity for growth in this area.
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Chapter 08 - Segment and Interim Reporting
3. There is a great deal of non-accounting information that one would need to determine a specific region of the world in which to focus expansion. For example, one might need to gather information to answer the following questions: • • • •
Is there a sufficiently large population with enough disposable income to be able to purchase the company’s products? Are raw materials available locally? Is there a well-developed transportation infrastructure that would allow the products to be brought to consumers at a reasonable cost? Do local customs, culture, religion, etc. affect drinking habits, especially the consumption of soft drinks?
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Chapter 09 - Foreign Currency Transactions and Hedging Foreign Exchange Risk
CHAPTER 9 FOREIGN CURRENCY TRANSACTIONS AND HEDGING FOREIGN EXCHANGE RISK Chapter Outline I.
In today’s global economy, a great many companies deal in currencies other than their reporting currencies. A. Merchandise may be imported or exported with prices stated in a foreign currency. B. For reporting purposes, foreign currency balances must be stated in terms of the company’s reporting currency by multiplying it by an exchange rate. C. Accountants face two questions in restating foreign currency balances. 1. What is the appropriate exchange rate for restating foreign currency balances? 2. How are changes in the exchange rate accounted for? D. Companies often engage in foreign currency hedging activities to avoid the adverse impact of exchange rate changes. E. Accountants must determine how to properly account for these hedging activities.
II.
Foreign exchange rates are determined in the foreign exchange market under a variety of different currency arrangements. A. Exchange rates can be expressed in terms of the number of U.S. dollars to purchase one foreign currency unit (direct quotes) or the number of foreign currency units that can be obtained with one U.S. dollar (indirect quotes). B. Foreign currency trades can be executed on a spot or forward basis. 1. The spot rate is the price at which a foreign currency can be purchased or sold today. 2. The forward rate is the price today at which foreign currency can be purchased or sold sometime in the future. 3. Forward exchange contracts provide companies with the ability to “lock in” a price today for purchasing or selling currency at a specific future date. C. Foreign currency options provide the right but not the obligation to buy or sell foreign currency in the future, and therefore are more flexible than forward contracts.
III. FASB Accounting Standards Codification Topic 830, Foreign Currency Matters (FASB ASC 830) prescribes accounting rules for foreign currency transactions. A. Export sales denominated in foreign currency are reported in U.S. dollars at the spot exchange rate at the date of the transaction. Subsequent changes in the exchange rate until collection of the receivable are reflected through a restatement of the foreign currency account receivable with an offsetting foreign exchange gain or loss reported in income. This is known as a two-transaction perspective, accrual approach. B. The two-transaction perspective, accrual approach also is used in accounting for foreign currency payables. Receivables and payables denominated in foreign currency create an exposure to foreign exchange risk; this is the risk that changes in the exchange rate over time will result in a foreign exchange loss.
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Chapter 09 - Foreign Currency Transactions and Hedging Foreign Exchange Risk
IV. FASB Accounting Standards Codification Topic 815, Derivatives and Hedging (FASB ASC 815) governs the accounting for derivative financial instruments and hedging activities including the use of foreign currency forward contracts and foreign currency options. A. The fundamental requirement is that all derivatives must be carried on the balance sheet at their fair value. Derivatives are reported on the balance sheet as assets when they have a positive fair value and as liabilities when they have a negative fair value. B. U.S. GAAP provides guidance for hedges of the following sources of foreign exchange risk: 1. foreign currency denominated assets and liabilities. 2. unrecognized foreign currency firm commitments. 3. forecasted foreign denominated currency transactions. 4. net investments in foreign operations (covered in Chapter 10). C. Companies prefer to account for hedges in such a way that the gain or loss from the hedge is recognized in net income in the same period as the loss or gain on the risk being hedged. This approach is known as hedge accounting. Hedge accounting for foreign currency derivatives may be applied only if three conditions are satisfied: 1. the derivative is used to hedge either a cash flow exposure or fair value exposure to foreign exchange risk, 2. the derivative is highly effective in offsetting changes in the cash flows or fair value related to the hedged item, and 3. the derivative is properly documented as a hedge. D. Hedge accounting is allowed for hedges of two different types of exposure: cash flow exposure and fair value exposure. Hedges of (1) foreign currency denominated assets and liabilities, (2) foreign currency firm commitments, and (3) forecasted foreign currency transactions can be designated as cash flow hedges. Hedges of (1) and (2) also can be designated as fair value hedges. Accounting procedures differ for the two types of hedges. E. For cash flow hedges of foreign currency denominated assets and liabilities, at each balance sheet date: 1. The hedged asset or liability is adjusted to fair value based on changes in the spot exchange rate, and a foreign exchange gain or loss is recognized in net income. 2. The derivative hedging instrument is adjusted to fair value (resulting in an asset or liability reported on the balance sheet), with the counterpart recognized as a change in Accumulated Other Comprehensive Income (AOCI). 3. An amount equal to the foreign exchange gain or loss on the hedged asset or liability is then transferred from AOCI to net income; the net effect is to offset any gain or loss on the hedged asset or liability. 4. An additional amount is removed from AOCI and recognized in net income to reflect (a) the current period’s amortization of the original discount or premium on the forward contract (if a forward contract is the hedging instrument) or (b) the change in the time value of the option (if an option is the hedging instrument). F. For fair value hedges of foreign currency denominated assets and liabilities, at each balance sheet date: 1. The hedged asset or liability is adjusted to fair value based on changes in the spot exchange rate, and a foreign exchange gain or loss is recognized in net income. 2. The derivative hedging instrument is adjusted to fair value (resulting in an asset or liability reported on the balance sheet), with the counterpart recognized as a gain or loss in net income.
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Chapter 09 - Foreign Currency Transactions and Hedging Foreign Exchange Risk
G.
Under fair value hedge accounting for hedges of foreign currency firm commitments: 1. the gain or loss on the hedging instrument is recognized currently in net income, and 2. the change in fair value of the firm commitment is also recognized currently in net income. This accounting treatment requires (1) measuring the fair value of the firm commitment, (2) recognizing the change in fair value in net income, and (3) reporting the firm commitment on the balance sheet as an asset or liability. A decision must be made whether to measure the fair value of the firm commitment through reference to (a) changes in the spot exchange rate or (b) changes in the forward rate. H. Cash flow hedge accounting is allowed for hedges of forecasted foreign currency transactions. For hedge accounting to apply, the forecasted transaction must be probable (likely to occur). The accounting for a hedge of a forecasted transaction differs from the accounting for a hedge of a foreign currency firm commitment in two ways: 1. Unlike the accounting for a firm commitment, there is no recognition of the forecasted transaction or gains and losses on the forecasted transaction. 2. The hedging instrument (forward contract or option) is reported at fair value, but because there is no gain or loss on the forecasted transaction to offset against, changes in the fair value of the hedging instrument are not reported as gains and losses in net income. Instead they are reported in other comprehensive income. On the projected date of the forecasted transaction, the cumulative change in the fair value of the hedging instrument is transferred from other comprehensive income (balance sheet) to net income (income statement).
V.
IFRS is very similar to U.S. GAAP with respect to the accounting for foreign currency transactions and hedging of foreign exchange risk. A. IAS 21 requires the use of a two-transaction perspective in accounting for foreign currency transactions with unrealized foreign exchange gains and losses accrued in net income in the period of exchange rate change. B. IAS 39 allows hedge accounting for foreign currency hedges of recognized assets and liabilities, firm commitments, and forecasted transactions when documentation requirements and effectiveness tests are met. Hedges are designated as cash flow or fair value hedges. C. One difference between IFRS and U.S. GAAP relates to the type of financial instrument that can be designated as a foreign currency cash flow hedge. Under U.S. GAAP, only derivative financial instruments can be used as a cash flow hedge, whereas IFRS also allows non-derivative financial instruments, such as foreign currency loans, to be designated as hedging instruments in a foreign currency cash flow hedge.
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Chapter 09 - Foreign Currency Transactions and Hedging Foreign Exchange Risk
Answer to Discussion Question Do we have a gain or what? This case demonstrates the differing kinds of information provided through application of current accounting rules for foreign currency transactions and derivative financial instruments. The Ahnuld Corporation could have received $200,000 [$2.00 x 100,000 tchecks] from its export sale to Tcheckia if it had required immediate payment. Instead, Ahnuld allows its customer six months to pay. Given the future exchange rate of $1.70, Ahnuld would have received only $170,000 if it had not entered into the forward contract. This would have resulted in a decrease in cash inflow of $30,000. In accordance with current accounting standards, the decrease in the value of the tcheck receivable is recognized as a foreign exchange loss of $30,000. This loss represents the cost of extending credit to the foreign customer if the tcheck receivable is left unhedged. However, rather than leaving the tcheck receivable unhedged, Ahnuld sells tchecks forward at a price of $180,000. Because the future spot rate turns out to be only $1.70, the forward contract provides a benefit, increasing the amount of cash received from the export sale by $10,000. In accordance with current accounting standards, the change in the fair value of the forward contract (from zero initially to $10,000 at maturity) is recognized as a gain on the forward contract of $10,000. This gain reflects the cash flow benefit from having entered into the forward contract, and is the appropriate basis for evaluating the performance of the foreign exchange risk manager. (Students should be reminded that the forward contract will not always improve cash inflow. For example, if the future spot rate were $1.85, the forward contract would result in $5,000 less cash inflow than if the transaction were left unhedged.) The net impact on income resulting from the fluctuation in the value of the tcheck is a loss of $20,000. Clearly, Ahnuld forgoes $20,000 in cash inflow by allowing the customer time to pay for the purchase, and the net loss reported in income correctly measures this. The $20,000 loss is useful to management in assessing whether the sale to Tcheckia generated an adequate profit margin, but it is not useful in assessing the performance of the foreign exchange risk manager. The net loss must be decomposed into its component parts to fairly evaluate the risk manager’s performance. Gains and losses on forward contracts designated as fair value hedges of foreign currency assets and liabilities are relevant measures for evaluating the performance of foreign exchange risk managers. (The same is not true for cash flow hedges. For this type of hedge, performance should be evaluated by considering the net gain or loss on the forward contract plus or minus the forward contract premium or discount.)
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Chapter 09 - Foreign Currency Transactions and Hedging Foreign Exchange Risk
Answers to Questions 1.
Under the two-transaction perspective, an export sale (import purchase) and the subsequent collection (payment) of cash are treated as two separate transactions to be accounted for separately. The idea is that management has made two decisions: (1) to make the export sale (import purchase), and (2) to extend credit in foreign currency to the foreign customer (obtain credit from the foreign supplier). The income effect from each of these decisions should be reported separately.
2.
Foreign currency receivables resulting from export sales are revalued at the end of accounting periods using the current spot rate. An increase in the value of a receivable will be offset by reporting a foreign exchange gain in net income, and a decrease will be offset by a foreign exchange loss. Foreign exchange gains and losses are accrued even though they have not yet been realized.
3.
Foreign exchange gains and losses are created by two factors: having foreign currency exposures (foreign currency receivables and payables) and changes in exchange rates. Appreciation of the foreign currency will generate foreign exchange gains on receivables and foreign exchange losses on payables. Depreciation of the foreign currency will generate foreign exchange losses on receivables and foreign exchange gains on payables.
4.
Hedging is the process of eliminating exposure to foreign exchange risk so as to avoid potential losses from fluctuations in exchange rates. In addition to avoiding possible losses, companies hedge foreign currency transactions and commitments to introduce an element of certainty into the future cash flows resulting from foreign currency activities. Hedging involves establishing a price today at which foreign currency can be sold or purchased at a future date.
5.
A party to a foreign currency forward contract is obligated to deliver one currency in exchange for another at a specified future date, whereas the owner of a foreign currency option can choose whether to exercise the option and exchange one currency for another or not.
6.
Hedges of foreign currency denominated assets and liabilities are not entered into until a foreign currency transaction (import purchase or export sale) has taken place. Hedges of firm commitments are made when a purchase order is placed or a sales order is received, before a transaction has taken place. Hedges of forecasted transactions are made at the time a future foreign currency purchase or sale can be anticipated, even before an order has been placed or received.
7.
Foreign currency options have an advantage over forward contracts in that the holder of the option can choose not to exercise if the future spot rate turns out to be more advantageous. Forward contracts, on the other hand, can lock a company into an unnecessary loss (or a reduced gain). The disadvantage associated with foreign currency options is that a premium must be paid up front even though the option might never be exercised.
8.
An enterprise is required to recognize all derivative financial instruments as assets or liabilities on the balance sheet and measure them at fair value.
9.
The fair value of a foreign currency forward contract is determined by reference to changes in the forward rate over the life of the contract, discounted to the present value. Three pieces of information are needed to determine the fair value of a forward contract at any point in time 9-5
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.
Chapter 09 - Foreign Currency Transactions and Hedging Foreign Exchange Risk
during its life: (a) the contracted forward rate when the forward contract is entered into, (b) the current forward rate for a contract that matures on the same date as the forward contract entered into, and (c) a discount rate; typically, the company’s incremental borrowing rate. The manner in which the fair value of a foreign currency option is determined depends on whether the option is traded on an exchange or has been acquired in the over the counter market. The fair value of an exchange-traded foreign currency option is its current market price quoted on the exchange. For over the counter options, fair value can be determined by obtaining a price quote from an option dealer (such as a bank). If dealer price quotes are unavailable, the company can estimate the value of an option using the modified BlackScholes option pricing model. Regardless of who does the calculation, principles similar to those in the Black-Scholes pricing model will be used in determining the value of the option. 10. Hedge accounting is defined as recognition of gains and losses on the hedging instrument in the same period as the recognition of gains and losses on the underlying hedged asset or liability (or firm commitment). 11. For hedge accounting to apply, the forecasted transaction must be probable (likely to occur), the hedge must be highly effective in offsetting fluctuations in the cash flow associated with the foreign currency risk, and the hedging relationship must be properly documented. 12. In both cases, (1) sales revenue (or the cost of the item purchased) is determined using the spot rate at the date of sale (or purchase), and (2) the hedged asset or liability is adjusted to fair value based on changes in the spot exchange rate with a foreign exchange gain or loss recognized in net income. For a cash flow hedge, the derivative hedging instrument is adjusted to fair value (resulting in an asset or liability reported on the balance sheet), with the counterpart recognized as a change in Accumulated Other Comprehensive Income (AOCI). An amount equal to the foreign exchange gain or loss on the hedged asset or liability is then transferred from AOCI to net income; the net effect is to offset any gain or loss on the hedged asset or liability. An additional amount is removed from AOCI and recognized in net income to reflect (a) the current period’s amortization of the original discount or premium on the forward contract (if a forward contract is the hedging instrument) or (b) the change in the time value of the option (if an option is the hedging instrument). For a fair value hedge, the derivative hedging instrument is adjusted to fair value (resulting in an asset or liability reported on the balance sheet), with the counterpart recognized as a gain or loss in net income. The discount or premium on a forward contract is not allocated to net income. The change in the time value of an option is not recognized in net income. 13. For a fair value hedge of a foreign currency asset or liability (1) sales revenue (cost of purchases) is recognized at the spot rate at the date of sale (purchase) and (2) the hedged asset or liability is adjusted to fair value based on changes in the spot exchange rate with a foreign exchange gain or loss recognized in net income. The forward contract is adjusted to fair value based on changes in the forward rate (resulting in an asset or liability reported on the balance sheet), with the counterpart recognized as a gain or loss in net income. The foreign exchange gain (loss) and the forward contract loss (gain) are likely to be of different amounts resulting in a net gain or loss reported in net income. 9-6 .
.
Chapter 09 - Foreign Currency Transactions and Hedging Foreign Exchange Risk
For a fair value hedge of a firm commitment, there is no hedged asset or liability to account for. The forward contract is adjusted to fair value based on changes in the forward rate (resulting in an asset or liability reported on the balance sheet), with a gain or loss recognized in net income. The firm commitment is also adjusted to fair value based on changes in the forward rate (resulting in a liability or asset reported on the balance sheet), and a gain or loss on firm commitment is recognized in net income. The firm commitment gain (loss) offsets the forward contract loss (gain) resulting in zero impact on net income. Sales revenue (cost of purchases) is recognized at the spot rate at the date of sale (purchase). The firm commitment account is closed as an adjustment to net income in the period in which the hedged item affects net income. 14. For a cash flow hedge of a foreign currency asset or liability (1) sales revenue (cost of purchases) is recognized at the spot rate at the date of sale (purchase) and (2) the hedged asset or liability is adjusted to fair value based on changes in the spot exchange rate with a foreign exchange gain or loss recognized in net income. The forward contract is adjusted to fair value (resulting in an asset or liability reported on the balance sheet), with the counterpart recognized as a change in Accumulated Other Comprehensive Income (AOCI). An amount equal to the foreign exchange gain or loss on the hedged asset or liability is then transferred from AOCI to net income; the net effect is to offset any gain or loss on the hedged asset or liability. An additional amount is removed from AOCI and recognized in net income to reflect the current period’s allocation of the discount or premium on the forward contract. For a hedge of a forecasted transaction, the forward contract is adjusted to fair value (resulting in an asset or liability reported on the balance sheet), with the counterpart recognized as a change in Accumulated Other Comprehensive Income (AOCI). Because there is no foreign currency asset or liability, there is no transfer from AOCI to net income to offset any gain or loss on the asset or liability. The current period’s allocation of the forward contract discount or premium is recognized in net income with the counterpart reflected in AOCI. Sales revenue (cost of purchases) is recognized at the spot rate at the date of sale (purchase). The amount accumulated in AOCI related to the hedge is closed as an adjustment to net income in the period in which the forecasted transaction was anticipated to occur. 15. In accounting for a fair value hedge, the change in the fair value of the foreign currency option is reported as a gain or loss in net income. In accounting for a cash flow hedge, the change in the entire fair value of the option is first reported in other comprehensive income, and then the change in the time value of the option is reported as an expense in net income. 16. The accounting for a foreign currency borrowing involves keeping track of two foreign currency payables—the note payable and interest payable. As both the face value of the borrowing and accrued interest represent foreign currency liabilities, both are exposed to foreign exchange risk and can give rise to foreign currency gains and losses.
9-7 .
.
Chapter 09 - Foreign Currency Transactions and Hedging Foreign Exchange Risk
Answers to Problems 1. C (Foreign exchange gain/loss on foreign currency transaction) An import purchase causes a foreign currency payable to be carried on the books. If the foreign currency depreciates, the dollar value of the foreign currency payable decreases, yielding a foreign exchange gain. 2. D (Method of accounting for foreign currency transactions) Current accounting standards require a two-transaction perspective, accrual approach. 3. B (Foreign exchange gain/loss on foreign currency transaction) Foreign exchange gains related to foreign currency import purchases are treated as a component of income before income taxes. If there is no foreign exchange gain in operating income, then the purchase must have been denominated in U.S. dollars or there was no change in the value of the foreign currency from October 1 to December 1, 2015. 4. C
(Calculate foreign exchange gain/loss on foreign currency transaction) The dollar value of the LCU receivable has decreased from $110,000 at December 31, 2015 to $95,000 at February 15, 2016. This decrease of $15,000 should be reported as a foreign exchange loss in 2016.
5. D
(Calculate foreign exchange gain/loss on foreign currency borrowing) The increase in the dollar value of the euro note payable represents a foreign exchange loss. In this case a $25,000 loss would have been accrued in 2015 and a $10,000 loss will be reported in 2016.
6. D
(Foreign exchange gain/loss on foreign currency transaction) A foreign currency receivable will generate a foreign exchange gain when the foreign currency increases in dollar value. A foreign currency payable will generate a foreign exchange gain when the foreign currency decreases in dollar value. Hence, the correct combination is franc (increase) and peso (decrease).
9-8 .
.
Chapter 09 - Foreign Currency Transactions and Hedging Foreign Exchange Risk
7. D
(Calculate foreign exchange gain/loss) The merchandise purchase results in a foreign exchange loss of $8,000, the difference between the U.S. dollar equivalent at the date of purchase and at the date of settlement. The increase in the dollar equivalent of the note’s principal results in a foreign exchange loss of $20,000. The total foreign exchange loss is $28,000 ($8,000 + $20,000).
8. D
(Forward contract cash flow hedge of foreign currency denominated asset/liability) The Thai baht is selling at a premium (forward rate exceeds spot rate). The exporter will receive more dollars as a result of selling the baht forward than if the baht had been received and converted into dollars on April 1. Thus, the premium results in additional revenue for the exporter.
9. D
(Forward contract fair value hedge of foreign currency firm commitment) The parts inventory will be recognized at the spot rate at the date of receipt (FC100,000 x $.23 = $23,000).
10. D (Determine the fair value of a forward contract) The forward contract must be reported on the December 31, 2015 balance sheet as a liability. Barnum has locked-in to purchase ringgits at $0.042 per ringgit but could have locked-in to purchase ringgits at $0.037 per ringgit if it had waited until December 31 to enter into the forward contract. The forward contract must be reported at its fair value discounted for two months at 12%, which is $4,901.50 [($.042 – $.037) x 1,000,000 x .9803]. 11. C (Calculate foreign exchange gain/loss on foreign currency transaction) The 10 million won receivable has changed in dollar value from $35,000 at 12/1/15 to $33,000 at 12/31/15. The won receivable will be written down by $2,000 and a foreign exchange loss will be reported in 2015 income. 12. B (Forward contract fair value hedge of foreign currency denominated asset/liability) The nominal value of the forward contract on December 31, 2015 is a positive $2,000, the difference between the amount to be received from the forward contract actually entered into, $34,000 ($.0034 x 10 million), and the amount that could be received by entering into a forward contract on December 31, 12.(c ontinued) 9-9 .
.
Chapter 09 - Foreign Currency Transactions and Hedging Foreign Exchange Risk
2015 that matures on March 31, 2016, $32,000 [$.0032 x 10 million]. The fair value of the forward contract is the present value of $2,000 discounted for three months, which is $1,941.20 [$2,000 x .9706]. On December 31, 2015, MNC Corp. will recognize a $1,941.20 gain on the forward contract and a foreign exchange loss of $2,000 on the won receivable. The net impact on 2015 income is –$58.80. 13. A (Forward contract cash flow hedge of forecasted foreign currency transaction) The krona is selling at a premium in the forward market, causing Pimlico to pay more dollars to acquire kroner than if the kroner were purchased at the spot rate on March 1. Therefore, the premium results in an expense of $10,000 [($.12 – $.10) x 500,000]. The Adjustment to Net Income is the amount accumulated in Accumulated Other Comprehensive Income (AOCI) as a result of recognizing the Premium Expense and the fair value of the forward contract. The journal entries would be as follows: 3/1
no journal entries
6/1
Premium Expense AOCI
$10,000
AOCI Forward Contract
$2,500
Foreign Currency Forward Contract Cash
$57,500 2,500
AOCI Adjustment to Net Income
$7,500
$10,000
$2,500
$60,000
$7,500
14. C (Option cash flow hedge of forecasted foreign currency transaction) This is a cash flow hedge of a forecasted transaction. The original cost of the option is recognized as an Option Expense over the life of the option.
9-10 .
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Chapter 09 - Foreign Currency Transactions and Hedging Foreign Exchange Risk
15-17. (Option fair value hedge of a foreign currency firm commitment) 15. B 16. D The easiest way to solve problems 15 and 16 is to prepare journal entries for the option fair value hedge and the firm commitment. The journal entries are as follows: 9/1/15 Foreign Currency Option Cash
$2,000 $2,000
12/31/15 Foreign Currency Option Gain on Foreign Currency Option Loss on Firm Commitment Firm Commitment [($.79 – $.80) x 100,000 = $1,000 x .9803 = $980.30] Net impact on 2015 net income: Gain on Foreign Currency Option Loss on Firm Commitment 3/1/16 Foreign Currency Option Gain on Foreign Currency Option
$300 $300 $980.30 $980.30
$300.00 (980.30) $(680.30) $700 $700
Loss on Firm Commitment $2,019.70 Firm Commitment [($.77 – $.80) x 100,000 = $3,000 – $980.30 = $2,019.70] Foreign Currency (C$) Sales
$77,000
Cash Foreign Currency (C$) Foreign Currency Option
$80,000
Firm Commitment Adjustment to Net Income
$3,000
$77,000
$77,000 3,000
$3,000
9-11 .
$2,019.70
.
Chapter 09 - Foreign Currency Transactions and Hedging Foreign Exchange Risk
15-17. (continued) Net impact on 2016 net income: Gain on Foreign Currency Option Loss on Firm Commitment Sales Adjustment to Net Income 17. B Net cash inflow with option ($80,000 – $2,000) Cash inflow without option (at spot rate of $.77) Net increase in cash inflow
$
700.00 (2,019.70) 77,000.00 3,000.00 $78,680.30 $78,000 77,000 $ 1,000
18-20. (Forward contract fair value hedge of a foreign currency firm commitment) The easiest way to solve problems 18 and 19 is to prepare journal entries for the forward contract fair value hedge of a firm commitment. The journal entries are as follows: 3/1
no journal entries
3/31
Forward Contract Gain on Forward Contract ($1,250 – $0)
$1,250
Loss on Firm Commitment Firm Commitment
$1,250
Net impact on first quarter net income is $0.
9-12 .
.
$1,250
$1,250
Chapter 09 - Foreign Currency Transactions and Hedging Foreign Exchange Risk
18-20. (continued) 4/30
Loss on Forward Contract Forward Contract [Fair value of Forward Contract is (($.120 – $.118) x 500,000) = $1,000; $1,000 – $1,250 = $250]
$250
Firm Commitment Gain on Firm Commitment
$250
$250
$250
Foreign Currency (pesos) Sales [500,000 pesos x $.118]
$59,000
Cash [500,000 x $.120] Foreign Currency (pesos) Forward Contract
$60,000
Firm Commitment Adjustment to Net Income
$1,000
$59,000 $59,000 1,000 $1,000
Net impact on second quarter net income is: Sales $59,000 – Loss on Forward Contract $250 + Gain on Firm Commitment $250 + Adjustment to Net Income $1,000 = $60,000. 18. A 19. C 20. B Cash inflow with forward contract [500,000 pesos x $.12] $60,000 Cash inflow without forward contract [500,000 pesos x $.118] 59,000 Net increase in cash flow from forward contract $ 1,000
9-13 .
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Chapter 09 - Foreign Currency Transactions and Hedging Foreign Exchange Risk
21-22. (Option cash flow hedge of a forecasted foreign currency transaction) The easiest way to solve problems 21 and 22 is to prepare journal entries for the option cash flow hedge of a forecasted transaction. The journal entries are as follows: 11/1/15 Foreign Currency Option Cash
$1,500 $1,500
12/31/15 Option Expense $400 Foreign Currency Option $400 (The option has no intrinsic value at 12/31/15 so the entire change in fair value is due to a change in time value; $1,500 – $1,100 = $400 decrease in time value. The decrease in time value of the option is recognized as an expense in net income.) Option Expense decreases net income by $400. 2/1/16 Option Expense $1,100 Foreign Currency Option 900 Accumulated Other Comprehensive Income (AOCI) (Record expense for the decrease in time value of the option; $1,100 – $0 = $1,100; and write-up option to fair value ($.40 – $.41) x 200,000 = $2,000 – $1,100 = $900.) Foreign Currency (BRL) [200,000 x $.41] Cash [200,000 x $.40] Foreign Currency Option
$82,000
Parts Inventory Foreign Currency (BRL)
$82,000
Accumulated Other Comprehensive Income (AOCI) Adjustment to Net Income
$2,000
$80,000 2,000
$82,000
9-14 .
$2,000
.
$2,000
Chapter 09 - Foreign Currency Transactions and Hedging Foreign Exchange Risk
21-22. (continued) Net impact on 2016 net income: Option Expense $ (1,100) Cost-of-Goods-Sold (82,000) Adjustment to Net Income 2,000 Decrease in Net Income $ (81,100) 21. B 22. C 23. (10 minutes) (Foreign currency payable -- import purchase) a. The decrease in the dollar value of the LCU payable from November 1 (60,000 x .345 = $20,700) to December 31 (60,000 x .333 = $19,980) is recorded as a $720 foreign exchange gain in 2015. b. The increase in the dollar value of the LCU payable from December 31 ($19,980) to January 15 (60,000 x .359 = $21,540) is recorded as a $1,560 foreign exchange loss in 2016. 24. (10 minutes) (Foreign currency receivable – export sale) a. The ostra receivable decreases in dollar value from (50,000 x $1.05) $52,500 at December 20 to $51,000 (50,000 x $1.02) at December 31, resulting in a foreign exchange loss of $1,500 in 2015. b. The further decrease in dollar value of the ostra receivable from $51,000 at December 31 to $49,000 (50,000 x $.98) at January 10 results in an additional $2,000 foreign exchange loss in 2016. 25. (10 minutes) (Foreign currency receivable – export sale) 9/15
9/30
10/15
Accounts Receivable (FCU) [100,000 x $.40] Sales
$40,000
Accounts Receivable (FCU) Foreign Exchange Gain [100,000 x ($.42 – $.40)]
$2,000
Foreign Exchange Loss Accounts Receivable (FCU) [100,000 x ($.37 – $.42)]
$5,000
$40,000
$2,000
Cash $37,000 Accounts Receivable (FCU) 26.(1 0 minutes) (Foreign currency payable -- import purchase) 9-15 .
.
$5,000
$37,000
Chapter 09 - Foreign Currency Transactions and Hedging Foreign Exchange Risk
12/1/15
Inventory Accounts Payable (LCU) [60,000 x $.88]
$52,800 $52,800
12/31/15 Accounts Payable (LCU) [60,000 x ($.82 – $.88)] $3,600 Foreign Exchange Gain 1/28/16
$3,600
Foreign Exchange Loss $4,800 Accounts Payable (LCU) [60,000 x ($.90 – $.82)]
$4,800
Accounts Payable (LCU) Cash
$54,000
$54,000
27. (15 minutes) (Determine U.S. dollar balance for foreign currency transactions) Inventory and Cost of Goods Sold are reported at the spot rate at the date the inventory was purchased. Sales are reported at the spot rate at the date of sale. Accounts Receivable and Accounts Payable are reported at the spot rate at the balance sheet date. Cash is reported at the spot rate when collected and the spot rate when paid. a. Inventory [50,000 pesos x 40% x $.17] ..................................................... $3,400 b. COGS [50,000 pesos x 60% x $.17] .......................................................... $5,100 c. Sales [45,000 pesos x $.18]....................................................................... $8,100 d. Accounts Receivable [45,000 – 40,000 = 5,000 pesos x $.21] ................ $1,050 e. Accounts Payable [50,000 – 30,000 = 20,000 pesos x $.21] ................... $4,200 f. Cash [(40,000 x $.19) – (30,000 x $.20)] .................................................... $1,600
9-16 .
.
Chapter 09 - Foreign Currency Transactions and Hedging Foreign Exchange Risk
28. (25 minutes) (Prepare journal entries for foreign currency transactions) 2/1/15
Equipment Accounts Payable (L) [40,000 x $.44]
$17,600
Accounts Payable (L) Foreign Exchange Loss Cash [40,000 x $.45]
$17,600 400
Inventory Accounts Payable (L) [30,000 x $.47]
$14,100
Accounts Receivable (L) [40,000 x $.48] Sales
$19,200
Cost-of-Goods Sold Inventory [$14,100 x 70%]
$9,870
Cash [30,000 x $.49] Accounts Receivable (L) [$19,200 x 3/4] Foreign Exchange Gain
$14,700
Accounts Payable (L) [$14,100 x 2/3] Foreign Exchange Loss [20,000 x ($.50 – $.47)] Cash [20,000 x $.50]
$9,400 600
12/31/15 Foreign Exchange Loss Accounts Payable (L) [10,000 x ($.52 – $.47)]
$500
Accounts Receivable (L) [10,000 x ($.52 – $.48)] Foreign Exchange Gain
$400
4/1/15
6/1/15
8/1/15
10/1/15
11/1/15
2/1/16
3/1/16
$18,000
$14,100
$19,200
$9,870
$14,400 300
$10,000
$500
$400
Cash [10,000 x $.54] Accounts Receivable (L) [10,000 x $.52] Foreign Exchange Gain
$5,400
Accounts Payable (L) [10,000 x $.52] Foreign Exchange Loss Cash [10,000 x $.55]
$5,200 300
9-17 .
$17,600
.
$5,200 200
$5,500
Chapter 09 - Foreign Currency Transactions and Hedging Foreign Exchange Risk
29. (20 minutes) (Determine income effect of foreign currency payable – import purchase) a.
Benjamin, Inc. has a liability of AL 160,000. On the date that this liability was created (December 1, 2015), the liability had a dollar value of $70,400 (AL 160,000 x $.44). On December 31, 2015, the dollar value has risen to $76,800 (AL 160,000 x $.48). The increase in the dollar value of the liability creates a foreign exchange loss of $6,400 ($76,800 – $70,400) in 2015. By March 1, 2016, when the liability is paid, the dollar value has dropped to $72,000 (AL 160,000 x $.45) creating a foreign exchange gain of $4,800 ($72,000 – $76,800) to be reported in 2016.
b. Benjamin, Inc. has a liability of AL 160,000. On the date that this liability was created (September 1, 2015), the liability had a dollar value of $73,600 (AL 160,000 x $.46). On December 1, 2015, when the liability is paid, the dollar value has decreased to $70,400 (AL 160,000 x $.44). The drop in the dollar value of the liability creates a foreign exchange gain of $3,200 ($70,400 – $73,600) in 2015. c.
Benjamin, Inc. has a liability of AL 160,000. On the date that this liability was created (September 1, 2015), the liability had a dollar value of $73,600 (AL 160,000 x $.46). On December 31, 2015, the dollar value has risen to $76,800 (AL 160,000 x $.48). The increase in the dollar value of the liability creates a foreign exchange loss of $3,200 ($76,800 – $73,600) in 2015. By March 1, 2016, when the liability is paid, the dollar value has dropped to $72,000 (AL 160,000 x $.45) creating a foreign exchange gain of $4,800 ($72,000 – $76,800) to be reported in 2016.
9-18 .
.
Chapter 09 - Foreign Currency Transactions and Hedging Foreign Exchange Risk
30. (30 minutes) (Foreign currency borrowing) a.
9/30/15
Cash $100,000 Note payable (dudek) [1,000,000 x $.10] (To record the note and conversion of 1 million dudeks into $ at the spot rate.)
12/31/15 Interest Expense $525 Interest Payable (dudek) [1,000,000 x 2% x 3/12 = 5,000 dudeks x $.105 spot rate] (To accrue interest for the period 9/30 – 12/31/15.) Foreign Exchange Loss Note Payable (dudek) [1 m x ($.105 – $.10)] (To revalue the note payable at the spot rate of $.105 and record a foreign exchange loss.) 9/30/16
$525
$5,000 $5,000
Interest Expense [15,000 dudeks x $.12] $1,800 Interest Payable (dudek) 525 Foreign Exchange Loss [5,000 dudeks x ($.12 – $.105)] 75 Cash [20,000 dudeks x $.12] (To record the first annual interest payment, record interest expense for the period 1/1 – 9/30/16, and record a foreign exchange loss on the interest payable accrued at 12/31/15.)
$2,400
12/31/16 Interest Expense $625 Interest Payable (dudek) [5,000 dudeks x $.125] (To accrue interest for the period 9/30 – 12/31/16.)
$625
Foreign Exchange Loss $20,000 Note Payable (dudek) [1 m x ($.125 – $.105)] (To revalue the note payable at the spot rate of $.125 and record a foreign exchange loss.)
9-19 .
$100,000
.
$20,000
Chapter 09 - Foreign Currency Transactions and Hedging Foreign Exchange Risk
30. (continued) 9/30/17
Interest Expense [15,000 dudeks x $.15] $2,250 Interest Payable (dudek) 625 Foreign Exchange Loss [5,000 dudeks x ($.15 – $.125)] 125 Cash [20,000 dudeks x $.15] (To record the second annual interest payment, record interest expense for the period 1/1 – 9/30/15, and record a foreign exchange loss on the interest payable accrued at 12/31/16.) Note Payable (dudek) $125,000 Foreign Exchange Loss 25,000 Cash [1 m dudeks x $.15] (To record payment of the 1 million dudek note.)
$3,000
$150,000
b. The effective cost of borrowing can be determined by considering the total interest expense and foreign exchange losses related to the loan and comparing this with the amount borrowed: 2015 Interest expense Foreign exchange loss Total 2016 Interest expense Foreign exchange losses Total 2017 Interest expense Foreign exchange losses Total
$525 5,000 $5,525 / $100,000 = 5.525% for 3 months 5.525% x 12/3 = 22.1% for 12 months $2,425 20,075 $22,500 / $100,000 = 22.5% for 12 months
$2,250 25,125 $27,375 / $100,000 = 27.38% for 9 months 27.38% x 12/9 = 36.5% for 12 months
Because of appreciation in the value of the dudek, the effective annual borrowing costs range from 22.1% – 36.5%.
9-20 .
.
Chapter 09 - Foreign Currency Transactions and Hedging Foreign Exchange Risk
30. (continued) The net cash flow from this borrowing is: Cash outflows: Interest ($2,400 + $3,000) Principal
Cash inflow: Borrowing Net cash outflow
$5,400 150,000 $155,400
(100,000) $ 55,400
Ignoring compounding, this results in an effective borrowing cost of approximately 27.7% per year [($55,400 / $100,000) = 55.4% over two years; 55.4% / 2 years = 27.7% per year].
9-21 .
.
Chapter 09 - Foreign Currency Transactions and Hedging Foreign Exchange Risk
31. (40 minutes) (Forward contract hedge of foreign currency receivable) a. Cash Flow Hedge
Date
Journal Entry
Debit
Credit
12/1/15
Accounts Receivable (K) $ 43,200.00 Sales $ 43,200.00 To record sales and foreign currency account receivable. No entry for the forward contract.
12/31/15
Accounts Receivable (K) $ 1,600.00 Foreign Exchange Gain $ 1,600.00 To revalue the foreign currency account receivable and recognize a foreign exchange gain. AOCI
$ 1,960.60
Forward Contract $ 1,960.60 To record the change in fair value of the forward contract as a liability. Loss on Forward Contract $ 1,600.00 AOCI $ 1,600.00 To record a loss on forward contract to offset the foreign exchange gain. AOCI
$
400.00
Premium Revenue $ 400.00 To allocate the forward contract premium over the life of the contract. Impact on 2015 income: Sales Foreign Exchange Gain Loss on Forward Contract Premium Revenue Total
$
43,200 1,600 (1,600) 400
$
43,600
9-22 .
.
Chapter 09 - Foreign Currency Transactions and Hedging Foreign Exchange Risk
31. (continued) a. Cash Flow Hedge (continued) Date
Journal Entry
Debit
3/1/16
Accounts Receivable (K) $ 2,400.00 Foreign Exchange Gain $ 2,400.00 To revalue the foreign currency account receivable and recognize a foreign exchange gain. AOCI
$
Credit
839.40
Forward Contract $ 839.40 To adjust the carrying value of the forward conract to its current fair value. Loss on Forward Contract $ 2,400.00 AOCI $ 2,400.00 To record a loss on forward contract to offset the foreign exchange gain. AOCI
$
800.00
Premium Revenue $ 800.00 To allocate the forward contract premium over the life of the contract. Foreign Currency (K) $ 47,200.00 Accounts Receivable (K) $ 47,200.00 To record the receipt of korunas from the foreign customer. Cash Forward Contract Foreign Currency (K) To record settlement of the forward contract. Impact on 2016 income: Foreign Exchange Gain Loss on Forward Contract Premium Revenue
$
2,400 (2,400) 800
Total
$
800
Impact on net income over both periods: which is equal to cash inflow.
$
44,400.00
9-23 .
.
$ 44,400.00 $ 2,800.00 $ 47,200.00
Chapter 09 - Foreign Currency Transactions and Hedging Foreign Exchange Risk
31. (continued) b. Fair Value Hedge
Date
Journal Entry
Debit
Credit
12/1/15
Accounts Receivable (K) $ 43,200.00 Sales $ 43,200.00 To record sales and foreign currency account receivable. No entry for the forward contract.
12/31/15
Accounts Receivable (K) $ 1,600.00 Foreign Exchange Gain $ 1,600.00 To revalue the foreign currency account receivable and recognize a foreign exchange gain. Loss on Forward Contract $ 1,960.60 Forward Contract $ 1,960.60 To record the change in fair value of the forward contract as a liability and recognize a loss on forward contract.
Impact on 2015 income: Sales Foreign Exchange Gain Loss on Forward Contract Total
$
43,200.00 1,600.00 (1,960.60)
$
42,839.40
9-24 .
.
Chapter 09 - Foreign Currency Transactions and Hedging Foreign Exchange Risk
31. (continued) b. Fair Value Hedge (continued)
Date
Journal Entry
Debit
Credit
3/1/16
Accounts Receivable (K) $ 2,400.00 Foreign Exchange Gain $ 2,400.00 To revalue the foreign currency account receivable and recognize a foreign exchange gain. Loss on Forward Contract $ 839.40 Forward Contract $ 839.40 To adjust the carrying value of the forward conract to its current fair value and recognize a loss on forward contract. Foreign Currency (K) $ 47,200.00 Accounts Receivable (K) $ 47,200.00 To record the receipt of korunas from the foreign customer. Cash Forward Contract Foreign Currency (K) To record settlement of the forward contract.
Impact on 2016 income: Foreign Exchange Gain Loss on Forward Contract
$
2,400.00 (839.40)
Total
$
1,560.60
Impact on net income over both periods: which is equal to cash inflow.
$
44,400.00
9-25 .
.
$ 44,400.00 2,800.00 $ 47,200.00
Chapter 09 - Foreign Currency Transactions and Hedging Foreign Exchange Risk
32. (40 minutes) (Forward contract hedge of foreign currency payable) a. Cash Flow Hedge
Date
Journal Entry
Debit
Credit
12/1/15
Cost of Goods Sold $ 43,200.00 Accounts Payable (K) $ 43,200.00 To recognize the purchase of materials immediately as cost of goods sold and record a foreign currency account payable. No entry for the forward contract.
12/31/15
Foreign Exchange Loss $ 1,600.00 Accounts Payable (K) $ 1,600.00 To revalue the foreign currency account payable and recognize a foreign exchange loss. Forward Contract $ 1,960.60 AOCI $ 1,960.60 To record the change in fair value of the forward contract as an asset. AOCI
$ 1,600.00 Gain on Forward Contract $ 1,600.00 To record a gain on forward contract to offset the foreign exchange loss. Premium Expense $ 400.00 AOCI $ 400.00 To allocate the forward contract premium over the life of the contract. Impact on 2015 income: Cost of Goods Sold Foreign Exchange Loss Gain on Forward Contract Premium Expense Total
$
(43,200) (1,600) 1,600 (400)
$
(43,600)
9-26 .
.
Chapter 09 - Foreign Currency Transactions and Hedging Foreign Exchange Risk
32. (continued) a. Cash Flow Hedge (continued) Date
Journal Entry
Debit
Credit
3/1/16
Foreign Exchange Loss $ 2,400.00 Accounts Payable (K) $ 2,400.00 To revalue the foreign currency account payable and recognize a foreign exchange loss. Forward Contract $ 839.40 AOCI $ 839.40 To adjust the carrying value of the forward contract to its current fair value. AOCI
$ 2,400.00
Gain on Forward Contract $ 2,400.00 To record a gain on forward contract to offset the foreign exchange loss. Premium Expense $ 800.00 AOCI $ 800.00 To allocate the forward contract premium over the life of the contract. Foreign Currency (K)
$ 47,200.00
Cash
Forward Contract To record settlement of the forward contract.
$ 44,400.00 $ 2,800.00
Accounts Payable (K) $ 47,200.00 Foreign Currency (K) $ 47,200.00 To record the payment of korunas to the foreign supplier. Impact on 2016 income: Foreign Exchange Loss Gain on Forward Contract Premium Expense
$
(2,400) 2,400 (800)
Total
$
(800)
Impact on net income over both periods: which is equal to cash outflow.
$ (44,400.00)
9-27 .
.
Chapter 09 - Foreign Currency Transactions and Hedging Foreign Exchange Risk
32. (continued) b. Fair Value Hedge
Date
Journal Entry
Debit
Credit
12/1/15
Cost of Goods Sold $ 43,200.00 Accounts Payable (K) $ 43,200.00 To recognize the purchase of materials immediately as cost of goods sold and record a foreign currency account payable. No entry for the forward contract.
12/31/15
Foreign Exchange Loss $ 1,600.00 Accounts Payable (K) $ 1,600.00 To revalue the foreign currency account payable and recognize a foreign exchange loss. Forward Contract $ 1,960.60 Gain on Forward Contract $ 1,960.60 To record the change in fair value of the forward contract as an asset and recognize a gain on forward contract.
Impact on 2015 income: Cost of Goods Sold Foreign Exchange Loss Gain on Forward Contract
$ (43,200.00) (1,600.00) 1,960.60
Total
$ (42,839.40)
9-28 .
.
Chapter 09 - Foreign Currency Transactions and Hedging Foreign Exchange Risk
32. (continued) b. Fair Value Hedge (continued)
Date
Journal Entry
Debit
Credit
3/1/16
Foreign Exchange Loss $ 2,400.00 Accounts Payable (K) $ 2,400.00 To revalue the foreign currency account payable and recognize a foreign exchange loss. Forward Contract $ 839.40 Gain on Forward Contract $ 839.40 To adjust the carrying value of the forward contract to its current fair value and recognize a gain on forward contract. Accounts Payable (K) $ 47,200.00 Foreign Currency (K) $ 47,200.00 To record the payment of korunas to the foreign supplier. Foreign Currency (K)
$ 47,200.00
Cash
Forward Contract To record settlement of the forward contract. Impact on 2016 income: Foreign Exchange Loss Gain on Forward Contract
$
(2,400.00) 839.40
Total
$
(1,560.60)
Impact on net income over both periods: which is equal to cash outflow.
$ (44,400.00)
9-29 .
.
$ 44,400.00 $ 2,800.00
Chapter 09 - Foreign Currency Transactions and Hedging Foreign Exchange Risk
33. (30 minutes) (Option hedge of foreign currency receivable) a. Cash Flow Hedge 6/1
6/30
Accounts Receivable (P) Sales [$.062 x 1,000,000]
$62,000
Foreign Currency Option Cash
$2,500
Accounts Receivable (P) Foreign Exchange Gain [($.066 – $.062) x 1,000,000]
$4,000
AOCI Foreign Currency Option [($.0018 – $.0025) x 1,000,000]
$700
Loss on Foreign Currency Option AOCI
$4,000
$62,000
$2,500
$4,000
Option Expense AOCI Date 6/1 6/30 9/1
Fair Value $2,500 $1,800 $1,000
$4,000 $700 $700
Intrinsic Value $0 $0 $1,000
9-30 .
$700
.
Time Value $2,500 $1,800 $0
Change in Time Value – – $ 700 – $1,800
Chapter 09 - Foreign Currency Transactions and Hedging Foreign Exchange Risk
33. (continued) 9/1
Foreign Exchange Loss Accounts Receivable (P) [($.061 – $.066) x 1,000,000]
$5,000
AOCI Foreign Currency Option [$1,800 – $1,000]
$800
AOCI Gain on Foreign Currency Option
$5,000
$800
$5,000 $5,000
Option Expense $1,800 AOCI (Change in time value of option is recognized as expense) Foreign Currency (P) Accounts Receivable (P)
$61,000
Cash Foreign Currency (P) Foreign Currency Option
$62,000
$1,800
$61,000
$61,000 1,000
Impact on Net Income over the Two Accounting Periods: Sales $62,000 Foreign Exchange Gain 4,000 Loss on Foreign Currency Option (4,000) Foreign Exchange Loss (5,000) Gain on Foreign Currency Option 5,000 Foreign currency option expense (2,500) Impact on net income $59,500 = Net cash inflow
9-31 .
.
Chapter 09 - Foreign Currency Transactions and Hedging Foreign Exchange Risk
33. (continued) b. Fair Value Hedge 6/1
6/30
Accounts Receivable (P) Sales [$.062 x 1,000,000]
$62,000
Foreign Currency Option Cash
$2,500
Accounts Receivable (P) Foreign Exchange Gain [($.066 – $.062) x 1,000,000]
$4,000
$2,500
Loss on Foreign Currency Option Foreign Currency Option 9/1
$62,000
Foreign Exchange Loss Accounts Receivable (P) [($.061 – $.066) x 1,000,000] Loss on Foreign Currency Option Foreign Currency Option
$4,000
$700 $700 $5,000 $5,000
$800 $800
Foreign Currency (P) Accounts Receivable (P)
$61,000
Cash Foreign Currency (P) Foreign Currency Option
$62,000
$61,000
$61,000 1,000
Impact on Net Income over the Two Accounting Periods: Sales $62,000 Foreign Exchange Gain 4,000 Foreign Exchange Loss (5,000) Loss on Foreign Currency Option (1,500) Impact on net income $59,500 = Net cash inflow
9-32 .
.
Chapter 09 - Foreign Currency Transactions and Hedging Foreign Exchange Risk
34. (30 minutes) (Option hedge of foreign currency payable) a. Cash Flow Hedge 6/1
6/30
Date 6/1 6/30 9/1
Inventory [$.085 x 1,000,000] Accounts Payable (M)
$85,000
Foreign Currency Option Cash
$2,000
Foreign Exchange Loss Accounts Payable (M) [($.088 – .085) x 1,000,000]
$3,000
Foreign Currency Option AOCI [$4,000 – $2,000]
$2,000
AOCI Gain on Foreign Currency Option
$3,000
Option Expense AOCI
$1,000*
Fair Value $2,000 $4,000 $5,000
$2,000
$3,000
$2,000
$3,000
$1,000
Intrinsic Value $0 $3,000 $5,000
9-33 .
$85,000
.
Time Value $2,000 $1,000 $0
Change in Time Value -$1,000* -$1,000**
Chapter 09 - Foreign Currency Transactions and Hedging Foreign Exchange Risk
34. (continued) 9/1
Foreign Exchange Loss Accounts Payable (M) [($.09 – $.088) x 1,000,000]
$2,000
Foreign Currency Option AOCI [$5,000 – $4,000]
$1,000
AOCI Gain on Foreign Currency Option
$2,000
Option Expense AOCI
$1,000**
Foreign Currency (M) Cash Foreign Currency Option
$90,000
Accounts Payable (M) Foreign Currency (M)
$90,000
$1,000
$2,000
$1,000
$85,000 $5,000
$90,000
Impact on net income: Option Expense
($2,000)
9-34 .
$2,000
.
Chapter 09 - Foreign Currency Transactions and Hedging Foreign Exchange Risk
34. (continued) b. Fair Value Hedge 6/1
6/30
9/1
Inventory Accounts Payable (M) [$.085 x 1,000,000]
$85,000
Foreign Currency Option Cash
$2,000
Foreign Exchange Loss Accounts Payable (M) [($.088 – $.085) x 1,000,000]
$3,000
Foreign Currency Option Gain on Foreign Currency Option [$4,000 – $2,000]
$2,000
Foreign Exchange Loss Accounts Payable (M) [($.09 – $.088) x 1,000,000]
$2,000
Foreign Currency Option Gain on Foreign Currency Option [$5,000 – $4,000]
$1,000
Foreign Currency (M) Cash Foreign Currency Option
$90,000
Accounts Payable (M) Foreign Currency (M)
$90,000
$85,000
$2,000
$2,000
$1,000
$85,000 5,000
($5,000) 3,000 ($2,000)
9-35 .
$2,000
$90,000
Impact on net income: Foreign Exchange Loss Gain on Foreign Currency Option Impact on net income
.
$3,000
Chapter 09 - Foreign Currency Transactions and Hedging Foreign Exchange Risk
35. (30 minutes) (Forward contract cash flow hedge of foreign currency denominated asset)
Date 11/01/15 12/31/15 4/30/16
Spot Rate $.53 $.50 $.49
Account Receivable (FCU) Forward U.S. Dollar Change in U.S. Rate to Value Dollar Value 4/30/16 $53,000 $.52 $50,000 -$3,000 $.48 $49,000 -$1,000 $.49
Forward Contract Change in Fair Value Fair Value $0 $3,8441 +$3,844 $3,0002 - $ 844
($52,000 – $48,000) x .961 = $3,844; where .961 is the present value factor for four months at an annual interest rate of 12% (1% per month) calculated as 1/1.01 4. 2 $52,000 – $49,000 = $3,000. 1
2015 Journal Entries 11/01/15 Accounts Receivable (FCU) Sales
$53,000 $53,000
There is no entry for the forward contract. 12/31/15 Foreign Exchange Loss Accounts Receivable (FCU)
$3,000
AOCI Gain on Forward Contract
$3,000
Forward Contract AOCI
$3,844
Discount expense AOCI [100,000 x ($.53 – $.52) x 2/6]
$333.33
$3,000
$3,000
$3,844
$333.33
The impact on net income for the year 2015 is: Sales Foreign Exchange Loss Gain on Forward Contract Net Gain (Loss) Discount Expense Impact on net income
$53,000.00 (3,000.00) 3,000.00 0.00 (333.33) $52,666.67
9-36 .
.
Chapter 09 - Foreign Currency Transactions and Hedging Foreign Exchange Risk
35. (continued) 2016 Journal Entries 4/30/16
Foreign Exchange Loss Accounts Receivable (FCU)
$1,000
AOCI Gain on Forward Contract
$1,000
$1,000
$1,000
AOCI Forward Contract
$844 $844
Discount expense AOCI
$666.67
Foreign Currency (FCU) Accounts Receivable (FCU)
$49,000
Cash Foreign Currency (FCU) Forward Contract
$52,000
$666.67
$49,000
$49,000 3,000
The impact on net income for the year 2016 is: Foreign Exchange Loss Gain on Forward Contract Net Gain (Loss) Discount Expense Impact on net income
$(1,000.00) 1,000.00 0.00 (666.67) $(666.67)
9-37 .
.
Chapter 09 - Foreign Currency Transactions and Hedging Foreign Exchange Risk
36. (30 minutes) (Forward contract fair value hedge of net foreign currency denominated asset) Account Receivable (Payable) (mongs) Forward Change in U.S. Rate to Date U.S. Dollar Value Dollar Value 1/31/16 11/30/15 $265,000 ($159,000) $.52 12/31/15 $250,000 ($150,000) -$15,000 (-$9,000) $.48 1/31/16 $245,000 ($147,000) -$ 5,000 (-$3,000) $.49
Forward Contract Change in Fair Value Fair Value $0 $7,9211 +$7,921 $6,0002 - $1,921
($104,000 – $96,000) x .9901 = $7,921; where .9901 is the present value factor for one month at an annual interest rate of 12% (1% per month) calculated as 1/1.01. 2 $104,000 – $98,000 = $6,000. 1
2015 Journal Entries 11/30
Accounts Receivable (mongs) Sales [$.53 x 500,000]
$265,000
Inventory Accounts Payable [$.53 x 300,000]
$159,000
$265,000
$159,000
There is no formal entry for the forward contract. 12/31
Foreign Exchange Loss Accounts Receivable (mongs)
$15,000
Accounts Payable (mongs) Foreign Exchange Gain
$9,000
Forward Contract Gain on Forward Contract
$7,921
$15,000
$9,000
$7,921
The impact on net income for the year 2015 is: Sales Net Foreign Exchange Loss $ (6,000) Gain on Forward Contract 7,921 Net Gain (Loss) Impact on net income
9-38 .
.
$265,000
1,921 $266,921
Chapter 09 - Foreign Currency Transactions and Hedging Foreign Exchange Risk
36. (continued) 2016 Journal Entries 1/31
Foreign Exchange Loss Accounts Receivable (mongs)
$5,000
Accounts Payable (mongs) Foreign Exchange Gain
$3,000
Loss on Forward Contract Forward Contract
$1,921
$5,000
$3,000
$1,921
Foreign Currency (mongs) Accounts Receivable (mongs)
$245,000
Accounts Payable (mongs) Foreign Currency (mongs)
$147,000
Cash Foreign Currency (mongs) Forward Contract
$104,000
$245,000
$147,000
$98,000 $6,000
The impact on net income for the year 2016 is: Net Foreign Exchange Loss Loss on Forward Contract Impact on net income
$(2,000) (1,921) $(3,921)
The net effect on the balance sheet is an increase in cash of $104,000 and an increase in inventory of $159,000 with a corresponding increase in retained earnings of $263,000 ($266,921 – $3,921).
9-39 .
.
Chapter 09 - Foreign Currency Transactions and Hedging Foreign Exchange Risk
37. (40 minutes) (Forward contract fair value hedge – foreign currency receivable and firm commitment (sale)) a. Foreign Currency Receivable 10/01
Accounts Receivable (LCU) Sales [100,000 x $.69]
$69,000 $69,000
There is no formal entry for the forward contract. 12/31
Accounts Receivable (LCU) Foreign Exchange Gain [($.71 – $.69) x 100,000] Loss on Forward Contract Forward Contract [($.74 – $.65) x 100,000 x .9901]
1/31
Accounts Receivable (LCU) Foreign Exchange Gain [($.72 – $.71) x 100,000] Forward Contract Gain on Forward Contract [(($.72 – $.65) x 100,000) – 8,910.90]
$2,000 $2,000
$8,910.90 $8,910.90
$1,000 $1,000
$ 1,910.90 $ 1,910.90
Foreign Currency (LCU) Accounts Receivable (LCU)
$72,000
Cash Forward Contract Foreign Currency (LCU)
$65,000 $7,000
$72,000
$72,000
The impact on net income: Sale Foreign Exchange Gain Loss on Forward Contract Gain on Forward Contract Impact on net income
$69,000.00 3,000.00 (8,910.90) 1,910.90 $65,000.00 = Cash Inflow
9-40 .
.
Chapter 09 - Foreign Currency Transactions and Hedging Foreign Exchange Risk
37. (continued) b. Foreign Currency Firm Commitment (Sale) 10/01
There is no entry to record either the sales agreement or the forward contract as both are executory contracts.
12/31
Loss on Forward Contract Forward Contract
$8,910.90
Firm Commitment Gain on Firm Commitment
$8,910.90
Forward Contract Gain on Forward Contract
$1,910.90
Loss on Firm Commitment Firm Commitment
$1,910.90
Foreign Currency (LCU) Sales
$72,000
Cash Forward Contract Foreign Currency (LCU)
$65,000 $7,000
Adjustment to Net Income Firm Commitment
$7,000
1/31
$8,910.90
$8,910.90
$1,910.90
$1,910.90
$72,000
$72,000
$7,000
Impact on Net Income: Sales Net Loss on Forward Contract Net Gain on Firm Commitment Adjustment to Net Income
$72,000 (7,000) 7,000 (7,000) $65,000 = Cash Inflow
9-41 .
.
Chapter 09 - Foreign Currency Transactions and Hedging Foreign Exchange Risk
38. (30 minutes) (Forward contract fair value hedge of a foreign currency firm commitment (purchase))
Date 8/1 9/30 10/31
Forward Rate to 10/31 $.30 $.325 $.320 (spot)
Forward Contract Firm Commitment Change in Change in Fair Value Fair Value Fair Value Fair Value $0 $0 $0 $4,950.501 + $4,950.50 $(4,950.50)1 – $4,950.50 $4,0002 – $ 950.50 $(4,000)2 + $ 950.50
($65,000 – $60,000) x .9901 = $4,950.5; where .9901 is the present value factor for one month at an annual interest rate of 12% (1% per month) calculated as 1/1.01. 2 ($64,000 – $60,000) = $4,000. 1
a. Journal entries 8/1
There is no entry to record either the purchase agreement or the forward contract as both are executory contracts.
9/30
Forward Contract Gain on Forward Contract
$4,950.50
Loss on Firm Commitment Firm Commitment
$4,950.50
Loss on Forward Contract Forward Contract
$950.50
Firm Commitment Gain on Firm Commitment
$950.50
Foreign Currency (rupees) Cash Forward Contract
$64,000
Inventories (Cost-of-Goods-Sold) Foreign Currency (rupees)
$64,000
Firm Commitment Adjustment to Net Income
$4,000
10/31
$4,950.50 $4,950.50 $950.50 $950.50 $60,000 4,000 $64,000 $4,000
b. Assuming the inventory is sold in the fourth quarter, the net impact on net income is negative $60,000: Cost-of-Goods-Sold Adjustment to Net Income Net impact on net income
$(64,000) 4,000 $(60,000)
c. The net cash outflow is $60,000. 39.(3 0 minutes) (Option fair value hedge of a foreign currency firm commitment 9-42 .
.
Chapter 09 - Foreign Currency Transactions and Hedging Foreign Exchange Risk
(sale))
Date
Spot Rate
Firm Commitment Change in Fair Value Fair Value
Option Premium for 9/1
Option Change in Fair Value Fair Value
6/1 6/30 9/1
$1.00 $0.94 $0.88
$(5,881.80)1 $(12,000)2
$0.020 $0.028 N/A
$2,000 $2,800 $12,000
– $5,881.80 – $6,118.20
+ $800 + $9,200
($94,000 – $100,000) x .9803 = $(5,881.80), where .9803 is the present value factor for two months at an annual interest rate of 12% (1% per month) calculated as 1/1.01 2. 2 $88,000 – $100,000 = $(12,000). 1
a. Journal Entries 6/1
Foreign Currency Option Cash
$2,000.00 $2,000.00
There is no entry to record the sales agreement because it is an executory contract. 6/30
Loss on Firm Commitment Firm Commitment
$5,881.80 $5,881.80
Foreign Currency Option Gain on Foreign Currency Option 9/1
$800.00
Loss on Firm Commitment Firm Commitment
$6,118.20
Foreign Currency Option Gain on Foreign Currency Option
$9,200.00
Foreign Currency (lek) Sales
$88,000.00
Cash Foreign Currency (lek) Foreign Currency Option
$100,000.00
Firm Commitment Adjustment to Net Income
$12,000.00
$6,118.20
$9,200.00
$88,000.00
$88,000.00 12,000.00
$12,000.00
39.(c ontinued) b. Impact on Net Income 9-43 .
$800.00
.
Chapter 09 - Foreign Currency Transactions and Hedging Foreign Exchange Risk
The impact on net income for the second quarter is: Loss on Firm Commitment Gain on Foreign Currency Option Impact on net income
$(5,881.80) 800.00 $(5,081.80)
The impact on net income for the third quarter is: Sales Loss on Firm Commitment Gain on Foreign Currency option Adjustment to Net Income Impact on net income
$88,000.00 (6,118.20) 9,200.00 12,000.00 $103,081.80
The impact on net income over the second and third quarters is: $98,000 ($103,081.80– $5,801.80) c. Net Cash Inflow The net cash inflow resulting from the sale is: $98,000 ($100,000 – $2,000)
9-44 .
.
Chapter 09 - Foreign Currency Transactions and Hedging Foreign Exchange Risk
40. (20 minutes) (Option fair value hedge of a foreign currency firm commitment (purchase))
Date
Spot Rate
11/20 $.20 a) 12/20 $.21 b) 12/20 $.18
Firm Commitment Change in Fair Value Fair Value
Option Premium for 12/20
Option Change in Fair Value Fair Value
$(500)1 $1,0002
$.008 $.0103 $.0004
$400 $500 $0
– $500 + $1,000
+ $100 – $400
$10,000 – $10,500 = $(500). $10,000 – $9,000 = $1,000. 3 The premium on 12/20 for an option that expires on that date is equal to the option’s intrinsic value. Given the spot rate on 12/20 of $.21, a call option with a strike price of $.20 has an intrinsic value of $.01 per pijio. 4 The premium on 12/20 for an option that expires on that date is equal to the option’s intrinsic value. Given the spot rate on 12/20 of $.18, a call option with a strike price of $.20 has no intrinsic value – the premium on 12/20 is $.000. 1 2
a.
The option strike price ($.20) is less than the spot rate ($.21) on December 20, the date the parts are to be paid for. Therefore, Big Arber will exercise its option. The journal entries are as follows: 11/20
Foreign Currency Option Cash
$400 $400
There is no entry to record the purchase agreement because it is an executory contract. 12/20
Loss on Firm Commitment Firm Commitment
$500
Foreign Currency Option Gain on Foreign Currency Option
$100
$500 $100
Foreign Currency (pijio) Cash Foreign Currency Option
$10,500
Parts inventory Foreign Currency (pijio)
$10,500
$10,000 500 $10,500
The following entry is made in the period when the inventory affects net income through cost-of-goods-sold: Firm Commitment Adjustment to Net Income
9-45 .
.
$500 $500
Chapter 09 - Foreign Currency Transactions and Hedging Foreign Exchange Risk
40. (continued) b. The option strike price ($.20) is greater than the spot rate ($.18) on December 20, the date the parts are to be paid for. Therefore, Big Arber will allow the option to expire unexercised. Foreign currency will be acquired at the spot rate on December 20. The journal entries are as follows: 11/20
Foreign Currency Option Cash
$400 $400
There is no entry to record the purchase agreement because it is an executory contract. 12/20
Firm Commitment Gain on Firm Commitment Loss on Foreign Currency Option Foreign Currency Option
$1,000 $1,000 $400 $400
Foreign Currency (pijio) Cash
$9,000
Parts Inventory Foreign Currency (pijio)
$9,000
$9,000 $9,000
The following entry is made in the period when the inventory affects net income through cost-of-goods-sold: Adjustment to Net Income Firm Commitment
9-46 .
.
$1,000 $1,000
Chapter 09 - Foreign Currency Transactions and Hedging Foreign Exchange Risk
41. (20 minutes) (Option cash flow hedge of a forecasted transaction) a. 12/15/15 Foreign Currency Option Cash [1 million marks x $.005]
$5,000 $5,000
No journal entry related to the forecasted transaction. 12/31/15 Foreign Currency Option $3,000 AOCI To recognize the increase in the value of the foreign currency option with the counterpart recorded in AOCI. Option Expense $1,000 AOCI To recognize the decrease in the time value of the option as expense. [($.584 – $.58) x 1,000,000 = $4,000 – $3,000 = $1,000] 3/15/16
Foreign Currency Option AOCI To recognize the increase in the value of the Foreign Currency Option with the counterpart recorded in AOCI.
$2,000
Option Expense AOCI To recognize the decrease in the time value of the option as expense.
$4,000
Foreign Currency (marks) Cash Foreign Currency Option To record exercise of the foreign currency option at the strike price of $.58 and close out the foreign currency option account.
9-47 .
$1,000
$2,000
$4,000
$590,000
Parts Inventory $590,000 Foreign Currency (marks) To record the purchase of parts and payment of 1 million marks to the supplier.
.
$3,000
$580,000 10,000
$590,000
Chapter 09 - Foreign Currency Transactions and Hedging Foreign Exchange Risk
41. (continued) AOCI Adjustment to Net Income To transfer the amount accumulated in AOCI as an adjustment to net income in the period in which the forecasted transaction occurs.
$10,000 $10,000
b. Impact on net income: 2015 – Option Expense
$(1,000)
2016 – Cost-of-goods-sold Option Expense Adjustment to Net Income
$(590,000) (4,000) 10,000 $(584,000)
The impact on net income over the two periods is $(585,000). c. Net cash outflow for parts: $585,000 = ($5,000 + $580,000) 42. (60 minutes) (Unhedged foreign currency transaction; forward contract and option hedge of foreign currency liability; forward contract and option hedge of foreign currency firm commitment (purchase)) Part a. Foreign Currency Liability (Unhedged) 9/15
9/30
10/31
Inventory Accounts Payable (euro)
$200,000
Foreign Exchange Loss Accounts Payable (euro)
$10,000
Foreign Exchange Loss Accounts Payable (euro)
$10,000
Foreign Currency (euro) Cash
$220,000
Accounts Payable (euro) Foreign Currency (euro)
$220,000
9-48 .
.
$200,000
$10,000
$10,000
$220,000
$220,000
Chapter 09 - Foreign Currency Transactions and Hedging Foreign Exchange Risk
42. (continued) Part b. Forward Contract Fair Value Hedge of a Foreign Currency Liability
Date 9/15 9/30 10/31
Spot Rate $1.00 $1.05 $1.10
Accounts Payable (C) U.S. Dollar Change in U.S. Value Dollar Value $200,000 $210,000 +$10,000 $220,000 +$10,000
Forward Rate to 10/31 $1.06 $1.09 $1.10
Forward Contract Change in Fair Value Fair Value $0 1 $5,940.60 +$5,940.60 $8,000.002 +$2,059.40
($218,000 – $212,000) x .9901 = $5,940.60; where .9901 is the present value factor for one month at an annual interest rate of 12% (1% per month) calculated as 1/1.01. 2 $220,000 – $212,000 = $8,000. 1
9/15
Inventory Accounts Payable (euro)
$200,000 $200,000
There is no formal entry for the forward contract. 9/30
10/31
Foreign Exchange Loss Accounts Payable (euro)
$10,000
Forward Contract Gain on Forward Contract
$5,940.60
Foreign Exchange Loss Accounts Payable (euro)
$10,000
Forward Contract Gain on Forward Contract
$2,059.40
Foreign Currency (euro) Cash Forward Contract
$220,000
Accounts Payable (euro) Foreign Currency (euro)
$220,000
$10,000
$5,940.60
$10,000
$2,059.40
$212,000 8,000
$220,000
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Chapter 09 - Foreign Currency Transactions and Hedging Foreign Exchange Risk
42. (continued) Part c. Forward Contract Fair Value Hedge of a Foreign Currency Firm Commitment (Purchase) 9/15
There is no formal entry for the forward contract or the purchase order.
9/30
Forward Contract Gain on Forward Contract
$5,940.60
Loss on Firm Commitment Firm Commitment
$5,940.60
Forward Contract Gain on Forward Contract
$2,059.40
Loss on Firm Commitment Firm Commitment
$2,059.40
Foreign Currency (euro) Cash Forward Contract
$220,000
Inventory Foreign Currency (euro)
$220,000
10/31
$5,940.60
$5,940.60
$2,059.40
$2,059.40
$212,000 8,000
$220,000
The following entry is made in the period when the inventory affects net income through cost-of-goods-sold: Firm Commitment Adjustment to Net Income
$8,000 $8,000
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Chapter 09 - Foreign Currency Transactions and Hedging Foreign Exchange Risk
42. (continued) Part d. Option Cash Flow Hedge of a Foreign Currency Liability The following schedule summarizes the changes in the components of the fair value of the euro call option with a strike price of $1.00 for October 31.
Spot Date Rate 09/15 $1.00 09/30 $1.05 10/31 $1.10
Option Fair Premium Value $.035 $7,000 $.070 $14,000 $.100 $20,000
Change in Fair Value + $7,000 + $6,000
Intrinsic Value $0 $10,0002 $20,000
Time Value $7,0001 $4,0002 $03
Change in Time Value - $3,000 - $4,000
1 Because the strike price and spot rate are the same, the option has no intrinsic
value. Fair value is attributable solely to the time value of the option. 2 With a spot rate of $1.05 and a strike price of $1.00, the option has an intrinsic
value of $10,000. The remaining $4,000 of fair value is attributable to time value. 3 The time value of the option at maturity is zero.
9/15
9/30
Inventory Accounts Payable (euro)
$200,000
Foreign Currency Option Cash
$7,000
Foreign Exchange Loss Accounts Payable (euro)
$10,000
Foreign Currency Option AOCI
$7,000
AOCI Gain on Foreign Currency Option
$10,000
Option Expense AOCI
$3,000
$200,000
$7,000
$10,000
$7,000
$3,000
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$10,000
.
Chapter 09 - Foreign Currency Transactions and Hedging Foreign Exchange Risk
42. (continued) 10/31
Foreign Exchange Loss Accounts Payable (euro)
$10,000
Foreign Currency Option AOCI
$6,000
AOCI Gain on Foreign Currency Option
$10,000
Option Expense AOCI
$4,000
$10,000
$6,000
$4,000
Foreign Currency (euro) Cash Foreign Currency Option
$220,000
Accounts Payable (euro) Foreign Currency (euro)
$220,000
$200,000 $20,000
$220,000
9-52 .
$10,000
.
Chapter 09 - Foreign Currency Transactions and Hedging Foreign Exchange Risk
42. (continued) Part e. Option Fair Value Hedge of a Foreign Currency Firm Commitment (Purchase)
Date 9/15 9/30 10/31
Spot Rate $1.00 $1.05 $1.10
Firm Commitment Change in Fair Value Fair Value $0 $ (9,901) –$ 9,9011 $(20,000) –$10,099
Option Premium for 10/31 $.035 $.070 $.100
Foreign Currency Option Change in Fair Value Fair Value $ 7,000 $14,000 +$7,000 $20,000 +$6,000
($200,000 – $210,000) x .9901 = $(9,901), where .9901 is the present value factor for one month at an annual interest rate of 12% (1% per month) calculated as 1/1.01. 1
9/15
9/30
10/31
Foreign Currency Option Cash
$7,000
Foreign Currency Option Gain on Foreign Currency Option
$7,000
Loss on Firm Commitment Firm Commitment
$9,901
Foreign Currency Option Gain on Foreign Currency Option
$6,000
Loss on Firm Commitment Firm Commitment
$10,099
Foreign Currency (euro) Cash Foreign Currency Option
$220,000
Inventory Foreign Currency (euro)
$220,000
$7,000
$7,000
$9,901
$6,000
$10,099
$200,000 20,000
$220,000
The following entry is made in the period when the inventory affects net income through cost-of-goods-sold: Firm Commitment Adjustment to Net Income
$20,000 $20,000
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Chapter 09 - Foreign Currency Transactions and Hedging Foreign Exchange Risk
Chapter 9 Develop Your Skills Research Case—International Flavors and Fragrances The responses to this assignment might change over time as the company changes its use of foreign currency derivatives or changes the manner in which it discloses its foreign currency hedging activities in the annual report. The following responses are based on IFF’s 2012 annual report. 1. In 2012, IFF provided information in the annual report related to its management of foreign exchange risk in the following locations: a. Item 7A. Quantitative and Qualitative Disclosures about Market Risk. c. Note 14. Financial Instruments, under “derivatives.” 2. Note 14 indicates that IFF uses foreign currency forward contracts to reduce exposure to cash flow volatility arising from foreign currency fluctuations associated with intercompany loans, foreign currency receivables and payables (hedges of foreign currency denominated assets and liabilities), and anticipated purchases of raw materials used in operations (hedges of forecasted transactions). The company also uses forward contracts to hedge net investments in foreign operations. (This topic is discussed in more detail in Chapter 10.) 3. Toward the end of Note 14, the company indicates that “the ineffective portion of the above noted cash flow hedges and net investment hedges was not material for the years ended December 31, 2012 and 2011.”
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Chapter 09 - Foreign Currency Transactions and Hedging Foreign Exchange Risk
Accounting Standards Case—Forecasted Transactions Questions asked in the case are: • Is management’s intent sufficient to assess that a forecasted transaction is likely to occur? • If not, what additional evidence must be considered? Source of guidance: FASB ASC 815-20-55-24 Derivatives and Hedging; HedgingGeneral; Implementation Guidance and Illustrations; Probability of a Forecasted Transaction ASC 815-20-55-24 states: “An assessment of the likelihood that a forecasted transaction will take place should not be based solely on management's intent because intent is not verifiable. The transaction's probability should be supported by observable facts and the attendant circumstances. Consideration should be given to all of the following circumstances in assessing the likelihood that a transaction will occur. a. The frequency of similar past transactions b. The financial and operational ability of the entity to carry out the transaction c. Substantial commitments of resources to a particular activity (for example, a manufacturing facility that can be used in the short run only to process a particular type of commodity) d. The extent of loss or disruption of operations that could result if the transaction does not occur e. The likelihood that transactions with substantially different characteristics might be used to achieve the same business purpose (for example, an entity that intends to raise cash may have several ways of doing so, ranging from a short-term bank loan to a common stock offering).” The answers to the specific questions asked in the case are: • Management’s intent is not sufficient to assess whether a forecasted transaction is likely to occur. • Additional evidence listed in items a.-e. in ASC 815-20-55-24 must be considered in assessing that likelihood.
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Chapter 09 - Foreign Currency Transactions and Hedging Foreign Exchange Risk
Excel Case—Determine Foreign Exchange Gains and Losses Note to Instructors: At the time this case is assigned to students, please verify that www.x-rates.com still reports the exchange rates used in the solution below. These exchange rates were obtained from www.x-rates.com in January 2013. For unexplained reasons, in the past, www.x-rates.com has made changes over time to the historical exchange rates that it reports. 1., 2. and 3. Spreadsheet for the calculation of the foreign exchange gains (losses) related to Import/Export Company’s foreign currency transactions for the year 2012.
Foreign Currency Brazilian real (BRL) Chilean peso (CLP) Swiss franc (CHF) Swiss franc (CHF)
Type of Transaction
Amount in Foreign Currency
Transaction Date
Exchange Rate at Transaction Date
$ Value on Transaction Date
Settlement Date
Exchange Rate at Settlement Date
$ Value on Settlement Date
Foreign Exchange Gain (Loss)
Import purchase
(100,000)
1/10/2012
0.553189
(55,318.90)
5/10/2012
0.511316
(51,131.60)
$4,187.30
Import purchase
(27,000,000)
1/10/2012
0.001968
(53,136.00)
5/10/2012
0.002056
(55,512.00)
(2,376.00)
Export sale
50,000
1/10/2012
1.05384
52,692.00
4/10/2012
1.087158
54,357.90
1,665.90
Import purchase
(50,000)
4/10/2012
1.087158
(54,357.90)
7/10/2012
1.020427
(51,021.35)
3,336.55
Euro
Export sale
40,000
1/10/2012
1.278102
51,124.08
4/10/2012
1.306505
52,260.20
1,136.12
Euro Chinese yuan (CNY) Total Net Foreign Exchange Gain (Loss)
Export sale
40,000
4/10/2012
1.306505
52,260.20
7/10/2012
1.225452
49,018.08
(3,242.12)
Import purchase
(340,000)
1/10/2012
0.158353
(53,840.02)
10/10/2012
0.158893
(54,023.62)
(183.60)
$4,524.15
Source of exchange rates: www.x-rates.com, Historical Lookup Import/Export Company reported a net foreign exchange gain of $4,524.15 in 2012 income. Possible discussion points for instructors: Note that all transactions had a $ value on transaction date of approximately $53,000. The size of the foreign exchange gains and losses reported in the last column differs substantially across transactions because of different rates and directions of change in the exchange rates across the currencies in which Import/Export Company had exposures. At one extreme, the large depreciation in value of the BRL from 1/10/12 to 5/10/12 coupled with the BRL liability exposure generated a large foreign exchange gain.
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Chapter 09 - Foreign Currency Transactions and Hedging Foreign Exchange Risk
Excel Case (continued) On the other hand, the large appreciation in the value of the CLP over the same time period resulted in a foreign exchange loss on a foreign currency payable. An appreciation in the Euro from 1/10/12 to 4/10/12 coupled with the Euro asset exposure resulting from the export sale on 1/10/12 generated a foreign exchange gain. The subsequent depreciation in value of the Euro from 4/10/12 to 7/10/12 coupled with an asset exposure resulting from the export sale on 4/10/12 created a large foreign exchange loss. Analysis Case—Cash Flow Hedge 1. Given the $6,000 total Premium Expense, the forward rate on 2/1/15 must have been $1.06 [($1.06 – $1.00 spot) x 100,000 euros = $6,000]. 2. Given that the forward contract is reported as a liability of $1,980 ($2,000 x .9901), the forward rate at 3/31/15 must have been $1.04 [($1.04 – $1.06) x 100,000 euros = $2,000]. The fact that the forward contract is a liability signals that the forward rate at 3/31 is less than the forward rate on 2/1. 3. Given that the cost of goods sold is $103,000, the spot rate on 5/1/15 must have been $1.03. Linber must pay $1.06 per euro under the forward contract, so the forward contract results in an economic loss of $3,000 [($1.06 – $1.03) x 100,000 euros]. The negative adjustment to net income reflects this economic loss. 4. The Premium Expense of $6,000 reflects the increase in cost for the parts from the date the transaction was forecasted until the date of purchase. If Linber had purchased 100,000 euros on 2/1/15 at the spot rate of $1.00, it could have saved $6,000.
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Chapter 09 - Foreign Currency Transactions and Hedging Foreign Exchange Risk
Internet Case—Historical Exchange Rates Note to Instructors: At the time this case is assigned to students, please verify that www.x-rates.com still reports the exchange rates used in the solution below. These exchange rates were obtained from www.x-rates.com in January 2013. For unexplained reasons, in the past, www.x-rates.com has made changes over time to the historical exchange rates that it reports. 1. Spreadsheets for the calculation of the foreign exchange gains (losses) related to Pier Ten Company’s foreign currency account receivables.
Currency
Code
Foreign Currency Account Receivable
Indian rupee
INR
1,062,000
0.018851
$ 20,019.76
Philippine peso
PHP
830,000
0.024108
20,009.64
Japanese yen
JPY
1,578,000
0.012687
20,020.09
Malaysian ringgit
MYR
61,200
0.32704
20,014.85
Exchange Rate on 10/15/12
U.S. Dollar Value on 10/15/12
$ 80,064.34
Currency
Code
Foreign Currency Account Receivable
Indian rupee
INR
1,062,000
0.018586
$ 19,738.33
Philippine peso
PHP
830,000
0.024307
20,174.81
165.17
Japanese yen
JPY
1,578,000
0.012512
19,743.94
(276.15)
Malaysian ringgit
MYR
61,200
0.328216
20,086.82
71.97
Exchange Rate on 10/31/12
U.S. Dollar Value on 10/31/12
Foreign Exchange Gain (Loss) on 10/31/12 $
$ 79,743.90
9-58 .
.
$
(281.43)
(320.44)
Chapter 09 - Foreign Currency Transactions and Hedging Foreign Exchange Risk
Internet Case (continued)
Currency
Code
Foreign Currency Account Receivable
Indian rupee
INR
1,062,000
0.018265
$ 19,397.43
Philippine peso
PHP
830,000
0.024279
20,151.57
(23.24)
Japanese yen
JPY
1,578,000
0.012319
19,439.38
(304.55)
Malaysian ringgit
MYR
61,200
0.326531
19,983.70
(103.12)
Exchange Rate on 11/15/12
U.S. Dollar Value on 11/15/12
Foreign Exchange Gain (Loss) on 11/15/12 $
$ 78,972.08
$
(340.90)
(771.82)
Currency
Code
Foreign Currency Account Receivable
Indian rupee
INR
1,062,000
$ 20,019.76
$ 19,397.43
Philippine peso
PHP
830,000
20,009.64
20,151.57
141.93
Japanese yen
JPY
1,578,000
20,020.09
19,439.38
(580.70)
Malaysian ringgit
MYR
61,200
20,014.85
19,983.70
(31.15)
$ 80,064.34
$ 78,972.08
$ (1,092.26)
U.S. Dollar Value on 10/15/12
U.S. Dollar Value on 11/15/12
Net Foreign Exchange Gain (Loss) $
(622.33)
Source of exchange rates: www.x-rates.com, Historical Lookup 2.P ier Ten would have reported a net foreign exchange loss of $320.44 in the fiscal year ended October 31, 2012 and a net foreign exchange loss of $771.82 in the fiscal year ended October 31, 2013 related to these foreign currency receivables. The transactions denominated in Indian rupees, Japanese yen, and Malaysian ringgits resulted in foreign exchange losses of $622.33, $580.70, and $31.15, respectively. The INR receivable, which generated the largest loss, would have been the most important to hedge. 3.A ssuming a strike price equal to the October 15, 2012 spot rate, the only foreign currency transactions for which the purchase of a put option costing $100 would have been beneficial are the transactions in Indian rupees and Japanese yen. Net cash inflow from the INR receivable would have been $522.33 greater ($622.33 FX loss avoided less $100.00 cost of the option) if a 9-59 .
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Chapter 09 - Foreign Currency Transactions and Hedging Foreign Exchange Risk
Internet Case (continued) put option in INR had been acquired, and the net cash flow from the JPY receivable would have been $480.70 greater ($580.70 FX loss avoided less $100.00 cost of the option) if a put option in JPY had been acquired. Because the strike price is greater than the spot rate on 11/15/12, the put option in MYR would be exercised, but it would result in a decrease in net cash flow of $68.85 ($31.15 loss avoided less $100.00 cost of the option). Because the strike price is less than the spot rate on 11/15/12 the put option in PHP would be allowed to expire unexercised. The purchase of the PHP option would result in a decrease in net cash inflow to Pier Ten of $100.00 (the cost of the option).
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Chapter 09 - Foreign Currency Transactions and Hedging Foreign Exchange Risk
Communication Case—Forward Contracts and Options To: Mr. Dewey Nukem, CEO, Palmetto Bug Extermination Company (PBEC) The primary advantage of using forward contracts to hedge foreign exchange risk is that there is no cost to enter into them. The disadvantage is that the company is obligated to exchange foreign currency for dollars at the contracted forward rate. Depending upon the future spot rate, this may or may not be advantageous for the company. In contrast, the primary disadvantage of using foreign currency options to hedge foreign exchange risk is that there is an upfront cost incurred to purchase them. The primary advantage is that the company is not required to exchange foreign currency for dollars at the option strike price if it is disadvantageous to do so. The company can simply allow the option to expire unexercised and the only cost is the initial premium that was paid to acquire the option. Exporters sometimes use forward contracts to hedge export sales (import purchases) when the foreign currency is selling at a forward premium (discount) as this locks in premium revenue (discount revenue). The risk associated with this strategy is that the customer may or may not pay on time. If an exporter enters into a forward contract to sell foreign currency, and the customer does not pay on time, the exporter will need to purchase foreign currency at the spot rate to settle the forward contract. This is essentially the same as speculation; a gain or loss could arise. In this case, the exporter might be better off by purchasing a foreign currency put option. The exporter can simply allow the option to exercise if it has not received foreign currency from the customer by the expiration date. Since PBEC is making import purchases, it has more control over the timing of when it will need foreign currency. In that case, it should be safe to enter into a forward contract to purchase foreign currency on the date when PBEC plans to pay for its purchases. However, there is always the risk that the supplier does not deliver on time, in which case the forward contract provides PBEC with foreign currency for which it has no current use. The bottom line is that there is no right or wrong answer to the question which hedging instrument should be used to hedge the Swiss franc exposure to foreign exchange risk. Both forward contracts and option have the advantages and disadvantages.
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Chapter 10 - Translation of Foreign Currency Financial Statements
CHAPTER 10 TRANSLATION OF FOREIGN CURRENCY FINANCIAL STATEMENTS Chapter Outline I.
In today's global economy, many companies have invested in operations in foreign countries. A. In preparing consolidated financial statements on a worldwide basis, the foreign currency accounts prepared by foreign operations must be restated into the parent company's reporting currency. B. There are two major issues related to the translation of foreign currency financial statements. 1. Which method should be used? 2. How should the resulting translation adjustment be reported on the consolidated financial statements? C. Translation methods differ on the basis of which accounts are translated at the current exchange rate and which are translated at a historical exchange rate. Translating accounts at the current exchange rate creates a translation adjustment. D. Historically, accountants have experimented with a number of different translation methods. The dominant methods currently in use are the temporal method and the current rate method. E. Translation adjustments can be either (1) reported as a gain or loss in income or (2) deferred in the stockholders' equity section of the balance sheet.
II. The primary objective of the temporal method is to maintain the underlying valuation method used by the foreign entity to account for its assets and liabilities. A. Assets and liabilities carried at current or future value are translated at the current exchange rate. Assets and liabilities carried at cost and stockholders' equity items are translated at a historical exchange rate. B. By translating some assets at the current exchange rate and others at historical rates the temporal method distorts financial ratios calculated in the foreign currency. C. Most income statement items are translated at average-for-the-period rates. However, cost-of-goods-sold, depreciation, and amortization expense are translated at relevant historical exchange rates. D. Balance sheet exposure under the temporal method is defined as cash, marketable securities, and receivables minus total liabilities. A net liability exposure often exists. 1. When a liability balance sheet exposure exists, depreciation of the foreign currency results in a positive translation adjustment (gain) and appreciation of the foreign currency results in a negative translation adjustment (loss). 2. Reporting a translation loss when the foreign currency appreciates is thought to be inconsistent with economic reality.
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Chapter 10 - Translation of Foreign Currency Financial Statements
III. With the current rate method, the net investment in a foreign operation is considered to be exposed to foreign exchange risk. A. Assets and liabilities are translated at the current exchange rate; equity is translated at historical rates. B. Translating assets which are carried at cost using the current exchange rate results in a translated value which is not readily interpretable; it is neither a current value nor a historical cost. C. However, translating all assets at the current rate does maintain underlying ratios and relationships that exist in the foreign currency statements. D. Revenues and expenses which occur evenly throughout the period are translated at the average-for-the-period exchange rate. Income items, such as gains and losses, which are the result of a discrete event, are translated at the actual exchange rate on the date of occurrence. E. Balance sheet exposure under the current rate method is equal to the foreign entity's net assets (stockholders' equity). 1. Appreciation in the foreign currency results in a positive translation adjustment (gain); depreciation results in a negative translation adjustment (loss). IV. FASB Accounting Standards Codification Topic 830, Foreign Currency Matters, (FASB ASC 830) provides guidelines for the translation of foreign currency financial statements by U.S.based multinational corporations. The appropriate translation method and disposition of translation adjustment depends upon the functional currency of the foreign entity. A. The functional currency is the primary currency of the foreign entity's operating environment. It can be either the U.S. dollar or a foreign currency. 1. U.S. GAAP lists six indicators that are to be used in determining an entity's functional currency. There are no guidelines as to how these indicators are to be weighted. B. If a foreign currency is the functional currency, the foreign entity's financial statements are "translated" using the current rate method and the resulting translation adjustment is reported as a separate component of equity. The average-for-the-period exchange rate is used to translate the foreign entity's income statement. 1. Upon the sale or liquidation of a specific foreign entity, the cumulative translation adjustment related to that entity is taken to income as an adjustment to the gain or loss on sale or liquidation. C. If the U.S. dollar is the functional currency, foreign currency financial statements are "remeasured" using the temporal method with "remeasurement" gains and losses reported in operating income. D. If a foreign entity operates in a highly inflationary economy (cumulative three-year inflation greater than 100%), its financial statements are remeasured into U.S. dollars using the temporal method and remeasurement gains and losses are reported in income. V. Some companies hedge the balance sheet exposures of their foreign entities so as to avoid adverse effects on income and/or stockholders' equity. A. FASB Accounting Standards Codification Topic 815, Derivatives and Hedging (FASB ASC 815) refers to this as a hedge of a net investment in a foreign operation and stipulates that gains and losses on hedging instruments used in this manner should be treated in the same fashion as the translation adjustment (remeasurement gain/loss) being hedged. B. The paradox of hedging balance sheet exposure is that by avoiding a translation adjustment (remeasurement gain/loss), realized foreign exchange gains and losses can arise.
10-2 .
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Chapter 10 - Translation of Foreign Currency Financial Statements
Answer to Discussion Question: How Do We Report This? This case represents the ongoing debate as to the proper reporting of foreign currency balances. Southwestern has invested the equivalent of $30,000 (150,000 vilseks) in each of three assets. The relative value of the vilsek has now changed. Thus, 150,000 vilseks now can be converted into $34,500. However, the subsidiary does not have vilseks--only land, inventory, and investments. Although the current exchange rate is given, the company has no apparent plans to convert its assets into dollars. Instead, these three assets are being held, each with a historical cost of 150,000 vilseks. Under the temporal method, these assets (except for the investments if carried at market value) would be reported in the parent's balance sheet at the original cost of $30,000. Unfortunately, as the Finance Director points out, an old, outdated rate is being utilized if the $30,000 figure is reported. (Of course, given that prices tend to change over time, the same can be said for any asset reported at historical cost.) Conversely, the current rate method requires that each of the three assets be reported at $34,500 based on the current exchange rate. As the controller indicates, though, $34,500 was not the original cost expended by Southwestern. In addition, using the current rate means that each of the assets will constantly report a "floating" value, one that will change with each exchange rate fluctuation. Finally, the $34,500 figure is based on the current value of the vilsek ($.23) and the historical cost in vilseks (150,000 vilseks) for the three assets. The current exchange rate is only significant if the assets are sold with the proceeds being converted into U.S. dollars. Since an imminent sale is not indicated, the validity of reporting the $34,500 might again be questioned. In addition, even if the assets were sold, $34,500 does not accurately reflect the proceeds in U.S. dollars because 150,000 vilseks is the historical cost and not the current market value of each of these assets. As a classroom exercise or written assignment, students could be required to select a reported value for each of the three assets and then defend their position. What figure is actually the fairest representation of each of the three assets? What figure is the best conveyor of information to an outside party? There is no single best answer to these questions. The purpose of this type of exercise is to encourage students to consider the objectives of financial reporting. Students should not just assume that the current official pronouncement is correct. One possible approach to the case is to assign several students to represent banks or stockholders and discuss the types of information that is most needed by these users. Another group of students can take the position of the company responsible for preparing the information and discuss management's preference for providing one type of information over another. Yet another group could take a purely theoretical approach and discuss the goals that accounting has attempted to reach. Although a final resolution may not be achieved, some excellent class discussion is possible. The temporal and current rate methods of translation differ primarily with regard to the exchange rate used to translate those assets that are reported at historical cost--inventories, prepaids, fixed assets, and intangibles. The debate regarding the appropriate exchange rate for translating assets exists only because some assets are reported at historical cost. If all assets were reported at their current value, there would be no need to use the historical exchange rate for translating assets in order to maintain the asset's historical cost in U.S. dollar terms. All assets would be translated at the current exchange rate. The differences between the temporal method and current rate method would disappear.
10-3 .
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Chapter 10 - Translation of Foreign Currency Financial Statements
Answers to Questions 1. The two major issues related to the translation of foreign currency financial statements are: (a) which method should be used and (b) where should the resulting translation adjustment be reported in the consolidated financial statements. The first issue relates to determining the appropriate exchange rate (historical, current, or average for the current period) for the translation of foreign currency balances. Those items translated at the current exchange rate are exposed to translation adjustment. The second issue relates to whether the translation adjustment should be treated as a gain or loss in income, or should be deferred as a separate component of stockholders’ equity. 2. Balance sheet exposure arises when a foreign currency balance is translated at the current exchange rate. By translating at the current exchange rate, the foreign currency item in essence is being revalued in U.S. dollar terms on the consolidated financial statements. There will be either a net asset balance sheet exposure or net liability balance sheet exposure depending upon whether assets translated at the current rate are greater or less than liabilities translated at the current rate. Balance sheet exposure generates a translation adjustment which does not result in an inflow or outflow of cash. Transaction exposure, which results from the receipt or payment of foreign currency, generates foreign exchange gains and losses which are realized in cash. 3. Although balance sheet exposure does not result in cash inflows and outflows, it does nevertheless affect amounts reported in consolidated financial statements. If the foreign currency is the functional currency, translation adjustments will be reported in stockholders’ equity. If translation adjustments are negative and therefore reduce total stockholders’ equity, there is an adverse (inflationary) impact on the debt to equity ratio. Companies with restrictive debt covenants requiring them to stay below a maximum debt to equity ratio, may find it necessary to hedge their balance sheet exposure so as to avoid negative translation adjustments being reported. If the U.S. dollar is the functional currency or an operation is located in a high inflation country, remeasurement gains and losses are reported in income. Companies might want to hedge their balance sheet exposure in this situation to avoid the adverse impact remeasurement losses can have on consolidated income and earnings per share. The paradox in hedging balance sheet exposure is that, by agreeing to receive or deliver foreign currency in the future under a forward contract, a transaction exposure is created. This transaction exposure is speculative in nature, given that there is no underlying inflow or outflow of foreign currency that can be used to satisfy the forward contract. By hedging balance sheet exposure, a company might incur a realized foreign exchange loss to avoid an unrealized negative translation adjustment or unrealized remeasurement loss. 4. The gains and losses arising from financial instruments used to hedge balance sheet exposure are treated in a similar manner as the item the hedge is intended to cover. If the foreign currency is the functional currency, gains and losses on hedging instruments will be taken to accumulated other comprehensive income. If the U.S. dollar is the functional currency, gains and losses on the hedging instruments will be offset against the related remeasurement gains and losses.
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.
Chapter 10 - Translation of Foreign Currency Financial Statements
5. The major concept underlying the temporal method is that the translation process should result in a set of translated U.S. dollar financial statements as if the foreign subsidiary’s transactions had actually been carried out using U.S. dollars. To achieve this objective, assets carried at historical cost and stockholders’ equity are translated at historical exchange rates; assets carried at current value and liabilities (carried at current value) are translated at the current exchange rate. Under this concept, the foreign subsidiary’s monetary assets and liabilities are considered to be foreign currency cash, receivables, and payables of the parent which are exposed to transaction risk. For example, if the foreign currency appreciates, then the foreign currency receivables increase in U.S. dollar value and a gain is recognized. Balance sheet exposure under the temporal method is analogous to the net transaction exposure which exists from having both receivables and payables in a particular foreign currency. The major concept underlying the current rate method is that the entire foreign investment is exposed to foreign exchange risk. Therefore all assets and liabilities are translated at the current exchange rate. Balance sheet exposure under this concept is equal to the net investment. 6. The Retained Earnings balance is created by a multitude of transactions: all revenues, expenses, gains, losses, and dividends since the company’s inception. Identifying each component of this account (so that a separate translation can be made) would be virtually impossible. Therefore, in the initial year that Statement 52 was applied, the ending balance calculated under Statement 8 was merely brought forward. Thereafter, the ending balance translated each year for retained earnings becomes the beginning figure to be reported for the following year. 7. The major differences relate to non-monetary assets carried at historical cost and related expenses, i.e., inventory and cost of goods sold; property, plant, and equipment and depreciation expense; and intangible assets and amortization expense. Under the temporal method, these items are all translated at historical exchange rates. Under the current rate method, the assets are translated at the current exchange rate and the related expenses are translated at the average exchange rate for the current period. 8. The functional currency is the currency of the subsidiary’s primary economic environment. It is usually identified as the currency in which the company generates and expends cash. FASB ASC 830 recommends that several factors such as the location of primary sales markets, sources of materials and labor, the source of financing, and the amount of intercompany transactions should be evaluated in identifying an entity’s functional currency. FASB ASC 830 does not provide any guidance as to how these factors are to be weighted (equally or otherwise) when identifying an entity’s functional currency. 9. The foreign subsidiary's net asset position in foreign currency at the beginning of the period is first determined. Changes in net assets are determined to explain the net asset balance in foreign currency at the end of the period. The beginning net asset position and changes in net assets are translated at appropriate exchange rates and the ending net asset position in dollars is determined. The ending net asset balance in foreign currency is then translated at the current rate and this result is subtracted from the ending net asset position in dollars (already calculated). The difference is the translation adjustment. It is positive if the actual dollar net asset position is less than the net asset position based on the current exchange rate. The translation adjustment is negative if the actual dollar net asset position is greater than if translated at the current rate. The cumulative translation adjustment is reported on the U.S. dollar Balance Sheet in the Stockholders’ Equity Section as a part of Accumulated Other Comprehensive Income.
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Chapter 10 - Translation of Foreign Currency Financial Statements
10. One theory mentioned by the FASB identifies the translation adjustment as a measure of unrealized increases and decreases that have occurred in the value of the foreign subsidiary because of exchange rate changes. A second theory argues that this adjustment is no more than a mechanically derived number that must be included to keep the balance sheet in equilibrium although the figure has no intrinsic meaning. The FASB did not indicate that either theory is considered more appropriate. 11. Translation is required when a foreign currency is the functional currency. Remeasurement is required in two situations: a. The U.S. dollar is the functional currency. b. The foreign subsidiary operates in a highly inflationary country. Remeasurement is carried out using the temporal method, with remeasurement gains and losses reported in consolidated income. Translation is done using the current rate method and the resulting translation adjustment is carried as a separate component of stockholders’ equity. 12. The temporal method must be used to remeasure the financial statements of operations in highly inflationary countries. One reason for mandating the use of the temporal method is that it avoids the disappearing plant problem that exists when the current rate method is used. Under the current rate method, fixed assets are translated at current exchange rates. With high rates of inflation, the foreign currency will depreciate significantly. When the historical cost of fixed assets is translated at a significantly lower current exchange rate, the dollar value of fixed assets “disappears.” This problem is avoided by translating at the historical exchange rate as is done under the temporal method. 13. Differences exist between IFRS and U.S. GAAP with regard to (a) the hierarchy of factors used to determine the functional currency and (b) the method used to translate the financial statements of a subsidiary located in a hyperinflationary country. IAS 21 establishes primary factors and other factors to be considered in determining an entity’s functional currency. When the indicators are mixed and the functional currency is not obvious, the parent must give priority to the primary indicators in determining the foreign entity’s functional currency. U.S. GAAP does not have a similar hierarchy. In translating the foreign currency financial statements of a subsidiary located in a highly inflationary economy, IAS 21 requires financial statements to first be restated for local inflation and then translated into the parent’s currency using the current exchange rate for all financial statement items. In contrast, U.S. GAAP requires use of the temporal method with no adjustment for inflation in this situation.
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Chapter 10 - Translation of Foreign Currency Financial Statements
Answers to Problems 1. C (Definition of functional currency) 2. C (Comparison of current rate and temporal methods) 3. C (Translation process (current rate method)) 4. B (Determine appropriate translation method and resulting translation adjustment) Because the peso is the functional currency, the financial statements must be translated using the current rate method. Therefore, answers a and d can be eliminated. Because the subsidiary has a net asset position and the peso has appreciated from $.16 to $.19, a positive translation adjustment will result. 5. A (Translation process (current rate method) – asset and related expense) All asset accounts are translated at current rates. 6. A (Translation process (current rate method) – assets) Because the foreign currency is the functional currency, a translation is required. All assets accounts are translated at current rates. 7. C (Remeasurement process (temporal method) – assets) Because the U.S. dollar is the functional currency, a remeasurement is required. All receivables are remeasured at current rates. Assets carried at historical cost, such as prepaid insurance and goodwill, are remeasured at historical rates. 8. A (Remeasurement process (temporal method) – inventory) The U.S. dollar is the foreign subsidiary’s functional currency, so a remeasurement is appropriate. Inventory is translated at the historical exchange rate [100,000 x $.16 = $16,000]. 9. A (Remeasurement process (temporal method) – cost of goods sold) The U.S. dollar is the foreign subsidiary’s functional currency, so a remeasurement is appropriate. Cost of goods sold is translated at the historical rate in effect when the inventory was acquired [100,000 x $.16 = $16,000]. 10. D (Translation process (current rate method) – marketable securities and inventory) The foreign currency is the functional currency, so a translation is appropriate. All assets are translated at the current exchange rate of $.19.
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Chapter 10 - Translation of Foreign Currency Financial Statements
11. C (Remeasurement process (temporal method) – marketable securities and inventory) The U.S. dollar is the functional currency, so a remeasurement is appropriate. Inventory (carried at cost) is remeasured at the historical exchange rate of $.16. Marketable equity securities (carried at market value) are remeasured at the current exchange rate of $.19. 12. C (Highly inflationary economy (temporal method) – cost of goods sold) Beginning inventory Purchases Ending inventory Cost of goods sold
FCU
200,000 x $1.00 = $ 200,000 10,300,000 x $0.80 = 8,240,000 (500,000) x $0.75 = (375,000) FCU 10,000,000 $8,065,000
13. C (Calculation of translation adjustment) Beginning net assets, 1/1………….. Increase in net assets: Net income .................................. Ending net assets, 12/31 ................. Ending net assets at current exchange rate ................ Translation adjustment (positive) .
P20,000
x $.15 =
$ 3,000
10,000 P30,000
x $.19 =
1,900 $ 4,900
P30,000
x $.21 =
$ 6,300 $(1,400)
14. C (Concepts underlying current rate and temporal methods) By translating items carried at historical cost by the historical exchange rate, the temporal method maintains the underlying valuation method used by the foreign subsidiary. 15. A (Calculation of remeasurement gain/loss) Beginning net monetary assets, 1/1 Increases in net monetary assets: Sale of inventory ........................ Decreases in net monetary assets: Purchase of equipment.............. Purchase of inventory ............... Transfer to parent ...................... Ending net monetary assets, 12/31 Ending net monetary assets at the current exchange rate ......... Remeasurement gain ......................
P100,000
x $.16 =
$16,000
50,000
x $.20 =
10,000
(60,000) (30,000) (10,000) P 50,000
x $.16 = x $.18 = x $.21 =
(9,600) (5,400) (2,100) $ 8,900
P 50,000
x $.22 =
(11,000) $(2,100)
16. C (Remeasurement process (temporal method)) Marketable equity securities are carried at market value and therefore translated at the current exchange rate under the temporal method.
10-8 .
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Chapter 10 - Translation of Foreign Currency Financial Statements
17. B (Determine appropriate translation method and treatment of translation adjustment) When the U.S. dollar is the functional currency, U.S. GAAP requires remeasurement using the temporal method with remeasurement gains and losses reported in income. 18. B (Translation process (current rate method) – wages expense and wages payable) Wages expense is translated at the average exchange rate; wages payable are translated at the current exchange rate. 19. C (Treatment of gains and losses on hedges of net investments) Gains and losses on hedges of net investments (whether through a forward contract, borrowing, or other technique) are offset against the translation adjustment being hedged. 20. D (Presentation of remeasurement gain/loss on income statement) Remeasurement gains are reported in the income statement as a part of income from continuing operations. 21. (10 minutes) (Specify appropriate exchange rates for the translation of foreign currency financial statements under the current rate method) Rent expense—use actual (historical) rate at time of recording. Rent expense would often be recorded evenly throughout the year so that an average rate for the period is acceptable. Dividends—use historical rate at time of recording, the date of declaration. Equipment—as an asset, use current rate at the balance sheet date. Notes payable—as a liability, use current rate at the balance sheet date. Sales—use actual (historical) rate at time of recording. Sales often occur evenly throughout the year so that an average rate is acceptable. However, if sales are more prevalent at a particular time during the year, historical rates should be used. Depreciation expense—use historic rate at time of recording. In most cases, average rate for the year is acceptable, because depreciation occurs evenly throughout the year. Depreciation is recorded at year-end only as a matter of convenience. Cash—as an asset, use the current rate at the balance sheet date. Accumulated depreciation—as a contra-asset account, use the current exchange rate at the balance sheet date.
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Chapter 10 - Translation of Foreign Currency Financial Statements
21. (continued) Common stock—as an equity account, use historic rate at time of recording, the date of issuance. 22. (5 minutes) Determine Translated Values under the Current Rate Method As a translation, both the asset (inventory) and the liability (accounts payable) utilize the current exchange rate at the balance sheet date (December 31). Thus, the translated values are as follows: Inventory
LCU120,000 x 25% left = LCU30,000 LCU 30,000 x $0.35 = $10,500
Accounts payable LCU120,000 x 40% unpaid = LCU48,000 LCU 48,000 x $0.35 = $16,800 23. (10 minutes) (Determine appropriate exchange rates under the current rate method [translation] and temporal method [remeasurement]) Translation Accounts payable $.16 C Accounts receivable $.16 C Accumulated depreciation $.16 C Advertising expense $.19 A Amortization expense $.19 A Buildings $.16 C Cash $.16 C Common stock $.28 H Depreciation expense $.19 A Dividends (10/1) $.20 H Notes payable $.16 C Patents (net) $.16 C Salary expense $.19 A Sales $.19 A
Remeasurement $.16 C $.16 C $.26 H $.19 A $.25 H $.26 H $.16 C $.28 H $.26 H $.20 H $.16 C $.25 H $.19 A $.19 A
* C = current rate, H = historical rate, A = average rate
10-10 .
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Chapter 10 - Translation of Foreign Currency Financial Statements
24. (20 minutes) (Calculate translation adjustment and remeasurement gain/loss and explain their economic relevance) The translation adjustment and remeasurement gain/loss can be determined as the plug figure that keeps the dollar balance sheet in balance:
Cash Inventory Fixed assets Total Notes payable Owners' equity Translation adjustment Retained earnings (remeasurement loss) Total
Translation CHF Rate 800,000 $ 1.10 1,300,000 $ 1.10 4,000,000 $ 1.10 6,100,000 2,100,000 $ 1.10 4,000,000 $ 1.00
6,100,000
RemeasureUS$ ment Rate 880,000 $ 1.10 1,430,000 $ 1.00 4,400,000 $ 1.00 6,710,000 2,310,000 $ 1.10 4,000,000 $ 1.00 400,000
US$ 880,000 1,300,000 4,000,000 6,180,000 2,310,000 4,000,000
(130,000) 6,180,000
6,710,000
Alternatively, the translation adjustment and remeasurement loss can be calculated by analyzing the subsidiary’s balance sheet exposure: Translation Beginning net assets, 12/18 Ending net assets, 12/31 at current exchange rate Translation adjustment (positive)
CHF 4,000,000 4,000,000
$ $
US$ 1.00 H $ 4,000,000 1.10 C 4,400,000 $ (400,000)
Remeasurement Beginning net monetary liabilities, 12/18 Ending net monetary liabilities, 12/31 (at current exchange rate) Remeasurement loss
CHF (1,300,000) $
US$ 1.00 H $ (1,300,000)
(1,300,000) $
1.10 C $
(1,430,000) 130,000
Economic Relevance of Translation Adjustment The translation adjustment increases stockholders’ equity by $400,000. The positive translation adjustment arises because the Swiss subsidiary has a net asset position of CHF4,000,000 and the Swiss franc appreciates by $.10 [CHF4,000,000 x $.10 = $400,000]. The positive translation adjustment is not realized in terms of dollar cash flow. It would be a realized gain only if Stephanie sold this operation on December 31 for exactly CHF4,000,000 and converted the sales proceeds into dollars at the current exchange rate of $1.10 per Swiss franc.
10-11 .
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Chapter 10 - Translation of Foreign Currency Financial Statements
24. (continued) Economic Relevance of Remeasurement Loss The remeasurement loss arises because the Swiss subsidiary has a net monetary liability position of CHF1,300,000 (Cash of CHF800,000 less Notes payable of CHF2,100,000) and the Swiss franc has appreciated by $.10 [CHF1,300,000 x $.10 = $130,000]. The loss is unrealized. It would be realized only if the Swiss subsidiary converted its Swiss franc cash into dollars at December 31, thereby realizing a transaction gain of $80,000 [CHF800,000 x ($1.10-$1.00)], and the parent paid off the Swiss franc note payable using U.S. dollars, thereby realizing a transaction loss of $210,000 [CHF2,100,000 x ($1.10-$1.00)]. (The note could have been paid at December 1 for $2,100,000 [CHF2,100,000 x $1.00]. At December 31, it takes $2,310,000 to pay off the note [CHF2,100,000 x $1.10].) 25. (15 minutes) (Determine the amounts at which foreign currency balances are reported on a foreign subsidiary’s trial balance and in the parent’s consolidated financial statements) a. Remeasurement of Swiss franc (CHF) balances into Israeli shekels (ILS) to report on the Israeli subsidary’s trial balance. December 31, 2015 Interest expense Interest payable Note payable
CHF 25,000 x 31,250 x 500,000 x
Exchange Rate 3.95 A = 4.02 C = 4.02 C =
ILS* 98,750 125,625 2,010,000
* Amounts at which the CHF balances are carried on the ILS trial balance b. Translation of remeasured Swiss franc (CHF) balances into U.S. dollars (USD) to report in the U.S. parent’s consolidated financial statements. December 31, 2015 Interest expense Interest payable Note payable
ILS 98,750 x 125,625 x 2,010,000 x
Exchange Rate USD** 0.27 A = 26,662.50 0.25 C = 31,406.25 0.25 C = 502,500.00
** Amounts at which the CHF balances are reported in the USD financial statements
10-12 .
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Chapter 10 - Translation of Foreign Currency Financial Statements
26. (30 minutes) (Prepare financial statements for a foreign subsidiary and then translate them into U.S. dollars) Fenwicke Company Subsidiary Income Statement LCU Rent revenue 60,000 x $1.90 A Interest expense (10,000) x $1.90 A Depreciation expense (14,000) x $1.90 A Repair expense (4,000) x $1.85*H Net income 32,000
= = = =
U.S. Dollars $114,000 (19,000) (26,600) (7,400) $ 61,000
* Repair expense is the only expense not incurred evenly throughout the year. Statement of Retained Earnings LCU Retained earnings, 1/1 -0Net income 32,000 (above) Dividends, 12/31 (5,000) x $1.80 H Retained earnings, 12/31 27,000
Cash Accounts receivable Building Accumulated depreciation Total assets Interest payable Note payable Common stock Retained earnings Translation adjustment Total liabilities and equities
Balance Sheet LCU 41,000 x $1.80 C 10,000 x $1.80 C 140,000 x $1.80 C (14,000) x $1.80 C 177,000 10,000 x $1.80 C 100,000 x $1.80 C 40,000 x $2.00 H 27,000 (above) (below) 177,000
Computation of Translation Adjustment Beginning net assets -0Increase in net assets: Issued common stock 40,000 Net income 32,000 Decrease in net assets: Dividends (5,000) Ending net assets 67,000 Ending net assets at current exchange rate 67,000 Translation adjustment (negative)
10-13 .
.
U.S. Dollars -0$61,000 = (9,000) $52,000 U.S. Dollars $ 73,800 18,000 252,000 (25,200) $318,600 = $ 18,000 = 180,000 = 80,000 52,000 (11,400) $318,600 = = = =
-0x $2.00 (above)
=
$ 80,000 61,000
x $1.80
=
(9,000) $132,000
x $1.80
=
120,600 $ 11,400
Chapter 10 - Translation of Foreign Currency Financial Statements
27. (30 minutes) (Prepare a statement of cash flows for a foreign subsidiary and then translate it into U.S. dollars) Fenwicke Company Subsidiary Statement of Cash Flows LCU
U.S. Dollars
Operating Activities: Net income 32,000 (from prob 26) $ 61,000 plus: depreciation 14,000 x $1.90 A = 26,600 less: increase in accounts receivable (10,000) x $1.90 A = (19,000) plus: increase in interest payable 10,000 x $1.90 A = 19,000 Cash flow from operations 46,000 87,600 Investing Activities: Purchase of building (140,000) x $2.00 H = (280,000) Financing Activities: Sale of common stock 40,000 x $2.00 H = 80,000 Borrowing on note 100,000 x $2.00 H = 200,000 Dividends (5,000) x $1.80 H = (9,000) 135,000 271,000 Increase in cash 41,000 78,600 Effect of exchange rate change on cash (4,800) Cash, 1/1 -0-0Cash, 12/31 41,000 x $1.80 C = $ 73,800
10-14 .
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Chapter 10 - Translation of Foreign Currency Financial Statements
28. (25 minutes) (Compute translation adjustment and remeasurement gain/loss) a. Translation—only changes in net assets have an impact on the computation of the translation adjustment. Net asset balance 1/1 Increases in net assets (income): Sold inventory at a profit 5/1 Sold land at a gain 6/1 Decreases in net assets: Paid a dividend 12/1 Depreciation recorded Net asset balance 12/31 Net asset balance 12/31 at current exchange rate Translation adjustment—positive
KM30,000
x $.32 =
$ 9,600
5,000 1,000
x $.34 = x $.35 =
1,700 350
(3,000) (2,000) KM31,000
x $.41 = x $.37 =
(1,230) ( 740) $ 9,680
KM31,000
x $.42 =
(13,020) $(3,340)
b. Remeasurement—only changes in net monetary assets and liabilities have an impact on the computation of the remeasurement gain. Beginning net monetary liability position KM (3,000) Increases in monetary assets: Sold inventory 5/1 15,000 Sold land 6/1 5,000 Decreases in monetary assets: Bought inventory 10/1 (12,000) Bought land 11/1 (4,000) Paid a dividend 12/1 (3,000) Ending net monetary liability position KM(2,000) Ending net monetary liability position at current exchange rate KM(2,000) Remeasurement gain
x $.32 =
$ ( 960)
x $.34 = x $.35 =
5,100 1,750
x $.39 = x $.40 = x $.41 =
(4,680) (1,600) (1,230) $(1,620)
x $.42 =
(840) $ (780)
Note: The purchase of land on account did not result in a decrease in monetary assets, rather an increase in monetary liabilities. Payment on the note payable and collection of accounts receivable do not affect the net monetary liability position.
10-15 .
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Chapter 10 - Translation of Foreign Currency Financial Statements
29. (20 minutes) (Compute translation adjustment and remeasurement gain/loss) a. The translation adjustment is based on changes in the net assets of the subsidiary. Net assets, 1/1 Changes in net assets: Rendered services Incurred expenses Net assets, 12/31 Net assets, 12/31 at current exchange rate Translation adjustment (positive)
90,000 LCU x
$0.35 =
$31,500
45,000 LCU x (27,000) LCU x 108,000 LCU
$0.36 = $0.37 =
16,200 (9,990) $37,710
108,000 LCU x
$0.41 =
44,280 $(6,570)
b. The remeasurement gain or loss is based on changes in the net monetary assets of the subsidiary. Net monetary assets, 1/1 Changes in net monetary assets: Rendered services Incurred expenses Net monetary assets, 12/31 Net monetary assets, 12/31 at current exchange rate Remeasurement gain c. Translated value of land Remeasured value of land
20,000 LCU x
$0.35 =
$7,000
45,000 LCU x (27,000) LCU x 38,000 LCU
$0.36 = $0.37 =
16,200 (9,990) $13,210
38,000 LCU x
$0.41 =
15,580 $(2,370)
70,000 LCU 70,000 LCU
x $.41 = x $.34 =
$28,700 $23,800
30. (10 minutes) (Determine the appropriate exchange rate under the current rate method [translation] and temporal method [remeasurement]) (a) Current Rate Method Account Translation Sales $0.20 A Inventory $0.22 C Equipment $0.22 C Rent expense $0.20 A Dividends $0.21 H Notes receivable $0.22 C Accumulated depreciation--equipment $0.22 C Salary payable $0.22 C Depreciation expense $0.20 A
(b) Temporal Method Remeasurement $0.20 A $0.19 H $0.13 H $0.20 A $0.21 H $0.22 C $0.13 H $0.22 C $0.13 H
C = current exchange rate, A = average exchange rate, H = Historical exchange rate
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Chapter 10 - Translation of Foreign Currency Financial Statements
31. (30 minutes) (Determine translation adjustment; prepare journal entries for forward contract hedge of balance sheet exposure; determine amount to be reported in accumulated other comprehensive income) a. Net assets, 1/1 (132,000 – 54,000) Change in net assets: Net income Dividends, 3/1 Dividends, 10/1 Net assets, 12/31 Net assets at current exchange rate, 12/31 Translation adjustment (negative)
78,000 kites
x $0.80 =
$62,400
26,000 kites (5,000) kites (5,000) kites 94,000 kites
x $0.77 = x $0.78 = x $0.76 =
20,020 (3,900) (3,800) $74,720
94,000 kites
x $0.75 =
70,500 $ 4,220
b. Forward contract journal entries 10/1 No entry 12/31
Forward Contract ................................. 2,000 Translation Adjustment (positive) . 2,000 (To record the change in the value of the forward contract as an adjustment to the translation adjustment) Foreign Currency (kites) ...................... 150,000 Cash ................................................. 150,000 (To record the purchase of 200,000 kites at the spot rate of $.75) Cash .................................................... 152,000 Foreign Currency (kites) ................. 150,000 Forward Contract ............................ 2,000 (To record delivery of 200,000 kites, receipt of $152,000, and close the forward contract account.)
c. The net negative translation adjustment (debit balance) to be reported in Accumulated Other Comprehensive Income at 12/31 is $2,220 ($4,220 – $2,000).
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Chapter 10 - Translation of Foreign Currency Financial Statements
32. (45 minutes) (Translation and remeasurement of foreign subsidiary trial balance) a. Translation of Subsidiary Trial Balance Debits Credits Cash…………………………………. 8,000 KQ x 1.62 $12,960 Accounts Receivable…………….. 9,000 KQ x 1.62 14,580 Equipment………………………….. 3,000 KQ x 1.62 4,860 Accumulated Depreciation……… 600 KQ x 1.62 $ 972 Land………………………………… 5,000 KQ x 1.62 8,100 Accounts Payable………………… 3,000 KQ x 1.62 4,860 Notes Payable…………………….. 5,000 KQ x 1.62 8,100 Common Stock…………………… 10,000 KQ x 1.71 17,100 Dividends……….…………………. 4,000 KQ x 1.66 6,640 Sales………………………………… 25,000 KQ x 1.64 41,000 Salary Expense…………………… 5,000 KQ x 1.64 8,200 Depreciation Expense…………… 600 KQ x 1.64 984 Miscellaneous Expense…………. 9,000 KQ x 1.64 14,760 $71,084 Translation Adjustment (negative) 948 $72,032 $72,032 Calculation of Translation Adjustment Net assets, 1/1………………………….. -0-0Increase in net assets: Common stock issued………………. 10,000 KQ x 1.71 $17,100 Sales……………………………………. 25,000 KQ x 1.64 41,000 Decrease in net assets: Dividends……..……………………….. ( 4,000) KQ x 1.66 (6,640) Salary expense……………………….. ( 5,000) KQ x 1.64 (8,200) Depreciation expense………………. ( 600) KQ x 1.64 ( 984) Miscellaneous expense ……………. ( 9,000) KQ x 1.64 (14,760) Net assets, 12/31………………………. Net assets, 12/31 at current exchange rate……………. Translation adjustment (negative)
16,400* KQ
$27,516
16,400 KQ x 1.62
26,568 $ 948
* This amount can be verified as ending assets (24,400 KQ) minus ending liabilities (8,000 KQ) – net assets, 12/31 = 16,400 KQ.
10-18 .
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Chapter 10 - Translation of Foreign Currency Financial Statements
32. (continued) b. Remeasurement of Subsidiary Trial Balance Cash Accounts Receivable Equipment Accumulated Depreciation Land Accounts Payable Notes Payable Common Stock Dividends Sales Salary Expense Depreciation Expense Miscellaneous Expense
8,000 9,000 3,000 600 5,000 3,000 5,000 10,000 4,000 25,000 5,000 600 9,000
KQ x 1.62 KQ x 1.62 KQ x 1.71 KQ x 1.71 KQ x 1.59 KQ x 1.62 KQ x 1.62 KQ x 1.71 KQ x 1.66 KQ x 1.64 KQ x 1.64 KQ x 1.71 KQ x 1.64
Remeasurement loss (debit)
Debits $12,960 14,580 5,130
Credits
$ 1,026 7,950 4,860 8,100 17,100 6,640 41,000 8,200 1,026 14,760 $71,246 840 $72,086
$72,086
Calculation of Remeasurement Loss Net monetary assets, 1/1 -0-0Increase in net monetary assets: Common stock issued 10,000 KQ x 1.71 $17,100 Sales 25,000 KQ x 1.64 41,000 Decrease in net monetary assets: Acquired equipment (3,000) KQ x 1.71 (5,130) Acquired land (5,000) KQ x 1.59 (7,950) Dividends (4,000) KQ x 1.66 (6,640) Salary expense (5,000) KQ x 1.64 (8,200) Miscellaneous expense (9,000) KQ x 1.64 (14,760) Net monetary assets, 12/31 Net monetary assets, 12/31 at current exchange rate Remeasurement loss (debit)
9,000* KQ
$15,420
9,000 KQ x 1.62
14,580 $ 840
* This amount can be verified as ending assets (17,000 KQ) minus ending liabilities (8,000 KQ) – net assets, 12/31 = 9,000 KQ.
10-19 .
.
Chapter 10 - Translation of Foreign Currency Financial Statements
33. (30 minutes) (Translate financial statements of a foreign subsidiary) LIVINGSTON COMPANY Income Statement For the Year Ending December 31, 2015
Sales Cost of goods sold Gross profit Less: Operating expenses Gain on sale of equipment Net income
Goghs 270,000 (155,000) 115,000 (54,000) 10,000 71,000
Ex Rate 1.59 1.59
Code A A
1.59 1.72
A H
U.S. Dollars 429,300 (246,450) 182,850 (85,860) 17,200 114,190
Statement of Retained Earnings For the Year Ending December 31, 2015
Retained earnings, 1/1 Net income Less: Dividends Retained earnings, 12/31
Goghs 216,000 71,000 (26,000) 261,000
Ex Rate given above 1.61
Code
H
U.S. Dollars 395,000 114,190 (41,860) 467,330
Balance Sheet December 31, 2015
Assets Cash Receivables Inventory Fixed assets (net) Total assets Liabilities and Equities Liabilities Common stock Retained earnings, 12/31 Translation adjustment Total liabilities and equities
Goghs
Ex Rate
Code
U.S. Dollars
44,000 116,000 58,000 339,000 557,000
1.54 1.54 1.54 1.54
C C C C
67,760 178,640 89,320 522,060 857,780
176,000 120,000
1.54 2.08
C H
271,040 249,600
above
467,330 (131,710) 856,260
261,000 557,000
10-20 .
.
Chapter 10 - Translation of Foreign Currency Financial Statements
33. (continued) Calculation of Translation Adjustment: Goghs 336,000 71,000 (26,000) 381,000 381,000
Net assets, 1/1 Net income Dividends Net assets, 12/31 Net assets at current exchange rate Translation adjustment, 2015 (negative) Cumulative translation adjustment, 1/1 (negative) Cumulative translation adjustment, 12/31 (negative)
Ex Rate Code 1.67 BOY above above 1.54
C
given
Code: A = average; C = current; H = historical; BOY = beginning of year
10-21 .
.
U.S. Dollars 561,120 114,190 (41,860) 633,450 586,740 46,710 85,000 131,710
Chapter 10 - Translation of Foreign Currency Financial Statements
34. (35 minutes) (Compute remeasurement gain/loss and translation adjustment) a. Remeasurement Gain or Loss
Net monetary assets, 1/1/15* Increases in net monetary assets: Issued Common Stock (4/1/15) Sold Building** (7/1/15) Sales (2015) Decreases in net monetary assets: Purchased Equipment (4/1/15) Paid Dividends (10/1/15) Rent Expense (2015) Salary Expense (2015) Utilities Expense (2015) Net monetary assets, 12/31/15 Net monetary assets, 12/31/15 at current exchange rate Remeasurement gain (credit)
KR 35,000
Exchange Rate x $3.00 =
US$ $105,000
13,000 10,000 162,000
x x x
$3.10 $3.30 $3.20
= = =
40,300 33,000 518,400
(64,000) (57,000) (21,500) (45,000) (7,000) 25,500
x x x x x
$3.10 $3.40 $3.20 $3.20 $3.20
= = = = =
(198,400) (193,800) (68,800) (144,000) (22,400) $69,300
25,500
x
$3.50
=
89,250 $(19,950)
* Net monetary assets: (Cash + Accounts Receivable) - (Account Payable + Bonds Payable) ** Cash proceeds from the sale of the building of KR10,000 is determined by adding the Book value of the building sold of KR1,500 and the Gain on sale of building of KR 8,500. b. Translation Adjustment
Net assets, 1/1/15* Increases in net monetary assets: Issued Common Stock (4/1/15) Gain on Sale of Building** (7/1/15) Sales (2015) Decreases in net monetary assets: Paid Dividends (10/1/15) Depreciation expense (2015) Rent Expense (2015) Salary Expense (2015) Utilities Expense (2015) Net monetary assets, 12/31/15 Net monetary assets, 12/31/15 at current exchange rate Translation adjustment (credit)
KR 124,000
Exchange Rate x $3.00 =
US$ $372,000
13,000 8,500 162,000
x x x
$3.10 $3.30 $3.20
= = =
40,300 28,050 518,400
(57,000) (40,000) (21,500) (45,000) (7,000) 137,000
x x x x x
$3.40 $3.20 $3.20 $3.20 $3.20
= = = = =
(193,800) (128,000) (68,800) (144,000) (22,400) $401,750
137,000
x
$3.50
=
479,500 $ (77,750)
* Net assets: Common stock + Retained earnings ** Selling a building at a gain of KR 8,500 increases net assets by that amount. 10-22 .
.
Chapter 10 - Translation of Foreign Currency Financial Statements
35. (90 minutes) (Remeasure non-functional currency accounts into foreign functional currency and then translate foreign functional currency financial statements into U.S. dollars) a. Remeasurement of Mexican Operations Accounts payable Accumulated depreciation Building and equipment Cash Depreciation expense Inventory (beginning —income statement) Inventory (ending —income statement) Inventory (ending—balance sheet) Purchases Receivables Salary expense Sales Main office
Canadian Dollars Debit Credit 17,150 4,750 10,000 20,650 500
Pesos 49,000 19,000 40,000 59,000 2,000
x .35 C x .25 H x .25 H x .35 C x .25 H
23,000
x .30 A (’14)
28,000 28,000 68,000 21,000 9,000 124,000 30,000
x .34 A (’15) x .34 A (’15) 9,520 x .34 A (’15) 23,120 x .35 C 7,350 x .34 A 3,060 x .34 A given
Remeasurement loss Total
Schedule One
6,900
10 81,110
9,520
42,160 7,530 81,110
Schedule One—Remeasurement Loss Pesos Canadian Dollars Net monetary liabilities, 1/1/15* (16,000) x .32 (5,120) Increases in net monetary assets Sales 124,000 x .34 42,160 Decreases in net monetary assets Purchases (68,000) x .34 (23,120) Salary Expense ( 9,000) x .34 ( 3,060) Net monetary assets, 12/31/15** 31,000 10,860 Net monetary assets, 12/31/15 at current exchange rate 31,000 x .35 10,850 Remeasurement loss 10 * Net monetary liabilities, 1/1/15, can be determined by first determining the net monetary assets at 12/31/15 and then backing out the changes in monetary assets and liabilities during 2015—sales, purchases, and salary expense. ** Net monetary assets, 12/31/15: Cash + Receivables – Accounts Payable
10-23 .
.
Chapter 10 - Translation of Foreign Currency Financial Statements
35. (continued) b. and c. The following C$ financial statements are produced by combining the figures from the main operation with the remeasured figures from the branch operation. The Branch Operation and Main Office accounts offset each other. Cost of goods sold for the Mexican branch is determined by combining beginning inventory, purchases, and ending inventory as remeasured in C$. Income Statement c. Translation into U.S. dollars— For the Year Ended December 31, 2015 Current Rate Method Sales Cost of goods sold Gross profit Depreciation expense Salary expense Utility expense Gain on sale of equipment Remeasurement loss Net income
C$
354,160 (223,500) 130,660 (8,500) (29,060) (9,000) 5,000 (10) C$ 89,090
x .67 A = x .67 A = x .67 A = x .67 A = x .67 A = x .68 H = x .67 A =
$ 237,287.20 (149,745.00) 87,542.20 (5,695.00) (19,470.20) (6,030.00) 3,400.00 (6.70) $ 59,740.30
Statement of Retained Earnings For the Year Ended December 31, 2015 Retained earnings, 1/1/15 Net income (above) Dividends Retained earnings, 12/31/15
C$ C$
135,530 89,090 ( 28,000) 196,620
10-24 .
.
Given Above x .69 H =
$ 70,421.00 59,740.30 (19,320.00) $110,841.30
Chapter 10 - Translation of Foreign Currency Financial Statements
35. (continued) b. and c. Balance Sheet December 31, 2015 Cash Receivables Inventory Buildings and equipment Accumulated depreciation Total
C$
C$
Accounts payable C$ Notes payable Common stock Retained earnings Cumulative translation adjustment Total C$
46,650 75,350 107,520 177,000 (31,750) 374,770
x .65 C = $ 30,322.50 x .65 C = 48,977.50 x .65 C = 69,888.00 x .65 C = 115,050.00 x .65 C = (20,637.50) $243,600.50
52,150 76,000 50,000 196,620
x .65 C = $ 33,897.50 x .65 C = 49,400.00 x .45 H = 22,500.00 Above 110,841.30 Schedule Two 26,961.70 $ 243,600.50
374,770
Schedule Two—Translation Adjustment Net assets, 1/1/15 C$ 185,530 x .70 = Changes in net assets Net income 89,090 Above Dividends (28,000) x .69 = Net assets, 12/31/15 C$ 246,620 Net assets, 12/31/15 at current exchange rate C$ 246,620 x .65 = Translation adjustment, 2015 (negative) Cumulative translation adjustment, 1/1/15 (positive) Cumulative translation adjustment, 12/31/15 (positive)
10-25 .
.
$129,871.00 59,740.30 (19,320.00) $170,291.30 160,303.00 9,988.30 (36,950.00) $(26,961.70)
$
Chapter 10 - Translation of Foreign Currency Financial Statements
36. (90 minutes) (Translate foreign currency financial statements and prepare consolidation worksheet) Step One Simbel's financial statements are first translated into U.S. dollars after reclassification of the 10,000 pound expenditure for rent from rent expense to prepaid rent. Credit balances are in parentheses. Translation Worksheet Exchange Account Pounds Rate Dollars Sales (800,000) 0.274 (219,200) Cost of goods sold 420,000 0.274 115,080 Salary expense 74,000 0.274 20,276 Rent expense (adjusted) 36,000 0.274 9,864 Other expenses 59,000 0.274 16,166 Gain on sale of fixed assets, 10/1/15 (30,000) 0.273 (8,190) Net income (241,000) (66,004) R/E, 1/1/15 Net income Dividends R/E,12/31/15
(133,000) (241,000) 50,000 (324,000)
Cash and receivables Inventory Prepaid rent (adjusted) Fixed assets Total
146,000 297,000 10,000 455,000 908,000
0.270 0.270 0.270 0.270
39,420 80,190 2,700 122,850 245,160
Accounts payable Notes payable Common stock Add’l paid-in capital Retained earnings, 12/31/15 Subtotal Cumulative translation adjustment (negative) Total
(54,000) (140,000) (240,000) (150,000) (324,000)
0.270 0.270 0.300 0.300 Above
(14,580) (37,800) (72,000) (45,000) (90,498) (259,878)
Schedule 2
14,718 (245,160)
(908,000)
10-26 .
.
Schedule 1 (38,244) Above (66,004) 0.275 13,750 (90,498)
Chapter 10 - Translation of Foreign Currency Financial Statements
36. (continued) Schedule 1—Translation of 1/1/15 Retained Earnings Retained earnings, 1/1/14 Net income, 2014 Dividends, 6/1/14 Retained earnings, 1/1/15
Pounds -0(163,000) 30,000 (133,000)
0.288 0.290
Dollars -0(46,944) 8,700 (38,244)
Schedule 2—Calculation of Cumulative Translation Adjustment at 12/31/15 Pounds Net assets, 1/1/14 (390,000) 0.300 Net income, 2014 (163,000) 0.288 Dividends, 6/1/14 30,000 0.290 Net assets, 12/3/14 (523,000) Net assets, 12/31/14 at current exchange rate (523,000) 0.280 Translation adjustment, 2014 (negative) Net assets, 1/1/15 (523,000) 0.280 Net income, 2015 (241,000) Above Dividends, 6/1/15 50,000 0.275 Net assets, 12/31/15 (714,000) Net assets, 12/31/15 at current exchange rate (714,000) 0.270 Translation adjustment, 2015 (negative) Cumulative translation adjustment, 12/31/15 (negative)
10-27 .
.
Dollars (117,000) (46,944) 8,700 (155,244) (146,440) (8,804) (146,440) (66,004) 13,750 (198,694) (192,780) (5,914) (14,718)
Chapter 10 - Translation of Foreign Currency Financial Statements
36. (continued) Step Two Cayce and Simbel's U.S. dollar accounts are then consolidated. Necessary adjustments and eliminations are made.
Account Sales Cost of goods sold Salary expense Rent expense Other expenses Dividend income Gain, 10/1/15 Net income
Consolidation Worksheet Adjustments and Consolidated Cayce Simbel Eliminations Balances Dollars Dollars Debit Credit Dollars (200,000) (219,200) (419,200) 93,800 115,080 208,880 19,000 20,276 39,276 7,000 9,864 16,864 21,000 16,166 37,166 (13,750) -0(I) 13,750 -0-0(8,190) (8,190) (72,950) (66,004) (125,204)
Ret earn, 1/1/15 Net income Dividends Ret earn, 12/31/15
(318,000) (72,950) 24,000 (366,950)
Cash and receivables 110,750 Inventory 98,000 Prepaid rent 30,000 Investment 126,000 Fixed assets 398,000 Total 762,750 Accounts payable Notes payable Common stock Additional PIC Ret earn, 12/31/15 Subtotal Cum trans adjust Total
(38,244) (S) 38,244 (*C) 38,244 (66,004) 13,750 (I) 13,750 (90,498)
(356,244) (125,204) 24,000 (457,448)
39,420 80,190 2,700 -0- (*C) 38,244 122,850 (S) 9,000 245,160
150,170 178,190 32,700 -0528,950 890,010
(14,580) (37,800) (72,000) (S) 72,000 (45,000) (S) 45,000 (90,498) (259,878) 14,718 (E) 900 (762,750) (245,160) 217,138
(60,800) (132,000) (120,000) (83,000) (366,950)
10-28 .
(S)164,244 (E) 900
.
217,138
(75,380) (169,800) (120,000) (83,000) (457,448) (905,628) 15,618 (890,010)
Chapter 10 - Translation of Foreign Currency Financial Statements
36. (continued) Explanation of Adjustment and Elimination Entries Entry *C Investment in Simbel ................................................... 38,244 Retained earnings, 1/1/15 ....................................... 38,244 To accrue 2015 increase in subsidiary book value (see Schedule 1). Entry is needed because parent is using the cost method. Entry S Common stock (Simbel) .......................................... 72,000 Add'l paid-in-capital (Simbel) ...................................... 45,000 Retained earnings, 1/1/15 (Simbel) ............................. 38,244 Fixed assets (revaluation) .......................................... 9,000 Investment in Simbel .......................................... 164,244 To eliminate subsidiary's stockholders' equity accounts and allocate the excess of acquisition consideration over book value to land (fixed assets). The excess of acquisition consideration over book value is calculated as follows: Acquisition consideration ...................................................... $126,000 Book value, 1/1/15 ................................................................... Common stock ...................................................................... (72,000) Add’l paid-in capital .............................................................. (45,000) Excess of acquisition consideration over book value $ 9,000 The excess of acquisition consideration over book value is 30,000 pounds. The U.S. dollar equivalent at 1/1/15, the date of acquisition, is $9,000 (£E30,000 x $.30). Entry I Dividend income .......................................................... 13,750 Dividends ................................................................. 13,750 To eliminate intra-entity dividend payments recorded by parent as income. Entry E Cumulative translation adjustment............................. 900 Fixed assets (revaluation) ..................................... 900 To revalue (write-down) the excess of acquisition consideration over book value for the change in exchange rate since the date of acquisition with the counterpart recognized in the consolidated cumulative translation adjustment. The revaluation of "excess" is calculated as follows: Excess of acquisition consideration over book value U.S. dollar equivalent at 12/31/15 £E30,000 x $.27 = $8,100 U.S. dollar equivalent at 1/1/15 £E30,000 x $.30 = 9,000 Cumulative translation adjustment related to excess, 12/31/15 (negative) $( 900)
10-29
Chapter 10 - Translation of Foreign Currency Financial Statements
37. (90 minutes) Translate [remeasure] foreign currency financial statements using U.S. GAAP and explain sign of translation adjustment [remeasurement gain/loss]) Part I (a). Czech koruna is the functional currency—current rate method KčS Sales 25,000,000 Cost of goods sold (12,000,000) Depreciation expense—equipment (2,500,000) Depreciation expense—building (1,800,000) Research and development expense (1,200,000) Other expenses (1,000,000) Net income 6,500,000 Retained earnings, 1/1/15 500,000 Dividends, 12/15/15 (1,500,000) Retained earnings, 12/31/15 5,500,000 Cash Accounts receivable Inventory Equipment Accum. deprec.—equipment Building Accum. deprec.—equipment Land Total assets
2,000,000 3,300,000 8,500,000 25,000,000 (8,500,000) 72,000,000 (30,300,000) 6,000,000 78,000,000
Accounts payable Long-term debt Common stock Additional paid-in capital Retained earnings, 12/31/15 Translation adjustment Total liabilities and equities
2,500,000 50,000,000 5,000,000 15,000,000 5,500,000 78,000,000
10-30 .
.
Exchange Rate US$ 0.035 875,000 0.035 (420,000) 0.035 (87,500) 0.035 (63,000) 0.035 (42,000) 0.035 (35,000) 227,500 given 22,500 0.031 (46,500) 203,500 0.030 0.030 0.030 0.030 0.030 0.030 0.030 0.030
60,000 99,000 255,000 750,000 (255,000) 2,160,000 (909,000) 180,000 2,340,000
0.030 75,000 0.030 1,500,000 0.050 250,000 0.050 750,000 above 203,500 to balance (438,500) 2,340,000
Chapter 10 - Translation of Foreign Currency Financial Statements
37.
(continued) Calculation of Translation Adjustment Translation adjustment, 2015 (negative) Net assets, 1/1/15 20,500,000 0.040 Net income, 2015 6,500,000 0.035 Dividends, 12/15/15 (1,500,000) 0.031 Net assets, 12/31/15 25,500,000 Net assets, 12/31/15 at current exchange rate 25,500,000 0.030 Translation adjustment, 2015 (negative) Cumulative translation adjustment, 12/31/15 (negative)
10-31 .
.
202,500 820,000 227,500 (46,500) 1,001,000 765,000 236,000 438,500
Chapter 10 - Translation of Foreign Currency Financial Statements
37. (continued) Part I (b). U.S. dollar is the functional currency—temporal method KčS Rate Sales 25,000,000 0.035 Cost of goods sold (12,000,000) Sched. A Depreciation expense—equipment (2,500,000) Sched. B Depreciation expense—building (1,800,000) Sched. C Research and development expense (1,200,000) 0.035 Other expenses (1,000,000) 0.035 Income before remeasurement gain 6,500,000 Remeasurement gain, 2015 Net income 6,500,000 Retained earnings, 1/1/15 500,000 given Dividends, 12/15/15 (1,500,000) 0.031 Retained earnings, 12/31/15 5,500,000
Exchange US$ 875,000 (493,500) (118,000) (85,200) (42,000) (35,000) 101,300 408,000 509,300 353,000 (46,500) 815,800
Cash Accounts receivable Inventory Equipment Accum. deprec.—equipment Building Accum. deprec.—equipment Land Total assets
2,000,000 3,300,000 8,500,000 25,000,000 (8,500,000) 72,000,000 (30,300,000) 6,000,000 78,000,000
0.030 60,000 0.030 99,000 0.032 272,000 Sched.B 1,180,000 Sched.B (418,000) Sched.C 3,408,000 Sched.C (1,510,200) 0.050 300,000 3,390,800
Accounts payable Long-term debt Common stock Additional paid-in capital Retained earnings, 12/31/15 Total liabilities and equities
2,500,000 50,000,000 5,000,000 15,000,000 5,500,000 78,000,000
0.030 0.030 0.050 0.050 above
75,000 1,500,000 250,000 750,000 815,800 3,390,800
KčS 6,000,000 14,500,000 (8,500,000) 12,000,000
ER 0.043 0.035 0.032
US$ 258,000 507,500 (272,000) 493,500
Schedule A—Cost of goods sold Beginning inventory Purchases Ending inventory Cost of goods sold
10-32 .
.
Chapter 10 - Translation of Foreign Currency Financial Statements
37. (continued) Schedule B—Equipment Old Equipment—at 1/1/14 New Equipment—acquired 1/3/15 Total
KčS 20,000,000 5,000,000 25,000,000
ER 0.050 0.036
US$ 1,000,000 180,000 1,180,000
Accum. Depr.—Old Equipment Accum. Depr.—New Equipment Total Deprec expense—Old Equipment Deprec expense—New Equipment Total
8,000,000 500,000 8,500,000 2,000,000 500,000 2,500,000
0.050 0.036
400,000 18,000 418,000 100,000 18,000 118,000
KčS 60,000,000 12,000,000 72,000,000 30,000,000 300,000 30,300,000 1,500,000 300,000 1,800,000
ER 0.050 0.034
KčS (37,000,000)
ER 0.040
US$ (1,480,000)
25,000,000
0.035
875,000
(14,500,000) (1,200,000) (1,000,000) (1,500,000) (5,000,000) (12,000,000) (47,200,000)
0.035 0.035 0.035 0.031 0.036 0.034
(507,500) (42,000) (35,000) (46,500) (180,000) (408,000) (1,824,000)
(47,200,000)
0.030
(1,416,000) (408,000)
0.050 0.036
Schedule C—Building Old Building—at 1/1/14 New Building—acquired 3/5/15 Total Accum. Depr.—Old Building Accum. Depr.—New Building Total Deprec. expense—Old Building Deprec. expense—New Building Total
0.050 0.034 0.050 0.034
US$ 3,000,000 408,000 3,408,000 1,500,000 10,200 1,510,200 75,000 10,200 85,200
Calculation of Remeasurement Gain Net mon. liab., 1/1/15 Increase in mon. assets: Sales Decrease in mon. assets: Purchase of inventory Research and development Other expenses Dividends, 12/15/15 Purchase of equipment, 1/3/15 Purchase of buildings, 3/5/15 Net mon liab, 12/31/15 Net mon liab, 12/31/15 at current exchange rate Remeasurement gain—2015
10-33 .
.
Chapter 10 - Translation of Foreign Currency Financial Statements
37. (continued) Part I (c). U.S. dollar is the functional currency—temporal method (no longterm debt) Exchange KčS Rate US$ Sales 25,000,000 0.035 875,000 Cost of goods sold (12,000,000) Sched. A (493,500) Depreciation expense—equipment (2,500,000) Sched. B (118,000) Depreciation expense—building (1,800,000) Sched. C (85,200) Research and development expense (1,200,000) 0.035 (42,000) Other expenses (1,000,000) 0.035 (35,000) Income before remeasurement loss 6,500,000 101,300 Remeasurement loss, 2015 (92,000) Net income 6,500,000 9,300 Retained earnings, 1/1/15 500,000 given (147,000) Dividends, 12/15/15 (1,500,000) 0.031 (46,500) Retained earnings, 12/31/15 5,500,000 (184,200) Cash Accounts receivable Inventory Equipment Accum. deprec.—equipment Building Accum. deprec.—equipment Land Total assets
2,000,000 3,300,000 8,500,000 25,000,000 (8,500,000) 72,000,000 (30,300,000) 6,000,000 78,000,000
Accounts payable Long-term debt Common stock Additional paid in capital Retained earnings, 12/31/15 Total liabilities and equities
2,500,000 0 20,000,000 50,000,000 5,500,000 78,000,000
0.030 60,000 0.030 99,000 0.032 272,000 Sched. B 1,180,000 Sched. B (418,000) Sched. C 3,408,000 Sched .C (1,510,200) 0.050 300,000 3,390,800 0.030 0.030 0.050 0.050 above
Schedule A—Cost of goods sold - same as in Part I (b) Schedule B—Equipment - same as in Part I (b) Schedule C—Building - same as in Part I (b)
10-34 .
.
75,000 0 1,000,000 2,500,000 (184,200) 3,390,800
Chapter 10 - Translation of Foreign Currency Financial Statements
37. (continued) Calculation of Remeasurement Loss Net monetary assets, 1/1/15 Increase in monetary assets: Sales Decrease in monetary assets: Purchase of inventory Research and development Other expenses Dividends, 12/15/15 Purchase of equipment, 1/3/15 Purchase of buildings, 3/5/15 Net monetary assets, 12/31/15 Net monetary assets, 12/31/15 at current exchange rate Remeasurement loss—2015
KčS 13,000,000
ER 0.040
US$ 520,000
25,000,000
0.035
875,000
(14,500,000) (1,200,000) (1,000,000) (1,500,000) (5,000,000) (12,000,000) 2,800,000
0.035 0.035 0.035 0.031 0.036 0.034
(507,500) (42,000) (35,000) (46,500) (180,000) (408,000) 176,000
2,800,000
0.030
84,000 92,000
10-35 .
.
Chapter 10 - Translation of Foreign Currency Financial Statements
37. (continued) Part II. Explanation of the negative translation adjustment in Part I (a), remeasurement gain in Part I (b), and remeasurement loss in Part I (c). The negative translation adjustment in Part I (a) arises because of two factors: (1) there is a net asset balance sheet exposure and (2) the Czech koruna has depreciated against the U.S. dollar during 2015 (from $.040 at 1/1/15 to $.030 at 12/31/15). A net asset balance sheet exposure exists because all assets are translated at the current exchange rate and exceed total liabilities which are also translated at the current exchange rate. The remeasurement gain in Part I (b) arises because of two factors: (1) there is a net monetary liability balance sheet exposure and (2) the Czech koruna has depreciated against the U.S. dollar. Under the temporal method, Cash and Accounts Receivable are the only assets translated at the current exchange rate (total KčS 5,300,000). Accounts Payable and Long-term Debt are also translated at the current exchange rate (total KčS 52,500,000). Because the Czech koruna amount of liabilities translated at the current rate exceeds the Czech koruna amount of assets translated at the current rate, a net monetary liability balance sheet exposure exists. The remeasurement loss in Part I (c) arises because of two factors: (1) there is a net monetary asset balance sheet exposure and (2) the Czech koruna has depreciated against the U.S. dollar during 2015. Cash and Accounts Receivable are the only assets translated at the current exchange rate (total KčS 5,300,000). Because there is no Long-term Debt in part 1(c), Accounts Payable is the only liability translated at the current exchange rate (total KčS 2,500,000). Because the Czech koruna amount of assets translated at the current rate exceeds the Czech koruna amount of liabilities translated at the current rate, a net monetary asset balance sheet exposure exists.
10-36 .
.
Chapter 10 - Translation of Foreign Currency Financial Statements
38. (90 minutes) Remeasure the foreign currency transactions of a foreign subsidiary into the subsidiary’s functional currency and then translate the subsidiary’s trial balance into the parent’s reporting currency a. Remeasurement of BRL Trial Balance into Mexican Pesos MXN BRL MXN Debit Credit Rate Debit Credit Cash 5,500 6.30 C 34,650 Accounts Receivable 28,000 6.30 C 176,400 Notes Payable 5,000 6.30 C 31,500 Sales 35,000 6.20 A 217,000 Rent Expense 6,000 6.20 A 37,200 Interest Expense 500 6.20 A 3,100 40,000 40,000 251,350 248,500 Remeasurement Gain 2,850 Total 251,350 251,350 Calculation of Remeasurement Gain Net monetary asset balance, 1/1/15 Increase in net monetary items: Income (sales less rent and interest) Decrease in net monetary items: Not applicable Net monetary assets, 12/31/15 Net monetary assets, 12/31/15, at current exchange rate Remeasurement loss (gain)
Rate
MXN
28,500
6.20 A
176,700
28,500 28,500
10-37 .
BRL 0
.
176,700 6.30 C
179,550 (2,850)
Chapter 10 - Translation of Foreign Currency Financial Statements
38. (continued) b. Translation of Mexican Peso (MXN) Balances into U.S. Dollars (USD) Unadjusted MXN MXN Adjustments Debit Credit Debit Credit Cash 1,000,000 34,650 Accounts Receivable 3,000,000 176,400 Inventory 5,000,000 Land 2,000,000 Depreciable Assets 15,000,000 Accumulated Depreciation 6,000,000 Accounts Payable 1,500,000 Notes Payable 4,000,000 31,500 Common Stock 12,000,000 Retained Earnings, 1/1/15 2,500,000 Sales 34,000,000 217,000 Cost of Goods Sold 28,000,000 Depreciation Expense 600,000 Rent Expense 3,000,000 37,200 Interest Expense 400,000 3,100 Remeasurement Gain/Loss 2,850 Dividends Paid, 7/1/15 2,000,000 Total 60,000,000 60,000,000 251,350 251,350 Cumulative Translation Adjustment Total
10-38 ..
Adjusted MXN MXN Debit Credit 1,034,650 3,176,400 5,000,000 2,000,000 15,000,000 6,000,000 1,500,000 4,031,500 12,000,000 2,500,000 34,217,000 28,000,000 600,000 3,037,200 403,100 2,850 2,000,000 60,251,350 60,251,350
Rate 0.072 0.072 0.072 0.072 0.072 0.072 0.072 0.072 Given Given 0.075 0.075 0.075 0.075 0.075 0.075 0.073
USD Debit 74,494.80 228,700.80 360,000.00 144,000.00 1,080,000.00
USD Credit
432,000.00 108,000.00 290,268.00 1,000,000.00 200,000.00 2,566,275.00 2,100,000.00 45,000.00 227,790.00 30,232.50 213.75 146,000.00 4,436,431.85
4,596,543.00
160,111.15 4,596,543.00
4,596,543.00
Chapter 10 - Translation of Foreign Currency Financial Statements
38. (continued) Calculation of Cumulative Translation Adjustment MXN Net asset balance, 1/1/15 14,500,000 Increase in net assets: Income, 2015 2,179,550 Decrease in net assets: Dividends, 12/1/2015 (2,000,000) Net assets, 12/31/15 14,679,550 Net assets, 12/31/15, at current exchange rate 14,679,550 Translation adjustment, 2015 (debit) Cumulative translation adjustment, 1/1/2015 (debit) Cumulative translation adjustment, 12/31/2015 (debit)
10-39 .
.
Rate 0.080 H
USD 1,160,000.00
0.075 A
163,466.25
0.073 H
(146,000.00) 1,177,466.25
0.072 C
1,056,927.60 120,538.65 39,572.50 160,111.15
Given
Chapter 10 - Translation of Foreign Currency Financial Statements
Chapter 10 Develop Your Skills Research Case 1—Foreign Currency Translation and Hedging Activities The responses to this assignment will depend upon the company selected by the student for analysis. It is unlikely that the company selected will disclose the amount of any remeasurement gains and losses. The amount of translation adjustment reported in accumulated other comprehensive income usually can be found in a statement of stockholders’ equity. A positive translation adjustment indicates that the foreign currency in which the company operates, on average, increased in dollar value during the year. A negative translation adjustment indicates the opposite.
Research Case 2—Foreign Currency Translation Disclosures in the Computer Industry The responses to requirements in this case will depend upon the annual reports used by students to complete the case. The solution provided here is based upon 2011 annual reports. a. In 2011, in addition to providing information related to foreign currency translation and hedging activities in its Form 10-K under 1A. Risk Factors, p. 14, IBM also provided information in its Annual Report on these activities in the following locations: i. Management Discussion, under Currency Rate Fluctuations, p. 61. ii. Note A. Significant Accounting Policies, under Translation of Non-U.S Currency Amounts and Derivatives and Derivative Financial Instruments, p. 83. iii. Note D. Financial Instruments, under Derivatives Financial Instruments and Foreign Exchange Risk, pp. 96-98. In its Form 10-K for the year ended February 3, 2012 (Fiscal 2012), Dell provided information related to foreign currency translation and hedging activities in the following locations: i. Item 1A. Risk Factors, p. 16, 17, 19. ii. Item 7A. Quantitative and Qualitative Disclosures about Market Risk, p. 56. iii. Note 1. Description of Business and Summary of Significant Accounting Policies, under Foreign Currency Translation and Hedging Instruments, p. 65, and Derivative Instruments, p. 71. iv. Note 6. Derivative Instruments and Hedging Activities, p. 80.
10-40
Chapter 10 - Translation of Foreign Currency Financial Statements
Research Case 2 (continued) b. IBM’s foreign operations do not have a predominant functional currency. The company indicates that it operates in multiple functional currencies (AR, p. 96). The majority of Dell’s foreign operations have the U.S. dollar as their functional currency (10-K, p. 65). Most of IBM’s foreign operations probably have the foreign currency as functional currency and therefore are translated into dollars using the current rate method with translation adjustments reflected in stockholders’ equity. Dell’s foreign operations, on the other hand, are remeasured into dollars using the temporal method with remeasurement gains and losses reflected in net income. These differences in translation method and disposition of the translation adjustment reduces the comparability of information provided by the two companies. c. From the Consolidated Statement of Comprehensive Income (AR, p. 71), it can be seen that IBM reported translation adjustments as follows over the period 2009-2011: 2009: positive $1,675 million 2010: positive $712 million 2011: negative $693 million The negative sign of the translation adjustment in 2011 indicates that, on average, the foreign currency functional currencies of IBM’s foreign operations decreased in value against the U.S. dollar in that year. The positive sign of the translation adjustment in 2009 and 2010 indicates that, on average, the foreign currency functional currencies of IBM’s foreign operations increased in value against the U.S. dollar in those years. Dell reported foreign currency translation adjustments in Consolidated Statements of Stockholders’ Equity as follows: Fiscal 2010: negative $29 million Fiscal 2011: positive $79 million Fiscal 2012: negative $74 million On average, the foreign currency functional currencies of Dell’s foreign operations decreased in value against the U.S. dollar in Fiscal 2010 and Fiscal 2012, and increased in value against the dollar in Fiscal 2011. The magnitude of the translation adjustments reported in stockholders’ equity is much larger for IBM than for Dell. This undoubtedly occurs because Dell has a much smaller balance sheet exposure related to foreign currency functional currency operations.
10-41 .
.
Chapter 10 - Translation of Foreign Currency Financial Statements
Research Case 2 (continued) d. In Note D. Financial Instruments, under Foreign Exchange Risk, IBM indicates that a significant portion of the company’s foreign currency denominated debt is designated as a hedge of its foreign currency balance sheet exposures (p. 97). The company also uses foreign currency forward contracts and cross-currency swaps to hedge its net investments in foreign operations. Although Dell reports that it hedges forecasted transactions and foreign currency payables and receivables (p. 80), the company makes no mention of hedging its balance sheet exposures. e. The response to this requirement will vary from student to student. Much of the information provided in requirements a. – d. above can be included in a formal report to satisfy this requirement.
10-42 .
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Chapter 10 - Translation of Foreign Currency Financial Statements
Accounting Standards Case 1—More than One Functional Currency This case requires students to search the authoritative literature to determine how the functional currency should be determined for a foreign entity that has more than one distinct and separable operation. Source of guidance: FASB ASC 830-10-55-6 Foreign Currency Matters; Overall; Implementation Guidance and Illustrations: The Functional Currency ASC 830-10-55-6 states: “In some instances, a foreign entity might have more than one distinct and separable operation. For example, a foreign entity might have one operation that sells parent-entity-produced products and another operation that manufactures and sells foreign-entity-produced products. If they are conducted in different economic environments, those two operations might have different functional currencies. Similarly, a single subsidiary of a financial institution might have relatively self-contained and integrated operations in each of several different countries. In those circumstances, each operation may be considered to be an entity as that term is used in this Subtopic, and, based on the facts and circumstances, each operation might have a different functional currency.” This guidance indicates that the functional currency should be determined separately for each distinct and separable operation of a single foreign entity. Within its Mexican subsidiary, Lynch should designate the Mexican peso as the functional currency for the Small Appliance division and the U.S. dollar as the functional currency for the Electronics division.
10-43 .
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Chapter 10 - Translation of Foreign Currency Financial Statements
Accounting Standards Case 2—Change in Functional Currency This case requires students to search the authoritative literature to determine how an entity should handle a change in foreign currency from the foreign currency to the U.S. dollar. Specific questions are: • Should the change in functional currency be treated as a change in accounting principle with retrospective restatement of the carrying values of nonmonetary assets? • Should the cumulative translation adjustment be removed from equity and, if so, where should it go? Source of guidance: FASB ASC 830-10-45-10 Foreign Currency Matters; General; Other Presentation Matters; Functional Currency Changes from Foreign Currency to Reporting Currency ASC 830-10-45-10 states: “If the functional currency changes from a foreign currency to the reporting currency, translation adjustments for prior periods shall not be removed from equity and the translated amounts for nonmonetary assets at the end of the prior period become the accounting basis for those assets in the period of the change and subsequent periods.” In essence, the authoritative guidance indicates that the change in functional currency from the Canadian dollar to the U.S. dollar should not be treated as a change in accounting principle with retrospective adjustments. Instead, the change should be handled prospectively with no adjustments made to the carrying amounts of nonmonetary assets or to the accumulated translation adjustment related to the Canadian subsidiary carried in AOCI.
10-44 .
.
Chapter 10 - Translation of Foreign Currency Financial Statements
Excel Case—Translating Foreign Currency Financial Statements a.b. Spreadsheet for the translation (current rate method) and remeasurement (temporal method) of the FC financial statements of Charles Edward Company’s foreign subsidiary. Current Rate Method
Temporal Method
FC
Rate
Rate
USD
Sales Cost of goods sold Gross profit Selling expense Depreciation expense Remeasurement gain/loss Income before tax Income taxes Net income Retained earnings, 1/1/15 Ret. earnings, 12/31/15
5,000 (3,000) 2,000 (400) (600) 0 1,000 (300) 700 0 700
$0.45 $0.45 subtotal $0.45 $0.45 n/a subtotal $0.45 subtotal
$0.45 A calculation subtotal $0.45 A $0.50 H to balance subtotal $0.45 A subtotal
$2,250 (1,360) 890 (180) (300) 355 765 (135) 630 0 630
Cash Inventory Fixed assets Less: accum/deprec Total assets
1,000 2,000 6,000 (600) 8,400
$0.38 $0.38 $0.38 $0.38 total
Current liabilities Long-term debt Contributed capital Cum. trans. adjust. Retained earnings Total liab and stock equity
1,500 3,000 3,200 0 700 8,400
December 31, 2015
total
USD A $2,250 A (1,350) 900 A (180) A (270) 0 450 A (135) 315 0 315 C C C C
380 760 2,280 (228) 3,192
$0.38 C $0.38 C $0.50 H to balance from I/S A=L+SE
570 1,140 1,600 (433)* 315 3,192
from B/S $0.38 $0.43 $0.50 $0.50 total
C H H H
380 860 3,000 (300) 3,940
$0.38 C $0.38 C $0.50 H n/a to balance A=L+SE
570 1,140 1,600 0 630 3,940
Exchange Rates January 1-31, 2015 Average 2015 December 31, 2015 Inventory purchases
Temporal method—COGS (on a FIFO basis) $0.50 BI 1,000 $0.50 H $500 $0.45 P 4,000 $0.43 H 1,720 $0.38 EI (2,000) $0.43 H (860) $0.43 COGS 3,000 $1,360
Key: Average Exchange Rate Current Exchange Rate Historical Exchange Rate
A C H 10-45
.
.
Chapter 10 - Translation of Foreign Currency Financial Statements
Excel Case (continued) *Computation of Translation Adjustment Net assets, 1/1/15 Net income, 2015 Net assets, 12/31/15 Net assets, 12/31/15 at current exchange rate Translation adjustment (negative)
FC 3,200 700 3,900
$0.50 $0.45
3,900
$0.38
USD 1,600 315 1,915 1,482 433
c. With the FC as functional currency, the U.S. dollar net income reflected in the consolidated income statement is $315. If the U.S. dollar were the functional currency, the amount would be twice as much—$630. The amount of total assets reported on the consolidated balance sheet is 23.4% smaller than if the U.S. dollar were functional currency [($3,940 – $3,192)/$3,192]. The relations between the current ratio, the debt to equity ratio, and profit margin calculated from the FC financial statements and from the translated U.S. dollar financial statements are shown below.
10-46 .
.
Chapter 10 - Translation of Foreign Currency Financial Statements
Excel Case (continued) FC Current ratio CA CL
Debt to equity ratio Total liabilities Total stockholders’ equity
Profit margin NI Sales
Return on equity NI Average TSE
Inventory turnover COGS Average Inventory
Current Rate
Temporal
3,000 1,500 2.0
1,140 570 2.0
1,240 570 2.1754
4,500 3,900
1,710 1,482
1,710 2,230
1.15385
1.15385
0.76682
700 5,000 0.14
315 2,250 0.14
630 2,250 0.28
700 3,550 0.19718
315 1,541 0.20441
630 1,915 0.32898
3,000 1,000 3
1,350 380 3.55263
1,360 430 3.16279
These results show that the temporal method distorts all ratios as calculated from the original foreign currency financial statements. The current rate method maintains all ratios that use numbers in the numerator and denominator from the balance sheet only (current ratio, debt-to-equity ratio) or the income statement only (profit margin). For ratios that combine numbers from the income statement and balance sheet (return on equity, inventory turnover), even the current rate method creates distortions. The U.S. dollar amounts reported under the temporal method for inventory and fixed assets reflect the equivalent U.S. dollar cost of those assets as if the parent had sent dollars to the subsidiary to purchase the assets. For example, to purchase FC 6,000 worth of fixed assets when the exchange rate was $.50/FC, the parent would have had to provide the subsidiary with $3,000. 10-47 .
.
Chapter 10 - Translation of Foreign Currency Financial Statements
Excel Case (continued) The U.S. dollar amounts reported under the current rate method for inventory and fixed assets reflect neither the equivalent U.S. dollar cost of those assets nor their U.S. dollar current value. By multiplying the FC historical cost by the current exchange rate, these assets are reported at what they would have cost in U.S. dollars if the current exchange rate had been in effect when they were purchased. This is a hypothetical number with little, if any, meaning.
10-48 .
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Chapter 10 - Translation of Foreign Currency Financial Statements
Excel and Analysis Case—Parker Inc. and Suffolk PLC This assignment requires translation of foreign currency financial statements under three different sets of assumptions regarding changes in the U.S. dollar value of the British pound. Under the first set of assumptions, the British pound appreciates steadily from $1.60 at 1/1/14 to $1.68 at 12/31/15. Under the second set of assumptions, the exchange rate remains $1.60 from 1/1/14 to 12/31/15. Under the third set of assumptions, the British pound depreciates steadily from $1.60 at 1/1/14 to $1.52 at 12/31/15. Part I—Appreciating Foreign Currency Relevant exchange rates:
January 1, 2014 2014 Average December 31, 2014 January 30, 2015 2015 Average December 31, 2015
10-49 .
.
$1.60 $1.62 $1.64 $1.65 $1.66 $1.68
Chapter 10 - Translation of Foreign Currency Financial Statements
Excel and Analysis Case (continued) a. Translation of Suffolk’s December 31, 2015 trial balance from British pounds to U.S. dollars. Suffolk PLC Trial Balance December 31, 2015 Pounds 1,500,000 5,200,000 18,000,000 36,000,000 (1,450,000) (5,000,000) (44,000,000) (8,000,000) (28,000,000) 16,000,000 2,000,000 6,000,000 1,750,000
Cash £ Accounts receivable Inventory Property, plant, & equipment (net) Accounts payable Long-term debt Common stock Retained earnings, 1/1/15 Sales Cost of goods sold Depreciation Other expenses Dividends, 1/30/15 Cumulative translation adjustment—positive (credit balance)
Exchange Rate Dollars $1.68 $ 2,520,000 $1.68 8,736,000 $1.68 30,240,000 $1.68 60,480,000 $1.68 (2,436,000) $1.68 (8,400,000) $1.60 (70,400,000) Schedule A (12,840,000) $1.66 (46,480,000) $1.66 26,560,000 $1.66 3,320,000 $1.66 9,960,000 $1.65 2,887,500
£ 0 Note: Amounts in parentheses are credit balances.
Schedule A Retained earnings, 1/1/14 Net income, 2014 Retained earnings, 12/31/14
Pounds £(6,000,000) (2,000,000) £(8,000,000)
10-50 .
.
$
Exchange Rate $1.60 $1.62
(4,147,500) 0
Dollars $ (9,600,000) (3,240,000) $(12,840,000)
Chapter 10 - Translation of Foreign Currency Financial Statements
Excel and Analysis Case (continued) b. Schedule detailing the change in Suffolk’s cumulative translation adjustment for 2014 and 2015. Determination of Cumulative Exchange Exchange Translation Adjustment Pounds Rate Rate Dollars Net assets, 1/1/14 £50,000,000 $1.64 $1.60 $2,000,000 Net income, 2014 2,000,000 $1.64 $1.62 40,000 Translation adjustment, 2014 (positive) $2,040,000 Net assets, 1/1/15 £52,000,000 $1.68 $1.64 2,080,000 Net income, 2015 4,000,000 $1.68 $1.66 80,000 Dividends, 2015 (1,750,000) $1.68 $1.65 (52,500) Translation adjustment, 2015 (positive) 2,107,500 Net assets, 12/31/15 £ 54,250,000 Cumulative Translation Adjustment, 12/31/15 (positive) $4,147,500
Cost Allocation Schedule Cost Book value Excess of cost over book value
Pounds £52,000,000 50,000,000 £ 2,000,000
Translation Adjustment Related to Excess of Cost Over Book Value Excess of cost over book value U.S. dollar value at 12/31/15 U.S. dollar value at 1/1/14 Translation adjustment related to excess, 12/31/15—positive
Pounds £2,000,000
Exchange Rate $1.68 $1.60
Dollars $83,200,000 80,000,000 $ 3,200,000
Dollars $3,360,000 3,200,000 $ 160,000
10-51 .
Exchange Rate $1.60 $1.60
.
Chapter 10 - Translation of Foreign Currency Financial Statements
Excel and Analysis Case (continued) c. Consolidation Worksheet—December 31, 2015 Parker
Suffolk
($70,000,000)
($46,480,000)
($116,480,000)
Cost of goods sold
34,000,000
26,560,000
60,560,000
Depreciation
20,000,000
3,320,000
23,320,000
Other expenses
6,000,000
9,960,000
15,960,000
Dividend income
(2,887,500)
Sales
Adjustments & Eliminations
2,887,500
Consolidated
0
Net income
($12,887,500)
($6,640,000)
Ret. earnings, 1/1/15
($48,000,000)
($12,840,000)
Net income
(12,887,500)
(6,640,000)
Dividends
4,500,000
2,887,500
($56,387,500)
($16,592,500)
($63,380,000)
Cash
$3,687,500
$2,520,000
$6,207,500
Accounts receivable
10,000,000
8,736,000
18,736,000
Inventory
30,000,000
30,240,000
60,240,000
Investment in Suffolk
83,200,000
Ret. earnings, 12/31/15
($16,640,000)
12,840,000
3,240,000
($51,240,000) (16,640,000)
2,887,500
3,240,000
83,240,000
4,500,000
0
3,200,000
Prop, plant & eq (net)
105,000,000
60,480,000
3,200,000
168,840,000
160,000
Accounts payable
(25,500,000)
(2,436,000)
(27,936,000)
Long-term debt
(50,000,000)
(8,400,000)
(58,400,000)
Common stock
(100,000,000)
(70,400,000)
Ret. earnings, 12/31/15
(56,387,500)
(16,592,500)
$0
$0
10-52 .
(100,000,000) (63,380,000)
(4,147,500)
Cum. trans. adj.
.
70,400,000
$92,727,500
160,000
(4,307,500)
$92,727,500
$0
Chapter 10 - Translation of Foreign Currency Financial Statements
Excel and Analysis Case (continued) d. Consolidated income statement and balance sheet—2015. Parker, Inc. Consolidated Income Statement For the year ended December 31, 2015 Sales Cost of goods sold Depreciation Other expenses Net income
$ 116,480,000 (60,560,000) (23,320,000) (15,960,000) $ 16,640,000 Parker, Inc. Consolidated Balance Sheet December 31, 2015
Assets Cash Accounts receivable Inventory Property, plant & equipment (net) Total
$
6,207,500 18,736,000 60,240,000 168,840,000 $254,023,500
Liabilities and Shareholders' Equity Accounts payable $ 27,936,000 Long-term debt 58,400,000 Common stock 100,000,000 Retained earnings 63,380,000 Accum. other comp. income 4,307,500 Total $254,023,500
10-53 .
.
Chapter 10 - Translation of Foreign Currency Financial Statements
Excel and Analysis Case (continued) Part II—Stable Foreign Currency Relevant exchange rates:
January 1, 2014 2014 Average December 31, 2014 January 30, 2015 2015 Average December 31, 2015
$1.60 $1.60 $1.60 $1.60 $1.60 $1.60
a. Translation of Suffolk’s December 31, 2015 trial balance from British pounds to U.S. dollars. Suffolk PLC Trial Balance December 31, 2015 Pounds 1,500,000 5,200,000 18,000,000 36,000,000 (1,450,000) (5,000,000) (44,000,000) (8,000,000) (28,000,000) 16,000,000 2,000,000 6,000,000 1,750,000
Cash £ Accounts receivable Inventory Property, plant, & equipment (net) Accounts payable Long-term debt Common stock Retained earnings, 1/1/15 Sales Cost of goods sold Depreciation Other expenses Dividends, 1/30/15 Cumulative translation adjustment
Exchange Rate $1.60 $1.60 $1.60 $1.60 $1.60 $1.60 $1.60 Schedule A $1.60 $1.60 $1.60 $1.60 $1.60
£ 0 Note: Amounts in parentheses are credit balances.
Schedule A Retained earnings, 1/1/14 Net income, 2014 Retained earnings, 12/31/14
Pounds £(6,000,000) (2,000,000) £(8,000,000)
10-54 .
.
Dollars $ 2,400,000 8,320,000 28,800,000 57,600,000 (2,320,000) (8,000,000) (70,400,000) (12,800,000) (44,800,000) 25,600,000 3,200,000 9,600,000 2,800,000
$
Exchange Rate $1.60 $1.60
0 0
Dollars $ (9,600,000) (3,200,000) $(12,800,000)
Chapter 10 - Translation of Foreign Currency Financial Statements
Excel and Analysis Case (continued) b. Schedule detailing the change in Suffolk’s cumulative translation adjustment for 2014 and 2015. Determination of Cumulative Translation Adjustment Net assets, 1/1/14 Net income, 2014 Translation adjustment, 2014 Net assets, 1/1/15 Net income, 2015 Dividends, 2015 Translation adjustment, 2015 Net assets, 12/31/15 Cumulative Translation Adjustment, 12/31/15
Pounds £50,000,000 2,000,000
Exchange Exchange Rate Rate $1.60 $1.60 $1.60 $1.60
$0 £52,000,000 4,000,000 (1,750,000)
$1.60 $1.60 $1.60
$1.60 $1.60 $1.60
0 0 0 0
£ 54,250,000 $0
Cost Allocation Schedule Cost Book value Excess of cost over book value
Pounds £52,000,000 50,000,000 £ 2,000,000
Translation Adjustment Related to Excess of Cost Over Book Value Excess of cost over book value U.S. dollar value at 12/31/15 U.S. dollar value at 1/1/14 Translation adjustment related to excess, 12/31/15
Pounds £2,000,000
Exchange Rate $1.60 $1.60
Exchange Rate $1.60 $1.60
Dollars $83,200,000 80,000,000 $ 3,200,000
Dollars $3,200,000 3,200,000 $0
10-55 .
Dollars $0 0
.
Chapter 10 - Translation of Foreign Currency Financial Statements
Excel and Analysis Case (continued) c. Consolidation Worksheet—December 31, 2015 Parker
Suffolk
($70,000,000)
($44,800,000)
($114,800,000)
Cost of goods sold
34,000,000
25,600,000
59,600,000
Depreciation
20,000,000
3,200,000
23,200,000
Other expenses
6,000,000
9,600,000
15,600,000
Dividend income
(2,800,000)
Sales
Adjustments & Eliminations
Consolidated
2,800,000
0
Net income
($12,800,000)
($6,400,000)
Ret. earnings, 1/1/15
($48,000,000)
($12,800,000)
Net income
(12,800,000)
(6,400,000)
Dividends
4,500,000
2,800,000
($56,300,000)
($16,400,000)
($63,100,000)
Cash
$3,600,000
$2,400,000
$6,000,000
Accounts receivable
10,000,000
8,320,000
18,320,000
Inventory
30,000,000
28,800,000
58,800,000
Investment in Suffolk
83,200,000
Ret. earnings, 12/31/15
($16,400,000)
12,800,000
3,200,000
($51,200,000) (16,400,000)
2,800,000
3,200,000
83,200,000
4,500,000
0
3,200,000
Prop, plant & eq (net)
105,000,000
57,600,000
3,200,000
165,800,000
0
Accounts payable
(25,500,000)
(2,320,000)
(27,820,000)
Long-term debt
(50,000,000)
(8,000,000)
(58,000,000)
Common stock
(100,000,000)
(70,400,000)
Ret. earnings, 12/31/15
(56,300,000)
(16,400,000)
$0
$0
10-56 .
(100,000,000) (63,100,000)
0
Cum. Trans. adj.
.
70,400,000
$92,400,000
0
0
$92,400,000
$0
Chapter 10 - Translation of Foreign Currency Financial Statements
Excel and Analysis Case (continued) d. Consolidated income statement and balance sheet—2015. Parker, Inc. Consolidated Income Statement For the year ended December 31, 2015 Sales Cost of goods sold Depreciation Other expenses Net income
$114,800,000 (59,600,000) (23,200,000) (15,600,000) $ 16,400,000 Parker, Inc. Consolidated Balance Sheet December 31, 2015
Assets Cash Accounts receivable Inventory Property, plant & equipment (net) Total
$
6,000,000 18,320,000 58,800,000 165,800,000 $248,920,000
Liabilities and Shareholders' Equity Accounts payable $ 27,820,000 Long-term debt 58,000,000 Common stock 100,000,000 Retained earnings 63,100,000 Accum. other comp. income 0 Total $248,920,000
10-57 .
.
Chapter 10 - Translation of Foreign Currency Financial Statements
Excel and Analysis Case (continued) Part III—Depreciating Foreign Currency Relevant exchange rates:
January 1, 2014 2014 Average December 31, 2014 January 30, 2015 2015 Average December 31, 2015
$1.60 $1.58 $1.56 $1.55 $1.54 $1.52
a. Translation of Suffolk’s December 31, 2015 trial balance from British pounds to U.S. dollars. Suffolk PLC Trial Balance December 31, 2015 Pounds 1,500,000 5,200,000 18,000,000 36,000,000 (1,450,000) (5,000,000) (44,000,000) (8,000,000) (28,000,000) 16,000,000 2,000,000 6,000,000 1,750,000
Cash £ Accounts receivable Inventory Property, plant, & equipment (net) Accounts payable Long-term debt Common stock Retained earnings, 1/1/15 Sales Cost of goods sold Depreciation Other expenses Dividends, 1/30/15 Cumulative translation adjustment—negative (debit balance)
Exchange Rate $1.52 $1.52 $1.52 $1.52 $1.52 $1.52 $1.60 Schedule A $1.54 $1.54 $1.54 $1.54 $1.55
£ 0 Note: Amounts in parentheses are credit balances.
Schedule A Retained earnings, 1/1/14 Net income, 2014 Retained earnings, 12/31/14
Pounds £(6,000,000) (2,000,000) £(8,000,000)
10-58 .
.
Dollars $ 2,280,000 7,904,000 27,360,000 54,720,000 (2,204,000) (7,600,000) (70,400,000) (12,760,000) (43,120,000) 24,640,000 3,080,000 9,240,000 2,712,500
$
Exchange Rate $1.60 $1.58
4,147,500 0
Dollars $ (9,600,000) (3,160,000) $(12,760,000)
Chapter 10 - Translation of Foreign Currency Financial Statements
Excel and Analysis Case (continued) b. Schedule detailing the change in Suffolk’s cumulative translation adjustment for 2014 and 2015. Determination of Cumulative Exchange Exchange Translation Adjustment Pounds Rate Rate Dollars Net assets, 1/1/14 £50,000,000 $1.56 $1.60 $(2,000,000) Net income, 2014 2,000,000 $1.56 $1.58 (40,000) Translation adjustment, 2014 (negative) $(2,040,000) Net assets, 1/1/15 £52,000,000 $1.52 $1.56 (2,080,000) Net income, 2015 4,000,000 $1.52 $1.54 (80,000) Dividends, 2015 (1,750,000) $1.52 $1.55 52,500 Translation adjustment, 2015 (negative) (2,107,500) Net assets, 12/31/15 £ 54,250,000 Cumulative Translation Adjustment, 12/31/15 (negative) $(4,147,500)
Cost Allocation Schedule Cost Book value Excess of cost over book value
Pounds £52,000,000 50,000,000 £ 2,000,000
Translation Adjustment Related to Excess of Cost Over Book Value Excess of cost over book value U.S. dollar value at 12/31/15 U.S. dollar value at 1/1/14 Translation adjustment related to excess, 12/31/15—negative
Pounds £2,000,000
Exchange Rate $1.52 $1.60
Dollars $83,200,000 80,000,000 $ 3,200,000
Dollars $3,040,000 3,200,000 $(160,000)
10-59 .
Exchange Rate $1.60 $1.60
.
Chapter 10 - Translation of Foreign Currency Financial Statements
Excel and Analysis Case (continued) c. Consolidation Worksheet—December 31, 2015 Parker
Suffolk
($70,000,000)
($43,120,000)
($113,120,000)
Cost of goods sold
34,000,000
24,640,000
58,640,000
Depreciation
20,000,000
3,080,000
23,080,000
Other expenses
6,000,000
9,240,000
15,240,000
Dividend income
(2,712,500)
Sales
Adjustments & Eliminations
2,712,500
Consolidated
0
Net income
($12,712,500)
($6,160,000)
Ret. earnings, 1/1/15
($48,000,000)
($12,760,000)
Net income
(12,712,500)
(6,160,000)
Dividends
4,500,000
2,712,500
($56,212,500)
($16,207,500)
($62,820,000)
Cash
$3,512,500
$2,280,000
$5,792,500
Accounts receivable
10,000,000
7,904,000
17,904,000
Inventory
30,000,000
27,360,000
57,360,000
Investment in Suffolk
83,200,000
Ret. earnings, 12/31/15
($16,160,000)
12,760,000
3,160,000
($51,160,000) (16,160,000)
2,712,500
3,160,000
83,160,000
4,500,000
0
3,200,000
Prop, plant & eq (net)
105,000,000
54,720,000
3,200,000
162,760,000 160,000
Accounts payable
(25,500,000)
(2,204,000)
(27,704,000)
Long-term debt
(50,000,000)
(7,600,000)
(57,600,000)
Common stock
(100,000,000)
(70,400,000)
Ret. earnings, 12/31/15
(56,212,500)
(16,207,500)
Cum. Trans. adj.
160,000
$0
$92,392,500
10-60 .
(100,000,000) (62,820,000)
4,147,500 $0
.
70,400,000
4,307,500 $92,392,500
$0
Chapter 10 - Translation of Foreign Currency Financial Statements
Excel and Analysis Case (continued) d. Consolidated income statement and balance sheet—2015. Parker, Inc. Consolidated Income Statement For the year ended December 31, 2015 Sales Cost of goods sold Depreciation Other expenses Net income
$ 113,120,000 (58,640,000) (23,080,000) (15,240,000) $ 16,160,000 Parker, Inc. Consolidated Balance Sheet December 31, 2015
Assets Cash Accounts receivable Inventory Property, plant & equipment (net) Total
$
5,792,500 17,904,000 57,360,000 162,760,000 $243,816,500
Liabilities and Shareholders' Equity Accounts payable $ 27,704,000 Long-term debt 57,600,000 Common stock 100,000,000 Retained earnings 62,820,000 Accum. other comp. income (4,307,500) Total $243,816,500
10-61 .
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Chapter 10 - Translation of Foreign Currency Financial Statements
Excel and Analysis Case (continued) Part IV—Risk Assessment Report and Financial Management Recommendations
Consolidated net income Percentage difference
December 31, 2015 Exchange Rate $1.68 $1.60 $1.52 $16,640,000 $16,400,000 $16,160,000 101.5% 100% 98.5% + 1.5% -- 1.5%
Cash flow from dividends Percentage difference
$2,887,500 103% + 3%
$2,800,000 100% --
$2,712,500 97% - 3%
Total Liabilities Total Stockholders’ equity Debt-to-equity ratio Percentage difference
$86,336,000 $167,687,500 51.5% 98% - 2%
$85,820,000 $163,100,000 52.6% 100% --
$85,304,000 $158,512,500 53.8% 102% + 2%
Appreciation of the British pound from $1.60 to $1.68 results in consolidated net income being 1.5% higher, cash flow from dividends being 3% higher, and the debt-to-equity ratio being 2% lower than if there had been no change in exchange rates. Depreciation of the British pound from $1.60 to $1.52 would have resulted in income being 1.5% lower, cash flow from dividends being 3% lower, and the debt-to-equity ratio being 2% higher than if there had been no change in exchange rates. An increase in the dollar value of the British pound results in higher profitability, greater cash inflow, and an improved debt-to-equity ratio. The opposite is true for a decrease in the dollar value of the British pound. If the British pound is expected to appreciate, Parker should not hedge its British pound exposure associated with its investment in Suffolk. However, if the British pound is expected to depreciate, Parker may wish to hedge its British pound net asset and cash flow exposure in some way. The decline in dollar value of future British pound dividend payments could be hedged by selling British pounds forward or by purchasing a British pound put option. The negative translation adjustment reported in accumulated other comprehensive income could be avoided using an option or forward contract, or by taking out a loan in British pounds.
10-62 .
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Chapter 11 - Worldwide Accounting Diversity and International Standards
CHAPTER 11 WORLDWIDE ACCOUNTING DIVERSITY AND INTERNATIONAL STANDARDS Chapter Outline I.
Accounting and financial reporting rules differ across countries. There are a variety of factors influencing a country’s accounting system. A. Legal system—primarily relates to how accounting principles are established; code law countries generally having legislated accounting principles and common law countries having principles established by non-legislative means. B. Taxation—financial statements serve as the basis for taxation in many countries. In those countries with a close linkage between accounting and taxation, accounting practice tends to be more conservative so as to reduce the amount of income subject to taxation. C. Financing system—where shareholders are a major provider of financing, the demand for information made available outside the company becomes greater. In those countries in which family members, banks, and the government are the major providers of business finance, there is less demand for public accountability and information disclosure. D. Inflation—historically, caused some countries, especially in Latin America, to develop accounting principles in which traditional historical cost accounting is abandoned in favor of inflation adjusted figures. As inflation has been brought under control in most countries, this factor is no longer of significant influence. E. Political and economic ties—can explain the usage of a British style of accounting throughout most of the former British Empire. They also help to explain similarities between the U.S. and Canada, and increasingly, the U.S. and Mexico. F. Culture—affects a country’s accounting system in two ways: (1) through its influence on a country’s institutions, such as its legal system and system of financing, and (2) through its influence on the accounting values shared by members of the accounting sub-culture.
II.
Nobes developed a general model of the reasons for international differences in financial reporting that has only two explanatory factors: (1) national culture, including institutional structures, and (2) the nature of a country’s financing system. A. A self-sufficient Type I culture will have a strong equity-outsider financing system which results in a Class A accounting system oriented toward providing information for outside shareholders. B. A self-sufficient Type II culture will have a weak equity-outsider financing system which results in a Class B accounting system oriented toward protecting creditors and providing a basis for taxation. C. Countries dominated by a country with a Type I culture will use a Class A accounting system even though they do not have strong equity-outsider financing systems. D. Companies with strong equity-outsider financing located in countries with a Class B accounting system will voluntarily attempt to use a Class A accounting system to compete in international capital markets.
III. Differences in accounting across countries cause several problems. A. Consolidating foreign subsidiaries requires that the financial statements prepared in accordance with foreign GAAP must be converted into the parent company’s GAAP. B. Companies interested in obtaining capital in foreign countries often are required to provide financial statements prepared in accordance with accounting rules in that country, which are likely to differ from rules in the home country. C. Investors interested in investing in foreign companies may have a difficult time in making 11-1 .
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Chapter 11 - Worldwide Accounting Diversity and International Standards
comparisons across potential investments because of differences in accounting rules across countries. IV. The International Accounting Standards Committee (IASC) was formed in 1973 in hopes of improving and promoting the worldwide harmonization of accounting principles. It was superseded by the International Accounting Standards Board (IASB) in 2001. A. The IASC issued 41 International Accounting Standards (IAS) covering a broad range of accounting issues. Ten IASs have been superseded or withdrawn, leaving 31 in effect. B. The membership of the IASC was composed of over 140 accountancy bodies from more than 100 nations. C. The IASC was not in a position to enforce its standards. Instead, member accountancy bodies pledged to work toward acceptance of IASs in the respective countries. D. Because of criticism that too many options were allowed in its standards and therefore true comparability was not being achieved, the IASC undertook a Comparability Project in the 1990s, revising 10 of its standards to eliminate alternatives. E. The IASC derived much of its legitimacy as an international standard setter through endorsement of its activities by the International Organization of Securities Commissions. IOSCO and the IASC agreed that, if the IASC could develop a set of core standards, IOSCO would recommend that stock exchanges allow foreign companies to use IASs in preparing financial statements. The IASC completed the set of core standards in 1998, IOSCO endorsed their usage by foreign companies in 2000, and many members of IOSCO adopted this recommendation. V.
The International Accounting Standards Board (IASB) replaced the IASC in 2001. A. The IASB originally consisted of 14 members – 12 full-time and 2 part-time. The number of board members was increased to 16 members in 2012, at least 13 of whom must be full-time. Full-time IASB members are required to sever their relationships with former employers to ensure independence. To ensure a broad international diversity, there normally are four members from Europe; four from North America; four from the Asia/Oceania region; one from Africa; one from South America; and two from any area to achieve geographic balance. B. IASB GAAP is referred to as International Financial Reporting Standards (IFRS) and consists of (a) IASs issued by the IASC (and adopted by the IASB), (b) individual International Financial Reporting Standards developed by the IASB, and (c) Interpretations issued by the Standing Interpretations Committee (SIC) (until 2001) and International Financial Reporting Interpretations Committee (IFRIC). C. In addition to 31 IASs and 13 IFRSs (as of January 2013), the IASB also has a Framework for the Preparation and Presentation of Financial Statements, which serves as a guide to determine the proper accounting in those areas not covered by IFRS. D. As of June 2012, more than 90 countries required the use of IFRS by all domestic publicly traded companies, and several important countries were to begin using IFRS in the near future. Other countries allow the use of IFRS by domestic companies. Many countries also allow foreign companies that are listed on their securities markets to use IFRS. E. There are two primary methods used by countries to incorporate IFRS into their financial reporting requirements for listed companies: (1) full adoption of IFRS as issued by the IASB, without any intervening review or approval by a local body, and (2) adoption of IFRS after some form of national or multinational review and approval process.
VI. The U.S. FASB has adopted a strategy of convergence with IASB standards. A. In 2002, the IASB and FASB signed the so-called “Norwalk Agreement” to “use their best efforts to (a) make their existing financial reporting standards fully compatible as soon as is practicable and (b) coordinate their work program to ensure that once achieved, compatibility is maintained.” 11-2 .
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Chapter 11 - Worldwide Accounting Diversity and International Standards
B.T
C.
he FASB-IASB convergence process has resulted in changes made to U.S. GAAP, IFRS, or both in a number of areas including: Business combinations, Non-controlling interests, Acquired in-process research costs, Share-based payment, Borrowing costs, Segment reporting, and Presentation of other comprehensive income. At the beginning of 2013, the FASB listed joint convergence projects with either an Exposure Draft or final standard expected to be issued in 2013 in the following areas: Leases, Insurance contracts, Financial instruments, Revenue recognition, Investment companies, and Consolidation: Policy and Procedures
VII. The U.S. SEC’s early interest in IFRS stemmed from IOSCO’s endorsement of IFRS for crosslisting purposes. A.A fter considering this issue for several years, in 2007 the SEC amended its rules to allow foreign registrants to prepare financial statements in accordance with IFRS without reconciliation to U.S. GAAP. Since 2007, foreign companies using IFRS have been able to list securities on U.S. securities markets without providing any U.S. GAAP information in their annual reports. B. To level the playing field for U.S. companies, in July 2007, the SEC issued a concept release to determine public interest in allowing U.S. companies to choose between IFRS and U.S. GAAP in preparing financial statements. Many comment letter writers were not in favor of allowing U.S. companies to choose between IFRS and U.S. GAAP instead recommending that U.S. companies be required to use IFRS. C. In November 2008, the SEC issued the so-called “IFRS Roadmap.” The SEC indicated it would monitor several milestones until 2011 at which time it decide whether to require U.S. companies to follow IFRS over a three-year phase-in period. The Roadmap indicated 2014 as the first year of IFRS adoption, but a subsequent SEC Release in February 2010 pushed that date back to “approximately 2015 or 2016.” D. In 2011, the SEC Staff published a discussion paper that suggests an alternative framework for incorporating IFRS into the U.S. financial reporting system. This framework combines the existing FASB-IASB convergence project with the endorsement process followed in many countries and the EU. Some refer to this method as “condorsement.” The framework would retain both U.S. GAAP and the FASB as the U.S. accounting standard setter. At the end of a transition period, a U.S. company following U.S. GAAP also would be able to represent that its financial statements are in compliance with IFRS. E. The 2011 deadline established by the SEC in its IFRS Roadmap came and went without the Commission making a decision whether to require the use of IFRS in the U.S. In July 2012, the SEC staff issued a Final Staff Report that summarized analysis conducted by the SEC Staff on the possible use of IFRS by U.S. companies, but it did not include conclusions or recommendation for action by the Commission and did not provide insight into the nature or timetable for next steps. Thus, at the time this book went to press, the SEC had not signaled when it might make a decision about whether and, if so, how IFRS should be incorporated into the U.S. financial reporting system. VIII. IFRS 1, First-time Adoption of IFRS, established guidelines that a company must use in transitioning from previously-used GAAP to IFRS. A. Companies transitioning to IFRS must prepare an opening balance sheet at the “date of transition.” The transition date is the beginning of the earliest period for which an entity presents full comparative information under IFRS. For example, for a company preparing its first set of financial statements for the calendar year 2017, the date of transition is January 1, 2015. B. An entity must complete the following steps to prepare the opening IFRS balance sheet: 11-3 .
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Chapter 11 - Worldwide Accounting Diversity and International Standards
1. Determine applicable IFRS accounting policies based on standards in force on the reporting date. 2. Recognize assets and liabilities required to be recognized under IFRS that were not recognized under previous GAAP and derecognize assets and liabilities previously recognized that are not allowed to be recognized under IFRS. 3. Measure assets and liabilities recognized on the opening balance sheet in accordance with IFRS. 4. Reclassify items previously classified in a different manner from what is acceptable under IFRS. IX. IAS 8, “Accounting Policies, Changes in Accounting Estimates and Errors,” establishes guidelines for determining appropriate IFRS accounting polices. A. Companies must use the following hierarchy to determine accounting polices that will be used in preparing IFRS financial statements. 1. Apply specifically relevant standards (IASs, IFRSs, or Interpretations) dealing with an accounting issue. 2. Refer to other IASB standards dealing with similar or related issues. 3. Refer to the definitions, recognition criteria, and measurement concepts in the IASB Framework. 4. Consider the most recent pronouncements of other standard-setting bodies that use a similar conceptual framework, other accounting literature, and accepted industry practice to the extent that these do not conflict with sources in 2. and 3. above. B. Because the FASB and IASB conceptual frameworks are similar, step 4 provides an opportunity for entities to adopt FASB standards in dealing with accounting issues where steps 1 through 3 are not helpful. X.
Numerous differences exist between IFRS and U.S. GAAP. A. Differences exist with respect to recognition, measurement, presentation, and disclosure. Exhibit 11.8 lists several key differences. B. IAS 1, “Presentation of Financial Statements,” provides guidance with respect to the purpose of financial statements, components of financial statements, basic principles and assumptions, and the overriding principle of fair presentation. There is no equivalent to IAS 1 in U.S. GAAP. C. The IASB follows a principles-based approach to standard setting, rather than the socalled rules-based approach used by the FASB. The IASB tends to avoid the use of bright line tests and provides a limited amount of implementation guidance in its standards.
XI. Even if all countries adopt a similar set of accounting standards, two obstacles remain in achieving the goal of worldwide comparability of financial statements. A. IFRS must be translated into languages other than English to be usable by non-English speaking preparers of financial statements. It is difficult to translate some words and phrases into other languages without a distortion of meaning. B. Culture can affect the manner in which an accountant interprets and applies an accounting standard. Differences in culture can lead to differences in application of the same standard across countries.
11-4 .
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Chapter 11 - Worldwide Accounting Diversity and International Standards
Answer to Discussion Question: Which Accounting Method Really is Appropriate? Students in the United States often assume that U.S. GAAP is superior and that all reporting issues can (or should) be resolved by following U.S. rules. However, the reporting of research and development costs is a good example of a rule where different approaches can be justified and the U.S. rule might be nothing more than an easy method to apply. In the United States, all such costs are expensed as incurred because of the difficulty of assessing the future value of these projects. International Financial Reporting Standards require capitalization of development costs when certain criteria are met. The issue is not whether costs that will have future benefits should be capitalized. Most accountants around the world would recommend capitalizing a cost that leads to future revenues that are in excess of that cost. The real issue is whether criteria can be developed for identifying projects that will lead to the recovery of those costs. In the U.S., the FASB felt that such decisions were too subjective and open to manipulation. Conversely, under IFRS, development costs must be recognized as an intangible asset when an enterprise can demonstrate all of the following: (a) the technical feasibility of completing the intangible asset so that it will be available for use or sale; (b) its intention to complete the intangible asset and use or sell it; (c) its ability to use or sell the intangible asset; (d) how the intangible asset will generate probable future economic benefits. Among other things, the enterprise should demonstrate the existence of a market for the output of the intangible asset or the existence of the intangible asset itself or, if it is to be used internally, the usefulness of the intangible asset; (e) the availability of adequate technical, financial and other resources to complete the development and to use or sell the intangible asset; and (f) its ability to measure the expenditure attributable to the intangible asset during its development reliably. The IFRS treatment of development costs begs the question: How easy is it for an accountant to determine whether the development project will result in an intangible asset, such as a patent, that will generate future economic benefits? In the U.S., a conservative approach has been taken because of the difficulty of determining whether an asset has been or will be created. To ensure comparability, all companies are required to expense all R&D costs. As a result, costs related to development costs that prove to be very valuable to a company for years to come are expensed immediately. Do the benefits of consistency and comparability (each company expenses all costs each year) outweigh the cost of producing financial statements that might omit valuable assets from the balance sheet? No definitive answer exists for that question. However, the reader of financial statements needs to be aware of the fundamental differences in approach that exist in accounting for development costs before making comparisons between companies from different countries.
11-5 .
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Chapter 11 - Worldwide Accounting Diversity and International Standards
Answers to Questions 1.
The five factors most often cited as affecting a country's accounting system are: (1) legal system, (2) taxation, (3) providers of financing, (4) inflation, and (5) political and economic ties. The legal system is primarily related to how accounting principles are established; code law countries generally having legislated accounting principles and common law countries having principles established by non-legislative means. In some countries, financial statements serve as the basis for taxation and in other countries they do not. In those countries with a close linkage between accounting and taxation, accounting practice tends to be more conservative so as to reduce the amount of income subject to taxation. Shareholders are a major provider of financing in some countries. As shareholder financing increases in importance, the demand for information made available outside the company becomes greater. In those countries in which family members, banks, and the government are the major providers of business finance, there tends to be less demand for public accountability and information disclosure. Historically, chronic high inflation caused some countries, especially in Latin America, to develop accounting principles in which traditional historical cost accounting is abandoned in favor of inflation adjusted figures. Because inflation has been brought under control in most countries of the world, this factor is no longer of much significance. Political and economic ties can explain the usage of a British style of accounting throughout most of the former British empire. They also help to explain similarities between the U.S. and Canada, and increasingly, the U.S. and Mexico. Culture also is viewed as a factor that has significant influence on the development of a country’s accounting system. This influence is described in more detail in the answer to question 3.
2.
Problems caused by accounting diversity for a company like Nestle include: (a) the additional cost associated with converting foreign GAAP financial statements of foreign subsidiaries to parent company GAAP to prepare consolidated financial statements, (b) the additional cost associated with preparing Nestle financial statements in foreign GAAP (or reconciling to foreign GAAP) to gain access to foreign capital markets, and (c) difficulty in understanding and comparing financial statements of potential foreign acquisition targets.
3.
Gray developed a model that hypothesizes that societal values, i.e., culture, affect the development of accounting systems in two ways: (1) societal values help shape a country’s institutions, such as legal system and financing system, which in turn influences the development of accounting, and (2) societal values influence accounting values held by members of the accounting sub-culture, which in turn influences the development of the accounting system. Gray provides specific hypotheses with respect to the manner in which specific cultural dimensions will influence specific accounting values. For example, he hypothesizes that in countries in which avoiding uncertainty is important, accountants will have a preference for more conservative measurement of profit.
4.
According to Nobes, the purpose for financial reporting determines the nature of a country’s financial reporting system. The most relevant factor for determining the purpose of financial reporting is the nature of the financing system. Some countries have a culture, and accompanying institutional structure, that leads to a strong equity financing system with large numbers of outside shareholders. A country with a self-sufficient Type I culture will have a strong equity-outsider financing system which in turn will lead that country developing a Class A accounting system oriented toward providing information for outside shareholders. A self-sufficient Type II culture will have a weak equity-outsider financing system which results in a Class B accounting system oriented toward protecting creditors and providing a basis for taxation.
11-6 .
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Chapter 11 - Worldwide Accounting Diversity and International Standards
5.
Several of the IASC’s original standards were criticized for allowing too many alternative methods of accounting for a particular item. As a result, through the selection of different acceptable options, the financial statements of two companies following International Accounting Standards still might not have been comparable. To enhance the comparability of financial statements prepared in accordance with International Accounting Standards, and at the urging of the International Organization of Securities Commissions, the IASC systematically reviewed its existing standards (in the so-called Comparability Project) and revised ten of them by eliminating previously acceptable alternatives.
6.
A major difference between the IASB and the IASC is the composition of the Board and the manner in which Board members are selected. IASB has at least 12 and as many as 14 fulltime members, the IASC had zero. Full-time IASB members must sever their employment relationships with former employers and must maintain their independence. Seven of the fulltime members have a liaison relationship with a national standard setter. At least five members must have been auditors, three must have been financial statement preparers, three must have been users of financial statements, and at least one must come from academia. The most important criterion for appointment to the IASB is technical competence. (Although not stated in the body of the chapter, there was a perception that some appointments to the IASC were based on politic connections and not competence.) [Some of the common features of the IASC and IASB are that both (a) issue/d “international standards,” (b) have/had their headquarters in London, and (c) use/d English as the working language.]
7.
This statement is true in that EU publicly traded companies are required to use IFRS in preparing consolidated financial statements. It is false in that non-public companies are not required to use IFRS and publicly traded companies do not use IFRS in preparing their parent company only financial statements.
8.
The bottom section of Exhibit 11.6 shows the countries as of June 2012 that do not allow domestic companies to use IFRS in preparing consolidated financial statements. The two most economically important countries in this group are China and the United States.
9.
The IASB and FASB have agreed to “use their best efforts to (a) make their existing financial reporting standards fully compatible as soon as is practicable and (b) coordinate their work program to ensure that once achieved, compatibility is maintained.”
10. Convergence implies a joint effort between two standard setters to reduce differences in the sets of standards for which they are responsible. Convergence could result in one standard setter adopting an existing standard developed by the other standard setter or by the two standard setters jointly developing a new standard. Convergence does not necessarily mean the two sets of standards that result from the convergence process will be the same. Indeed, the FASB and IASB acknowledge that differences between IFRS and U.S. GAAP will continue to exist even after convergence. In contrast to the approach taken by the FASB to influence future IASB standards, the European Union simply adopted IFRS as the national GAAP in member nations.
11-7 .
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Chapter 11 - Worldwide Accounting Diversity and International Standards
11. Since 2007, foreign companies listed on U.S. stock exchanges may file IFRS financial statements with the U.S. SEC without providing any reconciliation to U.S. GAAP. Domestic companies listed on U.S. stock exchanges must file financial statements prepared in accordance with U.S. GAAP. The SEC’s proposed condorsement framework combines the FASB–IASB convergence process with the IFRS endorsement process followed in many countries and in the EU. The framework would retain both U.S. GAAP and the FASB as the U.S. accounting standard setter. At the end of a transition period, a U.S. company following U.S. GAAP also would be able to represent that its financial statements are in compliance with IFRS. The two components of the framework are: • The FASB continues to participate in the process of developing new IFRSs and incorporates those standards into U.S. GAAP by means of an endorsement process. • The FASB would incorporate existing IFRSs into U.S. GAAP over a defined period of time, for example, five to seven years, with a focus on minimizing transition costs for U.S. companies. At the time this book went to press in the third quarter of 2013, the SEC still had not yet made a decision on the issue of incorporating IFRS into the U.S. financial reporting system. 12. When adopting IFRS, a company must prepare an “IFRS opening balance sheet” at the date of transition. The date of transition is the beginning of the earliest period for which comparative information must be presented, i.e., two years prior to the “reporting date.” A company must follow five steps in preparing its IFRS opening balance sheet: 1. Determine applicable IFRS accounting policies based on standards that will be in force on the reporting date. 2. Recognize assets and liabilities required to be recognized under IFRS that were not recognized under prior GAAP, and derecognize assets and liabilities recognized under prior GAAP that are not allowed to be recognized under IFRS. 3. Measure assets and liabilities recognized on the IFRS opening balance sheet in accordance with IFRS (that will be in force on the reporting date). 4. Reclassify items previously classified in a different manner from what is acceptable under IFRS. 5. Comply with all disclosure and presentation requirements. 13. The extreme approaches that a company might follow in determining appropriate accounting policies for preparing its initial set of IFRS financial statements are: 1. Adopt accounting policies acceptable under IFRS that minimize change from existing accounting policies used under current GAAP. 2. Take a fresh start, clean slate approach and develop accounting policies acceptable under IFRS that will result in financial statements that reflect the economic substance of transactions and present the most economically meaningful information possible. 14. According to the accounting policy hierarchy in IAS 8, if a company is faced with an accounting issue for which (a) there is no specific IASB standard that applies, (b) there are no IASB standards on related issues, and (c) reference to the IASB’s Framework does not help in determining an appropriate accounting treatment, then the company should consider the most recent pronouncements of other standard-setting bodies that use a similar conceptual framework. The FASB’s conceptual framework is similar to the IASB’s, so reference to FASB pronouncements would be acceptable under IAS 8 when conditions (a), (b), and (c) exist.
11-8 .
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Chapter 11 - Worldwide Accounting Diversity and International Standards
15. Potentially significant differences between IFRS and U.S. GAAP related to asset recognition and measurement are: • Acceptable use of LIFO under U.S. GAAP, but not IFRS. • Definition of “market” in the lower of cost or market rule for inventory – replacement cost under U.S. GAAP; net realizable value under IFRS. • Reversal of inventory writedowns allowed under IFRS, but not under U.S. GAAP. • Possible revaluation of property, plant, and equipment under IFRS (allowed alternative), but not under U.S. GAAP. • Capitalization of development costs as an intangible asset under IFRS, which is not acceptable under U.S. GAAP (except for computer software development costs). • Difference in the determination of whether an asset is impaired. • Subsequent reversal of impairment losses allowed by IFRS, but not U.S. GAAP. 16. Even if all countries adopt a similar set of accounting standards, two obstacles remain in achieving the goal of worldwide comparability of financial statements. First, IFRS must be translated into languages other than English to be usable by non-English speaking preparers of financial statements. It is difficult to translate some words and phrases found in IFRS into non-English languages without a distortion of meaning. Second, culture can affect the manner in which accountants interpret and apply accounting standards. Differences in culture can lead to differences in how the same standard is applied across countries.
11-9 .
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Chapter 11 - Worldwide Accounting Diversity and International Standards
Answers to Problems 1.
B
2.
C
3.
D
4.
C
5.
D
6.
D
7.
D
8.
A
9.
A
10. C 11. B 12. D 13. A 14. C
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Chapter 11 - Worldwide Accounting Diversity and International Standards
Problems 15-19 are based on the comprehensive illustration. 15. (15 minutes) (Carrying inventory at the lower of cost or “market”) Historical cost Replacement cost Net realizable value Normal profit margin Net realizable value less normal profit [$117,000 – (20% x$117,000)]
$120,000 $111,900 $117,000 20% $93,600
a. 1. Under U.S. GAAP, the company reports inventory on the balance sheet at the lower of historical cost or market, where market is defined as replacement cost (with net realizable value as a ceiling and net realizable value less a normal profit as a floor). In this case, inventory will be written down to replacement cost and reported on the December 31, 2015 balance sheet at $111,900. A $8,100 loss will be included in 2015 income. 2. In accordance with IAS 2, the company reports inventory on the balance sheet at the lower of historical cost and net realizable value. As a result, inventory will be reported on the December 31, 2015 balance sheet at its net realizable value of $117,000 and a loss on writedown of inventory of $3,000 will be reflected in 2015 net income. b. As a result of the differing amounts of inventory loss recognized under U.S. GAAP and IFRS, Lisali will add $5,100 to U.S. GAAP income to reconcile to IFRS income, and will add $5,100 to U.S. GAAP stockholders’ equity to reconcile to IFRS stockholders’ equity.
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Chapter 11 - Worldwide Accounting Diversity and International Standards
16. (25 minutes) (Measurement of property, plant, and equipment subsequent to acquisition) Cost Residual value Useful life Straight-line depreciation
$78,400 $10,000 6 years $11,400 per year
a. 1. Under U.S. GAAP, the company would report the equipment at its depreciated historical cost. Straight-line depreciation expense is $11,400 per year. The equipment would be reported at $67,000, $55,600, and $44,200, respectively, on the December 31, 2015, 2016, and 2017 balance sheets. 2. Under IFRS, the equipment would be depreciated by $11,400 in 2015, resulting in a book value of $67,000 at December 31, 2015. Under IAS 16’s allowed alternative treatment, the equipment would be revalued on January 1, 2016 to its fair value of $74,500. The journal entry to record the revaluation on January 1, 2016 would be: Dr. Equipment $7,500 Cr. Revaluation Surplus (stockholders’ equity) $7,500 (To revalue equipment from carrying value of $67,000 to appraisal value of $74,500.) Depreciation expense on a straight-line basis in 2016, 2017, and beyond would be $12,900 per year [($74,500 – $10,000) / 5 years]. The equipment would be reported on the December 31, 2016 balance sheet at $61,600 [$74,500 – $12,900], and on the December 31, 2017 balance sheet at $48,700 [$61,600 – $12,900]. The differences can be summarized as follows: Depreciation expense IFRS U.S. GAAP Difference
2015 $11,400 $11,400 $0
2016 $12,900 $11,400 $1,500
2017 $12,900 $11,400 $1,500
Book value of equipment IFRS U.S. GAAP Difference
12/31/15 $67,000 $67,000 $0
12/31/16 $61,600 $55,600 $ 6,000
12/31/17 $48,700 $44,200 $ 4,500
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Chapter 11 - Worldwide Accounting Diversity and International Standards
16. (continued) b. There is no difference in net income between IFRS and U.S. GAAP in 2015, so no reconciliation adjustments are necessary in 2015. In 2016, the additional amount of depreciation expense of $1,500 related to the revaluation surplus under IFRS must be subtracted from U.S. GAAP income to reconcile to IFRS net income. The additional depreciation taken under IFRS causes IFRS retained earnings to be $1,500 less than U.S. GAAP retained earnings at December 31, 2016. Under IFRS, the revaluation surplus causes IFRS stockholders’ equity to be $7,500 larger than U.S. GAAP stockholders’ equity. The adjustment to reconcile U.S. GAAP stockholders’ equity to IFRS is $6,000, the difference between the original amount of the revaluation surplus ($7,500) and the accumulated depreciation on that surplus ($1,500). $6,000 would be added to U.S. GAAP stockholders’ equity to reconcile to IFRS. In 2017, $1,500 again is added to IFRS net income to reconcile to U.S. GAAP net income, and $4,500 is subtracted from IFRS stockholders’ equity to reconcile to U.S. GAAP stockholders’ equity. $4,500 is the amount of revaluation surplus ($7,500) less accumulated depreciation on that surplus for two years ($3,000). 17. (15 minutes) (Research and development costs) Research and development costs Useful life
$650,000 (30% related to development) 10 years
a. 1. Under U.S. GAAP, $650,000 of research and development costs would be expensed in 2015. 2. In accordance with IAS 38, $455,000 [$650,000 x 70%] of research and development costs would be expensed in 2015, and $195,000 [$650,000 x 30%]of development costs would be capitalized as an intangible asset. The intangible asset would be amortized over its useful life of ten years, but only beginning in 2016 when the newly developed product is brought to market. b. In 2015, $195,000 would be added to U.S. GAAP net income to reconcile to IFRS and the same amount would be added to U.S. GAAP stockholders’ equity. In 2016, the company would recognize $19,500 [$195,000 / 10 years] of amortization expense on the deferred development costs under IFRS that would not be recognized under U.S. GAAP. In 2016, $19,500 would be subtracted from U.S. GAAP net income to reconcile to IFRS net income. The net adjustment to reconcile from U.S. GAAP stockholders equity to IFRS at December 31, 2016 would be $175,500, the sum of the $195,000 smaller expense under IFRS in 2015 and the $19,500 larger expense under IFRS in 2016. $175,500 would be added to U.S. GAAP stockholders’ equity at December 31, 2016 to reconcile to IFRS. 11-13 .
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Chapter 11 - Worldwide Accounting Diversity and International Standards
18.
(15 minutes) (Gain on sale and leaseback transaction)
Gain on sale of asset Life of leaseback
$76,000 4 years
a. 1. Under U.S. GAAP, the gain of $76,000 on the sale and leaseback transaction is deferred and amortized to income over the life of the lease. With a lease period of four years, $19,000 [$76,000 / 4 years] of the gain would be recognized in 2015. 2. In accordance with IAS 17, the entire gain of $76,000 on the sale and leaseback would be recognized in income in the year of the sale when the lease is an operating lease. b. In 2015, IFRS net income exceeds U.S. GAAP net income by $57,000, the difference ($76,000 vs. $19,000) in the amount of gain recognized on the sale and leaseback transaction. A positive adjustment of $57,000 would be made to reconcile U.S. GAAP net income and U.S. GAAP stockholders’ equity to IFRS. In 2016, a gain of $19,000 would be recognized under U.S. GAAP that would not exist under IFRS. As a result, $19,000 would be subtracted from U.S. GAAP net income to reconcile to IFRS. By December 31, 2016, $38,000 of the gain would have been recognized under U.S. GAAP and included in retained earnings, whereas retained earnings under IFRS includes the entire $76,000 gain. Thus, $38,000 would be added to U.S. GAAP stockholders’ equity at 12/31/16 to reconcile to IFRS.
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Chapter 11 - Worldwide Accounting Diversity and International Standards
19. (20 minutes) (Impairment of property, plant, and equipment) Cost of equipment Salvage value Useful life Depreciation expense, 2015 Carrying value, 12/31/15 Expected future cash flows, 12/31/15 PV of expected future cash flows, 12/31/15 Fair value (net selling price) less costs to dispose, 12/31/15
$135,000 zero 5 years $27,000 $108,000 116,000 100,000 96,600
a. 1. Under U.S. GAAP, an asset is impaired when its carrying value exceeds the expected future cash flows (undiscounted) to be derived from use of the asset. Expected future cash flows are $116,000, which exceeds the carrying value of $108,000, so the asset is not impaired. Depreciation expense for the year is $27,000 [$135,000 / 5 years], and the equipment will be carried on the December 31, 2015 balance sheet at $108,000. 2. In accordance with IAS 36, an asset is impaired when its carrying value exceeds its recoverable amount, which is the greater of (a) value in use (present value of expected future cash flows), and (b) net selling price, less costs to dispose. The carrying value of the equipment at December 31, 2015 is $108,000; original cost of $135,000 less accumulated depreciation of $27,000 [$135,000 / 5 years]. The asset’s recoverable amount is $100,000 (the higher of value in use of $100,000 and fair value of $96,600), so the asset is impaired. An impairment loss of $8,000 [$108,000 - $100,000] would be recognized at the end of 2015, in addition to depreciation expense for the year of $27,000. The equipment will be carried on the December 31, 2015 balance sheet at $100,000. b. An impairment loss of $8,000 was recognized in 2015 under IFRS but not under U.S. GAAP. Therefore, $8,000 must be subtracted from U.S. GAAP net income to reconcile to IFRS net income in 2015. The same amount would be subtracted from U.S. GAAP stockholders’ equity at December 31, 2015 to reconcile to IFRS stockholders’ equity. In 2016, depreciation under IFRS will be $25,000 [$100,000 / 4 years], whereas depreciation under U.S. GAAP is $27,000. $2,000 would be added to U.S. GAAP net income to reconcile to IFRS net income in 2016. To reconcile stockholders’ equity to IFRS at December 31, 2016, $6,000 must be subtracted from U.S. GAAP stockholders’ equity. This is the difference between the impairment loss of $8,000 in 2015 taken under IFRS and the difference in depreciation expense recognized under the two sets of standards in 2016. It also is equal to the difference in the carrying value of the equipment at December 31, 2016 under the two sets of accounting rules: Cost Depreciation, 2015 Impairment loss, 2015 Carrying value, 12/31/15 Depreciation, 2016 Carrying value, 12/31/16
IFRS $135,000 (27,000) (8,000) $100,000 (25,000) $75,000 11-15
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U.S. GAAP $135,000 (27,000) 0 $108,000 (27,000) $81,000
Chapter 11 - Worldwide Accounting Diversity and International Standards
Chapter 11 Develop Your Skills Analysis Case 1—Application of IAS 16 This assignment demonstrates the effect one difference between IFRS and U.S. GAAP would have on a company's net income and stockholders' equity over a 20-year period. Depreciation expense in Years 1 and 2 under both sets of rules: $10,000,000 / 20 years = $500,000 per year The building has a book value of $9,000,000 on January 1, Year 3. On that date, under IFRS, Abacab would revalue the building through the following journal entry: Dr. Building $3,000,000 Cr. Accumulated Other Comprehensive Income (AOCI)
$3,000,000
Under IFRS, the revalued amount of the building will be depreciated over the remaining useful life of 18 years at the rate of $666,667 per year [$12,000,000 / 18 years]. a.
Depreciation Expense IFRS U.S. GAAP
Year 2 $500,000 $500,000
Year 3 $666,667 $500,000
Year 4 $666,667 $500,000
b.
Book Value of Building IFRS U.S. GAAP Difference
1/2/Y3 $12,000,000 $9,000,000 $3,000,000
12/31/Y3 $11,333,333 $8,500,000 $2,833,333
12/31/Y4 $10,666,666 $8,000,000 $2,666,666
c.
Pre-tax income will be $166,667 smaller in each year (Year 3 -Year 20) under IFRS. Cumulatively, IFRS-pretax income will be $3,000,000 smaller than U.S. GAAP pretax income over this 18-year period. Stockholders' equity will be $3,000,000 greater under IFRS at January 1, Year 3. This difference will decrease by $166,667 each year (due to greater IFRS depreciation expense), such that stockholders' equity will be the same under both sets of rules at December 31, Year 20. The difference in stockholders' equity each year is equal to the difference in the book value of the building.
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Chapter 11 - Worldwide Accounting Diversity and International Standards
Analysis Case 2— Reconciliation of IFRS to U.S. GAAP Quantacc Ltd. Schedule to Reconcile IFRS Net Income and Stockholders’ Equity to U.S. GAAP 2015 Income under IFRS
$
100,000
Adjustments: Add depreciation on revaluation amount in current year under IFRS
3,500
Add gain on sale and leaseback recognized in current year under U.S. GAAP
10,000
Add current year’s amortization of deferred development costs
16,000
Income under U.S. GAAP
$
129,500 12/31/2015
Stockholders’ equity under IFRS
$
1,000,000
Adjustments: Subtract revaluation surplus
(35,000)
Add accumulated depreciation on revaluation amount under IFRS (2015 only) Subtract total amount of gain on sale and leaseback recognized under IFRS in 2014 Add cumulative amount of gain on sale and leaseback that would have been recognized under U.S. GAAP in 2014 and 2015
3,500 (200,000) 20,000
Subtract total amount of development costs capitalized under IFRS in 2014 Add cumulative amount of amortization expense on development costs recognized under IFRS (2015 only) Stockholders’ equity under U.S. GAAP
(80,000) 16,000 $
724,500
Explanation for adjustments: 1. Under IFRS – Quantacc recorded a Revaluation Surplus (stock equity account) of $35,000 on 1/1/2015. In 2015, $3,500 of depreciation expense was taken on the revaluation amount ($35,000 / 10 years). Under U.S. GAAP – neither of these would have been recognized. To reconcile from IFRS to GAAP – add $3,500 to IFRS 2015 net income; subtract a total of $31,500 from IFRS 12/31/2015 stockholders’ equity (subtract $35,000 Revaluation Surplus and add $3,500 of accumulated depreciation on the revaluation amount).
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Chapter 11 - Worldwide Accounting Diversity and International Standards
2. Under IFRS – Quantacc recognized a gain on sale/leaseback of $200,000 in 2014. No gain was recognized in 2015. Under GAAP – Quantacc would recognize a gain on sale/leaseback of $10,000 in both 2014 and 2015. To reconcile from IFRS to GAAP – add $10,000 to IFRS 2015 net income. At the end of 2015, the increase in retained earnings related to the gain on sale/leaseback under IFRS is $200,000, but would only be $20,000 under GAAP. To reconcile from IFRS to GAAP – subtract a total of $180,000 from IFRS 12/31/2015 stockholders’ equity. 3. Under IFRS – Quantacc recognized a development cost asset of $80,000 in 2014. In 2015, amortization expense related to this asset was $16,000 ($80,000 / 5 years). Under GAAP – Quantacc would have expensed development costs of $80,000 in 2014. In 2015, there is $16,000 more expense under IFRS than under GAAP. To reconcile from IFRS to GAAP – add $16,000 to IFRS 2015 net income. At 12/31/2015, the decrease in retained earnings is $64,000 larger under IFRS than under GAAP. To reconcile from IFRS to GAAP, subtract a total of $64,000 from IFRS 12/31/2015 stockholders’ equity.
Research Case—Reconciliation to U.S. GAAP Note to instructors: The SEC no longer requires a U.S. GAAP reconciliation from foreign companies using IFRS. As more foreign companies adopt IFRS over time, it will become increasingly more difficult for students to find foreign companies that provide a U.S. GAAP reconciliation in their Form 20-F. Exhibit 11.6 can help in identifying countries not using IFRS. In addition, students may find EDGAR to be of limited use in accessing foreign company annual reports because few foreign companies file electronically with the SEC. Instructors might want to emphasize to their students that they might have more luck accessing the annual report of their selected company from the company's website. This assignment requires students to find the note in Form 20-F in which foreign companies reconcile net income and stockholders' equity from foreign GAAP to U.S. GAAP. The responses to this assignment will depend upon the company selected by the student to research. Examining the reconciliation from foreign GAAP to U.S. GAAP in Form 20-F is a good way to learn some of the major differences between foreign and U.S. GAAP. Students may be surprised to learn how few adjustments most foreign companies make in reconciling to U.S. GAAP. 11-18 .
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Chapter 11 - Worldwide Accounting Diversity and International Standards
Communication Case—Voluntary Adoption of IFRS The response to the requirement in this case will vary by student. Potential benefits and potential risks from the voluntary adoption of IFRS that students might discuss in their memo include the following: •
Potential benefits. Preparing IFRS financial statements would make it easier for analysts to compare the company with foreign competitors that use IFRS. This could result in a lower cost of capital for the company. It also would make it easier for the company to benchmark against foreign competitors. For multinational companies with subsidiaries primarily using IFRS as their local GAAP, the use of IFRS would allow the parent company to avoid IFRS to U.S. GAAP conversions in preparing consolidated financial statements.
•
Potential risks. The major risk of voluntary adoption of IFRS is that the SEC might ultimately decide not to require the use of IFRS in the United States. In that case, the company would probably be required to switch back to U.S. GAAP. The company would have incurred substantial costs in changing its systems to IFRS, without being able to reap the potential benefits over a long period of time, and it would have to incur the cost of switching back to U.S. GAAP.
Internet Case—Foreign Company Annual Report The responses to this assignment will depend on the company selected by the student. A comparison of the findings across companies selected by students can lead to a lively classroom discussion. The instructor might wish to complete this assignment for a non-U S. company of his/her choice to lead the discussion.
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Chapter 12 - Financial Reporting and the Securities and Exchange Commission
CHAPTER 12 FINANCIAL REPORTING AND THE SECURITIES AND EXCHANGE COMMISSION Chapter Outline I.
In the United States, the Securities and Exchange Commission (SEC), created by Act of Congress, is responsible for ensuring that complete and reliable information concerning publicly traded securities is available to investors. A. Although the SEC regulates requirements created by many legislative acts, the most significant are the Securities Act of 1933, the Securities Exchange Act of 1934, and the Sarbanes-Oxley Act of 2002. B. The SEC has sought to accomplish its objectives by working to achieve several goals that include: 1. Assuring adequate disclosure of data before securities can be bought and sold, 2. Preventing the misuse of information by inside parties, 3. Regulating the operation of stock exchanges and other securities markets, and 4. Prohibiting the dissemination of materially misstated information. C. Disclosure requirements of the SEC are contained primarily in two sets of regulations: 1. Regulation S-K establishes rules for all nonfinancial information, such as management’s discussion of the issuer’s business activities. 2. Regulation S-X prescribes the form and content of the financial statements that are included in the various SEC filings. D. The ability to establish disclosure requirements gives the SEC the ultimate authority for accounting principles in this country, although it has generally allowed the FASB to set official guidance. E. The SEC's integrated disclosure system requires that most information that is reported to the SEC must also go to the company's stockholders at various times throughout the year.
II.
As a direct result of the corporate accounting scandals exposed in 2001 and 2002, Congress passed the Sarbanes-Oxley Act of 2002. This legislation has had a wideranging impact on corporate financial reporting and the accounting profession as a whole. A. One of the most important results of this act is the creation of the Public Company Accounting Oversight Board. 12-1
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Chapter 12 - Financial Reporting and the Securities and Exchange Commission
1. This five-member board is appointed by the SEC and funded by fees assessed against publicly traded companies. 2. The board has been given the authority to enforce auditing, quality control, and independence standards. Such power reduces the accounting profession’s ability to regulate itself as it has done in the past seven decades. B. All accounting firms that audit companies with securities that are publicly traded must register with the Public Company Accounting Oversight Board. 1. This registration process allows the new board to gather considerable information from the public accounting firms. 2. All registered firms are subject to inspection by the Public Company Accounting Oversight Board as often as each year. C. The Sarbanes-Oxley Act eliminates a number of consulting services that an accounting firm can perform for an audit client. The goal of this approach is to strengthen the independence of the auditing profession. D. The Sarbanes-Oxley Act also requires the audit committee of a company’s Board of Directors to be made up of individuals who are independent of the management. The audit committee is now responsible for the appointment and compensation of the independent auditors. E. Due to additional financial scandals, Congress supplemented Sarbanes-Oxley with The Wall Street Reform and Consumer Protection Act of 2010 to expand the federal government’s role in regulating corporate governance. Several methods can be used by the SEC to affect generally accepted accounting principles in the United States.
III.
A. Additional disclosure requirements. B. Moratorium on specific accounting practices. C. Challenging individual statements and other reporting by companies filing with the SEC. D. Overruling the FASB (as shown by the rejection of SFAS 19). Companies that offer securities for sale to the public must meet a number of filing requirements monitored by the SEC.
IV.
A. Registration statements are required prior to the issuance of any new security. 1. Depending on specific circumstances, specified forms are required for this purpose (including Forms S-1 and S-3). 2. After completing the appropriate registration form, a company will normally receive a letter of comments from the SEC requesting changes and/or additional disclosures that the SEC deems necessary. 12-2 .
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Chapter 12 - Financial Reporting and the Securities and Exchange Commission
3. Unless exempt from registration, securities cannot be sold until the registration statement is made effective by the SEC. B. Companies that have their securities publicly traded on an exchange must also make regular periodic filings with the SEC. Some of the most common of these disclosure documents are: 1. Form 10-K is an annual report presenting the company's activities and financial position. 2. Form 10-Q contains condensed interim financial statements. 3. Form 8-K discloses the occurrence of a unique or significant happening. 4. A proxy statement (Form 14A) solicits voting power to be used at stockholders' meetings. V.
The SEC has developed a system that allows investors to gain access to filed information electronically over the Internet. This system is known as EDGAR and contains extensive information and documentation relating to practically every publicly traded security.
Answer to Discussion Question Is the Disclosure Worth the Cost? No ultimate answer exists to the question of how the SEC should weigh the costs of disclosure versus the need for adequate information. Students often feel that the importance of the work of the SEC is unquestioned. That is far from reality, as many business owners and investors will advise. Businesses often resist all demands for additional disclosure as being unimportant and not worth the cost of gathering the data. This is also far from reality. This discussion question is intended to show the high cost to the American economy of ensuring that adequate and fair information is available. The $400 million estimation that was made in 1975 (nearly forty (40) years ago) is a staggering figure. It shows this concern has existed for decades. Could investors have been appropriately protected for a smaller amount? This question becomes especially relevant when coupled with the quotation from George Bentson that "I found that there was little evidence of fraud related to financial statements in the period prior to the enactment of the Securities Acts." The question is even more interesting considering the accounting scandals that were discovered in 2001 and 2002. These problems took place despite the presence of the SEC. On the other hand, perhaps the disclosure and compliance is still inadequate and the cost of additional compliance will result in future unknown benefits. One method of approaching this question is to ask students to envision what would result if the SEC was simply to be dissolved. How would companies entice investors into contributing funds? What methods would companies invent to provide assurance to investors? Would more or less money be invested? Would the allocation of resources to the various companies throughout the country be changed? Would investors be adequately protected? How would a new ‘start up’ company attract investors? In other words, does the work of the SEC have an actual impact on the amount of investments that are made and the distribution of these funds to the companies in the country?
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Chapter 12 - Financial Reporting and the Securities and Exchange Commission
Once the benefits of having an authority like the SEC are established, how should these benefits be weighed against the cost of disclosure? Although $400 million (which was the estimated cost forty (40) years ago, is an extremely large amount, it is a very small number in comparison to the dollars that are invested each year in the United States. Is this just the price that must be paid to provide comfort to the investing public? Although no resolution can be made of this question, it should provide for a good deal of class discussion.
Answers to Questions 1. Many of the federal securities laws were passed initially in hopes of putting an end to abuses that were present in securities trading. These problems were first brought to the public's attention by the stock market crash in 1929. Two special concerns were the manipulation of stock market prices in part through the dissemination of inaccurate financial data and the misuse of information by insiders, such as corporate officers and directors. However, the passage of legislative actions also was intended to help restore public confidence in the capital market system that was and is so essential to the American economy. 2. The corporate accounting scandals of this period took several forms. Some were based on manipulating loopholes in generally accepted accounting principles to allow companies to avoid adequately disclosing risky ventures. Others were simply fraudulent reporting of transactions; expenses, for example, were recorded as assets to make the company’s balance sheet(s) look better. Even others were based on the use of corporate funds for personal benefit. The reasons for such behavior can be many and varied. Personal greed is always a motivator. However, the need of a company to report ever-increasing profits in a stock market that was rising at an amazing speed during the mid and late 1990s put significant pressure on many executives. In hindsight, the lack of adequate safeguards in place at corporations, at accounting firms, and even at the SEC must also be considered as playing a role in creating an environment where such practices were allowed to take place. 3. The Sarbanes-Oxley Act has numerous provisions, almost all of which are designed in one way or another to restore public confidence. Several of those provisions include: ▪ ▪ ▪ ▪ ▪ ▪
A Public Company Accounting Oversight Board has been created to enforce and regulate auditing, quality control, and independence standards. All accounting firms that audit publicly-held issuers of securities must register with the Oversight Board and provide detailed information about their operations. All registered firms must be inspected by the Oversight Board to ensure adequate quality control in their audit work. Registered firms are prohibited from providing certain consulting services to audit clients. Corporate audit committees must be composed of members of the Board of Directors who are independent of management. Audit committees must have authority to employ and compensate the independent auditors.
4. The Sarbanes-Oxley Act gives the SEC the power and responsibility to oversee the work of the Public Company Accounting Oversight Board. For example, the five board members are appointed by the SEC. 5. According to the Sarbanes-Oxley Act, accounting firms are only required to register with the Public Company Accounting Oversight Board if they prepare, issue, or participate in the
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Chapter 12 - Financial Reporting and the Securities and Exchange Commission
preparation of an audit report for an “issuer.” An issuer is defined by the Act but normally refers to any organization issuing securities to the public. 6. Registration with the PCAOB forces the accounting firm to (a) provide a significant amount of information about its operations, (b) have its activities open to inspection by the Public Company Accounting Oversight Board, and (c) be subject to the rulings and authority of this Board. 7. The Sarbanes-Oxley Act gives the Public Company Accounting Oversight Board authority over auditing independence rules. Therefore, all future changes made by this body will be an indirect result of the legislation. Moreover, the Sarbanes-Oxley Act specifically eliminated the accounting firms’ ability to provide certain non-attestation services to their audit clients. It further required that audit committees be made up of members of an organization’s Board of Directors who are independent of management. The audit committee must then be responsible for the appointment and compensation of the independent auditors. 8. Prior to the Sarbanes-Oxley Act, most accounting firms were required to undergo periodic peer reviews of their audit documentation and their quality control procedures. However, those reviews were largely done by one firm on another and, given the accounting scandals discovered during 2001 and 2002, apparently did not do enough to ensure the quality of audit work. The new inspection process will be carried out under the authority of the Public Company Accounting Oversight Board. That inspection process will attempt to create a process that goes further in making certain that every firm does quality work on every engagement. 9. "Regulation S-K" establishes disclosure and other reporting requirements for the nonfinancial information that is contained in filings with the SEC. 10. "Regulation S-X" prescribes the form and content of the financial statements, notes, related schedules, and any other financial information included in the various reports filed with the SEC. 11. The Securities and Exchange Commission is composed of more than two dozen divisions and major offices. Some of these include the following: — Division of Corporation Finance—ensures that standards for reporting and disclosure are followed. — Division of Market Regulation—regulates national securities exchanges and investment brokers and dealers. — Division of Enforcement—supervises investigations and directs enforcement activities. — Office of the Chief Accountant—responsible for accounting and auditing matters in connection with the securities laws. — Office of Compliance Inspections and Examinations—verifies compliance by brokers, dealers, and investment companies. 12. The Securities Act of 1933 regulates the initial offering of securities by a company or its underwriters. This Act is often referred to as the “truth in securities act” and it is the statute that now governs the issuers’ registration statements.
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Chapter 12 - Financial Reporting and the Securities and Exchange Commission
13. The Securities Exchange Act of 1934 regulates the subsequent buying and selling of securities through brokers and exchanges. This regulation extends to virtually all aspects of the resale of non-exempt securities. 14. The goals of the SEC are many. However, several prominent goals are as follows: — Ensuring that full and fair information is disclosed to all investors before securities can be exchanged. — Prohibiting the use of materially misstated information. — Preventing the misuse of information, especially by parties inside of the company. — Regulating the operation of securities markets. 15. Information to be included in proxy solicitation material includes the following data: — Five-year summary of operations including sales, total assets, income from continuing operations, and cash dividends per share. — Description of business activities. — Three-year summary of industry segments, export sales, and foreign and domestic operations. — A list of the directors of the company and its executive officers. — Market price of the company's common stock for each quarterly period within the two most recent years. — Restrictions on the company's ability to continue dividend payments. — Management's discussion and analysis of financial conditions, changes in financial condition, and results of operations. — All nonaudit services provided by the company's independent auditors. — Statement as to whether the board of directors approved all nonaudit work of the independent auditors. — Percentage of nonaudit fees paid to the independent auditors in relation to total annual audit fees. — Individual nonaudit fees that are larger than 3 percent of the annual audit fee. 16. A proxy statement is a request made to stockholders for the right to cast their votes at stockholders' meetings. Obviously, the control of the entire company will rest with any group that is able to get a majority of votes through proxy agreements. Thus, the proxy statements are important because they are used in determining the control and direction of the company. 17. Any change made by the SEC in its Regulation S-X, the financial reporting regulation, will have a direct impact on the form and content of the financial reporting of the publicly-held companies in this country. Thus, the Commission has the ability to dictate generally accepted accounting principles. In addition, Financial Reporting Releases are issued by the SEC to explain changes to be made in accounting. Staff Accounting Bulletins are also prepared to explain views on current reporting matters. The SEC has historically limited the use of its authority over generally accepted accounting principles to (1) disclosure issues and (2) areas of accounting where authoritative guidance was thought to be lacking. For example, additional disclosure of specified matters may be required in areas deemed important by the SEC. The Commission can also prohibit practices that are not thought to be appropriate, especially where official guidance is not available. 18. Financial Reporting Releases are issued by the SEC to explain desired changes in reporting requirements. FRRs are used to supplement Regulations S-X and S-K. Staff Accounting Bulletins inform the financial community of views on current matters relating to accounting and disclosure issues. 12-6 .
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Chapter 12 - Financial Reporting and the Securities and Exchange Commission
19. Prior to 1977, the SEC had restricted the use of its accounting authority primarily to disclosure requirements and areas of financial reporting where authoritative guidance was not available. The FASB (and its predecessors in the private sector) had been allowed to establish generally accepted accounting principles in the U.S. The setting of accounting standards was viewed as a process that should be based on theory and research rather than being subjected to government edict. However, when the SEC overruled the FASB's method of reporting unsuccessful exploration costs incurred by gas and oil producing companies, several important precedents were set. The government (through the SEC) showed that it was willing to become a more active participant in setting rules for the accounting profession. The FASB (and other authoritative bodies) then had to be more concerned about pleasing the government prior to establishing standards. Many concerns were raised at the time (as well as since then) as to whether the development of generally accepted accounting principles should be at the mercy of the federal government. 20. Registration statements are designed to disclose and make available adequate relevant data about both a company and its new stock or bond (security) before the security can be issued to the public. 21. Disclosure of sufficient information – Registration Statement disclosure - is required by the Securities Act of 1933. 22. Part I of a registration statement is called a prospectus and must be furnished to every potential buyer of the securities to be issued. It contains information such as financial statements and supplementary data, an explanation of the intended use of the money being raised, a description of the capital structure of the company, and a description of the business and the properties that it holds. Part II of the registration statement provides information that is needed by the SEC staff. Part II includes data such as marketing arrangements for the new securities, the expenses of the issuance, sales to special parties, and the like. 23. Revenues are raised by the SEC, in part, through a registration fee for shares being initially issued. In 2013, this fee was $136.40 for each $1 million of security offering. 24. In the filing of registration statements, a number of different forms are available depending upon the circumstances. Of these forms, these two are especially common: — Form S-1 which is used by new registrants or by companies that have filed with the SEC for less than 36 months; — Form S-3 which is completed by larger companies, including foreign issuers that have filed with the SEC for a considerable length of time and have a significant following in the stock market. Form S-3 permits incorporation of other documents by reference. This permits inclusion of significant data concerning the Issuer, where the data has appeared in other filings. 25. Incorporation by reference is a process allowed when preparing filings with the SEC, and often other governmental agencies. It is intended to reduce the quantity of redundant information that must be processed. When data is required that has already appeared in a previous filing, the company need only refer to the earlier disclosure rather than repeat the information. 26. A pre-filing conference is a meeting between a prospective registrant and the staff of the SEC in hopes of resolving potential problems that may be expected to arise in an upcoming filing. The reporting and disclosure of complicated financial transactions may be discussed 12-7 .
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Chapter 12 - Financial Reporting and the Securities and Exchange Commission
by the parties. The conference may also be used to determine the appropriate handling of unusual problems. 27. A letter of comments (which is also known as a "deficiency letter") is issued by the SEC to a filing company after a registration statement has been reviewed. The letter lists changes and additional disclosures that the SEC feels are necessary before the registration statement can be made effective. 28. A prospectus is the first part of a registration statement, the portion that has to be furnished to every potential buyer of a new security. The prospectus discloses a significant amount of specified information about the issuing company as well as about the new security. For example, the financial statements of the company must be included along with a description of current business operations. The prospectus also informs potential buyers of the intended use of the new funds and the capital structure of the company. 29. Certain new security issues are exempt from the registration requirements monitored by the SEC. For example, securities sold within a single state are normally not subject to these federal laws. In addition, the securities of banks, savings and loan associations, and governments do not come under the Securities Act of 1933. Several other offerings are also exempt from completing formal registration statements although other legal filings may be required: Private placements to a limited number of sophisticated investors; Securities issued to current stockholders without a commission being paid (usually a stock dividend or stock split); Securities issued by nonprofit organizations; Small offerings of no more than $5 million; Offerings of no more than $5 million made to 35 or fewer purchasers 30. Private placements of securities have become extremely popular in recent years because they are exempt from the registration requirements of the SEC. The securities are issued to no more than 35 sophisticated investors (identified as having knowledge and experience in financial matters) who already have sufficient information available to them about the issuing company. General solicitation is not permitted. 31. Blue sky laws are securities laws enforced by individual states. In contrast to federal securities laws, blue sky laws usually apply only to sales that are restricted to a particular state. 32. A wraparound filing is one in which a company uses its annual report to shareholders to fulfill reporting requirements of the SEC in a Form 10-K. Rather than repeat the information within the Form 10-K, incorporation by reference is used to direct the SEC to the location of the required data in the annual report. 33. Form 8-K is not issued on a regular basis but only when disclosure of a unique or significant occurrence is to be made. Thus, a company has some choice as to the necessity of issuing a Form 8-K. The SEC does, however, list several events that require disclosure in this manner: —resignation of a director; —change in control of the company; —acquisition or disposition of assets; —changes in independent accountants; —bankruptcy or receivership. 34. The Management's Discussion and Analysis (MD&A) is a narrative description of the company's past, its present, and its future. The management describes its priorities,
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Chapter 12 - Financial Reporting and the Securities and Exchange Commission
accomplishments, and concerns. In many cases, the MD&A allows the management to share information with owners and other interested parties that would not otherwise be conveyed. 35. The Form 10-K is an annual report (financial statements and related information) whereas the Form 10-Q contains condensed interim financial statements and is filed quarterly. 36. The EDGAR system is intended to allow companies to file information with the SEC in an electronic format and then make that information available on-line to all interested parties.
Answers to Problems 1. D – A is false because intrastate offerings are typically exempt from registration; B is false because the 1934 Securities Act regulates post-issuance trading of securities; and C is false because blue sky legislation is state law. 2. B – Remember that regulation S-X is the regulation that financial information disclosure.
focuses upon
3. C – Regulation S-K addresses non-financial information filed with the SEC while Regulation S-X addresses the form and content of financial documentation filed with the SEC. 4. A – Remember that the 1933 Act deals with Registration and the 1934 Act deals with Regulation. 5. C – Not all auditing firms are required to register with the PCAOB, only those firms that prepare, issue, or participate in the preparation of an audit report for an issuer. Issuers do incur additional fees as a result of SOX. 6. C – The SEC appoints the five (5) PCAOB members. 7. B – Selection of the auditor and approval of the related contract, including the fees, is done by the firm’s audit committee. This committee must be composed of members of the client’s board who are independent of management. 8. A – The 1933 Act deals with the requirements for registration of a security prior to its initial offering. 9. D – S-3 is the form for registering securities if / when the issuer already has a significant public market following. The issuer will likely also file forms 8-K and 10-K, but those are not registration statements. 10. D – The SEC’s 1977 stand vis-à-vis oil and gas accounting principles was a unique situation wherein the SEC overruled the FASB as far as proper accounting treatment. 11. C – Recall that the letter of comments / deficiency letter relate to the SEC’s response subsequent to an issuer’s filing of a Registration Statement. 12. B – This is a useful approach to referencing data which has already been provided to the SEC, or other agency, so that the data is not redundantly produced.
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Chapter 12 - Financial Reporting and the Securities and Exchange Commission
13. A - Recall that the letter of comments / deficiency letter relate to the SEC’s response subsequent to an issuer’s filing of a Registration Statement. 14. D – The prospectus must be furnished to all potential new security buyers and is provided to the SEC as part of the registration statement filing. 15. C – Smaller public offerings of less than $5 million made within a 12-month period may be exempt from registration, however, $5.9 million exceeds this threshold. 16. B – A prospectus is filed only in connection with the initial offering of a security. Therefore it is not ‘regularly’ filed with the SEC, unless the issuer is ‘regularly’ issuing new securities. 17. C – Shelf registrations consist of registering securities in advance so that a large issuer may subsequently offer the securities without the need of additional SEC approval. 18. C – EDGAR = Electronic Data Gathering Analysis and Retrieval system. 19. (25 Minutes) (Series of questions about securities regulations). a. Blue Sky Laws—Individual state laws that regulate the issuance of securities when the transactions are limited to the residents of the state in which the issuing company is organized and principally doing business. Such securities are exempted from regulation by federal securities laws. b. S-8 Statement—A registration statement that must be filed with the SEC and made effective by that body before a company can issue securities in connection with employee stock plans. c. Letter of Deficiencies (also known as Deficiency Letters)—A request by the SEC for changes, explanations, or more information before a registration statement is made effective. The Division of Corporation Finance of the SEC reviews the registration statement and provides the company with a letter of deficiencies so that the company will be able to furnish the additional data needed or make the appropriate changes. This is also referred to as a Letter of Comment or Comment Letter. d. Public Company Accounting Oversight Board—This five (5) member Board was created by the Sarbanes-Oxley Act of 2002 as a result of the corporate accounting scandals that rocked the stock market and the investing community during 2001 and 2002. This Board falls under the jurisdiction of the SEC and has wide-ranging responsibilities from the registration of accounting firms and the inspection of these same firms to the establishment of auditing, quality control, and independence standards. e. Prospectus— The prospectus is the first part of a registration statement that contains financial statements for the company and indicates the use to be made of the money received from the sale of the securities, the capital structure of the company, and a description of the business and its properties. Every potential buyer of the new security must be furnished with a prospectus.
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Chapter 12 - Financial Reporting and the Securities and Exchange Commission
20. (25 Minutes) (Discussion of the Securities Act of 1933 and the Securities Exchange Act of 1934) The Securities Act of 1933 and the Securities Exchange Act of 1934 were passed to help rebuild confidence in the capital market system of the United States. Economic development in this country is based on generating large amounts of monetary capital through the issuance of stocks and bonds. To entice sufficient investment, public trust in the integrity of the system must be maintained. Following the stock market crash of 1929, public confidence reached a low level. Federal securities laws were subsequently passed in hopes of achieving several objectives designed to restore trust in the capital markets. Several aspects of these laws should be noted: — Companies were required to supply adequate information to potential buyers before a new security could be issued. — Companies having publicly traded securities were required to maintain an adequate and continual flow of information to the public. — Stock markets were to be regulated. — Manipulation of stock market prices was to be eliminated. — The use of inside information by corporate officials and directors was made Illegal. To help achieve these goals, the Securities and Exchange Commission (SEC) was created to monitor the capital market system. For example, registration statements had to be filed with the SEC before new stocks or bonds could be issued to the public. These statements were reviewed and could not become effective until all necessary disclosures and financial information were properly presented. Periodic filings (such as Form 10-K and Form 10-Q) were also required of companies having securities that were publicly traded. Because of its ability to require specific types of financial information, the SEC has the ultimate authority to develop generally accepted accounting principles in this country. The SEC also has the power to investigate possible misconduct in connection with corporate reporting and to seek prosecution where necessary. 21. (20 Minutes) (Description of the registration process) In filing a registration statement for a new security, a company must first select the appropriate SEC Registration form. For example, Form S-1 is used by new registrants while Form S-3 is filed by large companies that already have a significant following in the securities markets. Appropriate disclosures and other required data are then prepared in accordance with Regulation S-K and Regulation S-X. When the SEC receives the completed form, it is put through a review. All nonfinancial and financial information are verified against various standards. Legal aspects of the document are also checked along with the report of the independent auditor. A letter of comments (commonly referred to as a "deficiency letter") is prepared by the SEC to indicate changes and added disclosures that are considered necessary. The registrant has the right to discuss these issues with the SEC staff if company officials disagree with any part of the letter of comments. After the SEC is 12-11 .
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Chapter 12 - Financial Reporting and the Securities and Exchange Commission
satisfied that the registration statement fulfills all rules, it is made effective. The first part of this document, the prospectus, must be made available to any potential buyer of the new security. 22. (15 Minutes) (Discussion of the SEC's influence on generally accepted accounting principles) The SEC has far-ranging authority over the accounting principles in this country. Through its ability to modify Regulation S-X, the SEC holds the power to alter the financial reporting of publicly-traded companies. The SEC has historically chosen to limit such changes to disclosure requirements with the creation of accounting principles being left to the FASB (and its predecessors) Thus, the private sector of the accounting profession had been given de facto responsibility for developing generally accepted accounting principles. Although occasionally the object of criticism, this system (theoretically) allows accounting standards to be the result of research and study rather than government edict. However, the SEC has often acted in accounting areas where clear authoritative guidance was not available. In such cases, additional disclosure may be required or the Commission can decide to restrict or even prohibit a particular accounting procedure. The SEC did overrule in 1977 the FASB's method of accounting for unsuccessful exploration and drilling costs incurred by gas and oil producing companies. This action set several important precedents. First, it reaffirmed the SEC's ability to be involved in the standards-setting process. Second, notice was served to the FASB that the private sector needed to make certain that the SEC was satisfied prior to issuing new pronouncements. 23. (20 Minutes) (Listing of forms that are filed with the SEC on a regular periodic basis) Numerous forms may have to be filed regularly with the SEC by a publicly-held company. Four of these forms (Form 10-K, Form 10-Q, Form 8-K, and proxy statements) are frequently encountered. — Form 10-K is an annual report filed shortly after a company's year-end. — Form 10-Q contains condensed interim financial statements and must be filed after the end of each quarter, other than the year-end quarter – because the 10-K is filed after the year-end quarter. — Form 8-K is only filed when needed to disclose the occurrence of a unique or significant event such as the resignation of a director, changes in control, acquisition or disposition of assets, changes in independent accountants, and bankruptcy. Depending upon the frequency of these ‘unique’ events, the Form 8-K may not actually be filed regularly or periodically. — Proxy statements, called “Schedule 14A” are requests for the right to case a stockholder's votes at annual (or other) meetings. Included in the
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Chapter 12 - Financial Reporting and the Securities and Exchange Commission
information that must be provided are financial statements, disclosure of matters that are to be voted on, and an identification of the party making the solicitation. 24. (10 Minutes) (Describe the forms used to file with SEC for registration purposes) Some of the most commonly used forms for registering securities to be offered to the public are as follows: — Form S-1—for new registrants or companies that have been filing with the SEC for less than 36 months. This form is used when no other form is prescribed. — Form S-3—for larger companies that already have a significant following in the stock market. — Form S-4—for securities issued in connection with business combinations. — Form S-8—for securities issued in connection with employee stock plans. — Form S-11—for securities issued by various real estate companies. — Form F-3—for a foreign issuer. 25. (20 Minutes) (Discussions of the Form 8-K and proxy statements) The Form 8-K is designed to ensure the immediate disclosure by a company of any unique or significant event. Thus, any interested parties are able to obtain needed information without having to wait for a quarterly or annual statement. The filing of the Form 8-K must generally be made within 15 days of the occurrence. Events that necessitate the filing of a Form 8-K are left to the discretion of the company and its management. However, the SEC does list several circumstances that require such disclosure including the resignation of a director, change in control of the company, acquisition or disposition of assets, change in independent auditors, and bankruptcy. A proxy statement is the package of information that must accompany the request made to a stockholder for the right to cast that owner's votes at a stockholders' meeting. Since obtaining a significant number of proxies would allow an individual or company to influence or control an organization, the request for proxy rights is closely monitored by the SEC. The proxy statement has to be filed with the SEC before being distributed and must include specified information such as: —an annual report, —a disclosure of all matters that will be voted upon at the meeting, and —an identification of the party or parties making the solicitation. 26. (20 Minutes) (Describe responsibilities of the Public Company Accounting Oversight Board) The Sarbanes-Oxley Act of 2002 is a wide-ranging piece of legislation that covers a large number of different areas of corporate financial reporting. 12-13 .
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Chapter 12 - Financial Reporting and the Securities and Exchange Commission
Much of this Act deals with the establishment of the Public Company Accounting Oversight Board (PCAOB). The PCAOB is created / addressed in Title I of the Act. The PCAOB is in charge of all auditing, independence, and quality control standards for the accounting profession. PCAOB has the legal authority to write such rules and / or to simply oversee the work done by the profession (through the Auditing Standards Board and the AICPA). The ultimate authority for such rules now lies clearly with the PCAOB as illustrated at Title I, Sec. 103(a)(1) of the Act. All accounting firms that prepare, issue, or participate in the preparation of an audit report for an issuing organization will now have to register with the PCAOB in order to continue providing such services. This registration provides the PCAOB with the ability to gather an almost unlimited amount of information about the firms such as disagreements with audit clients, annual fees from both audit and nonaudit services, and the like. The PCAOB must periodically inspect the work of each of the registered accounting firms. The depth and breadth of this inspection will ultimately encompass both audit documentation and compliance with quality control standards. Large firms may undergo annual inspection whereas smaller firms will only be inspected every three years. 27. (30 Minutes) (Discussion of financial reporting and the SEC) a. Staff Accounting Bulletins—According to the website (www.sec.gov) of the Securities and Exchange Commission, “Staff Accounting Bulletins reflect the Commission staff’s views regarding accounting-related disclosure practices. They represent interpretations and policies followed by the Division of Corporation Finance and the Office of the Chief Accountant in administering the disclosure requirements of the federal securities laws.” b. Wraparound filing—the process of using the annual report furnished to shareholders to fulfill many of the requirements of the Form 10-K to be filed with SEC. The company simply indicates the location of the required information (a process known as incorporation by reference) within the annual report. c. Incorporation by reference—using information in one document filed with the SEC to fulfill other reporting requirements. In this manner, the amount of redundant information being reported is reduced. This process is usually part and parcel of a wrap around filing. d. Division of Corporation Finance—a division of the SEC that establishes standards of reporting and disclosure. This division also reviews the registration statements that are filed with the SEC and issues any needed letters of comments. e. Integrated disclosure system—the use of information that is being given to stockholders to meet the filing requirements of the SEC. f. Management's discussion and analysis—an inclusion in the Form 10-K that serves as the management's description of its priorities, accomplishments, 12-14 .
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Chapter 12 - Financial Reporting and the Securities and Exchange Commission
and concerns. The narrative describes the company's past performance, present condition, and future direction. g.C hief accountant of the SEC—the office of the SEC that is ultimately responsible for all accounting and auditing matters that involve the securities laws. 28. (10 Minutes) (Listing of organizations that are exempt from the registration requirements of the SEC) — Governments — Banks — Savings and loan associations — Companies that restrict the exchange of their securities to within one state — Companies that restrict an issuance to its own stockholders where no commission is paid to solicit the exchange — Nonprofit organizations — Companies that make small offerings of no more than $5 million (although a Regulation A offering circular must still be filed) — Companies that make offerings of no more than $1 million to any number of investors within a 12-month period. — Companies that make small offerings of no more than $5 million to 35 or fewer purchasers and an unlimited number of accredited investors. — Companies making private placements to no more than 35 sophisticated investors. Develop Your Skills RESEARCH CASE 1 (45 Minutes) The purpose of this question is to allow the student the opportunity of working with the actual regulations posted on the SEC web site. The URL given in the problem will take the student to the entire set of rules set out under Regulation A – for Conditional Small Issue(s) Exemptions. This information covers topics such as offering statements, offering circulars, and the filing of sales material. The student can literally read through the entirety of Regulation A in about fifteen (15) minutes. For this assignment, the student should probably focus on the heading “Scope of Exemption.” This reference provides several pages of information on the exemption from filing a registration statement that is provided to companies by Regulation A. There are a number of issues that the student might want to address in connection with this question: — Where does the company have to be legally incorporated? (The U.S., Canada, or one of the territories or possessions of the U.S.) — What is the total amount that can be received for the securities being issued? (Not more than $5 million) 12-15 .
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Chapter 12 - Financial Reporting and the Securities and Exchange Commission
— When both cash and non-cash consideration are received, how is the total amount of consideration determined? (It is based on the cash price). — What filing must be made with the SEC? (In most cases, a Form 1-A. — Can advertisements of the securities be made? (Yes, published ads as well as radio and television ads are allowed as long as only specified information is included). If Domer Corporation is a development stage company, the exempt provisions of Regulation A may not apply. Specifically, Reg. Sec. 230.251 (a) (3) provides that the exemption is not available to “a development stage company that either has no specific business plan or purpose, or has indicated that its business plan is to merge with an unidentified company or companies”. Thus Domer’s status as a development stage company, depending upon the status of its business plan, may preclude its use of the Regulation A exemption.
RESEARCH CASE 2 (30 Minutes) The SEC v. Calvo case involves a situation similar to the fact pattern in this research case. The student is directed to this case because of the many similarities. Use of legal / case research is a very valuable skill for accounting students and practitioners as courts ultimately interpret vague rules, regulations, statutes, and definitions. As was suggested in the text, the definition of ‘security’ is very broad. The 1933 Securities Act defines ‘security’ very broadly to include investment contracts. Investment contracts involve: (i) an investment of money or other consideration; (ii) for a common enterprise or undertaking; and (iii) with the expectation of profits to be derived from the efforts of others. In the instant example, the Tasch Corporation will ‘manage’ the customer’s enterprise, the customers are investing money, and the customers are expecting a profit – ie: the guaranteed return. A court would very likely conclude that the “service agreements” constitute an investment contract and thus a security. The next issue / question to address is whether the Tasch Corporation can / will be able to structure the issuance of these securities in a manner to avoid the registration requirements.
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Chapter 12 - Financial Reporting and the Securities and Exchange Commission
ANALYSIS CASE 1 (45 Minutes) This assignment requires the student to utilize the EDGAR database to find recent company filings by any publicly-held company. The results that a student gets will depend on the company name that is entered and the time frame for when the student accesses the database. The student may actually be overwhelmed by the amount of filings that a company must make with the SEC. For example, a search for Dell would display more than thirty-eight (38) filings in just the first three (3) months of 2013. 1. A number of 8-K forms can be found for most companies. Companies now tend to err on the side of over-disclosure with regard to 8-K filings, many of which merely incorporate by reference various press releases or other publicity-related filings. The specific content of the 8-K each student locates will depend on when the student completes the case analysis. 2. A further investigation of the Dell filings leads to a Form 10-K issued on March 12, 2013 (or later depending on when the student utilizes the database), that contains many attachments including the annual report for 2012. This Form 10-K provides extensive information to supplement the data normally reported to shareholders. 3. Finally, a definitive proxy statement can be located for Dell (DEFA 14A), as of April 1, 2013. This is the kind of information that students often have not had the opportunity to access unless they have explored the SEC web site.
Communication Case 1 Here, the student is asked to investigate and review that actual statutory components of the Sarbanes-Oxley Act of 2002. This Act encompasses approximately seventy (70) pages and contains an extensive list of requirements for auditors covered by the Statute. The first issue to consider for the Wojtysiak firm is whether it is presently required to register with the Public Company Accounting Oversight Board (PCAOB). It is not, however, if the Wojtysiak firm becomes the audit firm for the new publicly traded client (and ‘issuer’) then the firm will likely be required to register and then be subjected to additional disclosures and inspections, most likely on a triennial basis. Additionally, the Wojtysiak firm will need to carefully consider what services it can offer to the new client in light of the Sarbanes-Oxley independence requirements. The student will most likely wish to consider and incorporate the following provisions of the Act. 12-17 .
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Chapter 12 - Financial Reporting and the Securities and Exchange Commission
▪ ▪ ▪ ▪ ▪ ▪
Section 102 – Registration with the Board. Section 103 – Auditing, quality control, and independence standards and rules. Section 104 – Inspections of registered public accounting firms. Section 108 – Accounting standards. Section 201 – Services outside the scope of practice of auditors. Section 203 – Audit partner rotation.
The student should be able to write an extensive report on the impact of Sarbanes-Oxley on the Wojtysiak firm, based on these and other provisions of the Act.
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Chapter 13 - Accounting for Legal Reorganizations and Liquidations
CHAPTER 13 ACCOUNTING FOR LEGAL REORGANIZATIONS AND LIQUIDATIONS Chapter Outline I.
Because of a myriad of possible financial or business difficulties, a company may become insolvent, unable to pay its debts as they come due. A. To ensure the equitable treatment of all parties involved with an insolvent company (stockholders as well as creditors), laws have been written to provide structure for the bankruptcy process in the United States. B. At present, legal guidance is provided primarily by the Bankruptcy Reform Act of 1978 as amended. 1. This law attempts to arrive at a fair distribution of a debtor's assets. 2. It also seeks to discharge the obligations of an honest debtor.
II. Bankruptcy proceedings can be formally instigated by either the debtor or a group of creditors. A. A voluntary petition is filed with the court by the insolvent company while an involuntary petition must be filed by a minimum number of creditors with, at least, a minimum level of debt. B. After a bankruptcy petition is received, normally the court will grant an order for relief to halt all actions against the debtor. III. Within the bankruptcy process, determining the appropriate classification of every creditor is an important step in achieving a fair settlement. A. Fully secured creditors hold a collateral interest in assets of the insolvent company having a value in excess of the related liability. B. Partially secured creditors also have a collateral interest but the expected net realizable value will not satisfy the entire obligation. C. Some unsecured obligations (including administrative expenses, certain debts to employees, and government claims for unpaid taxes) have priority over other unsecured debts. D. All remaining unsecured creditors will receive assets from the debtor only after all of the above claims have been satisfied. IV. A Statement of Financial Affairs is frequently produced by an insolvent company to disclose its current financial position. A. Assets are reported at net realizable value along with the disclosure of any pledged amounts. Liabilities are classified according to the security or priority of the creditor. B. A Statement of Financial Affairs is especially useful if prepared at the beginning of the bankruptcy process to assist all parties in evaluating the outcome of various actions. C. Most of the asset balances reported in this statement are merely estimations, projections of future events. V. Bankruptcy proceedings often conclude with the assets of the debtor being liquidated to satisfy creditor claims (a Chapter 7 bankruptcy). 13-1 .
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Chapter 13 - Accounting for Legal Reorganizations and Liquidations
A. A trustee is appointed to oversee termination of business affairs, liquidation of noncash properties, and distribution of cash resources. B. The trustee prepares a periodic reporting of activities. Historically, that reporting has been in the form of a Statement of Realization and Liquidation. 1. This statement indicates the book value and classification of remaining assets and liabilities. 2. It also discloses the effects of all transactions that have occurred to date. 3. This statement is no longer appropriate for external reporting but can still be produced internally to help monitor the activities. C. At the point that liquidation becomes imminent, financial reporting must follow the liquidation basis of accounting. 1. Liquidation is viewed as imminent when a plan has been approved by the court or by individuals with that authority. 2. Under the liquidation basis, both a statement of net assets in liquidation and a statement of changes in net assets in liquidation must be produced. 3. Assets are reported under the liquidation basis at the cash amount that is expected which will often be lower than fair value. Liabilities are not adjusted until changed in some legal fashion. Vl. As an alternative to liquidation, a company may seek to stay in business and attempt to return to solvency (a Chapter 11 bankruptcy). A. A reorganization plan has to be devised that can win the approval of each class of creditors and each class of stockholders as well as the bankruptcy court. B. Reorganization plans normally lay out a specific course of action designed to save the company and can include proposed changes in operations, methods of generating additional working capital, and a settlement of the debts that were in existence on the day that the order for relief was entered. Vll. Financial reporting during reorganization is important to allow parties to follow the progress being made. A. FASB’s Accounting Standards Codification, Topic 852, Reorganizations provides guidance for preparing financial statements during the period that a company goes through reorganization. 1. Gains, losses, revenues, and expenses that result from reorganization must be reported separately on the income statement. 2. Professional fees incurred in connection with the bankruptcy must be expensed immediately. 3. Liabilities subject to compromise are reported on the balance sheet based on the expected amount of the allowed claims. VIII. Fresh start accounting is often required when a company emerges from reorganization. A. Assets are restated to current value but only if the fair value of assets is less than the allowed claims and the original owners are left holding less than 50 percent of company. B. The recognition of goodwill may also be required if the reorganization value of the emerging company is greater than the value of the identifiable assets (both tangible and intangible). C. Retained earnings must be set at zero to indicate that a new entity has been formed.
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Chapter 13 - Accounting for Legal Reorganizations and Liquidations
Answers to Discussion Questions What Do We Do Now? Students are given a chance in this case to look at a non-accounting business decision: the forcing of a valued client into bankruptcy. Thurber has already committed several unfortunate mistakes in this case. For example, he has seen a dramatic slowdown in cash payments by Abraham and Sons without seeking any further information about the prospects of the client. Furthermore, he has let the treasurer pressure him into providing additional credit without any valid justification. He is now being pushed by another company into filing a bankruptcy petition without adequate assurance that Abraham and Sons has a real problem. Because Thurber has not acted earlier, he should now request audited financial statements from Abraham and Sons so that he can make a reasonable decision as to the course of action to take. Once successful companies can falter and go bankrupt creating huge losses for their creditors. Thurber needs to assess the risk and take appropriate action. Many important figures can be gleaned from the company’s financial statements including the amount of working capital, the current ratio, the debt to equity ratio, the trend in sales, the trend in long-term debt, operating cash flows, the gross profit percentage, any expenses that have risen at a fast rate, the amount of property that has been mortgaged, and the like. Thurber should then ask for a face-to-face meeting with the treasurer (or another officer) of Abraham and Sons. In this meeting, Thurber should discuss the possibility of having the current debt secured in some manner as protection. The development of a formal repayment schedule would also be wise. If Thurber is not satisfied by the financial statements and the discussion with the client, he should meet with the clothing manufacturer who has called as well as with a lawyer and/or accountant. They should discuss possible actions and the outcomes that could result from each. Inevitably, if loss of the receivable seems probable unless some action is taken, filing an involuntary petition for bankruptcy may be the wisest decision. However, that procedure should only be undertaken after adequate study has been made. In the long run, companies do not prosper by having their clients go into bankruptcy. Students often address this type of case as either a black or white issue: give more credit or force the debtor into bankruptcy. The case simply does not provide enough data to arrive at either choice. Thus, the students should be directed to consider the types of information that could prove to be beneficial in making this decision. Often, in decision-making, the gathering of information is the key step in arriving at the proper conclusion. How Much Is That Building Really Worth? College textbooks frequently present fair value as if it were a known number that was easily determined. Students may view an asset’s fair value as if getting that much money was virtually assured. Thus, they often believe that producing a statement of financial affairs requires little more than establishing and reporting what a buyer will pay for an asset. This case was written to emphasize that net realizable value might actually be no more than a wild guess. Obviously, the value of most stocks and many bonds can be determined with accuracy. However, other assets such as the building in this case might eventually prove to have a liquidation value that can vary from zero (many deserted buildings are simply never sold because no one wants to buy that type of building in that particular location even if it is in great condition—many cities are filled with such structures) up to a significant amount.
13-3 .
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Chapter 13 - Accounting for Legal Reorganizations and Liquidations
The accountant faces the problem of preparing a statement of financial affairs that requires that a single number be reported as the value of each asset. Users of this statement can then make important financial decisions based on the number that is presented. Subsequently, the actual amount received may be significantly higher or lower than the figure shown. The users of the information may feel as if they have been mislead when, in fact, the accountant made the best estimate possible. Given the problems faced in determining fair value, the accountant will probably seek a very conservative number for reporting purposes. In most cases, less potential damage will be created by reporting a relatively low figure. However, use of a particularly low value may tempt the creditors to allow the company to reorganize because little would seem to be gained by forcing liquidation. For this reason, a conservative approach can favor the company attempting to avoid liquidation. Probably the most important lesson from this case is that decision makers should look with skepticism on many of the numbers reported as representing fair value. In some cases, fair value is a figure that can only be estimated and may depend on a number of factors that cannot be anticipated in advance by the accountant or by anyone else. Is this the Real Purpose of the Bankruptcy Laws? During the 1980s, as described in this case, the US saw a rash of bankruptcies that were filed to resolve major financial problems. Previously, bankruptcy laws had been used almost exclusively to settle insolvency problems. However, if a voluntary petition is filed and accepted by the courts, companies are provided with a method of settling issues before actual insolvency occurs. Sometimes the final results are good for the companies but not always. A. H. Robins, for example, had to agree to be bought as one of the conditions of its reorganization. In effect, the company lost its independence in order to satisfy the lawsuits resulting from Dalkon Shield litigation. As with many of the discussion questions in this book, this case is intended to alert students to a real-life issue and encourage them to consider the ramifications. To function in society, accounting students must know more than just the mechanical aspects of a bankruptcy. What are the objectives of the bankruptcy laws and do these particular cases fall outside of those objectives? Would either Manville or its claimants, for example, have been better served by having the company slowly pulled into insolvency over years or perhaps decades? Should a different set of bankruptcy laws be established for companies having these types of financial crises? Although these questions are not directly related to accounting, they are the types of questions that accountants (both as business people and as citizens) need to address.
Answers to Questions 1. "Insolvent" refers to a state of financial position whereby a company (or individual) is unable to pay debts as they come due. 2.
In the United States today, the primary piece of federal legislation that governs most bankruptcy proceedings is the Bankruptcy Reform Act of 1978 and its subsequent amendments.
3.
Bankruptcy cases have two overriding objectives: — To achieve a fair distribution of assets to the various parties that are involved with an insolvent company (or individual) and — To discharge the obligations of an honest debtor.
4. A voluntary bankruptcy petition is one filed by an insolvent company to gain protection from its creditors. Creditors may also seek to prevent or limit losses by filing their own 13-4 .
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Chapter 13 - Accounting for Legal Reorganizations and Liquidations
(involuntary) petition. Where a company has at least 12 unsecured creditors, a minimum of three (having total unsecured debts of over $15,325) must sign an involuntary petition. If fewer than 12 unsecured creditors exist, only one is needed to file the petition but the minimum debt level remains at $15,325. 5. The granting of an order for relief halts all actions against an insolvent company. The order for relief provides the company as well as the creditors with time to decide on a future course of action. It also brings the court into the process and provides a structure for what might otherwise be a chaotic event, the distribution of assets to the parties involved. 6. A fully secured creditor has an obligation from an insolvent company but holds a collateral interest in assets that have a value in excess of the debt. Thus, these parties can assume that they will suffer no loss regardless of the outcome of the bankruptcy proceedings. A partially secured creditor also has a collateral interest but the liability is larger than the anticipated proceeds from the realization of the attached assets. A portion of the liability is covered but a risk of loss still exists in connection with the remaining debt. Unsecured creditors have no collateral interest and can only hope to collect after the various secured interests have been satisfied. Obviously, this last group of creditors has the highest chance of incurring a loss. 7. A liability classified "with priority" is still unsecured. However, because of provisions of the Bankruptcy Reform Act of 1978, these debts must be paid before any other unsecured obligations. Thus, the chance of loss is reduced, sometimes significantly. Unsecured liabilities having priority include the following: — Claims for administrative expenses, — Obligations arising between the date that a bankruptcy petition is filed and the appointment of a trustee or the issuance of an order for relief. — Employee claims for wages earned during the 180 days preceding the filing of a bankruptcy petition (limited to $12,475 per person), — Employee claims for contributions to a benefit plan earned during the 180 days preceding the filing of a bankruptcy petition (within certain restrictions), — Deposits made with the company to acquire goods or services (up to a $2,775 limit), — Government claims for unpaid taxes. 8. Administrative expenses are classified as liabilities with priority to offer some protection to those individuals who serve the company during the period of insolvency. Without a legitimate chance for monetary reward, few people would be willing to provide the various administrative services needed during the bankruptcy process. Also, these debts were incurred after the order for relief. 9. In a Chapter 7 bankruptcy, the assets of the insolvent company are liquidated to satisfy the claims of the creditors. Business activities cease and noncash assets are sold. Conversely, in a Chapter 11 bankruptcy, the company attempts to survive its financial problems and return to solvency. A reorganization plan is developed that will allow the company to continue operations and reach a settlement of its debts. This reorganization plan must be accepted by each class of creditors, each class of stockholders, and the court. 10. Unsecured creditors often face the possibility of absorbing substantial losses in a Chapter 7 liquidation because their claims rank below fully secured and partially secured liabilities. Frequently, little or nothing is expected. Because of this possibility, unsecured creditors may feel that they have a better chance of limiting their losses by agreeing to a reorganization plan to keep the company alive as a potential future customer. 11. The statement of financial affairs helps the parties involved with a bankruptcy to anticipate their potential losses. It reports all assets of the insolvent company at net realizable value 13-5 .
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Chapter 13 - Accounting for Legal Reorganizations and Liquidations
whereas liabilities are classified as fully secured, partially secured, with priority, and unsecured. Based on the potential cash inflows and outflows, an estimation can be made of the losses that will be incurred by each group of claimants. A statement of financial affairs is considered especially useful at the beginning of the bankruptcy process since it can assist the parties in evaluating the outcome of various possible actions. 12. In general, a trustee is assigned to prevent loss of the insolvent company's assets and oversee the liquidation and distribution process. A number of rather procedural tasks are normally accomplished by the trustee shortly after appointment such as notifying the post office, changing locks, obtaining possession of corporate records, and opening a new bank account. Thereafter, the trustee might have to operate the company for a period of time to complete any business still in process. The trustee also has the power to void any transfer made by the debtor within 90 days prior to the filing of the bankruptcy petition if the company was insolvent at the time. Subsequently, the trustee works to liquidate noncash assets and make appropriate disbursements to the various claimants. During this entire process, the trustee needs to make periodic reportings to the court and other interested parties. 13. A trustee can demand the return of any payment (or other asset transfer) made within 90 days prior to the filing of a bankruptcy petition if the company was already insolvent. This legal procedure is known as the voiding of a preference transfer and is intended to prevent one party from gaining an unfair advantage over the remaining claimants. In effect, the payment is viewed as a distribution of the insolvent company's assets, a process that is to be controlled solely by the trustee and the court. 14. A statement of realization and liquidation is designed to report (1) the account balances of the insolvent company at the date the order for relief is entered, (2) the liquidation of noncash assets, (3) the cash distributions made to the various claimants, (4) any other transactions incurred during this period, and (5) any remaining asset and liability balances. Because of changes in U.S. GAAP, this statement is normally limited for internal reporting purposes. 15. A company must follow the liquidation basis of accounting once liquidation becomes imminent. That point is reached when a plan of liquidation has been approved by the appropriate court or by individuals who have the authority to make that decision. 16. Liquidation is viewed as imminent (so that the liquidation basis of accounting is necessary) if a formal plan of liquidation has been approved by the court in charge or by individuals who have the authority to make that decision. 17. When a company is viewed as being in liquidation, then, at a minimum, a statement of net assets in liquidation and a statement of changes in net assets in liquidation are required. 18. If the liquidation basis of accounting is applied, assets are reported at the amount of cash that is expected from that liquidation. Because assets often have to be liquidated rather quickly, the amount of cash expected is often a lower amount than the fair value of those assets. 19. If the liquidation basis of accounting is applied, liabilities continue to be reported based on the amount of each claim. The accountant does not attempt to estimate the amount that will have to be paid until formal agreements have been reached. 20. During the liquidation of an insolvent company, control is turned over to an outside trustee. However, in a Chapter 11 bankruptcy (a reorganization), operations will usually be continued so that an attempt can be made to arrive at a plan to save the company. While the bankruptcy proceeds, control is normally retained by the ownership, a group that is legally referred to as the debtor in possession. 13-6 .
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Chapter 13 - Accounting for Legal Reorganizations and Liquidations
21. In a Chapter 11 bankruptcy, the debtor in possession (the present ownership of the company) is given the initial opportunity of filing a reorganization plan with the court. If a formal proposal is not put forth by the debtor in possession within 120 days of the order for relief or is not accepted within 180 days, any interested party has the right to submit a plan. Bankruptcy proceedings often drag on for lengthy periods because the time limitations can be extended by the court. However, the debtor’s exclusivity to propose a plan cannot be extended beyond 18 months. In recent years, debtors have begun to push for quicker resolutions so that matters can be finalized even if liquidation becomes necessary. 22. Numerous types of proposals are found in reorganization plans. For example, many will set forth specific ideas for changes to be made in the company's operations (to increase profitability) such as selling assets, closing stores, or terminating complete lines of business. In addition, most reorganization plans identify sources that will be tapped in the future to generate additional funding. Proposed changes in management (and the board of directors) may also be spelled out in an attempt to persuade claimants that the company will have the ability to overcome past economic problems. Last, and probably most important, a reorganization plan must include some anticipated settlement of the claims against the company that were in existence at the time the order for relief was entered. Before any reorganization plan is approved, the creditors (as well as the court) must be convinced that the financial rewards will outweigh the amounts that could be received from liquidation. 23. To become effective, a reorganization plan must be accepted by all interested parties. For approval, each class of creditors (more than two-thirds in dollar amount and one-half in number) must vote for the proposal. Each group of stockholders (two-thirds of the shares being voted) must also accept the plan. The court will then confirm the reorganization plan but only if the court feels that all parties are being treated fairly. The court also has the authority to confirm a proposal even if not accepted by the creditors or stockholders. This procedure (known as a "cram down") is only used if the plan is judged to be fair and equitable. 24. A "cram down" is a legal provision whereby the court can confirm a reorganization proposal for an insolvent company even though the plan has not been accepted by a particular class of creditors or stockholders. This step is not taken unless the court believes the plan being put forth is fair and equitable. 25. During reorganization, some debts are in jeopardy of being settled at a significantly reduced amount whereas others will probably be paid at face value. Unsecured and partially secured liabilities are likely to be settled at a lowered figure. Conversely, fully secured liabilities and any debts incurred during the reorganization period are normally not at risk of being reduced. Thus, if a balance sheet is produced while a company is in reorganization, all liabilities are reported as either being subject to compromise (reduction) or not being subject to compromise. The debts subject to compromise are reported at the expected amount of allowed claims rather than at an estimate of the settlement figure. Such estimations are often difficult, if not impossible, to make. 26. A company going through a Chapter 11 bankruptcy will report specified reorganization items on its income statement separately from operating figures. However, these reorganization items are reported prior to income tax expense rather than in a manner similar to an extraordinary item. These separately disclosed figures include gains and losses on the sale of assets necessitated by the reorganization. Professional fees incurred in connection with the reorganization are also reported in a similar manner as well as any interest revenue that would not have been earned except for the bankruptcy proceeding. 27. Professional fees incurred during reorganization must be expensed as incurred. Capitalization is not allowed. 13-7 .
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Chapter 13 - Accounting for Legal Reorganizations and Liquidations
28. “Fresh start accounting” refers to the adjustment of a company's assets to current value at the time the organization emerges from bankruptcy. A company must use fresh start accounting if two criteria are met at the time the reorganization is finalized: (1) the fair value of the assets is less than the total allowed claims as of the date of the order for relief plus the liabilities incurred during reorganization and (2) the original owners are left with less than 50 percent of the voting stock. In fresh start accounting, all assets are reported at current value while liabilities are reported based on the present value of the settlement amounts. If the reorganization value of the company as a whole is greater than the total fair value of the individual assets, goodwill is reported for the excess. Initially, in fresh start accounting, retained earnings must be reported at a zero balance. 29. Fresh start accounting is used by companies that are emerging from a bankruptcy reorganization if the value of the assets held at that time are less than the allowed claims associated with company’s liabilities (those present at the date of the order for relief and those incurred since that date) and the original owners are left with less than 50 percent of the voting stock of the reorganized company. 30. In fresh start accounting, the tangible and intangible assets of the company are reported at their fair values. Liabilities are reported at the present value of the future cash flows. 31. When a company emerges from bankruptcy, the reorganization value of its assets as a whole must be determined. The figure is normally computed by discounting anticipated future cash flows from the business. This figure is then assigned to the various assets of the company based on individual fair values. The total reorganization value may well be greater than the current value of the individual assets. If so, the residual amount is recorded as the intangible account Goodwill. Each year (or more often in some cases) it is reviewed for impairment.
13-8 .
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Chapter 13 - Accounting for Legal Reorganizations and Liquidations
Answers to Problems 1. B 2. D 3. B 4. C 5. A 6. D 7. C 8. B 9. C 10. B 11. A 12. A 13. A 14. B 15. C 16. B 17. D 18. B 19. D 20. A 21. C 22. A 13-9 .
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Chapter 13 - Accounting for Legal Reorganizations and Liquidations
23. D 24. C 25. C
13-10 .
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Chapter 13 - Accounting for Legal Reorganizations and Liquidations
26. (10 Minutes) (Distribution of cash in a business liquidation) Free Assets: Current Assets .......................................................... Buildings and Equipment ........................................ Total ....................................................................
$ 35,000 110,000 $145,000
Liabilities with Priority: Administrative Expenses ......................................... Salaries Payable (only $3,000 per employee).......... Income Taxes ............................................................ Total ....................................................................
$ 20,000 6,000 8,000 $ 34,000
Free Assets after Payment of Liabilities with Priority ($145,000 – $34,000) ................................................
$111,000
Unsecured Liabilities Notes Payable (in excess of value of security) ...... Accounts Payable ..................................................... Bonds Payable .......................................................... Total ....................................................................
$ 30,000 85,000 70,000 $185,000
Percentage of Unsecured Liabilities to Be Paid: $111,000/$185,000 = 60 % Payment on Notes Payable: Value of Security (land) ............................................ 60% of Remaining $30,000 ....................................... Total Collected ...........................................................
13-11 .
.
$ 90,000 18,000 $108,000
Chapter 13 - Accounting for Legal Reorganizations and Liquidations
27. (5 Minutes) (Distribution of assets as a result of liquidation) Liabilities with Priority Paid first—administrative expense ............................... $3,450 Paid second—wages: total of $6,225 for Rankin but only up to a maximum of $12,475 for Key ....................... 18,700 Total priority claims ........................................................ 22,150 All remaining money available goes to: Government claims to unpaid taxes ........................ 4,050 Total of free assets .................................................... $26,200 No payments will be made by Xavier in connection with the remainder of (a) the salary to Key and (b) the government claims to unpaid taxes. No payments will be made on any of the unsecured accounts payable since no money is left. 28. (8 Minutes) (Distribution of assets to partially secured creditors) Free Assets: Other Assets ............................................................. Excess from Assets Pledged with Fully Secured Creditors ($116,000 – $70,000) ........................... Total ....................................................................
46,000 $126,000
Liabilities with Priority ...................................................
$ 42,000
Free Assets after Payment of Liabilities with Priority ($126,000 – $42,000) .................................................
$ 84,000
Unsecured Liabilities: Excess of Partially Secured Liabilities Over Pledged Assets ($130,000 – $50,000) ............................... Unsecured Creditors ................................................ Total ....................................................................
$ 80,000 200,000 $280,000
$ 80,000
Percentage of Unsecured Liabilities to Be Paid: $84,000/$280,000 = 30% Payment on Partially Secured Debt: Value of Pledged Asset ............................................ 30% of Remaining $80,000 ....................................... Total to be Collected by Holders of This Debt ...
13-12 .
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$ 50,000 24,000 $ 74,000
Chapter 13 - Accounting for Legal Reorganizations and Liquidations
29. (8 Minutes) (Distribution of assets to partially secured creditors) Free Assets: Cash .......................................................................... Excess from Assets Pledged with Fully Secured Creditors ($110,000 – $90,000) ............................ Total ......................................................................
$60,000 20,000 $80,000
Liabilities with Priority ....................................................
22,800
Free Assets after Payment of Liabilities with Priority .
$57,200
Unsecured Liabilities: Excess of Partially Secured Liabilities Over Pledged Assets ($170,000 – $140,000) ............... Accounts Payable ...................................................... Total ....................................................................
$ 30,000 190,000 $220,000
Percentage of Unsecured Liabilities to be Paid: $57,200/$220,000 = 26% Payment on Bond: Value of Pledged Asset ............................................. 26% of Remaining $30,000 ........................................ Total to be Received by holders .........................
13-13 .
.
$140,000 7,800 $147,800
Chapter 13 - Accounting for Legal Reorganizations and Liquidations
30. (12 Minutes) (Liquidation of assets to satisfy debt) The holder of Debt 2 will receive $100,000 from the sale of the pledged asset. This creditor wants to receive $142,000 out of the total debt of $170,000. Thus, $42,000 must be collected from the remaining debt of $70,000. That is a payoff of 60 percent of the unsecured debt ($42,000/$70,000). To get the additional $42,000, the company must be able to generate enough cash to (a) pay off 100 percent of the liabilities with priority ($110,000) and (b) also pay 60 percent of the unsecured liabilities. Unsecured Liabilities: Unsecured Creditors ..................................................... Excess Liability of Debt 1 in Excess of Pledged Asset ($210,000 – $180,000) ............................................... Excess Liability of Debt 2 in Excess of Pledged Asset ($170,000 – $100,000) ............................................... Total Unsecured Liabilities.................................. Necessary Payoff Percentage ....................................... Cash Needed For These Liabilities ...............................
$230,000 30,000 70,000 $330,000 60% $198,000
In order for the holder of Debt 2 to receive exactly $142,000, the other free assets must be sold for $308,000. With that much money, the liabilities with priority ($110,000) can be paid with the remaining $198,000 going to help cover the unsecured debts of $330,000. That is 60 percent coverage of those debts ($198,000/$330,000). This 60 percent figure would insure that the holder of Debt 2 would get $100,000 from the pledged asset and $42,000 ($70,000 x 60%) from the free assets.
13-14 .
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Chapter 13 - Accounting for Legal Reorganizations and Liquidations
31. (8 Minutes) (Payments to be made on unsecured and partially secured liabilities) a. The unpledged assets of $310,000 must be added to any excess to be received from assets pledged on fully secured debts ($220,000 – $160,000 = $60,000) to get amount of free assets available of $370,000. Amount Available ........................................................... Liabilities with Priority ................................................... Available for Unsecured Creditors ..........................
$370,000 (182,800) $187,200
Accounts Payable .......................................................... Partially Secured Debt in Excess of Pledged Assets ($510,000 – $390,000) ....................................... Unsecured Liabilities ......................................................
$400,000 120,000 $520,000
Distribution to Unsecured Creditors: $187,200/$520,000 = 36% An unsecured creditor to whom $13,000 is owed can expect to receive $4,680 ($13,000 x 36%). b. The bank will receive a total of $100,800. The secured interest will generate $90,000 (for the $120,000 note). The remaining $30,000 liability is unsecured so that only an additional payment of $10,800 (36%) can be expected.
13-15 .
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Chapter 13 - Accounting for Legal Reorganizations and Liquidations
32. (20 Minutes) (Distribution of cash assets resulting from liquidation) Free Assets: (fair value) Cash .......................................................................... Inventory .................................................................... Equipment .................................................................. Total ....................................................................
50,000 $120,000
Liabilities with Priority: Administrative Expenses ......................................... Income Taxes ............................................................ Total .....................................................................
$ 20,000 30,000 $ 50,000
Free Assets after Payment of Liabilities with Priority ($120,000 – $50,000) .................................................
$ 70,000
Unsecured Liabilities Note Payable A (in excess of value of security) .... Note Payable B (in excess of value of security) .... Note Payable C ......................................................... Accounts Payable ..................................................... Total ....................................................................
$ 20,000 80,000 60,000 120,000 $280,000
$ 10,000 60,000
Percentage of Unsecured Liabilities to Be Paid: $70,000/$280,000 = 25% Payment on Note Payable A: Value of Security (land) ................................................. 25% of Remaining $20,000 ............................................ Total Collected ..........................................................
$ 70,000 5,000 $ 75,000
Payment on Note Payable B: Value of Security (building) ........................................... 25% of Remaining $80,000 ............................................ Total Collected ..........................................................
$ 40,000 20,000 $ 60,000
Payment on Note Payable C (unsecured): 25% of $60,000 ...............................................................
$ 15,000
Payment on Administrative Expenses: As a liability with priority, the entire amount due is paid.
$ 20,000
Payment on Accounts Payable (unsecured): 25% of $120,000 .............................................................
$ 30,000
Payment on Income Taxes Payable: As a liability with priority, the entire amount due is paid.
$ 30,000
13-16 .
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Chapter 13 - Accounting for Legal Reorganizations and Liquidations
33. (15 Minutes) (Liquidation of assets to satisfy debt) Note payable B is unsecured. The holders want at least $129,000 of the total balance of $258,000. Thus, at least enough money must become available to pay 50 percent of the unsecured debts ($129,000/$258,000). All values for assets are known except for the company’s equipment. Unsecured Liabilities: Accounts payable ...................................................... $188,000 Note payable A—unsecured portion (186,000-168,000) 18,000 Note payable B .......................................................... 258,000 Total .................................................................... $464,000 Free Assets (except for equipment): Cash .......................................................................... Accounts receivable .................................................. Inventory .................................................................... Land (value does not cover related debt) ................ Buildings ($336,000 less $308,000 in bonds) ............................................................... Total ....................................................................
28,000 $160,000
Less: Liabilities with Priority: Estimated administrative expenses ......................... Taxes payable to government .................................. Total free assets except for equipment ..............
(20,000) (28,000) $112,000
$32,000 36,000 64,000 -0-
In order for unsecured creditors to receive 50 percent of their claims, $232,000 in free assets must be available (50 percent of the $464,000 in total unsecured debts). At present only $112,000 is available. Thus, $120,000 must be received from the liquidation of the equipment to have the needed resources ($232,000 – $112,000).
13-17 .
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Chapter 13 - Accounting for Legal Reorganizations and Liquidations
34. (15 Minutes) (Payment of various liabilities as a result of liquidation) Free Assets: Cash .................................................................... Receivables (30 percent collectible) ........................ Inventory .................................................................... Land (value in excess of secured note: $120,000 – $110,000) ............................................ Total .................................................................... Less: Liabilities with priority Salary payable (below maximum) ....................... Free assets available ........................................... Unsecured Liabilities: Accounts payable ...................................................... Bonds payable (less secured interest in building: $300,000 – $180,000) ............................ Unsecured liabilities ............................................
$30,000 15,000 39,000 10,000 $94,000
(10,000) $84,000
$90,000 120,000 $210,000
Percentage of unsecured liabilities to be paid: $84,000/$210,000 = 40% Amounts to be paid for: Salary payable (liability with priority to be paid in full) .................................................................... $10,000 Accounts payable (unsecured—will collect 40% of debts of $90,000) .............................................. $36,000 Note payable (fully secured by land—will collect entire balance) ..................................................... $110,000 Bonds payable (partially secured—will collect $180,000 from building and 40 percent of the remaining $120,000) ............................................. $228,000
35. (2 Minutes) (Reporting of debts during liquidation) Because of the uncertainty about the amount that will be paid on an unsecured debt, no attempt is made in financial reporting to anticipate the payment. Liabilities are reported at the expected amount of the allowed claim. In this case, the creditors apparently have a legitimate claim of $200,000.
13-18 .
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Chapter 13 - Accounting for Legal Reorganizations and Liquidations
36. (9 Minutes) (Adjusting a company’s records to fresh start accounting as it comes out of bankruptcy) The individual assets of Larisa Company have a total fair value of $700,000 but a reorganization value of $760,000. Thus, an intangible asset (Goodwill) equal to the $60,000 must be recognized. In addition, the retained earnings deficit must be eliminated and all other asset and liability accounts adjusted to the value on the day that the company exits from bankruptcy. Because common stock was transferred directly from the previous owners to the creditors, no entry is needed for the stock account. Because the reorganization value is $760,000 but liabilities are $300,000, stockholders’ equity must be $460,000. Retained earnings will be zero and common stock will remain $330,000. Thus, additional paid-in capital should be adjusted to $130,000 ($460,000 less $330,000). Receivables ($90,000 - $80,000) .................................... Inventory ($210,000 - $200,000) ..................................... Buildings ($400,000 - $300,000) ..................................... Goodwill .......................................................................... Retained Earnings ................................................ Additional Paid-In Capital ($130,000 – $20,000)........................................
13-19 .
.
10,000 10,000 100,000 60,000 70,000 110,000
Chapter 13 - Accounting for Legal Reorganizations and Liquidations
37.
(15 Minutes) (Prepare income statement for company going through a bankruptcy reorganization) ADDISON CORPORATION Income Statement Revenues ....................................................................... Costs and expenses: Cost of goods sold ................................................... Rent expense ............................................................ Salaries ....................................................................... Depreciation expense .............................................. Advertising expense ................................................ Interest expense ....................................................... Earnings before reorganization items and tax effects. Reorganization items: Loss on closing of branch ...................................... Professional fees ..................................................... Interest revenue ........................................................ Loss before income tax benefit ................................... Income tax benefit (20 percent) ................................... Net loss ....................................................................
13-20 .
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$ 467,000 $ 211,000 16,000 70,000 22,000 24,000 4,000
(109,000) (71,000) 32,000
(347,000) 120,000
(148,000) (28,000) 5,600 $(22,400)
Chapter 13 - Accounting for Legal Reorganizations and Liquidations
38. (15 Minutes) (Description of balance sheet for a company emerging from bankruptcy reorganization) a. FASB ASC Topic 852 (Reorganizations) states that a company that is exiting bankruptcy is considered a new entity (so that fair values would be applicable for reporting purposes) if two criteria are met. Otherwise, the company is simply considered to be a continuation of the old concern, a company that should keep reporting its historical cost figures. The first criterion is that the fair value of the assets of the emerging company must be less than the allowed claims as of the date of the order for relief (plus liabilities incurred during reorganization). The second criterion is that the original owners must be left with less than 50 percent of the voting stock of the emerging company. Whenever both of these criteria are met, the company's assets should be reported at their current fair values. b. Under fresh start accounting, the assets are adjusted to current value on the date that the company successfully emerges from bankruptcy reorganization. A reorganization value for the entity’s assets as a whole is first determined by discounting the cash flows that are anticipated. This balance is assigned to identifiable assets (both tangible and intangible) in the same manner as in a purchase combination. Any amount of the reorganization value that exceeds the assigned total is recorded as goodwill. c. The reorganization value in excess of the value of the identified assets and liabilities is reported as the intangible asset goodwill. Goodwill is reviewed each year for impairment.
13-21 .
.
Chapter 13 - Accounting for Legal Reorganizations and Liquidations
39. (15 Minutes) (Prepare a balance sheet for a company in bankruptcy reorganization) JAEZ CORPORATION Balance Sheet December 31, 2015 Current assets: Cash .......................................................................... Inventory ................................................................... Land, buildings, and equipment: Land .......................................................................... Buildings ................................................................... Equipment .................................................................. Total assets ......................................................... Liabilities not subject to compromise Current liabilities: Accounts payable ............................................... Long-term liabilities: Note payable (due 2017) ................ $110,000 Note payable (due 2018) ................ 100,000 Liabilities subject to compromise Accounts payable ..................................................... Accrued expenses .................................................... Income taxes payable .............................................. Note payable (due 2020) ........................................... Total liabilities ...................................................... Stockholders' equity Common stock .......................................................... Retained earnings (deficit) ....................................... Total liabilities and shareholders' (deficit) ........
13-22 .
.
$ 23,000 45,000
140,000 220,000 154,000
$ 68,000
514,000 $582,000
$ 60,000
210,000
123,000 30,000 22,000 170,000
$ 270,000
345,000 615,000
200,000 (233,000) $ 582,000
Chapter 13 - Accounting for Legal Reorganizations and Liquidations
40. (40 Minutes) (Prepare journal entries for company emerging from bankruptcy using fresh start accounting) Preliminary computations: BOOK VALUES PRIOR TO EMERGING FROM REORGANIZATION — Total assets at book value = $710,000 ($100,000 + $112,000 + $420,000 + $78,000) — Total liabilities at book value = $800,000 ($80,000 + $35,000 + $100,000 + $200,000 + $185,000 + $200,000) — Total common stock = $240,000 (given) — Deficit = $330,000 (given) — Since the above accounts balance, no additional paid-in capital must exist at this time. BOOK VALUES AFTER EMERGING FROM REORGANIZATION — Total assets = $780,000 (reorganization value) — Total liabilities = $340,000 ($5,000 + $4,000 + $100,000 + $50,000 + $71,000 + $110,000) — Total common stock = $240,000 (all 18,000 returned shares are reissued) — Deficit = -0- (eliminated by the reorganization) — Additional paid-in capital = $200,000 (figure needed to balance above accounts after reorganization) — Because the company will have 30,000 shares outstanding after the reorganization, the additional paid-in capital equals $6.66 per share ($200,000/30,000) — Because the company has a reorganization value of $780,000 but the assets have a fair value of only $735,000, goodwill of $45,000 must be recognized JOURNAL ENTRIES — Land and Buildings .................................................. 80,000 Goodwill .................................................................... 45,000 Accounts Receivable .......................................... Inventory .............................................................. Equipment ............................................................ Additional Paid-In Capital (to balance) .............. To adjust accounts to fair value as part of fresh start accounting. — Common Stock ......................................................... Additional Paid-In Capital ................................... To record shares turned in to the company by the owners as part of the reorganization plan, 18,000 shares at an $8 per share par value.
13-23 .
.
20,000 22,000 13,000 70,000
144,000 144,000
Chapter 13 - Accounting for Legal Reorganizations and Liquidations
40. (continued) — Accounts Payable ..................................................... Note Payable ........................................................ Common Stock ($8 per share par value) ........... Additional Paid-In Capital ($6.66 per share—see above, or 1/30 of company total) .................. Gain on Debt Discharge ...................................... To record settlement of accounts payable.
80,000
— Accrued Expenses .................................................. Note Payable ........................................................ Gain on Debt Discharge ...................................... To record settlement of accrued expenses.
35,000
— Note Payable ............................................................ Note Payable ........................................................ Common Stock ($8 per share par value) ........... Additional Paid-In Capital ($6.66 per share—see above, or 1/3 of company total) .................... Gain on Debt Discharge ...................................... To record settlement of note payable due in 2018.
200,000
— Note Payable ............................................................. Note Payable ........................................................ Common Stock ($8 per share par value) ........... Additional Paid-In Capital ($6.66 per share—see above, or 7/30 of company total) .................. Gain on Debt Discharge ...................................... To record settlement of note payable due in 2016.
185,000
— Note Payable ............................................................ Note Payable ........................................................ Gain on Debt Discharge ...................................... To record settlement of note payable due in 2017.
200,000
— Additional Paid-In Capital ($334,000 – $200,000) ... Gain on Debt Discharge .......................................... Retained Earnings (deficit) ................................. To adjust additional paid-in capital to appropriate balance, close out gain, and eliminate deficit balance as part of fresh start accounting.
134,000 196,000
13-24 .
.
5,000 8,000 6,666 60,334
4,000 31,000
50,000 80,000 66,667 3,333
71,000 56,000 46,667 11,333
110,000 90,000
330,000
Chapter 13 - Accounting for Legal Reorganizations and Liquidations
41. (25 Minutes) (Prepare a balance sheet for a company emerging from bankruptcy reorganization) a. Smith Corporation must apply fresh start accounting because it meets both requirements established by FASB: The reorganization value of $800,000 of the company is less than the allowed claims of $730,000 ($180,000 + $200,000 + $350,000) plus the liabilities incurred following the order for relief of $97,000. The original owners are left with less than 50 percent (40 percent actually) of the voting stock. b. Because the company has a reorganization value of $800,000 but only $653,000 can be assigned to specific assets based on fair value, the remaining $147,000 is reported as Goodwill. SMITH CORPORATION Balance Sheet December 31, 2015 ASSETS Current Assets: Accounts receivable ................................................. $ 18,000 Inventory ................................................................... 111,000 $129,000 Land, Buildings, and Equipment: Land and buildings ................................................... 278,000 Machinery .................................................................. 121,000 399,000 Intangible Assets: Patents ....................................................................... 125,000 Goodwill .................................................................... 147,000272,000 Total Assets ......................................................... $800,000 LIABILITIES AND STOCKHOLDERS' EQUITY Current Liabilities: Accounts payable ..................................................... Long-term Liabilities: Note payable (due in 2 years) .................................. $ 35,000 Note payable (due in 5 years) .................................. 50,000 Note payable (due in 8 years) .................................. 100,000 Total Liabilities .................................................... Stockholders' Equity: Common stock (par value) ....................................... $500,000 Additional paid-in capital .......................................... 18,000 Retained earnings .................................................... -0Total Liabilities and Stockholders' Equity ........
13-25 .
.
$ 97,000
185,000 $282,000
518,000 $800,000
Chapter 13 - Accounting for Legal Reorganizations and Liquidations
42. (15 Minutes) (Distribution of assets as a result of liquidation) Free assets: (liquidation value) Other assets .............................................................. Assets pledged with fully secured creditors in excess of debt ..................................................... Total free assets ..................................................
45,000 $126,000
Free assets after paying liabilities with priority ($126,000 – $36,000) .......................................................
$ 90,000
$ 81,000
Unsecured debts: Accounts payable ...................................................... $283,000 Partially secured liabilities in excess of pledged assets ($180,000 – $103,000) .......................................... 77,000 Total unsecured debts ........................................ $360,000 Percentage of unsecured debts to be paid: $90,000/$360,000 = 25% — Liabilities with priority collect the entire amount of $36,000 — Fully secured liabilities collect the entire amount of $200,000 — Partially secured liabilities collect $103,000 from the pledged assets and 25% of the remaining $77,000 ($19,250) for a total of $122,250. — Unsecured liabilities collect 25% of the $283,000 balance or $70,750.
13-26 .
.
Chapter 13 - Accounting for Legal Reorganizations and Liquidations
43. (35 Minutes) (Prepare statement of financial affairs) LIMESTONE COMPANY Statement of Financial Affairs June 3, 2015
Book Values $400,000
180,000
3,000 65,000 88,000
Assets Pledged with Fully Secured Creditors: Land and buildings $310,000 Less: Notes payable-long-term (190,000) Pledged with Partially Secured Creditors: Equipment $130,000 Notes payable—current (250,000) Free Assets: Cash ................................................................ Accounts receivable ...................................... Inventory ......................................................... Total amount available to pay liabilities with priority and unsecured creditors ..... Less: Liabilities with priority (listed below) .............................................. Available for unsecured creditors ................ Estimated deficiency ......................................
$736,000
13-27 .
.
Available for Unsecured Creditors
$120,000
-0-
3,000 26,000 80,000 $229,000 (42,000) $187,000 21,000 $208,000
Chapter 13 - Accounting for Legal Reorganizations and Liquidations
43. (continued) Book Values
Liabilities and Stockholders' Equity
$ 10,000
Liabilities with Priority: Administrative expenses ................ $ 18,000 Salaries payable ............................... 10,000 Taxes payable ................................... 14,000 Total .................................................. $ 42,000
190,000
Fully Secured Creditors: Notes payable - long-term .............. $190,000 Less: Land and buildings ................ (310,000)
-0-
Partially Secured Creditors: Notes payable current .................... $250,000 Less: Equipment ............................... (130,000)
$120,000
250,000
88,000 198,000 $736,000
Unsecured Creditors: Accounts payable (other than salaries) Stockholders' equity .......................................
13-28 .
Unsecured— Nonpriority Liabilities
.
88,000 -0$208,000
Chapter 13 - Accounting for Legal Reorganizations and Liquidations
44. (25 Minutes) (Distribution of assets as a result of liquidation) Free Assets: Cash ................................................................................................ Accounts Receivable .................................................................... Inventory ........................................................................................ Investments ..................................................................................... Land Value In Excess of Related Debt ($72,000 – $65,000) ........ Total ..........................................................................................
$ 6,000 18,000 31,000 8,000 7,000 $ 70,000
Liabilities with Priority: Administrative Expenses (estimated) ........................................... Salaries Payable ............................................................................. Taxes Payable ................................................................................. Total ..........................................................................................
$ 22,000 6,000 10,000 $ 38,000
Free Assets after Payment of Liabilities With Priority ($70,000 – $38,000) .......................................................................
$ 32,000
Unsecured Liabilities: Notes Payable (in excess of value of buildings) . ......................... Bonds Payable (in excess of value of equipment) ...................... Accounts Payable ........................................................................... Total ..........................................................................................
$ 10,000 80,000 70,000 $160,000
Percentage of Unsecured Liabilities to Be Paid: $32,000/$160,000 = 20% Payment on the $65,000 of notes payable secured by land will be made in total since the value of the land is greater than the debt. Payment on Notes Payable (secured by buildings): Value of Security (building) ................................................................. 20% of Remaining $10,000 .................................................................. Total Collected by holders .............................................................
$ 68,000 2,000 $ 70,000
Payment on Bonds Payable: Value of Security (equipment) ............................................................ 20% of Remaining $80,000 .................................................................. Total Collected by holders .............................................................
$ 35,000 16,000 $ 51,000
Payment on Accounts Payable (unsecured): 20% of $70,000 .....................................................................................
$ 14,000
Payment of Salaries Payable: As a liability with priority, the entire amount due is paid.
$ 6,000
Payment of Taxes Payable: As a liability with priority, the entire amount due is paid.
$ 10,000
Payment of Administrative Expenses: As a liability with priority, the entire amount due is paid.
$ 22,000
13-29 .
.
Chapter 13 - Accounting for Legal Reorganizations and Liquidations
45. (20 Minutes) (Reporting of a reorganization and a liquidation) a. Because the land's net realizable value is less than the amount of the secured note payable, the debt will be reported on a statement of financial affairs as a liability owed to "partially secured creditors." The $80,000 obligation is disclosed in this manner and then reduced by the $48,000 anticipated cash proceeds. The remaining $32,000 balance will be shown by Anteium as an unsecured nonpriority liability. The land is still reported as an asset, one pledged with partially secured creditors. The $31,000 cost is revealed within the statement of financial affairs although this information is not considered relevant in liquidation. The $48,000 net realizable value is reported but is offset by the $80,000 liability. Thus, no cash will be available to unsecured creditors unless a greater amount is generated by the sale. b. Fresh start accounting must be used because the reorganization value is less than the debts and the original owners are left with less than 50 percent of the voting stock. After reorganization, the assets will be reported at $82,000 with one $5,000 debt. Since the common stock has a total par value of $40,000, additional paid-in capital must be $37,000. Retained earnings will be zero. — Land .......................................................................... Investments ............................................................... Goodwill ..................................................................... Additional Paid-In capital ................................... To adjust asset values to fair market value (a total of $73,000) with a Goodwill asset established to bring the total up to $82,000 reorganization value.
17,000 5,000 9,000
— Note payable ............................................................. Additional Paid-In Capital (60% of company total) Gain on Discharge of Debt ................................. To record issuance of stock to bank in settlement of debt.
80,000
31,000
— Accounts Payable ..................................................... 20,000 Note Payable ........................................................ Gain on Discharge of Debt ................................. To record settlement of accounts payable for 3-year note.
13-30 .
.
22,200 57,800
5,000 15,000
Chapter 13 - Accounting for Legal Reorganizations and Liquidations
45. (continued) — Gain on Discharge of Debt ....................................... Additional Paid-In Capital ........................................ Retained Earnings (deficit) ................................. To reduce additional paid-in capital balance to correct figure, to close out gain account, and to eliminate deficit as a step in establishing fresh start accounting.
72,800 16,200 89,000
c. The bank will collect a total of $59,000. Obviously, the $50,000 proceeds generated by the land sale must go to the bank with the remaining $30,000 obligation then being ranked as an unsecured-nonpriority liability. Anteium (the insolvent company) will have $15,000 of the $26,000 cash left after paying the $11,000 administrative expenses. Unsecured debts total $50,000 ($30,000 from the note and $20,000 of accounts payable). Thus, 30% of these debts will be paid ($15,000/$50,000). The bank collects an additional $9,000 ($30,000 x 30%); the accounts payable collect $6,000 ($20,000 x 30%).
13-31 .
.
Chapter 13 - Accounting for Legal Reorganizations and Liquidations
46. (25 Minutes) (Prepare statement of realization and liquidation) a.
LITZ CORPORATION Statement of Realization and Liquidation
Balances, 8/8/15 Investments sold Inventory sold Payment is made on note from proceeds of auction Remaining debt is reclassified Administrative expenses incurred Land and buildings all sold Payment is made on note from proceeds of sale Reclassify liabilities with priority Equipment sold Receivables collected Administrative expenses paid Final balances remaining for unsecured creditors b. Total amount available to pay liabilities with priority and unsecured creditors (see part a) Less: liabilities with priority Available for unsecured creditors Percentage of claim to be received by each unsecured creditor ($180,000/$200,000)
Cash
Noncash Assets
$ 16,000 39,000 48,000
$763,000 (32,000) (69,000)
Fully Secured Creditors
Partially Secured Creditors
-0-
$259,000
$132,000
(48,000)
(48,000) (84,000)
StockUnsecured holders' Nonpriority Equity Liabilities (Deficits) $150,000 $238,000 7,000 (21,000)
84,000
$15,000 315,000
(15,000) (55,000)
(370,000)
(259,000)
(259,000) 34,000
84,000 34,000 (15,000)
(210,000) (82,000)
$214,000
-0-
(34,000) (126,000) (48,000)
(15,000)
$214,000 (34,000) $180,000
90%
13-32 ..
Liabilities with Priority
$34,000
-0-
-0-
$200,000 $(20,000)
Chapter 13 - Accounting for Legal Reorganizations and Liquidations
47. (40 Minutes) (Prepare journal entries for company emerging from bankruptcy using fresh start accounting) Becket Corporation must use fresh start accounting because the reorganization value of $650,000 is less than the company's allowed debts and the original owners hold less than 50 percent of the voting stock after the reorganization. BOOK VALUES AFTER EMERGING FROM REORGANIZATION — Total assets = $637,000 (reorganization value of $650,000 plus proceeds from sale of stock of $77,000 less $90,000 value of land and investments used to settle two debts) — Total liabilities = $350,000 ($130,000 + $40,000 + $180,000) — Total common stock = $160,000 (10,000 additional shares are issued with a $10 per share par value so that total outstanding shares = 16,000) — Deficit = -0- (eliminated by the reorganization) — Additional paid-in capital = $127,000 (figure needed to balance above accounts after reorganization) — Because the company has a reorganization value of $650,000 but the assets have a fair value of only $623,000, Goodwill must be established for $27,000. JOURNAL ENTRIES —Investments ................................................................ Land ............................................................................ Buildings .................................................................... Goodwill ...................................................................... Accounts Receivable ........................................... Inventory ............................................................... Equipment ............................................................. Additional Paid-In Capital (to balance) ................ To adjust accounts to fair value as part of fresh start accounting.
20,000 16,000 31,000 49,000
—Cash .......................................................................... Common Stock ($10 par value) .......................... Additional Paid-In Capital ................................... To record shares sold to new investor.
77,000
—Cash ............................................................................ Investments ......................................................... Investments sold.
40,000
13-33 .
14,000 23,000 52,000 27,000
.
70,000 7,000
40,000
Chapter 13 - Accounting for Legal Reorganizations and Liquidations
47. (continued) —Notes Payable—Current ............................................ Cash ........................................................................ Notes Payable (due in 2019) ................................. Gain on Discharge of Debt .................................... To record settlement of current notes.
220,000
—Accounts Payable ...................................................... Notes Payable (due in 2016) ................................. Gain on Discharge of Debt .................................... To record settlement of accounts payable.
129,000
—Notes Payable (due in 2018) ...................................... Land ........................................................................ Notes Payable (due in 2022) ................................. Common Stock ($10 par value) ............................. Additional Paid-In Capital (3/16 of total APIC requirement computed above) Gain on Discharge of Debt .................................... To record settlement of long-term debt.
325,000
—Gain on Debt Discharge ............................................. Additional Paid-In Capital ($127,000 – $79,813) .. Retained Earnings (deficit) ................................... To adjust additional paid-in capital to appropriate balance, close out gain, and eliminate deficit balance as part of fresh start accounting.
180,187
13-34 .
.
40,000 130,000 50,000
40,000 89,000
50,000 180,000 30,000 23,813 41,187
47,187 133,000
Chapter 13 - Accounting for Legal Reorganizations and Liquidations
48. (40 Minutes) (Prepare statement of financial affairs and determine amounts to be paid in liquidation) a. OREGON CORPORATION Statement of Financial Affairs Available for Book Unsecured Values Assets Creditors Pledged with Fully Secured Creditors: $33,000 Land (Plots A and D) $43,000 Less: Notes payable (30,000) $13,000 28,000
6,000 25,000
Pledged with Partially Secured Creditors: Land (Plots B and C) $25,000 Less: Notes payable (30,000) Free Assets: Cash Accounts receivable Total available to pay liabilities with priority and unsecured creditors Less: Liabilities with priority (listed below) Available for unsecured creditors Estimated deficiency
6,000 12,000 $31,000
$92,000
28,000 $ 3,000 47,000 $50,000
Book Values
Unsecured— Nonpriority Liabilities
Liabilities and Stockholders' Equity Liabilities with Priority: -0- Administrative expenses (estimated) $12,000 Salaries payable Total (as shown above) Fully Secured Creditors: 30,000 Notes payable Land (Plots A and D) Partially Secured Creditors: 30,000 Notes payable Land (Plots B and C) Unsecured Creditors: 25,000 Notes payable 20,000 Accounts payable (less salaries shown above) (25,000)* Stockholders' equity $92,000 *Derived as a balancing figure.
13-35 .
-0-
.
$16,000 12,000 $28,000 $30,000 (43,000)
-0-
$30,000 (25,000)
$ 5,000 25,000 20,000 $50,000
Chapter 13 - Accounting for Legal Reorganizations and Liquidations
48. (continued) b. According to the statement of financial affairs prepared above, $3,000 cash should be available for unsecured nonpriority creditors. Unfortunately, $50,000 in unsecured nonpriority liabilities exist. Thus, only 6% of these claims will be covered ($3,000/$50,000). Cash of $11,240 will be paid on the note payable that is secured by plot B. The land is to be sold for $11,000 leaving a $4,000 unsecured debt. Since 6% of this amount is expected to be paid, the holder will only receive an additional $240. c. As indicated in part b, only 6% of the unsecured nonpriority claims can be satisfied. Thus, just $1,500 will be paid on the unsecured $25,000 note payable. d. Selling plot D for $30,000 rather than $27,000 generates an additional $3,000 in available cash. The statement of financial affairs produced above would then report $6,000 as the amount available for unsecured nonpriority claims or 12% of the total ($6,000/$50,000). After plot B is sold for $11,000, the remaining $4,000 of this note is classified as an unsecured nonpriority liability. Since 12% of this amount is to be paid, an additional $480 is transferred to the holder of the note for a total of $11,480.
13-36 .
.
Chapter 13 - Accounting for Legal Reorganizations and Liquidations
49. (40 Minutes) (Prepare a statement of financial affairs) LYNCH, INC. Statement of Financial Affairs March 14, 2015
Book Values $40,000
14,000
1,000 25,000 100,000 15,000
Assets Pledged with Fully Secured Creditors: Land and building Less: Notes payable
$75,000 (70,000)
$5,000
Pledged with Partially Secured Creditors: Equipment $19,000 Less: Notes payable (150,000)
-0-
Free Assets: Cash Accounts receivable Inventory Investments Total available to pay liabilities with priority and unsecured creditors Less: Liabilities with priority (listed below) Available for unsecured creditors Estimated deficiency
$195,000
13-37 .
Available for Unsecured Creditors
.
1,000 15,000 33,000 21,000 $75,000 (22,000) $53,000 115,000 $168,000
Chapter 13 - Accounting for Legal Reorganizations and Liquidations
49. (continued) Book Values
Liabilities and Stockholders' Equity
-0$5,000 1,000
Liabilities with Priority: Administrative expenses (estimated) Salaries payable Payroll taxes payable Total (above)
$16,000 5,000 1,000 $22,000
70,000
Fully Secured Creditors: Notes payable Land and building
$70,000 (75,000)
-0-
Partially Secured Creditors: Notes payable Equipment
$150,000 (19,000)
$ 131,000
150,000
33,000 4,000 (68,000) $195,000
Unsecured Creditors: Accounts payable Advertising payable Stockholders' equity
33,000 4,000 $168,000
13-38 .
Unsecured— Nonpriority Liabilities
.
Chapter 13 - Accounting for Legal Reorganizations and Liquidations
50. (30 Minutes) (Prepare a statement of realization and liquidation) a. LYNCH, INC. Statement of Realization and Liquidation March 14, 2015 to July 23, 2015
Book balances, 3/14/15 Answer from Problem 45 Accounts receivable collected —remaining balance assumed to be uncollectible Inventory sold Accounts payable discovered Land and buildings all sold Fully secured note paid Equipment sold Payment made on partially secured debt Investments sold Administrative expenses accrued Remaining partially secured claims reclassified as unsecured liabilities Final balances remaining for unsecured creditors
Cash
Noncash Assets
Liabilities with Priority
$ 1,000
$194,000
$6,000
18,000 40,000
(25,000) (100,000)
71,000 (70,000) 11,000
(40,000)
Fully Secured Creditors
Partially Secured Creditors
StockUnsecured holders' Nonpriority Equity Liabilities (Deficits
$70,000
$150,000
$ 37,000 $(68,000)
10,000
(11,000) 21,000
(70,000) (14,000)
(3,000) (11,000)
(15,000)
6,000 (20,000)
20,000 _______ $81,000
(7,000) (60,000) (10,000) 31,000
-0-
$26,000
(139,000) -0-
-0-
139,000 $186,000$(131,000)
b. The statement of realization and liquidation prepared in (a) indicates that $81,000 in cash remains. $26,000 of this amount must be distributed to liabilities with priority leaving $55,000 for unsecured nonpriority creditors. Since (as shown) these unsecured liabilities amount to $186,000, only 30% (rounded) ($55,000/$186,000) of each debt will be paid. Thus, a creditor holding a $1,000 claim will receive cash of approximately $300.
13-39 ..
Chapter 13 - Accounting for Legal Reorganizations and Liquidations
51. (30 Minutes) (Prepare Journal entries for company emerging from bankruptcy using fresh start accounting) Holmes Corporation must use fresh start accounting because the reorganization value of $225,000 is less than the company's allowed debts and the original owners hold less than 50 percent of the voting stock after the reorganization. BOOK VALUES AFTER EMERGING FROM REORGANIZATION — Total assets = $248,200 ($225,000 reorganization value plus proceeds from sale of stock of $36,000 less $12,800 payment made to settle unsecured liabilities [20 percent of $64,000]) — Total liabilities = $118,000 ($18,000 + $70,000 + $30,000) — Total common stock = $105,000 (11,000 additional shares are issued with a $5 per share par value plus 10,000 existing shares so total outstanding shares = 21,000) — Deficit = -0- (eliminated by the reorganization) — Additional paid-in capital = $25,200 (figure needed to balance above accounts after reorganization) JOURNAL ENTRIES — Goodwill .................................................................... Additional Paid-In Capital ................................... To adjust to total reorganization value as part of fresh start accounting ($225,000 – $210,000).
15,000
— Salary Payable .......................................................... Note Payable—1 year .......................................... To record note issued for accrued salaries.
18,000
— Notes Payable ........................................................... Note Payable—6 years ........................................ Common Stock ($5 par value) ............................ Additional Paid-In Capital (5/21 of total required APIC computed above) Gain on Discharge of Debt ................................. To record settlement of partially secured debt.
140,000
— Cash ........................................................................... Common Stock ($5 par value) ............................ Additional Paid-In Capital ................................... To record shares sold to new investor.
36,000
13-40 .
15,000
.
18,000
30,000 25,000 6,000 79,000
30,000 6,000
Chapter 13 - Accounting for Legal Reorganizations and Liquidations
— Notes Payable ........................................................... Accounts Payable ..................................................... Accrued Expenses ................................................... Cash ..................................................................... Gain on Discharge of Debt ................................. To record payment of unsecured debts—20% payment made.
50,000 10,000 4,000
— Gain on Debt Discharge ........................................... Additional Paid-In Capital ($27,000 – $25,200) ....... Retained Earnings (deficit) ................................. To adjust additional paid-in capital to appropriate balance, close out gain, and eliminate deficit balance as part of fresh start accounting.
130,200 1,800
12,800 51,200
132,000
Develop Your Skills Research Case 1 This case allows the student to review the official information provided by the Securities and Exchange Commission in connection with bankrupt organizations, as well as gain information about reporting requirements for organizations in bankruptcies. In addition, this assignment allows the student to see how the SEC attempts to educate the public on matters pertaining to financial investing. This site includes a significant amount of general information including the following: ▪ ▪ ▪ ▪ ▪ ▪ ▪ ▪ ▪ ▪ ▪ ▪
The differences between a Chapter 7 and a Chapter 11 bankruptcy. The risks incurred by the various parties. A description of a prepackaged bankruptcy plan. The advantages of filing under Chapter 11. The appointment of creditor committees. The development of a reorganization plan. Steps in a Chapter 11 reorganization, especially those that involve the SEC. Conveyance of information about a bankruptcy. Voting on a reorganization plan. The effect on stockholders and bondholders. The steps of a Chapter 7 liquidation. Sources of additional information for a specific bankruptcy case.
Research Case 2 13-41 .
.
Chapter 13 - Accounting for Legal Reorganizations and Liquidations
This assignment provides the student with the chance to work with actual data from a real company. Thus, students get a feel for the process of retrieving information of interest about a company that is going through bankruptcy. In addition, this assignment can help them appreciate the frustration that sometimes comes about when analyzing financial statements. Textbooks often have information laid out for students so that analysis may resemble a “connect the dots” assignment. In reality, pages and pages of data are often available that require slow and meticulous study. Here is the actual note – parts (a) and (b) -- as supplied by the company. This information can serve as the basis for considerable class discussion. (a) Plan of Reorganization On April 30, 2010 (the ‘‘Effective Date’’), the Bankruptcy Court entered an order confirming the Debtors’ Modified Fourth Amended Joint Plan of Reorganization (the ‘‘Plan’’) and the Debtors emerged from Chapter 11 by consummating their restructuring through a series of transactions contemplated by the Plan including the following: • Name Change. On the Effective Date, but after the Plan became effective and prior to the distribution of securities under the Plan, SFI changed its corporate name to Six Flags Entertainment Corporation. As used herein, unless the context requires otherwise, the terms ‘‘we,’’ ‘‘our,’’ and ‘‘Six Flags’’ refer collectively to Six Flags Entertainment Corporation and its consolidated subsidiaries, and ‘‘Holdings’’ refers only to Six Flags Entertainment Corporation, without regard to the respective subsidiaries. As used herein, ‘‘SFI’’ means Six Flags, Inc. as a Debtor or prior to its name change to Six Flags Entertainment Corporation. As used herein, the ‘‘Company’’ refers collectively to SFI or Holdings, as the case may be, and its consolidating subsidiaries. • Common Stock. Pursuant to the Plan, all of SFI’s common stock, preferred stock purchase rights, preferred income equity redeemable shares (‘‘PIERS’’) and any other ownership interest in SFI including all options, warrants or rights, contractual or otherwise (including, but not limited to, stockholders agreements, registration rights agreements and rights agreements) were cancelled as of the Effective Date. On the Effective Date, Holdings issued an aggregate of 54,777,778 shares of common stock at $0.025 par value as follows: (i) 5,203,888 shares of common stock to the holders of unsecured claims against SFI, (ii) 4,724,618 shares of common stock to certain holders of the 121⁄4% Notes due 2016 (the ‘‘2016 Notes’’) in exchange for such 2016 Notes in the aggregate amount of $69.5 million, (iii) 34,363,950 shares of common stock to certain ‘‘accredited investors’’ that held unsecured claims who participated in a $505.5 million rights offering, 13-42 .
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Chapter 13 - Accounting for Legal Reorganizations and Liquidations
(iv) 6,798,012 shares of common stock in an offering to certain purchasers for an aggregate purchase price of $75.0 million, (v) 3,399,006 shares of common stock in an offering to certain purchasers for an aggregate purchase price of $50.0 million and (vi) 288,304 shares of common stock were issued to certain other equity purchasers as consideration for their commitment to purchase an additional $25.0 million of common stock on or before June 1, 2011, following approval by a majority of the members of Holdings’ Board of Directors (the ‘‘Delayed Draw Equity Purchase’’). On June 1, 2011, the Delayed Draw Equity Purchase option expired. These share amounts have been retroactively adjusted to reflect the June 2011 two-for-one stock split as described in Note 12. On June 21, 2010, the common stock commenced trading on the New York Stock Exchange under the symbol ‘‘SIX.’’ • Prepetition Indebtedness. Pursuant to the Plan and on the Effective Date, all outstanding obligations under notes issued by SFI and SFO (collectively, the ‘‘Prepetition Notes’’) were cancelled and the indentures governing such obligations were cancelled, except to the extent to allow the Debtors, Reorganized Debtors (as such term is defined in the Plan) or the relevant Prepetition Notes indenture trustee, as applicable, to make distributions pursuant to the Plan on account of claims related to such Prepetition Notes. The Prepetition Notes were as follows: (i) SFI’s 87⁄8% Senior Notes due 2010 (the ‘‘2010 Notes’’), (ii) SFI’s 93⁄4% Senior Notes due 2013 (the ‘‘2013 Notes’’), (iii) SFI’s 95⁄8% Senior Notes due 2014 (the ‘‘2014 Notes’’), (iv) SFI’s 4.50% Convertible Senior Notes due 2015 (the ‘‘2015 Notes’’), and (v) the 2016 Notes. Pursuant to the Plan and on the Effective Date, the Second Amended and Restated Credit Agreement, dated as of May 25, 2007 (as amended, modified or otherwise supplemented from time to time, the ‘‘Prepetition Credit Agreement’’), among SFI, SFO, SFTP (as the primary borrower), certain of SFTP’s foreign subsidiaries party thereto, the lenders thereto, the agent banks party thereto and JPMorgan Chase Bank, N.A., as Administrative Agent (in such capacity, the ‘‘Administrative Agent’’), was cancelled (except that the Prepetition Credit Agreement continued in effect solely for the purposes of allowing creditors under the Prepetition Credit Agreement to receive distributions under the Plan and allowing the Administrative Agent to exercise certain rights). • Financing at Emergence. On the Effective Date, we entered into two exit financing facilities: (i) an $890.0 million senior secured first lien credit facility comprised of a $120.0 million revolving loan facility, which could have been increased up to $150.0 million in certain circumstances, and a $770.0 million term loan facility (the ‘‘Exit First Lien Term Loan’’) and (ii) a $250.0 million senior secured second lien term loan facility (the ‘‘Exit Second Lien Facility’’ and, together with the Exit First Lien Facility, the ‘‘Exit Facilities’’). Also on the Effective Date, SFOG Acquisition A, Inc., SFOG Acquisition B, L.L.C., SFOT Acquisition I, Inc. and SFOT Acquisition II, Inc. (collectively, the ‘‘TW Borrowers’’) 13-43 .
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Chapter 13 - Accounting for Legal Reorganizations and Liquidations
entered into a credit agreement with TW-SF, LLC comprised of a $150.0 million multi-draw term loan facility (the ‘‘TW Loan’’) for use with respect to the Partnership Parks ‘‘put’’ obligations. See Note 8 for a discussion of the terms and conditions of these facilities and subsequent amendments, early repayments, and terminations from debt extinguishment transactions. • Fresh Start Accounting. As required by accounting principles generally accepted in the United States (‘‘GAAP’’), we adopted fresh start accounting effective May 1, 2010 following the guidance of Financial Accounting Standards Board (‘‘FASB’’) Accounting Standards Codification (‘‘ASC’’) Topic 852, Reorganizations (‘‘FASB ASC 852’’). The financial statements for the periods ended prior to April 30, 2010 do not include the effect of any changes in our capital structure or changes in the fair value of assets and liabilities as a result of fresh start accounting. The implementation of the Plan and the application of fresh start accounting results in financial statements that are not comparable to financial statements in periods prior to emergence. See Note 1(b) for a detailed explanation of the impact of emerging from Chapter 11 and applying fresh start accounting on our financial position. As used herein, ‘‘Successor’’ refers to the Company as of the Effective Date and ‘‘Predecessor’’ refers to SFI together with its consolidated subsidiaries prior to the Effective Date. (b) Fresh Start Accounting and the Effects of the Plan Fresh start accounting results in a new basis of accounting and reflects the allocation of the Company’s estimated fair value to its underlying assets and liabilities. The Company’s estimates of fair value are inherently subject to significant uncertainties and contingencies beyond the Company’s reasonable control. Accordingly, there can be no assurance that the estimates, assumptions, valuations, appraisals and financial projections will be realized, and actual results could vary materially. The implementation of the Plan and the application of fresh start accounting results in financial statements that are not comparable to financial statements in periods prior to emergence. Fresh start accounting provides, among other things, for a determination of the value to be assigned to the equity of the emerging company as of a date selected for financial reporting purposes, which for the Company is April 30, 2010, the date that the Debtors emerged from Chapter 11. The Plan required the contribution of equity from the creditors representing the unsecured senior noteholders of SFI, of which $555.5 million was raised at a price of $14.71 per share, as adjusted to reflect the June 2011 two-for-one stock split described in Note 12. Holdings also 13-44 .
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Chapter 13 - Accounting for Legal Reorganizations and Liquidations
issued stock at $14.71 per share to pay $146.1 million of SFO and SFI claims. The Company’s reorganization value reflected the fair value of the new equity and the new debt, the conditions of which were determined after extensive arms-length negotiations between the Debtors’ creditors, which included the input of several independent valuation experts representing different creditor interests, who used discounted cash flow, comparable company and precedent transaction analyses. The analysis supporting the final reorganization value was based upon expected future cash flows of the business after emergence from Chapter 11, discounted at a rate of 11.5% and assuming a perpetuity growth rate of 3.0%. The reorganization value and the equity value are highly dependent on the achievement of the future financial results contemplated in the projections that were set forth in the Plan. The estimates and assumptions made in the valuation are inherently subject to significant uncertainties. The primary assumptions for which there is a reasonable possibility of the occurrence of a variation that would have significantly affected the reorganization value include the assumptions regarding revenue growth, operating expense growth rates, the amount and timing of capital expenditures and the discount rate utilized. The four-column consolidated statement of financial position as of April 30, 2010 (see below) reflects the implementation of the Plan. Reorganization adjustments have been recorded within the condensed consolidated balance sheets as of April 30, 2010 to reflect effects of the Plan, including discharge of liabilities subject to compromise and the adoption of fresh start accounting in accordance with FASB ASC 852. The reorganization value of the Company of approximately $2.3 billion was based on the equity value of equity raised plus new indebtedness and fair value of Partnership Parks ‘‘put’’obligations as follows (in thousands): Equity value based on equity raised(1) . . . . . . . . . . . . . . . . . . . . . . . . . $ 805,791 Add: Redeemable noncontrolling interests(2) . . . . . . . . . . . . . . . . . . 446,449 Add: Exit First Lien Facility . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 770,000 Add: Exit Second Lien Facility . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 250,000 Add: Other debt(3) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 35,360 Add: Noncontrolling interests . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5,219 (11,450) Less: Net discounts on Exit Facilities . . . . . . . . . . . . . . . . . . . . . . . . Total emergence enterprise value . . . . . . . . . . . . . . . . . . . . . . . . . . $2,301,369 _______________________ (1) Equity balance is calculated based on 54,777,778 shares of Holdings common stock at the price of $14.71 per share pursuant to the Plan, as adjusted to reflect the June 2011 two-for-one stock split described in Note 12. (2) Redeemable noncontrolling interests are stated at fair value determined using the discounted cash flow methodology. The valuation was performed based on multiple scenarios with a certain number of ‘‘put’’ obligations assumed to be put each year. The analysis used a 9.8% rate of return adjusted for annual inflation for 13-45 .
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Chapter 13 - Accounting for Legal Reorganizations and Liquidations
the annual guaranteed minimum distributions to the holders of the ‘‘put’’ rights and a discount rate of 7%. (3) Other debt includes a $33.0 million refinance loan (the ‘‘Refinance Loan’’) for HWP Development, LLC, $32.2 million of which was outstanding as of April 30, 2010, as well as capitalized leases of approximately $2.1 million and short-term bank borrowings of $1.0 million. See Note 8 for a discussion of the terms and conditions of the Refinance Loan. _______________________
Under fresh start accounting, the total Company value is adjusted to reorganization value and is allocated to our assets and liabilities based on their respective fair values in conformity with the purchase method of accounting for business combinations in FASB ASC Topic 805, Business Combination (‘‘FASB ASC 805’’). The excess of reorganization value over the fair value of tangible and identifiable intangible assets and liabilities is recorded as goodwill. Liabilities existing as of the Effective Date, other than deferred taxes, were recorded at the present value of amounts expected to be paid using appropriate risk adjusted interest rates. Deferred taxes were determined in conformity with applicable income tax accounting standards. Predecessor accumulated depreciation, accumulated amortization, retained deficit, common stock and accumulated other comprehensive loss were eliminated. The valuations required to determine the fair value of the Company’s assets as presented below represent the results of valuation procedures performed by independent valuation specialists. The estimates of fair values of assets and liabilities have been reflected in the Successor Company consolidated balance sheet as of April 30, 2010. The adjustments below are to our April 30, 2010 balance sheet. The balance sheet reorganization adjustments presented below summarize the impact of the Plan and the adoption of fresh start accounting as of the Effective Date.
SIX FLAGS ENTERTAINMENT CORPORATION CONDENSED CONSOLIDATED BALANCE SHEET (in thousands) April 30, 2010 Reorganization Fresh Start 13-46 .
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Chapter 13 - Accounting for Legal Reorganizations and Liquidations
Predecessor Adjustments(1) Adjustments(2) Successor ASSETS Current assets: Cash and cash equivalents . . . . . . . . . . . . .$ 75,836 $(21,326) $— $ 54,510 Accounts receivable . . . . . . . . 36,288 — 4,876 41,164 Inventories . . . . . . . . . . . . . . . . 37,811 — (193) 37,618 Prepaid expenses and other current assets . . . 49,671 (9,750) (456) 39,465 Assets held for sale . . . . . . . . . . . 681 — — 681 Total current assets . . . . . . . 200,287 (31,076) 4,227 173,438 Other assets: Debt issuance costs . . . . . . . . 11,817 Restricted-use investment securities . . . . . . .2,753 Deposits and other assets . . . 97,677 Total other assets . . . . . . . . . 112,247 Property and equipment, at cost, net . . . . . 1,507,677 Assets held for sale . . . . . . . . . 6,978 Intangible assets, net of accumulated amortization(3) . . . . . . . . . . .10,164 Goodwill(4) . . . . . . . . . . . . .1,051,089 Total assets . . . . . . . . . . . $2,888,442
LIABILITIES and EQUITY (DEFICIT) Liabilities not subject to compromise: Current liabilities: Accounts payable . . . . . . . $ 92,198 Accrued compensation, payroll taxes and benefits . . . . . . . . . . . . . . . 15,019
28,184
—
40,001
— — 28,184
— 6,643 6,643
2,753 104,320 147,074
— —
(78,304) —
1,429,373 6,978
— — $ (2,892)
412,591 (420,841) $ (75,684)
422,755 630,248 $2,809,866
$ (20,272)
$
1,442 13-47
.
.
—
$71,926
—
16,461
Chapter 13 - Accounting for Legal Reorganizations and Liquidations
Accrued insurance reserves . 16,492 Accrued interest payable . . . .26,839 Other accrued liabilities . . . . .52,753 Deferred income . . . . . . . . . . .61,033 Liabilities from discontinued operations . . 5,409 Current portion of long-term debt . . . . . . 352,623 Total current liabilities not subject to compromise . . .622,366 Long-term debt . . . . . . . . . . .818,808 Other long-term liabilities . . . 46,868 Deferred income taxes . . . . .118,821 Total liabilities not subject to compromise . . . . . . . . 1,606,863 Liabilities subject to compromise . . . . . . . . . . 1,745,175 Total liabilities . . . . . . . . . . 3,352,038 Redeemable noncontrolling interests . . . . . . . . 355,933
19,074 (26,630) 2,883 —
(5,118) — 1,438 (1,324)
30,448 209 57,074 59,709
—
—
5,409
(317,946)
—
34,677
(341,449) 190,425 — —
(5,004) — (9,383) 110,955
275,913 1,009,233 37,485 229,776
(151,024)
96,568
1,552,407
(1,745,175) (1,896,199)
— 96,568
— 1,552,407
90,516
446,449
—
Stockholders’ equity (deficit): Preferred stock, $1.00 par value . . . . . . . . — — — — New common stock . . . . . . . . . . . — 685 — 685 Old common stock . . . . . . . . . 2,458 (2,458) — — Capital in excess of par value . . . . . . . . . 1,508,155 (703,049) — 805,106 Accumulated deficit . . . . .(2,308,699) 2,598,129 (289,430) — Accumulated other comprehensive loss . . . (26,535) — 26,535 — Total stockholders’ (deficit) equity . . . . (824,621) 1,893,307 (262,895) 805,791 Noncontrolling interests . . . . . 5,092 — 127 5,219 Total (deficit) equity . . . . . . .(819,529) 1,893,307 (262,768) 811,010 Total liabilities and equity (deficit) . . . . $ 2,888,442 $ (2,892) $ (75,684) $2,809,866 _________________ (1) Represents amounts recorded on the Effective Date for the implementation of the Plan, including the settlement of liabilities subject to compromise and related payments, the incurrence of new indebtedness under the Exit Facilities and repayment of the Prepetition Credit Agreement and Prepetition Notes, distributions of cash and Holdings common stock and the cancellation of SFI common stock.
13-48 .
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Chapter 13 - Accounting for Legal Reorganizations and Liquidations
The Plan’s impact resulted in a net decrease of $21.3 million in cash and cash equivalents. The significant sources and uses of cash were as follows (in thousands): Sources: Net amount borrowed under the Exit First Lien Term Loan . . . . . . . . . $ 762,300 Net amount borrowed under the Exit Second Lien Loan Facility . . . . . . 246,250 Proceeds from the Equity Offering . . . . . . . . . . . . . . . . . . . . . . . . . . . . 630,500 Total sources . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,639,050 Uses: Repayments of amounts owed: Prepetition Credit Agreement—long term portion of term loan . . . . . 818,125 2016 Notes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 330,500 Prepetition Credit Agreement—revolving portion . . . . . . . . . . . . . . . . 270,269 Prepetition TW Promissory Note . . . . . . . . . . . . . . . . . . . . . . . . . . . 30,677 Prepetition interest rate hedging derivatives . . . . . . . . . . . . . . . . . . . 19,992 Prepetition Credit Agreement—current portion of term loan . . . . . . . 17,000 Payments: Exit Facilities’ debt issuance costs . . . . . . . . . . . . . . . . . . . . . . . . . . . 29,700 Accrued interest . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 96,950 Professional fees and other accrued liabilities . . . . . . . . . . . . . . . . . . 47,163 Total uses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,660,376 Net cash uses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ (21,326) The gain on the cancellation of liabilities subject to compromise, before income taxes, was calculated as follows: Extinguishment of the 2010 Notes, 2013 Notes, 2014 Notes and 2015 Notes (collectively, the ‘‘SFI Senior Notes’’) . . . . . . . . . . . . . . . . . . .$ 868,305 Extinguishment of the PIERS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 306,650 Write-off of the accrued interest on the SFI Senior Notes . . . . . . . . . . . 29,868 Write-off debt issuance costs on the Prepetition Credit Agreement And the Prepetition TW Promissory Note . . . . . . . . . . . . . . . . . . . . . . .(11,516) Issuance of Holdings’ common stock . . . . . . . . . . . . . . . . . . . . . . . . . . (105,791) Gain on the cancellation of liabilities subject to compromise, before income taxes . . . . . . . . . . . . . . . . . . . . . .$1,087,516 (2) Reflects the adjustments to assets and liabilities to estimated fair value, or other measurements specified by FASB ASC 805, in conjunction with the adoption of fresh start accounting. Significant adjustments are summarized as follows and all are considered a Level 3 fair value measurement with the exception of the land values which are Level 2 fair value measurements. • Deposits and other assets—note receivable—An adjustment of approximately $7.4 million was recorded to the book value of a note receivable to its $8.4 million 13-49 .
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Chapter 13 - Accounting for Legal Reorganizations and Liquidations
estimated fair value, which was determined based on the discounted cash flow method over the life of the note. • Deposits and other assets—investment in nonconsolidated joint venture—This account was adjusted to its estimated fair values based on customary valuation methodologies, including comparable earnings multiples, discounted cash flows and negotiated transaction values. • Property and equipment, at cost—An adjustment of approximately $78.3 million was recorded to adjust the net book value of property, plant and equipment to fair value based on the new replacement cost less depreciation valuation methodology. Key assumptions used in the valuation of the Company’s property, plant and equipment were based on a combination of the cost or market approach adjusted for economic obsolescence where appropriate. The land value was obtained using a sales comparison approach. • General liability and workers compensation—An adjustment of approximately $5.1 million was recorded to adjust the value of the general liability and workers compensation accruals for future receipts from deposits and payments for claims discounted at a weighted average debt rate on emergence from Chapter 11 of 7%. • Deferred revenue—An adjustment of approximately $1.3 million was recorded to adjust the book value of deferred revenue attributable to season pass and other advance ticket sales to the fair value using appropriate profit margins and cost of service associated with related guest visitation. • Pension—This adjustment primarily reflects differences in assumptions, such as the expected return on plan assets and the weighted average discount rate related to the payment of benefit obligations, between the prior measurement date of March 31, 2010 and the Effective Date. For additional information on the Company’s pension, see Note 14. • Redeemable noncontrolling interests—These are stated at fair value determined using the discounted cash flow methodology. The valuation was performed based on multiple scenarios with certain number of ‘‘puts’’ assumed to be put each year. The analysis used a 9.8% rate of return adjusted for annual inflation for the annual guaranteed minimum distributions to the holders of the put rights and a discount rate of 7%. The Predecessor Company recognized a loss of $178.5 million, before income taxes, related to the fresh start accounting adjustments as follows (in thousands): Loss on fresh start accounting adjustments Establishment of Holdings’ goodwill . . . . . . . . . . . . . . . . . . . . . . . . . $ 630,248 Elimination of SFI’s goodwill . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (1,051,089) 13-50 .
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Chapter 13 - Accounting for Legal Reorganizations and Liquidations
Establishment of Holdings’ intangible assets . . . . . . . . . . . . . . . . . . . 421,510 Elimination of SFI’s intangible assets . . . . . . . . . . . . . . . . . . . . . . . . (8,919) Fair value adjustments: Notes receivable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7,389 Dick Clark Productions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7,400 Deposit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (8,146) Property and equipment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (78,304) Deferred income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,324 Accrued insurance reserves . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5,118 Redeemable noncontrolling interests . . . . . . . . . . . . . . . . . . . . . . . (90,516) Other, net . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (14,490) $ (178,475)
(3) The following represent the methodologies and significant assumptions used in determining the fair value of the significant intangible assets, other than goodwill and all are considered a Level 3 fair value measurement. Certain longlived intangible assets which include trade names, trademarks and licensing agreements were valued using a relief from royalty methodology. Group-sales customer relationships were valued using a multi-period excess earnings method. Sponsorship agreements were valued using the lost profits method. Certain intangible assets are subject to sensitive business factors of which only a portion are within control of the Company’s management. A summary of the key inputs used in the valuation of these assets are as follows: • The Company valued trade names, trademarks and its third party licensing rights using the income approach, specifically the relief from royalty method. Under this method, the asset values were determined by estimating the hypothetical royalties that would have to be paid if the trade name was not owned or the third-party rights not currently licensed. Royalty rates were selected based on consideration of several factors, including industry practices, the existence of licensing agreements, and importance of the trademark, trade name and licensed rights and profit levels, among other considerations. The royalty rate of 4% of expected adjusted net sales related to the respective trade names and trademarks was used in the determination of their fair values, and a rate of 1.5% was used for the third-party license agreement. The expected net sales were adjusted for certain international revenues, retail, licensing and management fees, as well as certain direct costs related to the licensing agreement. The Company anticipates using the majority of the trade names and trademarks for an indefinite period, while the license agreement intangible asset will be amortized through 2020. Income taxes were estimated at a rate of 39.5% and amounts were discounted using a 12% discount rate for trade names and trademarks and 15% for the thirdparty license agreement. Trade name and trademarks were valued at approximately $344 million and the third-party license agreement at approximately $24 million. 13-51 .
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Chapter 13 - Accounting for Legal Reorganizations and Liquidations
• Sponsorship agreements were valued using the lost profits method, also referred to as ‘‘with or without’’ method. Under this method, the fair value of the sponsorship agreements was estimated by assessing the loss of economic profits under a hypothetical condition where such agreements would not be in place and would need to be recreated. The projected revenues, expenses and cash flows were calculated under each scenario and the difference in the annual cash flows was then discounted to the present value to derive at an indication of the value of the sponsorship agreements. Income taxes were estimated at a rate of 39.5% and amounts were discounted using a 12% discount rate, resulting in approximately $43 million of value allocated to sponsorship agreements. • The Company valued group sales customer relationships using the income approach, specifically the multi-period excess earnings method. In determining the fair value of the group-sales customer relationships, the multi-period excess earnings approach values the intangible asset at the present value of the incremental after-tax cash flows attributable only to the customer relationship after deducting contributory asset charges. The incremental after-tax cash flows attributable to the subject intangible asset are then discounted to their present value. Only expected sales from current group sales customers were used which was calculated based on a two year life. The Company assumed a retention rate of 50% which was supported by historical retention rates. Income taxes were estimated at a rate 39.5% and amounts were discounted using a 12% discount rate. The group-sales customer relationships were valued at approximately $7 million under this approach. (4) Fresh start accounting eliminated the balance of goodwill and other unamortized intangible assets of the Predecessor Company and records Successor Company intangible assets, including reorganization value in excess of amounts allocated to identified tangible and intangible assets, also referred to as Successor Company goodwill. The Successor Company’s April 30, 2010 consolidated balance sheet reflects the allocation of the business enterprise value to assets and liabilities immediately following emergence as follows (in thousands): Enterprise value . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 2,301,369 Add: Fair value of non-interest bearing liabilities (non-debt liabilities) 508,497 Less: Fair value of tangible assets . . . . . . . . . . . . . . . . . . . . . . . . . . . .(1,756,863) Less: Fair value of identified intangible assets . . . . . . . . . . . . . . . . . . . (422,755) Reorganization value of assets in excess of amounts allocated to identified tangible and intangible assets (Successor Company goodwill) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 630,248
Analysis Case 1
13-52 .
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Chapter 13 - Accounting for Legal Reorganizations and Liquidations
Students may look up any one of a number of companies that have emerged recently from bankruptcy reorganization. The type of results that will be found will be based on the specific company. One company, for example, that has emerged from reorganization is Constar International. Here is a press release obtained at www.constar.net: Philadelphia, PA - June 1, 2009 -- Constar International Inc., a leading global producer of PET (polyethylene terephthalate) plastic containers for food and beverages, announced that the Company and its affiliated debtors completed their financial restructuring and successfully emerged from Chapter 11 on Friday, May 29, 2009. The reorganization was completed approximately five months from the filing of their Chapter 11 petitions on December 30, 2008. In conjunction with its emergence from Chapter 11, Constar also announced that it had converted its debtor-in-possession financing into an exit facility to provide the Company with ongoing liquidity. Michael Hoffman, President and Chief Executive Officer of Constar, commented, "On behalf of our Board and the management team, I want to thank our unsecured bond holders for their support and their willingness to restructure our debt. At the same time I want to express my appreciation to our loyal customers, committed suppliers and dedicated employees who have supported us and encouraged us throughout the process. We emerge a revitalized company with an improved balance sheet. Combining our improved financial condition with our strong technologies, we are better positioned than ever to provide our customers with the product quality, innovation and service they have come to expect from Constar." As required by the Plan approved by the Bankruptcy Court, Constar's old common stock (which has recently traded with the symbol CNSTQ) was cancelled in connection with the emergence from Chapter 11. Holders of the old common stock will not receive a distribution of any kind and no further transfers will be recorded on the Company's books. In accordance with the Plan, holders of the $175 million of Constar's prePetition Subordinated Notes will convert 100% of their face amount into new common stock of the reorganized Company. This common stock is initially expected to trade over-the-counter. The Company estimates that following the distribution of the new shares, there will be approximately 1.75 million shares of the new common stock outstanding (exclusive of approximately 195,000 additional shares reserved for issuance under equity incentive plans). Cautionary Note Regarding Forward-Looking Statements Except for historical information, all information in this news release consists of forward-looking statements within the meaning of the federal securities laws, including statements regarding the intent, belief or current 13-53 .
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Chapter 13 - Accounting for Legal Reorganizations and Liquidations
expectations of the Company and its management which are made with words such as "will," "expect," "believe," and similar words. These forward-looking statements involve a number of risks, uncertainties and other factors, which may cause the actual results to be materially different from those expressed or implied in the forward-looking statements. Important factors that could cause the actual results of operations or financial condition of the company to differ from expectations are identified from time to time in the Company's reports filed with the SEC, including the risk factors identified in its Annual Report on Form 10-K for the year ended December 31, 2008, and in subsequent filings made prior to, on or after today. The Company does not intend to review, revise, or update any particular forward-looking statements in light of future events.
A second source of information is the Securities and Exchange Commission. According to the SEC website, using an EDGAR search, Constar International filed a Form 8-K on the same date as the above press release that made public the following: Item 1.01
Entry into a Material Definitive Agreement.
On May 29, 2009 (the “Effective Date”), Constar International Inc. (the “Company”), together with certain of its affiliates (each, a “Debtor” and collectively, the “Debtors”) consummated the transactions contemplated by the Debtors’ Second Amended Joint Plan of Reorganization, as Further Modified, Pursuant to Chapter 11 of the Bankruptcy Code, as confirmed by the United States Bankruptcy Court for the District of Delaware (the “Bankruptcy Court”) on May 14, 2009 (as confirmed, the “Plan”). In connection with the consummation of the Plan, on the Effective Date, the Company’s existing Senior Secured Super-Priority Debtor in Possession and Exit Credit Agreement, dated as of December 31, 2008 (the “Credit Agreement”) was converted into exit financing in accordance with its terms. For a description of the Credit Agreement, reference is made to the description of such agreement in the Company’s Current Report on Form 8-K filed with the Securities and Exchange Commission (the “Commission”) on January 6, 2009, which description is incorporated by reference herein. Also in connection with the consummation of the Plan, the Company and its lenders entered into Amendment No. 2 to the Credit Agreement, primarily for the purposes of updating certain schedules to the Credit Agreement and permitting the Company’s Dutch subsidiary, Constar International Holland (Plastics) B.V., which is neither a party to nor a guarantor of the Credit Agreement, to enter into separate financing arrangements. The foregoing is not a complete description of Amendment No. 2 to the Credit Agreement, which is filed as Exhibit 99.1 to this Report and the terms of which are incorporated herein by reference. 13-54 .
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Chapter 13 - Accounting for Legal Reorganizations and Liquidations
Item 1.02
Termination of a Material Definitive Agreement.
In connection with the Company’s reorganization and emergence from bankruptcy, all existing shares of the Company’s capital stock were canceled pursuant to the Plan. In addition, in the same connection, all of the Company’s Senior Subordinated 11% Notes Due 2012 were canceled and the related indenture was terminated (except for purposes of allowing the noteholders to receive distributions under the Plan). The holders of the Class 4 Senior Subordinated Note Claims (as defined in the Plan) received 10 shares of new Common Stock per $1,000 face amount of the Senior Subordinated Notes pursuant to the Plan. In addition, upon the Effective Date, the following incentive plans were terminated (and any and all awards granted under such plans were terminated and will no longer be of any force or effect): (1) the 2007 NonEmployee Directors’ Equity Incentive Plan; (2) the 2007 Stock-Based Incentive Compensation Plan; (3) Constar International Inc. Non-Employee Directors’ Equity Incentive Plan; (4) Constar International Inc. 2002 StockBased Incentive Compensation Plan; (5) the Amended and Restated Constar International Inc. Supplemental Executive Retirement Plan; and (6) the Amended and Restated Constar International Inc. Annual Incentive and Management Stock Purchase Plan. The 2007 Incentive Plan was replaced by the Constar International Inc. Annual Incentive Plan, adopted May 26, 2009 (the “AIP”). For a description of the AIP, please see the Company’s Current Report on Form 8-K filed with the Commission on June 1, 2009. Finally, a search of on-line journals finds a number of articles discussing the bankruptcy reorganization of Constar International including: “Moody's Lowers PDR of Constar to D; CFR to Ca,” Moody's Investors Service Press Release, December 30, 2008. “Bottle Maker Constar Files for Bankruptcy,” Plastics News, January 5, 2009. “Constar International Inc. Receives Delisting Notice from NASDAQ Stock Market,” Business Wire, January 6, 2009. “Court Confirms Constar’s Plan of Reorganization,” Business Wire, May 4, 2009. “Constar International Inc - CNSTQ: Completes Restructuring and Emerges from Chapter 11 Bankruptcy,” Market News Publishing, June 1, 2009. 13-55 .
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Chapter 13 - Accounting for Legal Reorganizations and Liquidations
“Constar International Inc. Completed Its Financial Restructuring and Emerged From Chapter 11,” Business Wire, June 1, 2009. There are obviously many ways available to investors who are trying to get information about a bankruptcy reorganization plan.
Analysis Case 2 While a company is going through bankruptcy reorganization, creditors, investors, employees, and other interested parties all want to know the current status of the process. This assignment was designed simply to help students determine what information can be readily gained from a company’s website about a reorganization that is in process. Different companies will undoubtedly provide widely differing amounts of information. The following (along with a string of periodic press releases) was posted on the Web site of Borders (www.borders.com). Borders Group Files for Reorganization Relief Under Chapter 11 Secures Commitment for $505 Million in Debtor-in-Possession Financing Borders to Continue to Conduct Business in Ordinary Course Chapter 11 Provides Borders with Best Route to Reorganize and Reposition Company for the Long-Term Ann Arbor, Mich. Feb. 16, 2011 —“It has become increasingly clear that in light of the environment of curtailed customer spending, our ongoing discussions with publishers and other vendor related parties, and the company’s lack of liquidity, Borders Group does not have the capital resources it needs to be a viable competitor and which are essential for it to move forward with its business strategy to reposition itself successfully for the long term. To position Borders to remedy this condition, Borders Group, with the authorization of its board of directors, has filed a petition for reorganization relief under Chapter 11 of the Bankruptcy Code. This decisive action will give Borders the opportunity to achieve a proper infusion of capital in order to have the opportunity to have the time to reorganize in order to reposition itself to be a successful business for the long term,” said Mike Edwards, Borders Group President. “In this regard, operating under Chapter 11, Borders has received commitments for $505 million in Debtor-in-Possession (DIP) financing led by GE Capital, Restructuring Finance. This financing should enable Borders to meet its obligations going forward so that our stores continue to be competitive for customers in terms of goods, services and the shopping experience. It also 13-56 .
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Chapter 13 - Accounting for Legal Reorganizations and Liquidations
affords Borders the opportunity to move forward in implementing the appropriate business strategy designed to reposition Borders to be a potentially vibrant, national retailer of books and other products,” Mr. Edwards emphasized. The company said that it is serving customers in the normal course, including honoring its Borders Rewards program, gift cards and other customer programs. Additionally, the company expects to make employee payroll and continue its benefits programs for its employees. Borders said that it has many strengths upon which to build a solid plan of reorganization and implement a new business model for Borders to address the changing needs of the American reader. “For decades, Borders has been a beacon of engagement — a highly frequented destination for consumers and a significant venue for authors and vendors to showcase new books and merchandise. We have the ability, based on our brick and mortar presence nationally; the on-line capabilities we have in place; the loyalty of, and access to, our customers; and the products and services we offer to be an important and easy access destination of exploration and purchase for readers across the country,” commented Mr. Edwards. The company noted that, among other initiatives and subject to court approval, Borders plans to undertake a strategic Store Reduction Program to facilitate reorganization and its repositioning. Borders has identified certain underperforming stores — equivalent to approximately 30 percent of the company’s national store network — that are expected to close in the next several weeks. At the same time, the company noted that a major strength of Borders is its national presence, and its extensive network of remaining stores as well as Borders.com, will continue to run in normal course. The company emphasized that the closings were a reflection of economic conditions, cost structures and viability of locations, among other factors, and not on the dedication and productivity of the workforce in these stores. “We are confident that, with the protection afforded under Chapter 11 and with the support of employees, publishers, suppliers and creditors, and the reading public, a successful reorganization can be achieved enabling Borders to emerge from the process as a stronger and more vibrant book seller,” concluded Mr. Edwards. "We are very pleased to be able to make this commitment to Borders as support for their plan to reorganize the company," said Tim Tobin, Managing Director, Retail Restructuring, GE Capital, Restructuring Finance. The Chapter 11 petition for relief was filed in the U.S. Bankruptcy Court, Southern District of New York. Completion of the company’s DIP financing arrangements is subject to approval of the Bankruptcy Court and the satisfaction of certain 13-57 .
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Chapter 13 - Accounting for Legal Reorganizations and Liquidations
conditions provided in the financing commitments received by the company from the lenders providing such financing.
Communications Case 1 A study of almost any large bankrupt organization can lead to a considerable degree of speculation as to the reasons for the company’s decline. For example, the following articles provide a few examples of the discussions surrounding the struggles of Borders Group. Because the company was widely known, its bankruptcy has been closely followed by the press. “Today’s Corporate Restructuring Requires a NEW Approach,” Financial Executive, April 2011. “For Borders, a Scramble to Be Lean.” Wall Street Journal, March 14 2011. “Bookseller Borders Begins a New Chapter . . . 11.” Wall Street Journal, February 17, 2011. “When One of the Giants Falls.” New York Times, February 17 2011. “Borders bankruptcy: 200 store closings point to the rise of e-books,” The Christian Science Monitor, February 16, 2011. “Borders Bankruptcy to Ripple Through Industry,” Publishers Weekly, February 21, 2011. “Borders Bankruptcy Shines Light on Continued Weakness of Power Centers,” Penton Insight, February 16, 2011. “Borders ' bankruptcy filing result of failing to keep up with shoppers' book, music, DVD habits,” Associated Press Newswires, February 16, 2011.
COMMUNICATIONS CASE 2 This assignment is designed so that the student can work with several practical accounting journals such as the CPA Journal and the Journal of Accountancy. These sources provide a considerable amount of information about the nature of the work that can be performed for a company before, during, and after bankruptcy.
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Chapter 14 - Partnerships: Formation and Operation
CHAPTER 14 PARTNERSHIPS: FORMATION AND OPERATION Chapter Outline I.
Business organizations that are formed legally as partnerships, although they are not always as visible as corporations, still proliferate throughout this country especially in the legal, medical, and accounting professions. A. Advantages of the partnership format include ease of creation and the absence of the double taxation effect inherent to the income earned by a corporation and distributed to its owners. B. Partnerships, however, rarely grow to a significant size (when compared with large corporate organizations) primarily because of the unlimited liability being assumed by each general partner. C. Alternative legal formats have been created over the years to combine the benefits of corporations and partnerships such as S corporations, limited liability partnerships, and limited liability companies.
II. Partnership accounting and the capital accounts A. The distinctive aspects of partnership accounting center on the capital accounts maintained for each individual partner. B. The basis of accounting for these capital balances is the Articles of Partnership agreement which establishes provisions for initial investments, withdrawals, admission of a new partner, retirement of a partner, etc. C. The actual contribution made by the partners to the business should be recorded at fair market value. A problem arises, however, when a contribution is truly intangible such as a particular expertise or an established client base. 1. In the bonus method, only identifiable assets are valued and recorded. The capital account balances are then aligned to indicate the percentage of the actual contributions being made by each partner. 2. In the goodwill method, the amount being contributed and the corresponding percentage of the initial capital balance are used to calculate the value of the business and the presence of goodwill, a figure which is physically recorded as an intangible asset. III. Partnership income allocation A. At the end of each fiscal period, the revenue and expense accounts must be closed out with the resulting income figure being assigned to the individual capital accounts. B. The method of allocating income to the capital accounts should be established within the Articles of Partnership.
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Chapter 14 - Partnerships: Formation and Operation
1. The partners can simply assume an equal division of profits and losses. 2. The partners, however, can select any method that is designed to arrive at an equitable allocation. Such factors as the amounts of capital invested, the time worked in the business, and the degree of business expertise may all serve to influence the assignment of income. IV. Accounting for partnership dissolution A. Over time, the identity of the individuals within a partnership can change through admission of a new partner or the death, retirement, or withdrawal of a present partner. B. Each change in composition serves to dissolve the original partnership usually so that a new partnership can be formed to continue the business. Thus, dissolution does not necessarily affect the operations of the business. C. Admission of a new partner. 1. A new partner will often buy all (or a portion) of the interest owned by one or more of the present partners. a. The capital account balances can simply be reclassified to reflect the identity of the new ownership. b. As an alternative, all accounts may be adjusted to fair market value with the price paid being used as the basis for calculating any goodwill. 2. A new partner can also be admitted by a direct contribution to the partnership business. a. The bonus (or no revaluation) method records the identifiable assets being contributed at fair market value. The new partner’s capital is set equal to a prearranged percentage or amount. The remaining capital balances are then aligned based on profit and loss percentages. b. The goodwill (or revaluation) approach initially adjusts all assets and liabilities of the partnership to fair market value and records goodwill based on the amount being paid (which is used to calculate the implied value of the business). D. Withdrawal of a partner 1. The final asset distribution to an individual should be based on the agreement established in the Articles of Partnership and will often vary in amount from that partner's ending capital balance. 2. The difference between the amount paid and the final capital balance can simply be recorded as an adjustment to the remaining partners' capital accounts in the same manner as the bonus method. 3. As an alternative, all accounts can be adjusted to fair value with the amount of payment being used as the basis for computing goodwill.
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Chapter 14 - Partnerships: Formation and Operation
Answers to Discussion Questions What kind of business is this? The owners of this business face a common problem: they began operations without seriously considering the company’s legal form. The accountant now needs to specify the advantages and disadvantages of the partnership versus corporate or some other legal form. Eventually, the owners must make this decision but should consider all relevant factors in their choice. The accountant should discuss the following issues with the two owners: —Ease of formation. A formal partnership can be created by the writing of an Articles of Partnership. If income allocation and partners’ contributions are already determined, the document preparation should be relatively simple. Forming a corporation is a usually a more difficult task depending on individual state laws. The accountant should explain the specific procedures that apply to partnerships in the state where the business is organized and conducts its operations. —Business liabilities. In a partnership, any partner may be held liable for all business debts. Thus, if liabilities escalate and the business fails, each partner risks a large possible loss. The same problem does not exist in a corporation where owners and the business are separate entities. For the owners, potential losses are, in corporations, normally limited to the amount being invested. However, in many small, newly created, corporations, the owners are required to personally guarantee any loans. Therefore, to an extent, the concept of unlimited liability may actually be present in either case. The partners should forecast the amount of debts that will be incurred and the possible outcome if the business would happen to fail. —Lawsuits. Some businesses are more susceptible to lawsuits than others. A florist, for example, would likely have less risk than a pharmaceutical company. The concept of personal liability for business debts becomes especially important when litigation risk is high. To reduce such risk, creating a corporation to protect the personal property of the stockholders may be a wise move. The owners of a partnership may become personally responsible for losses created by a business mistake or accident. The need for this responsibility is recognized in states that prohibit doctors, lawyers, accountants, and the like from incorporating. Such states, however, allow licensed professionals to operate LLPs. —Taxation. In a partnership, all income is allocated to the owners immediately and they are taxed on this amount. Double-taxation is avoided. A corporation pays an income tax and any dividends are then taxed again when collected by the owners. Therefore, traditionally, partnerships are viewed as having a tax advantage. The accountant should also mention to the partners other possible tax factors that may affect their decision. For example, in small corporations, double taxation may not be a problem. If salaries paid to the owners are reasonable and approximate the company's profits so that no dividends are distributed, only one tax is paid in either case. As another issue, if a partnership suffers a loss (which often happens when companies begin operations), that loss is passed to the partners and can be used to reduce other taxable income. However, in a corporation, losses are carried back and forward to reduce other taxable income that is earned by the business, possibly delaying the benefits of the loss. As mentioned in the textbook, the owners should consider forming an S Corporation—a business that is incorporated but still taxed as a partnership. 14-3 .
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Chapter 14 - Partnerships: Formation and Operation
—Bankruptcy. If the business should ever fail and have to be liquidated, losses of a partnership are passed directly to the owners to reduce taxable income immediately. For a corporation, the loss is a capital loss to the stockholders which can only offset their own capital gains or be deducted at the rate of $3,000 per year. Thus, if a large loss is incurred, the tax benefits may not be realized for years into the future. —Growth potential. Traditionally, corporations have more growth potential than do partnerships. Ownership interests can be easily transferred. The limitation on liability encourages ownership by individuals who cannot participate in the management of the company. Partnerships are more restricted in adding new owners. Partnerships usually have to entice individuals who are willing to work in the business in order to obtain additional capital. Therefore, the accountant may want to address the following questions in advising these clients: ▪ What amount of time and energy is involved in becoming incorporated? ▪ How much profit or loss is anticipated from the operations of this business in the foreseeable future? ▪ How much debt will the new business incur? ▪ Will this debt be guaranteed by the owners? ▪ How much salary do the owners anticipate withdrawing from the business? ▪ What are the chances of incurring lawsuits? ▪ What is the possibility that the business will fail? ▪ How large do the owners expect this business to grow? Do they anticipate the need for new owners and new capital? ▪ Does the creation of an S Corporation apply to this particular business? How Will the Profits Be Split? This case is designed to point up the difficulty of designing a profit-sharing arrangement that is fair to all parties. Currently, these three individuals have incomes totaling an amount in excess of the first year income that is expected. Thus, the adopted plan will have an immediate impact on them. The reduction of income must be absorbed by the partners in some equitable manner. In addition, the income is projected to increase relatively fast so that the agreed-upon method needs to reward all participants properly over time. Dewars has built up the firm and still handles the bigger clients although he plans to reduce his workload over the next few years. Thus, one method of compensation would be to credit him with interest on the capital built up in the business. However, if that number alone is used, it will tend to escalate even if his work hours are reduced. For this reason, Dewars' share of the profits could also be based in some way on the number of hours that he works. According to the information presented, this number will probably shrink over the years, reducing the profits allocated to Dewars. Thus, this partner might be given interest equal to 10 percent of his capital balance and $50 for each hour worked. Huffman is contributing a significant number of hours to the firm but tends to work on the smaller jobs. A possible allocation technique would be to give this partner a per hour allocation but one that is somewhat smaller than Dewars. For example, Huffman could receive an income allocation of $30 per hour to begin. That number could then be programmed to escalate over the years as Huffman starts to take over the bigger jobs. 14-4 .
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Chapter 14 - Partnerships: Formation and Operation
Scriba's role is to develop a tax practice within the firm. Consequently, one suggestion would be to credit her capital account with a percentage of the tax revenues (20 percent, for example) each year. In that way, she benefits by the amount of business that she is able to bring to the organization. During the first years, though, she may have trouble getting the new part of this business to generate significant revenues. Thus, the partners may want to set a minimum figure for her income allocation. She could be credited, as an example, with 20 percent of tax revenues but not less than $50,000. Many answers to this question are possible. The above is just a simple suggestion based on the facts presented in the case. Income allocation techniques are usually designed to reward the partners for the attributes that they bring to the organization. Even with the above system, percentages would still be necessary to assign any remaining profit or loss. If the partners are not totally satisfied with the system as designed, the percentages could be weighted or adjusted to reward any partner not being properly compensated.
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Chapter 14 - Partnerships: Formation and Operation
Answers to Questions 1. The advantages of operating a business as a partnership include the ease of formation and the avoidance of the double taxation effect that inherently reduces the profits distributed to the owners of a corporation. In addition, because the losses of a partnership pass, for tax purposes, directly through to the owners, partnerships have historically been used (especially in certain industries) to reduce or defer income taxes. Several disadvantages also accrue from the partnership format. Each general partner, for example, has unlimited liability for all debts of the business. This potential liability can be especially significant in light of the concept of mutual agency, the right that each partner has to create liabilities in the name of the partnership. Because of the risks created by unlimited liability and mutual agency, the growth potential of most partnerships is severely limited. Few people are willing to become general partners in an organization unless they can maintain some day-to-day contact and control over the business. Further discussion of these issues can be found in the Answer to the first Discussion Question that appears above. 2. Specific partnership accounting problems center in the equity (or capital) section of the balance sheet. In a corporation, stockholders' equity is divided between earned capital and contributed capital. Conversely, for a partnership, each partner has an individual capital account that is not differentiated according to its sources. Virtually all accounting issues encountered purely in connection with the partnership format are related to recording and maintaining these capital balances. 3. The balance in each partner's capital account measures that partner's interest in the book value of the business’ net assets. This figure arises from contributions, earnings, drawings, and other capital transactions. 4. A Subchapter S corporation is formed legally as a corporation so that its owners enjoy limited legal liability and easy transferability of ownership. However, if a company qualifies and becomes a Subchapter S Corporation, it will be taxed in virtually the same manner as a partnership. Hence, income will be taxed only once and that is to the owners at the time that it is earned by the corporation. Use of this designation is quite restricted. To qualify as a Subchapter S Corporation, a company can only have one class of stock and must have no more than 100 owners. These owners can only be individuals, estates, certain tax-exempt entities, and certain types of trusts. Most corporations that do not qualify as Subchapter S Corporations are automatically Subchapter C Corporations. These entities are also corporations but they pay income taxes when the income is earned. Additionally, the owners are liable for a second income tax when dividends are distributed to them. Thus, the income earned by a Subchapter C Corporation faces the double taxation effect commonly associated with corporations. 5. In a general partnership, each partner can have unlimited liability for the debts of the business. Therefore, a partner may face a significant risk, especially in connection with the actions and activities of other partners. However, general partnerships are easy to form and often serve well in smaller businesses where all partners know each other. The major advantage of a general partnership is that all income earned by the business is only taxed 14-6 .
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Chapter 14 - Partnerships: Formation and Operation
once when earned by the business so that no second tax is incurred when distributions are made to owners. A limited liability partnership (LLP) is very similar to a general partnership except in the method by which a partner’s liability is measured. In an LLP, the partners can still lose their entire investment and be held responsible for all contractual debts of the business such as loans. However, partners cannot be held responsible for damages caused by other partners. For example, if one partner carelessly causes damage and is sued, the other partners are not held responsible. A limited liability company can now be created in certain situations. This type of organization is classified as a partnership for tax purposes so that the double-taxation effect is avoided. However, the liability of the owners is limited to their individual investments like a Subchapter C Corporation. Depending on state law, the number of owners is not restricted in the same manner as a Subchapter S Corporation so that there is a greater potential for growth. 6. The Articles of Partnership is a legal agreement that should be created as a prerequisite for the formation of a partnership. This document defines the rights and responsibilities of the partners in relation to the business and in relation to each other. Thus, it serves as a governing document for the partnership. The Articles of Partnership may contain any number of provisions but should normally specify each of the following: a. b. c. d. e.
Name and address of each partner Business location Description of the nature of the business Rights and responsibilities of each partner Initial investment to be made by each partner along with the method to be used for valuation f. Specific method by which profits and losses are to be allocated g. Periodic withdrawals to be allowed each partner h. Procedure for admitting new partners i. Method for arbitrating partnership disputes j. Method for settling a partner's share in the business upon withdrawal, retirement, or death 7. To give fair recognition to noncash contributions, all assets donated by the partners (such as land or inventory) should be recorded by the partnership at their fair values at the date of investment. However, for taxation purposes, the partner’s book value is retained. 8. In forming a partnership, one or more of the partners may be contributing some factor (such as an established clientele or an expertise) which is not viewed normally as an asset in the traditional accounting sense. In effect, the partner will be receiving a larger capital balance than the identifiable contributions would warrant. The bonus method of recording this transaction is to value and record only the identifiable assets such as land and buildings. The capital accounts are then aligned to recognize the proportionate interest being assigned to each partner's investment. If, for example, the capital balances are to be equal, they are set at identical amounts that correspond in total to the value of the identifiable assets. 14-7 .
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Chapter 14 - Partnerships: Formation and Operation
As an alternative, the amounts contributed along with the established capital percentages can be used to determine mathematically the implied total value of the business and the presence of any goodwill brought into the business. This goodwill is recognized at the time that the partnership is created so that the amount can be credited to the appropriate partner. 9. The Drawing account measures the amount of assets that a particular partner takes from the business during the current period. Often, only regularly allowed distributions are recorded in the Drawing account with larger, more sporadic withdrawals being recorded as direct reductions to the partner's capital balance. 10. At the end of each fiscal year, when revenues and expenses are closed out, some assignment must be made of the resulting income figure Because a partnership will have two or more capital accounts rather than a single retained earnings balance. This allocation to the capital accounts is based on the agreement established by the partners preferably as a part of the Articles of Partnership. 11. The allocation process can be based on any number of factors. The actual assignment of income should be designed to give fair and equitable treatment to each of the partners. Often, an interest factor is used to reward the capital investment of the partners. A salary allowance is utilized as a means of recognizing the amount of time worked by an individual or a certain degree of business expertise. The allocation process can be further refined by a ratio that is either divided evenly among the partners or weighted in favor of one or more members. 12. If agreement as to the allocation of income has not been specified, an equal division among all partners is presumed. If an agreement has been reached for assigning profits but no mention is made concerning losses, the assumption is made that the same method is intended in either case. 13. The dissolution of a partnership is the breakup or cessation of the partnership. Many reasons can exist for a partnership to dissolve. One partner may withdraw, retire, or die. A new partner may be admitted to the partnership. The original partnership terminates whenever the identity of the individuals serving as partners has changed. Dissolution, however, does not necessarily lead to the liquidation of the business. In most cases, but not all, a new partnership is formed which takes over the business. Such dissolutions are no more than changes in the composition of the ownership and should not affect operations. 14. A new partner can join a partnership by acquiring part or all of the interest of one or more of the present partners. This transaction is carried out with the individual partners directly and not with the partnership. A new partner may also enter through a contribution to the business. In such cases, the investment is made to the partnership rather than to the individuals. 15. In selling an interest in a partnership, three rights are conveyed to the new owner: a. The right of co-ownership of the business property; 14-8 .
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Chapter 14 - Partnerships: Formation and Operation
b. The right to a specified allocation of profits and losses generated by the partnership's business; and c. The right to participate in the management of the business. No problem exists in selling or assigning the first two of these rights. However, the right to participate in management decisions can only be transferred with the consent of all partners. 16. Goodwill recognized in a capital transaction is allocated to the original partners based on the profit and loss ratio. The amount is assumed to represent unrealized gains in the value of the business. To determine the amount of goodwill, the implied value of the business as a whole must be calculated based on the price being paid for a portion by the new partner. The difference between this implied value and the total capital is assumed to be goodwill or some other adjustment to asset value. 17. Allocating goodwill to an entering partner may be necessary for several reasons. One of the most common is that the partner is bringing to the partnership an attribute that is not an asset in the traditional accounting sense. For example, a new partner with an excellent business reputation might be credited with goodwill at the time of entrance. Other factors such as an established clientele or a professional expertise can justify attributing goodwill to the new partner. The partnership might make this same concession to an entering partner if cash is urgently needed by the business and a larger share of the capital has to be offered as an enticement to generate the new investment. 18. Book values in most cases measure historical cost expenditures which often have undergone years of allocation and changes in value. For this reason, book value will frequently fail to mirror or even resemble the actual worth of a business. In addition, the goodwill that is assumed to be present in a business as a going concern is not a factor that is always reflected within book values. Therefore, distributing partnership property to a withdrawing partner based on book value would not necessarily be fair. Hence, the Articles of Partnership should spell out a method by which an equitable settlement can be achieved.
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Chapter 14 - Partnerships: Formation and Operation
Answers to Problems 1. B 2. C 3. D 4. C Mary Ann's investment equals 1/3 of total capital ($50,000 ÷ $150,000). However, she receives only a 1/4 interest capital balance. One explanation for the difference is that the business assets are worth more than book value. To achieve agreement, the net assets could be valued upward to fair value with the adjustment credited to the original partners’ capital accounts. Alternatively, a bonus could be credited to the original partners. 5. D Based on the new contribution, the company’s implied value is $350,000 ($105,000 ÷ 30%) which is less than the capital balances ($315,000 in original capital plus $105,000 to be invested). Thus, either the assets are overvalued or the new partner is contributing goodwill in addition to a cash investment. Because the problem indicates that goodwill is recognized, goodwill must be computed. Note that the $105,000 is going into the business and, thus, increases capital. David's investment = 30% (Original capital plus David's investment) $105,000 + Goodwill = .30 ($315,000 + $105,000 + Goodwill) $105,000 + Goodwill = $126,000 + .30 Goodwill .70 Goodwill = $21,000 Goodwill = $30,000 David's investment (Capital) = $105,000 + $30,000 = $135,000 6. B The implied value of the company is $960,000 ($240,000 ÷ 25%). Because the current capital total is only $760,000, goodwill of $200,000 must be recognized. Krystal's investment is paid directly to the partners and does not affect the capital total. Of the $200,000 in goodwill, 30 percent or $60,000 is attributed to Dane which brings that capital balance to $340,000. Because a 25% interest is conveyed to the new partner, Dane's balance decreases by 25% or $85,000—resulting in a new balance of $255,000. 7. B Total capital is $200,000 ($110,000 + $40,000 + $50,000) after the new investment. As Kansas's portion is 30 percent, the capital balance becomes $60,000 ($200,000 × 30%). Because only $50,000 was paid, a bonus of $10,000 is taken from the two original partners based on their profit and loss ratios: Bolcar – $7,000 (70%) and Neary – $3,000 (30%). The reduction drops Neary's capital balance from $40,000 to $37,000.
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Chapter 14 - Partnerships: Formation and Operation
8. B Total capital is $270,000 ($120,000 + $90,000 + $60,000) after the new investment. However, the implied value of the business based on the new investment is $300,000 ($60,000 ÷ 20%). Thus, goodwill of $30,000 must be recognized with the offsetting allocation to the original partners based on their profit and loss ratio: Bishop – $18,000 (60%) and Cotton $12,000 (40%). The increase raises Cotton's capital from $90,000 to $102,000. 9. A Total capital is $450,000 ($210,000 + $140,000 + $100,000) after the new investment. As Claudius' portion is to be 20 percent, the new capital balance would be $90,000 ($450,000 × 20%). Because $100,000 was paid, a bonus of $10,000 is being given to the two original partners based on their profit and loss ratio: Messalina – $6,000 (60%) and Romulus – $4,000 (40%). The increase raises Messalina's capital balance from $210,000 to $216,000 and Romulus's capital balance from $140,000 to $144,000. 10. D ASSIGNMENT OF INCOME ALFRED
BERNARD
COLLINS
TOTAL
$ 3,000 18,000
$ 3,500
$ 9,000 18,000
9,900 $30,900
13,200 $16,700
33,000 $60,000
ALFRED
BERNARD
COLLINS
TOTAL
$50,000 12,400 (5,000) $57,400
$60,000 30,900 (5,000) $85,900
$70,000 $180,000 16,700 60,000 (5,000) (15,000) $81,700 $225,000
Interest—5% of $ 2,500 beginning capital ................ Salary ....................................... Allocation of remaining income 9,900 ($33,000 divided on a 3:3:4 basis) Totals ............................ $12,400 STATEMENT OF CAPITAL Beginning capital ................... Net income (above) ................ Drawings (given) .................... Ending capital ........................
11. A ASSIGNMENT OF INCOME—YEAR ONE WINSTON
Interest—10% of beginning capital .............. $11,000 Salary ....................................... 20,000 Allocation of remaining loss ($80,000 divided on a 5:2:3 basis) (40,000) Totals ............................ $(9,000)
DURHAM
SALEM
TOTAL
$ 8,000 -0-
$11,000 10,000
$30,000 30,000
(16,000) $ (8,000)
(24,000) (80,000) $ (3,000) $(20,000)
STATEMENT OF CAPITAL—YEAR ONE Beginning capital ................... Net loss (above) ..................... Drawings (given) .................... Ending capital ...................
WINSTON
DURHAM
$110,000 (9,000) (10,000) $ 91,000
$80,000 (8,000) (10,000) $62,000
14-11 .
.
SALEM
TOTAL
$110,000 $300,000 (3,000) (20,000) (10,000) (30,000) $ 97,000 $250,000
Chapter 14 - Partnerships: Formation and Operation
11. (continued) ASSIGNMENT OF INCOME—YEAR TWO WINSTON
Interest—10% of beginning capital .............. $ 9,100 Salary ....................................... 20,000 Allocation of remaining loss ($15,000 divided on a 5:2:3 basis) (7,500) Totals ............................ $21,600
DURHAM
SALEM
TOTAL
$ 6,200 -0-
$ 9,700 10,000
$25,000 30,000
(3,000) $3,200
(4,500) (15,000) $15,200 $ 40,000
STATEMENT OF CAPITAL—YEAR TWO Beginning capital (above) ..... Net income (above) ................ Drawings (given) .................... Ending capital ...................
WINSTON
DURHAM
$ 91,000 21,600 (10,000) $102,600
$62,000 3,200 (10,000) $55,200
SALEM
TOTAL
$ 97,000 $250,000 15,200 40,000 (10,000) (30,000) $102,200 $260,000
12. A Costello receives a $10,000 bonus ($100,000 less $90,000 capital balance). This bonus is deducted from the two remaining partners according to their profit and loss ratio (2:3). A 60 percent (3/5) reduction is assigned to Burns which decreases that partner’s capital balance from $30,000 to $24,000. 13. D Clark receives an additional $10,000. Because Clark receives 20 percent of profits and losses, this allocation indicates total goodwill of $50,000. 20% of Goodwill = $10,000 Goodwill = $10,000 ÷ .20 = $50,000 Goodwill Manning, capital (30%) Gonzalez, capital (30%) Clark, capital (20%) Freeney, capital (20%)
50,000 15,000 15,000 10,000 10,000
The above entry raises Manning’s capital from $130,000 to $145,000. 14. B Under the bonus method, Clark’s excess payment is deducted from the remaining partners’ capital accounts according to their relative profit and loss ratios, 3:3:2. Manning’s balance is then $126,250 = $130,000 – $3,750. Manning, capital Gonzalez, capital Freeney, capital Clark, capital Cash
3,750 3,750 2,500 80,000 90,000
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Chapter 14 - Partnerships: Formation and Operation
15. A The implied value of the company is $900,000 ($270,000 ÷ 30%). Because the money is going to the partners rather than into the business, the capital total is $490,000 before realigning the balances. Hence, goodwill of $410,000 is recognized based on the implied value ($900,000 – $490,000). This goodwill is assumed to represent unrealized business gains and is attributed to the original partners according to their profit and loss ratio. They will then each convey 30 percent ownership of the $900,000 partnership to Darrow for a capital balance of $270,000. 16. D Because the money goes into the business, total capital becomes $740,000 ($490,000 + $250,000). Darrow is allotted 30 percent of this total or $222,000. Because Darrow invested $250,000, the extra $28,000 is assumed to be a bonus to the original partners. Jennings will be assigned 40 percent of this extra amount or $11,200. This bonus increases Jennings’ capital from $160,000 to $171,200. 17. (10 Minutes) (Compute capital balances under both goodwill and bonus methods) a. Goodwill Method Implied value of partnership ($80,000 ÷ 40%) .............. Total capital after investment ($70,000 + $40,000 + $80,000) Goodwill .......................................................................... $ 10,000
$200,000 190,000
Goodwill to Hamlet (7/10) ..............................................
$
Goodwill to MacBeth (3/10) ...........................................
$ 3,000
Hamlet, capital (original balance plus goodwill) .........
$ 77,000
MacBeth, capital (original balance plus goodwill) ......
$ 43,000
Lear, capital (payment) (40% of total capital) ..............
$ 80,000
b. Bonus Method Total capital after investment ($70,000 + 40,000 + $80,000) Ownership portion—Lear .............................................. Lear, capital ....................................................................
$190,000 40% $ 76,000
Bonus payment made by Lear ($80,000 – $76,000) ......
$
4,000
Bonus to Hamlet (7/10) ..................................................
$
2,800
Bonus to MacBeth (3/10) ...............................................
$
1,200
Hamlet, capital (original balance plus bonus) .............
$ 72,800
MacBeth, capital (original balance plus bonus) ..........
$ 41,200
Lear, capital (40% of total capital) ................................
$ 76,000
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7,000
.
Chapter 14 - Partnerships: Formation and Operation
18. (15 Minutes) (Prepare journal entries to record admission of new partner under both the goodwill and the bonus methods) Part a. Total capital is $300,000 ($85,000 + $60,000 + $55,000 + $100,000) after the new investment. As Sergio's portion is 25 percent, this partner's capital balance would be $75,000. Because $100,000 was paid, a bonus of $25,000 is given to the three original partners based on their profit and loss ratio: Tiger—$12,500 (50%), Phil—$7,500 (30%), and Ernie—$5,000 (20%). Cash .......................................................................... Sergio, capital ...................................................... Tiger, capital ........................................................ Phil, capital .......................................................... Ernie, capital ........................................................
100,000 75,000 12,500 7,500 5,000
Part b. Total capital is $260,000 ($85,000 + $60,000 + $55,000 + $60,000) after the new investment. As Sergio's portion is 25 percent, this partner's capital balance is $65,000. Because only $60,000 was paid, a bonus of $5,000 is taken from the three original partners based on their profit and loss ratio: Tiger—$2,500 (50%), Phil—$1,500 (30%), and Ernie—$1,000 (20%). Cash .......................................................................... Tiger, capital ............................................................. Phil, capital ................................................................ Ernie, capital ............................................................. Sergio, capital ......................................................
60,000 2,500 1,500 1,000 65,000
Part c. Total capital is $272,000 ($85,000 + $60,000 + $55,000 + $72,000) after the new investment. However, the implied value of the business based on the new investment is $288,000 ($72,000 ÷ 25%). Consequently, goodwill of $16,000 must be recognized with the offsetting allocation to the original partners based on their profit and loss ratio: Tiger—$8,000 (50%), Phil— $4,800 (30%), and Ernie—$3,200 (20%). Goodwill ................................................................... Tiger, capital ........................................................ Phil, capital .......................................................... Ernie, capital ........................................................ Cash ........................................................................... Sergio, capital ......................................................
14-14 .
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16,000 8,000 4,800 3,200 72,000 72,000
Chapter 14 - Partnerships: Formation and Operation
19. (16 Minutes) (Determine capital balances after admission of new partner using both goodwill and bonus methods) Part a. Total capital is $490,000 ($200,000 + $120,000 + $90,000 + $80,000) after the new investment. However, the implied value of the business based on the new investment is only $444,444 ($80,000 ÷ 18%). According to the goodwill method, this situation indicates that the new partner must be bringing some intangible attribute to the partnership other than just cash. This contribution must be computed algebraically and is recorded as goodwill to the new partner. G's Investment = .18 ($200,000 + $120,000 + $90,000 + G's Investment) $80,000 + Goodwill = .18 ($410,000 + $80,000 + Goodwill) $80,000 + Goodwill = $88,200 + .18 Goodwill .82 Goodwill = $8,200 Goodwill = $10,000 The above goodwill balance indicates that Grant's total investment is $90,000 (cash of $80,000 and goodwill of $10,000). A $90,000 contribution raises the total capital to $500,000 so that Grant does, indeed, have an 18 percent interest ($90,000 ÷ $500,000). CAPITAL BALANCES: Nixon .................................................................... Hoover .................................................................. Polk .................................................................... Grant ....................................................................
$200,000 120,000 90,000 90,000
Part b. Total capital is $510,000 ($200,000 + $120,000 + $90,000 + $100,000) after the new investment. As Grant's portion is to be 20 percent, this partner's capital balance will be $102,000. Because only $100,000 was paid, a bonus of $2,000 is taken from the three original partners based on their profit and loss ratio: Nixon—$1,000 (50%), Hoover—$400 (20%), and Polk—$600 (30%). CAPITAL BALANCES Original
Nixon .................... Hoover .................. Polk ....................... Grant ..................... Total ................
$200,000 120,000 90,000 -0-
Investment
Bonus
Total
100,000
$(1,000) (400) (600) 2,000
$199,000 119,600 89,400 102,000 $510,000
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Chapter 14 - Partnerships: Formation and Operation
20. (10 Minutes) (Record admission of new partner and allocation of new income) Part a. Total capital is $167,000 ($70,000 + $60,000 + $37,000) after the new investment. However, the implied value of the business based on the new investment is $185,000 ($37,000 ÷ 20%). Consequently, goodwill of $18,000 must be recognized with the offsetting allocation to the original two partners based on their profit and loss ratio: Prince—$14,400 (80%) and Robbins—$3,600 (20%). Goodwill ................................................................ Prince, capital ................................................ Robbins, capital ............................................. Cash .................................................................... Jeffrey, capital ................................................
18,000 14,400 3,600 37,000 37,000
Part b. Interest .................................. Remaining loss ..................... Income allocation ...........
Prince $8,440 (1,750) $6,690
Robbins $6,360 (1,050) $5,310
Jeffrey $3,700 (700) $3,000
Total $18,500 (3,500) $15,000
Lane $ -045,000 (6,000) $39,000
Total $18,000 90,000 (18,000) $90,000
21. (5 Minutes) (Allocation of income to partners) Jones Bonus (20%) ......................... $18,000 Interest (15% of average capital) 15,000 Remaining loss ($18,000) ... (6,000) Income assignment ............. $27,000
14-16 .
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King $ -030,000 (6,000) $24,000
Chapter 14 - Partnerships: Formation and Operation
22. (15 Minutes) (Allocate income and determine capital balances) ALLOCATION OF INCOME Interest (10%) Salary Remaining income (loss): $ 23,600 (12,600) (51,000) $(40,000) Totals
Purkerson Smith $ 6,600 (below) $ 4,000 18,000 25,000
Traynor $ 2,000 8,000
Totals $12,600 51,000
(16,000)
(8,000)
(16,000)
(40,000)
$ 8,600
$21,000
$(6,000)
$23,600
CALCULATION OF PURKERSON'S INTEREST ALLOCATION Balance, January 1—April 1 ($60,000 × 3) Balance, April 1—December 31 ($68,000 × 9) Total ................................................................................ Months ............................................................................. Average monthly capital balance ................................. Interest rate .................................................................... Interest allocation (above) ............................................
$180,000 612,000 $792,000 12 $ 66,000 × 10% $ 6,600
STATEMENT OF PARTNERS' CAPITAL Beginning balances .............. Additional contribution ........ Income (above) ...................... Drawings ($1,000 per month) Ending capital balances ........
Purkerson
Smith
$60,000 8,000 8,600 (12,000) $64,600
$40,000 -021,000 (12,000) $49,000
14-17 .
.
Traynor
Totals
$20,000 $120,000 -08,000 (6,000) 23,600 (12,000) (36,000) $ 2,000 $115,600
Chapter 14 - Partnerships: Formation and Operation
23. (30 Minutes) (Allocate income for several years and determine ending capital balances) INCOME ALLOCATION—2014 Left Interest (12% of beginning capital) $2,400 Salary 12,000 Remaining income/loss: $(30,000) (15,600) (20,000) $(65,600) (19,680) Totals $(5,280)
Center $ 7,200 8,000
Right $ 6,000 -0-
Total $ 15,600 20,000
(32,800) $(17,600)
(13,120) (65,600) $(7,120) $(30,000)
STATEMENT OF PARTNERS' CAPITAL—DECEMBER 31, 2014
Beginning balances ........... Income allocation ............... Drawings ............................. Ending balances ...........
Left $20,000 (5,280) (10,000) $ 4,720
Center $60,000 (17,600) (10,000) $32,400
INCOME ALLOCATION—2015 Left Center Interest(12% of beginning capital above) *$566 $3,888 Salary ................................. 12,000 8,000 Remaining income/loss: $20,000 (8,400) (20,000) $(8,400) (2,520) (4,200) Totals.................. $10,046 $7,688 *Rounded
Right Total $50,000 $130,000 (7,120) (30,000) (10,000) (30,000) $32,880 $ 70,000
Right $3,946 -0-
Total $ 8,400 20,000
(1,680) $2,266
(8,400) $20,000
STATEMENT OF PARTNERS' CAPITAL—DECEMBER 31, 2015
Beginning balances (above) Additional investment ....... Income allocation ............... Drawings ............................. Ending balances ...........
Left $ 4,720 -010,046 (10,000) $ 4,766
14-18 .
.
Center $32,400 -07,688 (10,000) $30,088
Right $32,880 12,000 2,266 (10,000) $37,146
Total $70,000 12,000 20,000 (30,000) $72,000
Chapter 14 - Partnerships: Formation and Operation
23. (continued) INCOME ALLOCATION—2016 Left Center Interest (12% of beginning capital above)* .......................... $ 572 $ 3,611 Salary .................................. 12,000 8,000 Remaining income: $40,000 (8,640) (20,000) $11,360 ........................ 2,272 4,544 Totals ........................ $14,844 $16,155
Right
Total
$4,457 -0-
$ 8,640 20,000
4,544 $9,001
11,360 $40,000
*Rounded STATEMENT OF PARTNERS' CAPITAL—DECEMBER 31, 2016 Left Center Right Total Beginning balances (above) $ 4,766 $30,088 $37,146 $72,000 Income allocation 14,844 16,155 9,001 40,000 Drawings (10,000) (10,000) (10,000) (30,000) Ending balances $ 9,610 $36,243 $36,147 $82,000
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Chapter 14 - Partnerships: Formation and Operation
24. (12 Minutes) (Determine capital balances after retirement of a partner using both the goodwill and the bonus approaches) a. Fergie receives $30,000 more than her capital balance. Because Fergie is assigned 20 percent of all profits and losses, this extra allocation indicates total goodwill of $150,000, which must be split among all partners. 20% of Goodwill = $30,000 .20 G = $30,000 G = $150,000 CAPITAL BALANCES AFTER WITHDRAWAL Pineda Adams Fergie Gomez Total
Original Balance
Goodwill
$230,000 190,000 160,000 140,000
$45,000 45,000 30,000 30,000
Withdrawal
Final Balance
$(190,000)
$275,000 235,000 -0170,000 $680,000
b. A $50,000 bonus is paid to Pineda ($280,000 is paid rather than the $230,000 capital balance). This bonus is deducted from the three remaining partners according to their relative profit and loss ratio (3:2:1). A reduction of 50 percent (3/6) is assigned to Adams or a decrease of $25,000 which drops this partner's capital balance from $190,000 to $165,000. A reduction of 33.3 percent (2/6) is assigned to Fergie or a decrease of $16,667 which drops this partner's capital balance from $160,000 to $143,333. A reduction of 16.7 percent (1/6) is assigned to Gomez or a decrease of $8,333 which drops this partner's capital balance from $140,000 to $131,667. 25. (10 minutes) (Hybrid method for recording a partner withdrawal) Because the continuing partners do not wish to record goodwill, a hybrid approach records identifiable asset fair value changes and corresponding capital adjustments, but no goodwill. The remaining excess payment to the withdrawing partner after the revaluation is then treated as a bonus. Building Matteson, capital Richton, capital O’Toole, capital
40,000
O’Toole, capital Matteson, capital Richton, capital Cash
108,000 4,500 7,500
12,000 20,000 8,000
120,000 14-20
.
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Chapter 14 - Partnerships: Formation and Operation
26.
(45 Minutes) (P&L allocations and admission of a new partner) a. The interest factor was probably inserted to reward Hugh for contributing $50,000 more to the partnership than Jacobs. The salary allowance gives an additional $20,000 to Jacobs in recognition of the full-time (rather than part-time) employment. The 40:60 split of the remaining income was probably negotiated by the partners based on other factors such as business experience, reputation, etc. b. The drawings show the assets removed by a partner during a period of time. A salary allowance is added to each partner's capital for the year (usually in recognition of work done) and is a component of net income allocation. The two numbers are often designed to be equal but agreement is not necessary. For example, a salary allowance might be high to recognize work contributed by one partner. The allowance increases the appropriate capital balance. The partner might, though, remove little or no money so that the partnership could maintain its liquidity. c. Hugh, drawings ......................................................... 7,500 Repair expense .................................................... (To reclassify payment made to repair personal residence.) Hugh, capital ............................................................. Jacobs, capital .......................................................... Hugh, drawings (adjusted for home repairs) .... Jacobs, drawings ................................................ (To close drawings accounts for 2014.)
16,500 14,000
Revenues ................................................................... Expenses (adjusted by first entry) ..................... Income summary ................................................. (To close revenue and expense accounts for 2014.)
175,000
7,500
16,500 14,000
138,500 36,500
Income summary ...................................................... 36,500 Hugh, capital ........................................................ 12,600 Jacobs, capital .................................................... 23,900 (To close net income to partners' capital–see allocation plan shown below.) Allocation of Income Interest (10% of beginning balance) Salary allowances Remaining income (loss): Net income $ 36,500 Interest (25,000) Salary (30,000) Remainder $ (18,500) Profit allocation 14-21 .
.
Hugh $ 15,000 5,000
Jacobs $ 10,000 25,000
(7,400) (40%) $12,600
(11,100) (60%) $23,900
Chapter 14 - Partnerships: Formation and Operation
26. (continued) d. Total capital (original balances of $250,000 plus 2014 net income less drawings) ................................. $256,000 Investment by Thomas ............................................. 64,000 Total capital after investment .................................. $320,000 Ownership portion acquired by Thomas ................ 15% Thomas, capital ........................................................ $ 48,000 Amount paid .............................................................. 64,000 Bonus paid by Thomas—assigned to original partners $ 16,000 Bonus to Hugh (40%) ...............................................
$6,400
Bonus to Jacobs (60%) ............................................
$9,600
Cash .......................................................................... Thomas, capital (20% of total capital) ............... Hugh, capital ........................................................ Jacobs, capital ....................................................
64,000
14-22 .
.
48,000 6,400 9,600
Chapter 14 - Partnerships: Formation and Operation
27. (40 Minutes) (Reporting a change in the composition of a partnership) a. Exact amount of investment can only be computed algebraically: E Investment = 25% (Original Capital + E Investment) El = .25 ($270,000 + El) El = $67,500 + .25 El .75 El = $67,500 E Investment = $90,000 b. Implied value of partnership ($36,000 ÷ 10%) ......... Total capital after investment by E ($270,000 + $36,000) Goodwill .................................................................... $ 54,000 Allocation of Goodwill: A (30%) ............................................................... $16,200 B (10%) ............................................................... 5,400 C (40%) ............................................................... 21,600 D (20%) ............................................................... 10,800 Total ................................................................ $54,000
$360,000 306,000
CAPITAL BALANCES Original balances Goodwill (above) Investment Capital balances
A $20,000 16,200 -0$ 36,200
B $40,000 5,400 -0$45,400
C $ 90,000 21,600 -0$111,600
D $120,000 10,800 -0$130,800
E $-0-036,000 $36,000
c. Because E's investment of $42,000 is less than 20% of the resulting capital ($312,000). E is apparently bringing some other attribute to the partnership (goodwill) that must be computed: E Investment = 20% (Original Capital + E Investment) $42,000 + Goodwill = .20 ($270,000 + $42,000 + Goodwill) $42,000 + Goodwill = $62,400 + .20 Goodwill .80 Goodwill = $20,400 Goodwill = $25,500 E's investment is, therefore, $42,000 in cash and $25,500 in goodwill for a total capital balance of $67,500; the other capital accounts remain unchanged. Note that E's capital of $67,500 is 20% of the new total capital $337,500 ($270,000 + $67,500).
14-23 .
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Chapter 14 - Partnerships: Formation and Operation
27. (continued) d.
Total capital after investment ($270,000 + $55,000) $325,000 Amount acquired by E ............................................. E's capital balance .................................................... E's payment .............................................................. Bonus being given to E ............................................
20% $ 65,000 55,000 $ 10,000
Bonus from: A (10%) ............................................................... B (30%) ............................................................... C (20%) ............................................................... D (40%) ...............................................................
$1,000 3,000 2,000 4,000
$10,000
CAPITAL BALANCES A B C $20,000 $40,000 $90,000 -0-0-0(1,000) (3,000) (2,000) $19,000 $37,000 $88,000
D $120,000 -0(4,000) $116,000
E $-055,000 10,000 $65,000
Original balances Investment Bonus (above) Capital balances
e. C's capital balance C's collection (125%) Bonus being paid to C Bonus from: A (1/3) B (1/3) D (1/3)
$ 90,000 112,500 $ 22,500
$7,500 7,500 7,500
$22,500
CAPITAL BALANCES A B Original balances ................. $20,000 $40,000 Bonus (above) ...................... (7,500) (7,500) Payment ................................ -0-0Capital balances ................... $12,500 $32,500
14-24 .
.
C D $ 90,000 $120,000 22,500 (7,500) (112,500) -0$ -0- $112,500
Chapter 14 - Partnerships: Formation and Operation
28. (55 Minutes) (Allocation of income to the partners and determination of capital balances) ALLOCATION OF INCOME—2013 Boswell Johnson Total Salary (8 months) ................. $8,000 $-0$ 8,000 Remaining $3,000 ................. 1,200 (40%) 1,800 (60%) 3,000 Totals ............................... $9,200 $1,800 $11,000 STATEMENT OF PARTNERS' CAPITAL—DECEMBER 31, 2013 Boswell Johnson Total Beginning Balances ($114,000 Invested capital split evenly— market value used for assets) $57,000 $57,000 $114,000 Income allocation (above) ... 9,200 1,800 11,000 Drawings ............................... -0-0-0Ending balances ............. $66,200 $58,800 $125,000 WALPOLE INVESTMENT JANUARY 1, 2014 Walpole's $54,000 investment increases total capital to $179,000. Walpole is credited with a 40% interest or $71,600. According to the problem, the excess $17,600 is a bonus from the original partners. Of this amount, $10,560 is allocated from Johnson (60%) and $7,040 from Boswell (40%).
ALLOCATION OF INCOME—2014 Boswell Salary .................................... $12,000 Remaining $8,000 loss ($28,000 – $36,000) ........................... (960) Totals .......................... $11,040
Johnson $-0-
Walpole $24,000
Total $36,000
(3,840) $(3,840)
(3,200) $20,800
(8,000) $28,000
STATEMENT OF PARTNERS' CAPITAL—DECEMBER 31, 2014
Beginning balances ............. Walpole's contribution ........ Income allocation (above) ... Drawings ............................... Ending balances .............
Boswell $66,200 (7,040) 11,040 (5,000) $65,200
14-25 .
.
Johnson $58,800 (10,560) (3,840) (5,000) $39,400
Walpole Total $ -0- $125,000 71,600 54,000 20,800 28,000 (10,000) (20,000) $82,400 $187,000
Chapter 14 - Partnerships: Formation and Operation
28. (continued) ADMISSION OF POPE—JANUARY 1, 2015 Pope's payment was made directly to the partners. Therefore, neither goodwill nor a bonus need be recognized. Instead, 10% of each capital balance shown above will be reclassified to Pope. The journal entry would be as follows: Boswell, capital .............................................................. Johnson, capital ............................................................. Walpole, capital. .............................................................. Pope, capital .............................................................
6,520 3,940 8,240 18,700
ALLOCATION OF INCOME—2015 Salary Remaining $400 income
Totals
Boswell
Johnson
Walpole
Pope
Total
$12,000 54 $12,054
$-0162 $162
$24,000 144 $24,144
$9,600 40 $9,640
$45,600 400 $46,000
STATEMENT OF PARTNERSHIP CAPITAL—DECEMBER 31, 2015
Beginning balances Admission of Pope Allocation of income (above) Drawings Ending balances
Boswell Johnson $65,200 $39,400 (6,520) (3,940)
Walpole $82,400 (8,240)
Pope $-018,700
12,054 (5,000) $65,734
24,144 (10,000) $88,304
9,640 46,000 (4,000) (24,000) $24,340 $209,000
162 (5,000) $30,622
14-26 .
.
Total $187,000 -0-
Chapter 14 - Partnerships: Formation and Operation
29. (60 Minutes) (Allocate income and prepare a statement of partners' capital) a. Income Allocation—2013 Gray Salary allowance ($8 per billable hour) $13,680 Interest (see Note A) 25,928 Bonus (not applicable because salary and interest would necessitate a negative bonus) -0Remaining loss (split evenly): $ 65,000 (35,600) (58,328) $(28,928) (9,643) Profit allocation
$29,965
Stone
Lawson
Totals
$11,520 21,600
$10,400 10,800
$35,600 58,328
-0-
-0-
-0-
(9,643)
(9,642)
(28,928)
$23,477
$11,558
$65,000
Note A: Interest for Stone and Lawson is calculated at 12% of their beginning capital balances ($180,000 and $90,000, respectively) while for Gray the computation is based on a $210,000 balance for 4/12 of the year and $219,100 for the remaining 8/12. Capital Account Balances—1/1/13 – 12/31/13
Beginning contributions Added Investment Profit allocation (from above) Drawing (10% of beginning balances) Ending balances
Gray $210,000 9,100 29,965
Stone $180,000 -023,477
Lawson $90,000 -011,558
Totals $480,000 9,100 65,000
(21,000) $228,065
(18,000) $185,477
(9,000) $92,558
(48,000) $506,100
Prior to developing the information for 2014, a computation of Monet's investment must be made: Monet's Investment = 25% ($506,100 + Monet's Investment) Ml = $126,525 + .25 Ml .75 Ml = $126,525 Ml = $168,700
14-27 .
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Chapter 14 - Partnerships: Formation and Operation
29. a. (continued) Income Allocation—2014 Gray Salary allowance ($8 per billable hour) $14,400 Interest (12% of beginning capital balances for the year) 27,368 Bonus (not applicable) -0Remaining loss (split evenly): $ (20,400) (46,960) (80,976) $(148,336) (37,084) Loss allocation $ 4,684
Stone
Lawson
Monet
Totals
$ 12,000
$ 11,040
$ 9,520
$ 46,960
22,257 -0-
11,107 -0-
20,244 -0-
80,976 -0-
(37,084) $(2,827)
(37,084) $(14,937)
(37,084) $ (7,320)
(148,336) $(20,400)
Lawson $92,558
Monet $168,700
Totals $674,800
(14,937)
(7,320)
(20,400)
(9,256) $68,365
(16,870) $144,510
(67,480) $586,920
Stone
Lawson
Monet
Totals
$12,960
$10,480
$12,640
$ 51,120
19,692 2,604
8,204 -0-
17,341 -0-
70,430 5,208
6,510 $41,766
6,511 $25,195
6,511 $36,492
26,042 $152,800
Capital Account Balances 1/1/14 – 12/31/14 Gray Stone Beginning balances $228,065 $185,477 Loss allocation (from above) 4,684 (2,827) Drawings (10% of beginning balances) (22,806) (18,548) Ending balances $209,943 $164,102 Income Allocation—2015 Gray Salary allowance ($8 per billable hour) $15,040 Interest (12% of beginning capital balances for the year) 25,193 Bonus (see Note B) 2,604 Remaining profit split evenly: $152,800 (51,120) (70,430) (5,208) $ 26,042 6,510 Profit allocation $49,347
14-28 .
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Chapter 14 - Partnerships: Formation and Operation
29. a. (continued) Note B: The bonus to Gray and Stone can only be derived algebraically. Because each of the two partners is entitled to 10% of net income as defined, the total bonus is 20% and can be computed as follows: Bonus = 20% (Net income – Salary – Interest – Bonus) B = .2 ($152,800 – $51,120 – $70,430 – B) B = .2 ($31,250 – B) B = $6,250 – .2B 1.2 B = $6,250 B = $5,208 (or $2,604 per person) Capital Account Balances 1/1/15 – 12/31/15 Gray Stone $209,943 $164,102
Beginning balances Profit allocation (from above) 49,347 41,766 Drawings (10% of beginning balances) (20,994) (16,410) Ending balances $238,296 $189,458
Lawson $68,365
Monet $144,510
Totals $586,920
25,195
36,492
152,800
(6,837) $86,723
(14,451) $166,551
(58,692) $681,028
Lawson $68,365
Monet $144,510
Totals $586,920
25,195
36,492
152,800
(6,837) $86,723
(14,451) $166,551
(58,692) $681,028
b. GRAY, STONE, LAWSON, and MONET Statement of Partners' Capital For Year Ending December 31, 2015 Gray Stone Beginning balances $209,943 $164,102 Profit allocation (from above) 49,347 41,766 Drawings (10% of beginning balances) (20,994) (16,410) Ending balances $238,296 $189,458
14-29 .
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Chapter 14 - Partnerships: Formation and Operation
30. (40 Minutes) (Recording admission and retirement of partners using both the bonus and goodwill methods) a. Porthos, capital ......................................................... 35,000 D'Artagnan, capital .............................................. 35,000 (To reclassify Porthos's capital balance to reflect transfer of interest to D'Artagnan.) b. Goodwill .................................................... 50,000 Athos, capital (50%) ........................................... 25,000 Porthos, capital (30%) ........................................ 15,000 Aramis, capital (20%) ......................................... 10,000 (To record goodwill based on $250,000 implied value of partnership [$25,000 ÷ 10%]. Because current capital is only $200,000 [the $25,000 goes directly to the partners], goodwill of $50,000 has to be recorded and allocated using profit and loss ratio.) Athos, capital (10% of balance) ............................... 10,500 Porthos, capital (10% of balance) ........................... 8,500 Aramis, capital (10% of balance) ............................. 6,000 D'Artagnan, capital............................................... 25,000 (To reclassify 10% of each partner's capital to reflect transfer of interest to D'Artagnan.) c. Cash .......................................................................... 30,000 D'Artagnan, capital (10% of total capital) ........... 23,000 Athos, capital (50% of excess payment) ........... 3,500 Porthos, capital (30% of excess payment) ........ 2,100 Aramis, capital (20% of excess payment) ......... 1,400 (To record $30,000 payment by D'Artagnan which increases total capital to $230,000. D'Artagnan is credited for only 10% of that balance with the extra $7,000 payment being recorded as a bonus to the original partners.) d. Cash .......................................................................... 30,000 Goodwill .................................................................... 70,000 D'Artagnan, capital .............................................. 30,000 Athos, capital (50% of goodwill) ....................... 35,000 Porthos, capital (30% of goodwill) .................... 21,000 Aramis, capital (20% of goodwill) ...................... 14,000 (To record D'Artagnan's contribution to the partnership. The $30,000 payment for 10% interest indicates a $300,000 value for the business although the capital balances would only increase to $230,000. The $70,000 difference is recorded as goodwill, an amount assigned to the original partners.)
14-30 .
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Chapter 14 - Partnerships: Formation and Operation
30. (continued) e. Cash ........................................................................... 12,222 Goodwill . .................................................................. 10,000 D'Artagnan, capital .............................................. 22,222 To record investment by D'Artagnan. The implied value of the investment as a whole would be only $122,220 ($12,222 ÷ 10%). Because the capital balances are well in excess of this figure, D'Artagnan is apparently bringing some other factor (goodwill) into the partnership. This goodwill can be computed as follows: $12,222 + Goodwill = 10% (Original Capital + $12,222 + Goodwill) $12,222 + Goodwill = 10% ($200,000 + $12,222 + Goodwill) $12,222 + Goodwill = $21,222 + .10 Goodwill .90 Goodwill = $9,000 Goodwill = $10,000 f. Goodwill .................................................................... 80,000 Athos, capital (50%) ............................................ 40,000 Porthos, capital (30%) ......................................... 24,000 Aramis, capital (20%) .......................................... 16,000 (To record goodwill of $80,000 based on $280,000 appraisal of business.) Aramis, capital .......................................................... 66,000 Cash .................................................................... 66,000 (To distribute cash to retiring partner based on final capital balance.)
14-31 .
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Chapter 14 - Partnerships: Formation and Operation
31. (75 Minutes) (Recording of changes in the composition of a partnership including allocation of income) a. 1/1/13
Building ..................................................... 52,000 Equipment .................................................. 16,000 Cash ........................................................... 12,000 O'Donnell, capital ................................ 40,000 Reese, capital ...................................... 40,000 (To record initial investment. Assets recorded at fair value with two equal capital balances.)
12/31/13 Reese, capital ........................................... 22,000 12,000 O'Donnell, capital ................................ Income summary ................................. 10,000 (The allocation plan specifies that O'Donnell receives 20% in interest [or $8,000 based on $40,000 capital balance] plus $4,000 more [Because that amount exceeds 15% of the profits from the period]. The remaining $22,000 loss is assigned to Reese.) 1/1/14
Cash ........................................................... 15,000 O'Donnell, capital (15%) ........................... 300 Reese, capital (85%) ................................. 1,700 Dunn, capital ........................................ 17,000 (New investment by Dunn brings total capital to $85,000 after 2013 loss [$80,000 – $10,000 + $15,000]. Dunn's 20% interest is $17,000 [$85,000 × 20%] with the extra $2,000 coming from the two original partners [allocated between them according to their profit and loss ratio].)
12/31/14 O'Donnell, capital ..................................... 10,340 5,000 Reese, capital ........................................... Dunn, capital ............................................. 5,000 O'Donnell, drawings............................. 10,340 Reese, drawings .................................. 5,000 Dunn, drawings ................................... 5,000 (To close out drawings accounts for the year based on distributing 20% of each partner's beginning capital balances [after adjustment for Dunn's investment] or $5,000 whichever is greater. O'Donnell's capital is $51,700 [$40,000 + $12,000 – $300]) 12/31/14 Income summary ...................................... 44,000 16,940 O'Donnell, capital ................................ Reese, capital ...................................... 16,236 Dunn, capital ........................................ 10,824 (To allocate $44,000 income figure for 2014 as determined below.) 14-32 .
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Chapter 14 - Partnerships: Formation and Operation
31. a. (continued) O'Donnell
Reese
Dunn
$16,940
$16,236 $16,236
$10,824 $10,824
O'Donnell $40,000 12,000 (300) (10,340) 16,940 $58,300
Reese $40,000 (22,000) (1,700) (5,000) 16,236 $27,536
Dunn
Dunn, capital ............................................. Postner, capital ................................... (To reclassify balance to reflect acquisition of Dunn's interest.)
22,824
12/31/15 O'Donnell, capital ..................................... Reese, capital ........................................... Postner, capital ......................................... O'Donnell, drawings ............................ Reese, drawings .................................. Postner, drawings ............................... (To close out drawings accounts for the year based on 20% of beginning capital balances [above] or $5,000 [whichever is greater].)
11,660 5,507 5,000
Interest (20% of $51,700 beginning capital balance)........ 15% of $44,000 income .................. 60:40 split of remaining $27,060 income ....................................... Total ................................................
$10,340 6,600
Capital Balances as of December 31, 2014: Initial 2013 investment ................... 2013 profit allocation ..................... Dunn's investment ......................... 2014 drawings ................................ 2014 profit allocation ..................... 12/31/14 balances ........................... 1/1/15
22,824
11,660 5,507 5,000
12/31/15 Income summary ....................................... 61,000 O'Donnell, capital ................................ Reese, capital ...................................... Postner, capital ................................... (To allocate profit for 2015 determined as follows)
Interest (20% of $58,300 beg. capital) 15% of $61,000 income ............ 60:40 split of remaining $40,190 Totals ............................... 14-33 .
.
O'Donnell $11,660 9,150 ______ $20,810
$17,000 (5,000) 10,824 $22,824
20,810 24,114 16,076
Reese
Postner
$24,114 $24,114
$16,076 $16,076
Chapter 14 - Partnerships: Formation and Operation
31. a. (continued) 1/1/16 Postner, capital ......................................... O'Donnell, capital (15%) ........................... Reese, capital (85%) ................................. Cash ..................................................... (Postner's capital is $33,900 [$22,824 – $5,000 + $16,076]. Extra 10% payment is deducted from the two remaining partners' capital accounts.) b. 1/1/13
33,900 509 2,881 37,290
Building ...................................................... Equipment ................................................. Cash ........................................................... Goodwill .................................................... O'Donnell, capital ................................ Reese, capital ...................................... (To record initial capital investments. Reese is credited with goodwill of $80,000 to match O'Donnell's investment.)
52,000 16,000 12,000 80,000
12/31/13 Reese, capital ........................................... O'Donnell, capital ................................ Income summary ................................. (Interest of $16,000 is credited to O'Donnell [$80,000 × 20%] along with a base of $4,000. The remaining amount is now a $30,000 loss that is attributed entirely to Reese.)
30,000
1/1/14
15,000 22,500
Cash ........................................................... Goodwill .................................................... Dunn, capital ........................................ (Cash and goodwill being contributed by Dunn are recorded. Goodwill must be calculated algebraically.)
80,000 80,000
20,000 10,000
$15,000 + Goodwill = 20% (Current Capital + $15,000 + Goodwill) $15,000 + Goodwill = 20% ($150,000 + $15,000 + Goodwill) $15,000 + Goodwill = $33,000 + .2 Goodwill .8 Goodwill = $18,000 Goodwill = $22,500
14-34 .
.
37,500
Chapter 14 - Partnerships: Formation and Operation
31. b. (continued) 12/31/14 O'Donnell, capital ..................................... 20,000 Reese, capital ........................................... 10,000 Dunn, capital ............................................. 7,500 O'Donnell, drawings............................. Reese, drawings .................................. Dunn, drawings ................................... (To close out drawings accounts for the year based on 20 % of beginning capital balances: O'Donnell—$100,000, Reese— $50,000, and Dunn—$37,500.) 12/31/14 Income summary ...................................... 44,000 O'Donnell, capital ................................ Reese, capital ...................................... Dunn, capital ........................................ (To allocate $44,000 income figure as follows) O'Donnell Interest (20% of $100,000 beginning capital balance) 15% of $44,000 income 60:40 split of remaining $17,400 Totals
26,600 10,440 6,960
Reese
Dunn
$10,440 $10,440
$6,960 $6,960
Reese $80,000 (30,000)
Dunn
$20,000 6,600 $26,600
Capital balances as of December 31, 2014: O'Donnell Initial 2013 investment ... $ 80,000 2013 profit allocation ..... 20,000 Additional investment ... 2014 drawings ................ (20,000) 26,600 2014 profit allocation ..... 12/31/14 balances .......... $106,600 1/1/15
20,000 10,000 7,500
(10,000) 10,440 $50,440
$37,500 (7,500) 6,960 $36,960
Goodwill .................................................... 26,588 O'Donnell, capital (15%) ..................... 3,988 Reese, capital (51%) ............................ 13,560 Dunn, capital (34%) ............................. 9,040 (To record goodwill indicated by purchase of Dunn's interest.)
In effect, profits are shared 15% to O'Donnell, 51% to Reese – (60% of the 85% remaining after O'Donnell's income), and 34% to Dunn (40% of the 85% remaining after O'Donnell's income). Postner is paying $46,000, an amount $9,040 in excess of Dunn's capital ($36,960). The additional payment for this 34% income interest indicates total goodwill of $26,588 ($9,040 ÷ 34%). Because Dunn is entitled to 34% of the profits but only holds 19% of the total capital, an implied value for the company as a whole cannot be determined 14-35 .
.
Chapter 14 - Partnerships: Formation and Operation
directly from the payment of $46,000. Thus, goodwill can only be computed based on the excess payment. 31. b. (continued) 1/1/15
Dunn, capital .................................................. Postner, capital ......................................... (To reclassify capital balance to new partner.)
46,000 46,000
12/31/15 O'Donnell, capital ........................................... 22,118 Reese, capital ................................................. 12,800 Postner, capital .............................................. 9,200 O'Donnell, drawings ................................. 22,118 Reese, drawings ....................................... 12,800 Postner, drawings .................................... 9,200 (To close out drawings accounts for the year based on 20% of beginning capital balances [after adjustment for goodwill].) 12/31/15 Income summary ........................................... O'Donnell, capital ..................................... Reese, capital ........................................... Postner, capital ......................................... To allocate profit for 2015 as follows:
61,000
O'Donnell
Reese
Postner
$31,268
$17,839 $17,839
$11,893 $11,893
O'Donnell $106,600 3,988 (22,118) 31,268 $119,738
Reese $50,440 13,560 (12,800) 17,839 $69,039
Postner $36,960 9,040 (9,200) 11,893 $48,693
Interest (20% of $110,588 beginning capital balance) 15% of $61,000 income ....... 60:40 split of remaining $29,732 ............................ Totals ...............................
31,268 17,839 11,893
$22,118 9,150
Capital Balances as of December 31, 2015: 12/31/14 balances ................ Adjustment for goodwill ..... Drawings ............................... Profit allocation .................... 12/31/15 balances .................
Postner will be paid $53,562 (110% of the capital balance) for her interest. This amount exceeds her capital balance by $4,869. Because Postner is only entitled to a 34% share of profits and losses, the additional $4,869 indicates that the partnership as a whole is undervalued by $14,321 (4,869 ÷ 34%). Only in that circumstance is the extra payment to Postner justified:
14-36 .
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Chapter 14 - Partnerships: Formation and Operation
31. b. (continued)
1/1/16 Goodwill ............................................................... 14,321 O'Donnell, capital (15%) ................................ Reese, capital (51%) ...................................... Postner, capital (34%) .................................... (To recognize implied goodwill.)
2,148 7,304 4,869
1/1/16 Postner, capital ................................................... Cash ............................................................... (To record final distribution to Postner.)
53,562
14-37 .
.
53,562
Chapter 14 - Partnerships: Formation and Operation
Develop Your Skills Research Case This assignment allows the student to make use of the SEC website and, then, the EDGAR system. It also provides a chance to use actual statements created for a partnership rather than those typically produced for a corporation. Probably the most noticeable characteristic of the statements for Buckeye Partners is that they resemble corporate financial statements in most ways. A casual overview might not bring any differences to mind. However, a close reading will show several differences including the following: ▪ ▪ ▪ ▪ ▪
On the income statement, net income is allocated between the general partner and limited partners. Also, on the income statement earnings per share is replaced with a figure labeled as “earnings per partnership unit.” The balance sheet does not present a stockholders’ equity section but rather partnership capital. That section is comprised of just two figures: one for the general partner and the other for the limited partners. The first two paragraphs of Note One to the financial statements describe the partnership organization. A later paragraph presents a schedule reflecting the changes in partnership capital for both the general partner and the limited partners.
Analysis Case An unlimited number of allocation plans can be developed for any partnership. Here, Wilson will be interested in some reward for investing the capital used to create the business. Higgins will expect to be recognized for the work put into the operation. Poncelet should seek some reward for any new clients that she is able to bring to the business. One possibility would be to accrue interest to Wilson on her capital balance for the year based, perhaps, on the prime rate. Poncelet could be assigned a particularly high share of any revenues generated from new clients. The amount of income left would result from Higgins’s work in the day-to-day operations of the business so a large part of that remainder could be assigned to her. As an alternative, Wilson could be allocated an interest factor but only based on the initial amount invested in the business rather than the capital balance as a whole. Higgins could be assigned some type of allowance for the number of hours of work put in each period. Any remaining income could be divided evenly among the three partners but only up to a certain level. Beyond that, perhaps only Poncelet and Higgins would share in the income Because they are doing the 14-38 .
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Chapter 14 - Partnerships: Formation and Operation
work, one in gaining new clients and the other in the day-to-day operations of the business. Communication Cases 1 and 2 These two cases ask the student to identify the types of factors that will lend themselves toward the organization becoming a corporation (in Case 1) or a partnership (in Case 2). Several issues should be considered when looking into a legal format for a business enterprise: ▪
▪
▪
▪
▪
▪
Do state laws play any role in the decision? In some states, particular types of organizations are prohibited from operating as a corporation. Will state law come into play in making this decision? If so, the partnership form of organization will be required. How big do the owners expect the company to become? If the business will remain small, there may be no need to raise additional capital so that the ability to sell ownership may not be an issue. This favors creation of a partnership. However, if Birmingham and Roberts expect the business to prosper and grow, they should consider which type of business will enable them to attract other capital or debt investments. Usually, it is a corporation that is best set up to enable growth through the issuance of securities. How risky is the business operation? If the company is operating in a business where liability is not a significant problem, the limited liability of a corporation might not be of much interest. However, if there is some risk involved, the two owners may need the corporate type of organization just for their own financial security. How well do the owners know and trust each other? As with the previous comment, potential liability can be greatly enhanced if the owners do not know each other well or if additional owners are expected to join at a later point in time. Under that circumstance, everyone may feel more comfortable if the business is created as a corporation or as one of the limited liability organizations. If the owners, though, are comfortable with each other, they may not feel the necessity of creating a formalized corporation. What changes will occur in the tax laws? At this writing, dividends paid by a corporation to its owners are taxable at 15%. However, from time to time various politicians have proposed the elimination of part or all of that tax. Corporations gain appeal if dividend income is not taxed. How much money do they have available to create a legal organization? In most states, creation of a partnership can be virtually free whereas the legal formality of a corporation can cost money. If finances are tight, the business could begin as a partnership and then convert to a corporation at a later date as monetary restrictions ease.
14-39 .
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Chapter 14 - Partnerships: Formation and Operation
Excel Case: There are a variety of ways to create a spreadsheet to solve this particular problem. Here is one possible approach: In Cell A1, enter text “Net Income” and in Cell B1 enter $200,000. In Cell A2, enter text “Billable Hours–Red”. In Cell B2 enter 2,000. In Cell C2, enter $20 hourly rate. In Cell A3, enter text “Billable Hours–Blue”. In Cell B3 enter 1,500. In Cell C3, enter $30 hourly rate. In Cell A4, enter text “Investment–Red” and in Cell B4 enter $80,000. In Cell C4, enter the rate of return of 10%. In Cell A5, enter text “Investment–Blue” and in Cell B5 enter $50,000. In Cell C5, enter the rate of return of 10%. Perform calculation: In Cell D2, enter formula to multiply number of hours by hourly rate. Formula: =+B2*C2 The formula for the next three line items is identical to this first formula; copy the formula to Cells D3, D4, and D5. (To copy a formula across a range of cells, select the cell containing formula, then drag the fill handle, which is the small square in the lower right corner of this box, over the adjacent cells. Note that the formula will adjust automatically for the different lines.) In Cell A6, enter label text “Subtotal” and SUM the amounts in Cells D2 through D5. Click in Cell D6, press the symbol on the standard toolbar. Click and drag across the range of cells to be summed (D2 through D5) and press enter. Subtract the subtotal of the partner’s initial allocations (Cell D6) from the Net Income (Cell B1) with the following formula: In Cell A8, enter the label text “Profit to be Split” and in Cell D8, enter the following formula: =+B1-D6. Determine the distribution of Profit between partners: In Cell A10, enter label text “Profit – Red” and in Cell C10 enter “50%”. In Cell A11, enter label text “Profit – Blue” and in Cell C11 enter “50%”. Perform calculations: In Cell D10, enter formula to multiply Profit to be Split (Cell D8) by distribution percentage (Cell C10). Formula: =+D8*C10 Repeat this calculation for the other partner. In Cell D11, enter the formula: =+D8*C11 Once the spreadsheet is created, any variable may be changed and the results will adjust automatically. There are eleven variables that can be changed: B1, B2, B3, B4, B5, C2, C3, C4, and C5, as well as C10 and C11 (which must add up to 100%). Example: Net Income Billable Hours-Red Billable Hours-Blue Investment-Red Investment-Blue Subtotal
$200,000 2,000 1,500 $80,000 $50,000
$20 $30 10% 10%
Profit to be Split:
$102,000
Profit-Red Profit-Blue
50% 50% 14-40
.
$40,000 45,000 8,000 5,000 $98,000
.
$51,000 $51,000
Chapter 15 - Partnerships: Termination and Liquidation
CHAPTER 15 PARTNERSHIPS: TERMINATION AND LIQUIDATION Chapter Outline I.
The termination of a partnership and liquidation of its property may take place for a number of reasons. A. The death, withdrawal, or retirement of a partner can lead to cessation of business activity. B. The bankruptcy of either an individual partner or the partnership as a whole can necessitate termination and liquidation.
II. Because of the importance of liquidating and distributing assets fairly, all parties look to the accountant to play an important role in the process. A. The accountant provides timely financial information. B. The accountant works to ensure an equitable settlement of all claims. III. The statement of liquidation A. The liquidation process usually involves the disposal of noncash assets, payment of liabilities and liquidation expenses, and distribution of any remaining cash to the partners based on their final capital balances. B. A statement of liquidation should be produced periodically by the accountant to disclose losses and gains that have been incurred, remaining assets and liabilities, and current capital balances. IV. Deficit capital balances A. By the end of, or even during, the liquidation process, one or more partners may have a negative (or deficit) capital balance often as a result of losses incurred in disposing of assets. B. The Uniform Partnership Act indicates that any deficit capital balance should be eliminated by having that partner contribute enough additional assets to offset the negative balance. C. If this contribution is not immediately received, the remaining partners may request a preliminary distribution of any partnership cash that is available. 1. Safe payments of cash to individual partners are determined based on safe capital balances, the amounts that will remain in the individual capital accounts even if all deficits and other assets prove to be complete losses that must be absorbed by the remaining partners. 2. If a portion (or all) of a deficit is subsequently recovered from a partner, a further distribution to the other partners is made based on newly computed safe capital balances. 3. Any deficit that is not recovered from a partner must be charged to the remaining partners based on their relative profit and loss ratio.
15-1 .
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Chapter 15 - Partnerships: Termination and Liquidation
V. Treatment of partner’s loan to partnership A. The Uniform Partnership Act states that, in a liquidation, partnership assets should be used to first settle claims of partnership creditors, including claims of partners who are creditors. 1. This implies that the partnership would first repay partners’ loans before distributing any cash to partners based on their capital balances. B. However, in practice, to avoid making a cash distribution to a partner who subsequently develops a deficit capital balance, partners’ loan accounts typically are combined with partners’ capital accounts and funds are distributed accordingly. This text uses this practice. Vl. Preliminary distribution of assets to the partners A. The liquidation process can extend over a lengthy period of time as business activities wind down and property is sold. B. When the partnership terminates activity, or during the course of the liquidation, more cash may be available than the amount needed to extinguish all potential liabilities and liquidation expenses. C. If possible, the distribution of excess cash amounts should be made as quickly as possible to enable the partners to make use of their funds. 1. The accountant may choose to produce a proposed schedule of liquidation at such times to determine the equitable distribution of cash amounts that become available. 2. The proposed schedule of liquidation is developed based upon simulating the accounting recognition that would be required by a possible series of transactions: assets are sold, expenses are paid, etc. a. These events are simulated with the anticipation of maximum losses in each case. b. Noncash assets are assumed to have no resale value; maximum possible liquidation expenses are included; all partners are considered personally insolvent; etc. 3. Ending potential capital balances that remain on a proposed schedule of liquidation are safe capital balances, the amounts that could be immediately paid to each partner without jeopardizing future payments. Safe capital balances indicate that the partner will still have a sufficient interest in the partnership to absorb all potential losses even after a preliminary distribution. Vll. Predistribution plan A. The proposed schedule of liquidation (described above) can be used to determine safe payments based on safe capital balances but a newly revised schedule must be prepared each time a distribution of cash to partners is contemplated. B. Accountants often prefer to produce a single predistribution plan at the start of a liquidation to provide guidance for all payments made to the partners throughout this process. C. Information for the predistribution plan is generated by assuming the occurrence of a series of losses, each just large enough to eliminate one partner's claim to any partnership property.
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Chapter 15 - Partnerships: Termination and Liquidation
D. Once a series of losses has been simulated that would eliminate the capital balances of all partners, the actual plan is developed by measuring the effects that occur if the losses do not materialize. E. By working backwards through this series of possible losses, a predistribution plan can be produced that serves as a guide for all payments made during the liquidation.
Answer to Discussion Question: What Happens if a Partner Becomes Insolvent? This case demonstrates one of the nightmares of a partnership: the apparent insolvency of a partner is threatening the future of a successful business. The problem is especially acute to Wilkinson and Walker since this partnership was created solely for convenience; the partners share the facilities but do not actually work together. Therefore, the presence of Rogers is not essential to the other partners except that he pays a portion of the business's expenses. However, the claim that has been filed could lead to the actual liquidation of the entire business. Obviously, the partners should take no immediate action until they have spoken with Rogers. The entire issue may prove to be a mistake. Conversely, numerous other claims against Rogers may also be outstanding with the initial claim simply being the first to be filed. Because of the various possibilities, Wilkinson and Walker should consult with an attorney to learn of the partnership laws that apply in their state. They should also begin considering possible alternatives to salvage their business if Rogers is indeed insolvent. One alternative is for Wilkinson and Walker to buy out Rogers’ partnership interest. Rogers would receive his money and the remaining partnership could be left intact. However, they would have to prove—for legal reasons—that a fair price was being paid, and they would need to come up with a significant amount of cash in a short period of time. Finally, Wilkinson and Walker would have a building that was apparently larger than their needs. Unless they could utilize the space in some manner, they might have no way of recouping their additional investment. As a second possibility, a new dentist could be brought in to acquire Rogers’ interest in the partnership. Again, the money is conveyed to Rogers but now the original partners are not forced to make the payment. The building would continue to be fully utilized so that the partners' expenses would not escalate. In this case, though, a new partner may have to be identified in a short period of time. Furthermore, since the partners are sharing space, Wilkinson and Walker will probably want to ensure that the new partner is someone with whom they can work comfortably. Because of time considerations, they may not have the opportunity of getting the new partner they would like. Finally, the partnership can be liquidated. Wilkinson and Walker could then take their share of the proceeds and buy a new building for the continuation of their practices. Unfortunately, in liquidation, assets do not always bring fair market value. Thus, the partners may be forced to absorb significant losses as a result of Rogers' insolvency. In addition, the moving of any business can disrupt service and have a possible adverse impact on profitability. Although Wilkinson and Walker have several possible actions that can be taken, none of these is without problems. Therefore, partners should always include agreements within their Articles of Partnership to specify actions that will be taken in such cases. The insolvency of a partner is not a particularly unusual event. Hence, the partners (or their attorneys and accountants) should have the forethought to arrange the resolution of the business if insolvency of a partner does occur. 15-3 .
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Chapter 15 - Partnerships: Termination and Liquidation
Answers to Questions 1. A dissolution refers to the cessation of a partnership. In many cases, this process is simply a preliminary step in the transfer of business property to a newly formed partnership. Therefore, a dissolution does not necessarily affect the operations of the business or the sale of assets. In a liquidation, actual business activities cease. Partnership property is sold with the remaining cash distributed to creditors and to any partners with positive capital balances. Dissolution refers to changes in the composition of a partnership whereas liquidation is the selling of a partnership's assets. 2. Many reasons can exist that would lead to the termination and liquidation of a partnership. The business might simply have failed to generate sufficient profits or the partners may elect to enter other lines of work. Liquidation can also be required by the death, retirement, or withdrawal of one of the partners. In such cases, liquidation is often necessary to settle the partner's interest in the business. The bankruptcy of an individual partner can also force the termination of the business as can the bankruptcy of the partnership itself. 3. During the liquidation process, monitoring the balance of the partners' capital accounts becomes of paramount importance. That amount will eventually indicate either the cash to be received by the partners as final distributions or the additional contributions that they are required to pay to the partnership. Consequently, all liquidation gains and losses are recorded directly as changes to the partners’ capital balances. Such recording enhances the informational value of the accounts. As an additional factor, the computation of a net income figure is of diminished importance since normal operations have ceased. 4. Final distributions made to the various partners are based solely on their ending capital account balances unless the partners have agreed otherwise. If any partner has a deficit balance, that partner should make an additional contribution to the partnership to offset the negative capital balance. In some situations, a question may arise as to whether compensation for a deficit will ever be forthcoming from the responsible party. The remaining partners may choose to allocate the available cash immediately based on the assumption that the deficit balance eventually will prove to be a total loss. 5. A statement of liquidation summarizes the financial effect of the liquidation process as it has progressed to date. Information to be presented includes the balances of all remaining assets, the liability total, and the capital account of each partner. In addition, the allocation of all gains and losses incurred in the liquidation process as well as the payment of liquidation expenses should be reflected in the statement. 6. From a legal viewpoint, any partner who incurs a negative (or deficit) capital balance is obligated to make an additional contribution to offset that amount.
15-4 .
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Chapter 15 - Partnerships: Termination and Liquidation
7. A safe capital balance is the amount of a partner's capital account that exceeds all possible needs of a partnership as it goes through liquidation. A partner should, therefore, be able to receive this balance immediately without endangering the future amount to be received by any other party connected with the liquidation. Safe capital balances are computed by making a series of assumptions whereby the partnership undergoes maximum losses during the remainder of the liquidation process: all noncash assets are assumed to have no resale value, liquidation expenses are set at the largest possible estimation, and all partners are viewed as personally insolvent. Any capital balance that would remain after this series of anticipated events can be distributed to the partners immediately without incurring any risk. 8. Although the Uniform Partnership Act states that loans from partners rank ahead of the partners’ capital balances in the distribution of partnership assets, in practice a partner’s loan balance is usually merged with that partner’s capital balance to minimize the chance of a negative capital balance arising during the liquidation. This particular partner may get less money from the liquidation because of this treatment but the other partners are better protected. 9. A proposed schedule of liquidation is prepared by the accountant to determine the allocation of any cash available in the early stages of a liquidation that exceeds the amount needed to pay all liabilities and estimated liquidation expenses. The schedule is based on anticipating a series of assumed losses from the current day forward: all remaining noncash assets are scrapped, maximum liquidation expenses are incurred, and each partner is personally insolvent. The ending balances that would result from these simulated transactions represent safe capital balances. The amounts calculated as safe capital balances can be distributed as safe payments to individual partners and the partnership will still retain enough capital to absorb all future losses. 10. A predistribution plan is produced based on an assumed series of losses. Each loss is calculated to eliminate in turn the capital balance of one of the partners. In this manner, the accountant can determine the vulnerability to losses exhibited by each capital account. When the last balance is eliminated, the accountant will have established a series of losses that exactly offsets each balance. The predistribution plan is then developed by measuring the effects that are created if the losses do not occur. In effect, the accountant works backwards through the assumed losses to create a pattern of available cash, the predistribution plan.
15-5 .
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Chapter 15 - Partnerships: Termination and Liquidation
Answers to Problems 1. C 2. A 3. D 4. B (Partner with deficit capital balance)
Reported balances Potential loss from Cassidy deficit (split 5/8:3/8) Cash distributions
Angela, Capital $19,000
Woodrow, Capital $18,000
(7,500) $11,500
(4,500) $13,500
Cassidy, Capital $(12,000)
12,000 -0-
5. B (Insolvent partner) Reported balances Loss on sale of assets ($110,000) split on a 4:3:2:1 basis Adjusted balances Potential loss from Dennard deficit (split 4:3:1) Minimum cash distributions
Bell $50,000
Hardy $56,000
Dennard $14,000
Suddath $80,000
(44,000) $ 6,000
(33,000) $23,000
(22,000) $(8,000)
(11,000) $69,000
(4,000) $2,000
(3,000) $20,000
8,000 $ -0-
(1,000) $68,000
6. A (Predistribution plan)
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Chapter 15 - Partnerships: Termination and Liquidation
7. A (Proposed schedule of liquidation to determine safe payments before the liquidation begins; partner has deficit)
Reported balances .................................... Loss on sale of assets ($22,000) split on a 4:3:3 basis ....................................... Adjusted balances .................................... Anticipated liquidation expenses ($12,000) split on a 4:3:3 basis ............................... Anticipated maximum loss on inventory ($31,000) split on a 4:3:3 basis .............. Potential balances .................................... Potential loss from Art deficit (split 3:3) . Safe payments ...........................................
Art $18,000
Raymond $25,000
Darby $26,000
(8,800) $ 9,200
(6,600) $18,400
(6,600) $19,400
(4,800)
(3,600)
(3,600)
(12,400) $(8,000) 8,000 $ -0-
(9,300) $ 5,500 (4,000) $ 1,500
(9,300) $ 6,500 (4,000) $ 2,500
8. D (Proposed schedule of liquidation; partner has deficit) Since the partnership currently has total capital of $400,000, the $30,000 that is available would indicate maximum potential losses of $370,000. A Reported balances $100,000 Anticipated loss ($370,000) split on a 2:3:5 basis (74,000) Potential balances $ 26,000 Potential loss from C's deficit (split 2:3) (2,000) Current cash distribution $ 24,000
15-7 .
.
B $120,000
C $180,000
(111,000) $ 9,000 (3,000) $ 6,000
(185,000) $ (5,000) 5,000 $ -0-
Chapter 15 - Partnerships: Termination and Liquidation
9. C (Predistribution plan) To solve this problem a predistribution plan should be created. Maximum Losses That Can Be Absorbed Kevin Michael Brendan Jonathan
$59,000/40% $39,000/30% $34,000/10% $34,000/20%
$147,500 130,000 340,000 170,000
(most vulnerable to losses)
The assumption is made that a $130,000 loss occurs: Kevin Reported balances .................... $59,000 Assumed loss ($130,000) split on a 4:3:1:2 basis ................. (52,000) Adjusted balances ...................... $ 7,000
Michael $39,000
Brendan $34,000
Jonathan $34,000
(39,000) $ -0-
(13,000) $21,000
(26,000) $ 8,000
Maximum Losses That Now Can Be Absorbed Kevin $7,000 / 4/7 $12,250 (most vulnerable to losses) Brendan $21,000 / 1/7 147,000 Jonathan $8,000 / 2/7 28,000 The assumption is made that a $12,250 loss occurs: Kevin Reported balances ................................ $7,000 Assumed loss ($12,250) split on a 4:1:2 basis ................................. (7,000) Adjusted balances $ -0-
Brendan $21,000
Jonathan $8,000
(1,750) $19,250
(3,500) $4,500
Maximum Losses That Now Can Be Absorbed Brendan Jonathan
$19,250/1/3 $4,500/2/3
$57,750 6,750
(most vulnerable to losses)
The assumption is made that a $6,750 loss occurs: Reported balances ............................................ Assumed loss ($6,750) split on a 1:2 basis .... Adjusted balances ............................................
Brendan $19,250 (2,250) $17,000
Jonathan $4,500 (4,500) $ -0-
Brendan will receive a $17,000 distribution from the partnership before any of the other partners collect any cash. 10. C (Predistribution plan) To solve this problem, the following predistribution plan is created: 15-8 .
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Chapter 15 - Partnerships: Termination and Liquidation
• • • •
First $3,000 goes to Menton Next $15,000 goes to Menton (2/3) and Hoehn (1/3) Next $42,000 goes to Carney (4/7), Menton (2/7), and Hoehn (1/7) All remaining cash goes to Carney (4/10), Pierce (3/10), Menton (2/10), and Hoehn (1/10)
Beginning balances Assumed loss of $90,000 (see Schedule 1) (4:3:2:1 basis) Step one balances Assumed loss of $42,000 (see Schedule 2) (4:0:2:1 basis) Step two balances Assumed loss of $15,000 (see Schedule 3) (0:0:2:1 basis) Step three balances
Carney Pierce $60,000 $27,000
Menton $43,000
Hoehn $20,000
(36,000) (27,000) $24,000 $ -0-
(18,000) (9,000) $25,000 $11,000
(24,000) $ -0-
$ -0$ -0-
(12,000) $13,000
(6,000) $ 5,000
-0$ -0-
-0$ -0-
(10,000) $ 3,000
(5,000) $ -0-
Partner Carney Pierce Menton Hoehn
Schedule 1 Maximum Loss Capital Balance/ That Can Loss Allocation Be Absorbed $60,000/40% $150,000 $27,000/30% $ 90,000 (most vulnerable) $43,000/20% $215,000 $20,000/10% $200,000
Partner Carney Menton Hoehn
Schedule 2 Maximum Loss Capital Balance/ That Can Loss Allocation Be Absorbed $24,000/(4/7) $ 42,000 (most vulnerable) $25,000/(2/7) $ 87,500 $11,000/(1/7) $ 77,000
Partner Menton Hoehn
Schedule 3 Maximum Loss Capital Balance/ That Can Loss Allocation Be Absorbed $13,000/(2/3) $ 19,500 $ 5,000/(1/3) $ 15,000 (most vulnerable)
11. C (Partners with deficit capital balances; proposed schedule of liquidation; safe capital balances) The $16,000 available cash can be distributed but should be done under the assumption that all deficit balances will be total losses. After offsetting Jones' loan against his deficit capital balance, both Jones and Wayman 15-9 .
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Chapter 15 - Partnerships: Termination and Liquidation
have deficits of $2,000; total $4,000. Fuller and Rogers, the two partners with positive capital balances, share profits in a 30:20 relationship (the equivalent of a 60%:40% ratio). Fuller would absorb $2,400 of the potential $4,000 loss with Rogers being allocated $1,600. The remaining capital balances ($10,600 and $5,400) are safe capital balances and those amounts can be immediately distributed.
Reported balances Potential losses from Wayman and Jones split on a 3:2 basis Adjusted balances
Wayman (30%) $(2,000)
$
2,000 -0-
Jones (20%) $(2,000)
Fuller (30%) $13,000
Rogers (20%) $7,000
2,000 -0-
(2,400) $10,600
(1,600) $5,400
$
12. (8 minutes) (Determine safe payments; partner has deficit) Cleveland receives $6,800 and Pierce receives $1,200 Since the partnership currently has total capital of $350,000, the $8,000 that is available would indicate maximum potential losses of $342,000. Nixon
Cleveland
Pierce
Reported balances ............................. $170,000 Anticipated loss ($342,000) split on a 5:3:2 basis ............................. (171,000) Potential balances ............................. $ (1,000) Potential loss from Nixon's deficit (split 3:2) 1,000 Safe payments .................................... $ -0-
$110,000
$70,000
(102,600) $ 7,400 (600) $6,800
(68,400) $ 1,600 (400) $ 1,200
15-10 .
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Chapter 15 - Partnerships: Termination and Liquidation
13. (20 minutes) (Final settlement of a partnership being liquidated; various amounts of loss on sale of assets) Part a.
Brown gets $21,000, Fish gets $12,000, and Stone gets $2,000.
Reported balances ..................................... Loss on sale of land ($10,000) split on a 4:3:3 basis...................................... Cash distribution ....................................... Part b.
Fish $15,000
Stone $5,000
(4,000) $21,000
(3,000) $12,000
(3,000) $2,000
Brown $25,000
Fish $15,000
Stone $5,000
(8,000) $17,000 (571) $16,429
(6,000) $ 9,000 (429) $ 8,571
(6,000) $(1,000) 1,000 $ -0-
Brown $25,000
Fish $15,000
Stone $5,000
(12,000) $13,000 (2,286) $10,714
(9,000) $ 6,000 (1,714) $ 4,286
(9,000) $(4,000) 4,000 $ -0-
Brown gets $16,429 and Fish gets $8,571
Reported balances ..................................... Loss on sale of land ($20,000) split on a 4:3:3 basis ........................................... Adjusted balances ..................................... Potential loss from Stone's deficit (split 4:3) Cash distribution ....................................... Part c.
Brown $25,000
Brown gets $10,714 and Fish gets $4,286
Reported balances ..................................... Loss on sale of land ($30,000) split on a 4:3:3 basis ........................................... Adjusted balances ..................................... Potential loss from Stone's deficit (split 4:3) Cash distribution .......................................
14. (10 minutes) (Distribute cash contributed by partner with deficit balance) The entire $20,000 goes to Atkinson.
Reported balances Capital contribution Adjusted balances Potential loss from Dennsmore and Rasputin ($80,000) split on a 4:3 basis Adjusted balances Potential loss from Kaporale ($4,286) Cash distribution
Atkinson
Kaporale Dennsmore
Rasputin
$70,000 -0$70,000
$30,000 -0$30,000
$(42,000) -0$(42,000)
$(58,000) 20,000 $(38,000)
(45,714) $24,286
(34,286) $(4,286)
42,000 $ -0-
38,000 $ -0-
(4,286) $20,000
$
4,286 -0-
-0$ -0-
-0$ -0-
15.(8 minutes) (Determine safe payments) 15-11 .
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Chapter 15 - Partnerships: Termination and Liquidation
Ball gets $143, Eaton gets $1,429, and Lake gets $3,428. Ace Reported balances ....................... $25,000 Maximum losses on land and building ($85,000) split on a 3:3:2:2 basis (25,500) Estimated liquidation expenses ($5,000) split 3:3:2:2.................... (1,500) Potential balances ....................... $(2,000) Potential loss from Ace ($2,000) split on a 3:2:2 basis .......................... 2,000 Safe payments .............................. $ 0
Ball $28,000
Eaton $20,000
Lake $22,000
(25,500)
(17,000)
(17,000)
(1,500) $ 1,000
(1,000) $ 2,000
(1,000) $ 4,000
(857) 143
(571) $ 1,429
(572) $ 3,428
Saunders, Capital
Ferris, Loan & Capital
$
16. (15 minutes) (Prepare a proposed schedule of liquidation) HARDWICK, SAUNDERS, AND FERRIS Proposed Schedule of Liquidation Other Assets
Hardwick, Accounts Loan and Payable Capital
Cash Beginning balances 90,000 820,000 (210,000) (270,000) Sold assets 200,000 (328,000) 51,200 Assumed: loss on remaining assets (492,000) 196,800 Paid liabilities (210,000) (210,000) Safe balances 80,000 0 0 (22,000)
(200,000) (230,000) 38,400 38,400 147,600
147,600
(14,000)
(44,000)
Of the available $80,000 in cash, $22,000 can be paid safely to Hardwick, $14,000 to Saunders, and $44,000 to Ferris.
15-12 .
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Chapter 15 - Partnerships: Termination and Liquidation
17. (7 minutes) (Determine amount of cash needed to assure payments to all partners) Watson is the partner most vulnerable to a loss. A loss of only $100,000 would completely eliminate Watson's capital balance: Miller Tyson Watson
$69,000/60% = $115,000 loss to eliminate capital $69,000/20% = $345,000 loss to eliminate capital $20,000/20% = $100,000 loss to eliminate capital
Thus, if the loss on disposal is less than $100,000, all partners will retain positive capital balances and receive some cash in liquidation. Because of this, since "other assets" are $150,000, they must be sold for any amount over $50,000 for all partners to get cash. 18. (5 minutes) (Determine safe capital balances and safe payments) Maximum potential losses are $128,000: $8,000 in liquidation expenses and a complete $120,000 loss on the noncash assets. Such a loss would reduce the capital balances to: Babb $8,800, Whitaker ($5,600), and Edwards ($1,200). Babb must retain capital of $6,800 ($5,600 + $1,200) to be able to absorb the possible losses of Whitaker and Edwards. The remaining $2,000 ($8,800 $6,800) is a safe capital balance for Babb, and a safe payment of $2,000 can be made to this partner.
15-13 .
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Chapter 15 - Partnerships: Termination and Liquidation
19. (10 minutes) (Determine amount to be contributed by partner with a deficit capital balance) White and Blue are both insolvent and have negative capital balances (after offsetting the loan from White) totaling $15,000 (White, $3,000; Blue, $12,000). Absorption by the other partners of these losses would be as follows (on a 30:10:20 basis): Partner Black Green Brown
Current Capital Balance $ 3,000 $ (3,000) $15,000
Share of Loss 30/60 x $15,000 = $7,500 10/60 x $15,000 = $2,500 20/60 x $15,000 = $5,000
Adjusted Capital Balance $ (4,500) $ (5,500) $10,000
Black, who is also insolvent, now has a deficit capital balance of $4,500 that would have to be absorbed by Brown and Green (on a 10:20 basis): Partner Green Brown
Current Capital Balance $ (5,500) $10,000
Share of Loss 1/3 x $4,500 = $1,500 2/3 x $4,500 = $3,000
Thus, Green must contribute $7,000 that will go to Brown.
15-14 .
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Adjusted Capital Balance $(7,000) $ 7,000
Chapter 15 - Partnerships: Termination and Liquidation
20. (50 minutes) (Determine payments under a variety of circumstances; safe capital balances; predistribution plan) a. Dobbs receives the entire $10,000. Maximum potential losses of $250,000 on noncash assets would be allocated as follows: Partner Share of Loss New Capital Balance Adams 2/10 x $250,000 = $50,000 $ 30,000 Baker 3/10 x $250,000 = $75,000 $(45,000) Carvil 3/10 x $250,000 = $75,000 $(15,000) Dobbs 2/10 x $250,000 = $50,000 $ 40,000 Maximum total potential losses of $60,000 to be absorbed from Baker and Carvil above would then be allocated to Adams and Dobbs as follows on a 2:2 basis: Partner Share of Loss New Capital Balance Adams 2/4 x $60,000 = $30,000 -0Dobbs 2/4 x $60,000 = $30,000 $ 10,000 Absorbing this potential loss would leave Dobbs with a safe capital balance of $10,000. b. Adams receives the entire $10,000. Maximum potential losses of $250,000 on noncash assets would be allocated as follows: Partner Adams Baker Carvil Dobbs
Share of Loss New Capital Balance 2/10 x $250,000 = $50,000 $ 30,000 2/10 x $250,000 = $50,000 $(20,000) 3/10 x $250,000 = $75,000 $(15,000) 3/10 x $250,000 = $75,000 $ 15,000
Maximum total potential losses of $35,000 to be absorbed from Baker and Carvil above would be allocated to Adams and Dobbs as follows on a 2:3 basis: Partner Adams Dobbs
Share of Loss 2/5 x $35,000 = $14,000 3/5 x $35,000 = $21,000
New Capital Balance $ 16,000 $ (6,000)
Absorbing the final $6,000 loss from Dobbs would leave Adams with a safe capital balance of $10,000.
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Chapter 15 - Partnerships: Termination and Liquidation
20. (continued) c. Adams receives $57,500 and Dobbs gets $22,500. The $50,000 loss on sale of the building would be allocated as follows: Partner Adams Baker Carvil Dobbs
Share of Loss New Capital Balance 10% x $50,000 = $5,000 $ 75,000 30% x $50,000 = $15,000 $ 15,000 30% x $50,000 = $15,000 $ 45,000 30% x $50,000 = $15,000 $ 75,000
Maximum potential loss of $130,000 on the land would be allocated as follows: Partner Adams Baker Carvil Dobbs
Share of Loss New Capital Balance 10% x $130,000 = $13,000 $ 62,000 30% x $130,000 = $39,000 $ (24,000) 30% x $130,000 = $39,000 $ 6,000 30% x $130,000 = $39,000 $ 36,000
Maximum potential loss of $24,000 to be absorbed from Baker would be allocated as follows on a 1:3:3 basis: Partner Adams Carvil Dobbs
Share of Loss 1/7 x $24,000 = $3,428 3/7 x $24,000 = $10,286 3/7 x $24,000 = $10,286
New Capital Balance $ 58,572 $ (4,286) $ 25,714
Maximum potential loss of $4,286 to be absorbed from Carvil would be allocated as follows on a 1:3 basis: Partner Adams Dobbs
Share of Loss 1/4 x $4,286 = $1,072 3/4 x $4,286 = $3,214
New Capital Balance $57,500 $22,500
These amounts represent safe capital balances for distribution purposes.
15-16 .
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Chapter 15 - Partnerships: Termination and Liquidation
20. (continued) d. The land and building must be sold for over $115,000 to ensure that Carvil will receive some cash. This can be determined by preparing a predistribution plan as follows: Adams Beginning balances $ 80,000 Assumed loss of $100,000 (Schedule 1) (1:3:4:2 basis) (10,000) Step One balances $ 70,000 Assumed loss of $35,000 (Schedule 2) (1:0:4:2) (5,000) Step Two balances $ 65,000 Assumed loss of $90,000 (Schedule 3) (1:0:0:2) (30,000) Step Three balances $ 35,000
Baker $ 30,000
Carvil $ 60,000
Dobbs $ 90,000
$
(30,000) -0-
(40,000) $ 20,000
(20,000) $ 70,000
$
-0-0-
$
(20,000) -0-
(10,000) $ 60,000
$
-0-0-
$
-0-0-
(60,000) $ -0-
Schedule 1 Partner
Capital Balance/ Loss Allocation
Maximum Loss That Can Be Absorbed
Adams Baker Carvil Dobbs
$80,000/10% $30,000/30% $60,000/40% $90,000/20%
$800,000 $100,000 (most vulnerable) $150,000 $450,000
Partner
Capital Balance/ Loss Allocation
Maximum Loss That Can Be Absorbed
Adams Carvil Dobbs
$70,000/(1/7) $20,000/(4/7) $70,000/(2/7)
$490,000 $ 35,000 (most vulnerable) $245,000
Partner
Capital Balance/ Loss Allocation
Maximum Loss That Can Be Absorbed
Adams Dobbs
$65,000/(1/3) $60,000/(2/3)
$195,000 $ 90,000 (most vulnerable)
Schedule 2
Schedule 3
15-17 .
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Chapter 15 - Partnerships: Termination and Liquidation
20. d. (continued) PREDISTRIBUTION PLAN The first $35,000 available goes to Adams. Next $90,000 is split between Adams and Dobbs on a 1:2 basis. Next $35,000 is split between Adams, Carvil, and Dobbs on a 1:4:2 basis. All remaining cash is split between Adams, Baker, Carvil, and Dobbs on the original profit and loss ratio. Total cash of $125,000 ($35,000 + $90,000) has to be available before Carvil will receive any cash. Since the partnership already has $10,000 cash in excess of its liabilities, the land and building must be sold for over $115,000 to ensure Carvil of receiving some amount. As another approach to the problem, Carvil's capital balance is eliminated through the $100,000 Step One loss and the $35,000 Step Two loss. Thus, avoiding a complete $135,000 loss ensures that Carvil will receive cash. Since the land and buildings have a book value of $250,000, such losses would be avoided by receiving over $115,000.
15-18 .
.
Chapter 15 - Partnerships: Termination and Liquidation
21. (30 minutes) (Prepare journal entries for a partnership liquidation; prepare a final statement of partnership liquidation) Part A. Preparation of journal entries. a. The partnership has $100,000 in cash, liabilities of $80,000 and estimated liquidation expenses of $10,000. Thus, there is $10,000 that can be safely paid to the partners before the liquidation of noncash assets. This amount is allocated to the two partners on the basis of their potential capital balances assuming that noncash assets are scrapped for a loss of $200,000 and liquidation expenses are $10,000:
Partner Fred George
Current Capital Balance $100,000 $120,000
Share of Potential Maximum Loss* Capital 60% x $210,000 = $126,000 $(26,000) 40% x $210,000 = $84,000 $36,000
Because Fred has a potential deficit capital balance, the entire $10,000 currently available is distributed to George, which reduces this partner’s capital balance to $110,000. George, Capital .......................................................... Cash .....................................................................
10,000
b. Liabilities ................................................................... Cash .....................................................................
40,000
c. Cash. ........................................................................... Fred, Capital (60% of gain) ................................. George, Capital (40%) .......................................... Noncash assets ....................................................
220,000
10,000
40,000
Fred and George now have capital balances of $112,000 and $118,000, respectively.
15-19 .
.
12,000 8,000 200,000
Chapter 15 - Partnerships: Termination and Liquidation
21. (continued) d. To determine the safe payments to be made at this point in the liquidation, the accountant prepares the following proposed schedule of liquidation:
Non-cash Cash Assets
Liabilities
Fred, Capital (60%)
George, Capital (40%)
Beginning balances Distribution to partners Paid liabilities Sold noncash assets Updated balances
$100,000 (10,000) (40,000) 220,000 270,000
$200,000 -0-0(200,000) -0-
$(80,000) $(100,000) $(120,000) -0-010,000 40,000 -0-0-0(12,000) (8,000) (40,000) (112,000) (118,000)
Maximum liabilities Max. liquidation expenses Safe balances
(40,000) (10,000) $220,000
-0-0-
40,000 -06,000 4,000 -0- $(106,000) $(114,000)
Safe payments of $106,000 and $114,000 can be made to Fred and George, respectively at this point in the liquidation. Fred, Capital .............................................................. George, Capital ......................................................... Cash .....................................................................
106,000 114,000
e. Liabilities ................................................................... Cash .....................................................................
40,000
f. Fred, Capital (60% of expense) ................................ George, Capital (40%) ............................................... Cash ......................................................................
4,800 3,200
220,000
40,000
8,000
g. The statement of partnership liquidation presented on the next page shows that $2,000 cash remains after paying liquidation expenses. The partners have positive capital balances of $1,200 and $800, respectively, and the remaining partnership cash can be distributed based on these ending totals. Fred, Capital .............................................................. George, Capital ......................................................... Cash .....................................................................
15-20 .
.
1,200 800 2,000
Chapter 15 - Partnerships: Termination and Liquidation
21. (continued) Part B. Prepare a final statement of partnership liquidation. Fred and George Partnership Statement of Partnership Liquidation
Liabilities $(80,000) -040,000
Fred, Capital (60%) $(100,000) -0-0-
George, Capital (40%) $(120,000) 10,000 -0-
(200,000) -0-
-0(40,000)
(12,000) (112,000)
(8,000) (118,000)
(220,000) 50,000 (40,000)
-0-0-0-
-0(40,000) 40,000
106,000 (6,000) -0-
114,000 (4,000) -0-
Paid liquidation expenses Updated balances
(8,000) 2,000
-0-0-
-0-0-
4,800 (1,200)
3,200 (800)
Distribution to partners Closing balances
(2,000) $ -0-
-0-0- $
-0-0-
1,200 -0-
800 -0-
Beginning balances Distribution to partners Paid liabilities
Cash $100,000 (10,000) (40,000)
Non-cash Assets $200,000 -0-0-
Sold noncash assets Updated balances
220,000 270,000
Distribution to partners Updated balances Paid liabilities
$
15-21 .
.
$
$
Chapter 15 - Partnerships: Termination and Liquidation
22. (30 minutes) (Prepare a predistributlon plan) An assumed series of losses is simulated which eliminates each partner's capital account in turn: Larson Norris Spencer Harrison Beginning balances $ 15,000 $ 60,000 $ 75,000 $ 41,250 Assumed loss of $75,000 (Schedule 1) (2:3:2:3 basis) (15,000) (22,500) (15,000) (22,500) Step One balances $ -0$ 37,500 $ 60,000 $ 18,750 Assumed loss of $50,000 (Schedule 2) (0:3:2:3 basis) -0(18,750) (12,500) (18,750) Step Two balances $ -0$ 18,750 $ 47,500 $ -0Assumed loss of $31,250 (Schedule 3) (0:3:2:0 basis) -0(18,750) (12,500) -0Step Three balances $ -0$ -0$ 35,000 $ -0Schedule 1 Partner Larson Norris Spencer Harrison
Capital Balance/ Loss Allocation $15,000/20% $60,000/30% $75,000/20% $41,250/30%
Schedule 2 Partner Norris Spencer Harrison Schedule 3 Partner Norris Spencer
Capital Balance/ Loss Allocation $37,500/(3/8) $60,000/(2/8) $18,750/(3/8) Capital Balance/ Loss Allocation $18,750/(3/5) $47,500/(2/5)
Maximum Loss That Can Be Absorbed $ 75,000 (most vulnerable) $200,000 $375,000 $137,500 Maximum Loss That Can Be Absorbed $100,000 $240,000 $ 50,000 (most vulnerable) Maximum Loss That Can Be Absorbed $ 31,250 (most vulnerable) $118,750
PREDISTRIBUTION PLAN • First $55,000 goes to pay liabilities ($47,000) and liquidation expenses (estimated at $8,000). • Next $35,000 available goes to Spencer. • Next $31,250 is split between Norris and Spencer on a 3:2 basis. • Next $50,000 is split among Norris, Spencer, and Harrison on a 3:2:3 basis. • All remaining cash is split among Larson, Norris, Spencer, and Harrison on the original profit and loss ratio.
15-22 .
.
Chapter 15 - Partnerships: Termination and Liquidation
23. (20 minutes) (Prepare and use a predistribution plan) Part a. Maximum Losses That Can Be Absorbed Able* Moon Yerkl
$50,000/.2 $60,000/.3 $50,000/.5
$250,000 200,000 100,000 (most vulnerable to losses)
*Able's balance includes capital and the loan to the partnership. The assumption is made that a $100,000 loss occurs: Able Reported balances $50,000 Assumed loss ($100,000) split on a 2:3:5 basis (20,000) Adjusted balances $30,000
Moon $60,000 (30,000) $30,000
Yerkl $50,000 (50,000) $ 0
Maximum Losses That Now Can Be Absorbed Able Moon
$30,000/.4 $30,000/.6
$75,000 50,000 (most vulnerable to losses)
The assumption is made that a $50,000 loss occurs: Reported balances Assumed loss ($50,000) split on a 2:3 basis Adjusted balances
Able $30,000 (20,000) $10,000
Moon $30,000 (30,000) $ 0
PREDISTRIBUTION PLAN • • • •
The first $62,000 will go to pay liquidation expenses ($12,000) and liabilities ($50,000). The next $10,000 goes entirely to Able. The next $50,000 is split between Able and Moon based on a 2:3 basis, respectively. All remaining cash will be divided among the partners according to their profit and loss ratio.
Part b. After the sale of assets for $40,000, the partnership has $76,000 in cash. The first $62,000 should be held for the liabilities and the liquidation expenses, leaving $14,000 for immediate distribution to partners. The next $10,000 goes to Able. The remaining $4,000 is divided between Able ($1,600 or 40%) and Moon ($2,400 or 60%). Thus, Able receives $11,600 and Moon receives $2,400. 24.(2 5 minutes) (Prepare a predistribution plan for a partnership liquidation) Maximum Losses That Can Be Absorbed 15-23 .
.
Chapter 15 - Partnerships: Termination and Liquidation
Simpson Hart Bobb Reidl
$18,000/20% $40,000/40% $48,000/20% $135,000/20%
$ 90,000 (most vulnerable to losses) 100,000 240,000 675,000
The assumption is made that a $90,000 loss occurs: Simpson Hart Reported balances $18,000 $40,000 Assumed loss ($90,000) split on a 2:4:2:2 basis (18,000) (36,000) Adjusted balances $ 0 $ 4,000
Bobb $48,000
Reidl $135,000
(18,000) $30,000
(18,000) $117,000
Maximum Losses That Now Can Be Absorbed Hart Bobb Reidl
$4,000/4/8 $30,000/2/8 $117,000/2/8
$ 8,000 (most vulnerable to losses) 120,000 468,000
The assumption is made that an $8,000 loss occurs: Hart Reported balances $4,000 Assumed loss ($8,000) split on a 4:2:2 basis (4,000) Adjusted balances $ 0
Bobb $30,000 (2,000) $28,000
Reidl $117,000 (2,000) $115,000
Maximum Losses That Now Can Be Absorbed Bobb Reidl
$28,000/2/4 $115,000/2/4
56,000 (most vulnerable to losses) 230,000
The assumption is made that a $56,000 loss occurs: Reported balances Assumed loss ($56,000) split on a 2:2 basis Adjusted balances
Bobb $28,000 (28,000) $ 0
Reidl $115,000 (28,000) $ 87,000
PREDISTRIBUTION PLAN • • • • •
The first $59,000 goes to pay liabilities and expected liquidation expenses. The next $87,000 goes entirely to Reidl. The next $56,000 is split evenly between Bobb and Reidl. The next $8,000 is split among Hart (4/8), Bobb (2/8), and Reidl (2/8). All remaining cash is split among the partners according to their original profit and loss ratio.
15-24 .
.
Chapter 15 - Partnerships: Termination and Liquidation
25. (30 minutes) (Determine the ramifications of a variety of liquidation situations) Part A. Partner with Deficit Capital Balance (a) $48,000. Maximum losses of $100,000 on the noncash assets would increase Milburn's deficit balance by $40,000 (40%). (b) All $19,000 should go to Thomas. As Ross and Thomas view the current situation, maximum potential losses total $108,000: $100,000 on the noncash assets and $8,000 on Milburn's deficit balance. In determining safe capital balances, these assumed losses would be allocated on a 4:2 basis or $72,000 to Ross and $36,000 to Thomas. Since such a loss would entirely eliminate Ross' capital account, only Thomas has a safe capital balance at the current time. (c) The minimum cash payment to Thomas would be $35,667. A loss of $59,000 on the noncash assets would result in the following capital balances: Ross: $ 45,400 = $69,000 – (40% x $59,000) Milburn: $(31,600) = $(8,000) – (40% x $59,000) Thomas: $ 46,200 = $58,000 – (20% x $59,000) Milburn’s deficit further reduces the remaining partner's balances as follows: Ross: $24,333 = $45,400 – (4/6 x $31,600) Thomas: $35,667 = $46,200 – (2/6 x $31,600)
15-25 .
.
Chapter 15 - Partnerships: Termination and Liquidation
25. (continued) Part B. Partners with Deficit Capital Balances; Insolvent Partner (a) Carton will have to contribute $7,429. The $29,000 in deficits will have to be absorbed by Sampson and Carton on a 4:3 basis. Thus, Carton will be allocated $12,429 of this amount which creates a deficit for this partner of $7,429 ($5,000 - $12,429). (b) Klingon will have to contribute $19,667 [$17,000 + (20/90 x $12,000)] that will be distributed as follows: Creditors Sampson Carton
$15,000 $ 3,667 $ 1,000
Since Romulan is insolvent, the remaining partners will have to absorb the $12,000 deficit on a 4:2:3 basis. This allocation increases Klingon's deficit by 2/9 of $12,000 or $2,667. Klingon must contribute an amount equal to the new deficit balance of $19,667. The first $15,000 will go to the creditors that remain after the $9,000 in partnership cash is distributed. The remaining $4,667 is distributed to the two partners in accordance with their remaining positive capital balances after absorbing Romulan's loss, 4/9 to Sampson and 3/9 to Carton. Sampson has a postive capital balance of $3,667 [$9,000 – ($12,000 x 4/9)] and Carton has a positive capital balance of $1,000 [$5,000 – ($12,000 x 3/9)]. (c) Sampson should receive $500. If Klingon is insolvent, the $17,000 deficit balance will have to be absorbed by the remaining three partners on a 4:3:1 basis. This loss would decrease Sampson's capital balance by $8,500 (4/8 x $17,000) to $500.
15-26 .
.
Chapter 15 - Partnerships: Termination and Liquidation
26. (25 minutes) (Prepare journal entries for a partnership liquidation) JOURNAL ENTRIES a. Cash . .......................................................................... March, Capital (2/6 of loss) ...................................... April, Capital (3/6) ..................................................... May, Capital (1/6) ...................................................... Inventory ..............................................................
56,000 6,000 9,000 3,000 74,000
b. March, Capital (2/6 of expenses) ............................. April, Capital (3/6) ..................................................... May, Capital (1/6) ...................................................... Cash .....................................................................
2,500 3,750 1,250
c. Liabilities ................................................................... Cash .....................................................................
40,000
d. Cash ........................................................................... Accounts Receivable ..........................................
45,000
e. Partner March April May
Current Capital Adjusted $16,500 $62,250 $41,750
7,500
40,000
45,000
Share of Potential Maximum Loss* Capital 2/6 x $77,000 = $25,667 $ (9,167) 3/6 x $77,000 = $38,500 $23,750 1/6 x $77,000 = $12,833 $28,917
*Maximum losses could be suffered on the remaining $39,000 in accounts receivable and the $38,000 in land, building, and equipment. Based on the above potential losses, March would have a deficit capital balance of $9,167 which in turn has to be allocated to the two partners having positive capital balances:
Partner April May
Potential Capital (above) $23,750 $28,917
Share of March's Deficit 3/4 x $9,167 = $6,875 1/4 x $9,167 = $2,292
15-27 .
.
Potential Capital $16,875 $26,625
Chapter 15 - Partnerships: Termination and Liquidation
26. (continued) As the above amounts represent safe capital balances, payments can be presently made to these two partners. April, Capital ............................................................. 16,875 May, Capital ............................................................... 26,625 Cash ..................................................................... 43,500 f. Cash (30%) ................................................................ March, Capital (2/6 of loss) ...................................... April, Capital (3/6) ...................................................... May, Capital (1/6) ....................................................... Accounts Receivable ..........................................
11,700 9,100 13,650 4,550
g. Cash .......................................................................... March, Capital (2/6 of loss) ...................................... April, Capital (3/6) ..................................................... May, Capital (1/6) ...................................................... Land, Building and Equipment ..........................
17,000 7,000 10,500 3,500
h. Liabilities ................................................................... Cash .....................................................................
21,000
39,000
38,000
21,000
i. Since $28,700 cash remains and each partner has a positive capital balance, the money left can be distributed based on these ending totals. March, Capital ........................................................... April, Capital ............................................................. May, Capital ............................................................... Cash .....................................................................
15-28 .
.
400 21,225 7,075 28,700
Chapter 15 - Partnerships: Termination and Liquidation
27. (30 minutes) (Determine liquidation proceeds necessary to give partner a specified amount; predistribution plan) Answer: For Z to be able to pay his personal creditor $5,000 from the distribution of partnership property, the partnership’s other assets must be sold for at least $50,000. $27,000 in cash above the current level must first be generated for creditors and liquidation expenses. Based on the predistribution schedule below, the next $10,000 is received solely by Y. A third $8,000 would be split evenly between Y and Z (giving Z $4,000 of the $5,000 needed). Z needs $1,000 from the next cash generated in order to satisfy this personal claim. Since the next level (Step Two balances) is split on a 3:1:1 basis, Z is entitled to 1/5 of the proceeds. Thus, $5,000 must be collected for Z to receive $1,000. For Z's creditor to get $5,000, the other assets have to be sold for $50,000 ($27,000 + $10,000 + $8,000 + $5,000). A predistribution plan must be developed to generate this information:
Beginning capital Assumed loss of $120,000 (see Schedule 1) (5:3:1:1) Step One balances Assumed loss of $70,000 (see Schedule 2) (allocated on a 0:3:1:1 basis) Step Two balances Assumed loss of $8,000 (see Schedule 3) (allocated on a 0:0:1:1 basis) Step Three balances
W X $ 60,000 $ 78,000
Y $ 40,000
Z $ 30,000
(60,000) (36,000) $ -0- $ 42,000
(12,000) $ 28,000
(12,000) $ 18,000
$
-0-0-
(42,000) $ -0-
(14,000) $ 14,000
(14,000) $ 4,000
$
-0-0-
$
-0-0-
(4,000) $ 10,000
$
(4,000) -0-
Schedule 1 Partner W X Y Z
Capital Balance/ Loss Allocation $60,000/50% $78,000/30% $40,000/10% $30,000/10%
27. (continued) Schedule 2 15-29 .
.
Maximum Loss to Be Absorbed $120,000 (most vulnerable) $260,000 $400,000 $300,000
Chapter 15 - Partnerships: Termination and Liquidation
Partner X Y Z
Capital Balance/ Loss Allocation $42,000/(3/5) $28,000/(1/5) $18,000/(1/5)
Maximum Loss to Be Absorbed $ 70,000 (most vulnerable) $140,000 $ 90,000
Capital Balance/ Loss Allocation $14,000/(1/2) $ 4,000/(1/2)
Maximum Loss to Be Absorbed $ 28,000 $ 8,000 (most vulnerable)
Schedule 3 Partner Y Z
PREDISTRIBUTION PLAN • • • • • •
Current cash of $30,000 goes to creditors. Next $27,000 generated goes to remaining creditors ($12,000) and to pay liquidation expenses estimated at ($15,000). Next $10,000 goes to Y. Next $8,000 goes to Y and Z on a 1:1 basis. Next $70,000 goes to X, Y, and Z on a 3:1:1 basis. Any remaining cash is split among all four partners based on a 5:3:1:1 basis.
15-30 .
.
Chapter 15 - Partnerships: Termination and Liquidation
28. (35 minutes) (Determine monthly safe installment payments to partners) VAN, BAKEL, AND COX PARTNERSHIP Safe Installment Payments to Partners January 31
Profit and loss ratio Capital balances - January 1 Add (deduct) loans Adjusted capital balances - January 1 Allocation of January net loss (Schedule1) Capital balances - January 31 Potential loss (Schedule 1) Subtotal Allocation of deficit balances Safe payments to partners - January 31
Total Van Bakel 100% 50% 30% $ 312,000 $ 128,000 $ 100,000 $ (10,000) (50,000) 40,000 302,000 78,000 140,000 (58,000) (29,000) (17,400) 244,000 49,000 122,600 (229,000) (114,500) (68,700) 15,000 (65,500) 53,900 0 65,500 (39,300) $ 15,000 $ 0 $ 14,600 $
Schedule 1 Computation of Actual and Potential Gain (Loss) January Actual Gain Cash Book Value (Loss)
January transactions Actual gains and losses: Collect receivables Sold inventory Paid liquidation expenses Paid accounts payable Potential losses: Machinery and equipment Potential unrecorded liabilities and expenses - end of January
51,000 48,000 (4,000) (88,000)
(86,000) (72,000) 93,000
15-31 .
Potential Gain (Loss)
(35,000) (24,000) (4,000) 5,000
(209,000)
(209,000)
(20,000)
(20,000) (229,000)
(58,000)
.
Cox 20% 84,000 0 84,000 (11,600) 72,400 (45,800) 26,600 (26,200) 400
Chapter 15 - Partnerships: Termination and Liquidation
28. (continued) VAN, BAKEL, AND COX PARTNERSHIP Safe Installment Payments to Partners February 28 Total Van Bakel Profit and loss ratio 100% 50% 30% Capital balances - January 31 (above) $ 244,000 $ 49,000 $ 122,600 $ Safe payments - January 31 (15,000) 0 (14,600) Capital balances - February 1 $ 229,000 $ 49,000 $ 108,000 $ Allocation of February net loss (Schedule 2) (5,000) (2,500) (1,500) Capital balances - February 28 $ 224,000 $ 46,500 $ 106,500 $ Potential loss (Schedule 2) (217,000) (108,500) (65,100) Subtotal $ 7,000 $ (62,000) $ 41,400 $ Allocation of deficit balances 0 62,000 (37,200) Safe payments to partners - February 28 $ 7,000 $ 0 $ 4,200 $ Schedule 2 Computation of Actual and Potential Gain (Loss) February Actual Gain Cash Book Value (Loss)
February transactions Actual gains and losses: Paid liquidation expenses Potential losses: Machinery and equipment Potential unrecorded liablities and expenses - end of February
(5,000)
Potential Gain (Loss)
(5,000) (209,000)
(209,000)
(8,000)
(8,000) (217,000)
(5,000)
15-32
Cox 20% 72,400 (400) 72,000 (1,000) 71,000 (43,400) 27,600 (24,800) 2,800
Chapter 15 - Partnerships: Termination and Liquidation
28. (continued) VAN, BAKEL, AND COX PARTNERSHIP Safe Installment Payments to Partners March 31
Profit and loss ratio Capital balances - February 28 (above) Safe payments - February 28 Capital balances - March 1 Allocation of March net loss (Schedule 3) Capital balances - March 31 Final payments to partners - March 31 Ending balances - March 31
$ $ $ $
Total 100% 224,000 $ (7,000) 217,000 $ (60,000) 157,000 $ (157,000) 0 $
Van Bakel 50% 30% 46,500 $ 106,500 $ 0 (4,200) 46,500 $ 102,300 $ (30,000) (18,000) 16,500 $ 84,300 $ (16,500) (84,300) 0 $ 0 $
Schedule 3 Computation of Actual and Potential Gain (Loss) March Actual Gain (Loss) Cash Book Value
March transactions Actual gains and losses: Machinery and equipment Paid liquidation expenses
156,000 (7,000)
.
.
15-33
(209,000)
(53,000) (7,000) (60,000)
Cox 20% 71,000 (2,800) 68,200 (12,000) 56,200 (56,200) 0
Potential Gain (Loss)
Chapter 15 - Partnerships: Termination and Liquidation
29. (35 minutes) (Determine cash distributions for four different partnership liquidations; insolvent partners) Part A
Beginning balances Contribution by Jackson Capital balances Elimination of Jackson's deficit (40:20 basis) Final distribution
Part B Beginning balances $82,000 loss on disposal (allocated on a 50:40:10 basis) Liquidation expenses (50:40:10 basis) Capital balances Allocation of Luck's deficit (50:10 basis) Final distribution
Part C Beginning balances $82,000 loss on disposal (allocated on a 2:4:4 basis) Liquidation expenses (2:4:4 basis) Capital balances Allocation of Cummings' deficit balance (2:4 basis) Capital balances Allocation of Luck's deficit balance Final distribution
15-34 .
.
Simon, Capital $16,000 -0$16,000
Haynes, Loan and Capital $ 4,000 -0$ 4,000
(6,000) $10,000
(3,000) $ 1,000
Hough, Loan and Capital $82,000 (41,000) (10,500) 30,500 (1,000) $29,500 Hough, Loan and Capital $82,000
Jackson, Capital ($12,000) 3,000 ($ 9,000)
$
9,000 -0-
Luck, Loan and Cummings, Capital Capital $40,000 $20,000 (32,800) (8,400) (1,200) 1,200 $ -0-
(8,200) (2,100) 9,700 (200) $ 9,500
Luck, Loan and Cummings, Capital Capital $40,000 $20,000
(16,400) (1,200) $64,400
(32,800) (2,400) $ 4,800
(32,800) (2,400) ($15,200)
(5,067) $59,333 (5,333) $54,000
(10,133) ($ 5,333) 5,333 $ -0-
15,200 -0-0$ -0-
Chapter 15 - Partnerships: Termination and Liquidation
29. (continued) Part D
Beginning balances Allocation of Redmond's deficit balance (10:30:40 basis) Capital balances $32,000 contribution by Ledbetter and $3,000 contribution by Watson Final distribution*
Redmond, Loan and Capital ($16,000)
Ledbetter, Capital ($30,000)
Watson, Capital $ 3,000
Sandridge, Capital $15,000
16,000 -0-
(2,000) ($32,000)
(6,000) ($3,000)
(8,000) $ 7,000
-0$ -0-
32,000 $ -0-
3,000 $ -0-
-0$ 7,000
*Remaining $28,000 is used to pay liabilities.
15-35 .
.
Chapter 15 - Partnerships: Termination and Liquidation
30. (60 minutes) (Prepare a predistribution plan, a final statement of liquidation, and journal entries for a partnership liquidation) Part A
Preparation of Predistribution Plan Schedule 1
Partner Frick Wilson Clarke
Maximum Loss That Can Be Absorbed $215,000 $175,000 (most vulnerable to loss) $375,000
Capital Balance/ Loss Allocation $129,000/60% $ 35,000/20% $ 75,000/20%
Schedule 2
Partner Frick Clarke
Maximum Loss That Can Be Absorbed $ 32,000 (most vulnerable to loss) $160,000
Capital Balance/ Loss Allocation $24,000/(60/80) $40,000/(20/80)
Schedule 3
Beginning balances ............................... Loss of $175,000 assumed—Schedule 1 (allocated on a 60:20:20 basis) ........... Step One balances ................................. Loss of $32,000 assumed—Schedule 2 (allocated on a 60:20 basis) ................ Step Two balances ................................. Loss of $32,000 assumed ....................... Final balances .........................................
Frick, Capital $129,000
Wilson, Capital $35,000
Clarke, Capital $75,000
(105,000) 24,000
(35,000) -0-
(35,000) 40,000
(24,000) -0-0$ -0-
-0-0-0-0-
(8,000) 32,000 (32,000) $ -0-
$
PREDISTRIBUTION PLAN • • • •
First, payment of liabilities and liquidation expenses must be assured. Next $32,000 goes to Clarke. Next $32,000 is split between Frick and Clarke on a 60:20 basis. Any further cash is split among Frick, Wilson, and Clarke on a 60:20:20 basis.
15-36 .
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Chapter 15 - Partnerships: Termination and Liquidation
30.
(continued) Part B Preparation of Final Statement of Partnership Liquidation FRICK, WILSON, AND CLARKE Statement of Partnership Liquidation Final Balances Frick, Wilson, Clarke, Noncash Capital Capital Capital Assets 60% 20% 20% Cash Liabilities $ 60,000 $ 219,000 $ 40,000 $ 129,000 $ 35,000 $ 75,000
Beginning balances 1. Distribution of $12,000* in accordance (12,000) with predistribution plan Updated balances $ 48,000 $ 219,000 $ 2. Noncash assets sold 60,000 (94,000) Updated balances $ 108,000 $ 125,000 $ 3. Liabilities paid (40,000) Updated balances $ 68,000 $ 125,000 $ 4. Distribution of $60,000** in accordance with predistribution plan First $20,000 (remainder of first (20,000) distribution of $32,000) Next $32,000 (32,000) Next $8,000 (8,000) Updated balances $ 8,000 $ 125,000 $ 5. Noncash assets sold 51,000 (125,000) Updated balances $ 59,000 $ -0- $ 6. Liquidation expenses paid (6,000) Updated balances $ 53,000 $ -0- $ 7. Final distribution based on ending capital balances (53,000) Ending balance $ -0- $ -0- $
35,000 $ (6,800) 28,200 $
(12,000) 63,000 (6,800) 56,200
28,200 $
56,200
-0- $
(24,000) (4,800) 79,800 $ (44,400) 35,400 $ (3,600) 31,800 $
(1,600) 26,600 $ (14,800) 11,800 $ (1,200) 10,600 $
(20,000) (8,000) (1,600) 26,600 (14,800) 11,800 (1,200) 10,600
-0- $
(31,800) -0- $
(10,600) -0- $
(10,600) -0-
40,000 $ 129,000 $ (20,400) 40,000 $ 108,600 $ (40,000) -0- $ 108,600 $
-0- $ -0- $
* $12,000 in cash is immediately available for distribution: Cash of $60,000 less Liabilities of $40,000 and Estimated Liquidation Expenses of $8,000. ** $60,000 in cash is available for distribution: Cash of $68,000 less Estimated Liquidation Expenses of $8,000. 15-37 ..
Chapter 15 - Partnerships: Termination and Liquidation
30. (continued) Part C 1.
2.
3.
4.
5.
6.
7.
Journal Entries Clarke, Capital .................................................................. Cash ...................................................................... Cash payments are made to partners in accordance with predistribution plan.
12,000
Cash ................................................................................ Frick, Capital (60% of $34,000 loss) ................................ Wilson, Capital (20%) ....................................................... Clarke, Capital (20%) ........................................................ Noncash Assets ................................................... Noncash assets are sold with losses allocated to partners.
60,000 20,400 6,800 6,800
Liabilities ........................................................................... Cash ...................................................................... All liabilities are paid.
40,000
Frick, Capital .................................................................... Wilson, Capital ................................................................. Clarke, Capital .................................................................. Cash ...................................................................... Cash payments are made to partners in accordance with predistribution plan.
28,800 1,600 29,600
Cash .................................................................................. Frick, Capital (60% of $74,000 loss) ................................ Wilson, Capital (20%) ....................................................... Clarke, Capital (20%) ........................................................ Noncash Assets ................................................... Noncash assets are sold with losses allocated to partners.
51,000 44,400 14,800 14,800
Frick, Capital .................................................................... Wilson, Capital ................................................................. Clarke, Capital .................................................................. Cash ...................................................................... Liquidation expenses are paid.
3,600 1,200 1,200
Frick, Capital .................................................................... Wilson, Capital ................................................................. Clarke, Capital .................................................................. Cash ...................................................................... Final cash payments are made to partners based on ending capital balances.
31,800 10,600 10,600
15-38 .
.
12,000
94,000
40,000
60,000
125,000
6,000
53,000
Chapter 15 - Partnerships: Termination and Liquidation
31. (50 minutes) (Prepare a predistribution plan and journal entries for a partnership liquidation) Part A
Preparation of Predistribution Plan Schedule 1
Partner
Capital Balance/ Loss Allocation
Wingler Norris Rodgers Guthrie
$120,000/30% $ 88,000/10% $109,000/20% $ 60,000/40%
Maximum Loss That Can Be Absorbed $400,000 $880,000 $545,000 $150,000 (most vulnerable to loss)
Schedule 2
Partner Wingler Norris Rodgers
Maximum Loss That Can Be Absorbed $150,000 (most vulnerable to loss) $438,000 $237,000
Capital Balance/ Loss Allocation $75,000/(30/60) $73,000/(10/60) $79,000/(20/60)
Schedule 3
Partner Norris Rodgers
Maximum Loss That Can Be Absorbed $144,000 $ 43,500 (most vulnerable to loss)
Capital Balance/ Loss Allocation $48,000/(10/30) $29,000/(20/30)
15-39 .
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Chapter 15 - Partnerships: Termination and Liquidation
31. (continued) Schedule 4 Wingler, Capital $120,000
Beginning balances ............... Loss of $150,000 assumed (allocated on a 30:10:20:40 basis) see Schedule 1 ......... (45,000) Step One balances ................. $ 75,000 Loss of $150,000 assumed (allocated on a 30:10:20 basis) see Schedule 2 ..................... (75,000) Step Two balances ................. $ -0Loss of $43,500 assumed (allocated on a 10:20 basis) see Schedule 3 ........................... -0Step Three balances ............... $ -0-
Norris, Capital $88,000
Rodgers, Loan and Capital $109,000
Guthrie, Capital $60,000
(15,000) $73,000
(30,000) $ 79,000
(60,000) $ -0-
(25,000) $48,000
(50,000) $ 29,000
$
-0-0-
(14,500) $33,500
(29,000) $ -0-
$
-0-0-
PREDISTRIBUTION PLAN • • • • •
Payment of all liabilities and liquidation expenses must be assured. Next $33,500 goes entirely to Norris. Next $43,500 is allocated to Norris (10/30) and Rodgers (20/30). Next $150,000 is allocated to Wingler (30/60), Norris (10/60), and Rodgers (20/60). Any further cash distributions are divided on the original profit and loss ratio: Wingler (30%), Norris (10%), Rodgers (20%), and Guthrie (40%).
15-40 .
.
31. (continued) Part B
Journal Entries
1.
Cash ........................................................................... 65,600 Wingler, Capital (30% of $16,400 loss) .................... 4,920 Norris, Capital (10%) ................................................. 1,640 Rodgers, Capital (20%) ............................................. 3,280 Guthrie, Capital (40%) ............................................... 6,560 Accounts Receivable ..................................... Receivables are collected with losses allocated to partners.
2.
Cash ........................................................................... 150,000 Wingler, Capital (30% of $103,000 loss) .................. 30,900 Norris, Capital (10%) ................................................. 10,300 Rodgers, Capital (20%) ............................................. 20,600 Guthrie, Capital (40%) ............................................... 41,200 Land ............................................................... 85,000 Building and Equipment ............................... 168,000 Land, building and equipment are sold with losses allocated to partners.
3.
Wingler, Capital ......................................................... 31,800 Norris, Capital ........................................................... 58,600 Rodgers, loan ............................................................ 35,000 Rodgers, Capital ....................................................... 15,200 Cash ................................................................ 140,600 Payments made to partners in accordance with the predistribution plan based on a current cash balance of $230,600. The first $35,000 paid to Rodgers extinguishes the loan made to the partnership. • • • • •
First $90,000 is held to pay liabilities ($74,000) and estimated liquidation expenses ($16,000); $140,600 is paid to partners. Next $33,500 goes entirely to Norris. Next $43,500 is split between Norris ($14,500) and Rodgers ($29,000). Remaining $63,600 is allocated to Wingler ($31,800), Norris ($10,600) and Rodgers ($21,200). Total payments: Norris, $58,600; Rodgers, $50,200; Wingler, $31,800.
31. b. (continued) 15-41 .
82,000
.
Chapter 15 - Partnerships: Termination and Liquidation
4.
No journal entry is currently required by Guthrie's insolvency.
5.
Liabilities ........................................................ Cash ..................................................... All liabilities are paid.
6.
74,000
Cash ................................................................ 71,000 Wingler, Capital (30% of $30,000 loss) ......... 9,000 Norris, Capital (10%) ...................................... 3,000 Rodgers, Capital (20%) .................................. 6,000 Guthrie, Capital (40%) ................................... 12,000 Inventory ............................................... Inventory is sold with loss allocated to partners.
101,000
7.
Wingler, Capital ............................................... 35,500 Norris, Capital ................................................. 11,833 Rodgers, Capital ............................................. 23,667 Cash ...................................................... 71,000 Distribution of available cash according to predistribution plan. Although $87,000 in cash is held by the partnership, $16,000 must be retained to pay liquidation expenses. The remaining $71,000 is divided among Wingler, Norris, and Rodgers on a 30:10:20 basis. According to the predistribution plan, a total of $150,000 must be divided on this ratio but only $63,600 was allocated in this manner in the first distribution above. Therefore, all $71,000 (making a total of $134,600) is paid out on this 30:10:20 basis.
8.
Wingler, Capital (30% of expenses)............... Norris, Capital (10%) ....................................... Rodgers, Capital (20%) ................................... Guthrie, Capital (40%)..................................... Cash ...................................................... Liquidation expenses are paid.
9.a.
3,300 1,100 2,200 4,400 11,000
Wingler, Capital (30/60 of deficit)................... 2,080 Norris, Capital (10/60) ..................................... 693 Rodgers, Capital (20/60) ................................. 1,387 Guthrie, Capital ........................................ 4,160 To eliminate the deficit balance of insolvent partner as computed on the next page.
15-42 .
74,000
.
31. b. (continued) CAPITAL ACCOUNT BALANCES Wingler, Capital $120,000 (4,920)
Beginning balances ................. Loss on accounts receivable.. Loss on land, building, and equipment ............................. Cash distribution ..................... Loss on inventory.................... Cash distribution ..................... Liquidation expenses .............. Subtotal ............................. Guthrie insolvent ..................... Current balances ..................... 9.b.
(30,900) (31,800) (9,000) (35,500) (3,300) 4,580 (2,080) $2,500
Guthrie, Capital $60,000 (6,560)
(10,300) (58,600) (3,000) (11,833) (1,100) 1,527 (693) $ 834
(41,200) -0(12,000) -0(4,400) (4,160) 4,160 $ -0-
(20,600) (50,200) (6,000) (23,667) (2,200) 3,053 (1,387) $1,666
Wingler, Capital ............................................... 2,500 Norris, Capital ................................................. 834 Rodgers, Capital ............................................. 1,666 Cash .......................................................... 5,000 To distribute remaining cash based on final capital balances.
15-43 .
Rodgers, Norris, Loan and Capital Capital $88,000 $109,000 (1,640) (3,280)
.
Chapter 15 - Partnerships: Termination and Liquidation
Chapter 15 Develop Your Skills Research Case 1.S tudents often seem to believe that definitive answers can be found for all accounting and legal questions if a serious enough investigation is performed. However, here, there simply may be no easy answer to the question as to the amount of liability that the other six doctors in this case are facing. 2.S everal questions can be raised that may impact the ultimate resolution: ▪ ▪
▪ ▪
In what state will the court case be handled? Different states have somewhat different laws as to the potential liabilities incurred by partners and different courts seem to have varying ways of interpreting those laws. How difficult was the surgery that was performed? Should the doctor have been able to perform the work without accident? Or, perhaps, was it an extremely risky surgery where death might have been anticipated under any conditions? How much did the other doctors know about this doctor’s ability to do this particular surgery? Did they have any reason to believe that such work should not be undertaken? What is meant in the case by the term “very poor judgment?” How serious was the mistake made by the doctor?
The answers to such questions as these can have a huge impact on the extent of the liability of the other doctors. Here are several quotes from The Wall Street Journal article mentioned in the case that might pertain to the issue at hand: “Concerns are growing among Andersen's roughly 1,750 U.S. partners that even those who had nothing to do with the firm's work for Enron Corp. could eventually face personal liability stemming from the botched audit. Worried about what protection the limited-liability partnership provides them, many are now consulting lawyers for advice.” “The limited-liability partnership is a comparatively new corporate structure, untested by the kind of stress now besetting Andersen. But that testing appears to be just around the corner as Enron creditors, shareholders and employees seek to recover the billions of dollars they have lost from someone.” “Because it is unclear how much protection the LLP structure will provide Andersen partners, partnership and bankruptcy lawyers are expected to be following the matter closely. ‘As far as I know, there has never been a litigation test of the extent of the LLP shield, and there have been very few LLP cases about liability at all,’ said Larry Ribstein, a law professor at George Mason University.” 15-44 .
.
“The limited-liability partnership was invented about a decade ago in the wake of the savings-and-loan debacle to protect members of partnerships from being wiped out by claims against their firms. Under the structure, capital invested by partners into the firm is fair game for creditors. In theory, no partner is supposed to lose more than what he or she has invested in the firm.” "‘There is a strong legal tradition that you don't pierce the corporate veil and go after individual partners except under extraordinary circumstances,’ said Lynn LoPucki, a professor at the University of California Los Angeles law school. ‘But the law is very vague and lets the courts do what they feel appropriate. It is very case specific and fact intensive.’” “In 1990, prior to the advent of limited-liability partnerships, the accounting firm of Laventhol & Horwath filed for Chapter 11 bankruptcy-court protection, in part due to lawsuits over questionable accounting. The firm's assets were insufficient to cover the claims of creditors and litigants. Under a plan negotiated with the firm's creditors, the 360 partners and former partners who had spent time at the firm since 1984 were required to dig into their own pockets to share a $46 million liability.”
15-45 .
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Chapter 15 - Partnerships: Termination and Liquidation
Analysis Case 1. In looking at the financial statements of a partnership, a number of obvious differences can be spotted in comparison to the financial statements of a corporation. For example, in looking at this set of statements, the following differences can be noted: ▪ The balance sheet shows “partners’ (deficiency) capital” rather than stockholders’ equity. ▪ The income statement (statement of operations) reports “net loss allocated to general partner” and “net loss allocated to limited partners.” This statement also reports “net loss per limited partnership interest” rather than earnings (loss) per share. ▪ A “statement of changes in partners’ (deficiency) capital” is presented rather than a statement of changes in stockholders’ equity. A potential investor in this partnership would become one of the “limited partners,” whose aggregate capital is disclosed in the balance sheet. 2. There is a considerable amount of information provided in the notes to the financial statements about the unique characteristics of a limited partnership: ▪ Note 1 – Organization and Summary of Significant Accounting Policies discusses the creation and structure of this limited partnership under the heading “Organization.” ▪ Note 2 – Investments in and Advances to Local Partnerships provides information about the entity’s investment in other limited partnerships. ▪ Note 5 – Transactions with Affiliated Parties describes the obligation of the partnership to the General Partner. ▪ Note 6 – Income Taxes describes the manner in which individual partners are taxed on their share of partnership income. In addition, in Item 5 (page 5), which precedes the financial statements, disclosures are provided related to the market for partnership interests. Because the partnership’s “shares” are not publicly traded, an individual investor may not be able to sell his/her limited partner interest in the partnership. As a limited partnership, potential investors (other than the general partner) would probably view an investment in NTCI II as being fairly similar to that of holding shares in a corporation. The major difference relates to the possible inability to sell a limited partner interest in the company.
15-46 .
.
Communication Case The bankruptcy of Laventhol & Horwath was one of the main reasons for the creation of the limited liability partnership business structure. As a general partnership, the litigation losses of this partnership that arose from poor accounting and auditing practices fell on all partners and not just on those involved. Partners were required to make contributions from their own personal funds, often in amounts of up to several hundred thousand dollars to pay off the debts of the partnership after its failure. A number of the partners eventually went bankrupt as a result of the litigation that arose. Today, the partners in a general partnership would still seem to have the same risk that the partners of Laventhol & Horwath faced. However, the alternatives such as a limited liability partnership or a Subchapter S corporation would place fewer individuals in this precarious position. Thus, more than anything else, these articles on Laventhol & Horwath may be educational in showing why such alternatives have been created and why they have become so popular.
15-47 .
.
Chapter 15 - Partnerships: Termination and Liquidation
Excel Case There are a number of different ways that a spreadsheet could be created to solve this particular problem. Here is one possible approach: —Create Column Headings: In Cell A1, enter label text “Partner”. In Cell B1, enter label text “Capital Balance”. In Cell C1, enter label text “Share P/L”. In Cell D1, enter label text “Initial Loss Share”. In Cell E1, enter label text “Subsequent Loss Share”. In Cell F1, enter label text “Remaining Balance”. —Enter Account Information for each partner: In Cell A2, enter label text “Wilson.” In Cell B2, enter Wilson’s Capital Balance of $200,000 and, in Cell C2, enter 40% as share of profit and loss. In Cell A3, enter label text “Cho.” In Cell B3, enter Cho’s Capital Balance of $180,000 and, in Cell C3, enter 20% as share of profit and loss. In Cell A4, enter label text “Arrington.” In Cell B4, enter Arrington’s Capital Balance of $110,000 and, in Cell C4, enter 40% as share of profit and loss. —Enter the amounts on which to base the calculations for each partner: In Cell A7, enter label text “Losses during liquidation” and, in Cell B7, enter the amount of $50,000. In Cell A8, enter label text “Final Losses” and, in Cell B8, enter the amount of $100,000. —Calculate Initial Loss Share: Multiply the “Losses during liquidation” amount by the percentage of “Share P/L” for each partner. To calculate the Initial Share Loss for Wilson, create the following formula in Cell D2: =+B7*C2. We need to also use this same general formula for both Cho and Arrington. However, if we drag the fill handle in Cell D2 into Cell D3 and D4, the reference to Cell B7 will automatically change to B8 and B9 respectively and the reference to Cell C2 will change to C3 and C4 respectively in order to adjust for the new cell position. The change to C3 and C4 is correct because those are the individual profit and loss percentages. No change, though, should be made to the reference to B7 because that is the overall loss in question. In order to “hold” the reference to Cell B7 when it is copied, we need to create what is known as an “ABSOLUTE” reference. Absolute references, which are cell references that always refer to cells in a specific location, can be created by placing a $ symbol before the Column letter and/or the Row number. Thus, in Cell D2, change the formula to read =$B$7*C2, and then copy this formula to cells D3 15-48 .
.
and D4. The resulting formula in Cell D3 will be =$B$7*C3 and in Cell D4 it will be =$B$7*C4. The location of the reference to Cell B7 does not change due to the $ symbol in front of the B and in front of the 7. —Calculate the Partners’ Share of any Subsequent Losses: Repeat the same process as above, creating a formula in Cell E2 as follows: =+$B$8*C2 Copy this formula to Cells E3 and E4. —Calculate the Remaining Capital Balance: To calculate the Remaining Capital Balance, the beginning Capital Balance must be reduced by the Initial Loss Share and Subsequent Loss Share. In creating this last formula, it is important to note that the losses should be added together and then subtracted in total from the beginning capital balance. Therefore, enter the following function in Cell F2: =+B2-(D2+E2). The computation inside the parenthesis is performed first and then subtracted from the beginning capital balance (B2). Copy this formula to Cells F3 and F4 to complete the worksheet. Note that the use of the $ is not used here because we do want B2, D2, and E2 to adjust to the new position when copied. Once this spreadsheet has been created, any of the variables may be changed and the results will adjust automatically. There are eight variables that can be changed: B2, B3, B4, B7, B8, C2, C3, and C4. C2, C3,and C4 must always add to 100%.
15-49 .
.
Chapter 15 - Partnerships: Termination and Liquidation
Spreadsheet to Determine the Remaining Capital Balances for Wilson, Cho, and Arrington A
B
C
Partner
Capital Balance
Share P/L
D Initial Loss Share
E
F
Subsequent Loss Share
Remaining Balance
Wilson
$200,000
40%
$20,000
$40,000
$140,000
Cho
180,000
20%
10,000
20,000
150,000
Arrington
110,000
40%
20,000
40,000
50,000
$490,000
100%
$50,000
$100,000
$340,000
1
2 3 4 5 6 7 Losses during liquidation 8 Final losses
50,000 100,000
15-50 .
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Chapter 16 - Accounting for State and Local Governments (Part 1)
CHAPTER 16 ACCOUNTING FOR STATE AND LOCAL GOVERNMENTS (PART ONE) Chapter Outline I.
State and local government units are different than for-profit entities in a number of specific ways. A. Governments serve a broader group of stakeholders. B. Most government revenues are raised through involuntary taxes and tolls. C. Monitoring compliance with budgeted public policy priorities is central to public accountability. D. Governments exist longer than for-profit businesses. E.T he primary purpose of governments is to enhance or maintain the well-being of its citizens.
II. State and local government units produce two complete and distinct sets of financial statements. A. User needs for governmental financial information are so diverse that the Governmental Accounting Standards Board (GASB) requires two sets of statements to be prepared. The fund financial statements are more for the citizens whereas the government-wide statements are more for investors, such as bondholders. B. Fund financial statements are designed primarily to present information about the General Fund and other major activities. This approach stresses the government’s fiscal accountability over its financial resources. a. For governmental funds, all current financial resources and claims to those financial resources are presented using modified accrual accounting for timing purposes. b. For proprietary funds and fiduciary funds, all economic resources are reported using accrual accounting for timing purposes. C. Government-wide financial statements (a statement of net position and a statement of activities) are designed to present an overview of the government as a whole and emphasizes operational accountability. a. In these statements, all economic resources are measured using accrual accounting for timing purposes. b. The governmental funds and most of the internal service funds are combined and reported together as governmental activities. c. The enterprise funds and any remaining internal service funds are combined and reported as business-type activities. d. Because the government does not have control over the use of the assets held in the fiduciary funds, they are excluded from the government-wide financial statements. III. For internal purposes, governmental accounting records its individual activities within a number of self-balancing sets of accounts known as funds. A. Governmental funds account for activities where service to the public is the main emphasis. a. General fund b. Special revenue funds 16-1 .
.
Chapter 16 - Accounting for State and Local Governments (Part 1)
c. Capital projects funds d. Debt service funds e. Permanent funds B. Proprietary funds account for activities of the government where a user charge is assessed. a. Enterprise funds b. Internal service funds C. Fiduciary funds account for assets held in a trustee capacity for external parties. a. Investment trust funds b. Private-purpose trust funds c. Pension trust funds d. Agency funds IV. In reporting current financial resources and the claims to the current financial resources of a governmental fund, the Fund Balance account indicates the use that can be made of these resources by government officials. A. Fund-Balance—Nonspendable – the amount of resources reported by a fund that cannot be spent by government officials. B. Fund-Balance—Restricted – the amount of resources held by a fund that must be spent in a manner designated by an external party. C. Fund-Balance—Committed – the amount of resources designated for a particular purpose by the highest level of decision-making authority in the government. D. Fund-Balance—Assigned – the amount of resources designated for a particular purpose internally but not by the highest level of decision-making authority. E. Fund-Balance—Unassigned – the amount of resources where no use has yet been specified. This is only found in the General Fund because resources only appear in other funds if there is some intended use for them. V.G overnmental accounting has traditionally stressed establishing control over current financial resources to ensure appropriate usage of the public’s money. A. Budgets are required to be approved by the citizens of the government, represented by the governing body – for example, city council, state legislature. When amendments are made to the budget, the governing body has to approve them also. B.B udgetary entries are recorded for a number of the activities within the governmental funds. a. The entry is recorded at the start of the year and is then reversed to remove at the end of the year. b. Budget amendments may be recorded during the year. C.F inancial commitments (such as contracts and purchase orders) are recorded during the year as encumbrances. a. These entries help avoid overspending of appropriated amounts. b. Encumbrances are removed from the records when the commitment becomes a liability. VI. In government-wide financial statements, acquiring a capital asset is reported as a capital asset and incurring an expense is reported as an expense in the same manner as a forprofit business. However, in reporting the governmental funds within the fund financial statements, the purchase of a capital asset, incurrence of an expense, and payment of a noncurrent debt are all reported as expenditures to reflect the reduction in current financial resources. Through this reporting, the statements report the usage made of the current financial resources held by the government activity. 16-2 .
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Chapter 16 - Accounting for State and Local Governments (Part 1)
A. On the fund financial statements, supplies and prepaid items can be reported by either the consumption method (expenditure is recorded as the acquired item is consumed) or the purchases method (expenditure is recorded when liability is incurred). The consumption method is required for the government-wide statements. B. On the government-wide financial statements, acquisitions of infrastructure items —such as bridges and sidewalks— are required to be recorded as capital assets. VII. Governments often have nonexchange transactions where revenues such as taxes and grants are received without a corresponding earning process. To guide the timing of recognition of such transactions, four separate categories have been identified. A. Derived tax revenues—such as income taxes and sales taxes—are recognized when the underlying event occurs. B. Imposed nonexchange transactions—such as property taxes, fines, and penalties—are recognized as revenues when the resources are required to be used or in the first period when use is permitted. C. Government-mandated nonexchange transactions, usually a government grant to fulfill a legally required objective, are recognized when all eligibility requirements have been met. D. Voluntary nonexchange transactions—such as most grants and gifts—are recognized when all eligibility requirements have been met. VIII. Governments often raise significant amounts of financial resources by issuing long-term bonds. A. In the government-wide financial statements, the debt is a liability on the Statement of Net Position. B. In the fund financial statements for the governmental funds, the inflow of financial resources is reported as an “other financing source.” Eventual payment of the debt is shown as an expenditure. Noncurrent debt balances are not shown in the fund financial statements for the governmental funds. IX. Transfers are separated into three categories: intra-activity transactions, interactivity transactions, and internal exchange transactions.
Answer to Discussion Question Is it an Asset or a Liability? Even after more than 20 years, Mautz’s comments go straight to the problem posed by government accounting. State and local governments are just fundamentally different than forprofit businesses. Some students seem to believe that the unique features of government financial reporting are more arbitrary than substantive. To them, accounting is accounting and the specific type of reporting entity should not be an important consideration. For that reason, this discussion question is placed early in the coverage of governmental accounting to point out that governments do not necessarily view transactions in the same manner as for-profit businesses. Discussing the construction of a new high school building is an excellent example of the essential accounting problems created by a government’s unique perspective. The decision to build this facility virtually assures the government that it will incur significant cash outflows for 16-3 .
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Chapter 16 - Accounting for State and Local Governments (Part 1)
years to come. A business constructs a building in hopes of generating significant net cash inflows. Government officials are aware that the costs of maintenance, heating, etc. of the school will far outweigh any direct cash inflows. Hence, Mautz’s question—is it an asset or a liability—is not easy to answer. Governmental accounting solves this issue in a very unique way. In the fund financial statements, construction costs are reported as expenditures whereas, in the government-wide financial statements, the high school is reported as a capital asset. The reduction in current financial resources is the focus of one statement whereas the cost of construction is shown as an asset in the other set of statements. Prior to class discussion, students can be asked to read Mautz’s entire article as additional background information. In class, students can be encouraged to discuss whether showing this high school building in two such different ways is misleading or actually provides the information needed. Students should be asked their opinion as to the benefit of having two completely different sets of financial statements. A quality, in-depth discussion can certainly result from the article described here.
Answers to Questions 1. Individuals and groups who seek information about a state or local government have needs that are often complex and contradictory. Specific procedures in the governmental reporting process are an outgrowth of those needs. Three primary user groups have been identified: citizenry, legislative and oversight bodies, and investors and creditors. The needs of these users are broad and no single set of financial statements and accounting principles can meet all expectations. The satisfaction of diverse user needs is a constant focus (and challenge) of governmental accounting. This has led to the dual-perspective model which results in the production of two distinct types of financial statements. 2. Accountability and control have been a constant goal of governmental accounting over the decades. Governmental accounting provides the citizenry of a democracy with a method for evaluating the essential government activities of raising and allocating resources. Elected and appointed officials have authority over the public’s money. They should be held accountable for first generating and then using those resources wisely in meeting the public’s needs. Control should be established to prevent waste and theft. The accounting system should be structured to help citizens evaluate these officials based on the honesty, wisdom, and stewardship of their actions. 3. The traditional approach of government accounting places its priority on individual accountability for the various separate government activities. Unfortunately, the resulting information has not necessarily met all user needs (especially the needs of bond investors who want to know whether a government will be able to repay its debts). Today, government reporting still focuses on current financial resources in the fund financial statements (for the governmental funds), but also provides extensive additional data about all assets and all liabilities in the government-wide financial statements. Thus, a broader range of user needs are met. 4. Two financial statements make up the government-wide financial statements: The Statement of Net Position and the Statement of Activities. There are a number of fund financial statements. The two fundamental financial statements covered in the current chapter are the Balance Sheet for the governmental funds and the Statement of Revenues,
16-4 .
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Chapter 16 - Accounting for State and Local Governments (Part 1)
Expenditures, and Other Changes in Fund Balances for the governmental funds. Additional fund financial statements will be introduced in the following chapter. 5. In fund accounting, governmental funds use the current financial resources measurement focus and the modified accrual basis for the timing of revenue and expense recognition. Current financial resources include assets such as cash, receivables, and investments that can be used for spending. Reported liabilities are ones to be paid from current resources. Some deferred outflows of resources and deferred inflows of resources might also be reported in these statements. The modified accrual basis recognizes revenues when they become available and measurable. Expenditures are recorded when they create a reduction in current financial resources. Governments must disclose the length of time being used to determine availability. A period of 60 days is common although not required except for property tax revenues. Proprietary and fiduciary funds generally use the economic resources measurement focus and the accrual basis for the timing of revenue and expense recognition. The economic resources measurement focus reports all assets (including capital and other noncurrent assets) as well as all liabilities (including long-term obligations). Deferred outflows of resources and deferred inflows of resources also might require recognition. 6. Government-wide financial statements use the economic resources measurement focus and accrual accounting for the timing of revenue and expense recognition. The accounting is very similar to that of for-profit organizations. 7. Current financial resources are primarily cash, investments, and receivables because they can be quickly turned into cash for spending purposes. These resources are expected to be used to meet the current period spending needs of the governmental funds. 8. Liabilities are recognized under the current financial resources focus when a claim against current financial resources is created. That normally means that a debt is owed and payment will be made during the current period or a short time into the subsequent period. Disclosure is required for the number of days being applied for that time extension. Often, 60 days is used, a time period that is mandated for property taxes. 9. Governmental Funds: Account for activities with a service orientation a. General Fund b. Special Revenue Fund c. Capital Projects Fund d. Debt Service Fund e. Permanent Fund Proprietary Funds: Account for functions that are financed (at least in part) by user charges. a. Enterprise Fund b. Internal Service Fund
Fiduciary Funds: Account for monies held by the government in a trustee capacity. a. Investment Trust Fund b. Private-Purpose Trust Fund c. Pension Trust Fund d. Agency Fund 16-5 .
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Chapter 16 - Accounting for State and Local Governments (Part 1)
10. The following fund types fall within the governmental funds classification: a. The General Fund is used to account for ongoing activities such as public safety and sanitation. More specifically, the General Fund records any activities that do not fall under one of the other fund types. b. Special Revenue Funds account for financial resources that have been restricted as to expenditure for a specified operating purpose (other than debt service and capital asset construction or acquisition). This money often comes from sources such as grants, taxes, and gifts. c. Capital Projects Funds account for monies (and their eventual expenditure) that have been designated (either externally or internally) for the acquisition or construction of government facilities or other capital assets. d. Debt Service Funds account for the accumulation of resources that will be used to pay the principal and interest of long-term debts incurred by the service activities. e. Permanent Funds account for assets conveyed to a government with the stipulation that the principal cannot be spent but any income should be used by the government, often for a designated purpose. 11. The following fund types fall within the proprietary funds classification: a. An Enterprise Fund accounts for any governmental activity that is open to the public and financed in whole or in part by user charges, such as a subway system or a toll road. b. An Internal Service Fund is used to record any activity that provides service to other departments or agencies within the government on a cost-reimbursement basis. A motor pool, a centralized computer operation, or a print shop can be accounted for as Internal Service Funds if a user fee is charged and they only exist to serve the other functions of government. 12. Fiduciary Funds: Account for monies held by the government in a trustee capacity. a. Investment Trust Fund. Accounts for the outside portion of investment pools where the reporting government has accepted funds from other governments resulting in a larger investment and hopefully a higher return. b. Private-Purpose Trust Fund. Accounts for money held in a trustee capacity, for example, unclaimed property, specifically designated external parties, or money confiscated from illegal operations. c. Pension Trust Fund. Accounts for the employee retirement system. d. Agency Fund. Accounts for resources held by the government as an agent for individuals, private organizations, or other government units. 13. In government-wide financial statements, financial figures are shown as either governmental activities or business-type activities. All governmental funds and most internal service funds are included within the governmental activities. All enterprise funds and any remaining internal service funds are lumped together to form the business-type activities. Internal service funds are grouped in governmental activities or business-type activities based on the funds that are primarily serviced. Fiduciary funds are not shown in the government-wide financial statements because those resources are not available in any way to government officials. 14. In fund financial statements, for governmental funds, a separate column must be shown for (a) the General Fund, (b) any other fund that qualifies as major, and (c) all remaining funds accumulated as a whole. 16-6 .
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Chapter 16 - Accounting for State and Local Governments (Part 1)
15. Fund-balance—nonspendable – provides the balance for all current financial resources that cannot be spent by government officials. Prepaid items and supplies, for example, cannot be spent by their very nature. Resources conveyed to a government where only subsequent income can be spent also fall into this category. ---Fund-balance—restricted – provides the balance for all current financial resources that must be used in a designated fashion as specified by a party outside of the government. Amounts usually come from gifts or from grants from other organizations or governments. ---Fund-balance—committed – provides the balance for all current financial resources that must be used in a designated fashion as specified by the highest level of decision-making authority within the government. --Fund-balance—assigned – provides the balance for all current financial resources that must be used in a designated fashion as specified by individuals within the government but who do not possess the highest level of decision-making authority. --Fund-balance—unassigned – provides the balance for all current financial resources that have not been designated in some fashion. Government officials are free to use these assets as they see fit. 16. The physical recording of a budget is viewed as a method of disclosing government policies and financial intent, providing a financial plan for the period. The budget establishes spending limitations, which enhances financial planning and control. The adoption of the budget for each activity anticipates the inflow of financing resources and sets approved expenditure levels. Subsequently, comparisons can be drawn between actual and budgeted figures at any time during the fiscal period, thus evaluating the performance of the government. Any subsequent amendments also have to be approved by the governing body. 17. Comparisons between the original budget, the final budget (as amended), and actual figures must be reported in the required supplemental information presented after the notes to the financial information in the comprehensive annual financial report. Alternatively, the information can be presented as a separate statement within the government’s fund financial statements. 18. An encumbrance is the recording of a purchase commitment (such as a contract or a purchase order). The encumbrance entry is recorded at the time the commitment is made prior to incurring a liability. This recording supports the spending control emphasis of the fund financial statements. At any point in time, summation of the Expenditures account and the Encumbrances balance provides the total amount of current financial resources spent and committed to date. Thus, the chance of an over-commitment of resources is decreased. The encumbrance is removed when this commitment becomes a legal liability. Until then, no transaction has taken place so encumbrances are not included in government-wide financial statements. 19. Expenditures include outflows or reductions of net current financial resources from the acquisition of goods or services (or the payment of a noncurrent liability). Modified accrual accounting recognizes these expenditures when a claim against current financial resources is incurred that will be paid from resources that are available. Fund accounting for the governmental funds records expenditures instead of both expenses and capital assets as a way of disclosing the use made of a fund’s financial resources during the current period.
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Chapter 16 - Accounting for State and Local Governments (Part 1)
20. Modified accrual accounting recognizes expenditures when a claim against the current financial resources is incurred that will be paid from financial resources that are available. Governments must disclose the length of time (often 60 days) used to determine availability. 21. Within the governmental funds, fund financial statements focus on expenditures rather than expenses or capital assets. Expenditures should be recorded when the related liability is incurred. Therefore, the entire cost of capital assets is treated as an expenditure when the liability is incurred. Government-wide financial statements record capital assets in a manner similar to that used in the reporting of for-profit organizations. The cost of buildings, machines, and other capital assets are capitalized and depreciated to expense over their useful lives. 22. Traditionally, in government accounting, the purchases method has been used for prepaid items and supplies. The cost is recorded immediately as an expenditure when the liability is incurred. Any assets that remain at the end of the period are inserted into the records along with an offsetting increase to “Fund Balance-Nonspendable.” Another method has been developed for reporting these items and is known as the consumption method. It is similar to the approach used by for-profit organizations and is used in the government-wide financial statements and by the proprietary and fiduciary funds. Supplies and prepayments are recorded as assets when acquired even though they are not current financial resources. Over time, as they are consumed, they are recorded as expenditures matching them with the appropriate fiscal period. At the end of the period, an amount equal to the remaining assets is reclassified from fund balance-unassigned to fundbalance—nonspendable. On fund financial statements for the governmental funds, either the purchases method or the consumption method can be selected. 23. The four classifications of nonexchange revenues that a state or local government can recognize are: a. Derived tax revenues. A tax assessment is imposed because an underlying exchange takes place. The revenue is recorded at the time of the underlying event. For example, revenues are recognized for a sales tax when a sale occurs and the tax is imposed. b. Imposed nonexchange revenues. An assessment is imposed but no underlying transaction takes place. Examples include property taxes and fines or penalties that are levied. Revenues are recognized in the period when resources are required to be used or in the first period in which use is permitted. c. Government-mandated nonexchange transactions. Monies are provided from one government to another to help pay for legally required programs or actions. Examples include grants from the federal government to a city that must be used to help achieve a mandated legal requirement such as an improvement in the school system. Revenues are recognized when all eligibility requirements have been met. d. Voluntary nonexchange transactions. Monies conveyed willingly to a state or local government by an individual, another government, or an organization usually for a specific purpose but without legally mandated requirements. Revenues are recognized when all eligibility requirements have been met. An example would be money donated to the city for the beautification of the local parks.
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Chapter 16 - Accounting for State and Local Governments (Part 1)
24. A receivable is not recorded for property taxes until the demand for money represents an enforceable legal claim, which is normally specified by state or local laws. Many governments encourage early payment of property taxes (by sending out bills early or by giving some type of a cash discount). Thus, cash can actually be reported before the government even records the initial receivable. Revenue from the property tax is reported net of estimated uncollectible amounts in the period in which the money is supposed to be used or the first period in which it can be used. For example, property taxes assessed to finance the government's costs in 2015 should be reported as revenue in 2015. Because the receivable and the revenue recognition are split, it is possible to record the receivable (or cash, if collected early) before the revenue. In that case, a unavailable property tax account is established which is reclassified when revenue recognition is appropriate. This is not normally a liability (the money will not have to be repaid) so it is reported as a deferred inflow of resources. 25. No revenues are recognized in either set of financial statements because the proceeds of bonds must be repaid. In fund financial statements, Cash is increased along with an “Other Financing Sources” figure. For example, if the bonds were issued for a construction project, this entry is recorded in the Capital Projects Fund. Payments of both interest and debt are then recorded when they become a claim on current financial resources. An Expenditure account is recognized for the debt and for the related interest and is usually shown in the Debt Service Fund. In government-wide financial statements, the cash and debt are both increased when issued and the subsequent payment of debt and interest is reported in a manner similar to that of a for-profit enterprise. 26. A special assessment is an improvement made to property by a government, which is paid for in part or in whole by the owners of the property being benefited. Adding curbing and sidewalks to a local street is an example of a special assessment if the residents of that street are required to pay a portion of the cost. Typically, the government places a lien on the property to insure payment. Accounting for special assessment projects depends on the liability for the work being incurred by the government. If the government is in no way liable for the work done and any debt that is incurred, an Agency Fund is used to record the monetary inflows and outflows. The government is simply serving as a conduit to get the project completed and the debt paid. If the government is responsible (even secondarily responsible) for the cost of the project, a more elaborate method of accounting is necessary. In the government-wide financial statements, both the debt and the infrastructure asset are recorded. Amounts are assessed, reported as revenues, collected, and used to pay the debt. Even if the government has liability, the infrastructure asset and long-term debt are not recorded in the fund financial statements. Instead, expenditures for the work are recorded in a Capital Projects Fund while cash collected from citizens is recorded as revenue and accumulated in a Debt Service Fund to pay off any amount borrowed to finance the work. 16-9 .
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Chapter 16 - Accounting for State and Local Governments (Part 1)
27. In fund financial statements, interfund transactions are recorded in both funds simultaneously at the time of authorization. For example, monetary transfers from the General Fund to another fund such as the Debt Service Fund are recorded in both funds. The recipient records this transfer as an “Other Financing Source” and the party making the transfer records an “Other Financing Use.” These balances both appear in the statement of revenues, expenditures, and other changes in fund balance but are not offset in arriving at totals for the government. If the transfer is being made to a proprietary fund, it is shown in the statement of revenues, expenses, and other changes in net position for that fund usually as a “capital contribution” or as a “transfer in.” 28. Intra-activity transactions occur totally within the governmental activities or totally within the business-type activities so that no net effect is created for that group of funds. Therefore, these transfers do not appear in the reporting of government-wide financial statements. Interactivity transactions occur between a governmental activity and a business-type activity so that they affect the balances in each. Consequently, the impact of these transactions is reported in both columns on the government-wide financial statements but are then offset so that no figure is reported in the total column. 29. An internal exchange transaction is a transfer within the government that is recorded as if the transaction had actually occurred with an outside party. Such transactions occur between one of the government’s activities and an internal service or enterprise fund and are paid for work or services rendered. These exchanges are reported as revenues and as either expenditures or expenses. An example would be a payment from a police department to the city’s motor pool for vehicle maintenance. This exchange is included by both departments in the fund financial statements as if it were a transaction with an outside party. On government-wide financial statements, any such transactions between a government activity and a related internal service fund is considered an intra-activity transaction because both fund types are classified as government activities and, therefore, there is no impact on overall figures.
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Chapter 16 - Accounting for State and Local Governments (Part 1)
Answers to Problems 1.
B (Internal service fund is a proprietary fund)
2.
A
3.
D
4.
D
5.
A (The term “interperiod equity” refers to incurring a cost in one period that is paid for in a later period.)
6.
C
7.
D
8.
A
9.
D (Capital assets are not reported as assets in the fund financial statements of the governmental funds. Only current financial resources as well as prepaid items and supplies are reported as assets in this set of financial statements.)
10.
B (Because the assistant treasurer was not the highest level of decisionmaking authority, his decision to use the money in this way was indicated by showing a Fund Balance-Assigned. The city council is the highest level of authority. Therefore, council’s designation switches the fund balance amount from assigned to committed.
11.C(
When the budget is passed, Estimated Revenue is debited and the
Appropriations account is credited. That entry is reversed off the records at the end of the year.) 12.B(
As a governmental fund, the General Fund records expenditures rather
than expenses.) 16-11 .
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Chapter 16 - Accounting for State and Local Governments (Part 1)
13. C (The claim on current financial resources [the expenditure] is actually $3,020.) 14. B 15. B (Depreciation is an expense and not a reduction in current financial resources. Therefore, it is not recorded in the fund financial statements for the governmental funds.) 16. C (Under the consumption method, the inventory is recorded when acquired and then reclassified as an expenditure as consumed.) 17. A 18. C (A law was passed and then a government provided money to meet the requirements of that law. That is a government-mandated nonexchange revenue.) 19. C (Because of the reimbursement clause, the grant is actually earned by making appropriate expenditures.) 20. B (This is not a long-term liability and is, therefore, reported the same in the fund financial statements as in the government-wide financial statements.) 21. A 22. C (Debt issuance costs are not capitalized in state and local government accounting; thus, for government-wide financial statements, the amount is expensed.) 23. C (Any loss on the refunding of a debt is reported as a deferred outflow of resources and amortized over time.)
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Chapter 16 - Accounting for State and Local Governments (Part 1)
24. C (As a noncurrent liability, the balance is not reported in the fund financial statements.) 25. D (Because the city has a liability in connection with this project, all amounts must be recorded as with normal governmental fund transactions.) 26. C 27. D (The transfer here is between a Government Activity and a Business-Type Activity.) 28. A (The transfer occurred entirely within the Government Activities and created no net impact on the total amounts reported.) 29. B 30. D (This transaction was the same as might have occurred with an outside party and is accounted for in the same manner.) 31. C (This transaction was the same as might have occurred with an outside party and is accounted for in the same manner.) 32.
(5 Minutes) (Budgetary entries) Beginning of Year-Recording of budget GENERAL FUND Estimated Revenues .................................................... 1,000,000 Estimated Other Financing Sources—Bond Proceeds 400,000 Appropriations Control ........................................... Appropriations-Other Financing Uses—Operating Transfers Out ...................................................... (Budgetary) Fund Balance.......................................
End of Year-Removal of budget GENERAL FUND Appropriations ........................................................ Appropriations-Other Financing Uses—Operating Transfers Out ...................................................... 16-13 .
.
900,000 300,000
900,000 300,000 200,000
Chapter 16 - Accounting for State and Local Governments (Part 1)
(Budgetary) Fund Balance....................................... 200,000 Estimated Revenues .......................................... 1,000,000 Estimated Other Financing Sources—Bond Proceeds 400,000 33.
(8 Minutes) (Order of a capital asset and subsequent receipt) GOVERNMENT-WIDE FINANCIAL STATEMENTS GOVERNMENT ACTIVITIES Computer Vouchers (or Accounts) Payable Vouchers (or Accounts) Payable Cash
89,400 89,400 89,400 89,400
As a result of the purchase and payment, capital assets have gone up by the cost of the computer and cash has been reduced by the same amount.
FUND FINANCIAL STATEMENTS GENERAL FUND Encumbrances - Computer Encumbrances Outstanding
88,000 88,000
Encumbrances Outstanding Encumbrances - Computer
88,000
Expenditures - Computer Vouchers Payable
89,400
Vouchers Payable Cash
89,400
88,000
89,400
89,400
On the statement of revenues, expenditures, and other changes in fund balance, an expenditure of $89,400 will be shown. Cash will also decrease by that amount.
34.
(10 Minutes) (Issuance of bond to finance construction project) GOVERNMENT-WIDE FINANCIAL STATEMENTS
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Chapter 16 - Accounting for State and Local Governments (Part 1)
GOVERNMENT ACTIVITIES (Intra-activity transfer from the General Fund to the Capital Projects Fund is not reported because Government Activities totals are not affected.) Issuance of Bonds Cash Bonds Payable
1,800,000
Completion of Construction Buildings Cash
1,890,000
1,800,000
1,890,000
On the statement of net position, for the governmental activities, the Buildings account goes up by $1,890,000, the Bonds Payable go up by $1.8 million, and cash goes down by $90,000. FUND FINANCIAL STATEMENTS To Record Transfer GENERAL FUND Other Financing Uses—Transfers Out Cash CAPITAL PROJECTS FUND Cash Other Financing Sources—Transfers In
90,000 90,000
90,000 90,000
Sale of Bonds Cash Other Financing Sources—Bond Proceeds
1,800,000
Completion of Construction Expenditures Cash
1,890,000
1,800,000
1,890,000
On the statement of revenues, expenditures, and other changes in fund balance, the General Fund reports an other financing uses – transfer out of $90,000. On its balance sheet, it reports $90,000 less cash. For the capital projects fund, there is an expenditure of $1,890,000 and two other financing sources: $90,000 as a transfer-in and $1.8 million from bond proceeds. 35.
(12 Minutes) (Reporting of fund balance amounts) Fund-Balance—Nonspendable ---Prepaid items $ 7,000 ---Supplies 5,000
16-15 .
.
$ 12,000
Chapter 16 - Accounting for State and Local Governments (Part 1)
Fund-Balance—Restricted ---Cash from bond issuance ---Investments donated by citizen ---State grant for kindergarten teachers
$80,000 33,000 53,000
166,000
Fund-Balance—Committed ---Cash to be used for renovation
62,000
Fund-Balance—Assigned ---Cash to upgrade roads
40,000
Fund-Balance—Unassigned
25,000
Total Fund-Balance
$305,000
The Fund-Balance—Unassigned amount ($25,000) was determined by taking the net current financial resources of the governmental funds ($445,000 less $140,000 or $305,000) and then subtracting the fund balance amounts that were nonspendable, restricted, committed, and assigned.
36.
(8 Minutes) (Reporting of commitments)
In the government-wide financial statements, the commitment for this computer will not be formally reported because no liability has yet been incurred. A disclosure note is likely to allow readers of the statements to understand that these funds have been committed. In the fund financial statements, a $6,400 balance will be shown as a Fund Balance-Committed. This will enable readers to see that this portion of the governmental fund’s current financial resources have to be used to satisfy this obligation when incurred. This recognition reduces the amount otherwise labeled as Fund Balance-Unassigned.
37.
(20 Minutes) (Recording of basic journal entries) FUND FINANCIAL STATEMENTS a. General Fund Estimated Revenues 16-16
.
.
Chapter 16 - Accounting for State and Local Governments (Part 1)
Estimated Other Financing Sources (Budgetary) Fund Balance Appropriations b. Capital Projects Fund (could also be recorded initially in the General Fund with a subsequent transfer to the Capital Projects Fund) Cash Other Financing Sources—Bond Proceeds c. General Fund Encumbrances - Computer Encumbrances Outstanding d. General Fund Encumbrances Outstanding Encumbrances - Computer Expenditures - Computer Vouchers Payable e. General Fund Vouchers Payable Cash f. General Fund Other Financing Uses—Transfers Out—Capital Projects Due to Capital Projects Fund (Special Assessment) Capital Projects Fund Due from General Fund Other Financing Sources—Transfers In—General Fund g. General Fund Other Financing Uses—Transfers Out—Motor Pool Cash Internal Service Fund Cash Contributed Capital h. General Fund Property Taxes Receivable Revenues—Property Taxes Allowance for Uncollectible Taxes i. Special Revenue Fund 16-17 .
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Chapter 16 - Accounting for State and Local Governments (Part 1)
Cash Grant Revenue Collected in Advance j. Special Revenue Fund Expenditures—Salaries Cash Grant Revenue Collected in Advance Revenues—Grant GOVERNMENT-WIDE FINANCIAL STATEMENTS a. No entry b. Governmental Activities Cash Bonds Payable c. No entry d. Governmental Activities Equipment Vouchers Payable e. Governmental Activities Vouchers Payable Cash f. No entry (it is an intra-activity transfer within the governmental activities) g. No entry (assuming the internal service fund is treated as a governmental activity so that this is an intra-activity transaction) h. Governmental Activities Property Taxes Receivable Revenues—Property Taxes Allowance for Uncollectible Taxes i. Governmental Activities Cash Grant Revenue Collected in Advance j. Governmental Activities Expense—Public Safety Cash
16-18 .
.
Chapter 16 - Accounting for State and Local Governments (Part 1)
Grant Revenue Collected in Advance Revenue 38.
(16 Minutes) (Recording of basic journal entries) FUND FINANCIAL STATEMENTS a. General Fund Encumbrances - Truck Encumbrances Outstanding
94,000
b. General Fund Expenditures (or Supplies) Due to Internal Service Fund
1,200
c. Capital Projects Fund Cash Other Financing Sources—Bonds Proceeds d. General Fund Other Financing Uses—Transfers Out— Swimming Pool Cash e. General Fund Encumbrances Outstanding Encumbrances - Truck
1,200
11,000,000 11,000,000
140,000 140,000
94,000 94,000
Expenditures - Truck Vouchers Payable
96,000 96,000
f. General Fund Other Financing Uses—Transfers Out Cash
Capital Projects Fund Cash Other Financing Sources—Transfers In g. Special Revenue Fund Cash Unearned Grant Revenue
32,000
32,000 32,000
30,000
16-19 .
32,000
30,000
h. Special Revenue Fund
.
94,000
Chapter 16 - Accounting for State and Local Governments (Part 1)
Unearned Grant Revenue Revenues
5,000
Expenditures Cash
5,000
5,000
5,000
GOVERNMENT-WIDE FINANCIAL STATEMENTS a. No entry b. No entry (Assuming print shop is a governmental activity.) c. Governmental Activities Cash Bonds Payable
11,000,000 11,000,000
d. Governmental Activities Transfers Out—Swimming Pool Cash
140,000
Business Type Activities Cash Transfers In—General Fund
140,000
e. Governmental Activities Equipment—Trucks Vouchers or Accounts Payable
96,000
140,000
140,000
96,000
f. No entry – intra-activity transfer g. Governmental Activities Cash Unearned Grant Revenue
30,000
h. Governmental Activities Expense—Public Service Cash
5,000
30,000
5,000
Unearned Grant Revenue Revenues 39.
5,000 5,000
(15 Minutes) (Prepare basic journal entries) FUND FINANCIAL STATEMENTS 16-20
.
.
Chapter 16 - Accounting for State and Local Governments (Part 1)
a. Capital Projects Fund (could also be recorded in the General Fund followed by a transfer into the Capital Projects Fund) Cash 900,000 Other Financing Sources—Bonds Proceeds 900,000 b. Capital Projects Fund Encumbrances - Warehouse Encumbrances Outstanding c. General Fund Other Financing Uses—Transfers Out Cash Debt Service Fund Cash Other Financing Sources—Transfers In d. General Fund Encumbrances Outstanding Encumbrances - Equipment Expenditures Control—Machinery and Equipment Vouchers Payable
1,100,000 1,100,000
130,000 130,000
130,000 130,000
11,800 11,800 12,000 12,000
e. General Fund Inventory of Supplies Cash
2,000
f. Special Revenue Fund Grant Receivable Unavailable Grant Revenue
90,000
2,000
g. General Fund Taxes Receivable Revenues – Property Taxes Allowance for Uncollectible Current Taxes
90,000
600,000 576,000 24,000
GOVERNMENT-WIDE FINANCIAL STATEMENTS a. Governmental Activities Cash Bonds Payable
900,000 900,000
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.
Chapter 16 - Accounting for State and Local Governments (Part 1)
b. No entry (commitments are not recorded) c. No entry (this is an intra-activity transfer) d. Governmental Activities Machinery and Equipment Vouchers or Accounts Payable
12,000
e. Governmental Activities Inventory of Supplies Cash
2,000
f. Governmental Activities Grant Receivable Unearned Grant Revenue
90,000
2,000
90,000
g. Governmental Activities Taxes Receivable Revenues – Property Taxes Allowance for Uncollectible Current Taxes
40.
12,000
600,000 576,000 24,000
(25 Minutes) (Answer questions about ledger account balances) a. As the Appropriations account balance in the General Fund shows a total of $171,000, that amount of money has been authorized for expenditure during this fiscal period. Thus, only that total can be expended or committed. To date, a total of $119,000 has been spent or committed ($110,000 of expenditures and $9,000 in encumbrances). The remaining $52,000 is still available. Of course, if the budget is amended, additional amounts could be spent.
b. The governmental funds are all designed to monitor current financial resources and their inflows and outflows. Therefore, the Capital Projects Fund records expenditures made to acquire or construct capital assets and the sources of that money. The purpose of that fund is not to record the asset itself. Consequently, these assets are reported in the government-wide financial statements but not in the fund statements created for the governmental funds. c. The Appropriations balance represents the amount that government officials have authorized to be spent on a particular construction project. The amount was established by the passage of a formal budget.
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Chapter 16 - Accounting for State and Local Governments (Part 1)
d. At the end of the year, any remaining commitments will be removed from the accounting records by reversing the original encumbrance entry (which eliminates both the encumbrance and the encumbrance outstanding). The government might agree to pay for these commitments even though they did not arrive until the following fiscal year. If so, in creating a balance sheet for the governmental funds, this amount is shown as a fund-balance restricted, committed, or assigned, depending on who made the decision to spend the resources in this manner. e. Money is not recorded in any of the governmental funds (except for the General Fund) without some explicit reason. It comes from a tax, perhaps, or a gift or grant. These amounts are only put into these funds because each has a particular purpose. Thus, a fund balanceunassigned is not possible in any fund other than the General Fund. The asset could simply not be in another fund unless some designation (either externally or internally) had been made. Whether the fund balance is restricted, committed, or assigned depends on the party that made the decision to spend the money in this particular way. f. Two reasons are most likely for the $150,000 Other Financing Sources balance. First, a bond may have been issued to finance the construction project. Because the debt itself is not recorded in the fund financial statements, the governmental fund must record the receipt by means of an Other Financing Sources designation. Second, the $150,000 may have come from a transfer (most likely from the General Fund). Such transfers are not considered revenue by the recipient and, therefore, the inflow of current financial resources is recorded as an Other Financing Source. g. The Debt Service Fund is utilized to accumulate money to pay off the principal and interest of any long-term liability incurred by the governmental funds. Payment of both debt and interest is made from the Debt Service Fund and those payments are recorded as expenditures. Noncurrent debt is not maintained in the fund financial statements but does appear in the government-wide financial statements. h. Special assessment projects are undertaken by a government to benefit particular properties with the owners bearing part (or all) of the cost. Curbing, as an example, or the installation of lights can be special assessment projects.
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Chapter 16 - Accounting for State and Local Governments (Part 1)
If the government has no responsibility for costs, recording of all financial resources inflows and outflows is made in an Agency Fund. However, if government does maintain some responsibility (if, for example, the government is secondarily liable for debts incurred), the construction is recorded in a Capital Projects Fund. Thus, receivable balance shown here would indicate that this project is being recorded in this manner. Collection of the receivable will be made from the citizens being benefited. The money will be used in paying for the construction. i. This designation indicates that the government is reporting one or more assets that are not free to be spent for future expenditures. In the asset section of the trial balance, a $4,000 figure is included as the government’s Inventory of Supplies. That amount is reported but is not available to be spent. Thus, an equal portion of the fund balance is shown as nonspendable. j. Budgetary entries are optional for Debt Service Funds and are not typically used. Expenditure levels (for principal and interest) are set contractually by the debt indenture. Thus, additional financial control is not obtained by the inclusion of budgetary amounts. 41.
(25 Minutes) (Analyzing and reporting government transactions for fund financial statements) a. Estimated Revenues Appropriations Budgetary Fund Balance
$232,000 225,000 $ 7,000
Because estimated revenues exceed the appropriations, a surplus is anticipated which is mirrored through a credit balance in the Budgetary Fund Balance account. The size of the fund is expected to grow by that much over the course of the year. b. Initially, under the consumption method, all of the school supplies are recorded in an asset account such as “Inventory of Supplies.” As the supplies are used, the cost is reclassified into an Expenditures account. On the balance sheet, a portion of the Fund Balance-Unassigned is separated and reported as nonspendable to show that this amount of the reported assets does not represent current financial resources that can be spent by government officials. c. At the end of the year, both the encumbrance balance and the encumbrance outstanding are removed from the financial records. They do not represent actual transactions. In creating a balance sheet for the governmental funds, if this amount has already been set up as a fundbalance restricted, committed, or assigned, no further action is needed. 16-24 .
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Chapter 16 - Accounting for State and Local Governments (Part 1)
This shows that this money cannot be freely spent but must be held to meet the financial commitment. However, if no amount has been disclosed in the fund balance, then the expected monetary amount to be paid should be reclassified from fund balance-unassigned to either fund balance-committed or fund balanceassigned depending on the level of authority that made the commitment. A fund balance-restricted designation cannot be established internally. d. FUND FINANCIAL STATEMENTS General Fund Encumbrances Outstanding Encumbrances - Ambulance Expenditures - Ambulance Vouchers Payable
111,000 111,000 120,000 120,000
e. General Fund Other Financing Uses—Transfers Out Cash Debt Service Fund Cash Other Financing Sources—Transfers In f. REVENUES: Government grant appropriately expended Property taxes to be received Business licenses and parking meters Total revenues g. EXPENDITURES: Salary for police officers Rent on equipment (assuming payments are from current financial resources) City hall acquisition Salary for ambulance drivers Supplies (60% of $16,000) Ambulance acquisition School bus acquisition Total expenditures
33,000 33,000
33,000 33,000
$ 24,000 190,000 14,000 $228,000
$ 21,000 3,000 1,044,000 24,000 9,600 120,000 40,000 $1,261,600
h. FUND FINANCIAL STATEMENTS Capital Projects Fund (or this entry could be recorded in the General Fund with the money then transferred to the Capital Projects Fund) 16-25 .
.
Chapter 16 - Accounting for State and Local Governments (Part 1)
Cash Other Financing Sources
42.
300,000 300,000
(20 Minutes) (Prepare basic journal entries for both fund financial statements and government-wide financial statements) FUND FINANCIAL STATEMENTS a. General Fund Estimated Revenues Appropriations Estimated Other Financing Uses— Operating Transfers Budgetary Fund Balance
834,000 540,000 242,000 52,000
b. Capital Projects Fund (encumbrances for these types of contracts are optional but are more likely to be made when budgetary entries are being used) Encumbrances – Office Building 8,000,000 Encumbrances Outstanding 8,000,000 c. Capital Projects Fund Cash Other Financing Sources
8,000,000
d. Capital Projects Fund Encumbrances Outstanding Encumbrances – Office Building
8,000,000
8,000,000
Expenditures Contracts Payable
8,000,000
Contracts Payable Cash
8,000,000
8,000,000
8,000,000
e. General Fund Other Financing Uses Cash
1,000,000 1,000,000
Debt Service Fund Cash Other Financing Resources f. Debt Service Fund Expenditures—Bonds
1,000,000 1,000,000
900,000 16-26
.
8,000,000
.
Chapter 16 - Accounting for State and Local Governments (Part 1)
Expenditures—Interest Cash
100,000 1,000,000
g. General Fund Property Taxes Receivable Revenues – Property Taxes Allowance for Uncollectible Taxes (4%) h. Special Revenue Fund Cash Revenues
800,000 768,000 32,000
120,000 120,000
i. Permanent Fund (when the balance sheet is created, a Fund BalanceNonspendable of $300,000 must be reported because only the income can be spent.) Investments 300,000 Contribution Revenue 300,000 GOVERNMENT-WIDE FINANCIAL STATEMENTS a. No entry (budgets are not reported) b. No entry (commitments are not reported) c. Governmental Activities Cash Bonds Payable
8,000,000
d. Governmental Activities Buildings Cash
8,000,000
8,000,000
8,000,000
e. No entry (transfer is within the government activities) f. Governmental Activities Bonds Payable Interest Expense Cash
900,000 100,000 1,000,000
g. Governmental Activites Proprety Taxes Receivable Revenues – Property Taxes Allowance for Uncollectible Taxes
16-27 .
.
800,000 768,000 32,000
Chapter 16 - Accounting for State and Local Governments (Part 1)
h. This entry is made in Governmental Activities unless toll road is reported as an Enterprise Fund (a business-type activity). Cash 120,000 Revenues—Reserved for Highway Maintenance i. Government Activities Investments Revenues—Donations
120,000
300,000 300,000
43. (15 Minutes) (Prepare fund financial statements) CITY OF JENNINGS GENERAL FUND Statement of Revenues, Expenditures, and Other Changes in Fund Balance (Condensed) Year Ending December 31, 2015 Revenues $ 760,000 Expenditures (530,000) Excess (deficiency) of revenues over expenditures $ 230,000 Other financing sources (uses): Bond proceeds $300,000 Transfers in 50,000 Transfers out (470,000) Total Other Financing Sources and Uses (120,000) Change in Fund Balance $110,000 Fund Balance, Beginning 170,000 Fund Balance, Ending $280,000
16-28 .
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Chapter 16 - Accounting for State and Local Governments (Part 1)
CITY OF JENNINGS GENERAL FUND Balance Sheet (condensed) December 31, 2015 Assets Cash Investments Taxes receivable Due from Capital Projects Fund Total Assets
$ 30,000 410,000 220,000 60,000 $720,000 Liabilities
Accounts payable Vouchers payable Contracts payable Due to Debt Service Fund Total Liabilities
$ 90,000 180,000 90,000 40,000 $400,000
Deferred Inflows of Resources Unavailable Revenues Total Deferred Inflows of Resources
$ 40,000 $ 40,000
Fund Balances Unassigned
$280,000
Total Fund Balance
280,000
Total Liabilities, Deferred Inflows of Resources, and Fund Balances
44.
$720,000
(40 Minutes) (Prepare government-wide and fund financial statements) The most difficult aspect of this problem is gathering the information for both the government-wide financial statements and the fund financial statements. One way to overcome this difficulty is to make journal entries for the transactions that are described in the question.
Government-wide financial statements: 16-29 .
.
Chapter 16 - Accounting for State and Local Governments (Part 1)
1 Property Tax Receivable Cash General Revenues—Property Taxes
80,000 320,000
2 Salary Expense Rent Expense Equipment Land Maintenance Expense Cash
100,000 70,000 50,000 30,000 20,000
400,000
270,000
Depreciation Expense Accumulated Depreciation—Equipment 3 Building Noncurrent Liability
10,000 10,000
200,000 200,000
Neither depreciation nor interest is recognized on these two balances since this transaction took place on the last day of the year. 4 Computers Vouchers Payable
8,000 8,000
No depreciation is recognized on the computer since this transaction occurred on the last day of the year. 5 Cash Program Revenues—Student Fees
3,000 3,000
Fund financial statements: 1 Property Tax Receivable Cash Revenues—Property Taxes Unavailable Revenues
80,000 320,000 370,000 30,000
The $30,000 is not viewed as revenue in 2015 because it will not be available within 60 days to pay claims against current financial resources. 16-30 .
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Chapter 16 - Accounting for State and Local Governments (Part 1)
This balance is not reported as a liability because there is no chance of repayment. Instead, it is a deferred inflow of resources. 2 Expenditures—Salaries Expenditures—Rent Expenditures—Equipment Expenditures—Land Expenditures—Maintenance Cash
100,000 70,000 50,000 30,000 20,000 270,000
3 No entry is made on the building acquisition since there was no impact on current financial resources. 4 Expenditures—Computer Vouchers Payable
4,000 4,000
The second computer is not included here because payment will not be made within 60 days of the end of the year so there is no impact on current financial resources. 5 Cash Revenues—Student Fees
3,000 3,000
Part a GOVERNMENT-WIDE FINANCIAL STATEMENTS STATEMENT OF ACTIVITIES For the Year Ended December 31, 2015
Direct Expenses Program Revenues Governmental Activities: —School System
$200,000
$3,000
General Revenues: —Property Taxes Change in Net Position Beginning Net Position Ending Net Position STATEMENT OF NET POSITION December 31, 2015
Governmental Activities (net expense) $(197,000)
400,000 $ 203,000 -0$ 203,000
Governmental 16-31 .
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Chapter 16 - Accounting for State and Local Governments (Part 1)
Activities Assets —Cash —Property Tax Receivable —Computers —Building —Equipment Less: Accumulated Depreciation —Land Total Assets
$53,000 80,000 8,000 200,000 $ 50,000 (10,000)
40,000 30,000 $411,000
Liabilities —Vouchers Payable —Long-Term Liabilities
$ 8,000 200,000
$208,000
Net Position —Net investment in capital assets —Unrestricted
$ 78,000 125,000
$203,000
Part b -- FUND FINANCIAL STATEMENTS STATEMENT OF REVENUES, EXPENDITURES AND CHANGES IN FUND BALANCE 16-32 .
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Chapter 16 - Accounting for State and Local Governments (Part 1)
For the Year Ended December 31, 2015 General Fund Revenues —Property Taxes —Student Fees Total Revenues
$370,000 3,000 $373,000
Expenditures —Salaries —Rent —Equipment —Land —Maintenance —Computer Total Expenditures
$100,000 70,000 50,000 30,000 20,000 4,000 $274,000
Change in Fund Balance
$ 99,000
Fund Balance—Beginning of Year
-0-
Fund Balance—End of Year
$ 99,000
BALANCE SHEET December 31, 2015 General Fund Assets —Cash —Property Tax Receivable Total Assets
$ 53,000 80,000 $133,000
Liabilities —Voucher Payable Deferred Inflows of Resources —Unavailable Revenues Total Deferred Inflows and Liabilities
$
4,000
$ 30,000 $ 34,000
Fund Balance —Unassigned Total Liabilities, Deferred Inflows of Resources, and Fund Balance
$ 99,000 $133,000
45.
(25 Minutes) (Assessing the impact of various government transactions.) a. This statement is false. Internal service funds are included in governmental accounting within the proprietary funds. However, most internal service funds are reported in government-wide financial statements as 16-33 .
.
Chapter 16 - Accounting for State and Local Governments (Part 1)
governmental activities. Therefore, the proprietary funds will almost always be larger than the business-type activities. b. This statement is false because not enough information is available to say that this fund “must be” reported as a major fund. The asset balance ($32,000) for this governmental fund is larger than 10 percent of the total assets held by all governmental funds ($300,000). This is one of the criteria for being judged a major fund. (The same threshold can also be used with liabilities, revenues, or expenditures/expenses.) However, a second criterion also must be met. The asset (or other) balance ($32,000) for this fund must be at least 5 percent of the total for both the governmental funds and the enterprise funds. No separate information is provided here about the enterprise funds. Thus, there is not enough information available to make the required determination. c. This statement is false. If (a) the user charge is the sole security for the debts of the bus system or (b) the activity’s costs are required to be recovered through the fee or (c) the fee is set to recover the activity’s costs, then reporting as an Enterprise Fund is required. Otherwise, if a user charge is present, recording as an Enterprise Fund is allowed but that classification is not required. None of the requirements is met in this case so the city has the option of recording the bus system either in an Enterprise Fund or in the General Fund. d. This statement is true. To record a budget so that the projected increase or decrease in the fund balance will be obvious (a credit shows an anticipated surplus and a debit is an anticipated deficit), estimated revenues are debited and appropriations are credited. e. This statement is false. To record a budget so that the projected increase or decrease in fund balance will be obvious (a credit is an anticipated surplus and a debit is an anticipated deficit), estimated revenues are debited and appropriations are credited. Expenditures are not recorded in a budgetary entry because no reduction in current financial resources has yet occurred. f. This statement is true. In the purchases method, the total prepaid expenses or supplies acquired is recorded as an expenditure. In the consumption method, only the amount used or consumed during the period is recorded as an expenditure. Three years of insurance has been bought but only one year has been used. The expenditure is larger for the purchase method. g. This statement is true. Income taxes and sales taxes are both derived tax revenues because the tax is assessed based on a specific event (the earning of income or the making of a sale). h. This statement is true. Accrual accounting is used for governmentwide financial statements. Derived taxes (like income taxes) are recognized at 16-34 .
.
Chapter 16 - Accounting for State and Local Governments (Part 1)
the time of the underlying event (the earning of income). Therefore, the revenue is recognized in Year Five and is $98,000, the amount expected to be collected. i. This statement is false. The encumbrance (commitment) is removed and an expenditure and liability is then recognized. However, the encumbrance is removed at its original $43,000 balance before the $44,000 expenditure and liability are recorded. j. This statement is false. “Fund balance - committed” is used when financial resources have been designated by the highest level of government authority. Here, the city council has that authority rather than the police chief. This amount should be recorded as a “fund balance - assigned” to reflect the difference in this level of authority. k. This statement is false. This is an intra-activity transaction between two governmental funds. Total balances for the governmental activities are not affected. Within the governmental funds, the inflow and outflow of the transfer cancel each other out. Therefore, no reporting is necessary.
46.
(25 Minutes) (The handling of various government transactions.) a. This statement is false. This transfer is an internal exchange transaction; it is payment for work done. Because the purchase and sale of printing services was the same as with an outside party, the transaction will be handled in that way. The school system records an expenditure rather than an other financing use. The print shop records revenue for the work done. b. This statement is false. No increase in net position is recognized in Year Five because these resources come from an imposed nonexchange revenue that cannot be used until Year Six. No change in net position occurs in Year Five. c. This statement is false. No increase in fund balance is recognized in Year Five because these resources come from an imposed nonexchange revenue that cannot be used until Year Six. No change in fund balance occurs in Year Five.
d. This statement is false. The $5,000 cannot be used at this time. However, revenue recognition will occur after the passage of time. The government has no reason to expect to have to repay this amount. The balance is shown as “unavailable property tax collections” which is reported as a deferred inflow of resources following the liability section of the balance sheet. e.T
his statement is false. The $5,000,000 can never be spent so a fund 16-35
.
.
Chapter 16 - Accounting for State and Local Governments (Part 1)
balance – nonspendable figure is appropriate. Use of the $480,000 (the subsequent income) has been restricted by an outside party and is labeled as a fund balance – restricted. f. This statement is false. This grant is a government-mandated nonexchange transaction. g. This statement is false. Agency funds fall within the fiduciary funds. Fiduciary funds are not included in government-wide financial statements. h. This statement is false. All eligibility requirements have been met and the money will be received within 75 days of the end of the year. It is revenue recognized on both government-wide financial statements and fund financial statements. 47.
(25 Minutes) (Prepare a statement of revenues, expenditures, and other changes in fund balance) One way to approach this problem is to make the journal entries for the transactions that are described as the basis for gathering the information needed for the financial statement to be produced. In this problem, the journal entries are prepared based on the rules for creating fund financial statements for the General Fund. a. Cash 700,000 Property Taxes Receivable 100,000 Revenues—Property Taxes Unavailable Property Tax Revenues
750,000 50,000
The second $50,000 to be collected is not viewed as revenue in 2015 because it will not be available within 60 days to pay claims against current financial resources.
b. Expenditures—Police Cars Cash
200,000 200,000
If previously recorded, an encumbrance would also have to be removed. However, that possible entry does not affect the statement of revenues, expenditures, and other changes in fund balance.
16-36 .
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Chapter 16 - Accounting for State and Local Governments (Part 1)
No depreciation is recorded on the police cars because fund financial statements are being produced for the General Fund. c. Other Financing Uses—Transfers Out 90,000 Cash
90,000
Because the statements being prepared here are only for the General Fund, the entry for the Debt Service Fund is not included. d. Cash 200,000 Other Financing Sources—Bond Proceeds
200,000
No interest is accrued because current financial resources will not be required in this period. Payment will not be until next June 30. e. Encumbrances - Computer Encumbrances Outstanding f. Expenditures—Salaries Cash Salary Payable
40,000 40,000
40,000 30,000 10,000
g. Encumbrances Outstanding Encumbrances - Computer
40,000 40,000
Expenditures—Computer Vouchers Payable
41,000 41,000
h. Expenditures—Supplies Cash
10,000
i. Supplies Fund Balance—Nonspendable
2,000
10,000
2,000
FUND FINANCIAL STATEMENTS CITY OF LOST ANGELS STATEMENT OF REVENUES, EXPENDITURES AND OTHER CHANGES IN FUND BALANCE 16-37 .
.
Chapter 16 - Accounting for State and Local Governments (Part 1)
For the Year Ended December 31, 2015 General Fund Revenues —Property Taxes
$750,000
Total Revenues
$750,000
Expenditures —Police cars —Salaries —Computer —Supplies Total Expenditures
$200,000 40,000 41,000 10,000 $291,000
Excess of revenues over expenditures
$459,000
Other Financing Sources (Uses) —Transfer to Debt Service Fund —Issued Long-Term Bond
$(90,000) 200,000
Net Other Financing Sources
$110,000
Change in Fund Balance
$569,000
Fund Balance—Beginning of Year
180,000
Fund Balance—End of Year
$749,000
48. (25 Minutes) (Prepare a statement of net position for governmental activities) One way to approach this problem is to make the journal entries for the transactions that are described as the basis for gathering information for the financial statement to be produced. Here the journal entries are prepared based on the need to create government-wide financial statements for the General Fund (a governmental activity). a. Cash Property Taxes Receivable Property Tax Revenue
700,000 100,000 800,000
16-38 .
.
Chapter 16 - Accounting for State and Local Governments (Part 1)
b. Police Cars Cash
200,000 200,000
Depreciation Expense Accumulated Depreciation
10,000 10,000
c. No entry is needed because no change occurs in the total net position of the governmental activities. It is an intra-activity transaction. d. Cash Bonds Payable
200,000 200,000
Interest Expense Interest Payable
10,000 10,000
Interest is accrued here based on $200,000 x 10 percent x 1/2 year. e. No entry—this is a commitment and not a transaction. f. Salary Expense Cash Salary Payable
40,000 30,000 10,000
g. Computer Vouchers Payable
41,000 41,000
Depreciation Expense Accumulated Depreciation
4,100 4,100
h. Supplies Cash
10,000
i. Supplies Expense Supplies
8,000
10,000
8,000
This problem indicates that the General Fund held $180,000 in cash at the start of the year. The following account balances have been determined based on the above journal entries. 16-39 .
.
Chapter 16 - Accounting for State and Local Governments (Part 1)
GOVERNMENT-WIDE FINANCIAL STATEMENTS CITY OF LOST ANGELS STATEMENT OF NET POSITION December 31, 2015
Governmental Activities
Assets —Cash —Property Tax Receivable —Supplies —Computers Less: Accumulated Depreciation
$ 41,000 (4,100)
36,900
—Police Cars Less: Accumulated Depreciation
200,000 (10,000)
190,000
$840,000 100,000 2,000
Total Assets
$1,168,900
Liabilities —Vouchers Payable —Salary Payable —Interest Payable —Bonds Payable
$41,000 10,000 10,000 200,000
261,000
Net Position —Net investment in capital assets —Unrestricted
$226,900 681,000
$907,900
The total net position figure of $907,900 can be found by taking the opening balance of $180,000 and then adding the revenues for the period and subtracting the expenses.
49.
(10 Minutes) (The budgetary process) A. True—The initial approval of spending was $380,000 and that amount should be recorded immediately. The budgetary entry debits Estimated Revenues and credits Appropriations. B. False—The budgetary information is normally presented as required supplemental information in the comprehensive annual financial report. However, it can also be shown as a separate statement within the fund financial statements. Government officials have that choice. C. True—At one time, only the final budget and the actual figures for the 16-40
.
.
Chapter 16 - Accounting for State and Local Governments (Part 1)
period were reported. That was considered somewhat misleading since the budget could be revised near the end of the year to establish agreement. Now, the original budget must also be disclosed. D. False—A Budgetary Fund Balance account has to be set up as part of the budget entry to indicate that a surplus (or deficit) is anticipated. However, an expected surplus requires a credit to the Budgetary Fund Balance rather than a debit. E. False—Budgetary information only relates to fund financial statements to show the inflows and outflows of current financial resources and has no impact on the government-wide financial statements. 50.
(10 Minutes) (The recording of grants) A. False—This grant appears to be voluntary exchange transaction. Revenue should be recognized when all eligibility requirements have been met. Here, the eligibility requirements, if any, could have been met during 2015. It is certainly possible that the eligibility requirements have not been met but that is not necessarily the case. B. False—If no eligibility requirements are included with the grant, the revenue should be recognized immediately in December 2015 when the award is made. C. False—A grant is a government-mandated nonexchange transaction if the award was made to help the recipient government meet legal requirements. That is not specified here and cannot be assumed. However, if the state government had passed a law whereby all school children had to receive hot lunches and had then furnished this grant to help meet that requirement, it would have been a government-mandated nonexchange transaction. D. True—Cash is recognized because it had been received but no revenue is reported because all eligibility requirements have not yet been met. Thus, unavailable revenue should be established for the amount received.
51.
(20 Minutes) (Impact of various government transactions) a.F und financial statements – the fund balance goes up by $6 million because of the inflow of current financial resources. Government-wide financial statements – the net position balance does not change. Both assets (cash) and liabilities (bonds payable) go up by the same $6 million amount. No increase is created in net position. 16-41
.
.
Chapter 16 - Accounting for State and Local Governments (Part 1)
b. Fund financial statements – the fund balance goes down by $149,000 because of the outflow of current financial resources. Government-wide financial statements – the net position balance does not change. One asset (truck) goes up while a second asset (cash) goes down. c. Fund financial statements – the fund balance goes down for the General Fund by $17,000 because of the outflow of current financial resources. Government-wide financial statements – the net position balance does not change. This is an internal exchange transaction within the governmental activities so that no net change is created. The motor pool is an internal service fund that is part of governmental activities because it services the vehicles of the fire and police departments. d. Fund financial statements – the fund balance is not affected because the resources will not be collected quickly enough to be available in the current period. An asset (receivable) is recognized along with a liability (unearned revenue) so that the size of the fund balance is not affected. Government-wide financial statements – a $75,000 receivable and related revenue are recognized; the net position balance goes up by that amount. e. Fund financial statements – the fund balance is not affected. The grant is not recognized as revenue until all eligibility requirements have been met. Because that does not appear to be the case here, the cash will go up along with a liability for the amount being held that might have to be returned.
Government-wide financial statements – the net position balance does not change. The accounting is the same as explained for the fund financial statements. f. Fund financial statements – the fund balance should go up by $500,000. Sales took place in the current year but only half of the financial resources will all be received within the 75 day period being used to define available resources. The remainder will be unavailable revenue. Government-wide financial statements – the net position balance goes up by $1 million because the sales were made in the current period.
16-42 .
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Chapter 16 - Accounting for State and Local Governments (Part 1)
g. Fund financial statements – the fund balance is not affected. Although an encumbrance may be recorded to avoid spending more than the appropriated amount, that entry has no impact on the total amount reported for the fund balance. The commitment might change the way the fund balance is labeled but not the total amount of the fund balance to be reported. Government-wide financial statements – a purchase order or other commitment has no impact on the net position balance. h. Fund financial statements – the fund balance for the General Fund goes down by $18,000 because the transfer has been approved and will remove current financial resources from this fund. Government-wide financial statements – no impact occurs on the net position balance of the governmental activities because this is an intraactivity transfer from one Governmental Fund to another. There is no net effect. 52.
(12 Minutes) (The financial impact of fund transfers) A. False—A transfer out will be shown by the governmental activities and a transfer in will be reported by the business-type activities. Those two figures will be netted together so that no overall impact is shown in the total column for the government as a whole. However, both figures do appear in their own separate columns. B. True—Because only funds within the governmental activities are involved, the transfer creates no difference in the overall total of that column. This is an intra-activity transfer.
C. True—The General Fund reports the resource outflow as an other financing use. Financial resources were reduced but it was not for an expenditure. The transfer in is not recorded within the governmental funds. D. False—The General Fund will report the transfer out as an other financing use and the column for "all other funds" will show the transfer-in as an other financing source. E. False—The General Fund does not report expenses in the fund financial statements but rather expenditures. An expenditure of this amount is reported.
16-43 .
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Chapter 16 - Accounting for State and Local Governments (Part 1)
53.
(15 Minutes) (Special assessment project) A. Correct change in the fund balance is a $40,000 increase—According to the information provided, the Capital Projects Fund reported an increase in its fund balance for the year of $40,000. In arriving at that figure, $10,000 in revenue and the related expenditure were both recorded in that fund for this bus stop construction. Because the government had no obligation, these cash flows should actually have all been reported in the Agency Fund. The auditing firm will remove both the revenue of $ 10,000 and the expenditure of $10,000 from the Capital Projects Fund. Because they are of the same amount but have an opposite effect on current financial resources, this removal leaves the overall increase in the fund balance unaffected at $40,000. B. Correct change in net position is a $140,000 increase—According to the information provided, the overall change in the net position of the city reported on the government-wide financial statements was a $150,000 increase. As a result of the special assessment, revenue of $10,000 was reported within the government-wide statements. However, because the city had no obligation, that revenue should have been reported as a liability to the contractor in an Agency Fund. Removing this revenue (and the asset that was recorded at the same time) from the governmental activities reduces the net position increase for the city from $150,000 to $140,000.
54.
(5 Minutes) (Issuance of short-term note)x The correct change in the fund balance for 2015 is an increase of $10,000. According to the information provided, the General Fund reported an increase in its fund balance for the year of $30,000. However, the $20,000 gained from the issuance of the debt should have increased liabilities since payment was due in just 60 days. Removing the other financing source of $20,000 reduces the increase in the fund balance from $30,000 to $10,000.
55.
(15 Minutes) (Reclassifying an activity as an enterprise fund) A. The correct change in the fund balance for the General Fund is a $66,000 increase. According to the information provided, the General 16-44
.
.
Chapter 16 - Accounting for State and Local Governments (Part 1)
Fund reported an increase in its fund balance of $30,000. However, the $9,000 revenue and $45,000 in expenditures were erroneously recorded in that fund. Together, those transactions caused a net reduction in the fund balance of $36,000. These transactions must be removed from the General Fund (in order to record them within an enterprise fund) which causes the overall increase in the fund balance to rise from $30,000 to $66,000. B. The correct change in the net position on the government-wide financial statements is a $150,000 increase. According to the information provided, the overall increase in net position during the year (on the government-wide financial statements) was $150,000. An error has been made in that this art display was reported in the governmental activities (General Fund) rather than in the business-type activities (Enterprise Fund). Fixing that mistake decreases one column in the statement of net position (the business-type activities) and increases the other (the governmental activities) by exactly the same amount. The art display had a loss for the period. That is why the business-type activities will now decrease while the governmental activities increase. Moving these transactions does not change the overall totals for the government as a whole.
56.
C. The correct change in the Enterprise Fund is a $54,000 increase. According to the information provided, the overall change in net position of the Enterprise Fund on the fund financial statements was a $60,000 increase. However, the art display was not included as it should have been. Even for fund financial statements, proprietary funds are accounted for like government-wide financial statements (and for-profit businesses). Adding in the $9,000 revenue and deducting the $15,000 expense creates a $6,000 net reduction that drops the positive change from $60,000 to $54,000. The acquisition of the land increases one asset and decreases another so that no change occurs in net position. (12 Minutes) (Property tax assessments) A. The correct change in the net position of the city on the statement of net position is a $42,000 increase. According to the information provided, the increase in net position on the government-wide financial statements was $150,000. The government, though, has recognized revenue for the amount received in the current period. The amount of the assessment received is $300,000 times 40% or $120,000. However, the discount reduces that figure by $12,000 (10 percent) to $108,000. This money cannot be spent until 2016 and must be reported in 2015 as unavailable revenue (a deferred inflow of resources) and not as revenue. Removing this revenue reduces the overall increase in net position by $108,000 from $150,000 to $42,000.
16-45 .
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Chapter 16 - Accounting for State and Local Governments (Part 1)
B. The correct change in the fund balance reported for the General Fund is a $78,000 decrease. According to the information provided, the General Fund reported an increase in its fund balance for the year of $30,000. The government, though, had recognized revenue for the amount of cash received. As shown in explanation A above, the amount received should have been $300,000 times 40% or $120,000. However, the discount reduces that figure by $12,000 to $108,000. This money cannot be spent until 2016. It must be reported in 2015 as unavailable revenue and not as revenue. Removing this $108,000 revenue reduces the overall change in the fund balance from an increase of $30,000 to a decrease of $78,000. 57.
(12 Minutes) (Property tax assessments) A. The correct change in the net position reported in the government-wide financial statements is a $42,000 increase. According to the information provided, the overall change in the net position of the city on the government-wide financial statements was a $150,000 increase. However, as shown above in 56 (part A), $108,000 was received that should have been recorded as deferred revenue until the period when it can be used (2016). Incorrectly, the city recorded the $108,000 immediately as revenue. When this amount is removed, the increase in net position drops from $150,000 to $42,000. Recognition (and removal) of the $180,000 receivable and the unavailable revenue cause no change in net position since one is an asset and the other is a deferred inflow of resources. B. The correct change in the fund balance for the General Fund is a $78,000 decrease. According to the information provided, the General Fund reported an increase in its fund balance for the year of $30,000. However, as shown above, $108,000 was received that should have been recorded as an unavailable revenue until the period when it can be used (2016). The city incorrectly recorded the $108,000 as revenue. When removed, the increase in net position drops from an increase of $30,000 to a decrease of $78,000. Recognition (and removal) of the $180,000 receivable and the deferred revenue cause no change in net position since one is an asset and the other a liability.
58.
(12 Minutes) (Recording of grant money) A. The correct change in the fund balance reported by the General Fund is a $290,000 decrease. According to the information provided, the General Fund reported an increase in its fund balance for the year of $30,000. However, $320,000 was recognized here as revenue although an eligibility requirement does remain (lowering air pollution by 25 percent). No part of this revenue can be recognized until all eligibility 16-46
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requirements have been met. Changing the $320,000 from revenue to unavailable revenue reduces the $30,000 increase in the fund balance to a $290,000 decrease. B. The correct change in the net position reported on the government-wide financial statements is a $170,000 decrease. According to the information provided, the change in net position of the city on government-wide financial statements was a $150,000 increase. However, $320,000 was recognized as revenue although an eligibility requirement remains (lowering air pollution by 25 percent). No revenue can be recognized until that time. Changing $320,000 from revenue to unearned revenue reduces the $150,000 increase in the fund balance to a $170,000 decrease. Depreciation of the machine is being handled properly. 59.(8
Minutes) (Reporting of program revenues) A. The correct change in the net position on the government-wide statements is a $150,000 increase. According to the preliminary information, the overall change in the net position of the city on the government-wide financial statements was a $150,000 increase. Moving revenue from general revenue to program revenue does not affect the overall change in net position. B. The correct amount of net expenses reported by the parks is $90,000. According to the preliminary information, the parks reported net expenses of $100,000. This net expense figure is computed as direct expenses less program revenues. The $10,000, though, should have been a program revenue. If this revenue had been appropriately included, net expenses would have been $90,000 rather than $100,000.
Develop Your Skills Research Case 1 No textbook is ever able to cover all of the many areas discussed within complex authoritative pronouncements. The subtle nuances of such rules can only be experienced and appreciated through the study of the official literature. Students need to be aware of the extent of the guidance that is available and gain confidence by working directly with these pronouncements. Here, an issue has been raised in connection with the handling of several unusual transactions. In real life, no better method of resolving such questions exists than to actually study the official standard itself. A review of the GASB Codification indicates that Section 2200 covers the “Comprehensive Annual Financial Report.” Paragraphs 143 through 149 are 16-47 .
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labeled as “Special and Extraordinary Items” and paragraph 168 is also shown as “Special and Extraordinary Items.” Paragraph 143 defines extraordinary items as "transactions or other events that are both unusual in nature and infrequent in occurrence." The paragraph directs the reader to paragraphs 145 through 149 for further information on the exact nature of the terms "unusual in nature" and "infrequent in occurrence." Paragraph 144 defines special items as "significant transactions or other events within the control of management that are either unusual in nature or infrequent in occurrence." Paragraph 168 indicates that special and extraordinary items “should be reported separately after ‘other financing sources and uses.’” The pronouncement goes on to state that “significant transactions or other events that are either unusual or infrequent but not within the control of management should be separately identified within the appropriate revenue or expenditure category.” In this case, the GASB Codification provides clear guidance as to the identity of these two accounts as well as their placement in the financial statements. In practice, accountants rarely refer to textbooks when official guidelines are available. Students, therefore, need to become comfortable with locating the source of authoritative information about a topic in order to become proficient at reading and understanding the material provided.
Research Case 2 Here, the accountants and officials of the City of Danmark are looking for assistance in classifying a revenue as either a program revenue (reported directly with a specific activity) or a general revenue (shown for the government as a whole). 1. A search of the GASB Codification provides extensive assistance in this case. Section 2200.136 spells out that "program revenues derive directly from the program itself or from parties outside the reporting government's taxpayers or citizenry, as a whole; they reduce the net cost of the function to be financed from the government's general revenues. The statement of activities should separately report three categories of program revenues: (a) charges for services, (b) program-specific operating grants and contributions, and (c) program-specific capital grants and contributions.” 2. Examples of program revenues are then given in Section 2200.137-139 that include: ▪ Revenue collected for garbage collection. 16-48 .
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▪ ▪ ▪
Building permits. A state grant for the sheriff’s department to participate in a drug awareness and enforcement program. Earnings on endowments if the money is restricted to a program specifically identified in the endowment agreement
3. In contrast, general revenues are defined in the negative in Section 2200.140 as: "all revenues are general revenues unless they are required to be reported as program revenues." Thus, if any revenue does not meet the specific definition of program revenue, it is labeled automatically as general revenue. 4. Sales taxes and property taxes are included in this category as well as any other revenues of the government that do not meet the program revenue criteria.
Analysis Case 1 1)H
ere is the independent auditor’s report for the financial statements
Independent Auditor’s Report Honorable Mayor and Members of the City Council City of Phoenix, Arizona We have audited the accompanying financial statements of the governmental activities, the business-type activities, the aggregate discretely presented component units, each major fund, and the aggregate remaining fund information of the City of Phoenix, Arizona (the “City”) as of and for the year ended June 30, 2012, which collectively comprise the City’s basic financial statements, as listed in the financial section of the table of contents. These financial statements are the responsibility of the City’s management. Our responsibility is to express opinions on these financial statements based on our audit. We conducted our audit in accordance with auditing standards generally accepted in the United States of America established by the American Institute of Certified Public Accountants and the standards applicable to financial audits contained in Government Auditing Standards, issued by the Comptroller General of the United States. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the City’s internal control over financial reporting. Accordingly, we express no such opinion. An audit also includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, 16-49 .
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assessing the accounting principles used and the significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audit provides a reasonable basis for our opinions. In our opinion, the financial statements referred to above present fairly, in all material respects, the respective financial position of the governmental activities, the business-type activities, the aggregate discretely presented component units, each major fund, and the aggregate remaining fund information of the City of Phoenix, Arizona as of June 30, 2012, and the respective changes in financial position and cash flows, where applicable, thereof and the respective budgetary comparison for the general fund and the transit special revenue fund for the year then ended in conformity with accounting principles generally accepted in the United States of America. In accordance with Government Auditing Standards, we have also issued our report dated December 21, 2012, on our consideration of the City’s internal control over financial reporting and on our tests of its compliance with certain provisions of laws, regulations, contracts, and grant agreements and other matters. The purpose of that report is to describe the scope of our testing of internal control over financial reporting and compliance and the results of that testing, and not to provide an opinion on the effectiveness of the City’s internal control over financial reporting or on compliance. That report is an integral part of an audit performed in accordance with Government Auditing Standards and should be considered in assessing the results of our audit. Accounting principles generally accepted in the United States of America require that the management’s discussion and analysis and the schedule of funding progress on pages 3 through 12 and 93, respectively, be presented to supplement the basic financial statements. Such information, although not a required part of the basic financial statements, is required by the Governmental Accounting Standards Board who considers it to be an essential part of financial reporting for placing the basic financial statements in an appropriate operational, economic, or historical context. The required supplementary information is the responsibility of management. We have applied certain limited procedures to the required supplementary information in accordance with auditing standards generally accepted in the United States of America established by the American Institute of Certified Public Accountants. These limited procedures consisted of inquiries of management about the methods of preparing the information and comparing the information for consistency with management’s responses to our inquiries, the basic financial statements, and other knowledge we obtained during our audit of the basic financial statements. We do not express an opinion or provide any assurance on the information because the limited procedures do not provide us with sufficient evidence to express an opinion or provide any assurance. Our audit was conducted for the purpose of forming opinions on the financial statements that collectively comprise the City’s basic financial statements. The 16-50 .
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non-major governmental funds and other supplementary information as listed in the table of contents is presented for purposes of additional analysis and is not a required part of the basic financial statements. Such supplementary information is the responsibility of management and was derived from and relates directly to the underlying accounting and other records used to prepare the basic financial statements. The information has been subjected to the auditing procedures applied in the audit of the basic financial statements and certain additional procedures. These additional procedures included comparing and reconciling the information directly to the underlying accounting and other records used to prepare the basic financial statements or to the basic financial statements themselves, and other additional procedures in accordance with auditing standards generally accepted in the United States of America established by the American Institute of Certified Public Accountants. In our opinion, the supplementary information is fairly stated, in all material respects, in relation to the basic financial statements as a whole. Our audit was conducted for the purpose of forming an opinion on the basic financial statements taken as a whole. The introductory section and the statistical section are presented for the purposes of additional analysis and is not a required part of the basic financial statements. Such information has not been subjected to the auditing procedures applied in the audit of the basic financial statements, and accordingly, we express no opinion on it. Grant Thornton LLP Phoenix, Arizona December 21, 2012 Many aspects of this independent auditor’s report look very much like an audit of a for-profit business. Other parts are different. In an audit of a state or local government, the independent auditor's report is based on Government Auditing Standards (issued by the Comptroller General of the United States). As can be seen in this example, the report mentions the report that is available about the government's internal control procedures as well as its compliance with laws and regulations. This information could be provided in the audit report or through separate reports. In addition, the mention shown here of the supplementary information is not typically found in the audit report of a for-profit business. 2) A number of items are shown in order to reconcile the net changes in fund balances for the governmental funds and the changes in net position. Here is the reconciliation for the City of Phoenix for the year ended June 30, 2012 (all numbers in thousands). Net change in fund balances - total governmental funds 16-51 .
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$
(16,109)
Chapter 16 - Accounting for State and Local Governments (Part 1)
Amounts reported for governmental activities in the statement of activities are different because: ---Governmental funds report capital outlays as expenditures. However, in the statement of activities, the cost of those assets is allocated over their estimated useful lives as depreciation expense. This is the amount by which capital acquisitions ($179,340) minus the decrease in the equity share of the joint venture ($15,750) exceeded depreciation ($159,573) and loss on disposals of capital assets ($2,761) in the current period.
1,256
---Revenues in the statement of activities that do not provide current financial resources are not reported as revenues in the funds
(459)
---Bond proceeds provide current financial resources to governmental funds, but issuing debt increases long-term liabilities in the statement of net assets. Repayment of bond principal is an expenditure in the governmental funds, but the repayment reduces long-term liabilities in the statement of net assets. Additions to bonded debt, net of deferred loss Bond principal payments and other reductions Amortization of bond premium/discount
(126,296) 94,169 3,751
---Some expenses reported in the statement of activities do not require the use of current financial resources and therefore are not reported as expenditures in governmental funds Compensated absences Insurance claims Other Postemployment Benefit (OPEB) Asset Pollution Remediation Water Repayment Agreements
(3,651) 11,641 (303) (2,432) 122
Change in net assets of governmental activities - statement of activities
$ (38,311)
3)T he largest sources of general revenues for many cities are property taxes and sales taxes. However, a wide variety of revenue sources are possible. For the City of Phoenix for the year ended June 30, 2012, the largest source of general revenues was excise taxes of approximately $723 million. 4)T he amount of expenditures will vary widely based on the size of government. Classifications usually include public safety, sanitation, and the like. For the City of Phoenix for the year ended June 30, 2012, the largest amount of 16-52 .
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expenditures shown for the General Fund was $646 million for public safety and $139 million for community enrichment. 5)T he General Fund primarily shows current financial resources as its assets: cash and investments, various receivables, and amounts due from other funds. Although not current financial resources, prepaid items and an inventory of supplies are also included in most cases. As of June 30, 2012, the largest amounts of assets shown by the General Fund of the City of Phoenix were investments of $88 million, due from other funds of $76 million, and taxes receivable of $74 million 6)M ost governments will indicate in a note to their financial statements that payables and receivables are viewed as available if collected within 60 days of the end of the year. Other lengths of time, though, can be used. A note to the 2012 financial statements for the City of Phoenix states: “The City considers revenues to be available if they are collected within 60 days after year-end.” 7)T his question focuses on interperiod equity: Is the government spending more than it takes in so that future generations may have to suffer? Or, is the government taking in more than it spends so future generations will have the benefit of an inherited surplus? For the year ended June 30, 2012, the fund balance for the General Fund of the City of Phoenix decreased in size by $3.3 million. Communication Case 1 Students need to continue updating their knowledge throughout their careers. One method for doing this is to become familiar with the information available on the GASB website. This assignment directs the students to look at any Current Projects being studied by the GASB for the possibility of impacting generally accepted accounting. By looking at this site on a regular basis, an accountant can keep up with all issues studied by the Board as well as the authoritative evolution of accounting pronouncements as new standards are produced. At the time of this writing, nine items are listed under “Current Projects.” One of these is identified as “Lease Accounting—Reexamination of NCGA Statement 5 and GASB Statement 13.” Deliberations on that project will begin in a few months. Most of the rest of the projects are labeled as currently being deliberated. By clicking on any of these, students can gain a wealth of information about the issues and potential reporting changes that might be made. Clicking on any one of the “Current Projects” and reading the information provided is a way to help understand the evolutionary nature of financial accounting. To a student, such readings might seem tedious and difficult—at least initially. However, any person who is involved actively in the financial reporting of a state or local government is probably willing to spend time and 16-53 .
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energy to be aware of possible financial reporting changes and their consequences. All of these discussions may eventually lead to no change, slight change, or radical change in U.S. GAAP for state and local governments.
Communication Case 2 Most accountants and accounting students understand that the GASB sets official standards for the accounting and financial reporting to be carried out by state and local governments. Probably only a small portion of either of these groups truly knows what the established goals and mission of GASB actually are. The following information comes from the GASB website under “About GASB” and then “Mission, Vision, and Core Values.” “Vision “Greater accountability and well-informed decision making through excellence in public-sector financial reporting. “Mission “To establish and improve standards of state and local governmental accounting and financial reporting that will: ---Result in useful information for users of financial reports, and ---Guide and educate the public, including issuers, auditors, and users of those financial reports. “The mission is accomplished through a comprehensive and independent process that encourages broad participation, objectively considers all stakeholder views, and is subject to oversight by the Financial Accounting Foundation’s Board of Trustees. “Core Values “Independence: The autonomy to pursue the best answer for all constituents, free from undue influence or pressure. “Integrity: Honest, ethical, and forthright behavior in relationships with all constituents. “Objectivity: Impartial decisions informed by credible research and thorough deliberations, including due consideration of the views of constituents and the work of other standards setters. “Transparency: An open process that encourages and values public 16-54 .
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Chapter 16 - Accounting for State and Local Governments (Part 1)
participation.” Communication Case 3 Students do not always appreciate the amount of discussion, debate, and compromise that FASB and GASB usually must go through to arrive at an official accounting pronouncement. Because of their inexperience, students sometimes see the creation of accounting standards as a quest for the one true and correct path. One way of accounting is right for each situation and all other ways are necessarily wrong. In practice, though, many possible "right" ways usually exist as potential solutions to any accounting problem. Because of the public debate created by many of these issues, authoritative bodies often receive numerous recommendations whenever any new standard is being discussed. The Board has to study each suggestion and then arrive at the one approach that best fits with the members' conceptual understanding of accounting and reporting. There are also political ramifications to consider as the Board attempts to arrive at a final solution that pacifies the qualms of the various interested parties. However, the Board does help to explain its standards by presenting extensive background information. This assignment is designed to give students the opportunity of looking at some of the alternatives examined by GASB prior to establishing Statement No. 34. This pronouncement was the revolutionary standard that created the dual system of reporting government financial statements. Probably no other statement has had such a significant impact on the financial reporting of a state or local government. The paragraphs assigned here present a number of different approaches that were suggested by members of the public and considered by the GASB. In all cases, individuals who had some interest in government accounting felt that these alternatives were better solutions than the dual system of government-wide financial statements and fund financial statements mandated by GASB 34. ▪
Many respondents preferred a single set of financial statements rather than the dual approach finally chosen. However, GASB found that there was no consensus that any one set of statements was preferable or provided the needed information by itself.
▪
Others simply felt that no significant change was necessary in government accounting and that the system in use at that time (very similar to the current fund financial statements) was adequate. GASB justifies its decision to move away from the previous model by stating (in paragraph 245) that "some of the information that today's users need surpasses the capabilities of the previous reporting model, particularly for governmental activities." 16-55
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▪
The suggestion was also made that fund financial statements for governmental funds not be based on measuring and reporting current financial resources. Rather, each government would use the basis of accounting utilized for budgetary purposes (such as a cash system or a modified cash system). This argument held that fund financial statements are created to provide control and financial accountability which is established by the budgetary process and should, therefore, reconcile with the budget. GASB rejected this idea because the wide variety of possible budgetary methods would eliminate consistency and comparability.
▪
Another solution put forth was to leave the current model as it is but make significant changes to it. Basically, GASB responded that one set of statements could simply not expand to suit the wide array of user needs that had arisen over the years.
▪
Other suggestions encompassed trying to adapt the basis of accounting utilized for the governmental funds to be more useful to a wider array of financial statement users. In other words, significant changes were recommended for this portion of the fund financial statements. GASB indicated here that the Board felt that useful information was being provided by the previous model which focused on current financial resources and that such information should not be lost by the creation of a new model.
Communication Case 4 One of the truly significant additions to state and local government accounting in recent years has been the requirement of the Management’s Discussion and Analysis (MD&A). The MD&A is meant to be a discussion of the financial information reported by the government in a verbal rather than purely quantitative fashion. Students often do not understand the range of information that can be uncovered within an MD&A. Here, the student can read the MD&A for an actual city. The information that is provided is quite extensive and often covers a wide range of subjects such as the following: ▪ ▪ ▪ ▪ ▪ ▪ ▪
An explanation of fund financial statements. An explanation of government-wide financial statements. An explanation of governmental funds, proprietary funds, and fiduciary funds. The purpose of the various funds such as the general fund and the debt service fund. A comparison of the governmental activities and the business-type activities. The method by which the government generates revenues. The diversity of expenditures made within the governmental funds. 16-56
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▪ ▪ ▪ ▪ ▪
The bond rating for the government. A discussion of the budgetary process. Information about both capital assets and long-term liabilities. The reporting of infrastructure assets that were acquired before the creation of government-wide financial statements. Information about proprietary operations.
Excel Case 1 Creation of this type of spreadsheet would appear to be very helpful in budget planning because city officials could plug in various increase and decrease rates and see the impact on the fund balance over time. There are a number of different ways that a spreadsheet could be created to solve this particular problem. Here is one possible approach:
Create Column Headings: In Cell A4, enter label text "Year" In Cell B4, enter label text "Revenue Change" In Cell C4, enter label text "Revenues" In Cell D4, enter label text "Expenditures Change" In Cell E4, enter label text "Expenditures" In Cell F4, enter label text "Ending Fund Balance" In Cell G4, enter label text "Projected Change in Revenue" In Cell H4, enter label text "Projected Change in Expenditures" Click and drag across Cells A4 to H4. Select Format, Cells, Alignment, and click the "Wrap Text" box. Click OK. If needed, place the cursor on the line between the Column Letters and drag the boundary on the right side of the column headings until the columns are the width you want. In Cell A5, enter label text "2014" for first year. In Cell C5, enter Revenues of $1,400,000. In Cell E5, enter Expenditures of $1,480,000. In Cell F5, enter beginning Fund Balance of $400,000 In Cell G5, enter -2% for Projected Change in Revenue Per Year. In Cell H5, enter +3% for Projected Change in Expenditures Per Year. In Cell A6, enter label text "2015." Perform Calculations: In Cell B6, enter formula to calculate Revenue Change (Revenue times Projected Revenue Change): =+C5*$G$5. Note here that adding the $ symbol to Column and Row addresses creates an "absolute" reference which will remain static 16-57 .
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Chapter 16 - Accounting for State and Local Governments (Part 1)
throughout the spreadsheet. In Cell C6, enter formula to adjust Revenues by Revenue Change: =+C5+B6 In Cell D6, enter formula to calculate Expenditures Change (Expenditures times Projected Expenditures Change): =+E5*$H$5 In Cell E6, enter formula to change Expenditures by Expenditures Change: =+E5+D6 In Cell F6, enter formula to calculate the new ending Fund Balance (initial Fund Balance plus Revenue minus Expenditures): =+F5+C6-E6 Copy formulas to adjacent rows: Click and drag across Cells A6 through F6 and release. Place cursor on Fill Handle (small black box in lower right corner of selection box) and click and drag down through Row 8. At that point, you should see that the city will have a negative fund balance of $277,539 at the end of 2017. Simply, by changing cells G5 and H5, the impact of any different level of rate changes can be ascertained. For example, if revenues decrease 5% and expenditures decrease 3% each year, changing those two cells will show that the fund balance will be a positive $14,937 at the end of 2017. Or, by assuming revenues increase by 4% and expenditures increase by 7%, the fund balance will be a negative $146,066 at the end of 2017. Any other combination of changes can be examined in the same way.
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Chapter 17 - Accounting for State and Local Governments (Part 2)
CHAPTER 17 ACCOUNTING FOR STATE AND LOCAL GOVERNMENTS (PART TWO) Chapter Outline I.
This chapter looks at the reporting for a number of significant transactions that are common for state and local governments. For example, these entities often obtain property by lease rather than by purchase. A. Leases are recorded as either capital leases or operating leases based upon the criteria first established by the Financial Accounting Standards Board (FASB) for the reporting of for-profit businesses. Thus, a lease that meets any one of the following criteria is a capital lease for either a state or local government or a for-profit business. a. The lease transfers ownership of the property to the lessee by the end of the lease term. b. The lease contains an option to purchase the leased property at a bargain price. c. The lease term is equal to or greater than 75 percent of the economic life of the leased property. d. The present value of minimum lease payments equals or exceeds 90 percent of the fair value of the leased property. B. For a state or local government, the recording of a capital lease depends on the set of financial statements being prepared. a. In government-wide financial statements, a capital lease is reported as an asset and liability at the present value of the minimum leases payments and then depreciation expense (of the asset’s cost) and interest expense (on the liability balance) are recognized over time. b. In fund financial statements for the governmental funds, the present value of the minimum lease payments is recorded as an expenditure and as an other financing source. Eventual interest and principal payments are recorded as expenditures. No depreciation is reported because capital assets are not recognized in the governmental funds.
II.
Governments often establish solid waste landfills for use by the citizens and businesses. These facilities can be recorded either within the proprietary funds, if a user fee is assessed, or as part of the General Fund if the landfill is open to the public without a charge. A. A landfill can eventually create a large liability for a government because of closure costs and postclosure maintenance and monitoring. B. On government-wide financial statements, recognition of this liability is based on accrual accounting and the economic resource measurement focus. Thus, the liability is recognized proportionally as the available space becomes filled. If the landfill is recorded as an Enterprise Fund, this same reporting is also appropriate for fund financial statements. C. If the landfill is reported within the General Fund, a liability is only reported on the fund statements when a claim to current financial resources comes into existence.
III. Many state and local government entities have defined benefit pension plans for their employees such as school teachers and police officers. Pension trust funds are often set 17-1 .
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up as fiduciary funds to manage the money and investments held to pay for these pensions. As fiduciary funds, these pension trust funds are not included in governmentwide financial statements. A.G overnment-wide financial statements must now report a net pension liability if the present value of the estimated future payments that relate to past work is greater than the net position of the pension trust fund. That is a net pension liability. B. GASB requires that in most cases, but not all, the present value of the future benefits is determined based on the estimated long-term investment yield for plan assets. That decision has created a significant amount of controversy because it creates a lower amount of reported debt. C. The components to be recognized as pension expense are the service cost for the current period, interest expense on the total pension liability, and projected earnings on plan investments. In addition, any increases or decreases in the liability caused by changes in benefit terms are also included in pension expense immediately. IV. Works of art and historical treasures A.A rtworks, historical treasures, and similar assets should be capitalized at cost (or fair value at the date of donation) in government-wide financial statements. B. An expense rather than an asset can be recorded but only if the item does not generate economic benefits and meets the following three criteria. a. Held for public exhibition, education, or research in furtherance of public service, rather than financial gain. b. Protected, kept unencumbered, cared for, and preserved. c. Subject to the policy that revenues generated from sales of items in the collection be used to add to the collection. C. If capitalized, depreciation is not required if this type of asset is considered to be inexhaustible. D. On fund financial statements for the governmental funds, expenditures are recognized for any purchases because the acquired property is not a current financial resource. V.
Infrastructure Assets and Depreciation A.N ewly-acquired infrastructure assets (such as roads, bridges, and sidewalks) are capitalized at historical cost in the government-wide financial statements and also in fund financial statements for proprietary funds. B.I n fund financial statements for the governmental funds, these acquisitions are recorded as expenditures. C. If capitalized, depreciation of all capital assets other than land and inexhaustible artworks is required. D. Infrastructure assets are also subject to depreciation. However, the “modified approach” allows the expensing of maintenance costs in lieu of depreciation for infrastructure assets if specified criteria are met. a. A minimum acceptable condition level is established for a network of infrastructure assets and documentation is provided to verify that this minimum level has been maintained. b. An asset management system must be in place to monitor the condition of the items in this system of assets.
VI. Primary governments produce a comprehensive annual financial report (CAFR) which includes general purpose external financial statements. These statements are divided into three distinct sections. 17-2 .
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Chapter 17 - Accounting for State and Local Governments (Part 2)
A. Management’s discussion and analysis (MD&A) which provides a broad range of information to help decision-makers evaluate the operations and financial position of the government entities. B. Financial statements a. Government-wide financial statements. b. Fund financial statements. c. Notes to the financial statements. C. Other required supplementary information. VII. In governmental accounting, a general purpose government (such as a city, town, county, state or the like) is a primary government that must produce a CAFR. In creating this CAFR, the government might also have to include component units which are legally separate organizations or activities. A. Any agency, board, or the like that meets either of the following two criteria is reported as a component unit within the CAFR of the primary government even though the separate organization is an independent operation. a. It must be fiscally dependent upon the primary organization and the primary government and the component unit must be financially interdependent (there is a relationship of potential financial benefit or burden between the two of them) or b. The primary government must appoint a voting majority of the governing board and either be able to impose its will on the board or the separate organization provides a financial benefit or imposes a financial burden on the primary government. B. Once identified, component units can be discretely presented in a separate column on the right side of the government-wide statements or blended with the primary government as if it made up one of the funds within the primary government. C. In addition, a special purpose government (such as a school board, university, or water commission) qualifies as a primary government if it meets the following three criteria: a. It has a separately elected governing body. b. It is legally independent c. It is fiscally independent of any other state and local governments VIII. Government entities will occasionally combine. These transactions can be recorded as acquisitions or as mergers. A. In a merger, significant consideration is not exchanged. The governments simply come together—often to form a new government unit. The net carrying value of all assets, liabilities, deferred outflows of resources, and deferred inflows of resources are retained. No excess consideration is paid nor recognized. B. In an acquisition, significant consideration is exchanged. Assets, liabilities, deferred outflows of resources, and deferred inflows of resources are recorded at acquisition value—the amount required to buy or dispose of the items on that day. Any excess consideration is recorded as a deferred outflow of resources and amortized to expense over a period of time determined based on a number of factors. IX. Public colleges and universities are required to meet GASB standards for reporting purposes, whereas private schools are required to use FASB standards. A. Private colleges and universities generally depend more on tuition and usually have larger endowments whereas governments generally provide a major part of the support for public schools.
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B. GASB assumes public colleges and universities are special purpose entities so that they must use the same reporting model as a state or local government. However, many of these schools assume that they function solely as an Enterprise Fund (open to the public for a user charge). Thus, they are allowed to produce fund financial statements (for a proprietary fund) without need for government-wide statements. The government-wide statements are viewed as redundant.
Answer to Discussion Question Is It Part of the County? In financial accounting for a for-profit organization, the boundary that defines the reporting entity and its various activities (or subsidiaries) is relatively easy to determine. US GAAP provides the basis for inclusion in consolidated financial statements, which includes all entities over which a company has control. In accounting for state and local governments, the distinction is not so clear. What constitutes a reporting entity? Obviously, a primary government such as a city or county is a reporting entity. What about other governmental operations and activities that exist but which are separate from a primary government? When do those operations qualify as special purpose governments and when should they be viewed as component units to be reported along with a primary government? A special purpose government is also a primary government for reporting purposes. To qualify, it must have a separately elected governing body, be legally independent, and also be fiscally independent. The entity can demonstrate its fiscal independence by setting its own budget, levying taxes, and/or issuing bonds without outside approval. Here, the industrial development commission is not fiscally independent of Harland County. Harland County has the ability to impose its will on the separate organization because it has the right to approve the commission’s budget. Therefore, the industrial development commission is not a special purpose government. Is the industrial development commission a component unit? An activity is classified as a component unit if it is fiscally dependent on a primary government. In addition, the primary government and the component unit must be financially interdependent (there is a relationship of potential financial benefit or burden between the two of them). Here, because the commission’s budget must be approved by the county government and deficits will be covered by the county, the commission appears to qualify as a component unit for Harland County. Can the commission also be a component unit of the state? Fiscal dependence is not present but a component unit does exist if the primary government appoints a voting majority of the board and (a) the primary government can impose its will on that board or (b) the separate organization provides a financial benefit for the primary government or imposes a financial burden. The state appoints 15 out of 20 of the board members. Appointment of that number of board members indicates state control. However, no evidence or information is presented here that indicates that the state can impose its will on the board or that the separate organization provides a financial benefit or imposes a financial burden on the state (as it does on the county). Therefore, unless other information becomes available indicating that one of these requirements is present, the industrial commission is not a component unit of the state. 17-4 .
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Chapter 17 - Accounting for State and Local Governments (Part 2)
However, because of the appointment of the majority of the board, the commission is a related organization to the state. In that case, the state must disclose the nature of the relationship in its financial statements.
Answers to Questions 1. GASB has adopted the same rules as FASB to determine whether a lease is viewed as a capital lease or as an operating lease. However, both GASB and FASB are currently studying the possibility of changes in these rules. A lease that meets any one of the following criteria is held to be a capital lease: a. The lease transfers ownership of the property to the lessee by the end of the lease term. b. The lease contains an option to purchase the leased property at a bargain price. c. The lease term is equal to or greater than 75 percent of the estimated economic life of the leased property. d. The present value of rental or other minimum lease payments equals or exceeds 90 percent of the fair value of the leased property. 2. Within government-wide financial statements, the accounting for capitalized leases is the same as for-profit enterprises. The asset and liability are recorded initially at the present value of the minimum lease payments. Accrual accounting and the economic resource measurement basis are appropriately followed. The equipment is increased along with the liability obligation. Subsequently, both depreciation expense and interest expense must be recognized. The entries in the fund financial statements are the same if a proprietary fund is involved. The recording of a capital lease in one of the governmental funds (within the fund financial statements) involves the following three steps: a. The initial entry reports the present value of the liability as an other financing resource. b. The same present value is also recorded as an expenditure consistent with the current financial resources approach being used. c. When each subsequent lease payment is made, the debt reduction and interest payment are both recorded as expenditures. 3. In government-wide financial statements, the lease payment is treated the same as in a forprofit organization: part of the payment is considered interest and reported as an expense with the rest viewed as a payment of the lease obligation. In fund financial statements for a proprietary fund, the recording is the same as above. However, the recording of a capital lease payment in fund financial statements for governmental funds involves the recording of expenditures for both the reduction of the debt and the payment of interest. 4. Solid waste landfills can be a significant source of liability for many local governments. The federal government has strict rules on closure of a landfill as well as groundwater monitoring and postclosure activities. All of these legal obligations can necessitate large payments over an extended period of time to close and then maintain the landfill into the future.
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Chapter 17 - Accounting for State and Local Governments (Part 2)
5. Government-wide financial statements recognize expenses on the accrual and economic resource measurement basis. Therefore, seven percent of the expected landfill closure liability cost is accrued during the current year as an expense along with the related liability. In the fund financial statements, the entry is the same as above if an Enterprise Fund is involved. In the fund statements, if the landfill is recorded in the General Fund, the only charge to expenditures is for any current payment or for any claim against current financial resources. The eventual liability is ignored unless it will be paid from current financial resources. 6. Government-wide financial statements recognize expenses on the accrual and economic resource measurement basis. At the end of the first year, 11 percent is multiplied times the expected closing and other related costs and that figure is recognized as both an expense and a liability. Current costs are used for this estimation process. At the end of the second year, 24 percent is multiplied times the expected costs (which may have changed since the end of year one) and the liability to be reported is then raised to this new amount. It is the change in the liability that creates the amount of expense reported for the second year. For fund financial statements, assuming the landfill is reported in the General Fund, no recording is made unless (a) an actual payment is made because of the eventual closure or (b) some part of that liability represents a claim to current financial resources in this period. 7. The money set aside by this government for its retirement program is maintained in a pension trust fund that will likely have a positive net position because of the money and investments being held for future payments. At the same time, an estimate is made of the future amount of money that will have to be paid as a result of the defined benefit plan. The portion of that total that relates to work that has already been provided is then determined. The present value of that part of those future cash payments is calculated. If the resulting pension liability is greater than the net position of the pension trust fund, the excess amount is reported in the government-wide financial statements as a net pension liability. 8. For state and local government units, pension expense begins with the service cost for the current year and is increased by interest expense on the amount of the obligation. The resulting figure is then reduced by any projected earnings on plan investments. In addition, any increases or decreases in the liability caused by changes in benefit terms are included in pension expense immediately. Numerous assumptions are also necessary in order to arrive at a total amount to be paid (such as the life expectancy of retired individuals). The impact of (a) any changes in those assumptions and (b) differences between previous assumptions and actual experience is not included immediately by the government within pension expense. Instead, those amounts are recorded as either deferred outflows of resources or deferred inflows of resources and amortized to pension expense over time. 9. Governments should capitalize donated works of art, historical treasures, and similar assets at the fair value at the date of the gift. However, if no charge is assessed for admission to see the art, it is difficult to consider it an asset in a traditional sense because no direct economic benefit is raised for the government. Thus, the artwork does not have to be capitalized if all of the following criteria are met:
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a. Held for public exhibition, education, or research in furtherance of public service, rather than financial gain. b. Protected, kept unencumbered, cared for, and preserved. c. Subject to an organizational policy that requires the proceeds from sales of collection items to be used to acquire other items for collections. If capitalized, depreciation is only required if the asset is viewed as exhaustible (the asset is used up by display, education, or research). Otherwise, depreciation is not required. 10. Revenue still must be reported because of the donation. If the government chooses not to record the qualifying asset in the government-wide financial statements, an expense is reported in place of the asset (whether the item was purchased or received as a gift). If received by donation, the revenue portion of the entry is still required. 11. The modified approach is an alternative to depreciating infrastructure assets. This option allows the government to expense all maintenance costs rather than record depreciation but only if specified guidelines are met. The government must accumulate certain information about the infrastructure assets within either a network or subsystem of a network. The government must establish a minimum acceptable level for the network or subsystem of the network and maintain documentation that this level is being maintained. An asset management system has to be in place to monitor and provide records of the infrastructure assets. The ongoing condition is assessed and an annual estimation made of the cost of maintaining and preserving the infrastructure to meet the established condition levels. Government officials must decide whether this amount of effort and cost should be incurred simply to avoid the recording of depreciation. To date, use of the modified approach has not been widespread. 12. If the modified approach is applied, depreciation of infrastructure assets is not recorded but all maintenance costs are expensed. Certain disclosures are required on the governmentwide financial statements. This requirement includes disclosure that the government is accumulating certain information about particular infrastructure assets within either a network or subsystem of a network. The disclosure must include specific information about the minimum acceptable level for the network or subsystem of the network and that this level is being maintained and monitored by an asset management system. 13. A Management’s Discussion and Analysis (MD&A) similar to that found in for-profit financial statements is required for state and local governments.The MD&A is presented before the financial statements and provides the following information: (1) A brief discussion of the financial statements and information provided and their relationships to each other. (2) Condensed financial information at least including a. Total capital and other assets b. Total long-term and other liabilities c. Total net position, including amounts invested, in capital assets net of debt, restricted and unrestricted amounts. d. Program revenues, by major source. e. General revenues, by major source. f. Total revenues. g. Program expenses, by function. 17-7 .
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Chapter 17 - Accounting for State and Local Governments (Part 2)
h. Total expenses i. Excess or deficiency before contributions to term and permanent fund principal, special and extraordinary items, and transfers. j. Contributions k. Special and extraordinary items l. Transfers m. Change in net position n. Ending net position (3) Overall financial position and results of operations (4) Balances and transactions analyses with an explanation of significant changes (5) Analysis of significant variations between original and final budget amounts (6) Description of significant capital asset and long-term debt activity (7) Information about the modified approach for infrastructure assets (8) Any known facts, decisions, or conditions that are expected to significantly impact on financial position or results of operations. 14. The Comprehensive Annual Financial Report (CAFR) includes three sections a. Introductory Section 1. Letter of transmittal 2. Organizational chart 3. List of principal officers b. Financial Section 1. MD&A (Management’s Discussion & Analysis) 2. General purpose financial statements 3. Auditor’s report 4. Other required supplementary information c. Statistical Section 15. A general purpose government is a traditional government such as a city, county, or state. A special purpose government (such as a school system or transit authority) can also be a primary government for reporting purposes if certain requirements are met. Classification as a special purpose government requires meeting three criteria: a. It has a separately elected governing body. b. It is legally independent. It can sue and be sued and buy, sell, and lease property. c. It is fiscally independent of other state and local governments. It can determine its own budget, levy and set tax rates, and issue bonded debt without outside approval. 16. Classification as a component unit requires an organization to meet one of two criteria: a. The activity is fiscally dependent on a primary government. It cannot determine its own budget, levy and set tax rates, or issue bonded debt without outside approval. Further, the primary government and the component unit must be financially interdependent (a relationship exists of potential financial benefit or burden between the two). or b. An outside primary government appoints a voting majority of the governing board of the activity. The primary government must also be able to do one or more of the following: impose its will on the board of the other organization, or provide a financial benefit to the component organization, or the component provides a financial benefit to the primary government. 17. If blended, component units are included in the primary government as if they were part of the government (one of its own funds). The component unit is legally separate but so 17-8 .
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Chapter 17 - Accounting for State and Local Governments (Part 2)
intertwined and substantially the same as the primary government so that inclusion is necessary for appropriate presentation. A component unit will be blended if its total debt will be repaid entirely, or almost entirely, from resources of the primary government. A discretely presented component unit is shown separately on the far right side of the government-wide financial statements because the organization is not substantially the same as the government and can stand alone. 18. The two government-wide financial statements are the Statement of Net Position and the Statement of Activities. The Statement of Net Position includes: a. All assets and long-term liabilities. b. Capital assets net of accumulated depreciation including newly acquired infrastructure assets. c. Deferred outflows of resources and deferred inflows of resources. d.T he primary government is divided into governmental activities and business-type activities. e.T he internal balances reflect inter-activity transactions between governmental activities and business-type activities. These balances are offset in coming up with totals for the government. f.D iscretely presented component units are shown to the far right of the statement. The Statement of Activities includes: a. Expenses reported by function for governmental activities, business-type activities and component units. b. Interest expense on long-term debt, often shown as a function c. Related program revenues including charges for services, operating grants and contributions, and capital grants and contributions. d. Net expense or net revenue for each function. e. Net expense or net revenue for each category of the government. f. General revenues for governmental activities, business-type revenues, or component units. g. Special items that are significant transactions or other events within the control of management that are either unusual or infrequent in nature. h. Transfers between governmental activities and business-type activities. 19. The two fund financial statements for the governmental funds are the Balance Sheet and the Statement of Revenues, Expenditures, and Changes in Fund Balance. The Balance Sheet measures current financial resources and uses modified accrual accounting and includes: a. Separate columns are included for the general fund and every other major fund that report current financial resources and claims against current financial resources b. Non-major funds are combined and reported as “other governmental funds.” c. Totals for government funds. d. Fund Balance amounts should be classified as nonspendable, restricted, committed, assigned, or unassigned. The Statement of Revenues, Expenditures, and Other Changes in Fund Balance includes: a. The general fund and each major fund in separate columns, with all other funds combined in another column. b. Revenues. 17-9 .
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c. d. e. f.
Expenditures. Other financing sources and uses. Special items. A reconciliation between the ending change in fund balances and the ending change in net position for governmental activities in the government-wide financial statements.
20. Program revenues are those revenues derived from a specific program (such as parks and recreation) or from outsiders seeking to contribute to the cost of that function. They include charges rendered for services, operating grants and contributions, and capital grants and contributions. General revenues are those from the population as a whole including property taxes, sales taxes, unrestricted grants, and investment income. They are not traced to any individual program, activity, or function. This distinction is important because program revenues are matched with expenses for each activity providing a net expense or net revenue figure to disclose the cost or the benefit of providing that activity. 21. The net expense or net revenue format allows the readers of a government’s financial statements to determine the relative financial burden (or benefit) that each of its reporting functions has on its taxpayers. In other words, the users of the statement can determine what it costs for the government to provide benefits such as public safety or library. 22. On government-wide financial statements, internal service funds are combined with the governmental activities (or business-type activities if that connection is more appropriate). Their placement is based on the identity of the functions that they primarily serve. If an internal service fund is mainly used to assist one or more governmental funds, then it should be included with the governmental activities. 23. A combination is viewed as a merger if two legally separate entities are brought together to form a new entity and no significant consideration is exchanged. A merger is also formed if one of those entities ceases to exist while the other continues. In a merger, the net carrying values for all assets, deferred outflows of resources, liabilities, and deferred inflows of resources are combined. No additional account balances are recognized. However, in an acquisition, a significant amount of consideration is exchanged. For government-wide financial statements, the acquiring government records all of the acquired assets, deferred outflows of resources, liabilities, and deferred inflows of resources (other than a few specific exceptions such as landfills) at acquisition value. Acquisition value is the market-based entry price—the amount that would have to be paid to acquire or discharge each item at this time. Any excess consideration is reported as a deferred outflow of resources on the statement of net position. This balance is written off to expense over a period of time that is determined based on several factors including the service life of capital assets, technology, and contracts acquired. When an acquisition takes place, fund financial statements record all of the acquired current financial resources and claims against those resources at acquisition value. 24. In for-profit accounting, excess consideration paid in an acquisition is reported as goodwill and then tested periodically for impairment. For a state or local government, excess consideration paid in an acquisition is not reported on the statement of net position as an asset but rather as a deferred outflow of resources. That balance is then allocated to
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expense over a period of time determined by an examination of several factors such as the service life of capital assets and technology. 25. From an external reporting perspective, FASB sets accounting standards for private colleges and universities whereas GASB sets standards for public schools. Operationally, public schools receive signficant funding from the government (usually a state government). Private universities rely more on tuition charges and endowment income. Because of the ability to generate funding from the government, public colleges and universities generally have smaller endowments. 26. Many public colleges and universities make the assumption that they are solely an Enterprise Fund because they are open to the public but have a user charge (tuition and other fees). An Enterprise Fund is a proprietary fund. For proprietary funds, governmentwide financial statements and fund financial statements are quite similar. Consequently, authoritative guidelines allow such schools to produce only fund financial statements and avoid the redundancy of also creating government-wide statements.
Answers to Problems 1.
A (Both the asset and liability are reported at the present value of the minimum lease payments.)
2.
D (Record $49,000 in expenditures on the first day of the capital lease and then $70,000 more in the form of payments made over the life of the lease)
3.
B (Only the amount of the initially reported liability is identified as an other financing source)
4.
D (Interest is the $69,000 balance times 10 percent.)
5.
A (At this time, there is no claim to current financial resources.)
6.
D
7.
C (The liability must be increased from 8 percent of $1 million to 19 percent. The 11 percent jump is recorded as expense.)
8.
C (Same handling as in 7)
9.
A (The landfill creates no claim to current financial resources)
10.
B (The present value of the pension payments that have been earned to date is $49.8 million. The net position of the pension trust fund is $32.7 million. Thus, the $17.1 million difference is the net pension 17-11
.
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Chapter 17 - Accounting for State and Local Governments (Part 2)
liability.) 11.
D (Changes in the amount of the pension liability that are necessary because of a change in economic or demographic assumptions are not expensed immediately. Instead, those amounts are recorded as either deferred outflows of resources or deferred inflows of resources and amortized to pension expense over a length of time that is set based on a number of factors.)
12.
C
13.
A
14.
B
15.
A (Sidewalks do not have an indefinite life and are depreciated unless the modified approach is used.)
16.
D
17.
B
18.
B (Special purpose governments do not have boundaries in the traditional style.)
19.
A
20.
C
21.
B (In a merger, these assets are combined at their net carrying amounts.)
22.
C
23.
A
24.
A
25.
C
26.
C
27. (12 Minutes) (Accounting for lease on government-wide financial statements and fund financial statements)
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The lease signed by the Enterprise Fund is accounted for in the same way on the government-wide financial statements (as a business-type activity) and the fund financial statements (as a Proprietary Fund). Leased Asset (present value) Depreciation Expense (6 year life) Accumulated Depreciation Interest Expense (10 percent of $28,750) Reduction in Liability ($6,000 payment less $2,875 interest) Liability ($28,750 less $3,125)
$28,750 4,792 4,792 2,875 3,125 25,625
** The lease signed by the General Fund will be accounted for in the following manner for the government-wide financial statements (as a governmental activity). Leased Asset (present value) Depreciation Expense (5 year life) Accumulated Depreciation Interest Expense (10 percent of $33,350) Reduction in Liability ($8,000 payment less $3,335 interest) Liability ($33,350 less $4,665)
$33,350 6,670 6,670 3,335 4,665 28,685
This same lease will be accounted for in the following manner on the fund financial statements (as a General Fund). Initial Recording: —Expenditures —Other Financing Sources Payment of $8,000: —Expenditures-Interest (above) —Expenditures-Principal (above)
$33,350 33,350 3,335 4,665
28. (12 Minutes) (Journal entries for lessee on government-wide financial statements and fund financial statements) a. 17-13 .
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Chapter 17 - Accounting for State and Local Governments (Part 2)
GOVERNMENT-WIDE FINANCIAL STATEMENTS (the two leases are combined here) January 1, 2015 Assets—Capital Lease 49,600 Capital Lease Obligation 49,600 December 31, 2015 Interest Expense ($49,600 x 12%) Capital Lease Obligation ($12,000 - $5,952) Cash
5,952 6,048 12,000
Depreciation Expense—Governmental Accumulated Depreciation (10-year life)
1,900
Depreciation Expense—Business-type Accumulated Depreciation (4-year life)
7,650
b. FUND FINANCIAL STATEMENTS Enterprise Fund January 1, 2015 Assets—Capital Lease Capital Lease Obligation
1,900
7,650
30,600 30,600
December 31, 2015 Interest Expense ($30,600 x 12%) Capital Lease Obligation ($9,000 - $3,672) Cash Depreciation Expense Accumulated Depreciation—(4-year life)
General Fund Expenditures—Leased Assets Other Financing Sources— Capital Lease
3,672 5,328 9,000 7,650 7,650
19,000 19,000
Expenditures—Interest ($19,000 x 12%) 2,280 720 Expenditures—Principal ($3,000 - $2,280) Cash 3,000 29. (15 Minutes) (Journal entries for lessee on government-wide financial statements and fund financial statements) a. GOVERNMENT-WIDE FINANCIAL STATEMENTS 17-14 .
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Chapter 17 - Accounting for State and Local Governments (Part 2)
January 1, 2015 Truck—Capital Lease Cash Capital Lease Obligation
87,800 22,000 65,800
December 31, 2015 Interest Expense ($65,800 x 8%) Capital Lease Obligation ($22,000 - $5,264) Cash
5,264 16,736
Depreciation Expense Accumulated Depreciation (5-year life)
17,560
22,000
17,560
December 31, 2016 (obligation is now $49,064 or $65,800 less $16,736) Interest Expense ($49,064 x 8%) 3,925 Capital Lease Obligation ($22,000 - $3,925) 18,075 Cash 22,000 Depreciation Expense Accumulated Depreciation
17,560 17,560
b. FUND FINANCIAL STATEMENTS General Fund January 1, 2015 Expenditures—Leased Asset Other Financing Sources—Capital Lease Expenditures—Lease Obligation Cash
87,800 87,800 22,000 22,000
December 31, 2015 Expenditures—Interest (above) Expenditures—Lease Obligation Cash
5,264 16,736 22,000
29. (continued) December 31, 2016 Expenditures—Interest (above) Expenditures—Lease Obligation Cash
3,925 18,075 22,000 17-15
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Chapter 17 - Accounting for State and Local Governments (Part 2)
c. FUND FINANCIAL STATEMENTS Proprietary Fund (should be same as handling in government-wide statements) January 1, 2015 Truck—Capital Lease 87,800 Cash 22,000 Capital Lease Liability 65,800 December 31, 2015 Interest Expense ($65,800 x 8%) Capital Lease Liability Cash
5,264 16,736 22,000
Depreciation Expense Accumulated Depreciation
17,560 17,560
December 31, 2016 Interest Expense ($49,064 x 8%) Capital Lease Liability Cash
3,925 18,075 22,000
Depreciation Expense Accumulated Depreciation
17,560 17,560
30. (20 Minutes) (Journal entries for landfill on government-wide financial statements and fund financial statements) a. GOVERNMENT-WIDE FINANCIAL STATEMENTS Accounted for as an Enterprise Fund (within the Business-type Activities) December 31, 2015 17-16 .
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Chapter 17 - Accounting for State and Local Governments (Part 2)
Expense—Landfill Closure (3% of $1.9 million) Landfill Closure Liability
57,000
Landfill Closure Liability Cash
50,000
57,000
50,000
December 31, 2016 Expense—Landfill Closure (9% of $2.1 million less $57,000) Landfill Closure Liability
132,000 132,000
Landfill Closure Liability Cash
50,000 50,000
b. GOVERNMENT-WIDE FINANCIAL STATEMENTS (same as above in a.) Accounted for within the General Fund (part of the Governmental Activities) December 31, 2015 Expense—Landfill Closure Landfill Closure Liability
57,000 57,000
Landfill Closure Liability Cash
50,000 50,000
December 31, 2016 Expense—Landfill Closure Landfill Closure Liability
132,000 132,000
Landfill Closure Liability Cash
50,000 50,000
30. (continued) c. FUND FINANCIAL STATEMENTS (same as above in a.) Accounted for as an Enterprise Fund (within the Proprietary Funds) December 31, 2015 Expense—Landfill Closure Landfill Closure Liability
57,000 57,000 17-17
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Chapter 17 - Accounting for State and Local Governments (Part 2)
Landfill Closure Liability Cash
50,000 50,000
December 31, 2016 Expense—Landfill Closure Landfill Closure Liability
132,000 132,000
Landfill Closure Liability Cash
50,000 50,000
d. FUND FINANCIAL STATEMENTS Accounted for within the General Fund (one of the Governmental Funds) December 31, 2015 Expenditures—Landfill Closure Cash
50,000
December 31, 2016 Expenditures—Landfill Closure Cash
50,000
50,000
50,000
There are no other claims to the current financial resources held by the government.
31.(1 0 Minutes) (Reporting a landfill in both government-wide financial statements and fund financial statements) a.G OVERNMENT-WIDE FINANCIAL STATEMENTS December 31, 2015 Landfill Closure Liability
$1,296,000 (54 percent of $2.4 million)
Expense—Landfill Closure
$1,296,000 (amount needed to establish above liability) 17-18
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Chapter 17 - Accounting for State and Local Governments (Part 2)
b. FUND FINANCIAL STATEMENTS December 31, 2015 Despite the huge eventual liability, nothing is reported at the end of 2015 because no claim to current financial resources exists at this time.
32. (15 Minutes) (The reporting of a defined benefit pension plan by a state or local government) a. To determine the balance to be reported as a state or local government’s net pension liability, an estimation is made of the total benefits that will have to be eventually paid. The portion of that amount that relates to employee past performance (or work that has already been done) is then determined. The present value of that part of the future cash flows is calculated. If this amount is greater than the net position reported by any related pension trust fund, the excess is reported in the governmentwide financial statements as the net pension liability. b. For a state or local government, the amount of pension expense to be recognized in the current period is made up of several components including the service cost for the current period, interest expense on the debt, and projected earnings on plan investments. Any increases or decreases in the pension liability caused by changes in benefit terms are included in pension expense immediately. Finally, numerous assumptions are also necessary to arrive at a total amount to be paid (such as the life expectancy of retired individuals). The impact of any changes in those assumptions and differences between previous assumptions and actual experience is not included immediately within pension expense. Instead, such amounts are recorded as either deferred outflows of resources or deferred inflows of resources and amortized to pension expense over time (with the number of years based on several factors).
c. Because pension plans often establish payments that will not be made until far into the future, reporting on the fund financial statements for governmental funds is often quite limited. Monetary amounts transferred to a pension trust fund must obviously be recorded. Otherwise, unless additional payments reduce current financial resources, no other reporting is necessary. 33. (8 Minutes) (Reporting the donation of an artwork) a. GOVERNMENT-WIDE FINANCIAL STATEMENTS (recognize donation at fair value) 17-19 .
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Chapter 17 - Accounting for State and Local Governments (Part 2)
Museum Piece—Artwork
300,000
Revenue—Donation
300,000
b. GOVERNMENT-WIDE FINANCIAL STATEMENTS (Depreciation recognized) Museum Piece—Artwork Accumulated Depreciation—Museum Piece Book Value
300,000 (30,000) 270,000
Revenue—Donation
300,000
Depreciation Expense
30,000
c. GOVERNMENT-WIDE FINANCIALSTATEMENTS (gift not recognized as asset) Revenue – Donation
300,000
Expense – Artwork
300,000
34. (5 Minutes) (Purchase of artwork with capitalization required) a. GOVERNMENT-WIDE FINANCIAL STATEMENTS (Governmental Activities) January 1, 2015 Museum Piece—Artwork Cash
60,000
December 31, 2015 Depreciation Expense Accumulated Depreciation
3,000
60,000
3,000
17-20 .
.
Chapter 17 - Accounting for State and Local Governments (Part 2)
b. FUND FINANCIAL STATEMENTS (General Fund) January 1, 2015 Expenditures—Artwork Cash
60,000 60,000
35. (8 Minutes) (Accounting for infrastructure in government-wide financial statements) GOVERNMENT-WIDE FINANCIAL STATEMENTS One possibility: Infrastructure assets are capitalized with depreciation recorded Infrastructure Assets—Street Lights Cash Subsequent Entries Depreciation Expense Accumulated Depreciation —Infrastructure Assets
300,000 300,000
30,000 30,000
Maintenance Expense—Infrastructure Assets Cash
48,000 48,000
(There is no indication that any part of this cost should be capitalized. However, if this work extends the life of the assets beyond the original expectation, the debit here would be to Accumulated Depreciation.) Infrastructure Assets—Street Lights Cash 35. (continued)
78,000 78,000
Second possibility: Infrastructure assets capitalized with government using the modified approach Infrastructure Assets—Street Lights 300,000 Cash 300,000 Subsequent Entries (no depreciation reported) Maintenance Expense—Infrastructure Assets Cash Infrastructure Assets—Street Lights Cash
17-21 .
.
48,000 48,000 78,000 78,000
Chapter 17 - Accounting for State and Local Governments (Part 2)
36. (12 Minutes) (The reporting of a special purpose government and a component unit) a. The major criterion for inclusion in a government’s comprehensive annual financial report (CAFR) is financial accountability. b. An activity is viewed as a special purpose government if it meets the following criteria: 1. Has a separately elected governing board 2. Is legally separate 3. Is fiscally independent of other governments c. Legal separation is usually demonstrated by having corporate powers such as the right to buy and sell property and the right to sue and be sued. Corporate powers depend on state law; thus, determination of legal separation may differ from one state to another. d. The fiscal independence of a government is indicated by having authority to do specific actions: 1. Determine and modify its budget without having to get the approval of another government 2. Levy taxes and set rate fees without having to get the approval of another government 3. Issue bonded debt without having to get the approval of another government
36. (continued) e. A component unit is any activity that is legally separate from a primary government but so closely tied to that government that some inclusion in the government’s CAFR is necessary. The account balances of the component unit are included along with the financial statements of the primary government. However, these reported figures are normally discretely presented separate from the balances of the primary government. The financial information for the components is usually reported to the right side of the primary government in government-wide statements. All component units may be shown individually, combined into a single column, or combined into separate columns for governmental and business-type operations. As indicated in (g) below, blending is also a
17-22 .
.
Chapter 17 - Accounting for State and Local Governments (Part 2)
possible method for reporting a component unit by including the activity as if it were a fund of the separate government. f. One of the criteria for identifying a component unit includes the primary government’s ability to impose its will on the component unit. A primary government is assumed to have this ability if it can (1) remove an appointed board member at will, (2) modify or approve budgets, (3) override decisions of the board, or (4) hire as well as dismiss the individuals in charge of the day-to-day activities of the component unit. g. Normally, as indicated above, the financial position and operations of a component unit are shown separately from the primary government. However, if the component unit is sufficiently intertwined with the primary government, it can be included within the government figures (as if it were a fund). Inclusion in this manner is referred to as blending. A component unit must be blended if its total debt will be repaid entirely, or almost entirely, from resources of the primary government.
37. (15 Minutes) (Journal entries for an enterprise fund) 1/1/15 2/1/15 3/1/15 4/1/15 5/1/15 6/1/15 7/1/15
Cash Capital Contributions Cash Notes Payable No Journal Entry—Only a Commitment Truck Cash Cash Unearned Revenue Prepaid Rent Cash Accounts Receivable Revenues--Services Cash 17-23
.
.
160,000 160,000 130,000 130,000 110,000 110,000 20,000 20,000 12,000 12,000 13,000 13,000 11,000
Chapter 17 - Accounting for State and Local Governments (Part 2)
Accounts Receivable 8/1/15 Interest Expense (130,000 x 12% x 6/12) Notes Payable ($10,000 - $7,800) Cash 9/1/15 Salaries Expense Cash Unearned Revenue Revenue--Grant 10/1/15 Maintenance Expense Cash 11/1/15 Salaries Expense Cash Unearned Revenue Revenue—Grant 12/31/15 Accounts Receivable Revenues--Services Cash Accounts Receivable ADJUSTING ENTRIES 12/31/15 Interest Expense (127,800 x 12% x 5/12) Interest Payable 12/31/15 Depreciation Expense (110,000 x 1/10 x 9/12) Accumulated Depreciation 12/31/15 Rent Expense ($1,000 x 7 months) Prepaid Rent
17-24 .
.
11,000 7,800 2,200 10,000 18,000 18,000 18,000 18,000 1,000 1,000 10,000 10,000 2,000 2,000 19,000 19,000 3,000 3,000
6,390 6,390 8,250 8,250 7,000 7,000
Chapter 17 - Accounting for State and Local Governments (Part 2)
38. (65 Minutes) (Prepare financial statements for government-wide financial statements and fund financial statements) a.
CITY OF WILLIAMSON STATEMENT OF ACTIVITIES For Year Ended December 31, 2015
Functions/Programs
Expenses
Governmental activities General Government Public Safety Health and Sanitation Interest on Debt Total governmental activities
$149,000 90,000 70,000 16,000 $325,000
Program Revenues Operating Charges for Grants and Services Contributions
Capital Grants and Governmental Business-type Contributions Activities Activities Total
$ 5,000 3,000 42,000
$14,000
($130,000) ( 87,000) (28,000) (16,000) ($261,000)
$130,000) (87,000) (28,000) (16,000) $261,000
$50,000
$14,000
General Revenues: Property taxes Franchise taxes Investments (gain)
$401,000 42,000 13,000
$401,000 42,000 13,000
Total general revenues Change in net position Net position—beginning Net position—ending
$456,000 195,000 0 $195,000
$456,000 195,000 0 $195,000
17-25 ..
Net (Expense) Revenue and Changes in Net Position
Chapter 17 - Accounting for State and Local Governments (Part 2)
38. a. (continued) Computations: General Governmental [$66,000 + 11,000 + 21,000 + 8,000 + 4,000 (salaries payable) + 13,000 (compensated absences) + 14,000 (art work) + 12,000 (depreciation on building: $120,000/10 years)] = $149,000 Public Safety [$39,000 + 18,000 + 5,000 + 9,000 (expired insurance) + 12,000 (supplies used) + 7,000 (salaries payable)] = $90,000 Health and Sanitation [$22,000 + 3,000 + 9,000 + 12,000 + 8,000 (salaries payable) + 16,000 (depreciation on equipment: $80,000/5 years)] = $70,000
CITY OF WILLIAMSON STATEMENT OF NET POSITION December 31, 2015 Governmental Activities Assets Cash and cash equivalents Prepaid expenses Investments Receivables (net) Inventories Capital assets (net) Total assets
Business-type Activities
Total
$ 62,000 2,000 103,000 81,000 3,000 172,000 423,000
$ 62,000 2,000 103,000 81,000 3,000 172,000 $423,000
19,000
19,000
13,000 196,000 $228,000
13,000 196,000 $228,000
Net position Invested in capital assets, net of related debt Unrestricted (deficit) Total net position
(24,000) 219,000 $195,000
(24,000) 219,000 $195,000
.
.
Liabilities Salaries payable Compensated absences liability Noncurrent liabilities
17-27
Chapter 17 - Accounting for State and Local Governments (Part 2)
38. (continued) b. CITY OF WILLIAMSON STATEMENT OF REVENUES, EXPENDITURES, AND OTHER CHANGES IN FUND BALANCES Governmental Funds For Year Ended December 31, 2015 Revenues: Property Taxes Franchise Taxes Charges for Services Investments (Gain)
General Fund $401,000 42,000 50,000 13,000 $506,000
Total Government Funds $401,000 42,000 50,000 13,000 $506,000
$110,000 90,000 54,000
$110,000 90,000 54,000
4,000 16,000
4,000 16,000
Capital outlay Total expenditures Excess (Deficiency) of Revenues over Expenses Other Financing Sources: Proceeds from Long-term Note
200,000 $474,000
200,000 $474,000
32,000
32,000
200,000
200,000
Total Other Sources
200,000
200,000
Net Changes in Fund Balance 232,000 Fund Balances (Beginning) -0Fund Balances (Ending) $232,000
232,000 -0$232,000
Expenditures: General Government Public Safety Health and Sanitation Debt Service: Principal Payment on Debt Interest on Debt
17-28 .
.
Chapter 17 - Accounting for State and Local Governments (Part 2)
38. b. (continued) CITY OF WILLIAMSON BALANCE SHEET Governmental Funds December 31, 2015 General Fund
Total Governmental Funds
Assets Cash and cash equivalents Prepaid expenses Investments Receivables, net Inventories Total assets
$ 62,000 2,000 103,000 81,000 3,000 $251,000
$ 62,000 2,000 103,000 81,000 3,000 $251,000
Liabilities Salaries payable Total Liabilities
19,000 $19,000
19,000 $19,000
Fund Balances —Nonspendable —Committed for Equipment —Unassigned Total Fund Balances
5,000 12,000 215,000 232,000
5,000 12,000 215,000 232,000
Total Liabilities and Fund Balances
$251,000
$251,000
17-29 .
.
Chapter 17 - Accounting for State and Local Governments (Part 2)
39. (70 Minutes) (Prepare financial statements for government-wide financial statements and fund financial statements) a.
CITY OF BERNARD STATEMENT OF ACTIVITIES For Year Ended December 31, 2015 Net (Expense) Revenue and Program Revenues Changes in Net Position
Functions/Programs Governmental Activities: General Government Public Safety Public Works Health and Sanitation Interest on Debt Total Governmental Activities
Expenses
Charges for Grants and Services Contributions
Governmental Activities
Total
$180,000 158,000 159,500 37,000 42,000
$15,000 8,000 12,000 31,000 ______
$25,000 _______
($165,000) ( 150,000) (147,500) 19,000 (42,000)
($165,000) ( 150,000) (147,500) 19,000 (42,000)
$576,500
$66,000
$25,000
($485,500)
($485,500)
General Revenues: Property Taxes Sales Taxes Dividend Income Gain on Sale of Investments Gain on Value of Investments Total general revenues
$630,000 99,000 20,000 14,000 5,000 $768,000
$630,000 99,000 20,000 14,000 5,000 $768,000
Change in net position: Change during 2015 Net position—beginning Net position—ending
$ 282,500 120,000 $402,500
$ 282,500 120,000 $402,500
17-30 ..
Chapter 17 - Accounting for State and Local Governments (Part 2)
39. a. (continued) Computations: General Governmental [$90,000 + 9,000 + 25,000 + 12,000 + 14,000 (salaries payable) + 30,000 depreciation] = $180,000 Public Safety [$94,000 + 16,000 + 12,000 + 10,000 + 17,000 (salaries payable) + 9,000 depreciation] = $158,000 Public Works [$69,000 + 13,000 + 9,000 + 5,000 (salaries payable) + 14,000 supplies expense + 39,000 landfill closing costs + 10,500 depreciation] = $159,500 Health and Sanitation [$22,000 + 4,000 + 4,000 + 7,000] = 37,000 Landfill [260,000 x 15%] = $39,000
CITY OF BERNARD STATEMENT OF NET POSITION December 31, 2015 Governmental Activities
Totals
$139,000 6,000 116,000 120,000 6,000 387,000
$139,000 6,000 116,000 120,000 6,000 387,000
$240,000
$240,000
199,500 81,000 $64,000
199,500 81,000 $64,000
$971,500
$971,500
Assets Current Assets: Cash and Cash Equivalents Prepaid Insurance Investments Receivables (net) Supplies Total Current Assets Capital Assets: Building-General Government (net of depreciation) Building-Public Works (net of depreciation) Equipment (net of depreciation) Truck (capital lease)
Total Assets
39a. (continued) 17-31 .
.
Chapter 17 - Accounting for State and Local Governments (Part 2)
Liabilities Current Liabilities: Salaries Payable
$36,000
$36,000
$64,000 39,000 430,000 569,000
$64,000 39,000 430,000 569,000
154,500 3,000 245,000 $402,500
154,500 3,000 245,000 $402,500
Noncurrent Liabilities: Lease Obligation Payable Closure Liability Landfill Long-term Notes Payable Total Liabilities Net Position Invested in Capital Assets, Net of Related Debt Restricted for Salaries (Grant) Unrestricted (deficit) Total Net Position
17-32 .
.
Chapter 17 - Accounting for State and Local Governments (Part 2)
39. (continued) b. CITY OF BERNARD STATEMENT OF REVENUES, EXPENDITURES, AND OTHER CHANGES IN FUND BALANCES - Governmental Funds For Year Ended December 31, 2015 General Fund Revenues: Property taxes Sales taxes Dividend income Charges for services Grant Investments (realized gain) Investments (unrealized gain) Total
$630,000 99,000 20,000 66,000 25,000 14,000 5,000 $859,000
Expenditures: Current: General governmental Public safety Public works Health and sanitation
$150,000 149,000 122,000 37,000
Debt Service: Principal payment on debt Interest on debt
10,000 42,000
Capital Outlay: Building Equipment Truck—leased Total expenditures Excess (deficiency) of revenues over expenses)
$(15,000)
Other Financing Sources: Proceeds from long-term note Capitalized lease—truck
200,000 64,000
210,000 90,000 64,000 $874,000
264,000
Total other financing sources Net changes in fund balance
249,000
Fund balance—beginning
90,000
Fund balance—ending (other than nonspendable) 39. b. (continued)
$339,000* 17-33
.
.
Chapter 17 - Accounting for State and Local Governments (Part 2)
*The fund balance shown here is $339,000. Of that amount, $31,000 is committed for the encumbrances for supplies and equipment. Another $3,000 is restricted for the payment of salaries for health care workers ($25,000 grant less $22,000 spent this year). That leaves $305,000 as unassigned. Because the purchases method is applied to supplies and prepaid expenses, neither asset nor fund balance has yet been recorded for the $12,000 amount still held at the end of the year. Those balances are recorded at year-end. This recording increases the assets by that amount as well as the fund balance which is classified as nonspendable.
CITY OF BERNARD BALANCE SHEET Governmental Funds December 31, 2015 General Fund ASSETS Cash and cash equivalents Investments Receivables, net Supplies Prepaid Insurance
$139,000 116,000 120,000 6,000 6,000
Total Assets
$387,000
LIABILITIES AND FUND BALANCES Liabilities: Salaries Payable
$ 36,000
Fund Balances: --Nonspendable $12,000 --Restricted for Salaries 3,000 --Committed for Equipment and Supplies 31,000 --Unassigned 305,000
$351,000
Total Liabilities and Fund Balance
$387,000
17-34 .
.
Chapter 17 - Accounting for State and Local Governments (Part 2)
40. (75 Minutes) (Prepare government-wide financial statements) One way to accumulate the information here for the government-wide financial statements is to prepare journal entries for the listed transactions. a. The transfer is within the governmental activities and is not recorded. Governmental Activities—Parks and Recreation Land Cash b. Governmental Activities—Parks and Recreation Cash Bonds Payable c. Governmental Activities—General Cash Property Tax Receivable General Revenues—Property Taxes d. Governmental Activities—Parks and Recreation Building Cash e. Governmental Activities—Parks and Recreation Sidewalk Cash f. Governmental Activities—Parks and Recreation Cash Program Revenues—Park g. Business-Type Activities—Civic Auditorium Parking Deck Cash Notes Payable
17-35 .
.
20,000 20,000
110,000 110,000
510,000 90,000 600,000
80,000 80,000
10,000 10,000
8,000 8,000
200,000 20,000 180,000
Chapter 17 - Accounting for State and Local Governments (Part 2)
40. (continued) h. Governmental Activities—Education Cash Unearned Revenues
100,000
Expenses—School Lunches Cash
37,000
Unearned Revenues Program Revenues—Operating Grant
37,000
37,000
i. Governmental Activities—Education Cash Receivables—School Fees Program Revenues—School Fees j. Governmental Activities—Education Supplies Cash Expenses—Supplies Supplies
37,000
5,400 600 6,000
22,000 22,000 17,000 17,000
k. Governmental Activities—Education Expenses—Art Program Revenues—Capital Gift l. Governmental Activities—General Transfers Cash
80,000 80,000
20,000 20,000
Business-Type Activities—Civic Auditorium Cash Transfers m. No entry
17-36 .
100,000
.
20,000 20,000
Chapter 17 - Accounting for State and Local Governments (Part 2)
40. (continued) n. Governmental Activities—Education School Bus Cash o. Governmental Activities—Education Expenses—Salaries Expenses—Vacations Cash Salary Payable Vacations Payable p. Business-Type Activities—Civic Auditorium Expenses—Salaries Expenses—Vacations Cash Salary Payable Vacations Payable q. Business-Type Activities—Civic Auditorium Cash Rent Receivable Program Revenues—Rent r. Governmental Activities—Parks and Recreation Expenses—Maintenance Cash s. Governmental Activities—Parks and Recreation Expenses—Interest Bonds Payable Cash t. Business-Type Activities—Civic Auditorium Expenses—Interest Interest Payable
17-37 .
.
102,000 102,000
270,000 23,000 240,000 30,000 23,000
45,000 5,000 42,000 3,000 5,000
110,000 20,000 130,000
9,000 9,000
9,000 5,000 14,000
13,000 13,000
Chapter 17 - Accounting for State and Local Governments (Part 2)
40. (continued) No entries are needed for the financial information from the museum. The totals for the period are provided for reporting purposes. Also: Depreciation Entries: Governmental Activities—Education (School Building—$1,000,000/20) Expenses—Depreciation Accumulated Depreciation Governmental Activities—Parks and Recreation (Building—$80,000/10 x ½) Expenses—Depreciation Accumulated Depreciation Business-Type Activities—Civic Auditorium ($600,000/30) Expenses—Depreciation Accumulated Depreciation Governmental Activities—Education (School Bus—$102,000/5 x 3/12) Expenses—Depreciation Accumulated Depreciation Business-Type Activities—Parking Deck ($200,000/20 x ½) Expenses—Depreciation Accumulated Depreciation
50,000 50,000
4,000 4,000
20,000 20,000
5,100 5,100
5,000 5,000
Balances for all of the above accounts can be determined by posting each of these entries.
17-38 .
.
Chapter 17 - Accounting for State and Local Governments (Part 2)
40. (continued) City of Pfeiffer Statement of Activities Government-Wide Financial Statements Year ending December 31, 2015
Expenses
Program Revenues
Grants and Gifts
Governmental Activities —Education $482,100 —Parks and Recreation 22,000
$ 6,000 8,000
$117,000
$(359,100) ( 14,000)
$(359,100) ( 14,000)
$14,000
$117,000
$(373,100)
$(373,100)
Total for Governmental Activities
$504,100
Business-Type Activities —Civic Auditorium Total for Primary Government Component Unit: —Museum
88,000
130,000
$592,100
$144,000
$
$50,000
42,000
$117,000
$(373,100)
Total
$42,000
42,000
$42,000
$(331,100)
Component Unit
$8,000
General Revenues —Property Taxes
600,000
Transfers
(20,000)
20,000
-0-
Total General Revenues and Transfers
$580,000
$20,000
$600,000
-0-
Change in Net Position
$206,900
$62,000
$268,900
$8,000
Net Position, Beginning of Year
1,123,000
662,000
1,785,000
106,000
Net Position, End of Year
$1,329,900
$724,000 $2,053,900
$114,000
17-39 .
Net (Expenses)/Revenues Governmental Business-Type
.
600,000
Chapter 17 - Accounting for State and Local Governments (Part 2)
40. (continued) City of Pfeiffer Statement of Net Position Government-Wide Financial Statements December 31, 2015 Governmental Activities
Business-Type Activities
Total
Component Unit
$302,400 90,000 600 -05,000 20,000 10,000 96,900 -01,026,000
$130,000 -0-020,000 -0-0-0-0195,000 580,000
$432,400 90,000 600 20,000 5,000 20,000 10,000 96,900 195,000 1,606,000
$24,000 -0-0-0-0-0-0-0-0300,000
$1,550,900
$925,000
$2,475,900
$324,000
$30,000 23,000 -063,000 105,000
$3,000 5,000 13,000 -0180,000
$33,000 28,000 13,000 63,000 285,000
-0-0-0-0$210,000
Total Liabilities
$221,000
$201,000
$422,000
$210,000
Net Position: —Capital Assets, less Related Debt —Unrestricted
$1,047,900 282,000
$582,000 142,000
$1,629,900 424,000
$ 90,000 24,000
Total Net Position
$1,329,900
$724,000
$2,053,900
$ 114,000
Assets: —Cash —Property Tax Receivables —Receivables-School Fees —Rent Receivable —Supplies —Land —Sidewalk —School Bus —Parking Deck (net) —Buildings (net) Total Assets Liabilities: —Salary Payable —Vacation Payable —Interest Payable —Unearned Revenues (*) —Bonds and Notes Payable
(*) The unearned revenue is a liability and not a deferred inflow of resources because an action is required rather than the simple passage of time.
17-40 .
.
Chapter 17 - Accounting for State and Local Governments (Part 2)
41. (70 Minutes) (Prepare fund financial statements) One way to accumulate the information for the fund financial statements is to prepare journal entries for the listed transactions. a. General Fund Other Financing Uses—Transfer Cash Capital Projects Fund Cash Other Financing Sources—Transfer Expenditures—Land Cash
70,000
70,000 70,000 20,000 20,000
b. Capital Projects Fund Cash Other Financing Sources—Bond c. General Fund Cash Property Tax Receivable Revenues—Property Taxes Unavailable Property Tax Collections d. Capital Projects Fund Expenditures—Building Cash
110,000 110,000
510,000 90,000 560,000 40,000
80,000 80,000
e. Capital Projects Fund Expenditures—Sidewalk Cash
10,000 10,000
f. General Fund Cash Revenues—Park
8,000 8,000
17-41 .
70,000
.
Chapter 17 - Accounting for State and Local Governments (Part 2)
41. (continued) g. Enterprise Fund Parking Deck Cash Notes Payable
200,000 20,000 180,000
h. Special Revenue Fund Cash Unearned Revenues
100,000 100,000
Expenditures—School Lunches Cash
37,000
Unearned Revenues Revenues—Operating Grant
37,000
i. General Fund Cash Receivables—School Fees Revenues—School Fees
37,000
37,000
5,400 600 6,000
j. General Fund Expenditures—Supplies Cash
22,000 22,000
k. No entry because there is no impact on current financial resources. l. General Fund Other Financing Uses—Transfer Cash Enterprise Fund Cash Other Financing Sources—Contribution
17-42 .
.
20,000 20,000
20,000 20,000
Chapter 17 - Accounting for State and Local Governments (Part 2)
41. (continued) m. General Fund Encumbrances - School Bus Encumbrances Outstanding n. General Fund Encumbrances Outstanding Encumbrances – School Bus Expenditures—School Bus Cash
99,000
99,000 99,000 102,000 102,000
o. General Fund Expenditures—Salaries Cash Salary Payable
270,000 240,000 30,000
p. Enterprise Fund Expenses—Salaries Expenses—Vacations Cash Salary Payable Vacations Payable
45,000 5,000 42,000 3,000 5,000
q. Enterprise Fund Cash Rent Receivable Program Revenues—Rent
110,000 20,000 130,000
r. General Fund Expenditures—Maintenance Cash
9,000 9,000
17-43 .
99,000
.
Chapter 17 - Accounting for State and Local Governments (Part 2)
41. (continued) s. General Fund (mention is made that no separate Debt Service Fund is used) Expenditures—Interest 9,000 Expenditures—Bonds Payable 5,000 Cash 14,000 t. Enterprise Fund Expenses—Interest Interest Payable
13,000 13,000
Also: Recognition of remaining supplies (from j above) General Fund Supplies Fund Balance—Nonspendable
5,000 5,000
Depreciation Entries: Enterprise Fund—Civic Auditorium ($600,000/30) Expenses—Depreciation Accumulated Depreciation
20,000
Enterprise Fund—Parking Deck ($200,000/20 x ½) Expenses—Depreciation Accumulated Depreciation
5,000
20,000
5,000
Balances for the above accounts can be determined by posting each of these entries into the appropriate ledger account.
17-44 .
.
Chapter 17 - Accounting for State and Local Governments (Part 2)
41. (continued) City of Pfeiffer Statement of Revenues, Expenditures, and Changes in Fund Balance Fund Financial Statements – Governmental Funds Year ending December 31, 2015
Special Revenue Funds
Revenues -Property Taxes -Park -Operating Grant -School Fees Total Revenues
$560,000 8,000 -06,000 $574,000
-0-0$ 37,000 -0$ 37,000
-0-0-0-0-0-
$560,000 8,000 37,000 6,000 $611,000
Expenditures -Land -Buildings -Sidewalk -School Lunches -Supplies -School Bus -Salaries -Maintenance -Interest -Bond Payment Total Expenditures
-0-0-0-022,000 102,000 270,000 9,000 9,000 5,000 $417,000
-0-0-037,000 -0-0-0-0-0-0$37,000
20,000 80,000 10,000 -0-0-0-0-0-0-0$110,000
20,000 80,000 10,000 37,000 22,000 102,000 270,000 9,000 9,000 5,000 $564,000
Excess (deficiency) of revenues over expenditures
$157,000
-0-
$(110,000)
$ 47,000
180,000
180,000
Other Financing Sources (Uses) -Other Financing Sources -Other Financing Uses
-0-
-0-
(90,000)
-0-
Total Other Financing Sources (Uses)
$(90,000)
-0-
$180,000
$ 90,000
Change in Fund Balance
$ 67,000
-0-
$ 70,000
$137,000
Fund Balance – Beginning
123,000
-0-
-0-
123,000
Fund Balance – Ending
$190,000
-0-
$70,000
$260,000
17-45 .
Capital Projects Funds
Total Governmental Funds
General Fund
.
-0- (90,000)
Chapter 17 - Accounting for State and Local Governments (Part 2)
41. (continued) City of Pfeiffer Balance Sheet Fund Financial Statements - Governmental Funds December 31, 2015 General Fund
Special Revenue Funds
Capital Projects Funds
Total Governmental Funds
$169,400
$63,000
$70,000
$302,400
90,000
-0-
-0-
90,000
600 5,000
-0-0-
-0-0-
600 5,000
$265,000
$63,000
$70,000
$398,000
Liabilities -Salary Payable -Unearned Revenues
$ 30,000 40,000
-0$63,000
-0-0-
$ 30,000 103,000
Total Liabilities
$ 70,000
$63,000
-0-
$133,000
Fund Balances -Nonspendable -Committed -Unassigned
$ 5,000 -0190,000
-0-0-0-
-0$70,000 -0-
$ 5,000 70,000 190,000
Total Fund Balances
$195,000
-0-
$70,000
$265,000
Total Liabilities And Fund Balances
$265,000
$63,000
$70,000
$398,000
Assets -Cash -Property Tax Receivable -Receivables – School Fees -Supplies Total Assets
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Chapter 17 - Accounting for State and Local Governments (Part 2)
41. (continued) City of Pfeiffer Statement of Revenues, Expenses, and Changes in Net Position Fund Financial Statements—Proprietary Funds Year Ending December 31, 2015 Enterprise Fund (Civic Auditorium) Operating Revenues —Rent Revenues
$130,000
Operating Expenses —Salaries —Vacations —Depreciation
$ 45,000 5,000 25,000
Total Operating Expenses
$ 75,000
Operating Income
$ 55,000
Non-operating Expenses —Interest Expense
$ 13,000
Income before Capital Contribution
$ 42,000
Capital Contribution
20,000
Change in Net Position
$ 62,000
Total Net Position—Beginning
662,000
Total Net Position—Ending
$724,000
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Chapter 17 - Accounting for State and Local Governments (Part 2)
41. (continued) City of Pfeiffer Statement of Net Position Fund Financial Statements—Proprietary Funds December 31, 2015 Enterprise Fund (Civic Auditorium) Assets Current Assets —Cash —Rent Receivable
$130,000 20,000
Total Current Assets
$150,000
Noncurrent Assets —Parking Deck (net) —Buildings (net)
$195,000 580,000
Total Noncurrent Assets
$775,000
Total Assets
$925,000
Liabilities Current Liabilities —Salary Payable —Vacation Payable —Interest Payable
$ 3,000 5,000 13,000
Total Current Liabilities
$ 21,000
Noncurrent Liabilities —Notes Payable
$180,000
Total Liabilities
$201,000
Net Position —Invested in Capital Assets, less related debt —Unrestricted
$582,000 142,000
Total Net Position
$724,000
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Chapter 17 - Accounting for State and Local Governments (Part 2)
42. (17 Minutes) (Impact of various government transactions) a. False – A pension trust fund is one of the fiduciary funds because the money cannot be used by city officials for the benefit of the government. Fiduciary funds do not appear in the government-wide financial statements although separate statements are presented as part of the fund financial statements. Any net pension liability does appear in the government-wide financial statements but that is not the question here. b. True – The permanent funds are included within the governmental funds because the income generated from the resources being held is to be used by the government. Although the principal amount cannot be spent by government officials, the income can. c. True – A commitment of current financial resources was made when this order was placed. Thus, an encumbrance should have been recognized at that time. However, the actual amount of the obligation proved to be slightly higher. When the liability was incurred, the original encumbrance should have been removed and the expenditure recorded for the actual amount of current financial resources required. d. True – The expense to be recognized each year is the adjustment required to establish the proper liability. At the end of Year One, that liability should be $96,000 or 12 percent of $800,000. At the end of the second year, the liability has grown to $172,000 (20 percent of $860,000). Increasing the liability from $96,000 to $172,000 necessitates an expense of $76,000. Even though the question relates to the fund financial statements, Enterprise Funds accrue expenses as incurred in the same way as in governmentwide financial statements. e. True – The expense to be recognized each year is the adjustment required in the liability. At the end of Year One, that liability should be $99,000 or 11 percent of $900,000. At the end of the second year, the liability has grown to $170,000 (20 percent of $850,000). Increasing the liability from $99,000 to $170,000 necessitates an expense of $71,000. Although the question relates to the General Fund, government-wide financial statements always accrue expenses as incurred. f. False – In the governmental funds, a capitalized lease is recorded based on the present value of the future cash flows. Thus, the initial recording is an expenditure of $39,000.
42. (continued) 17-49 .
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Chapter 17 - Accounting for State and Local Governments (Part 2)
g. False – An Agency Fund is used when passing money through the government to a specified recipient. Thus, the only two accounts typically found in an Agency Fund are cash (or similar monetary assets) and the liability to indicate where that cash is destined. h. True – The asset is capitalized at $39,000, the present value of the future cash flows. Over a six-year life, depreciation expense of $6,500 should be recognized each year ($39,000/6 years). A related liability of $29,000 is also recorded (after the first payment is removed). Based on an annual interest rate of 10 percent, interest expense of $2,900 should be recognized in the first year. Total expenses to be reported are $9,400 ($6,500 plus $2,900). 43. (12 Minutes) (Recording the gift of a work of art) a. This gift did not involve a current financial resource and should not have been recorded in the fund financial statements (for the governmental funds). In this problem, nothing indicates that it was recorded in the fund financial statements. The recording of the asset and depreciation is only made in the government-wide statements. Thus, the increase in the fund balance of $30,000 was correct and should not be changed. b. Apparently, in the government-wide financial statements, revenue of $15,000 was reported when the asset was recognized at that value. Depreciation recognized for the first year would have been $500 ($15,000 capitalized amount allocated over a 30-year life) so that an increase in the net position was reported as $14,500. That was the result of the reporting process. If the allowed alternative had been followed as officials wished, both revenue and expense would have been increased initially by $15,000 for no net effect. The increase and decrease cancel out each other. Consequently, removing the $14,500 increase that was reported (so that no net effect is shown) changes the net expense figure for this function from $130,000 to $144,500. c.G overnment officials wanted to use the alternative which was to record an expense (rather than an asset) along with a revenue for the donation. However, no entry was made by the art museum. Thus, there was no change created in the net position figure. Had the desired entry been made, both revenue and expense would have risen by $15,000, but then, again, no net effect would result because they would have off set each other. Although the individual totals are wrong, the increase in net position stays at $140,000 44. (8 Minutes) (Recording the lease of a police car) 17-50 .
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Chapter 17 - Accounting for State and Local Governments (Part 2)
a.O n the government-wide statements, an expense of $20,000 was reported but no further entry. Instead, an asset and liability of $62,000 should have been reported. At the end of the year, depreciation on the asset (over a five-year period) would have been $12,400 with interest expense of $6,200 (10 percent of $62,000). Thus, total expenses should have been reported as $18,600 ($12,400 plus $6,200). The reported expense ($20,000) was $1,400 too high. Removing that amount of expense causes the increase in net position to rise from $140,000 to $141,400. b. A $62,000 expenditure should have been recorded on the first day of the year because of the capitalized lease. In addition, a $62,000 “other financing source” should have also been recorded. The $20,000 expenditure was properly reported on the last day of the year to record the payment made at that time. That entry was correct. Because both the initial expenditure ($62,000) and the other financing source ($62,000) were left out, the net effect of the omission is zero. That mistake cancels out. The $30,000 increase in the fund balance that is shown for the General Fund is correct. 45. (5 Minutes) (Reporting a component unit) The revenue of $30,000 and the expense of $42,000 were not included within the primary government figures for the government-wide financial statements. They were discretely presented but should have been blended. Adding these two figures to the primary government-wide totals reduces the overall increase in net position by $12,000 ($30,000 minus $42,000) from $140,000 to $128,000. 46.(1 0 Minutes) (Recording a city landfill) a.A pparently, the amounts recorded this year (in the parks which is within the General Fund) were in the wrong fund. The landfill should have continued to be reported as an Enterprise Fund. By itself, that does not have any net impact on the net position reported for the entire government on the government-wide statements. The amounts are simply in the wrong columns. However, the clean-up liability has not been reported for the current year (the problem says that no other recording was made this year). An additional 8 percent was filled in the current year so that the liability to be reported should have increased by $16,000 (8 percent of $200,000). That needed adjustment reduces the overall increase in net position from $140,000 to $124,000. b. Revenues ($4,000) and expenses ($15,000) for the current year must now be moved from the General Fund to the Enterprise Funds ($11,000 net reduction). In addition, the $16,000 clean-up liability computed in (a) 17-51 .
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above should be recorded here so that the overall decrease in net position in connection with the landfill is $27,000 ($11,000 + $16,000). For the Enterprise Funds, the net increase is net position is not $60,000 but rather $33,000. c. Revenues and expenditures have been correctly reported this year within the General Fund. In addition, there is no indication that the clean-up costs for the landfill will require any current financial resources. Thus, no part of that cost needs to be reported in the fund financial statements. The increase in the fund balance of the General Fund of $30,000 appears to be correct. 47. (6 Minutes) (Recording and depreciating capital assets) a. The modified approach only applies to infrastructure assets and not to machines and the like that have a definite life. Thus, $4,000 in depreciation expense for the year ($20,000/5 years) has been incorrectly omitted. Including the recording of depreciation reduces the increase in net position from $140,000 to $136,000. b. The depreciation expense discussed in (a) above increases the net expenses for education from $710,000 to $714,000. 48. (15 Minutes) (Recording leases in government-wide and fund financial statements) a. False – Assuming that the next payment is not due until July 1, Year Two, it is not a claim to current financial resources. Therefore, no liability should be reported on fund financial statements at the end of Year One. b. False – The original liability of $78,000 should be reported and immediately reduced by $20,000 to $58,000. Interest for the last six months of Year One is accrued ($58,000 x 10 percent x 6/12 year or $2,900) to raise the liability to $60,900. c. True – Interest for the last six months of Year One is accrued ($58,000 x 10 percent x 6/12 year) or $2,900. d. False – On fund financial statements, the expenditure total equals the $78,000 present value of the cash flows plus the first $20,000 payment. e. True – The asset is initially capitalized at $78,000. At the end of the first year, depreciation of $7,800 should be recognized ($78,000 x 1/5 x 6/12) which reduces the net leased asset to $70,200.
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Chapter 17 - Accounting for State and Local Governments (Part 2)
f. False – On fund financial statements, the expenditure total equals the present value of the future cash flows. That entry is made when the contract is signed regardless of whether the first payment is made then. As an ordinary annuity (rather than an annuity due), the present value will be different than $78,000. g. False – Four separate criteria exist for a capitalized lease. One of those is that the life of the lease is 75 percent or more of the life of the asset. If the car has an eight-year life, the five year lease is only 62.5% of the life of the asset. However, the lease contract might well meet one of the other three criteria so that capitalization would still be necessary. h. False – Payments totaling $100,000 are being made and the car will be used up. The total expense has to be $100,000 on the government-wide statements no matter how the reporting is done. For fund financial statements, the present value of the future cash flows is recognized as an expenditure ($78,000) and then the eventual payments are also recognized as expenditures (five payments of $20,000 each). This total is more than $100,000 (but the impact is partially offset by the reporting of an other financing source). 49.(1 0 Minutes) (Reporting by a government of a solid waste landfill) a. False – The handling in the government-wide financial statements will be the same whether the landfill is reported as a part of the General Fund or as an Enterprise Fund. b. False – Because the city has a December 31 year-end, no claim to current financial resources exists at that time. Payments will not be required for six months. c. False – The Enterprise Fund should report a liability equal to 26 percent of $2 million less the amount of cash that has already been paid. d. True – Enterprise Funds are generally reported the same in the government-wide financial statements and in the fund financial statements. e. True – The liability is $2 million times 26 percent or $520,000. However, payments of $100,000 have already been made by this time so the reported liability is only $420,000. f. True – In either case, $2 million will be spent. That will show up as an expense in the government-wide financial statements and as an expenditure in the fund financial statements (because the landfill is reported in the General Fund). 17-53 .
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Chapter 17 - Accounting for State and Local Governments (Part 2)
50.(1 0 Minutes) (Reporting by a government of a landfill) a. True – The amount of the liability to be reported in each of the past years would then have been based on $3 million rather than on $2 million. b. True – The government-wide financial statements accrue all liabilities whether they are governmental activities or business-type activities. The government has to report the current obligation for closing the landfill. That liability is 40 percent of $3 million or $1.2 million. c. True – At the end of Year Two, a liability of $420,000 is reported (26 percent of $2 million less $100,000 in payments). The Year Three payment reduces that balance to $370,000. At the end of Year Three, a liability of $1,050,000 is reported (40 percent of $3 million less $150,000 in payments). Adjusting the liability balance of $370,000 to $1,050,000 necessitates recognizing an expense of $680,000. d. False – Present value is not used for landfill closure costs. The current cost of closure (rather than estimation of future cash payments) is the basis for recognition so that present value is not necessary. 51.(1 2 Minutes) (Reporting the gift of a historical treasure to a government) a. True – One of the requirements for being able to choose to not capitalize an art work or historical treasure is that a formal policy must be in place requiring that any proceeds from a future sale be used for a similar purchase. Thus, the item is not actually a kind of disguised investment. b. False – If the asset is viewed as being inexhaustible (this document is already over 200 years old), depreciation is not required. c. False – The city can record the $10,000 value as an expense immediately but it can also choose to capitalize the asset and then depreciate it over its expected useful life. d. False – Revenue recognition is required for gifts of this type. It is only the decision as to whether to record an asset or an expense that is at the option of the government. e. True – Both revenue and an equal expense can be reported for this donation so that net position is not impacted. 52.(8 Minutes) (The presentation of component units) a. False – Although the city here appoints a majority of the board members, nothing here indicates that (a) the city can impose its will on this board, (b) 17-54 .
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that the library provides a financial benefit or a financial burden for the city, or (c) that the library is financially dependent on the city. Appointing a majority of the board makes the library a related organization but not necessarily a component unit. b. True – If the results of the component unit are included within the governmental activities (in the same manner as a fund), this reporting is known as blending the component unit. Blending is appropriate when the component unit is closely entwined with the government. c. False – Blending of a component unit is a judgment made when financial statements are being prepared based on how entwined the activity is with the government. In addition, a component unit will need to be blended if its total debt will be repaid entirely, or almost entirely, from resources of the primary government. That responsibility is not mentioned here. 53. (12 Minutes) (The basic reporting of a state or local government.) a.F alse – The $900,000 will be added and not subtracted. On the fundbased financial statements, an expenditure is reported which reduces the fund balance. On the government-wide financial statements, the cost is capitalized so that no change occurs in the government’s overall net position. The reconciliation starts with the total change in fund balances for the governmental funds (including this $900,000 reduction) and moves to the total change in net position in the governmental activities (no change for this transaction). To go from a $900,000 reduction to no change, an addition of $900,000 is required. b. False – Appointing the governing board alone is not sufficient to be labeled as a component unit. In addition, either the primary government must be able to impose its will on that board or the separate organization provides a financial benefit or imposes a financial burden on the primary government. c. False – A separate body is a component unit if it fiscally depends on the primary government. In addition, the primary government and the component unit must be financially interdependent. These rules do not necessarily require the appointment of members of the board. d. False – The election of the board fulfills one of the requirements for a special purpose government but not all. It must also be legally independent and fiscally independent. e. True – The modified approach was developed because many infrastructure assets (such as streets and bridges) have lives that can be extended for virtually an unlimited period of time through appropriate maintenance. 17-55 .
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Chapter 17 - Accounting for State and Local Governments (Part 2)
The modified approach enables governments to avoid recording depreciation for these particular items. f. False – The textbook indicates some use of the modified approach but not a significant amount. Apparently, the cost of the work necessitated by the application of the modified approach is more than the value to government officials of avoiding the recording of depreciation. g. False – The fee here is assessed directly by this function to the individuals being benefited. Therefore, the money received is reported as a program revenue and not a general revenue. h. True – Both works of art meet the three criteria that are necessary before such items can be recorded as expenses rather than as assets. i. False – Because this debt will be paid in only 30 days (and will, thus, use current financial resources), it is recorded as a debt on the fund financial statements rather than as an other financing source. The handling is the same in the government-wide financial statements and the fund financial statements so that no adjustment is needed for reconciliation purposes.
Develop Your Skills Research Case 1 GASB 34 required the creation of government-wide financial statements which necessitated the reporting of capital assets and other infrastructure items. When released in 1999, one of the most controversial aspects of GASB 34 was the capitalization of previously acquired and constructed infrastructure items (such as bridges, sidewalks, streets, and the like) that, in most cases, had gone unreported. In many cases, cost figures were no longer available. Determining a reported value, for example, for miles of sidewalks constructed over a number of decades was looked at as an almost impossible feat with little or no reporting value to the readers of the financial statements. Because of this criticism, GASB tempered this one reporting requirement more than any other. First, only a limited number of these earlier assets had to be reported. According to the GASB Codification, Section 1400.167, “governments are required to capitalize and report major general infrastructure assets that were acquired (purchased, constructed, or donated) in fiscal years ending after June 30, 1980, or that received major renovations, restorations, or improvements during that period.” So, the reporting of only “major general infrastructure assets” is required. That size requirement was identified as a subsystem that made up at least 5 percent of 17-56 .
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Chapter 17 - Accounting for State and Local Governments (Part 2)
the total of all general capital assets or a network that made up at least 10 percent of the total of all general capital assets. In addition, only assets acquired or renovated after June 30, 1980, had to be assessed for reporting purposes. This parameter limited the required reporting to assets that were relatively new at that time. For example, a bridge constructed in 1922 did not have to be reported unless renovated after June 30, 1980. Finally, governments were given an extra four years beyond the required implementation deadline for GASB 34 to report these previously obtained infrastructure assets. This extension was allowed to provide government officials with sufficient time to make the necessary computations. For the actual computation of these figures, the GASB Codification explains: “The initial capitalization amount should be based on historical cost. If determining historical cost is not practical because of inadequate records, estimated historical cost may be used.” (Section 1400.170) “A government may estimate the historical cost of general infrastructure assets by calculating the current replacement cost of a similar asset and deflating this cost through the use of price-level indexes to the acquisition year (or estimated acquisition year if the actual year is unknown). There are a number of price-level indexes that may be used, both private- and public-sector, to remove the effects of price-level changes from current prices. Accumulated depreciation would be calculated based on the deflated amount, except for general infrastructure assets reported according to the modified approach.” (Section 1400.171) Section 1400.173 goes on to provide additional guidance: “Other information may provide sufficient support for establishing initial capitalization. This information includes bond documents used to obtain financing for construction or acquisition of infrastructure assets, expenditures reported in capital project funds or capital outlays in governmental funds, and engineering documents.”
Research Case 2 The reason for this question is rather obvious: The transit authority has lost money and city officials are concerned by how those negative financial results will impact the financial picture reported by the city. The reporting rules for component units were first created by GASB Statement No. 14, The Reporting Entity. Those rules are now part of the GASB Codification: 17-57 .
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Chapter 17 - Accounting for State and Local Governments (Part 2)
“Financial statements of the reporting entity should provide an overview of the entity, yet allow users to distinguish between the primary government and its component units. (Section 2600.105) “Most component units should be included in the financial reporting entity by discrete presentation. Discrete presentation entails reporting component unit financial data in columns and rows separate from the financial data of the primary government.” (Section 2600.107) “Even though it is desirable for users to be able to distinguish between the primary government and its component units, there are nevertheless some component units that, despite being legally separate from the primary government, are so intertwined with the primary government that they are, in substance, the same as the primary government. These component units should be reported as part of the primary government in both fund financial statements and the government-wide financial statements. That is, the component unit's balances and transactions should be reported in a manner similar to the balances and transactions of the primary government itself. This method of inclusion is known as blending.” (Section 2600.112) In the case presented here, the facts should be easy to determine so that the decision about reporting can be made. Is the transit authority fiscally dependent on the city? Does the transit authority create a financial benefit or financial burden for the city? Do transit authority officials have to get permission from the city to adopt its budget or set rates for passenger use? Can the transit authority issue bonds without having to get approval of city officials? These questions should be fairly easy to answer. The transit authority can also be a component unit of the city if city officials appoint a voting majority of the transit authority’s board. In that case, the transit authority is viewed as a component unit if (a) city officials can impose their will on this board or (b) the transit authority provides a potential financial benefit or burden for the city. The question of potential financial burden is especially relevant because the transit authority has been losing money. Eventually, if that situation does not improve, what responsibility will the city have? Analysis Case 1 Students often appear to believe that the financial reporting presented in a textbook has actually been applied, unchanged, for decades. They often do not fully appreciate the speed of evolution that can take place in the applicable generally accepted accounting principles.
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Accounting for state and local governments provides an excellent example of the change that can occur, even over a relatively short period of time. GASB 34 was issued in June of 1999 and became mandatory a few years later. That pronouncement provides a clear line of demarcation between the financial statements that are currently reported and those that were traditionally used for many decades. In looking at any source of information prior to 2000, several significant differences should be evident: --Only one set of financial statements was reported. Government-wide financial statements did not exist. --The financial statements prior to 2000 will look quite a bit like fund financial statements that are still prepared. --The columnar presentation will include fund types (General Fund, Special Revenue Fund, Capital Projects Fund, and the like) rather than showing specific major funds within these categories. --Because only current financial resources were reported, at least in the governmental funds, no capital assets or long-term liabilities are reported. However, columns identified as “general fixed asset account group” and “general long-term debt account group” were included as a listing of capital assets and long-term debts. --Some of the fund type names have changed over the years. For example, the Permanent Fund within the governmental funds did not exist prior the passage of GASB 34. --Depreciation was not reported in connection with the reporting of capital assets by the governmental funds. --Infrastructure assets were reported as expenditures as those costs were incurred and, then, probably in no other way. In most cases, no inclusion at all could be seen of bridges, sidewalks, and the like. --Certain liabilities such as landfill costs were probably ignored. --Budgetary information was reported but through the use of a different type of format. --A management’s discussion and analysis is now included in government financial statements to provide a verbal explanation of the financial events of the period. Analysis Case 2 One of the most significant changes in governmental accounting created by GASB 34 in 1999 was the requirement that the Management’s Discussion and Analysis be included as part of the CAFR. This written report is meant to be a discussion of the financial information for the government in a verbal rather than a purely quantitative fashion. Students often do not understand the range of information provided by the MD&A. In this assignment, the student can read the MD&A for an actual city. 17-59 .
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Here are just some of the pieces of information discussed in the 2012 MD&A for the City of Phoenix, Arizona. --On the Government-Wide Financial Statements, total assets of the City exceeded its total liabilities at the close of the fiscal year by $8.5 billion (net assets). --Approximately 28.4 percent of the total governmental fund balance amount, or $412.9 million, is designated by the City as committed, assigned and unassigned. The remaining 71.6 percent or $1,042.1 million is designated as non-spendable or restricted. --The largest portion of the City’s net assets ($5.3 billion or 62.1 percent) reflects its investments in capital assets, e.g., land, buildings, improvements, equipment, and infrastructure, less any related debt used to acquire those assets that is still outstanding. -- Major additions to capital assets during the fiscal year included design and construction related to the Sky Harbor Sky Train (valued at $178.6 million) and various street and storm sewer projects throughout the city (valued at $84.5 million). --The City had total long-term liabilities or obligations of $7.4 billion. -- During fiscal year ended 2012, excise tax revenues and charges for services increased by 4.6 and 3.1 percent, respectively due to continued growth in the economy. --The City maintains twenty-five individual Governmental Funds. -- The Transit Special Revenue Fund accounts for the voter approved excise taxes dedicated to the construction, operation and maintenance of the public transit system.
Communication Case 1 Students do not always fully comprehend the evolutionary nature of financial accounting and reporting. In connection with for-profit businesses, ongoing changes have occurred over a number of decades under the Financial Accounting Standards Board, the Accounting Principles Board, and a variety of other organizations. In comparison, the Governmental Accounting Standards Board has been in operation for a shorter period of time and has produced fewer official standards. The changes that governmental accounting has gone through over the years may be a bit easier for a student to grasp. This assignment is simply intended to provide the student with an overview of the recent history of governmental accounting. The listed articles (and any others that the students may find through their own library and Internet searches) show 17-60 .
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how governmental accounting is gradually building up an official set of generally accepted accounting principles to provide a structure for reporting that, up until recently, has been very unstructured. The amount of authoritative guidance has gone from almost nonexistent just a few decades ago to a fairly well developed system of financial reporting. Communication Case 2 If the city assesses a user charge, then officials always have the right to record the landfill as an Enterprise Fund. However, such a classification is not required unless the fee (a) is set at an amount intended to cover the various costs of the service or (b) serves as the sole security for debts of the activity. If the landfill is recorded as an Enterprise Fund, then accounting in the government-wide financial statements and fund financial statements is quite similar. The statements measure all economic resources and timing is recorded based on accrual accounting. Perhaps most importantly, the anticipated cost of closure and post-closure activities must be accrued in both sets of financial statements. Conversely, if the landfill is recorded within the General Fund, there is no impact on the government-wide financial statements except that all transactions and balances are shown as governmental activities rather than as business-type activities. However, in the fund financial statements, as a governmental fund, only current financial resources and the changes in those financial resources are reported. Capital assets, in these statements, as well as long-term liabilities such as closure costs are omitted.
Excel Case This spreadsheet would be extremely helpful for a government attempting to determine the historical cost (less depreciation) of infrastructure assets not previously reported. This spreadsheet is designed along the guidelines established in GASB Codification, Section 1400.167-175. There are a number of different ways that a spreadsheet could be created to solve this particular problem. Here is one possible approach: In Cell A1, enter text label “City of Loveland—Reported Value of Each Mile of Road” In the next three rows, enter the criteria on which calculations will be based: In Cell A3, enter text label of “Per 1 Mile of Road as of 12/31/2015” and in Cell E3 enter “$2,300,000” 17-61 .
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In Cell A4, enter text label of “Yearly Inflation” and in Cell E4 enter “8%” In Cell A5, enter text label of “Depreciation” and in Cell E5 enter “2%” Any of the above three variables can be changed to develop different schedules. Enter Column Headings: In Cell A7, enter text label of “# of Years.” In Cell B7, enter text label of “Date.” In Cell C7, enter text label of “Inflation Reduced Cost.” In Cell D7, enter text label of “Total Depreciation.” In Cell E7, enter text label of “Reported Value.” Enter Row Headings: In Cell A8, enter text label “1” and in Cell A9, enter text label “2.” Once you establish a pattern, Excel can automatically fill in a series of numbers. To continue the numbering for Years 3-20, click and drag across Cells A8 and A9. Once these cells are highlighted, you will see a small black box in the lower right corner of this selection, which is the “fill handle.” Click on the fill handle and drag across Cells A10 through A27 and release to display numbers 3 through 20. The numbers will be displayed in increasing order since that is the criteria that was established in Cells A8 and A9. In Cell B8, enter text label “12/31/2014” and in Cell B9, enter text label “12/31/2013.” Perform the same click and drag operation above to fill the date in Cells B10 through B27. The dates will be displayed in decreasing order since that is the criteria that was established in Cells B8 and B9.
Enter Formulas: In Cell C8, enter formula to calculate Inflation Reduced Cost as of 12/31/2012. Reduce Per Mile figure established on 12/31/2015 (in Cell E3) by Yearly Inflation Rate (in Cell E4): =+E3/($E$4+100%) (NOTE: Absolute references, which are cell references that always refer to cells in a specific location, can be created by placing a $ symbol before the Column letter and/or the Row number. In this problem, we need to always refer to the Yearly Inflation figure in Cell E4 and the Depreciation figure in Cell E5.) In Cell D8, enter formula to calculate Total Depreciation. Multiply Inflation Reduced Cost figure on 12/31/2014 by Yearly Depreciation Rate: =+C8*($E$5*A8) In Cell E8, enter formula for Reported Value of road for current year by deducting Depreciation from Inflation: =+C8-D8. In Cell C9, enter formula to calculate Inflation Reduced Cost figure as of 12/31/2013: Reduce Inflation on 12/31/2014 (in Cell C8) by Yearly Inflation Rate (in Cell E4): =+C8/($E$4+100%) 17-62 .
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Chapter 17 - Accounting for State and Local Governments (Part 2)
Copy formulas from Cells D8 and E8 to Cells D9 and E9 by clicking and dragging fill handle. Format Cells to display currency. Click and drag across Cells C8 to E9. Select Format, Cells, and under the Number tab, select Currency. Change the Decimal places to 0 and click OK. Copy Formulas: Click and drag across Cell C9 through Cell E9. Place the cursor on the “fill handle” in the lower right corner of this section box and drag the cursor down to Cell E27 and release. The formulas are automatically adjusted to correspond to the current year information.
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Chapter 18 - Accounting and Reporting for Private Not-for-Profit Entities
CHAPTER 18 ACCOUNTING AND REPORTING FOR PRIVATE NOT-FOR-PROFIT ENTITIES Chapter Outline I.
Historically, the financial reporting for private not-for-profit entities has differed significantly according to the type of organization (such as a health care entity versus a college or university). The reporting of these entities has now been largely standardized by FASB pronouncements that focus on (a) the reporting of financial statements for the entity as a whole and (b) significant events such as the receipt of contributions and the recording of mergers and acquisitions. However, public colleges and universities and similar organizations still must follow the standards issued by GASB. A. This chapter examines the financial reporting for private not-for-profit entities with special emphasis on private colleges and universities, voluntary health and welfare entities, and health care operations. B. Reporting for these entities is usually similar to a business enterprise unless critical differences exist that impact the needs of financial statement users. Several of these critical differences can be identified. 1. Many private not-for-profit entities receive a significant amount of their financial resources from contributions rather than from revenues or capital investments. 2. A significant amount of the financial resources given to a private not-for-profit entity include donor-imposed restrictions. 3. No single indicator of success is present in the financial reporting. No number such as net income provides a means for evaluation as it does with a for-profit business.
II. FASB has established the following financial statements for private not-for-profit entities. A. Statement of Financial Position reports assets, liabilities, and net assets. B. Statement of Activities reports revenues, expenses, gains, and losses. C. Statement of Cash Flows D. A voluntary health and welfare entity is also required to present a Statement of Functional Expenses which indicates the amount of resources spent for program services (to meet the goals of the entity) and supporting services (to operate the entity and raise funds). III. For reporting purposes, all economic resources held by a private not-for-profit entity are classified within one of three categories. A. "Unrestricted net assets" indicates the amount of an entity's resources that are not subject to external donor restrictions. Entity officials can make whatever use they wish of these assets. B. "Temporarily restricted net assets" are restricted by an outside party (often a donor) for a particular purpose or for use in a future period of time. When the restriction is eventually satisfied, the classification of these resources is switched to unrestricted net assets. At that time, on the statement of activities, temporarily restricted net assets are reclassified
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Chapter 18 - Accounting and Reporting for Private Not-for-Profit Entities
as unrestricted net assets when the appropriate time has passed or the resource is used as stipulated. C. "Permanently restricted net assets" are expected to remain restricted for as long as the entity exists. Income from these assets is normally unrestricted or temporarily restricted based on the specifications of the donor. IV. Contributions should be recognized as increases in net assets when received. A. Restricted contributions are reported either within temporarily restricted net assets or permanently restricted net assets based on stipulations established by the donor. B. Donated assets are recorded at fair value. Recognition of art works, historical treasures, and the like is not required (although allowed) if three conditions are all met. 1. The items are added to a collection for public exhibition, education, or research. 2. The items are protected and preserved. 3. If sold, receipts must be used to acquire other collection items. C. Unconditional promises to give that are received by a private not-for-profit entity should be reported immediately as both a receivable and an increase in net assets. 1. If not to be collected within one year, the promise is recorded at the present value of the future cash flows. Subsequent amortization of the discount is recorded as contribution rather than as interest. 2. Uncollectible balances are also estimated and deducted. 3. Conditional promises are not recognized until the conditions are met. D. Services contributed to a not-for-profit entity are recognized as increases in net assets if the services (1) create or enhance a nonfinancial asset or (2) require a specialized skill possessed by the donor that would have been purchased if not donated. If the donated service comes from an affiliated group, the amount is recognized at the cost paid to the employee by the affiliate. If that cost does not reflect the legitimate value of the services rendered, the charity has the option of reporting fair value. E. If a not-for-profit entity accepts a donation that must be conveyed to a separate individual or other beneficiary, the entity normally records the asset along with an accompanying liability to reflect the accepted responsibility. However, if the entity is given variance powers to change the beneficiary, an increase in net assets is recognized instead of a liability because the donation falls under the entity’s control. V. Education institutions (such as private colleges and universities) record tuition revenue at the gross amount billed and then show the revenue net of scholarships and financial aid in the statement of activities VI. Over the years, mergers and acquisitions have become more common in private not-forprofit entities at least in part because of the economic downturn. The rules for recording these combinations are different than those applied to a for-profit business because the transaction can be either an acquisition or a merger. A. In an acquisition, one entity gains control over another 1. All identifiable assets and liabilities of the acquired company are combined at fair value on the date of acquisition.
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Chapter 18 - Accounting and Reporting for Private Not-for-Profit Entities
2. If the acquisition value of the acquired company is greater than the sum of the fair value of all identified assets and liabilities, the difference is often reported as goodwill. 3. However, if the acquisition value of the acquired company is greater than the sum of the fair value of all identified assets and liabilities, the excess is charged off immediately as a reduction in net assets if the acquired company expects to be predominantly supported by contributions and investment income in the future. B. In a merger, two not-for-profits come together to form a new entity with a new governing board. Identifiable assets and liabilities are not adjusted to fair value but retain their previous carrying amounts. VII. Health care entities exhibit some unique reporting features that must be addressed in not-for-profit accounting. A. Third-party payors such as Medicare and insurance companies have a significant impact on the reporting process because of their need for usable financial information B. A net patient service revenue figure is actually reported by these entities but only after reduction for contractual adjustments. These adjustments are decreases allowed for some third-party payors based on the approved cost for a particular service in that geographic region. C. Charity care services are not included in receivables or revenues if there is no expectation of collection. The cost of that charity work must be disclosed. D. FASB requires the inclusion of performance indicators (such as revenues in excess of expenses) to help show operational effectiveness because net income is not viewed as applicable for a not-for-profit entity.
Answers to Discussion Questions Are Two Sets of GAAP Really Needed for Colleges and Universities? Over the years, a number of differences have appeared between the accounting for public colleges and universities and for those that are private. GASB holds authority over the reporting of public schools whereas FASB has authority over private educational institutions. Consequently, GASB statements do not apply to private schools and FASB Statements do not apply to pubic schools unless specifically made applicable by GASB. For this reason, FASB pronouncements on depreciation, pledges, contributions, and financial statement format for not-for-private entities do not affect public schools until and unless so stated by GASB. Because of this division of responsibility, the financial statements for these two types of schools have developed independently. GASB states that public schools must follow the guidelines of GASB 34 which created appropriate financial statements for state and local governments. However, these guidelines are not as radically different from private schools as might be imagined. Public colleges and universities are allowed to identify themselves as solely Enterprise Funds if they meet the required criteria. If this decision is made, the school need report only fund financial statements as would be produced by a proprietary fund. These statements have a definite resemblance to the statements prepared by private schools. However, important distinctions do continue to exist. Students can be asked to address the question of whether a public and a private school need to have comparable financial statements. Net income is not an issue, rather the sources and utilization of resources is usually emphasized. Is the adoption of a single set of generally accepted accounting principles necessarily essential? Will a decision-maker care if the University of North Carolina at Chapel 18-3 .
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Chapter 18 - Accounting and Reporting for Private Not-for-Profit Entities
Hill (a public school) has one statement format while Duke University (a private school) has another? Should the financial statements for the College of William and Mary (a public school) reflect the same reporting as the University of Richmond (a private school)? This controversy leads to the important question of user needs. Why does a company or individual look at the financial statements of a college or university? Donors might have one answer to that question while creditors could have an entirely different response. Once that question has been addressed, the need for comparability is easier to assess. No ultimate answer for that query currently exists but students can be asked to develop their own list of user needs and then note whether the existence of two different sets of GAAP has an adverse impact on those needs. Is This Really an Asset? In theory, accounting for a pledge is a relatively straightforward process. If unconditional, a receivable is established (at present value if the money is not to be received within the year) along with an adequate allowance for doubtful collections. However, in practice, the reporting process might be much more complicated. In this case, for example, was a pledge actually made or was this just a superfluous statement spoken at a moment of overwhelming emotions? Is this a promise to give or an intention to give? Can the donor change his mind? Does this potential donor really own land in Idaho and can it be sold for $30 million? How can an adequate allowance be determined for this pledge? If the individual's mother should die, might he lose interest in supporting the hospital? If the $10 million is reported as a receivable and then is not collected, what is the impact on the readers of the financial statements? How much time and energy should the hospital invest in attempting to arrive at a proper method of financial reporting for this item? The accountant must address all of these questions (and more) to determine the appropriate accounting treatment. At a minimum, hospital officials need to contact this donor and have a serious discussion. He needs to understand their reasons for attempting to establish a valuation of this promise. In class discussion, students can be asked to identify questions that should be posed to this person. They would probably include the following: —Does he really plan to give $10 million to the hospital? —When does he project that the land will be sold and the gift conveyed? —How did he establish a $30 million price? Could the land ultimately be sold for less and, if so, how will that impact on the gift to the hospital? —How does the donor want the $10 million to be used? —Is there any chance that he will change his mind? —What other charities has he supported? Has he previously made such large gifts? —Would he be willing to furnish financial statements as well as a list of references who could verify his intentions and his ability to carry out those intentions? —Does the hospital have legal recourse to force fulfillment of the promise since it is in writing and signed? If this individual has supported other charities over the years, is committed to the work of Mercy Hospital, has adequate financial resources, and the land appears to be worth $30 million, the hospital should report the pledge as a receivable. However, a large allowance should probably be established because of the uncertainties involved in collecting this money over an extended period of time. Conversely, if too much uncertainty exists (a value for the land cannot be determined or the donor refuses to provide information about his ability to meet the 18-4 .
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Chapter 18 - Accounting and Reporting for Private Not-for-Profit Entities
commitment), the hospital may decide that there is no pledge but merely the promise of a possible future pledge. In that case, the information should be spelled out in a disclosure note. Unless clear evidence exists to substantiate the pledge, disclosure is most likely.
Answers to Questions 1. The Financial Accounting Standards Board (FASB) has authority for establishing accounting standards for private not-for-profit entities. In addition, audit and accounting guides produced by the AICPA provide further guidance for the preparation of financial statements by these entities. 2. If a user of financial statements is a potential donor, that party is interested in assessing whether a gift to a not-for-profit entity is a wise use of resources. To make that assessment, the individual needs to know whether the entity uses its resources appropriately to achieve stated goals. In this way, donors can decide which entity deserves to receive support and how much will be donated. For this reason, the reported division between the amount spent on program services and supporting services can be helpful. If a user of financial statements is a creditor, that company or person is primarily interested in whether the entity can generate sufficient cash flows to pay its debts as they come due. 3. According to FASB, three financial statements are required to be produced by private not-for-profit entities: a statement of financial position, a statement of activities, and a statement of cash flows. A voluntary health and welfare entity must also produce a statement of functional expenses. 4. Temporarily restricted net assets have been restricted by an external donor or grantor for a specified purpose or for use at a future point in time. For example, cash might be given to a charity that had to be spent to buy a bus or that could not be spent for three years. Such restrictions are eventually lifted when the intended usage is fulfilled or when the time limit has been met. 5. Permanently restricted net assets have been restricted by an external donor and grantor. That restriction is expected to last for as long as the entity continues to function. Normally, any income generated by these assets can be used by the entity although its specific usage may be restricted. For example, investments worth $3 million might be given to a private not-for-profit entity with the stipulation that that could never be sold. However, the income produced by these investments over time could be designated by the donor for the purchase of computer equipment or might be available to the entity’s officials for whatever purpose they deemed necessary. 6. The two general types of expenses are (a) program service expenses and (b) supporting service expenses. Program service expenses are those that relate to the goals and objectives of the not-for-profit entity. Supporting service expenses encompass the costs of operating the entity (general and administrative) and raising funds. 7. Not-for-profit entities (especially voluntary health and welfare entities) are frequently evaluated based on the ratio of program service expenses to total expenses. This ratio tells readers of the statements what portion of each dollar of expense can be attributed to achieving the goals identified by the entity. 18-5 .
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Chapter 18 - Accounting and Reporting for Private Not-for-Profit Entities
8. A statement of functional expense is produced by a voluntary health and welfare entity to assist the reader of its financial statements in measuring the entity’s efficiency in using resources. The assumption is that an entity should use a greater portion of those resources to meet stated goals and a smaller part for administrative costs and fundraising. This statement provides a simple way of evaluating one not-for-profit entity in comparison to another. 9. When a donor conveys a gift to a private not-for-profit entity (such as the United Way) that must be conveyed to a separate beneficiary, a question arises as to the recording of the expense and the contribution. Under normal circumstances, the original donor records an expense at the time of the conveyance while the charity reports both an asset and a liability until the gift can be conveyed to the beneficiary. At the same time, the eventual beneficiary should record a receivable and an increase in net assets because action has been taken that will lead to the receipt of this gift. In this way, the entity that initially collected and then conveyed the gift recorded neither expense nor an increase in net assets because the resources cannot really be used. They simply pass through to the beneficiary. Other possibilities do exist if the donor has given the initial charity variance powers that allow for a possible change in beneficiaries. 10. If a donor makes a contribution to a charity for conveyance to a separate beneficiary but can still revoke or redirect the gift before it is made, the donor records a receivable (rather than an expense) until the gift is actually transferred to the beneficiary. At that point, the receivable is reclassified as an expense. The charity initially receiving the gift shows a liability but, in this situation, the balance is directed back to the donor and not to the beneficiary. Because the beneficiary is not completely certain that the gift will be received, no recording is made until the time of receipt. The donor has retained a significant degree of control which impacts the method by which the gift is reported. 11. If a donor makes a contribution to a charity for conveyance to a separate beneficiary but grants it variance powers to change the identity of the beneficiary, the donor reports an expense immediately. Because control of the gift now lies with the charity, that party should record contribution revenue instead of a liability. The beneficiary makes no entry until the gift is received because of the uncertainty involved. The identity of the ultimate recipient may still change. Here, the charity initially receiving the gift records both revenue and, eventually, an expense for the contribution even though it was not the original donor. 12. The value of donated services is recognized by a private not-for-profit entity if the service (a) creates or enhances a nonfinancial asset (such as adding a room to a building) or (b) requires a specialized skill possessed by the donor that would have been purchased by the organization except for the gift. An example of this second criterion is the donation of medical services by a surgeon to a children’s hospital. If the service is donated by an affiliated entity, recognition is still necessary based usually on the cost paid to those workers. 13. Except in specified situations, the costs of a direct mailing that contains a solicitation for funds is classified entirely as a fundraising (supporting services) expense. However, within certain guidelines, these costs can be allocated in a logical manner between supporting services and program services. Allocation becomes necessary when the mailing has a specific call for action that would have been made even without the fundraising solicitation. 18-6 .
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Chapter 18 - Accounting and Reporting for Private Not-for-Profit Entities
This call for action must further the mission of the entity and the appeal cannot be made purely to potential donors. For example, assume a mailing was sent out by a private not-for-profit blood service asking all previous blood donors to donate blood during the next six weeks. Assume further that this call for action was accompanied by a request for monetary donations. All of the direct mail costs should probably be allocated between program service costs and supporting service costs. 14. Unconditional promises to give must be recorded immediately by a private not-for-profit entity at present value (if not to be received within the next year) and net of an allowance for uncollectible amounts. An unconditional promise is one that requires no future service or action by the charity. 15. An unconditional promise to give is recorded immediately by the private not-for-profit entity that anticipates receiving the gift. Conversely, an intention to give is not recorded. In practice, the difference between the two can be rather subtle. If donors have the ability or the right to change their minds, the assumption is that they have only expressed their intention to make a gift at some time in the future but have not yet made an unconditional promise. If an action is required of the charity in advance of the gift, the promise is not unconditional. 16. A number of private not-for-profit entities collect dues from their membership and also receive contributions. Dues are considered earned revenues rather than contributions if the member receives a benefit in return. That benefit can take the form of a periodic newsletter or journal or can be the use of the facilities (such as at the YMCA) and services provided by the entity. However, if nothing of value is really being given to the member, the dues are considered to be merely donations. Often, an allocation must be made between the portion of the membership dues that qualifies as revenue and the part that is viewed as a contribution. 17. If a not-for-profit entity gains control over another entity, combined financial statements should be prepared. This type of transaction is viewed as an acquisition. If two not-for-profit entities come together to form a new (third) not-for-profit with a new governing board, combined statements are also needed. However, this event is viewed as a merger. 18. Because one party gained control over the other, this transaction is viewed as an acquisition. Here, the acquisition value is in excess of the fair value of all identifiable assets and liabilities by $200,000 ($2.3 million less $2.1 million). In a for-profit consolidation, this excess is reported as goodwill. The same handling is often true for combined statements created when a not-for-profit entity gains control over another. However, if the acquired entity is expected to be predominantly supported by contributions and investment income, then the extra $200,000 is reported as a reduction in unrestricted net assets on the statement of activities. In that situation, the amount is not capitalized as goodwill.
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Chapter 18 - Accounting and Reporting for Private Not-for-Profit Entities
19. If Helping Hand acquires Fancy Fingers, then the reported value of the equipment on consolidated statements is $2.3 million. That figure is the net carrying value reported by Helping Hand ($1.1 million) plus the fair value of the property held by Fancy Fingers ($1.2 million). If Fancy Fingers acquires Helping Hand, then the reported value for the equipment will be $2.4 million. That figure is the net carrying value reported by Fancy Fingers ($1.0 million) plus the fair value of the property held by Helping Hand ($1.4 million). If the two companies are brought together to form a new third entity under a new governing board, the equipment is reported at $2.1 million. This transaction is a merger and the carryover method is used. The reported figure is the combination of the net carrying value of these assets from both sets of financial statements ($1.1 million plus $1.0 million). 20. A third-party payor is any outside entity who assumes responsibility for a portion or even all of a patient's medical charges. The most commonly encountered third-party payors include insurance companies, Medicare, and the like. Because third parties bear a significant portion of the medical costs in this country, they are able to demand extensive as well as accurate financial information. Health care entities have long been required, therefore, to develop and maintain accounting systems that provide this needed data. 21. A contractual adjustment refers to a portion of a patient's charged fee that a health care entity estimates will not be received because of agreements with third-party payors. These arrangements specify that the provider (the health care entity) is willing to accept an amount that is less than its normal charge if the third-party payor determines that the lesser figure is reasonable for the services rendered. As an example, if a hospital charges $272,000 for a specific service but the third-party payor responsible for payment remits only $195,000 (based on its determination of reasonable costs for this service in this area of the world), the hospital must accept that amount as payment in full. The $77,000 reduction is recorded by the hospital as a contractual adjustment. These reductions may take an extended period of time to finalize. Thus, the expected amount of these reductions is estimated by the health care entity so that they can be recorded at the time that the original invoice is submitted. 22. Charity care is not recorded by a not-for-profit health care entity because the service was performed for patients with no real ability to pay. However, the financial impact of that decision needs to be disclosed. Therefore, the cost of such charity care must be reported in a disclosure note to the financial statements.
Answers to Problems 1. D (Amounts charged to patients less contractual adjustments and the provision for bad debts)
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Chapter 18 - Accounting and Reporting for Private Not-for-Profit Entities
2. A 3. B (Private NFPs report depreciation expense. A public university is normally reported as an Enterprise Fund. Enterprise Funds also record depreciation expense.) 4. B (Permanently restricted net assets have increased by only $120,000.) 5. B (Because the donor continues to have control, an asset [a receivable] will be reported until the gift is conveyed to Charity Two. As a result of this uncertainty, Charity Two reports nothing until the money is actually received.) 6. B (For private schools, financial aid is shown as a direct reduction to the tuition revenue so that revenues and support here should total only $780,000.) 7. C (The work of the librarian does not enhance a nonfinancial asset nor does it require a specialized skill that would be purchased if not donated.) 8. D (If the other information that is included contains a call for a specific action that will help accomplish the mission of the charity and if the mailing is not directed solely to potential donors, a portion of the costs can be allocated to program service expenses. Otherwise, all of the cost is assigned to supporting services.) 9. A (In its original standards for not-for-profit entities, FASB wanted to get away from financial reporting based on fund accounting. The statements were designed to provide information about the private not-for-profit entity as a whole.) 10. C (The money to be used for the building is temporarily restricted for that purpose whereas the other $2 million is permanently restricted so that only the subsequent income earned can be used.) 11. C (Although an investment was sold to generate this cash, that asset was received from a donor and was liquidated almost immediately upon receipt. FASB has held that this is an operating activity cash inflow. 12. C (Because the accountant has a specialized skill that would otherwise have to be acquired, the donated service is reported. The amount paid by the affiliated entity is used for recording purpose since it mirrors fair value here.) 13. A (Patient service revenue is reduced by any charity care services. That amount is not recorded because the entity does not expect to be paid. In 18-9 .
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Chapter 18 - Accounting and Reporting for Private Not-for-Profit Entities
addition, a direct reduction is shown for the provision for doubtful accounts. Thus, net patient service revenue is $1 million less $94,000 and $200,000 or $706,000.) 14. C (Charity care is not recorded by a not-for-profit health care entity because the entity provided services for individuals with no ability to pay. The financial impact of that decision must be disclosed in a note to the financial statements that provides information about the direct and indirect costs of these services.) 15. D (The charity must convey the donation to the designated beneficiary. Unless the charity was given variance powers that allowed it to change the beneficiary, this donation represents a liability to the Jones family. The gift is simply being passed through the charity [in the form of furniture] to the ultimate beneficiary.) 16. B (In this way, no financial benefit accrues to the charity from the sale of the artifact.) 17. A (Because of the time restriction, the amount spent for playground equipment remains in temporarily restricted net assets until depreciated. The equipment was bought at the end of the current year so that no depreciation was recorded and no reclassification was made. The $80,000 was properly spent on the salaries for the teachers and must be reclassified from temporarily restricted net assets to unrestricted net assets when the expense is recognized.) 18. A (The key factor here is that YZ is expected to be predominantly supported by contributions. Thus, future exchange revenues will likely be minor. The acquisition value ($1 million) in excess of the fair value of all assets and liabilities ($700,000) is $300,000. Because most support comes from contributions and investment income, this $300,000 is charged off against unrestricted net assets on the statement of activities. No goodwill is recognized.) 19. A (When two not-for-profit entities come together to form a new not-for-profit entity with a new governing board, a merger has occurred. In reporting a merger, the carryover method is used. Thus, book value of individual assets and liabilities is retained. The $300,000 book value for BC’s land plus the $500,000 book value for OP’s land gives a reported land account of $800,000.) 20. B (This transaction is an acquisition and the acquired entity is not supported predominantly by contributions or investment income. Thus, the difference in the acquisition value of Northeast ($980,000) and the fair value of the two
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Chapter 18 - Accounting and Reporting for Private Not-for-Profit Entities
recognized assets ($950,000 or $150,000 plus $800,000) is recognized as goodwill.) 21. D 22. C 23. C 24. C (The charity care work should not be recorded in any way because the entity has no expectation of collection. That reduction drops the reported amount for patient service revenue to $600,000. The contractual adjustment is reported as a contra balance to the revenue reducing it to a net amount of $400,000. Likewise, the provision for bad debts reduces the net patient service revenue another $100,000 to $300,000.) 25. B (Use of the money is limited to the donor’s specified purpose.) 26. B (This donated service meets the rules for recognition. The expense and the contributed support are both reported.) 27. A (Form 990 is the annual informational form that most tax-exempt organizations are required to file by the IRS.) 28. A (As an educational institution, Belwood University will qualify as a 501(c)(3) tax-exempt organization.) 29. D (These volunteer services, although important, do not meet the criteria for recognition. They do not require a specialized skill that would be otherwise purchased. They do not enhance a nonfinancial asset.) 30. B (The gift was not specifically designated for this particular family so the entity recognizes both the revenue and expense.) 31. A (The work performed requires a specialized skill that would otherwise have to be acquired by the not-for-profit entity.) 32. B 33. A (The fundraising costs and administrative salaries are supporting service expenses.) 34. B 35. D
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Chapter 18 - Accounting and Reporting for Private Not-for-Profit Entities
36. (10 minutes) (Reporting of various account balances by a not-for-profit health care entity) Donated medicines = an asset is reported as well as an increase in unrestricted net assets because of the contribution Donated services (replacing salaried workers) = the fair value of the services contributed causes an increase in unrestricted net assets along with an accompanying decrease in unrestricted net assets because the expense is also recognized Donated services (not replacing salaried workers) = not recorded Interest income = revenue is an increase in unrestricted net assets Charges to patients = increase in unrestricted net assets shown as net patient service revenues Charity care = not recorded if the entity has no intention of seeking collection; if an amount has been recorded, it must be removed from the receivable and the revenue. Provision for bad debts = amount is anticipated and this provision for bad debts is reported as a direct reduction in patient service revenues to arrive at net patient service revenues. 37. (15 Minutes) (Series of questions about the reporting of health care entities) a. A third-party payor is an entity (such as Medicare or an insurance company) that pays a portion, or all, of a patient's medical expenses. They are common due to the extremely high cost of medical care. Because of their need for accurate financial information, such third party payors have exerted pressure on health care entities over the decades to develop adequate accounting principles and reliable accounting systems. b. A contractual adjustment is a reduction to patient service revenues created when a lesser amount is paid by a third-party payor than the billed amount but is still accepted as payment in full by a health care entity. These outside parties often establish contractual arrangements whereby the health care entity agrees to accept a lower amount for a service if the third party determines the figure to be reasonable in that particular area. These contractual adjustments create an accounting problem for the health care entity because the amount that eventually will be collected is not always known. Thus, the entity recognizes the full amount of the invoice as patient service revenue at the time the service is performed. The entity then estimates and establishes an offsetting Contractual Adjustment account to reduce the net reported revenue to the amount anticipated as being collected. c. At the time that materials are donated to a health care entity (or any private not-for-profit entity), the asset is recorded at fair value. Because of the donation, the contribution is recognized as an increase in unrestricted net assets. If the asset has a finite life, officials can assume a time restriction on 18-12 .
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Chapter 18 - Accounting and Reporting for Private Not-for-Profit Entities
the use of the asset so that the contribution is reported initially as an increase in temporarily restricted net assets. An amount is also reclassified to unrestricted net assets each period equal to depreciation expense. Donated services are recorded as a contribution increasing unrestricted net assets and as salary expense also within unrestricted net assets. FASB requires private not-for-profit entities to recognize donated services but only if they (a) enhance nonfinancial assets or (b) require specialized skills, are provided by individuals possessing those skills, and would need to be purchased if not provided by donation. If the donated service enhances a nonfinancial asset, an increase in the asset’s reported balance is recognized rather than as salary expense. 38. (6 Minutes) (Reporting of various accounts by a not-for-profit entity) Only $7.6 million is reported as patient service revenues. Charity care of $1.4 million is not recorded because no attempt at collection is anticipated. Then, the $800,000 contractual adjustment is netted with the revenue to leave the hospital with a net patient service revenue figure to report of $6.8 million. The supplies are recorded at their $4,000 value with an offsetting increase in unrestricted net assets as a result of the contribution. As the supplies are used, the $4,000 asset will be reclassified as an expense. 39. a). (8 Minutes) (Recording donations by a voluntary health and welfare entity) Pledges .......................................................................... Anticipated Amount Deemed to be Uncollectible (15%) Net Pledge Balance ...................................................
$600,000 (90,000) $510,000
Increase in Unrestricted Net Assets in 2015— Contributed Support (60% of above) .......................
$306,000
Increase in Temporarily Restricted Net Assets in 2015—Contributed Support (40% of above) ............
$204,000
b). Both contributed support and salary expense are recognized as $12,000 ($20 per hour times 600 hours) within unrestricted net assets. No overall effect is created on net assets but impact of the donation is reflected. 40. (65 Minutes) (Preparation of statements for a private not-for-profit entity) a. Statement of Activities Public Support a. Contributions
Unrestricted Net Assets
Temporarily Restricted Net Assets
$210,000
$78,000 18-13
.
.
Permanently Restricted Net Assets
Chapter 18 - Accounting and Reporting for Private Not-for-Profit Entities
b. Contribution—Interest
3,000
Revenue c. Membership dues d. Investment income
30,000 3,900
9,100
e. Net assets released from restriction
72,000
(72,000)
Total Public Support and Revenue
$315,900
$18,100
Expenses Program service expenses —Cure disease f. Salaries g. Depreciation h. Supplies Total
(26,500) (16,000) (93,000) (135,500)
Supporting service expenses – General and administrative i. Salaries j. Depreciation Total
(32,000) (2,000) (34,000)
– Fundraising k. Salaries l. Advertising m. Depreciation Total
(26,500) (2,000) (2,000) (30,500)
Total Expenses
(200,000)
Change in Net Assets
$115,900
$18,100
-0-
Net Assets - Beginning of Year
400,000
200,000
$100,000
Net Assets - End of Year
$515,900
$218,100
$100,000
18-14 .
.
Chapter 18 - Accounting and Reporting for Private Not-for-Profit Entities
40. (continued) Explanation of Balances a. Contributions. The balances to be reported are the unrestricted gifts ($210,000) plus present value of unrestricted pledge ($78,000). Pledge is viewed as temporarily restricted because it will not be collected for three years. b. Contribution-Interest. The pledge is recorded at its present value of $78,000. Interest that is recognized to raise the balance to the pledge amount is reported as a contribution. c. Membership dues. The amount received is shown as revenue and not as public support because rights are being conveyed to the members equal in value to the amount collected. d. Investment income. Although this income ($13,000) is earned on permanently restricted net assets, 70 percent is shown as temporarily restricted because the donor has specified that it must be spent on advertising. The remaining 30 percent is unrestricted. e. Net assets released from restriction. Three restricted amounts were properly spent during the period: $20,000 for salaries, $50,000 for equipment, and $2,000 for advertising. No implied time restriction was assumed for the equipment so the entire reclassification was made immediately. f. Salaries. During the period, $24,000 in salaries were paid (30 percent of $80,000 was assigned here) and another $2,500 was owed at the end of the year (50 percent of year-end accrual). g. Depreciation. Of the total expense ($20,000) for the period, 80 percent was allocated to program service expenses because that amount of the equipment was used for that purpose. h. Supplies. A total of $93,000 was acquired and used during the year. i. Salaries. Administrative salaries amounted to $32,000 for the year (40 percent of overall total). j. Depreciation. Of the total for the period, 10 percent was allocated to general and administrative expenses. k. Salaries. During the period, $24,000 was paid in salaries (30 percent of $80,000 was assigned here) and another $2,500 was owed at the end of the year (50 percent of year-end accrual). l. Advertising. Only $2,000 in advertising costs were incurred during the period. m. Depreciation. Of the total for the period ($20,000), 10 percent was allocated to fundraising expenses. ---Because it qualifies as a museum piece, recording of the painting is optional. Officials do not want to report the painting, and they are not required to do so. ---The $10,000 gift must be conveyed to an outside beneficiary and is reported by the not-for-profit entity as a liability.
18-15 .
.
Chapter 18 - Accounting and Reporting for Private Not-for-Profit Entities
40. (continued) b. Statement of Financial Position Assets a. Cash b. Pledge Receivable c. Equipment d. Accumulated Depreciation Total Assets
$738,000 81,000 $300,000 (20,000)
280,000 $1,099,000
Liabilities e. Salaries Payable f. Notes Payable g. Donated Amount Due to Separate Entity
$5,000 250,000
Net Assets (see Statement of Activities) Unrestricted Temporarily Restricted Permanently Restricted
10,000
$265,000
$515,900 218,100 100,000
834,000
Explanation of Balances: a. Cash. The final balance is the beginning cash figure of $700,000 plus $210,000 in contributions, less $80,000 for salaries, less $50,000 for equipment, plus $30,000 in membership dues, plus $10,000 contribution that must be conveyed to a separate entity, plus $13,000 investment income, less $2,000 paid for advertising, and less $93,000 paid for supplies. b. Pledges receivable. The amount to be reported is the present value as of the end of the year (the original $78,000 plus the $3,000 interest recognized for the period). c. Equipment. Entity acquired $300,000 of equipment during the year. d. Accumulated Depreciation. The $20,000 amount of depreciation recorded for this initial year of ownership. e. Salaries Payable. The amount owed to employees as of the end of the year. f. Notes Payable. The liability incurred in acquiring equipment. g. Donated Amount Due to Separate Entity. Amount given by a donor that must be conveyed to a separate organization. The amount must be shown as a liability since no mention was made that the entity here had variance powers that would allow it to change the beneficiary.
18-16 .
.
Chapter 18 - Accounting and Reporting for Private Not-for-Profit Entities
41. (50 Minutes) (Effect of various transactions on unrestricted and restricted net assets) a. Investments—Internally Restricted .............................. Cash ......................................................................
160,000
b. Cash ................................................................................. Contributed Support— Permanently Restricted Net Assets ................
80,000
c. Inventory of Medicines ................................................... Cash ......................................................................
25,000
Reclassification—Temporarily Restricted Net Assets ............................................... Reclassification—Unrestricted Net Assets .......................................................
160,000
80,000
25,000
25,000 25,000
d. Accounts Receivable—Patients .................................... Accounts receivable—Third-Party Payors ........................................................................ Patient service revenues .....................................
120,000
e. Depreciation Expense .................................................... Accumulated Depreciation ..................................
38,000
f. Cash ................................................................................. Interest Revenue— Unrestricted Net Assets (internally restricted)
15,000
g. Provision for Bad Debts ................................................. Allowance for Uncollectible Accounts .........................................................
20,000
Contractual Adjustment ................................................. Allowance for Reduced Charges ........................
30,000
18-17 .
.
480,000 600,000
38,000
15,000
20,000
30,000
Chapter 18 - Accounting and Reporting for Private Not-for-Profit Entities
41. (continued) h. Supplies Expense .......................................................... Inventory of Medicines ........................................
25,000
i. Cash ................................................................................ Investments—Internally Restricted .................... Gain on Sale of Investments—Unrestricted Net Assets .......................................................
172,000
Equipment ....................................................................... Cash ($172,000 + $15,000 + $25,000) ..................
212,000
Reclassification—Temporarily Restricted Net Assets ............................................... Reclassification—Unrestricted Net Assets ....................................................... j. Cash ................................................................................. Pledges Receivable (present value) .............................. Allowance for Uncollectible Pledges .................. Contributed Support—Unrestricted Net Assets ....................................................... Contributed Support—Temporarily Restricted Net Assets .....................................
18-18 .
.
25,000
160,000 12,000
212,000
25,000 25,000 12,600 98,000 9,000 12,600 89,000
Chapter 18 - Accounting and Reporting for Private Not-for-Profit Entities
41. (continued) Unrestricted Net Assets
Calculation of Changes in Net Assets Temporarily Restricted Permanently Restricted Net Assets Net Assets
a. No change b. Donation— Income for Salaries
80,000
c. Stipulation Met—Reclassification
25,000
d. Patient Services
600,000
e. Depreciation
(38,000)
f. Interest
15,000
g. Bad Debts
(20,000)
Contractual Adjustment
(30,000)
(25,000)
h. Supplies Expense
(25,000)
i. Gain on Investments
12,000
Stipulation Met—Reclassification
25,000
(25,000)
12,600
89,000
576,600
39,000
j. Pledges Increase (Decrease) In Net Assets
18-19 .
.
80,000
Chapter 18 - Accounting and Reporting for Private Not-for-Profit Entities
42. (70 minutes) (Produce journal entries for a private university as well as a statement of activities) a. Tuition Receivable Tuition Revenues
1,200,000 1,200,000
b. Investments Contributions—Permanently Restricted Net Assets
300,000
c. Cash Contributions—Temporarily Restricted Net Assets
700,000
d. Scholarships—Financial Aid Tuition Receivable
100,000
e. Salary Expenses Cash
310,000
f. Salary Expense Contributed Support— Unrestricted Net Assets
80,000
g. Equipment Cash
200,000
300,000
700,000
100,000
310,000
80,000
200,000
Temporarily Restricted Net Assets— Reclassification Unrestricted Net Assets— Reclassification
200,000
h. Investments Unrealized Gain on Investments— Permanently Restricted Net Assets
30,000
i. Cash Dividend Revenue—Unrestricted Net Assets
9,000
j. Depreciation Expense Accumulated Depreciation
32,000
30,000
9,000
32,000
k. Cash—Internally Restricted Cash 42. (continued)
100,000 100,000
18-20 .
200,000
.
Chapter 18 - Accounting and Reporting for Private Not-for-Profit Entities
l. Pledge Receivable Contribution—Temporarily Restricted Net Assets
7,000 7,000
m. No entry because of choice made by officials n. Utilities and Other Expenses Cash
212,000 212,000
o. No entry—does not require a specialized skill.
18-21 .
.
Chapter 18 - Accounting and Reporting for Private Not-for-Profit Entities
42. (continued) University of Danville Statement of Activities Unrestricted Net Assets Revenues and Gains -Tuition 1,200,000 -Scholarships (100,000)
Temporarily Restricted Net Assets
1,100,000
-Unrealized Gain on Investments -Dividend Revenue
9,000
Contributions -Cash and Other Assets -Services
80,000
Total
1,100,000
30,000
30,000 9,000
707,000
300,000
1,007,000 80,000
330,000
2,226,000
330,000
2,226,000
Total Revenues, Gains, And Contributions
1,189,000
707,000
Net Assets Released From Restriction
200,000
(200,000)
1,389,000
507,000
Totals
Permanently Restricted Net Assets
Operating Expenses -Salaries -Depreciation 32,000 -Utilities and Other Expenses
390,000 32,000
390,000
212,000
212,000
Total Expenses
634,000
634,000
Increase in Net Assets
755,000
507,000
330,000
1,592,000
Net Assets—Beginning Of Year
400,000
200,000
100,000
700,000
1,155,000
707,000
430,000
2,292,000
Net Assets—End of Year
43. (30 Minutes) (Series of questions about private not-for-profit entities) a. Many private non-for-profit entities depend heavily on gifts and grants from outside parties. An earning process is not present in connection with such conveyances. Asset inflows are simply created by donations. Such amounts are reported as public (or contributed) support. These same entities, however, 18-22 .
.
Chapter 18 - Accounting and Reporting for Private Not-for-Profit Entities
do sometimes earn (in an accounting sense) some of the funds that are received. Membership dues, for example, are not viewed as gifts if rights that have value are conveyed to the members. A not-for-profit entity might also gain assets from sources such as interest or dividend income. Money derived in this fashion is not a donation and is, thus, recorded as earned revenue. b. A statement of functional expenses is required to be included in the financial statements of voluntary health or welfare entities and is permitted for all other private not-for-profits. This statement enables readers to determine the ultimate usage of the money that has been raised. Expenses are separated according to program service expenses (directed towards activities that relate to the entity’s goals and mission) and supporting service expenses (dealing with the cost of running the entity and raising funds). This statement permits interested parties such as potential donors to see the utilization made of the not-for-profit entity’s resources. c. Some charities (Goodwill Industries and the Salvation Army, for example) receive a large amount of contributions in the form of donated materials such as clothing and furniture. If the value of these goods has a clearly measurable basis, recording the gifts as contributed support is appropriate. d. A not-for-profit entity may receive gifts (or unconditional promises to give) from outside parties that (1) must be expended for a particular purpose or (2) cannot be expended until a particular point in the future. Because the organization does not have free use of these assets, they are included within "Temporarily Restricted Net Assets." At the time that the stipulation is met or the designated time period arrives, the asset is reclassified into the Unrestricted Net Asset category. Other gifts may be given where the donor specifies that only subsequent income can be expended (frequently for a designated purpose). Because the assets received in the original gift cannot be expended, they are included within the “Permanently Restricted Net Assets." e. Donated services are extremely common in the operation of many not-forprofit entities. Literally thousands of individuals solicit funds for entities such as the Heart Fund, Salvation Army, and March of Dimes. In addition, individuals often voluntarily fill positions of responsibility throughout many of these not-for-profits. Donated services are formally recognized in the accounting records but only if one of two specific circumstances are met: 1. The service creates or enhances a nonfinancial asset or 2. The service requires a specialized skill possessed by the donor that the entity would have had to be purchased if not donated. 18-23 .
.
Chapter 18 - Accounting and Reporting for Private Not-for-Profit Entities
f. Prior to 1987, the costs of direct mailings and other solicitations for support were recorded by private not-for-profit entities as fundraising expenses even if educational materials were included. In that year, this requirement was modified so that an allocation of the joint costs could be made between educational expenses (a program service cost) and fundraising (a supporting service cost). Some entities took advantage of this rule. They included educational materials with their fundraising appeals because they could allocate part of the mailing and other distribution costs to program services which made their statements look like these entities were spending more to meet their goals. In 1998, the AICPA issued its Statement of Position 98-2 “Accounting for Costs of Activities of Not-for-Profit Organizations and State and Local Governmental Entities That Include Fund-Raising” which is now part of the FASB Accounting Standards Codification. This rule stated that direct mailing costs should be assigned entirely to fundraising costs unless a specific call for action was being included that was not limited to potential donors. This call for action had to be one that would further the mission of the not-for-profit. If these requirements were met, a logical portion of the direct mailing costs could be assigned to program service expenses. Otherwise, the entire cost is included within fundraising. g. Donated materials are normally reported as assets at their fair value accompanied by an increase in unrestricted net assets (see answer [c] above). However, the recording of art works, historical treasures, museum pieces, and the like is optional. An item qualifies for such treatment if (1) it is part of a collection for public exhibition, education, or research, (2) it is protected and preserved, and (3) if sold, the money received must be used to acquire other collection items. If these criteria are all met, no recording is required (although recording is allowed). 44. (25 Minutes) (Determine impact of various transactions on a private college.) (1)---False. The January 1, Year 1, restriction is an internal action and, therefore, causes no changes in the amount of unrestricted net assets. Such changes can only be created by external donors. (2)---True. The stipulation of the April 1, Year 1, gift is that only subsequent cash income can be used for the designated purpose. Therefore, changes in value are shown as adjustments to the permanently restricted net assets. The interest income earned during the year is temporarily restricted (3)---True. As indicated in (2), the donor has indicated that only cash income can be used for the football stadium. The change in value increases (or decreases) the amount held as permanently restricted net assets. (4)---True. The school has properly spent the $500,000 earned on the donated investments. The school has not set a policy that assumes a time restriction on 18-24 .
.
Chapter 18 - Accounting and Reporting for Private Not-for-Profit Entities
the use of this stadium. Therefore, the reclassification to unrestricted net assets is made immediately at the time of proper expenditure. Spending of the boarddesignated $1.9 million does not change the amount of net unrestricted assets— just the composition. (5)---False. Depreciation expense is appropriate for all long-lived assets with a finite life regardless of the policy of the school. A time restriction indicates when any related donations for this project are released from restriction. (6)---False. This is the same answer as in (5). Depreciation expense is appropriate for all long-lived assets with a finite life regardless of the policy of the school about use of the property. (7)---True. The acquisition of the football stadium seat has two effects. Because the value of that seat for watching football games is $12,000, the school should recognize that amount as revenue. Dr. Johnson paid an extra $18,000, apparently as a gift to the school. (8)---True. This answer is the same as in (7). Dr. Johnson paid an extra $18,000, apparently as a gift to the school. (9)---True. These donated services meet the requirement for being reported so that contributed service support as well as a salary expense are recognized for the $14,000 value. (10)---False. Based on the information given, both the contributed support and the expense must be reported. “Might” implies an option which is not available for this type of donation. If a donated service meets the criteria, it is reported. (11)---False. This answer is the same as in (10). Both the contributed support and the expense must be reported. Unrestricted net assets both go up (for the contribution support) and go down (for the salary expense). (12)---False. If this painting does not qualify as a work of art, the school must record the asset at $30,000 along with a contribution of that same amount. However, if the painting qualifies as a work of art, the school can either make this entry or simply make no entry. Therefore, under one set of circumstances, recognition of a contribution is not required. (13)---False. As in answer (12), the handling depends on whether this painting qualifies as a work of art. However, if the value of the donated gift is $30,000, no situation can exist where the school is not allowed to recognize revenue. 45. (30 Minutes) (Determine changes in net asset balances for several different types of transactions) 18-25 .
.
Chapter 18 - Accounting and Reporting for Private Not-for-Profit Entities
Part (1) --Unrestricted Net Assets – No net change. When the $22,000 in designated funds is spent as designated, a reclassification of that amount is made into Unrestricted Net Assets. At that time, though, a faculty salary expense of the same amount is also recognized. The two amounts balance out for no net impact on Unrestricted Net Assets. --Temporarily Restricted Net Assets – Category increases by $9,000. The $31,000 of investment income increases this category because its use is restricted. However, it is then reduced by the $22,000 reclassified into Unrestricted Net Assets because that amount is properly spent. --Permanently Restricted Net Assets – Category increases by $400,000. The current donation increases this category. Because subsequent income must be spent for salaries, it increases Temporarily Restricted Net Assets. Part (2) --Unrestricted Net Assets – No net change. Because of the restriction on the use of the machine for this period of time, the $200,000 gift is initially reported as an increase in Temporarily Restricted Net Assets. At the end of the year, the asset balance will be reduced by $20,000 in depreciation. Thus, a $20,000 reclassification moves $20,000 from Temporarily Restricted Net Assets to Unrestricted Net Assets. That $20,000 increase will exactly offset the $20,000 in depreciation expense also recognized within Unrestricted Net Assets. --Temporarily Restricted Net Assets – Category Increases by $180,000. Because of the restriction on the time use of the asset, the $200,000 is initially recorded in Temporarily Restricted Net Assets. The $20,000 reclassification discussed above reduces that net increase to $180,000. --Operating Expenses – Category increases by the $20,000 in depreciation expense for the year. Part (3) --Unrestricted Net Assets – Category increases by $1.6 million. The tuition revenue of $2 milion is reduced by the $700,000 in financial aid for a net increase of $1.3 million. However, because $300,000 of previously restricted net assets was used here, a reclassification of that amount from Temporarily Restricted Net Assets to Unrestricted Net Assets causes the overall increase to be $1.6 million. --Operating Expenses – There are no operating expenses. Financial aid is a reduction to tuition revenue and not an operating expense. --Temporarily Restricted Net Assets – Category decreases by $300,000. Money that had previously been restricted was properly utilized. Thus, a reclassification of this amount is reported. 46. (65 Minutes) (Prepare financial statements for a private not-for-profit entity.) a. Entries for this not-for-profit entity are presented below. The numbers in parenthesis indicate account totals at that point in time. This method is used as an easy way to monitor account balances. 18-26 .
.
Chapter 18 - Accounting and Reporting for Private Not-for-Profit Entities
Contributions receivable ........................... 20,000 Contributed support—interest--unrestricted net assets ........................................... Cash .......................................................... 100,000 Allowance for uncollectible pledges ........ 4,000 Contributions receivable ....................... Cash .......................................................... 180,000 Contributed support—unrestricted net assets ............................................. Salary expense ........................................... Cash ..................................................... Reclassification - temporarily restricted net assets.................................................. Reclassification - unrestricted net assets ....................................................
20,000
104,000
(net of 120,000) (380,000)
180,000
(180,000)
90,000
( 90,000) (290,000)
15,000
Land, buildings, and equipment .............. 500,000 Note payable ........................................... Cash .....................................................
( 20,000) (200,000)
90,000
Cash .......................................................... 12,000 Contributed support—temporarily restricted (To record gift to go to a specified beneficiary. Entity records this contribution because it holds variance powers.)
Reclassification - temporarily restricted net assets.................................................. Reclassification - unrestricted net assets .................................................... (To record reclassification of restricted amount properly spent.)
(220,000)
( 15,000) 15,000
( 15,000)
12,000
(302,000) ( 12,000)
450,000 50,000
(700,000) (450,000) (252,000)
50,000
( 65,000) 50,000
( 65,000)
30,000
(282,000) ( 30,000)
46. (continued) Cash ........................................................... 30,000 Membership revenue—unrestricted net assets (Membership dues are listed as revenues and not as contributions because members receive substantial benefits.) 18-27 .
.
Chapter 18 - Accounting and Reporting for Private Not-for-Profit Entities
Cash ............................................................ 30,000 Investment revenue—unrestricted net assets (Income is earned on permanently restricted net assets but use of the income is unrestricted.) Rent expense .............................................. Advertising expense ................................. Utilities expense ........................................ Cash .....................................................
30,000
(312,000) ( 30,000)
43,000
( 12,000) ( 15,000) ( 16,000) (269,000)
12,000 15,000 16,000
Contributions receivable ........................... 149,000 Contributed support—temporarily restricted net assets ........................................... (Although pledge is unrestricted, it will not be collected for five years and, therefore, the proceeds are viewed as temporarily restricted.)
(269,000) 149,000
(161,000)
Contributions receivable ........................... 6,000 Contributed support—interest--temporarily restricted net assets ........................
6,000
(
Depreciation expense ............................... Land, buildings, and equipment .........
40,000 40,000
( 40,000) (660,000)
Interest expense ......................................... Cash .....................................................
15,000 15,000
( 15,000) (254,000)
18-28 .
.
(275,000) 6,000)
Chapter 18 - Accounting and Reporting for Private Not-for-Profit Entities
46. (continued) Based on the final balances computed above, the following statements can be prepared.
WATSON FOUNDATION STATEMENT OF ACTIVITIES For Year Ending December 31, 2015 Temporarily Restricted Net Assets $ 161,000 6,000
Permanently Restricted Net Assets
_______ $ 167,000
________
65,000
( 65,000)
________
Total support, revenues, and net Assets released from restriction $ 325,000
$ 102,000
________
Contributed support Contributions -- interest Investment revenue Membership revenue Total support and revenues Net assets released from restriction
Unrestricted Net Assets $ 180,000 20,000 30,000 30,000 $ 260,000
Expenses: General and administrative —Rent —Salary —Advertising —Utilities —Depreciation —Interest
$ (12,000) (90,000) (15,000) (16,000) (40,000) (15,000)
Total expenses
$(188,000)
Excess of total support, revenues and net assets released from restriction over expenses $137,000
$102,000
-0-
Net assets at beginning of year
400,000
100,000
$300,000
Net assets at end of year
$537,000
$202,000
$300,000
46. (continued) 18-29 .
.
Chapter 18 - Accounting and Reporting for Private Not-for-Profit Entities
b. WATSON FOUNDATION STATEMENT OF FINANCIAL POSITION December 31, 2015 ASSETS Cash Contributions receivable (net) Investments Land, buildings, and equipment (net) Total assets
$ 254,000 275,000 300,000 660,000 1,489,000
LIABILITIES Notes payable
450,000
NET ASSETS - Unrestricted - Temporarily restricted - Permanently restricted
$537,000 202,000 300,000
$1,039,000
47. (40 minutes) (Accounting for mergers and acquisitions) a. In an acquisition, the assets and liabilities of the acquired entity are included at fair value. Thus, the buildings and equipment reported by Swim For Safety must be increased by $140,000 from $590,000 to $730,000. Because the acquisition value ($1 million) exceeds the total fair value recognized for the individual assets and liabilities ($1,470,000 plus $140,000 less $690,000 or $920,000), the excess ($80,000 in this case) is reported as goodwill. Goodwill is reported because Swim For Safety is primarily supported by contributions and investment income. Cash held by Help & Save must be reduced by the $1 million payment as must the balance shown for its unrestricted net assets. The increases in the buildings & equipment ($140,000) as well as the increase in goodwill ($80,000) are reflected by increases in unrestricted net assets since no external restriction is in place for these assets. Balances To Be Reported: --Cash - $1,100,000 ($1,600,000 less $1,000,000 plus $500,000) --Contributions receivable (net) - $280,000 ($70,000 plus $210,000) --Investments - $470,000 ($300,000 plus $170,000) --Buildings & equipment - $1,430,000 ($700,000 plus $730,000) 47.(c ontinued) 18-30 .
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Chapter 18 - Accounting and Reporting for Private Not-for-Profit Entities
--Goodwill - $80,000 (above) --Total assets - $3,360,000 (summation) --Accounts payable and accrued liabilities - $180,000 ($110,000 plus $70,000) --Notes payable - $1,720,000 ($1,100,000 plus $620,000) --Total liabilities - $1,900,000 (summation) --Unrestricted net assets - $740,000 ($1,100,000 less $1,000,000 payment plus $140,000 increase in buildings and equipment plus $80,000 in goodwill plus $420,000 from Swim for Safety) --Temporarily restricted net assets - $440,000 ($250,000 plus $190,000) --Permanently restricted net assets - $280,000 ($110,000 plus $170,000) --Total net assets - $1,460,000 (summation) --Total liabilities and net assets - $3,360,000 ($1,900,000 plus $1,460,000) b. In an acquisition, the assets and liabilities of the acquired entity are included at fair value. Thus, the buildings and equipment reported by Swim For Safety must be increased by $140,000 from $590,000 to $730,000. Because the acquisition value ($990,000) exceeds the total fair value recognized for the individual assets and liabilities ($1,470,000 plus $140,000 less $690,000 or $920,000), the excess ($70,000 in this case) is normally reported as goodwill. However, one exception is made. If the acquired company is predominantly supported by contributions and investment income (as is the case here), then the excess $70,000 is not recognized as an asset. Instead, the excess $70,000 within the $990,000 payment is reported as an immediate reduction in unrestricted net assets with no accompanying increase in goodwill. Cash held by Help & Save must be reduced by the $990,000 payment as must the balance shown for its unrestricted net assets. The increase in the buildings & equipment ($140,000) is reflected by an increase in unrestricted net assets since no external restriction is in place for these assets. Goodwill is not recognized so that no additional increase in unrestricted net assets is needed. Balances To Be Reported: --Cash - $1,110,000 ($1,600,000 less $990,000 plus $500,000) --Contributions receivable (net) - $280,000 ($70,000 plus $210,000) --Investments - $470,000 ($300,000 plus $170,000) --Buildings & equipment - $1,430,000 ($700,000 plus $730,000) --Total assets - $3,290,000 (summation) 47. (continued) --Accounts payable and accrued liabilities - $180,000 ($110,000 plus $70,000) 18-31 .
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Chapter 18 - Accounting and Reporting for Private Not-for-Profit Entities
--Notes payable - $1,720,000 ($1,100,000 plus $620,000) --Total liabilities - $1,900,000 (summation) --Unrestricted net assets - $670,000 ($1,100,000 less $990,000 payment plus $140,000 addition to buildings and equipment plus $420,000 balance for Swim for Safety) --Temporarily restricted net assets - $440,000 ($250,000 plus $190,000) --Permanently restricted net assets - $280,000 ($110,000 plus $170,000) --Total net assets - $1,390,000 (summation) --Total liabilities and net assets - $3,290,000 ($1,900,000 plus $1,390,000) c. This transaction is a merger: two not-for-profit entities are brought together to form a new not-for-profit under a newly-formed governing body. As a merger, the carryover method is used. Book values are simply added together to get new balances to be reported. No cash was spent and no adjustments to fair value are made. Balances To Be Reported: --Cash - $2,100,000 ($1,600,000 plus $500,000) --Contributions receivable (net) - $280,000 ($70,000 plus $210,000) --Investments - $470,000 ($300,000 plus $170,000) --Buildings & equipment - $1,290,000 ($700,000 plus $590,000) --Total assets - $4,140,000 (summation) --Accounts payable and accrued liabilities - $180,000 ($110,000 plus $70,000) --Notes payable - $1,720,000 ($1,100,000 plus $620,000) --Total liabilities - $1,900,000 (summation) --Unrestricted net assets - $1,520,000 ($1,100,000 plus $420,000) --Temporarily restricted net assets - $440,000 ($250,000 plus $190,000) --Permanently restricted net assets - $280,000 ($110,000 plus $170,000) --Total net assets - $2,240,000 (summation) --Total liabilities and net assets - $4,140,000 ($1,900,000 plus $2,240,000)
48.(1 0 minutes) (Adjusting totals for incorrectly reported student tuition) a.T he tuition was properly recorded as revenue. However, the financial aid figure should have been a direct reduction to the tuition revenue rather 18-32 .
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Chapter 18 - Accounting and Reporting for Private Not-for-Profit Entities
than a separate expense. In either case, the aid reduces unrestricted net assets so the $400,000 total computed at the end of the year is correct. b. As indicated in (a), the financial aid should not have been an expense but, rather, a reduction in the tuition revenue. Removing the $140,000 from the recognized amount of expenses reduces that total from $500,000 to $360,000. 49.(1 5 minutes) (Adjusting totals for incorrectly recorded restricted giving) a. Because the use of the interest was specified by the donor, both interest balances should have been recorded initially as increases within Temporarily Restricted Net Assets. Later, when properly spent, these amounts would have been reclassified into Unrestricted Net Assets. Instead, this entity recorded the amounts immediately in Unrestricted Net Assets. Since the amounts have now been properly spent, they did wind up in the category where they were supposed to be reported. The $400,000 shown as unrestricted net assets is correct. b. Each amount was reported as expenses in unrestricted net assets and that handling was correct. No change is needed so that the $500,000 reported as expenses is shown properly. c.A s indicated in (a), the $5,000 and the $7,000 should have initially increased Temporarily Restricted Net Assets and then been removed through a reclassification leaving no net effect. Because nothing was ever recorded by the entity in Temporarily Restricted Net Assets, the total of $300,000 is correct. 50.(1 5 minutes) (Adjusting the incorrect recording of a donation and subsequent expenditure) a. Because a time restriction has been assumed, only $5,000 ($50,000/10 years) should have been reclassified from Temporarily Restricted Net Assets into Unrestricted Net Assets. However, the entity increased Unrestricted Net Assets by $50,000. The final balance being reported, therefore, is $45,000 too high. Removing this $45,000 inflation reduces the final Unrestricted Net Asset figure from $400,000 to $355,000. b. Depreciation expense of $5,000 ($50,000/10 years) was recorded within the Unrestricted Net Assets. That handling is appropriate so that the $500,000 expense figure that is reported is correct. c.T he problem says that the correct entry was made in Year One. Thus, a $50,000 balance resides in Temporarily Restricted Net Assets as a result of the gift. Because a time restriction was assumed, only an amount 18-33 .
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Chapter 18 - Accounting and Reporting for Private Not-for-Profit Entities
($5,000) equal to the depreciation recorded should have been reclassified to Unrestricted Net Assets. That $5,000 amount was never removed. Reclassifying the $5,000 reduces Temporarily Restricted Net Assets from the reported $300,000 to $295,000. The $50,000 reclassification error does not affect this category. Permanently Restricted Net Assets should not have been reduced by $50,000 but that is not relevant to this particular question. 51. (5 minutes) (Incorrect reporting of membership dues) In this case, because nothing was received in exchange for the members’ dues, these collections should have been recorded as contributed support which would increase Unrestricted Net Assets. Instead, the dues were recorded as membership (or earned) revenue which is incorrect but it does increase Unrestricted Net Assets by the correct amount. Although the source is wrongly reported, the total Unrestricted Net Assets is correctly stated at $400,000. 52. (15 minutes) (Reporting of donated services) a. The problem here is that an expense of $70,000 was reported when the donation was a garage that should have been capitalized as an asset. Subsequently, this asset should have been depreciated at the rate of $7,000 per year. For this reason, at the end of Year 2 expenses are overstated by $63,000 ($70,000 minus $7,000) which causes Unrestricted Net Assets to be understated by $63,000. Instead of an Unrestricted Net Assets balance of $400,000, the entity should report $463,000. b. The entity reported no assets as a result of the contributed garage. The entity should report a $70,000 garage less $7,000 in accumulated depreciation. If the net balance of $63,000 is added to the reported total for assets of $900,000, a corrected figure of $963,000 is determined. c. As indicated in (a) above, the expenses were overstated by $63,000. Removing this $63,000 drops the expense total from $500,000 to $437,000.
53.(1 0 minutes) (Reporting a gift that must be transferred to another party) a.B ecause the donor can take the money back, the gift is still under the control of the donor. Consequently, the not-for-profit entity should have recorded a liability to the donor until a final resolution takes place. Instead, the charity recorded contributed support which served to increase Unrestricted Net Assets. That $40,000 should be removed so that Unrestricted Net Assets are $360,000 and not $400,000. 18-34 .
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Chapter 18 - Accounting and Reporting for Private Not-for-Profit Entities
b. The issue in this problem is about whether contributed service or a liability should be reported by the entity. The total amount reported as assets is not in question and is, thus, correctly stated at $900,000. 54. (15 minutes) (Handling of various events by two different charities) a. Charity A debits repair expense and credits contributed support. These two changes offset so that unrestricted net assets are not impacted. Charity B makes no entry at all so that unrestricted net assets are not impacted. After this reporting, the two charities report the same amount of unrestricted net assets. b. Charity A will report the investment income as an increase in unrestricted net assets and then report salary expense for the same amount. These two changes offset so that unrestricted net assets are not impacted. Charity B records the salary expense and then records an increase in unrestricted net assets because the restricted balance has been released. These two changes cancel out so that unrestricted net assets are not impacted. After this reporting, the two charities report the same amount of unrestricted net assets. c. The only difference here between Charity A and Charity B is in the handling of the excess $20,000 acquisition value. Charity A records this amount as goodwill because the acquired charity gains a significant amount of its support from exchange transactions. Charity B records this excess as a reduction in net assets because the acquired charity gets most of its resources from donations. Because of this reduction, total unrestricted net assets will be $20,000 lower for Charity B. d. Charity A records the $100,000 as patient service revenue and then writes the amount off as uncollectible. The provision for bad debts is a direct reduction in patient service revenues and not an expense. Charity B simply records the $100,000 from the beginning because of a lack of any intention to collect. In either approach, patient service revenue is reduced by $100,000. The new entities have the same amount of net patient service revenues. e. Charity A reports the entire $50 per cake as earned revenue. Charity B reports $30 per cake as earned revenue and $20 per cake as contributed support. In both cases, unrestricted net assets are increased by $50 per cake. The two entities will report the same amount of unrestricted net assets.
Develop Your Skills 18-35 .
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Chapter 18 - Accounting and Reporting for Private Not-for-Profit Entities
Research Case 1 This assignment is an excellent way to demonstrate the wealth of information available on the Internet about charities and other not-for-profit entities. Many individuals want to be generous and help entities that deserve assistance. Determining whether a specific entity is truly worthy of support is not necessarily easy. Every charity will claim that it is effectively helping to improve some element of society that is in need. Obviously, the information that a student finds at this website depends on the specific charities that are examined. However, some of the information that is normally available includes: ▪ the entity’s stated purpose, ▪ year it was started, ▪ website address, ▪ the existence of any affiliated organizations, ▪ whether this entity has met all of the standards of the group that created the website and, if not, what was the problem, ▪ a discussion of the charity’s programs along with the program expenses, ▪ identification of the chief executive officer (along with compensation), ▪ number of individuals on the board and the number of staff members working in the entity, ▪ methods used for fundraising, ▪ tax status, ▪ sources of funding, including dollar amounts From this type of information, a student should be able to write a detailed overview of the not-for-profit entity and its operations and finances.
Research Case 2 Charity Navigator provides a wealth of information about its methodology that should help students understand how a charity can be evaluated. The following outline of information was listed on this website at June 23, 2013, under methodology: “Charity Navigator works to guide intelligent giving. Our goal is to help people give to charity with confidence. At the same time, we aim to help charities by shining lights on truly effective entities. In doing so, we believe we can help ensure that charitable giving keeps pace with the growing need for charitable programs. “Our approach to rating charities is driven by those two objectives: helping givers and celebrating the work of charities. The pages listed below describe how 18-36 .
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Chapter 18 - Accounting and Reporting for Private Not-for-Profit Entities
we select charities to evaluate, how we classify and rate them, and what givers can conclude based on our ratings. What Kind of Charities Do We Evaluate? How Do We Classify Charities? How Do We Rate Charities? How Do We Rate Charities' Financial Health? Financial Ratings Tables How Do We Rate Charities' Accountability and Transparency? Accountability and Transparency Ratings Tables How Do We Calculate the Overall Score and Star Rating? What Do Our Ratings Mean? What Other Information Do We Present on the Charities We Evaluate? How Current are Our Ratings? How Do We Decide To Post A Donor Advisory? How Do We Decide To Remove A Donor Advisory? How Do We Plan To Evaluate Results Reporting? Glossary of Terms” ** Each of these links provides an extensive amount of information. For example, the link “How Do We Rate Charities' Financial Health?” provides a description of seven different performance metrics. 1 – Program expenses 2 – Administrative expenses 3 – Fundraising expenses 4 – Fundraising efficiency 5 – Primary revenue growth 6 – Program expenses growth 7 – Working capital ratio 18-37 .
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Chapter 18 - Accounting and Reporting for Private Not-for-Profit Entities
Based on all of the available information, students should be able to write a memo on how this organization rates various charities.
Research Case 3 This case is designed to introduce students to the information that can be found on the Form 990 that must be made public by tax-exempt organizations. Some of this information can be found in the entity’s financial statements but much of it goes beyond what is otherwise available. The filing of Form 990 ensures that such information is made public. Because of the sheer number and visibility, most not-for-profit entities that students might research are likely to qualify as Section 501(c)(3) charities. The available salary information will give students the opportunity to discuss whether officials of these entities are paid too much or too little. Do the amounts seem reasonable in comparison to the amount of revenues generated or the quantity of assets managed? What, for example, would the president of a comparable-sized for-profit business make in salary and other compensation? Throughout the chapter, mention was made of the statement of functional expenses and the amount expended by an entity for program service expenses. One possibility is to make a list in class of a number of well known charities and compare their ratio of program service expenses to total expenses just to see the range present. Another exercise that can be done is to simply list on the classroom board the types of information that the students uncover in the Form 990. What data seems most important and why include each of these items?
Research Case 4 Students often have trouble envisioning the amount of evolution that can take place in accounting and financial reporting. By comparing the 1987 financial statements for Georgetown University to the current statements, students should note how much change has taken place. Here are just a few of the more obvious examples that students might list. --The influence of government accounting in 1987 is obvious. These statements resemble fund financial statements for the Governmental Funds of a state or local government more than they resemble the current financial statements of a private not-for-profit entity. 18-38 .
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Chapter 18 - Accounting and Reporting for Private Not-for-Profit Entities
--Instead of a statement of activities, the university reports a statement of changes in fund balance. --The statements have multiple columns that include Current Funds, Loan Funds, and Plant Funds. --Current funds are separated into “unrestricted” and “restricted” but the type of restriction (temporarily restricted or permanently restricted) is not evident. --Expenditures are listed rather than expenses. --Scholarships and fellowships are listed as expenditures and not as reductions in tuition revenue. --Transfers between funds are listed. --There is no statement of cash flows.
Analysis Case 1 Many times a potential donor might be interested in an array of information that can best be found by studying the actual financial statements of a not-for-profit entity. The purpose of financial statements is to provide a complete picture of the financial operations and position of the entity to help outsiders make decisions. Students can observe the construction of financial statements in textbooks but only by actually making use of these statements can they come to appreciate the information that is available. One way to approach this assignment is to ask the students to list the five most interesting pieces of information that they uncover about a particular charity. The web site for many not-for-profit entity’s can be found by going to www.give.org and then clicking on “Charity Reports and Standards” and then clicking on “List of National BBB Wise Giving Reports.” At that spot, a large number of charities are listed. By clicking on a specific organization, the student can get considerable information including the website address. The exact information that is found will, obviously, depend on the not-for-profit entity that is studied. As just one example, the following information comes from recent financial statements for the American Heart Association for June 30, 2012, and the year then ended: 1--This not-for-profit entity has four program services listed in its financial statements: research, public health education, professional education/training, and community services. 2--The charity reported total expenses for the year ended June 30, 2012, in excess of $617 million. Of that total, nearly $130 million was reported in connection with supporting services. Thus, approximately 21 percent of each dollar of expense was incurred in connection with supporting services (management and general and fundraising). 18-39 .
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Chapter 18 - Accounting and Reporting for Private Not-for-Profit Entities
3--In the statement of activities, the American Heart Association recognized $54.3 million in contributed services and materials for the year ended June 30, 2012. The biggest single source of contributed materials was $44.2 million for public health . The biggest single source of contributed services was $6.1 million for research. Note 1, section j, spells out additional information about these donations as well as other donated services that were not recognized. 4--A question that is raised in connection with virtually any charity has to do with the amount of financial resources that are expended to raise more resources. In the year ended June 30, 2012, the American Heart Association, incurred $80.9 million in fundraising expenses. That amount makes up approximately 13 percent of the total expenses for the period. 5—As of June 30, 2012, the financial statements show that the American Heart Association held $284.3 million in unrestricted net assets, $224.5 million in temporarily restricted net assets, and $165.2 million in permanently restricted net assets. 6—For the year ended June 30, 2012, $147.9 million of temporarily restricted net assets were reclassified as unrestricted. Either the related purpose restriction had been satisfied ($93.4 million) or a time restriction expired ($54.5 million).
Analysis Case 2 Most private colleges and universities now place their latest audited financial statements on their Website. However, in some cases, a bit of searching is needed to locate these statements. The method by which the statements are made available is certainly not standardized. The information that will be uncovered by reading through these financial statements will depend entirely on the school being used. Here are the answers to the posed questions for Baylor University as of May 31, 2012, and the year then ended (http://www.baylor.edu/content/services/document.php/185324.pdf) 1--Tuition and fee revenue for the period totaled $463.5 while the total for the school’s “scholarships” was $184.8 million. Hence, this financial aid covered approximately 39.9 percent of the tuition and fees charged to students. To put this information another way, the “average” student paid 60.1 percent of the school’s tuition and fee charges. 2-- Note five to the financial statements provides the following information about contributions receivable as of May 31, 2012 (all numbers in thousands): 18-40 .
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Chapter 18 - Accounting and Reporting for Private Not-for-Profit Entities
Restricted current funds Endowment funds Plant Projects: Due in 1 year Due in 2 to 5 years Due in 6 to 10 years Split interest agreements Less: Present value adjustments Total contributions receivable
$
63 1,000
6,570 27,780 12,070 21,355 (10,561) $ 58,277
In addition, the footnote states that another $26,246,000 has been deemed an intent to give and not yet reported because they are not viewed as unconditional promise. 3--This is an extremely difficult question for any school to answer because the costs of “educating the students” can be included within several different accounts: instruction, academic support, student services & activities, institutional support, and the like. So, no exact comparison between educational costs and research costs is possible here. However, considerable information can be determined about the school’s priorities simply by comparing instruction expenses ($209.6 million) and research and public service expenses ($14.5 million). 4--For the year ended May 31, 2012, Baylor University shows “gifts” of $16.5 million under unrestricted net assets, $56.6 million under temporarily restricted net assets, and $29.2 million under permanently restricted net assets. 5—As of May 31, 2012, Baylor University reported $450.1 million in unrestricted net assets, $298.6 million in temporarily restricted net assets, and $624.7 million in permanently restricted net assets. For these last two figures, the restrictions had to have been put in place by an outside party (probably the donor). 6—Footnote 4 indicates a single figure (a loss of $45.1 million) as the net realized and unrealized gains (and losses). 7--The problem with this computation is determining exactly what is meant by “education expenses.” One way to compute that figure for the Baylor University for the year ended May 31, 2012 is as follows: Net Tuition and Fees Education Expenses (one way that term can be defined) —Instruction $209,565,000 —Academic Support 48,520,000 —Student Services and Activities 96,634,000 18-41 .
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$278,721,000
Chapter 18 - Accounting and Reporting for Private Not-for-Profit Entities
—Institutional Support
65,732,000
Net Loss on Educating Students
(420,451,000) $(141,730,000)
Many students feel that, because of the high amounts being charged, colleges and universities should be making a great profit from tuition. Depending on how education costs are defined, most schools will show a monetary loss (and often a considerable loss) from the process of educating students. This is one computation that can really interest a college student.
Communication Case Under each principle listed for Strong Financial Oversight, the Core Concepts will include a considerable amount of practical guidance for the accountant of a private not-for-profit entity. Students will already expect some of these recommendations based on their education and experiences but much of it may be new to them. What they focus on will depend on their personal interests. Here are the Core Concepts for financial records: • It is important for the staff to keep complete, accurate, and current financial records and share appropriate records with the board in a timely manner. • The board should review financial statements at least quarterly. • Some organizations are required by law to have an audit. Almost every entity should consider the benefits of having an audit, review, or compilation by an independent CPA. • Separating the audit committee from the finance committee provides a check and balance. • The auditor reports to the board, not to the staff.
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Chapter 19 - Accounting for Estates and Trusts
CHAPTER 19 ACCOUNTING FOR ESTATES AND TRUSTS Chapter Outline I.
Estate accounting encompasses the recording and reporting of events that occur from the time of a person's death until distribution of all property. A. An individual who dies "testate" had prepared a valid will whereas one who dies "intestate" expires without a valid will. 1. State probate laws govern wills and estates. These statutes facilitate three (3) goals. a. To gather and preserve the decedent’s property. b. To ascertain the decedent's intent for his/her property. c. To settle debts and distribute the remaining assets consistent with the decedent’s intentions. 2. Where no will exists, the laws of descent (for real property) and the laws of distribution (for personal property) govern the distribution of the decedent’s property. B. A will should name an executor of the estate to oversee the management and conveyance of property. If an executor is not named or is not able to serve, the probate court will appoint an administrator. C. Claims against the estate must be paid in a specific order of priority. 1. Expenses of administering the estate – which include legal costs, executor fees and similar items. 2. Funeral expenses and medical expenses of last illness. 3. Taxes and debts given legal preference. 4. All other claims. D. Estate distributions. 1. Devise—a testamentary gift of real property. 2. Specific legacy (or bequest)—an item of personal property that is identified directly by the testator in his/her will.
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Chapter 19 - Accounting for Estates and Trusts
3. Demonstrative legacy—a cash gift made from a particular identified source. 4. General legacy—a cash gift made with no source designated. 5. Residual legacy—a gift of any remaining estate property. 6. If sufficient property is not available to satisfy all legacies, the process of abatement is used to reduce the various gifts. E. Estate and inheritance taxes. 1. Federal estate tax—an excise tax on the right to convey property. a. The fair market value of estate property is taxed after reduction for funeral expenses, estate administration expenses, liabilities, charitable bequests, and the value of all property conveyed to spouse. b. In 2010, the federal estate tax was repealed, except for estates electing to be covered by such. Beginning in 2011 a portable exemption from federal estate taxes in the amount of $5.0 million became available. This exemption is now indexed and was $5.12 million in 2012 and $5.25 million in 2013. c. An individual was allowed an annual exclusion from federal gift taxes of $13,000 per donee plus a $5.0 million lifetime exclusion for 2011 (indexed for inflation to $5.12 million in 2012); $14,000 annual exclusion and $5.25 million lifetime exclusion in 2013 which will continue to be indexed prospectively. 2. State inheritance tax—assessed on the right to receive property. This tax varies significantly from state to state. 3. Estate income tax—tax on income earned by estate property. F. Recording the transactions of an estate 1. Assets are recorded at fair value. 2. Debts, expenses, and distributions are only recorded when paid. 3. Income and principal have their balances and transactions separately identified because testators often transfer income and principal to different beneficiaries. 4. Charge and Discharge statements are prepared as necessary to report on the progress being made in settling the estate. II. Trust funds are created so that a fiduciary can be put in charge of specified assets that will be distributed ultimately (the income and/or principal) to one or more designated parties. 1. Trusts ensure that the distribution of a person's assets is as intended. 19-2 .
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Chapter 19 - Accounting for Estates and Trusts
2. An inter vivos trust is created by a living individual. 3. A testamentary trust is created by a will. B. CPAs often utilize trusts to decrease the size of a client's estate and, thus, reduce estate taxes. C. Many types of trusts exist including: 1. Qualified Terminable Interest Property Trust—income goes to one or more parties with the principal eventually being conveyed to a different party. 2. Charitable Remainder Trust—income goes to one or more parties with the principal eventually being conveyed to a specified charity. 3. Spendthrift Trust – income is utilized for the benefit of the beneficiaries in a manner that protects the trust income and assets, from the beneficiaries’ creditors and also from the beneficiaries’ own financial indiscretions. 4. Life Insurance Trust – assets are utilized to obtain life insurance on a party and provided that the trust is irrevocable, the proceeds of the life insurance policies are not included in the insured’s taxable estate. D. Accounting for a trust. 1. In many trusts, the distinction between income and principal is essential. a. Investing costs, improvements, and the cost of preparing property in order to sell are viewed as adjustments to the trust's principal. b. Interest, insurance, and rent are typically adjustments to the trust's income. 2. Income and principal have their transactions and balances separately identified.
Answer to Discussion Question Is this Really an Asset? Fulfilling the instructions found in a will is not always an easy task. In this case, the will contains a specific legacy: letters written by the decedent's grandfather were to be given to a cousin. Perhaps the decedent intended for this property to be retained by a family member. However, the cousin cannot now be located. Moreover, sufficient cash does not exist to satisfy a general cash legacy of $20,000 that remains. Normally, a sale of the letters would be ordered to help resolve this cash shortage but differing opinions exist as to the value of the property. Finding a buyer (if one can be located) may take a considerable amount of time and energy. How should the administrator report these letters and what should be done?
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Chapter 19 - Accounting for Estates and Trusts
The administrator should begin by contacting an attorney to learn of the specific probate laws of the state in which the estate is located. For reporting purposes, the letters should be listed on a charge and discharge statement but with no dollar value attached. They must, however, be identified as an asset of the estate. With any property of this type, no true worth can be determined until a legitimate offer to purchase is made. Thus, to report a value without any prospect of a buyer could be misleading and could even result in the imposition of a transfer or inheritance tax. The administrator will probably need to confer with representatives of the local church (which is entitled to the $20,000 general legacy) as well as with any parties who are to receive residual amounts from the estate. If the letters are clearly worth less than $6,000, church officials may opt to take the letters in hopes of eventually locating a future buyer. Conversely, if the letters might be worth more than $6,000 (so that a residual legacy may be left), the administrator may have to convey the letters to a dealer with the order to liquidate the property so that the distribution of the estate can be concluded. This discussion question identifies one of many situations in which an administrator should obtain the services of a qualified professional – an attorney, or other experienced estate representative.
Answers to Questions 1. The term "testate" refers to a decedent who dies leaving a valid will. "Intestate" indicates an individual who has died without having written a valid will. 2. When an individual dies without having prepared a valid will, state inheritance laws become applicable. Normally, these laws are written to correspond with the most common methods used in distributing property, such as providing for spouses, children, and close relatives. Such laws are referred to as "laws of descent" when they describe the appropriate conveyance of real property. "Laws of distribution" specify the methods that are used for conveying personal property. 3. Probate laws are state statutes which govern wills and estates. Depending upon the nature and extent of a decedent’s will (or lack of a will), these statutes may play a significant role in the manner of administering and distributing the decedent’s estate. 4. Probate laws provide an orderly structure for the process of administering and distributing a decedent’s estate. The objectives of probate laws are —To gather and preserve all of the decedent's property, —To discover the decedent's intent for the property held at death and then implement those wishes if possible, and —To carry out an orderly and fair settlement of all debts and distribution of property. 5. The executor (or administrator if an executor is not named in the will or is unable to serve) must first ensure that all applicable laws are satisfied. Second, the executor must attempt to learn the decedent's wishes and then carry them out, if possible. The executor is a fiduciary of the estate and has a high standard of care when dealing with property for the benefit of the estate’s beneficiaries. The student should note that the executor may be compensated for her responsibilities and such compensation is frequently based upon a percentage (%) of the estate’s value. 6. Estate assets are reported at fair market value since historical cost (if known) would not be important in paying debts, making distributions, or determining transfer tax obligations.
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Chapter 19 - Accounting for Estates and Trusts
7. All assets of an estate should be presented on the discharge statement. If the asset has a speculative value the asset should be identified but without a dollar value. With assets of this type, it is extremely difficult to ascertain a true value unless or until a legitimate offer to purchase is made. Reporting a value without any prospect of a buyer could be misleading and could even result in the imposition of a transfer or inheritance tax. 8. Since an executor must satisfy (if possible) all of the claims against an estate, an adequate search for these claims must be made. In most states, a public notice has to be placed in an appropriate newspaper at least one time per week for two or three weeks. All claims must then be received by the executor within a reasonable period of time, frequently four (4) months from the date of the first notice. 9. Because of the possibility that estate assets may be insufficient to satisfy all debts and claims, state probate laws usually specify the following order of priority. Thus, if a shortage of assets does occur, the claims at the top of this list are paid first followed by the second level and so on. —Expenses of administering the estate. —Funeral expenses and the medical expenses of any last illness. —Taxes and debts given preference under federal or state laws. —All other claims. 10. An estate that is heavily in debt could possibly leave the members of the decedent’s immediate family with nothing. This potential hardship is often viewed by state probate laws as unfair. Therefore, a small homestead allowance is allowed to a surviving spouse and/or minor and dependent children prior to the payment of claims against the estate. In addition, a monthly family allowance is provided (for a specified period) while the estate is being settled. Consequently, family members are entitled to a relatively small amount of money from every estate prior to the payment of debts and expenses. 11. A devise is a gift of real property such as land or a building. In contrast, a legacy (or bequest) is the conveyance of personal property such as an automobile or cash. It would also include the conveyance of intangible personal property. 12.
—A specific legacy is the conveyance of an identified piece of personal property. The gift of a car, for example, or shares of corporate stock would be viewed as a specific legacy. —A demonstrative legacy is a cash gift that is made from a specific source. The gift of $6,000 from a savings account in a local bank would be deemed a demonstrative legacy. —A general legacy is a cash gift where the source is not identified. The gift of $6,000 in cash would be a general legacy. —A residual legacy is simply a gift of any property that remains in an estate after all other legacies have been fulfilled.
13. The process of abatement is utilized if an estate has insufficient resources to satisfy all of the legacies spelled out in a will. This guideline dictates the reductions that must be made to legacies during the distribution process. The process of abatement is also relevant if specified property or cash from a particular source was no longer available at the time of the decedent’s death to fulfill specific or demonstrative legacies. 14. The federal estate tax is an excise tax on the right to convey property. Thus, the value of the decedent's property at death is the basis for this assessment although an alternate valuation date (six months after death or at the date of distribution, whichever comes first) can be
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Chapter 19 - Accounting for Estates and Trusts
chosen by the executor. The value of estate assets is then reduced by a series of costs, debts, and distributions including: —funeral expenses, —estate administration expenses, —liabilities —casualties and thefts during the administration of the estate, —charitable bequests, —marital deduction for property conveyed to spouse. The federal estate tax is computed on the net value of the estate using graduated rates. The estate is then allowed to reduce the amount of net assets based on an exemption that was $5.0 million in 2011, $5.12 million in 2012, and $5.25 million in 2013. This exemption is indexed for inflation in future years. 15. The ATRA makes most changes made by the Tax Relief, Unemployment Insurance
Reauthorization, and Job Creation Act (TRA 2010) permanent with regard to federal estate taxes, gift taxes and generation skipping taxes. This results in an estate tax exemption of $5.25 Million in 2013 and a larger, indexed-for-inflation exemption in future years. 16. Individuals are allowed to make gifts of up to $14,000 per person per year (the amount is $28,000 if given by a married couple) without incurring any gift taxes. This amount is to be indexed for inflation. Amounts beyond the $14,000 per donee exclusion are taxable. 17. Distributions to a spouse directly decrease the taxable value of an estate and, hence, reduce the amount of federal estate taxes. However, when the spouse eventually dies, a large estate may be left by the subsequently deceased spouse, thus creating a significant tax liability. Estate planners often attempt to devise methods to reduce the future value of the remaining spouse's estate. One approach that is popular is the creation of a credit shelter trust fund at the time of the first death. If an individual’s unified transfer credit has not been previously decreased in order to avoid taxation of gifts, an estate of a certain size is tax free. Because of the ATRA, an estate of $5.25 million or less could be conveyed without creating a tax effect. Hence, if all other property is conveyed to the decedent’s spouse or to charity, a trust fund of the appropriate amount can be created (usually with the trust income going to the spouse until death) without incurring an estate tax. Four desirable results occur: 1. No estate taxes are paid on the first decedent’s estate. 2. The income of the trust fund assets can still be used for the benefit of the spouse. 3. The assets of the trust fund can be directed to a chosen recipient at the spouse’s eventual death. 4. The estate of the spouse is reduced by a considerable amount of assets, creating a large savings in estate taxes at the second spouse’s death. 18. Several deductions are allowed in the computation of estate income taxes: —A personal exemption of $600. —Amounts of income conveyed to charities.
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—Amounts incurred as ordinary and necessary expenses for the production or generation of the estate’s taxable income (such as accountant or attorney fees). —Amounts of income conveyed currently to the beneficiaries. 19. In addition to identifying the proper distribution of assets, a testator may identify proposed guardians for minor or incapacitated children in a will. In fact for many individuals, this concern may be more compelling than the fear of estate or transfer taxes. 20. The distinction between principal and income may be of paramount importance especially if they are to be conveyed to different parties. Assets held at the decedent's death comprise the principal of an estate whereas any earnings thereafter are income. Unfortunately, in reality, drawing a distinction may be quite difficult for a number of unique transactions. Therefore, in the decedent's will, instructions as to the impact that transactions have on principal and on income should be specified. If the decedent has not provided guidance in this area, state laws apply. The answer to question 21 gives examples of the typical method by which this distinction is made. 21. The following are examples of the usual method by which the distinction between the principal and income of an estate is established: Adjustments to principal: gains and losses on the sale of securities, debts incurred prior to death, funeral expenses, major improvements to rental property, and dividends declared prior to death even if received after death. Adjustments to income: property taxes, repair expenses, utilities, insurance, and management expenses. Note that the decedent can vary from the above distinctions by addressing the allocation of expenses in her will. 22. For federal estate tax purposes, the value of an estate at the date of the decedent's death should be determined. An alternate valuation date may be chosen by the executor if this decision will reduce the estate taxes to be paid. The alternate date is the earlier of six months after death or the date of conveyance. 23. The executor is given the responsibility of locating, valuing, and distributing all estate assets. Therefore, the reporting process emphasizes the value of all assets being held and their ultimate disposition. Liabilities, expenses, and distributions are only recorded at the time that they reduce these estate assets. The primary reason for this approach is that the estate’s liabilities are often not fully identified until a point in time well after the decedent’s date of death. 24. The charge and discharge statement of an estate is produced for several purposes. It lists the assets originally included in the estate. The statement also reports the assets that have been distributed to date to satisfy debts, expenses, or the stipulations of the decedent's will. Finally, the charge and discharge statement lists the value of assets still being held and indicates whether they are attributed to principal or income. This statement permits the probate court and beneficiaries to monitor the executor’s progress in administering and distributing the decedent’s estate. 25. A trust fund is comprised of assets that have been conveyed to a fiduciary who will manage and distribute them as specified by the party (the trustor) creating the fund. The trust fund is managed for the benefit of the trust’s beneficiaries and the trustee has fiduciary obligations to the beneficiaries.
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26. Trust funds have become popular as a means of reducing the size of a decedent's estate, as well as shielding assets from third parties. Thus, trusts may serve to decrease the amount that must be paid to the government in estate taxes. Furthermore, they are often created so that professional managers will oversee a decedent's assets and ensure that these assets are used as that person intended. 27. An inter vivos trust is simply one that is started by a living individual. Such a trust may be revocable or irrevocable. If the trust is revocable, the value of the assets in such a trust will be included in the trustor’s taxable estate upon his/her passing. 28. A testamentary trust is simply a trust created by a will. 29.
—QTIP Trust (Qualified Terminable Interest Property Trust)—The income of the trust (and possibly some of the principal) is conveyed to a party (frequently a spouse) for a period of time. After that time, the remaining principal goes to a different party. —GRATs (Grantor Retained Annuity Trusts)—The trustor continues to collect fixed payments (ie: annuities) from the trust fund assets. After a stated period, the principal is conveyed to a named beneficiary. —Charitable Remainder Trust—All income is paid to one or more beneficiaries until death or for a stated period. The principal is then given to a named charity.
30. The distinction between principal and income is especially important in accounting for a trust because in many cases they are to be given to different parties. Many trusts are created so that one group of beneficiaries is to collect income for a period of time with the principal then going to a different group of beneficiaries. Only by keeping principal and income balances separate can all parties receive the amounts that are appropriate.
Answers to Problems 1. B (the laws of distribution apply to the distribution of an intestate person’s personal property). 2. D (real property that is owned by joint tenants or by tenants in the entirety typically becomes the property of the surviving tenant (owner) by operation of law). 3. A (the laws of distribution are state statutes that apply to the transfer of personal property when someone passes without a valid will). 4. D (effectively a modified accrual process is utilized to determine how to treat earned – ie: accrued – interest which is received after the date of death). 5. B (although it is prudent to have a will, the law does not require such). 6. A (although state probate statutes vary, most states require the publication of notice of death and then permit claims against the decedent’s estate only for a statutorily shortened period of time). 7. B (many persons pass without sufficient assets to satisfy their obligations and the prioritization of the decedent’s claims permits an executor/executrix to 19-8 .
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Chapter 19 - Accounting for Estates and Trusts
distribute assets with the confidence that she will not be personally liable for a misapplication of estate assets). 8. D (personal debts, such as unpaid rent, are typically not priority claims against an estate). 9. C (the term for the transfer of real property is ‘devise’). 10. C (the homestead allowance is designed to ensure that surviving spouses and children have the financial ability to maintain a modest residence or homestead). 11. D (a specific legacy is a transfer of personal property that is actually or ‘specifically’ identified in the testator’s will). 12. C (a demonstrative legacy is the transfer of assets, often cash, from a specified source). 13. A (if an estate is not sufficient to permit all of the transfers identified by the testator, then the executor must reduce some transfers through the process of ‘abatement’ which instructs the executor how to go about reducing or eliminating transfers). 14. C (estate values are typically based upon the date of death, although an alternate date is permitted if such would result in a reduction in estate taxation – the alternate date is the earlier of six months after the date of death or the actual date of asset distribution). 15. C (the ATRA of 2012 provided a $5.25 million exemption per transferor beginning in 2013, as a result of indexing). 16. B (losses are deductible for Estate income tax purposes). 17. A (only Fitzgerald will have a taxable estate since for calendar year 2013, a decedent is able to transfer $5,250,000 without incurring a federal estate tax liability). 18. B (the alternate valuation date is the earlier of the date of distribution or six (6) months after the date of death). 19. B (the alternate valuation date is the earlier of the date of distribution or six (6) months after the date of death). 20. B (the ATRA of 2012 provides a $5.25 million exemption for gifts, but does not eliminate the gift tax entirely). 21. A (the use of this estate / trust planning will reduce the overall size of the couple’s taxable estates while still providing income for the surviving spouse). 22. B (funeral expenses are deductible from the estate for federal estate tax purposes).
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23. A (the remainderman gets the ‘remainder’ – that is what is left after another beneficiary receives income / assets for a specified period of time). 24. C (property taxes relate to the production of income for / from rental property and are likely charged as an expense related to income). 25. D (liabilities are recorded when satisfied due in part to the fact that not all liabilities are known to the executor until after notice has been provided of the decedent’s passing). 26. B (inter vivos refers to being created ‘within the life’). 27. C (the charity gets the ‘lead’ portion of the trust). 28. B (1,400,000 – 700,000 – 420,000 – 50,000 – 20,000 – 110,000 = 100,000). 29. A (Rental income of $5,000 less $600 exemption).
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Chapter 19 - Accounting for Estates and Trusts
30. (30 Minutes) (Define terms used in estate accounting) a. Will—the instructions, prepared consistent with the applicable state laws, given by an individual to direct the distribution to be made of the person's property after death. b. Estate—the legal entity that holds title to all of a decedent's property until those assets are properly distributed. c. Intestate—refers to the death of an individual who passes without having prepared a valid, legal will. d. Probate laws—state laws that govern and regulate wills and estates. e. Trust—a fund of assets that has been conveyed to a fiduciary who will manage and then distribute those assets according to the specifications of the individual who created the trust. f. Inter vivos trust—a trust fund created by a living person rather than as a result of the specifications of a will. g. Charitable remainder trust—a trust fund where the income is paid to one or more beneficiaries for a specified period (or until their death). After that point in time, the principal is conveyed to a named charity. h. Remainderman—a beneficiary of a trust who is entitled to receive a principal balance but only after a specified time. Until then, the income is distributed to a different income beneficiary (often for the life of that person). i. Executor—an individual who oversees an estate in a stewardship (fiduciary) capacity. The person must follow any applicable laws, locate all assets, discover and satisfy all valid claims against the estate, and uncover and follow (if possible) the intent of the decedent for any remaining property. j. Homestead allowance—an amount that is provided to a decedent's surviving spouse and/or minor and dependent children before claims against the estate are paid. This allowance ensures that (if assets are available) some amount is given to the immediate family regardless of the amount of debt incurred by the decedent.
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Chapter 19 - Accounting for Estates and Trusts
31. (30 Minutes) (Discussion of questions about estates) a. Probate laws are state laws that govern wills and estates. These laws provide an orderly structure for the process of administering a decedent’s estate (property). The Uniform Probate Code has been adopted by many states so that laws are consistent, at least between those particular states. The general objectives of probate laws are: —To gather and preserve all of the decedent's property held at death. —To locate and provide a fair settlement for all debts. —To discover the decedent's intent for any remaining property and to follow those wishes if possible. b. The executor must locate and preserve all of the assets owned by the decedent at death, discover and satisfy (if sufficient assets are available) all valid claims against the estate, determine the wishes of the decedent as to any remaining property, comply with all laws, and distribute assets according to the intentions of the decedent. The executor is also entitled to reasonable compensation for his/her performance of these tasks. c. All property of value should be included in an inventory of estate assets. Thus, cash, investments, receivables, and other valuables should all be listed. In some states, real property (such as land) is conveyed directly to a beneficiary at death so that it is not included in the estate. However, even this real property is assumed to be part of the estate for estate tax purposes. Additionally, chooses in action (the ability or right to pursue a claim) may have value and should be considered by the executor. d. The order of priority for paying claims against an estate are as follows: (1)—expenses of administering the estate. (2)—funeral expenses and the medical expenses of any last illness. (3)—taxes and debts given preference under federal or state laws. (4)—all other claims.
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Chapter 19 - Accounting for Estates and Trusts
32. (20 Minutes) (Identify parties in connection with will) a. Howard Amadeus has been designated to receive the principal of the trust fund after Lucy Van Jones' death and is, therefore, referred to as the remainderman. b. Josh O’Brien has established the trust fund and is known legally as the trustor and in some states is referred to as the settlor – same meaning as trustor. c. A demonstrative legacy is a cash gift from a particular source. The gift of all money from the First Savings Bank to Richard Blaine is a demonstrative legacy. d. Since the $9,000 cash gift to Nelson Tucker does not come from a designated source, it is known as a general legacy. If it were to originate from a specified source, then it would be a demonstrative legacy. e. The gift of the antique collection to Lisa Lunn is a specific legacy because it is a gift of specified personal property. f. Lucy Van Jones will receive the income from the trust fund for the remainder of her life, a position known as a life tenant. g. Josh O’Brien is the testator – the decedent passing with a valid will. 33. (30 Minutes) (Distribution to be made of an estate) a. 800 shares of Coca-Cola Co. stock are given to Cindy Cheng. Since the estate does not own more Coca-Cola stock, this is all Cindy will receive. Title to the house goes to Dennis Davis as the decedent directed. $41,000 cash in the First National Bank goes to Jack Abrams. Because this bequest was limited to $50,000 in this bank account, and the account contained less than $50,000, the $41,000 is all that Jack Abrams will receive. $16,000 cash in the New Hampshire Savings and Loan still remains. However, the will specifically directs that Suzanne is to receive $18,000. Therefore, to have the $16,000 amount, more cash must be added. Either the Xerox stock or the other property (or both) must be liquidated in order to give Suzanne Benton $18,000. Any remaining property is conveyed to Wilbur N. Ed, the residuary beneficiary. b. 1,000 shares of Coca-Cola Co. stock are given to Cindy Cheng. The additional 200 shares will either be transferred to the residuary beneficiary, or liquidated if necessary to satisfy other bequests. $50,000 cash in the First National Bank goes to Jack Abrams. $5,000 cash remains in the First National Bank along with $6,000 in the New Hampshire Savings and Loan. To this total, more cash must be added in order 19-13 .
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Chapter 19 - Accounting for Estates and Trusts
to obtain enough cash to satisfy Suzanne’s bequest. Either the Xerox stock, the remaining Coca-Cola stock, and/or the other remaining property must be liquidated in order to give Suzanne Benton a total of $18,000. Any remaining property is conveyed to Wilbur N. Ed. 34. (5 Minutes) (Compute the taxable estate value) Value of estate assets ................................................... Conveyed to spouse ...................................................... Conveyed to charities .................................................... Funeral expenses ........................................................... Administrative expenses ............................................... Debts ............................................................................... Taxable estate ...............................................................
$2,300,000 (1,000,000) (260,000) (23,000) (41,000) (246,000) $ 730,000
Amounts conveyed to children or to most trusts are not deductible in computing the taxable value of a decedent’s estate. Thus the $500,000 transfer and the $230,000 transfers are components of the taxable estate. 35. (15 Minutes) (Determine taxable estate value) Gross Estate (fair market value) ................................... Funeral Expenses ......................................................... Administration Expenses ............................................. Charity Bequests .......................................................... Marital Deduction .......................................................... Taxable Estate ..........................................................
$2,381,000 $ 20,000 10,000 60,000 870,000
(960,000) $1,421,000
36. (5 Minutes) (Computation of income tax on an estate) Rental income ............................................................... Interest income .............................................................. Dividend income ............................................................ Total income ................................................................... Personal exemption ....................................................... Gift to charity .................................................................. Distributed to beneficiary .............................................. Taxable income ..............................................................
$ 9,000 6,000 5,000 $20,000 (600) (5,000) (6,000) $ 8,400
37. (60 Minutes) (Record journal entries for an estate and prepare charge and discharge statement) a. –– Cash—Principal ........................................................ Life Insurance Receivable ....................................... Investment in Stocks and Bonds ............................. Rental Property ......................................................... Personal Property .................................................... 19-14 .
.
300,000 200,000 100,000 90,000 130,000
Chapter 19 - Accounting for Estates and Trusts
Estate Principal .............................................. (To record property held by Rose Shields at death.)
820,000
1. No entry. Estates do not record liabilities until assets are used in payment. 5,000 2. Cash—Principal ........................................................ Cash—Income .......................................................... 7,000 Assets Subsequently Discovered (Interest Rec.) 5,000 Estate Income ............................................... 7,000 (To record receipt of interest income. The $5,000 earned prior to the decedent's death was not included in original listing of estate assets so it is an ‘asset subsequently discovered’.) 6,000 3. Expenses—Income ................................................... Cash—Income ................................................ 6,000 (Ordinary repair expenses are made to rental property and are generally charged to income rather than principal.) 4. Debts of the Decedent ............................................. Cash—Principal ............................................. (To pay liabilities and obligations of the decedent.)
80,000
5. Cash—Principal ....................................................... Investments in Stocks and Bonds ................
19,000
80,000
16,000
Gain on Sale of Stocks Principal .................. (To record sale of stocks and to reflect gain on such sale with the additional proceeds becoming part of the estate’s principal.)
3,000
6. Cash—Principal ....................................................... 2,000 12,000 Cash—Income .......................................................... Assets Subsequently Discovered (Rent Rec.) 2,000 Estate Income ................................................ 12,000 (To record receipt of rental income. The $2,000 earned prior to the decedent's death was not included in original listing of estate assets and is therefore an ‘asset subsequently discovered’.) 7. Legacy—Jim Arness ............................................... Cash—Income ................................................ (Payment is made to income beneficiary.)
6,000
8. Cash—Principal ....................................................... Life Insurance Receivable ............................. (Collection is made from life insurance policy.)
200,000
Legacy—Amanda Blake ...........................................
200,000
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.
6,000
200,000
Chapter 19 - Accounting for Estates and Trusts
Cash—Principal ............................................. (Payment is made of proceeds from life insurance policy.) 9. Funeral Expenses ..................................................... Cash—Principal .............................................. (To record cost of decedent's funeral.)
200,000
10,000 10,000
b. ESTATE OF ROSE SHIELDS Charge and Discharge Statement As to Principal I charge myself with: Assets per original inventory .................................. Assets subsequently discovered: Interest receivable ............................................... Rental income receivable ................................... Gain on sale of stocks ............................................. Total charges .......................................................
I credit myself with: Debts of decedent .................................................... Funeral expenses ..................................................... Legacy: Amanda Blake (proceeds of life insurance) ............................................................ Estate principal ...................................................
$820,000 $ 5,000 2,000
7,000 3,000 830,000
80,000 10,000 200,000
Estate principal: Cash ........................................................................... Investments in stocks and bonds ........................... Rental property ......................................................... Personal property ..................................................... Estate principal ...................................................
290,000 $540,000
$236,000 84,000 90,000 130,000 $540,000
As to Income I charge myself with: Interest income ......................................................... Rental income ...........................................................
$ 7,000 12,000
I credit myself with: Repair expenses .......................................................
$ 6,000
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$19,000
Chapter 19 - Accounting for Estates and Trusts
Legacy: Jim Arness .................................................. Balance as to Income .........................................
6,000
12,000 $ 7,000
Balance as to income: Cash ...........................................................................
$ 7,000
38. (45 Minutes) (Prepare charge and discharge statement for an estate) ESTATE OF GINA PURCELL Charge and Discharge Statement As to Principal I charge myself with: Assets per original inventory .................................. Assets subsequently discovered: Rental income receivable ................................... Dividends receivable .......................................... Gain on sale of Polaroid stock ................................ Total charges ....................................................... I credit myself with: Debts of decedent .................................................... Funeral and executor expenses .............................. Legacy: Charitable remainder trust ....................... Transfer of Dell stock ............................... Estate principal ...................................................
$1,204,000 $ 4,000 2,000
$ 81,000 33,000 300,000 32,000
Estate principal: Cash .......................................................................... Investments ............................................................... Rental property ......................................................... Estate principal ................................................... As to Income I charge myself with: Rental income ........................................................... Dividend income ....................................................... I credit myself with: Repair expenses ....................................................... Legacy: income to beneficiary ................................ Balance as to income ......................................... Balance as to income: Cash .......................................................................... 39. (30 Minutes) (Prepare journal entries for an estate)
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.
6,000 3,000 $1,213,000
446,000 $ 767,000 $ 422,000 45,000 300,000 $ 767,000
$ 7,000 10,000 2,000 4,000
$17,000
6,000 $11,000 $11,000
Chapter 19 - Accounting for Estates and Trusts
Note: Since the income and principal of this estate are both to go to the same beneficiary, no reason exists for separately labeling the assets as being derived from principal and income. a. Cash ............................................................................... Interest receivable ......................................................... Life insurance receivable (payable to estate) .............. Residence ....................................................................... Investment in Coca-Cola ............................................... Investment in Polaroid .................................................. Investment in Ford .......................................................... Estate Principal .........................................................
80,000 6,000 300,000 200,000 50,000 110,000 140,000
b. Cash ............................................................................... Interest receivable .................................................... Estate income interest .............................................
7,000
c. Funeral expenses ........................................................... Cash ............................................................................
20,000
886,000 6,000 1,000 20,000
d. No entry. Debts are only recorded by an estate when paid. e. Cash ............................................................................... Assets subsequently discovered ............................
12,000
f. Legacy—Kevin Simmons .............................................. Residence ...............................................................
200,000
g. Cash ............................................................................... Life Insurance receivable (payable to estate) ........
300,000
h. Debts of the decedent ................................................... Cash ...........................................................................
100,000
12,000 200,000 300,000 100,000
No entry for discovery of additional debts. Debts are only recorded by an estate when paid. i. Legacy—Thomas Thorne .............................................. Cash ...........................................................................
150,000
j. Cash ............................................................................... Investment in Polaroid ............................................. Gain on sale ..............................................................
112,000
k. Administrative expenses ............................................... Cash ............................................................................
10,000
150,000 110,000 2,000 10,000
40. (60 Minutes) (Prepare journal entries for an estate and a charge and discharge statement) 19-18 .
.
Chapter 19 - Accounting for Estates and Trusts
Note: Since the income and principal of this estate are both to go to the same beneficiary, no reason exists for separately labeling the assets as being derived from principal and income. 1. Cash ............................................................................... Certificates of deposit ................................................... Dividend receivable ....................................................... Life insurance receivable — payable to estate ............ Residence and personal effects ................................... Investment in Ford Motor Co. ....................................... Investment in Xerox ....................................................... Estate Principal ...........................................................
19,000 90,000 3,000 450,000 470,000 72,000 97,000
2. Cash ............................................................................... Life insurance receivable — payable to estate ......
450,000
3. Cash ............................................................................... Dividend receivable .................................................. Estate income ...........................................................
4,000
1,201,000 450,000 3,000 1,000
4. No entry. Debts are only recorded by an estate when paid. 5. Legacy—Sue Pope ......................................................... Residence and personal effects ..............................
470,000
6. Land ............................................................................... Assets subsequently discovered ............................
15,000
7. Debts of the decedent ................................................... Cash ...........................................................................
108,000
470,000 15,000 108,000
No entry is made for the discovery of additional debts, since debts are only recorded by an estate when paid. 8. Funeral and administrative expenses .......................... Cash ...........................................................................
31,000
9. Legacy—Ned Pope ....................................................... Cash ...........................................................................
110,000
10. Cash ............................................................................... Investment in Ford Motor Co .................................... Gain on sale ..............................................................
81,000
11. Funeral and administrative expenses .......................... Cash ...........................................................................
16,000
12. Legacy—Harwood Pope ................................................. Cash ............................................................................
81,000
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31,000 110,000 72,000 9,000 16,000 81,000
Chapter 19 - Accounting for Estates and Trusts
Part b. ESTATE OF LENNIE POPE Charge and Discharge Statement As to principal and income I charge myself with: Assets per original inventory .................................. $1,201,000 Assets subsequently discovered: 15,000 Land ...................................................................... Gain on sale of Ford Motor Co. stock ..................... 9,000 1,000 Dividend income ....................................................... $1,226,000 Total charges ....................................................... I credit myself with: Debts of decedent .................................................... Funeral and administrative expenses...................... Legacies distributed: $470,000 Sue Pope ......................................... Ned Pope ......................................... 110,000 81,000 Harwood Pope ................................ Total credits ......................................................... Balance on hand ............................................................ As: Estate principal: Cash ........................................................................... Certificates of deposit .............................................. Land ........................................................................... Shares of Xerox ........................................................ Estate principal ................................................... Estate Income: Cash .....................................................................
$108,000 47,000
661,000 816,000 $ 410,000 $207,000 90,000 15,000 97,000 $409,000 $
1,000
41. (30 Minutes) (Prepare journal entries for a trust) a. Cash—Principal ............................................................. Investments in Stocks ................................................... Rental Property .............................................................. Trust Principal ..........................................................
300,000 200,000 150,000
b. Investments in Bonds .................................................... Cash—Principal ........................................................
260,000
Commission Expense—Principal ................................. Cash—Principal ........................................................
3,000
c. Repair Expense—Principal ........................................... Cash—Principal ........................................................
7,000
d. Cash—Principal ............................................................. Cash—Income ............................................................... Trust Principal .......................................................... Trust Income—Dividends ........................................
1,000 3,000
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.
650,000 260,000 3,000 7,000
1,000 3,000
Chapter 19 - Accounting for Estates and Trusts
e. Insurance Expense—Income ........................................ Cash—Income ...........................................................
2,000
f. Cash—Income ............................................................... Trust Income—Rental ..............................................
8,000
g. Trustee Expense—Principal ......................................... Trustee Expense—Income ............................................ Cash—Principal ........................................................ Cash—Income ...........................................................
3,000 1,000
h. Equity in Income: Beneficiary ....................................... Cash—Income ...........................................................
5,000
19-21 .
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2,000 8,000
3,000 1,000 5,000
Chapter 19 - Accounting for Estates and Trusts
42. (20 Minutes) (Prepare journal entries for a trust) Land ............................................................................... Trust—Principal .........................................................
320,000
Cash—Income ............................................................... Trust—Income ..........................................................
60,000
Insurance Expense—Income ........................................ Cash—Income ...........................................................
4,000
Property Taxes Expense—Income ............................... Cash—Income ...........................................................
6,000
Land Improvements ....................................................... Cash—Income ...........................................................
4,000
320,000 60,000 4,000 6,000 4,000
(This payment for paving is made from cash income because no principal cash is held. The trust agreement should indicate how such payments are to be made and recorded. The following adjustment is also likely necessary to indicate that this payment has been made from income rather than principal.) Due from Trust—Principal ............................................ Due to Trust—Income ..............................................
4,000
Maintenance Expense—Income ................................... Cash—Income ...........................................................
8,000
Equity in Income: Beneficiary ....................................... Cash—Income ...........................................................
30,000
19-22 .
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4,000 8,000 30,000
Chapter 19 - Accounting for Estates and Trusts
Develop Your Skills (60 Minutes) Research Case 1 This case is designed to help the student experience how the Internet can be used to research practical accounting issues in a quick way. Here, a client wants to know about a Minor's Section 2503(c) Trust. Perhaps no one currently with this CPA firm knows much about this type of trust. However, a significant amount of information is readily available using the Internet. The student is directed to www.finaid.org. This particular website provides extensive information about a variety of financial strategies that can be utilized to finance a college . A search of the term "Minor's Section 2503(c) Trust" leads to http://www.finaid.org/savings/2503ctrust.phtml This page provides the following information about this specific type of trust. Obviously, more information may be needed to enable the CPA to work at an appropriate level with the client but this coverage provides a basic understanding. Some of the information that can be obtained from this site includes: ▪
Gifts can be held in this type of trust until the child reaches the age of 21.
▪
In 2008, up to $12,000 that was given by each person to the trust could be excluded from any gift tax consideration. In 2009, this amount was $13,000. In 2013 this amount was $14,000.
▪
For the exclusion to apply, the recipient must receive a present interest; in other words, the gift must be open to the recipient's immediate use.
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All property and income must be expended before the recipient reaches the age of 21. Any remaining assets must be distributed to the person at the time of the 21st birthday.
▪
The trustee can use the money in the trust to pay for the recipient's college costs (that is obviously why it is being covered on this particular website).
▪
Some trusts of this type are set up so that the recipient can only withdraw the undistributed assets for a short period after the person's 21st birthday. If not taken then, the money reverts to the trust fund.
▪
After the recipient's 21st birthday, gifts can still be made to the trust fund but no exclusion is allowed. However, this problem can be avoided by setting up the Minor's Section 2503(c) Trust in conjunction with another type of trust known as a Crummey Trust.
19-23 .
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Chapter 19 - Accounting for Estates and Trusts
▪
Income earned by the trust is taxed at trust income rates unless distributed directly to the recipient so that it is then taxed at the recipient's tax rates. After the recipient's 21st birthday, the income is taxable to that person whether received or not.
▪
There are a number of specific problems associated with this type of trust including high administrative costs, high income tax rates on trust income, and the possibility of causing the recipient problems trying to qualify for other types of college financial aid.
▪
The website suggests considering the Uniform Gift/Transfer to Minor's Act as a good alternative to the Minor's Section 2503(c) Trust.
As can be seen, this website does not make the reader an expert in this type of trust but it certainly does provide a wealth of information so that initial discussions can be held in a knowledgeable way with the client. The link to the New York State Society of CPAs provides additional information about this type of trust fund. The student might be encouraged to search for other on-line resources which are not provided in the text, in order to enhance the student’s grasp for the depth of information now available electronically.
Research Case 2 (60 Minutes) Students often believe that all answers can be found in textbooks or the needed information is simply a part of every CPA's basic knowledge. However, in real life, most issues are resolved by research. Here, the CPA firm is faced with a tax question concerning the deduction allowed an estate for distributable net income. The CPA may well know the answer to that question or, if not, will have to look it up. This assignment allows, and requires, the students to find instructions provided on-line by the Internal Revenue Service. Once the instruction form for 1041 is found through a search, the student will probably go to the index of this document. The link for the 1041 instructions can be located at: http://www.irs.gov/pub/irs-pdf/i1041.pdf "The income distribution deduction allowable to estates and trusts for amounts paid, credited, or required to be distributed to beneficiaries is limited to distributable net income (DNI). This amount, which is figured on Schedule B, line 7, is also used to determine how much of an amount paid, credited, or required to be distributed to a beneficiary will be includible in his or her gross income." From the above quote as well as from the table of contents for these instructions, 19-24 .
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Chapter 19 - Accounting for Estates and Trusts
the student can determine that Schedule B is used to compute the amount of distributable net income. Therefore, the student can scroll down through these instructions (about 15-20 pages) and come upon over a page of actual guidance on how Schedule B is completed, including line-by-line instructions. This schedule provides the student (and the CPA) with the necessary information to determine DNI. Note, though, that some parts of this process are relatively easy while other steps are more complex. However, through a careful reading, the method by which this figure is determined can be ascertained.
Research Case 3 (45 Minutes) This research case requires the student to use a legal or commercial search engine to locate a specific state’s probate code. Every state has a probate statutory scheme. Approximately twenty (20) states have adopted a version of the uniform probate code, in an attempt to utilize a consistent asset distribution process. Montana is one of the states that has adopted a version of the uniform probate code, although the professor may wish to permit students to work this research case based on their home state’s laws. The student should ultimately arrive at the following link for the relevant statutory provisions: http://data.opi.mt.gov/bills/mca_toc/72.htm. Depending upon the student’s familiarity, it may be prudent for the professor to provide the link for the student and evaluate the student’s answer based on the student’s application of the statute. This statue, which is similar to the statutes of the other states which have adopted the uniform probate code, provides the following: 72-2-113. Share of heirs other than surviving spouse. (1) Any part of the intestate estate not passing to the decedent's surviving spouse under 72-2-112, (http://data.opi.mt.gov/bills/mca/72/2/72-2-112.htm) or the entire intestate estate if there is no surviving spouse, passes in the following order to the individuals designated below who survive the decedent: (a) to the decedent's descendants by representation; (b) if there is no surviving descendant, to the decedent's parents equally if both survive or to the surviving parent; (c) if there is no surviving descendant or parent, to the descendants of the decedent's parents or either of them by representation; (d) if there is no surviving descendant, parent, or descendant of a parent and the decedent is: (i) survived by one or more grandparents or descendants of grandparents: (A) one-half to: (I) the decedent's paternal grandparents equally if both survive; (II) the surviving paternal grandparent; or (III) the descendants of the decedent's paternal grandparents or either of them 19-25 .
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Chapter 19 - Accounting for Estates and Trusts
if both are deceased, the descendants taking by representation; and (B) the other one-half to the decedent's maternal relatives in the same manner; or (ii) not survived by a grandparent or descendant of a grandparent on either the paternal or the maternal side, the entire estate to the decedent's relatives on the other side in the same manner as the half; (e) if there is no surviving descendant, grandparent, or descendant of a grandparent, to the person of the closest degree of kinship with the decedent. Except as provided in subsection (2), if more than one person is of that closest degree, those persons share equally. (2) If more than one person is of the closest degree as provided in subsection (1)(e) but they claim through different ancestors, those who claim through the nearer ancestor must receive to the exclusion of those claiming through a more remote ancestor. Section 72-2-113-1(c) will provide that Ms. Voga’s cousins could inherit from her grandmother through Ms. Voga’s great grandparents, if in fact Ms. Voga’s grandmother had no decendants. Clearly the grandmother has at least one decendant – Ms. Voga. However, the prudent professional should explain this process to the client as there is no guarantee that Ms. Voga will outlive her grandmother.
Analysis Case 1 (45 Minutes) Many resources exist on the Internet to explain different legal and tax benefits of various estate planning techniques. One link that provides a good overview is located at: www.estate-plan.com/pdf/Art_Grat.pdf . It is one of dozens of links that are located by searching for “Grantor Retained Annuity Trust”. The student should have little difficulty in locating relevant resources. Included in the information about GRATs at this suggested link and at many other links is the following: ▪
It can be used to transfer profitable and quickly appreciating property to a donee, such as the donor’s child(ren), in such a way as to minimize gift and estate taxes.
▪
Property is transferred into an irrevocable trust but the income is retained for a period of time (or for the shorter of a period of time or the person’s remaining life).
▪
At the end of the specified period, the property goes to the named beneficiary.
19-26 .
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Chapter 19 - Accounting for Estates and Trusts
▪
The person creating the trust is allowed to get a stream of cash from the income of the asset over the period specified.
▪
Hopefully, the value of the property placed in the estate will grow so that the beneficiary receives a particularly high amount in comparison to what was initially placed in the trust.
▪
For gift tax purposes, the conveyed value is the value when the trust was created less the value of the annuity interest that the original owner retains.
▪
The reduced value limits or eliminates any potential gift tax effects.
▪
Consequently, income is retained by the original owner while conveying the property to the eventual recipient at a lower set value as a way to reduce the amount taken by the government in taxes.
This trust is, thus, advantageous when an individual wishes to transfer wealth to subsequent generations while also minimizing the transfer taxes. It is particularly useful if the transferor can identify and transfer rapidly appreciating assets.
Analysis Case 2 (45 Minutes) In setting the value of an estate, the executor has the option to choose an alternate date for valuation purposes if that decision will reduce the taxes to be paid. This case was created to help the student obtain additional information about this decision if ever encountered in the real world. Because this is a tax issue, the student is being directed to make use of the Internal Revenue Service website as well as the instructions printed for each taxation area. For many areas of accounting, the more the student knows about the IRS website the better prepared the student will be. By doing a search of the IRS site, the instructions for the Form 706 can be located. That is the form used for federal estate tax filing purposes. By going directly to the index at the back of these instructions, the student can locate information on the topic of "alternate valuation." The information provided in the instructions discusses the basic issues concerning valuation at death versus the option of either six-months after death or the date of transfer whichever comes first. Within that coverage, special issues such as interest, rents, and dividends are explained in detail. Basically, this information is provided here by the IRS so that the average person can perform the duties of an executor or, at least, understand the impact of the decisions made by the executor, such as the decision as to the proper valuation date.
19-27 .
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