Advanced Accounting, 5th Edition , Debra C Jeter, Paul K Chaney Solution Manual by Ace Test Banks

Advanced Accounting, 5th Edition By Debra C. Jeter, Paul K. Chaney

Email: Richard@qwconsultancy.com

CHAPTER 1 ANSWERS TO QUESTIONS 1. Internal expansion involves a normal increase in business resulting from increased demand for products and services, achieved without acquisition of preexisting firms. Some companies expand internally by undertaking new product research to expand their total market, or by attempting to obtain a greater share of a given market through advertising and other promotional activities. Marketing can also be expanded into new geographical areas. External expansion is the bringing together of two or more firms under common control by acquisition. Referred to as business combinations, these combined operations may be integrated, or each firm may be left to operate intact. 2. Four advantages of business combinations as compared to internal expansion are: (1) Management is provided with an established operating unit with its own experienced personnel, regular suppliers, productive facilities and distribution channels. (2) Expanding by combination does not create new competition. (3) Permits rapid diversification into new markets. (4) Income tax benefits. 3. The primary legal constraint on business combinations is that of possible antitrust suits. The United States government is opposed to the concentration of economic power that may result from business combinations and has enacted two federal statutes, the Sherman Act and the Clayton Act to deal with antitrust problems. 4. (1) A horizontal combination involves companies within the same industry that have previously been competitors. (2) Vertical combinations involve a company and its suppliers and/or customers. (3) Conglomerate combinations involve companies in unrelated industries having little production or market similarities. 5. A statutory merger results when one company acquires all of the net assets of one or more other companies through an exchange of stock, payment of cash or property, or the issue of debt instruments. The acquiring company remains as the only legal entity, and the acquired company ceases to exist or remains as a separate division of the acquiring company. A statutory consolidation results when a new corporation is formed to acquire two or more corporations, through an exchange of voting stock, with the acquired corporations ceasing to exist as separate legal entities. A stock acquisition occurs when one corporation issues stock or debt or pays cash for all or part of the voting stock of another company. The stock may be acquired through market purchases or through direct purchase from or exchange with individual stockholders of the investee or subsidiary company. 6. A tender offer is an open offer to purchase up to a stated number of shares of a given corporation at a stipulated price per share. The offering price is generally set above the current market price of the shares to offer an additional incentive to the prospective sellers. 7. A stock exchange ratio is generally expressed as the number of shares of the acquiring company that are to be exchanged for each share of the acquired company. 1-1

8. Defensive tactics include: (1) Poison pill – when stock rights are issued to existing stockholders that enable them to purchase additional shares at a price below market value, but exercisable only in the event of a potential takeover. This tactic is effective in some cases. (2) Greenmail – when the shares held by a would-be acquiring firm are purchased at an amount substantially in excess of their fair value. The shares are then usually held in treasury. This tactic is generally ineffective. (3) White knight or white squire – when a third firm more acceptable to the target company management is encouraged to acquire or merge with the target firm. (4) Pac-man defense – when the target firm attempts an unfriendly takeover of the would-be acquiring company. (5) Selling the crown jewels – when the target firms sells valuable assets to others to make the firm less attractive to an acquirer. 9. In an asset acquisition, the firm must acquire 100% of the assets of the other firm, while in a stock acquisition, a firm may gain control by purchasing 50% or more of the voting stock. Also, in a stock acquisition, formal negotiations with the target’s management can sometimes be avoided. Further, in a stock acquisition, there might be advantages in keeping the firms as separate legal entities such as for tax purposes. 10. Does the merger increase or decrease expected earnings performance of the acquiring institution? From a financial and shareholder perspective, the price paid for a firm is hard to justify if earnings per share declines. When this happens, the acquisition is considered dilutive. Conversely, if the earnings per share increases as a result of the acquisition, it is referred to as an accretive acquisition. 11. Under the parent company concept, the writeup or writedown of the net assets of the subsidiary in the consolidated financial statements is restricted to the amount by which the cost of the investment is more or less than the book value of the net assets acquired. Noncontrolling interest in net assets is unaffected by such writeups or writedowns. The economic unit concept supports the writeup or writedown of the net assets of the subsidiary by an amount equal to the entire difference between the fair value and the book value of the net assets on the date of acquisition. In this case, noncontrolling interest in consolidated net assets is adjusted for its share of the writeup or writedown of the net assets of the subsidiary. 12. a) Under the parent company concept, noncontrolling interest is considered a liability of the consolidated entity whereas under the economic unit concept, noncontrolling interest is considered a separate equity interest in consolidated net assets. b) The parent company concept supports partial elimination of intercompany profit whereas the economic unit concept supports 100 percent elimination of intercompany profit. c) The parent company concept supports valuation of subsidiary net assets in the consolidated financial statements at book value plus an amount equal to the parent company’s percentage interest in the difference between fair value and book value. The economic unit concept supports valuation of subsidiary net assets in the consolidated financial statements at their fair value on the date of acquisition without regard to the parent company’s percentage ownership interest. d) Under the parent company concept, consolidated net income measures the interest of the shareholders of the parent company in the operating results of the consolidated entity. Under the 1-2

economic unit concept, consolidated net income measures the operating results of the consolidated entity which is then allocated between the controlling and noncontrolling interests. 13. The implied fair value based on the price may not be relevant or reliable since the price paid is a negotiated price which may be impacted by considerations other than or in addition to the fair value of the net assets of the acquired company. There may be practical difficulties in determining the fair value of the consideration given and in allocating the total implied fair value to specific assets and liabilities. In the case of a less than wholly owned company, valuation of net assets at implied fair value violates the cost principle of conventional accounting and results in the reporting of subsidiary assets and liabilities using a different valuation procedure than that used to report the assets and liabilities of the parent company. 14. The economic entity is more consistent with the principles addressed in the FASB’s conceptual framework. It is an integral part of the FASB’s conceptual framework and is named specifically in SFAC No. 5 as one of the basic assumptions in accounting. The economic entity assumption views economic activity as being related to a particular unit of accountability, and the standard indicates that a parent and its subsidiaries represent one economic entity even though they may include several legal entities. 15. The FASB’s conceptual framework provides the guidance for new standards. The quality of comparability was very much at stake in FASB’s decision in 2001 to eliminate the pooling of interests method for business combinations. This method was also argued to violate the historical cost principle as it essentially ignored the value of the consideration (stock) issued for the acquisition of another company. The issue of consistency plays a role in the recent proposal to shift from the parent concept to the economic entity concept, as the former method valued a portion (the noncontrolling interest) of a given asset at prior book values and another portion (the controlling interest) of that same asset at exchange-date market value. 16. Comprehensive income is a broader concept, and it includes some gains and losses explicitly stated by FASB to bypass earnings. The examples of such gains that bypass earnings are some changes in market values of investments, some foreign currency translation adjustments and certain gains and losses, related to minimum pension liability. In the absence of gains or losses designated to bypass earnings, earnings and comprehensive income are the same.

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ANSWERS TO BUSINESS ETHICS CASE

1. The third item will lead to the reduction of net income of the acquired company before acquisition, and will increase the reported net income of the combined company subsequent to acquisition. The accelerated payment of liabilities should not have an effect on net income in current or future years, nor should the delaying of the collection of revenues (assuming those revenues have already been recorded). 2. The first two items will decrease cash from operations prior to acquisition and will increase cash from operations subsequent to acquisition. The third item will not affect cash from operations. 3. As the manager of the acquired company I would want to make it clear that my future performance (if I stay on with the consolidated company) should not be evaluated based upon a future decline that is perceived rather than real. Further, I would express a concern that shareholders and other users might view such accounting maneuvers as sketchy. 4. a) Earnings manipulation may be regarded as unethical behavior regardless of which side of the acquirer/acquiree equation you’re on. The benefits that you stand to reap may differ, and thus your potential liability may vary. But the ethics are essentially the same. Ultimately the company may be one unified whole as well, and the users that are affected by any kind of distorted information may view any participant in an unsavory light. b) See answer to (a).

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ANSWERS TO ANALYZING FINANCIAL STATEMENTS AFS1-1 Kraft and Cadbury PLC (1) Discuss some of the factors that should be considered in analyzing the impact of this merger on the income statement for the next few years. Factors to consider would include items such as a) cost savings b) increasing global presence and increased revenue (from increased market share) c) gaining access to emerging markets, d) geographical and cultural differences between the two companies. Companies generally project EPS for a few years following the merger, and compare these proforma calculations to the EPS prior to the merger. If the EPS increases, the merger is viewed as accretive. If not, it is dilutive. If costs can be eliminated due to redundancies, this helps move toward an accretive EPS. These costs may be related to personnel, computer systems, advertising, etc. However, the impact on the attitudes and incentives of the remaining personnel is not always easy to predict or to quantify. Synergies, in contrast, may serve to boost EPS and create an even more positive environment going forward than anticipated. (2) Discuss the pros and cons that Kraft might have weighed in choosing the medium of exchange to consummate the acquisition. Do you think they made the right decision? If possible, use figures to support your answer. The use of each to consummate a merger represents an opportunity cost, in that the cash obviously cannot be used elsewhere. A company needs to weigh the alternative uses available at a given point in time. The use of stock increases the denominator of the EPS calculation thus diluting the earnings for a the existing shareholders. This is not necessarily a poor choice, though, as long as the increase in the numerator justifies the impact on the denominator. The current stock price of the two companies determines the exchange ratio, and most companies are more comfortable using stock when its value is high because it takes fewer shares to reach a specified acquisition price. This view is not entirely sound, however, as the price of the target may be inflated also when the market prices are generally higher. The use of debt to consummate a merger is associated with increased interest costs; hence, debt is generally a wiser choice when interest rates are low. (3) In addition to the factors mentioned above, there are sometimes factors that cannot be quantified that enter into acquisition decisions. What do you suppose these might be in the case of Kraft's merger with Cadbury? One issue to consider is the cultural differences between the two companies. If one company has a _______ management style while the other is predominantly ________, the merger can create morale problems for individuals accustomed to being evaluated and treated in a different fashion. (4) This acquisition is complicated by the lack of consistency between the two companies' methods of accounting and currency. Discuss the impact that these issues are likely to have on the merged company in the years following the acquisition. Differences in methods, such as depreciation, approaches to estimated bad debts and other reserves, inventory valuation, etc. can lead to headaches and soaring costs following a merger. Translating currency into uniform denomination, whether dollars or euros, leads to translation gains or losses, which impact either earnings or other comprehensive income and more headaches.

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AFS1-2 Kraft and Cadbury PLC A. Cadbury’s Performance Cadbury

ROE 2009 2008 2007

14.5% 10.3% 9.7%

ROA 2009 2008 2007

Leverage 2009 2.308 2008 2.517 2007 2.717

6.3% 4.1% 3.6%

Profit Margin 2009 8.5% 2008 6.8% 2007 8.6%

Asset Turnover 2009 0.735 2008 0.605 2007 0.414

Asset/MV 2009 0.663 2008 1.079 2007 1.183

Profit Margin (PM%) 2009 8.5% 2008 6.8% 2007 8.6%

NI/CFO 2009 0.973 2008 0.776 2007 0.499

MV/BV 2009 3.483 2008 2.332 2007 2.296

Asset turnover 2009 0.735 2008 0.605 2007 0.414

CFO/Sales 2009 8.8% 2008 8.7% 2007 17.3%

Sales/WC 2009 (19.337) 2008 (7.150) 2007 (2.333)

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WC/Assets 2009 -3.8% 2008 -8.5% 2007 -17.8%

AFS1-1 (continued) Part A Computations ROE

Net Income 2009 509 2008 364 2007 405

Equity 3,522 3,534 4,173

ROE 14.5% 10.3% 9.7%

ROA

Net Income Assets 2009 509 8,129 2008 364 8,895 2007 405 11,338

PM%

Net Income 2009 509 2008 364 2007 405

Sales 5,975 5,384 4,699

PM% 8.5% 6.8% 8.6%

Asset Turn. 2009 2008 2007

Sales 5,975 5,384 4,699

Assets Asset Turn. 8,129 0.735 8,895 0.605 11,338 0.414

NI/CFO Net Income 2009 509 2008 364 2007 405

CFO 523 469 812

NI/CFO 0.973 0.776 0.499

CFO/Sales 2009 2008 2007

CFO 523 469 812

Sales CFO/Sales 5,975 8.8% 5,384 8.7% 4,699 17.3%

Sales/WC 2009 2008 2007

Sales 5,975 5,384 4,699

WC Sales/WC (309) (19.337) (753) (7.150) (2,014) (2.333)

WC/Assets 2009 2008 2007

WC Assets WC/Assets (309) 8,129 -3.8% (753) 8,895 -8.5% (2,014) 11,338 -17.8%

leverage 2009 2008 2007

Assets 8,129 8,895 11,338

Equity Asset/equity 3,522 2.308 3,534 2.517 4,173 2.717

Assets/MV 2009 2008 2007

Assets 8,129 8,895 11,338

MV Asset/MV 12,266 0.663 8,241 1.079 9,581 1.183

MV/Equity 2009 2008 2007

MV 12,266 8,241 9,581

Discussion 1-7

ROA 6.3% 4.1% 3.6%

Equity MV/equity 3,522 3.483 3,534 2.332 4,173 2.296

AFS1-1 (continued) Part A The trend in Cadbury’s performance from 2007 to 2009 is very strong. The profitability ratios all increases. ROE increased from 9.7% to 14.5%, while ROA increased from 3.6% to 6.3%. The profit margin decreased slightly in 2008 but was still strong at 6.8%. The gross margins (not shown) remained fairly constant over the three years averaging around 46%. Cadbury generated more than 8% cash from operation (CFO) in each year. The leverage ratio decreased and the market value to book value ratio increased every year to 3.483 in 2009 (indicating good growth potential). The asset turnover ratio (sales to assets) increased in every year, primarily from increased revenues and decreasing assets. Working capital was negative in every year but also has been improving as Cadbury has been reducing the amount of current liabilities over time.

Gross margin percentages

2007 46.7%

2008 46.7%

2009 46.3%

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Cadbury’s ROE and ROA

The solid lines in each graph represent a line where the ROE or ROA is equal to the three year average ROE or ROA for Cadbury. As shown in the last year (2009) both ratios exceeded the three-year average for both ROE and ROA. Consider the ROA graph. Even though the profit margin percentage was relatively constant (hovering around 8%) because the asset turnover was increasing (increased sales and decreasing assets), ROA was increasing over time. Consider the ROE graph. Because Leverage was decreasing and ROA was increasing, ROE was increasing over time.

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AFS1-2 (continued) B. Kraft Foods Ratio Analysis ROE 2009 2008 2007

11.6% 12.9% 9.5%

ROA 2009 2008 2007

Leverage 2009 2.569 2008 2.826 2007 2.491

4.5% 4.6% 3.8%

Profit Margin 2009 7.8% 2008 7.1% 2007 7.0%

Asset Turnover 2009 0.581 2008 0.641 2007 0.548

Asset/MV 2009 1.663 2008 1.313 2007 1.347

Profit Margin 2009 7.8% 2008 7.1% 2007 7.0%

NI/CFO 2009 0.594 2008 0.696 2007 0.725

MV/BV 2009 1.544 2008 2.152 2007 1.849

Asset turnover 2009 0.581 2008 0.641 2007 0.548

CFO/Sales 2009 13.1% 2008 10.2% 2007 9.6%

Sales/WC 2009 40.243 2008 (35.929) 2007 (5.866)

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WC/Assets 2009 1.4% 2008 -1.8% 2007 -9.3%

AFS1-2 (part b continued) Computations: ROE

Net Income 2009 3,021 2008 2,884 2007 2,590

Equity 25,972 22,356 27,295

ROE 11.6% 12.9% 9.5%

ROA

Net Income Assets 2009 3,021 66,714 2008 2,884 63,173 2007 2,590 67,993

ROA 4.5% 4.6% 3.8%

PM%

Net Income 2009 3,021 2008 2,884 2007 2,590

Sales 38,754 40,492 37,241

PM% 7.8% 7.1% 7.0%

Asset Turn. 2009 2008 2007

Sales 38,754 40,492 37,241

Assets Asset Turn. 66,714 0.581 63,173 0.641 67,993 0.548

NI/CFO Net Income 2009 3,021 2008 2,884 2007 2,590

CFO 5,084 4,141 3,571

NI/CFO 0.594 0.696 0.725

CFO/Sales 2009 2008 2007

CFO 5,084 4,141 3,571

Sales CFO/Sales 38,754 13.1% 40,492 10.2% 37,241 9.6%

Sales/WC 2009 2008 2007

Sales 38,754 40,492 37,241

WC Sales/WC 963 40.243 (1,127) (35.929) (6,349) (5.866)

WC/Assets 2009 2008 2007

WC Assets WC/Assets 963 66,714 1.4% (1,127) 63,173 -1.8% (6,349) 67,993 -9.3%

leverage 2009 2008 2007

Assets 66,714 63,173 67,993

Equity Asset/equity 25,972 2.569 22,356 2.826 27,295 2.491

Assets/MV 2009 2008 2007

Assets 66,714 63,173 67,993

MV Asset/MV 40,111 1.663 48,110 1.313 50,480 1.347

MV/Equity 2009 2008 2007

MV 40,111 48,110 50,480

Equity MV/equity 25,972 1.544 22,356 2.152 27,295 1.849

Discussion The trend in Kraft Food’s performance from 2007 to 2009 is strong. The profitability ratios have generally increased over time with a slight decrease in 2009. ROE increased from 9.5% to 11.6% (decreasing by 1.3% in 2009), while ROA increased from 3.8% to 4.5% (with a 0.1% decline in 2009). The profit margin increased every year and was 7.8% in 2009. The gross margins (not shown) remained fluctuated over the three years averaging around 34%. Kraft generated around 10% cash from operation (CFO) in each year. The leverage ratio has fluctuated and the market value to book value ratio initially increased but then decreased by 0.6 in 2009 (indicating potential growth issues). The asset turnover ratio (sales to assets) is showing an overall increasing trend relative to 2007. Working capital has been negative but turned positive in 2009 current assets have been growing while current liabilities are decreasing. Gross margin percentages

2007 33.8%

2008 32.9%

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2009 36.0%

Kraft Foods ROE and ROA

The solid lines in each graph represent a line where the ROE or ROA is equal to the three year average ROE or ROA for Kraft Foods. As shown in the last two years (2008 and 2009) both ratios exceeded their three-year averages. Consider the ROA graph. Even though the profit margin percentage increased in every year, the increase in the profit margin in 2009 was able to offset the decreased asset turnover keeping ROA constant from 2008 to 2009. Consider the ROE graph. In 2009, ROE dropped even though ROA remained fairly constant from 2008 to 2009 because leverage decreased in 2009.

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ANSWERS TO EXERCISES Exercise 1-1 Part A Normal earnings for similar firms = ($15,000,000 - $8,800,000) x 15% = $930,000 Expected earnings of target: Pretax income of Condominiums, Inc., 2005 Subtract: Additional depreciation on building ($960,000  30%) Target’s adjusted earnings, 2005

$1,200,000 (288,000)

Pretax income of Condominiums, Inc., 2006 Subtract: Additional depreciation on building Target’s adjusted earnings, 2006

$1,500,000 (288,000)

912,000

1,212,000

Pretax income of Condominiums, Inc., 2007 Add: Extraordinary loss Subtract: Additional depreciation on building Target’s adjusted earnings, 2007 Target’s three year total adjusted earnings Target’s three year average adjusted earnings ($3,086,000  3)

$950,000 300,000 (288,000) 962,000 3,086,000 1,028,667

Excess earnings of target = $1,028,667 - $930,000 = $98,667 per year Present value of excess earnings (perpetuity) at 25%:

$98,667 = $394,668 (Estimated Goodwill) 25%

Implied offering price = $15,000,000 – $8,800,000 + $394,668 = $6,594,668.

Part B Excess earnings of target (same as in Part A) = $98,667 Present value of excess earnings (ordinary annuity) for three years at 15%: $98,667  2.28323 = $225,279 Implied offering price = $15,000,000 – $8,800,000 + $225,279 = $6,425,279. Note: The sales commissions and depreciation on equipment are expected to continue at the same rate, and thus do not necessitate adjustments.

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Exercise 1-2 Part A Cumulative 5 years net cash earnings Add nonrecurring losses Subtract extraordinary gains Five-years adjusted cash earnings  $831,000   Average annual adjusted cash earnings  5  

$850,000 48,000 (67,000) $831,000 $166,200

(a) Estimated purchase price = present value of ordinary annuity of $166,200 (n=5, rate= 15%) $166,200  3.35216 = $557,129 (b) Less: Market value of identifiable assets of Beta Less: Liabilities of Beta Market value of net identifiable assets Implied value of goodwill of Beta

$750,000 320,000

Part B Actual purchase price Market value of identifiable net assets Goodwill purchased

430,000 $127,129 $625,000 430,000 $195,000

Exercise 1-3 Part A Normal earnings for similar firms (based on tangible assets only) = $1,000,000 x 12% = $120,000 Excess earnings = $150,000 – $120,000 = $30,000 (1)

Goodwill based on five years excess earnings undiscounted. Goodwill = ($30,000)(5 years) = $150,000

(2)

Goodwill based on five years discounted excess earnings Goodwill = ($30,000)(3.6048) = $108,144 (present value of an annuity factor for n=5, I=12% is 3.6048)

(3)

Goodwill based on a perpetuity Goodwill = ($30,000)/.20 = $150,000

Part B The second alternative is the strongest theoretically if five years is a reasonable representation of the excess earnings duration. It considers the time value of money and assigns a finite life. Alternative three also considers the time value of money but fails to assess a duration period for the excess earnings. Alternative one fails to account for the time value of money. Interestingly, alternatives one and three yield the same goodwill estimation and it might be noted that the assumption of an infinite life is not as absurd as it might sound since the present value becomes quite small beyond some horizon. Part C Goodwill = [Cost less (fair value of assets less the fair value of liabilities)], Or, Cost less fair value of net assets Goodwill = ($800,000 – ($1,000,000 - $400,000)) = $200,000 1-14

ANSWERS TO ASC (Accounting Standards Codification) EXERCISES ASC1-1 Cross-Reference The conditions determining whether a lease is classified as an operating lease or a capital lease were prescribed in SFAS No. 13, paragraph 7. Where is this located in this Codification? Step 1: Choose the cross reference tab on the opening page of the Codification. Step 2: Use the ‘By Standard’ drop down menu. Choose FAS as the standard type and 013 as the standard number. Click on ‘Generate Report.’ Paragraph 7 of SFAS No. 13 is included in five paragraphs in the Codification; FASB ASC paragraphs 840-10-25 1,29,30,31, and 41. FASB ASC paragraph 840-10-25-1 lists the four basic criteria (transfer of ownership, bargain purchase option, lease term, and minimum lease payments). ASC1-2 Cross-Reference The rules defining the conditions to classify an item as extraordinary on the income statement were originally listed in APB Opinion No 30, paragraph 20. Where is this information located in the Codification? Step 1: Choose the cross reference tab on the opening page of the Codification. Step 2: Use the ‘By Standard’ drop down menu. Choose APB as the standard type and 30 as the standard number. Click on ‘Generate Report.’ Paragraph 20 of APB Opinion No 30 is included in three paragraphs in the Codification; FASB ASC paragraphs 225-20-45-2 and 8 and FASB ASC paragraph 225-20-15-2. The definition for extraordinary item is also included in the master glossary. FASB ASC paragraph 22520-45-2 lists the two criteria to classify an event or transaction as an extraordinary item: unusual nature and infrequency of occurrence. ASC1-3 Disclosure Suppose a firm entered into a capital lease, debiting an asset account and crediting a lease liability account for $150,000. Does this transaction need to be disclosed as part of the statement of cash flows? If so, where? Disclosure requirements are always section 50 in the Codification (ASC xxx-xx-50-x). Presentation of the statement of cash flows is found under general topic number 200 as topic 230, (ASC 230-xx-50-x). Yes FASB ASC paragraphs 230-10-50-3 and 4. Information about all investing and financing activities of an entity during a period that affect recognized assets or liabilities but that do not result in cash receipts or cash payments in the period shall be disclosed. Examples include obtaining an asset by entering into a capital lease. ASC1-4 General Principles Accounting textbooks under the former GAAP hierarchy were considered level 4 authoritative. Where do accounting textbooks stand in the Codification? The topic that established the Codification as authoritative GAAP is Topic 105. FASB ASC paragraph 105-10-05-3 states that accounting textbooks are nonauthoritative accounting guidance and literature.

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ASC1-5 Presentation How many years of comparative financial statements are required under current GAAP? Authoritative guidance for financial statement presentation is found in FASB ASC Topic 205 [, Presentation of Financial Statements] FASB ASC paragraph 205-10-45-2 states that it is desirable that the statement of financial position, the income statement, and the statement of changes in equity be presented for one or more preceding years, as well as for the current year.

ASC1-6 Overview Can the provisions of the Codification be ignored if the item is immaterial? Overview and background requirements are always section 05 in the Codification (ASC xxx-xx-05-x). In the search box on the Codification homepage, search for Immaterial. In the ‘narrow by area’ column, click in the box next to ‘general principles’ since the question asks whether GAAP needs to be followed if an item is immaterial. Click on go. The result indicates that FASB ASC paragraph 105-10-05-6 states that the provisions of the codification need not be applied to immaterial items.

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Chapter 1 CHAPTER ONE – INTRODUCTION TO BUSINESS COMBINATIONS I.

BUSINESS COMBINATIONS A business combination occurs when the operations of two or more companies are brought under common control. Merger activity over time is presented in Illustration 1-1 Part A.

II.

NATURE OF THE COMBINATION A.

Nature of the combination 1. In a friendly combination, the boards of directors of the potential combining companies negotiate mutually agreeable terms of a proposed combination. The proposal is then submitted to the stockholders of the involved companies for approval. 2.

An unfriendly (hostile) combination results when the board of directors of a company targeted for acquisition resists the combination. A formal tender offer enables the acquiring firm to deal directly with individual shareholders. 1

Chapter 1 B.

Defense tactics Resistance often involves various moves by the target company. Whether or not such defenses are ultimately beneficial to shareholders remains a controversial issue. 1. Poison pill: Issuing stock rights to existing shareholders enabling them to purchase additional shares at a price below market value, but exercisable only in the event of a potential takeover. Example:

Cisco creates "poison pill" to block takeovers by James Niccolai http://www.computerworld.com/ Cisco Systems, Inc. said yesterday that its board of directors has approved a shareholder rights plan designed to protect the networking company's investors in the event of a hostile takeover bid. Known in the business world as a "poison pill," the plan is a strategic maneuver to make the company's stock less attractive to potential bidders and to encourage bidders to solicit offerings through the company's board of directors, the San Jose, Calif., company said. A company spokeswoman said Cisco isn't currently the target of a takeover bid, but added that such plans aren't uncommon at large corporations. Under the plan, Cisco shareholders would have the right to acquire for half price one share in the company for each share held as of June 22. The plan would kick in if a person or company acquires or announces an offer to acquire 15% or more of the company's common stock, Cisco said.

Greenmail: The purchase of any shares held by the would-be acquiring company at a price substantially in excess of their fair value. The purchased shares are then held as treasury stock or retired.

White knight or white squire: Encouraging a third firm more acceptable to the target company management to acquire or merge with the target company.

Pac-man defense: Attempting an unfriendly takeover of the wouldbe acquiring company.

Selling the crown jewels: The sale of valuable assets to others to make the firm less attractive to the would-be acquirer. The negative aspect is that the firm, if it survives, is left without some important assets.

Leveraged buyouts: The purchase of a controlling interest in the target firm by its managers and third party investors, who usually incur substantial debt in the process and subsequently take the firm

Chapter 1 private. The bonds issued often take the form of high interest, high risk “junk” bonds.

III.

BUSINESS COMBINATIONS: WHY? WHY NOT? A.

A company may expand in several ways. Some firms concentrate on internal expansion. For other firms external expansion is the goal; a company may achieve significant cost savings as a result of external expansion. In addition to rapid expansion, the business combination method, or external expansion, has several other potential advantages over internal expansion: 1.

Operating synergies may take a variety of forms. In the case of vertical mergers (a merger between a supplier and a customer), synergies may result from the elimination of certain costs related to negotiation, bargaining, and coordination between the parties. In the case of a horizontal merger (a merger between competitors), potential synergies include the combination of sales forces, facilities, outlets, etc., and the elimination of unnecessary duplication in costs.

Combination may enable a company to compete more effectively in the international marketplace.

Business combinations are sometimes entered into to take advantage of income tax laws. The opportunity to file a consolidated tax return may allow profitable corporations’ tax liability to be reduced by the losses of unprofitable affiliates.

Diversification resulting from a merger offers a number of advantages, including increased flexibility, an internal capital market, an increase in the firm’s debt capacity, more protection from competitors over proprietary information, and sometimes a more effective utilization of the organization’s resources.

Divestitures accounted for over 30% of the merger and acquisitions activity in each quarter from 1995 into mid-1998 and from 2001 to 2010. Shedding divisions that are not part of a company’s core business became common during this period. In some cases the divestitures may be viewed as “undoing” or “redoing” past acquisitions.

Notwithstanding its apparent advantages, business combination may not always be the best means of expansion. 1.

An overriding emphasis on rapid growth may result in the pyramiding of one company on another without sufficient 3

Chapter 1 management control over the resulting conglomerate. Unsuccessful or incompatible combinations may lead to future divestitures.

IV.

In order to avoid large dilutions of equity, some companies have relied on the use of various debt and preferred stock instruments to finance expansion, only to find themselves unable to provide the required debt service during a period of decreasing economic activity. The junk bond market used to finance many of the mergers in the 1980s had essentially collapsed by the end of that decade.

Business combinations may destroy, rather than create, value in some instances.

BUSINESS COMBINATIONS -- AN HISTORICAL PERSPECTIVE A.

In the United States there have been three fairly distinct periods characterized by many business mergers, consolidations, and other forms of combinations: 1880-1904; 1905-1930; and 1945-present. 1.

1880-1904: Huge holding companies, or trusts, were created by investment bankers seeking to establish monopoly control over certain industries. This type of combination is generally called horizontal integration because it involves the combination of companies within the same industry.

1905-1930: Business combination activity of this period, fostered by the federal government during World War I, was encouraged to obtain greater standardization of materials and parts and to discourage price competition. After the war, these combinations were efforts to obtain better integration of operations, reduce costs, and improve competitive positions rather than attempts to establish monopoly control over an industry. This type of combination is called vertical integration because it involves the combination of a company with its suppliers or customers.

1945-present. The third period has exhibited rapid growth in merger activity since the mid-1960s, and even more rapid since the 1980s. Some observers have called this activity "merger mania.'' Illustration 1-1 presents two rough graphs of the level of merger activity from 1972 to 2010 in number of deals, and from 1979 to 2010 in dollar volume. Illustration 1-2 presents summary statistics on the level of activity for the year 2010 by industry sector for acquisitions with purchase prices valued in excess of $10 million.

Chapter 1

Illustration 1-2

10 Most Active Industries by Number of Transactions in 2010 Number Rank Industry

of Deals

% of all M&A Deals

Business Services

1,329

19.5%

Software

577

8.5%

Health Services

276

4.1%

Real Estate

267

3.9%

Oil & Gas

261

3.8%

Investment & Commodity Firms

242

3.6%

Commercial Banks

227

3.3%

Measuring, Medical & Photographic Equipment

206

3.0%

Electronic and Electrical Equipment

180

2.6%

Utilities Distribution

171

2.5%

Insurance

171

2.5%

This most recent period can be further subdivided to focus on trends of particular decades or subperiods. 1.

From the 1950s to the 1970s most mergers were conglomerate mergers. Here the primary motivation for combination was often to diversify business risk

The 1980s were characterized by a relaxation in antitrust enforcement during the Reagan administration and by the emergence of high-yield junk bonds to finance acquisitions. The dominant type of acquisition during this period and into the 1990s has been strategic acquisitions claiming to benefit from operating synergies. A temporary decline in activity near the end of the 1980s may be traced to the collapse of the junk bond market

Chapter 1 and to an economic recession. 3.

By the mid-1990s the credit markets had recovered, and the upsurge in mergers renewed to greater levels than ever before. Deregulation undoubtedly played a role in the popularity of combinations in the 1990sIn industries that were once fragmented because concentration for forbidden, the pace of mergers picked up significantly. During the early 2000s, merger activity began to decline, however the merger frenzy returned with steady growth from 2003 to 2006. Eighteen percent of all deals were in the service sector in 2005. By the end of 2008, a decline in merger activity was a direct result of the decline in the economy. In August 2011, the Justice Department sued to halt AT&T’s acquisition of T-Mobile due to competition concerns.

TERMINOLOGY AND TYPES OF COMBINATIONS A.

From an accounting perspective, the distinction that is most important at this stage is between an asset acquisition and a stock acquisition. An asset acquisition involves the purchase of all of the acquired company’s net assets, whereas a stock acquisition involves the attainment of control via purchase of a controlling interest in the stock of the acquired company.

A statutory merger results when one company acquires all the net assets of one or more other companies through an exchange of stock, payment of cash or other property, or the issue of debt instruments (or a combination of these methods). Thus, if A Company acquires B Company in a statutory merger, the combination is often expressed as Statutory Merger A Company

B Company

A Company

A statutory consolidation results when a new corporation is formed to acquire two or more other corporations through an exchange of voting stock; the acquired corporations then cease to exist as separate legal entities. Thus, if C Company is formed to consolidate A Company and B Company, the combination is generally expressed as Statutory Consolidation A Company

B Company

C Company

Chapter 1 +

A stock acquisition occurs when one corporation pays cash or issues stock or debt for all or part of the voting stock of another company, and the acquired company remains intact as a separate legal entity. Thus, if A Company acquires 50% of the voting stock of B Company), a parent subsidiary relationship results. Consolidated financial statements (explained in later chapters) are prepared and the business combination is often expressed as Consolidated Financial Statements

Financial Statements of A Company

Financial Statements of B Company

Consolidated Financial Statements of A Company and B Company

VII. TAKEOVER PREMIUMS A takeover premium is the term applied to the excess of the amount offered, or agreed upon, in an acquisition over the prior stock price of the acquired firm.

VIII. AVOIDING THE PITFALLS BEFORE THE DEAL To consider the potential impact on a firm’s earnings realistically, the acquiring firm’s managers and advisors must exercise due diligence in considering the information presented to them. Some of the factors to beware include: A.

Be cautious in interpreting any percentages presented by the selling company.

Don’t neglect to include assumed liabilities in the assessment of the cost of the merger. In addition to liabilities that are on the books of the acquired firm, be aware of the possibility of less obvious liabilities.

Watch out for the impact on earnings of the allocation of expenses and the effects of production increases, standard cost variances, LIFO liquidations, and by-product sales.

Note any nonrecurring items which may have artificially or temporarily boosted earnings. In addition to nonrecurring gains or revenues, look for recent changes in estimates, accrual levels, and methods.

Chapter 1 E.

IX.

Be careful of CEO egos.

DETERMINING PRICE AND METHOD OF PAYMENT IN BUSINESS COMBINATIONS Whether an acquisition is structured as an asset acquisition or a stock acquisition, the acquiring firm must choose to finance the combination with cash, stock, or debt (or some combination).

When a business combination is effected through an open-market acquisition of stock, no particular problems arise in connection with determining price or method of payment. Price is determined by the normal functioning of the stock market, and payment is generally in cash, although some or all of the cash may have to be raised by the acquiring company through debt or equity issues.

When a business combination is effected by a stock swap, or exchange of securities, both price and method of payment problems arise. In this case, the price is expressed in terms of a stock exchange ratio, which is generally defined as the number of shares of the acquiring company to be exchanged for each share of the acquired company, and constitutes a negotiated price. It is important to understand that each constituent of the combination makes two kinds of contributions to the new entity -- net assets and future earnings. The accountant often becomes deeply involved in the determination of the values of these contributions.

NET ASSET AND FUTURE EARNINGS CONTRIBUTIONS A.

Determination of an equitable price for each constituent company, and of the resulting exchange ratio, requires the valuation of each company's net assets, as well as their expected contribution to the future earnings of the new entity. To estimate current replacement costs of real estate and other items of plant and equipment, the services of appraisal firms may be needed.

Estimation of the value of goodwill to be included in an offering price is subjective. A number of alternative methods are available, usually involving the discounting of expected future cash flows (or free cash flows), earnings, or excess earnings over some period of years. Generally, the use of free cash flows or earnings yields an estimate of the entire firm value (including goodwill), whereas the use of excess earnings yields an estimate of the goodwill component of total firm value.

Steps in the excess earnings approach: Excess Earnings Approach to Estimating Goodwill 8

Chapter 1 1. 2.

3. 4.

XI.

Identify a normal rate of return on assets for firms similar to the company being targeted. Apply the rate of return identified in step 1 to the level of identifiable assets (or net assets) of the target to approximate what the “normal” firm in this industry might generate with the same level of resources. We will refer to the product as “normal earnings.” Estimate the expected future earnings of the target. Subtract the normal earnings calculated in step 2 from the expected target earnings from step 3. The difference is “excess earnings.” If the normal earnings are greater than the target’s expected earnings, then no goodwill is implied under this approach. To compute estimated goodwill from “excess earnings,” we must assume an appropriate time period and a discount rate. The shorter the time period and the higher the discount rate, the more conservative the estimate. Because of the assumptions needed in step 5, a range of goodwill estimates may be obtained simply by varying the assumed discount rate and/or the assumed discount period. Add the estimated goodwill from step 5 to the fair value of the firm’s net identifiable assets to arrive at a possible offering price.

ALTERNATIVE CONCEPTS OF CONSOLIDATED FINANCIAL STATEMENTS A.

Parent Company Concept: The parent company concept emphasizes the interests of the parent's shareholders. As a result, the consolidated financial statements reflected those stockholder interests in the parent itself, plus their undivided interests in the net assets of the parent's subsidiaries.

Economic Unit Concept: The economic unit concept emphasizes control of the whole by a single management. As a result, under this concept, consolidated financial statements are intended to provide information about a group of legal entities - a parent company and its subsidiaries - operating as a single unit. In its most recent pronouncements, FASB has opted to adopt this concept, and the 5th edition chapters (2 through 9) are based on the economic unit concept.

Noncontrolling Interest 1.

Under the economic unit concept, a noncontrolling interest is a part of the ownership equity in the entire economic unit.

Chapter 1 2.

Under the parent company concept, the nature and classification of a noncontrolling interest are unclear.

Consolidated Net Income 1.

Under the parent company concept, consolidated net income consists of the realized combined income of the parent company and its subsidiaries after deducting noncontrolling interest in income; that is, the noncontrolling interest in income is deducted as an expense item in determining consolidated net income.

Under the economic unit concept, consolidated net income consists of the total realized combined income of the parent company and its subsidiaries. The total combined income is then allocated proportionately to the noncontrolling interest and the controlling interest. Noncontrolling interest in income is considered an allocated portion of consolidated net income, rather than an element in the determination of consolidated net income.

Consolidated Balance Sheet Values 1.

Under the parent company concept, the value assigned to the net assets should not exceed cost to the parent company.

Under the economic unit concept, on the date of acquisition, the net assets of the subsidiary are included in the consolidated financial statements at their book value plus the entire difference between their fair value and their book value.

Elimination of Unrealized Intercompany Profit The elimination methods associated with these two points of view are generally referred to as total (100%) elimination and partial elimination. Note: this issue is unlikely to mean much to students at this point in their study, and may be returned to after chapter 6. It is included here, nonetheless, for the sake of thoroughness and because the discussion is fairly intuitive. 1.

Partial elimination is consistent with the parent company concept.

Total elimination is consistent with the economic unit concept.

Current and Past Practice

Commented [S1]: This part 3 needs to be shown as G. 3 a and b are separate from F.

Chapter 1 a.

Current (and past) practice follows neither the parent company nor the economic unit concept entirely. The differences in practice relate primarily to the classification of noncontrolling interest and the total elimination of unrealized intercompany profits in assets acquired from an affiliate. However, as previously stated, the expectation is that the economic entity concept will be followed in the future. Current accounting standards require the total elimination of unrealized intercompany profit in assets acquired from affiliated companies, regardless of the percentage of ownership.

XII. FASB CODIFICATION (SOURCE OF GAAP) A. On July 1, 2009, the Financial Accounting Standards Board (FASB) launches the FASB Accounting Standards Codification (ASC) as the single source of authoritative non-governmental U.S. generally accepted accounting principles (GAAP).

B. The GAAP Codification starts with 9 very general topics: General Principles, Presentation, Assets, Liabilities, Equity, Revenues, Expenses, Broad Transactions, and Industry. These general topics are then divided into 90 specific general topics. Each specific topic is divided into subtopics. Subtopics contain the sections and the paragraphs with the accounting guidance.

XIII. APPENDIX A EVALUATING FIRM PERFORMANCE A. The appendix provides a structured ratio analysis that can be used to evaluate firm performance. B. The structured approach begins with return on equity (ROE). This ratio can be decomposed into two ratios: Return on Assets (ROA) and Leverage. C. Return on assets can be decomposed into the profit margin ratio (Net income divided by sales) and the asset turnover ratio (Sales divided by assets). D. The two primary decompositions are shown graphically on the next page.

Commented [S2]:

Chapter 1

CHAPTER 2 Note: The letter A indicated for a question, exercise, or problem means that the question, exercise, or problem relates to a chapter appendix. ANSWERS TO QUESTIONS 1.

At the acquisition date, the information available (and through the end of the measurement period) is used to estimate the expected total consideration at fair value. If the subsequent stock issue valuation differs from this assessment, the Exposure Draft (SFAS 1204-001) expected to replace FASB Statement No. 141R (codified in FASB ASC 805-30-35) specifies that equity should not be adjusted. The reason is that the valuation was determined at the date of the exchange, and thus the impact on the firm’s equity was measured at that point based on the best information available then.

Pro forma financial statements (sometimes referred to as “as if” statements) are financial statements that are prepared to show the effect of planned or contemplated transactions.

For purposes of the goodwill impairment test, all goodwill must be assigned to a reporting unit. Goodwill impairment for each reporting unit should be tested in a two-step process. In the first step, the fair value of a reporting unit is compared to its carrying amount (goodwill included) at the date of the periodic review. The fair value of the unit may be based on quoted market prices, prices of comparable businesses, or a present value or other valuation technique. If the fair value at the review date is less than the carrying amount, then the second step is necessary. In the second step, the carrying value of the goodwill is compared to its implied fair value. (The calculation of the implied fair value of goodwill used in the impairment test is similar to the method illustrated throughout this chapter for valuing the goodwill at the date of the combination.)

The expected increase was due to the elimination of goodwill amortization expense. However, the impairment loss under the new rules was potentially larger than a periodic amortization charge, and this is in fact what materialized within the first year after adoption (a large impairment loss). If there was any initial stock price impact from elimination of goodwill amortization, it was only a short-term or momentum effect. Another issue is how the stock market responds to the goodwill impairment charge. Some users claim that this charge is a non-cash charge and should be disregarded by the market. However, others argue that the charge is an admission that the price paid was too high, and might result in a stock price decline (unless the market had already adjusted for this overpayment prior to the actual writedown).

ANSWERS TO BUSINESS ETHICS CASE a and b. The board has responsibility to look into anything that might suggest malfeasance or inappropriate conduct. Such incidents might suggest broader problems with integrity, honesty, and judgment. In other words, can you trust any reports from the CEO? If the CEO is not fired, does this send a message to other employees that ethical lapses are okay? Employees might feel that top executives are treated differently. ANSWERS TO ANALYZING FINANCIAL STATEMENTS EXERCISES AFS2-1 eBay acquires Skype (A) Goodwill computation Acquisition price Net tangible and intangible assets Goodwill

$ 2,593 million 262 million $ 2,331 million

(B) Factors used to determine in the contingent consideration is part of the exchange or not. (FASB ASC paragraphs 805-10-55-24 and 25) The acquirer should consider the following if the contingent payments are made to employees or selling shareholders. 1. Is the selling shareholder a continuing employee? If the contingent payment is canceled if the employee’s employment is terminated, then the consideration might be post-acquisition compensation for services. 2. If the selling shareholder is a continuing employee and the period of required continuing employment is longer than the contingent payment period, the contingent payments might, in substance, be compensation. 3. If the selling shareholder is a continuing employee and the employee’s compensation is reasonable in comparison to other key employees, the contingent payment may indicate additional consideration rather than compensation. 4. If the contingent payment for non-employees is less than the contingent payments for continuing employees, the additional contingent payments for employees may indicated compensation rather than additional consideration. (C) It is not clear why eBay would settle the earnout for $530.3 million when it is not clear that the conditions for having to make the additional contingent payments (up to $1.3 billion) were probably not going to be made. Under current GAAP, if the amount of the contingent payment exceeded the previously expected amount, the difference is reflected in earnings. Under the rules in effect for the Skype transaction the contingent payment was simply an adjustment of goodwill. Because eBay was settling the earnout for approximately a third of the total potential payments indicates that Skype was not performing well. Notice that eBay wrote down$1.39 billion in goodwill at the same time. One potential reason that eBay

might have agreed to the payment is that the former CEO of Skype was stepping down and the contingent payment may have been incentive. In addition, the earnout may have prevented eBay from selling Skype.

AFS2-2 eBay Sells Skype

eBay's Income Statement Net revenues Cost of net revenues Gross profit Operating expenses: Sales and marketing Product development General & administrative Provision for trans. & loan losses Amortization of acquired intangible assets Restructuring Impairment of goodwill Total operating expenses Income from operations Interest and other income Income before income taxes

As Reported 2007

2008

Adjustments

Adjusted

2009

2007

2008

2009

2007

2008

2009

$7,672,329

$8,541,261

$8,727,362

-364,564

-550,841

-620,403

$7,307,765

$7,990,420

$8,106,959

1,762,972

2,228,069

2,479,762

-337,338

-434,588

-462,701

1,425,634

1,793,481

2,017,061

5,909,357

6,313,192

6,247,600

(27,226)

(116,253)

(157,702)

5,882,131

6,196,939

6,089,898

1,882,810

1,881,551

1,885,677

1,882,810

1,881,551

1,885,677

619,727

725,600

803,070

619,727

725,600

803,070

904,681

998,871

1,418,389

904,681

998,871

1,075,189

293,917

347,453

382,825

293,917

347,453

382,825

204,104

234,916

262,686

204,104

234,916

262,686

49,119

38,187

49,119

38,187

(343,200)

3,905,239

4,237,510

4,447,634

1,390,938

(343,200)

(1,390,938)

5,296,177

4,237,510

4,790,834

(1,390,938)

613,180

2,075,682

1,456,766

1,363,712

137,671

107,882

1,422,385

750,851

2,183,564

2,879,151

Provision for income taxes Net income

(402,600)

(404,090)

(490,054)

$348,251

$1,779,474

$2,389,097

Ratios Gross Margin Percentage Operating Margin Percentage Income before taxes %

2007

2008

2009

77.0%

73.9%

71.6%

8.0%

24.3%

9.8%

25.6%

185,498

1,976,892

1,959,429

1,642,264

(1,400,000)

137,671

107,882

22,385

(1,214,502)

2,114,563

2,067,311

1,664,649

2007

2008

2009

80.5%

77.6%

75.1%

16.7%

27.1%

24.5%

20.3%

33.0%

28.9%

25.9%

20.5%

1,363,712

7.5%

(116,253)

21.1%

25.4%

There are four adjustments to eliminate the effect of Skype from eBay’s books. First, we eliminate the revenues and the direct expenses

AFS2-2 solution continued: from each year. We eliminated 100% of Skype’s revenues and direct expenses disclosed in the footnotes in 2009 because it was not clear from the disclosure whether those amounts were the amounts included on eBay’s statements or whether they were for the entire year. An acceptable solution would be to eliminate 11.5/12 or 95.8%. Second, the impairment of goodwill was added back in 2007. Third, the gain on the sale of $1.4 million was subtracted from interest and other income in 2009. And finally, the charge from the legal settlement was added back (or subtracted from costs) in 2009. Performance: Including Skype, eBay’s gross margin declined from 77% to 71.6%. Without Skype, the gross margin still declined, but the decline was smaller (80.5% to 75.1%). Including Skype, income before taxes showed a rather large increase in absolute dollars increasing to $2,879,151 from $648,251 (283% increase). After Skype is eliminated we find a decreasing trend from $2,114,563 to 1,664,649 (a 21.3% decline). A similar trend exists for the income before tax as a percentage of revenues. The unadjusted percentage increased from 9.8% to 33% while the adjusted percentage decreased from 28.9% to 20.5%. The most interesting aspect of the numbers is that eBay recorded an impairment charge of $1.4 million in 2007 and then in 2009 recorded an $1.4 million gain on the sale. ANSWERS TO EXERCISES Exercise 2-1 Part A Receivables Inventory Plant and Equipment Land Goodwill ($2,154,000 - $1,824,000) Liabilities Cash

228,000 396,000 540,000 660,000 330,000

Part B Receivables Inventory Plant and Equipment Land Liabilities Cash Gain on Acquisition of Saville $990,000)

228,000 396,000 540,000 660,000

594,000 1,560,000

Ordinary ($1,230,000 -

2-5

594,000 990,000 240,000

Exercise 2-2 Cash Receivables Inventories Plant and Equipment (net) ($3,840,000 + $720,000) Goodwill Total Assets

$680,000 720,000 2,240,000 4,560,000 120,000 $8,320,000

Liabilities Common Stock, $16 par ($3,440,000 + (.50  $800,000)) Other Contributed Capital ($400,000 + $800,000) Retained Earnings Total Equities

1,520,000 3,840,000 1,200,000 1,760,000 $8,320,000

Entries on Petrello Company’s books would be: Cash Receivables Inventory Plant and Equipment Goodwill * Liabilities Common Stock (25,000  $16) Other Contributed Capital ($48 - $16)  25,000

200,000 240,000 240,000 720,000 120,000 320,000 400,000 800,000

* ($48  25,000) – [($1,480,000 – ($800,000 – $720,000) – $320,000] = $1,200,000 – [$1,480,000 – $80,000 – $320,000] = $1,200,000 – $1,080,000 = $120,000

2-6

Exercise 2-3 Accounts Receivable Inventory Land Buildings and Equipment Goodwill Allowance for Uncollectible Accounts ($231,000 - $198,000) Current Liabilities Bonds Payable Premium on Bonds Payable ($495,000 - $450,000) Preferred Stock (15,000  $100) Common Stock (30,000  $10) Other Contributed Capital ($25 - $10)  30,000 Cash

231,000 330,000 550,000 1,144,000 848,000 33,000 275,000 450,000 45,000 1,500,000 300,000 450,000 50,000

Cost of acquisition ($1,500,000 + $750,000 + $50,000) = $2,300,000 Fair value of net assets (198,000 + 330,000 + 550,000 + 1,144,000 – 275,000 – 495,000) = 1,452,000 Goodwill = $848,000 Exercise 2-4 Cash Receivables Inventory Land Plant and Equipment Goodwill* Accounts Payable Bonds Payable Premium on Bonds Payable** Cash

96,000 55,200 126,000 198,000 466,800 137,450 44,400 480,000 45,050 510,000

** Present value of maturity value, 12 periods @ 4%: Present value of interest annuity, 12 periods @ 4%: Total present value Par value Premium on bonds payable

0.6246  $480,000 = 9.38507  $24,000 =

*Cash paid Less: Book value of net assets acquired ($897,600 – $44,400 – $480,000) Excess of cash paid over book value Increase in inventory to fair value (15,600) Increase in land to fair value (28,800) Increase in bond to fair value 45,050 Total increase in net assets to fair value Goodwill

2-7

$299,808 225,242 525,050 480,000 $ 45,050 $510,000 (373,200) 136,800

650 $137,450

Exercise 2-5 Current Assets Plant and Equipment Goodwill Liabilities Cash Liability for Contingent Consideration

960,000 1,440,000 336,000 216,000 2,160,000 360,000

Exercise 2-6 The amount of the contingency is $500,000 (10,000 shares at $50 per share) Part A Part B

Goodwill Paid-in-Capital for Contingent Consideration - Issuable

500,000

Paid-in-Capital for Contingent Consideration - Issuable Common Stock ($10 par) Paid-In-Capital in Excess of Par

500,000

500,000 100,000 400,000

Platz Company does not adjust the original amount recorded as equity. Exercise 2-7 1. (c) Cost (8,000 shares @ $30) Fair value of net assets acquired Excess of cost over fair value (goodwill)

$240,000 228,800 $ 11,200

2. (c) Cost (8,000 shares @ $30) Fair value of net assets acquired ($90,000 + $242,000 – $56,000) Excess of fair value over cost (gain)

$240,000 276,000 $ 36,000

Exercise 2-8 Current Assets Long-term Assets ($1,890,000 + $20,000) + ($98,000 + $5,000) Goodwill * Liabilities Long-term Debt Common Stock (144,000  $5) Other Contributed Capital (144,000  ($15 - $5))

362,000 2,013,000 395,000

* (144,000  $15) – [$362,000 + $2,013,000 – ($119,000 + $491,000)] = $395,000 2-8

119,000 491,000 720,000 1,440,000

 $700 ,000 $20 ,000  Total shares issued  +  = 144,000 $5 $5   Fair value of stock issued (144,000  $15) = $2,160,000

Exercise 2-9 Case A Cost (Purchase Price) Less: Fair Value of Net Assets Goodwill

$130,000 120,000 $ 10,000

Case B Cost (Purchase Price) Less: Fair Value of Net Assets Goodwill

$110,000 90,000 $ 20,000

Case C Cost (Purchase Price) Less: Fair Value of Net Assets Gain

$15,000 20,000 ($ 5,000)

Case A Case B Case C

Goodwill

Assets Current Assets

Long-Lived Assets

$10,000 20,000 0

$20,000 30,000 20,000

$130,000 80,000 40,000

2-9

Liabilities $30,000 20,000 40,000

Retained Earnings (Gain) 0 0 5,000

Exercise 2-10 Part A. 2011: Step 1: Fair value of the reporting unit Carrying value of unit: Carrying value of identifiable net assets $330,000 Carrying value of goodwill ($450,000 - $375,000) 75,000

$400,000

405,000 $ 5,000

Excess of carrying value over fair value The excess of carrying value over fair value means that step 2 is required. Step 2: Fair value of the reporting unit Fair value of identifiable net assets Implied value of goodwill Recorded value of goodwill ($450,000 - $375,000) Impairment loss 2012: Step 1: Fair value of the reporting unit Carrying value of unit: Carrying value of identifiable net assets Carrying value of goodwill ($75,000 - $15,000)

$400,000 340,000 60,000 75,000 $ 15,000 $400,000 $320,000 60,000 380,000 $ 20,000

Excess of fair value over carrying value

The excess of fair value over carrying value means that step 2 is not required. 2013: Step 1: Fair value of the reporting unit Carrying value of unit: Carrying value of identifiable net assets Carrying value of goodwill ($75,000 - $15,000)

$350,000 $300,000 60,000

Excess of carrying value over fair value

360,000 $ 10,000

The excess of carrying value over fair value means that step 2 is required. Step 2: Fair value of the reporting unit Fair value of identifiable net assets Implied value of goodwill Recorded value of goodwill ($75,000 - $15,000) Impairment loss

2 - 10

$350,000 325,000 25,000 60,000 $ 35,000

Part B. 2011:

Impairment Loss—Goodwill Goodwill

2012:

No entry

2013:

Impairment Loss—Goodwill Goodwill

15,000 15,000

35,000 35,000

Part C. FASB ASC paragraph 350-20-45-1 specifies the presentation of goodwill in the balance sheet and income statement (if impairment occurs) as follows: • The aggregate amount of goodwill should be a separate line item in the balance sheet. • The aggregate amount of losses from goodwill impairment should be shown as a separate line item in the operating section of the income statement unless some of the impairment is associated with a discontinued operation (in which case it is shown net-of-tax in the discontinued operation section). Part D. In a period in which an impairment loss occurs, FASB ASC paragraph 350-20-45-2 mandates the following disclosures in the notes: (1) A description of the facts and circumstances leading to the impairment; (2) The amount of the impairment loss and the method of determining the fair value of the reporting unit; (3) The nature and amounts of any adjustments made to impairment estimates from earlier periods, if significant. Exercise 2-11 a. Fair Value of Identifiable Net Assets Book values $500,000 – $100,000 = Write up of Inventory and Equipment: ($20,000 + $30,000) = Purchase price above which goodwill would result

$400,000 50,000 $450,000

b. Equipment would not be written down, regardless of the purchase price, unless it was reviewed and determined to be overvalued originally. c. A gain would be shown if the purchase price was below $450,000. d. Anything below $450,000 is technically considered a bargain. e. Goodwill would be $50,000 at a purchase price of $500,000 or ($450,000 + $50,000).

2 - 11

Exercise 2-12A Cash Accounts Receivable Inventory Land Plant Assets Discount on Bonds Payable Goodwill* Allowance for Uncollectible Accounts Accounts Payable Bonds Payable Deferred Income Tax Liability Cash

20,000 112,000 134,000 55,000 463,000 20,000 127,200 10,000 54,000 200,000 67,200 600,000

Cost of acquisition $600,000 Book value of net assets acquired ($80,000 + $132,000 + $160,000) 372,000 Difference between cost and book value 228,000 Allocated to: Increase inventory, land, and plant assets to fair value ($52,000 + $25,000 + $71,000) (148,000) Decrease bonds payable to fair value (20,000) Establish deferred income tax liability ($168,000  40%) 67,200 Balance assigned to goodwill $127,200 ANSWERS TO ASC (Accounting Standards Codification) EXERCISES ASC2-1 Presentation Does current GAAP require that the information on the income statement be reported in chronological order with the most recent year listed first, or is the reverse order acceptable as well? Alternative one: Step 1: In the search box on the home page, enter ‘chronological order’. Step 2: Two results are obtained. Alternative two: Step 1: Use the drop-down menus under the ‘presentation’ general topic on the homepage and choose ‘Presentation of financial statements’; then under the second drop-down menu, choose ’10-overall’. Step 2: Click on the ‘Expand’ option and scroll through the topics looking for ‘chronological order’. The very last line is SAB Topic 11.E Chronological Ordering of Data. FASB ASC 205-10-S99-9 under SEC guidance indicates that the SEC staff have not preference in what order the data are presented (e.g., the most current data displayed first, etc.) as long as all schedules in the report are ordered in the same chronological order. ASC2-2 General Principles In the 1990s, the pooling of interest method was a preferred method of accounting for consolidations by many managers because of the creation of instant earnings if the acquisition occurred late in the year. Can the firms that used pooling of interest in the 1990s continue to use the method for those earlier consolidations, or were they required to adopt the new standards for previous business combinations retroactively? 2 - 12

This issue is related to whether the rules for pooling of interest have been grandfathered or not. Alternative one: Step 1: Below the search box on the home page, click on ‘advanced search.’ Enter ‘Pooling of interests’ in the text/keyword box and click on exact phrase. Step 2: Three results are obtained and the first alternative is the correct answer. Alternative two: Step 1: Use the drop-down menus under the ‘General Principles’ general topic on the homepage and choose ‘Generally Accepted Accounting Principles’; then under the second drop-down menu, choose ’10-overall’. Step 2: Section 70 is always the section for grandfathered guidance. FASB ASC subparagraph 105-10-70-2(a) lists pooling of interests is listed as a grandfathered method. ASC2-3 Glossary What instruments qualify as cash equivalents? On the Codification homepage, click on ‘Master Glossary’ in the left-hand column. In the ‘glossary term quick find’ menu type ‘cash equivalent’ and hit return. Cash equivalents are short-term, highly liquid investments that have both of the following characteristics: a. Readily convertible to known amounts of cash b. So near their maturity that they present insignificant risk of changes in value because of changes in interest rates. ASC2-4 Overview If guidance for a transaction is not specifically addressed in the Codification, what is the appropriate procedure to follow in identifying the proper accounting? The topic that established the Codification as authoritative GAAP is Topic 105. Step 1: Use the drop-down menus under the ‘General Principles’ general topic on the homepage and choose ‘Generally Accepted Accounting Principles’; then under the second drop-down menu, choose ’10-overall’. Step 2: click on the red ‘Join all Sections’ button. Scroll through the paragraphs. FASB ASC paragraph 105-10-05-2 states that if the guidance for a transaction or event is not specified within a source of authoritative GAAP for that entity, an entity shall first consider accounting principles for similar transactions or events within a source of authoritative GAAP for that entity and then consider nonauthoritative guidance from other sources.

2 - 13

ASC2-5 General List all the topics found under General Topic 200—Presentation (Hint:There are 15 topics). Presentation 205 210 215 220 225

Presentation of Financial Statements Balance Sheet Statement of Shareholder Equity Comprehensive Income Income Statement

230 235 250 255 260

Statement of Cash Flows Notes to Financial Statements Accounting Changes and Error Corrections Changing Prices Earnings Per Share

270 272 274 275 280

Interim Reporting Limited Liability Entities Personal Financial Statements Risks and Uncertainties Segment Reporting

ASC2-6 Cross-Reference The rules providing accounting guidance on subsequent events were originally listed in FASB Statement No. 165. Where is this information located in the Codification? List all the topics and subtopics in the Codification where this information can be found (i.e., ASC XXXXX). Step 1: Choose the cross reference tab on the opening page of the Codification. Step 2: Use the ‘By Standard’ drop down menu. Choose FAS as the standard type and 165 as the standard number. Click on ‘Generate Report.’ FASB ASC subtopic 855-10 [, Subsequent Events – Overall] ASC2-7 Overview Distinguish between an asset acquisition and the acquisition of a business. This is a more difficult issue to find. Alternative one: Step 1: Below the search box on the home page, click on ‘advanced search.’ Enter ‘asset acquisition’ in the text/keyword box and click on exact phrase. Step 2: Sixteen results are obtained. You can narrow the search by clicking on ‘business combinations’ in the Narrow by related term section. Then, notice that the section on ‘related issues’ seems to be where acquisition of assets rather than a business is located. FASB ASC paragraph 805-50-05-3 states that the guidance in the ‘acquisition of assets rather than a business’ subsections address transactions in which the assets acquired and liabilities assumed do not constitute a business. A business is considered an integrated set of activities and assets that is capable of being conducted and managed for the purpose of providing a return in the form of dividends, lower costs, or other economic benefits directly to investors or other owners, members, or participants. 2 - 14

Alternative two: Step 1: Use the drop-down menus under the ‘Broad Transactions’ general topic on the homepage and choose ‘Business Combinations’; then under the second drop-down menu, choose ’10-overall’. Expand the sections. Since nothing is listed related to the search, go to the scope section (805-10-15). FASB ASC subparagraph 805-10-15-4(b) tells you the scope of section 10 does not cover asset acquisitions. Step 2: Go back and search for ‘asset acquisition. ASC2-8 Measurement GAAP requires that firms test for goodwill impairment on an annual basis. One reporting unit performs the impairment test during January while a second reporting unit performs the impairment test during July. If the firm reports annual results on a calendar basis, is this acceptable under GAAP? This can be a difficult issue to find depending on the student’s knowledge of goodwill. If a general search is used with the term ‘goodwill impairment’ the correct section can be found. The student must be aware that ‘subsequent measurement’ would be related to impairment testing of goodwill since impairment tests are subsequent measurements of goodwill. However, since the correct paragraph is paragraph 28, a lot of scrolling is needed. Alternative two Step 1: Use the drop-down menus under the ‘Assets’ general topic on the homepage and choose ‘350 – Intangibles-Goodwill and other’; then under the second drop-down menu, choose ’20-Goodwill’. Expand the sections. Since nothing is listed related to the search, go to the scope section (805-10-15). FASB ASC subparagraph 805-10-15-4(b) tells you the scope of section 10 does not cover asset acquisitions. Step 2: click on subsequent measurement and click on ‘expand’ topics. One of the topics is ‘when to test goodwill impairment’. FASB ASC paragraph 350-20-35-28 states that different reporting units may be tested for impairment at different times. ANSWERS TO PROBLEMS Problem 2-1 Current Assets Plant and Equipment Goodwill* Liabilities Common Stock [(20,000 shares @ $10/share)] Other Contributed Capital [(20,000  ($15 – $10))]

85,000 150,000 100,000

Acquisition Costs Expense Cash

20,000

Other Contributed Capital Cash To record the direct acquisition costs and stock issue costs

6,000

35,000 200,000 100,000

20,000

2 - 15

6,000

* Goodwill = Excess of Consideration of $335,000 (stock valued at $300,000 plus debt assumed of $35,000) over Fair Value of Identifiable Assets of $235,000 (total assets of $225,000 plus PPE fair value adjustment of $10,000) Problem 2-2

Acme Company Balance Sheet October 1, 2011 (000)

Part A. Assets (except goodwill) ($3,900 + $9,000 + $1,300) Goodwill (1) Total Assets

$14,200 1,160 $15,360

Liabilities ($2,030 + $2,200 + $260) Common Stock (180  $20) + $2,000 Other Contributed Capital (180  ($50 – $20)) Retained Earnings Total Liabilities and Equity

$4,490 5,600 5,400 (130) $15,360

(1) Cost (180  $50) Fair value of net assets acquired: Fair value of assets of Baltic and Colt Less liabilities assumed Goodwill

$9,000 $10,300 2,460

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7,840 $1,160

Problem 2-2 (continued) Part B. Baltic 2012: Step1: Fair value of the reporting unit $6,500,000 Carrying value of unit: Carrying value of identifiable net assets 6,340,000 Carrying value of goodwill 200,000* Total carrying value 6,540,000 *[(140,000 x $50) – ($9,000,000 – $2,200,000)] The excess of carrying value over fair value means that step 2 is required. Step 2: Fair value of the reporting unit Fair value of identifiable net assets Implied value of goodwill Recorded value of goodwill Impairment loss

$6,500,000 6,350,000 150,000 200,000 $ 50,000

(because $150,000 < $200,000) Colt 2012: Step1: Fair value of the reporting unit $1,900,000 Carrying value of unit: Carrying value of identifiable net assets $1,200,000 Carrying value of goodwill 960,000* Total carrying value 2,160,000 *[(40,000 x $50) – ($1,300,000 – $260,000)] The excess of carrying value over fair value means that step 2 is required. Step 2: Fair value of the reporting unit Fair value of identifiable net assets Implied value of goodwill Recorded value of goodwill Impairment loss

$1,900,000 1,000,000 900,000 960,000 $ 60,000

(because $900,000 < $960,000) Total impairment loss is $110,000. Journal entry: Impairment Loss Goodwill

$110,000 $110,000

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Problem 2-3 Present value of maturity value, 20 periods @ 6%: 0.3118  $600,000 = Present value of interest annuity, 20 periods @ 6%: 11.46992  $30,000 = Total Present value Par value Discount on bonds payable Cash Accounts Receivable Inventory Land Buildings Equipment Bond Discount ($40,000 + $68,822) Current Liabilities Bonds Payable ($300,000 + $600,000) Gain on Acquisition of Stalton (ordinary)

$187,080 344,098 531,178 600,000 $68,822 114,000 135,000 310,000 315,000 54,900 39,450 108,822 95,300 900,000 81,872

Computation of Excess of Net Assets Received Over Cost Cost (Purchase Price) ($531,178 plus liabilities assumed of $95,300 and $260,000) Less: Total fair value of assets received Excess of fair value of net assets over cost

$886,478 $968,350 ($ 81,872)

Problem 2-4 Part A January 1, 2011 Accounts Receivable Inventory Land Buildings Equipment Goodwill* Allowance for Uncollectible Accounts Accounts Payable Note Payable Cash Liability for Contingent Consideration *Computation of Goodwill Cost of Acquisition ($720,000 + $135,000) Total fair value of net assets acquired ($1,064,000 - $263,000) Goodwill

2 - 18

72,000 99,000 162,000 450,000 288,000 54,000 7,000 83,000 180,000 720,000 135,000 $855,000 801,000 $ 54,000

Problem 2-4 (continued) Part B January 2, 2013 Liability for Contingent Consideration Cash

135,000 135,000

Part C January 2, 2013 Liability for Contingent Consideration Income from Change in Estimate

Problem 2-5

135,000 135,000

Pepper Company Pro Forma Balance Sheet Giving Effect to Proposed Issue of Common Stock and Note Payable for All of the Net Assets of Salt Company December 31, 2010

Cash Receivables

Audited Balance Sheet $180,000 230,000

Inventories Plant Assets Goodwill Total Assets

231,400 1,236,500 _________ $1,877,900

Accounts Payable

$255,900

Notes Payable, 8% Mortgage Payable Common Stock, $20 par Additional Paid-in Capital Retained Earnings Total Liabilities and Equity

0 180,000 900,000 270,000 272,000 $1,877,900

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Adjustments 405,000 (60,000) 117,000 134,000 905,000 (1) 181,500 (60,000) 180,000 300,000 152,500 600,000 510,000 (2)

Pro Forma Balance Sheet $585,000 287,000 365,400 2,141,500 181,500 $3,560,400 $375,900 300,000 332,500 1,500,000 780,000 272,000 $3,560,400

Problem 2-5 (continued) Change in Cash Cash from stock issue ($37  30,000) Less: Cash paid for acquisition Plus: Cash acquired in acquisition Total change in cash

$1,110,000 (800,000) 95,000 $ 405,000

Goodwill: Cost of acquisition Net assets acquired ($340,000 + $179,500 + $184,000) Excess cost over net assets acquired Assigned to plant assets Goodwill (1) $690,000 + $215,000

Problem 2-6

$1,100,000 703,500 $396,500 215,000 $ 181,500

(2) ($37 - $20)  30,000

Ping Company Pro Forma Income Statement for the Year 2011 Assuming a Merger of Ping Company and Spalding Company

Sales (1) Cost of goods sold: Fixed Costs (2) Variable Costs (3) Gross Margin

$6,345,972 $824,706 2,464,095

Selling Expenses (4) Other Expenses (5)

$785,910 319,310

Net Income

3,288,801 3,057,171 1,105,220 $1,951,951

$499,411 $1,951,951 – ($952,640 + $499,900) = = $2,497,055 0 . 20 0.20 Since $2,497,055 is greater than $1,800,000 Ping should buy Spalding.

(1) $3,510,100 + $2,365,800 = $5,875,900  1.2  .9 = (2) ($1,752,360  .30) + ($1,423,800  .30  .70) = (3) $1,752,360  .70 

$5,875,900  1.2 $3,510,100

$6,345,972 $824,706 $2,464,095

(4) ($632,500 + $292,100)  .85 =

$785,910

(5) $172,600  1.85 =

$319,310

NOTE: In this problem, Part B states that fixed manufacturing expenses have been 35% of cost of goods for each company and that variable manufacturing expense of Ping Company is 70% of 2 - 20

cost of goods sold. This is an error because the percentages must equal 100%. For this solution, use 30% for fixed manufacturing expenses. Problem 2-7A Part A Receivables Inventory Land Plant Assets Patents Deferred Tax Asset ($60,000 x 35%) Goodwill* Current Liabilities Bonds Payable Premium on Bonds Payable Deferred Tax Liability Common Stock (30,000  $2) Other Contributed Capital (30,000  $26)

Cost of acquisition (30,000  $28) Book value of net assets acquired ($120,000 + $164,000 + $267,000) Difference between cost and book value Allocated to: Increase inventory, land, plant assets, and patents to fair value Deferred income tax liability (35%  $266,500) Increase bonds payable to fair value Deferred income tax asset (35%  $60,000) Balance assigned to goodwill

Part B Income Tax Expense (Balancing amount) Deferred Tax Liability ($51,125  35%)* Deferred Tax Asset ($6,000  35%) Income Tax Payable ($468,000  35%) * Inventory: $100,000 Plant Assets, 10 $105,000 Patents, 8 Total

$28,000 10,000 13,125 $51,125

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125,000 195,000 120,000 567,000 200,000 21,000 154,775 89,500 300,000 60,000 93,275 60,000 780,000

$840,000 551,000 289,000 (266,500) 93,275 60,000 (21,000) $154,775

148,006 17,894 2,100 163,800

Chapter 2 CHAPTER TWO – ACCOUNTING FOR BUSINESS COMBINATIONS I.

METHOD OF ACCOUNTING FOR NET ASSET ACQUISITIONS: PURCHASE OR ACQUISITION ACCOUNTING A. Accounting standards now mandate the use of the acquisition method for accounting for mergers & acquisitions. Previously, companies had a choice, albeit strictly regulated, between these two methods: 1) the pooling of interests method (until June 30, 2001) and 2) purchase method (fiscal years beginning before December 31, 2008). B. Under current GAAP the fair values of all assets and liabilities on the acquisition date, defined as the date the acquirer obtains control of the acquiree, are reflected in the financial statements. 1. The acquired business should be recognized at its fair value on the acquisition date rather than its cost, regardless of whether the acquirer purchases all or only a controlling percentage (even if the combination is achieved in stages). 2. The standards for business combinations now apply to business combinations involving only mutual entities, those achieved by contract alone, and the initial consolidation of variable interest entities (VIEs). VIEs are discussed in Chapter 3.

II.

PRO FORMA STATEMENTS AND DISCLOSURE REQUIREMENT A. Pro forma statements have historically served two functions in relation to business combinations: 1. To provide information in the planning stages of the combination, and 2. To disclose relevant information subsequent to the combination. B.

The term “pro forma” is also frequently used, aside from mergers, to indicate any calculations which are computed “as if” alternative rules or standards had been applied. For example, a firm may disclose in its press releases that earnings excluding certain one-time charges reflect a more positive trend than the GAAP-reported EPS. However, the SEC has recently cracked down on the extent to which these types of pro forma calculations may be presented, and the details that should be included in such announcements.

If a material business combination (or series of combinations material in the aggregate) occurred during the year, notes to financial statements should include on a pro forma basis: 1. Results of operations for the current year as though the companies had combined at the beginning of the year, unless the acquisition was at or near the beginning of the year.

Chapter 2

III.

2. Results of operations for the immediately preceding period as though the companies had combined at the beginning of that period if comparative financial statements are presented. EXPLANATION AND ILLUSTRATION OF ACQUISITION ACCOUNTING A. If cash is used, payment equals cost; if debt securities are used, present value of future payments represents cost. B.

Assets acquired via issued shares are recorded at fair values of the stock given or the assets received whichever is more clearly evident.

If stock is actively traded, market price is a better estimate of fair value than appraisal values. D. Under FASB ASC paragraph 805-10-25-23, acquisition related costs are excluded from the measurement of the consideration paid, because such costs are not part of the fair value of the acquiree and are not assets. a. Both direct and indirect expenses are expensed, and the cost of issuing securities is also excluded from the consideration paid. In the absence of more explicit guidance, we assume that security issuance costs reduce additional contributed capital for stock issues or adjust the premium or discount on bond issues. E.

Goodwill (GW) is recorded as any excess of total cost over the sum of amounts assigned to identifiable assets and liabilities and, under SFAS No. 142 [ASC 350] is no longer amortized.

Goodwill must be tested for impairment at a level referred to as a reporting unit – generally a level lower than that of the entire entity. If the implied fair value of the reporting unit’s goodwill is less than its carrying amount, goodwill is considered impaired. See Flowcharton the next page. .

Goodwill impairment losses should be aggregated and presented as a separate line item in the operating section of the income statement.

Bargain acquisition—when the net amount of fair values of identifiable assets less liabilities exceeds the total cost of the acquired company—a gain is recognized in the period of the acquisition under current GAAP.

When S Company acquires P Company with stock, common stock is credited for the par value of the shares issued, with the remainder credited to other contributed capital. Individual assets acquired and liabilities assumed are recorded at their fair values. Plant assets and other long-lived assets are recorded at their fair values. Bonds payable are recorded at their fair value by recognizing a premium or a discount on the bonds. When the cost exceeds the fair value of identifiable net assets, any excess of cost

Commented [S1]: I am not sure if the Flowchart will appear on the next page. Also, adding “D” may have created a spacing problem.

Chapter 2 over the fair value is recorded as goodwill. J.

Income Tax Consequences of Acquisition Method Business Combinations: deferred tax assets and/or liabilities should be recognized for differences between the assigned values and tax bases of the assets and liabilities acquired. Such differences are likely when the combination is tax-free to the sellers.

Chapter 2

Chapter 2 IV.

CONTINGENT CONSIDERATION IN AN ACQUISITION A. Contingency—transfer of assets (or other consideration) subsequent to acquisition to the seller, generally dependent on some measure of performance. Current GAAP requires that all contractual contingencies, as well as non-contractual liabilities for which it is more likely than not that an asset or liability exists, be measured and recognized at fair value on the acquisition date. B.

Contingency based on earnings is probably the most common, but it may create conflicts upon implementation because of measures which are out of the control of certain managers after the merger, as well as creating possible incentives for manipulation of earnings numbers (and may lead to decisions which are short-term rather than long-term focused).

Contingency based on security prices serves to correct some of the shortcomings of contingency calculations based on earnings (manipulation of numbers, for example), but leads to its own set of problems; for example, market prices fluctuate in response to many economy-wide factors that are almost completely outside the managers’ control. Illustration 2-4 Deals with Contingent Payments 2000 to 2006 $ Billions Year No. of Deals Value 2000 140 32.2 2001 120 20.7 2002 118 9.8 2003 92 29.2 2004 123 13.9 2005 127 19.5 2006 175 29.2

Earn-out Value 5.9 6.1 2.5 5.0 4.5 4.6 5.3

Source: Mergers & Acquisitions, February 2007.

Chapter 2 V.

LEVERAGED BUYOUTS (LBO) A. Group of employees/management and third-party investors create a new company to acquire all the outstanding shares of employer/original company. The management group contributes whatever stock they hold to the new corporation and borrows sufficient funds to acquire the remainder of the common stock. 1. The LBO term results because most of the capital of the new corporation comes from borrowed funds. B.

The basic accounting question relates to the net asset values (fair or book) to be used by the new corporation. 1. The economic entity concept should be applied; thus LBO transactions are viewed as business combinations.

Illustration 2-5 The Leveraged Buyout Market (LBO) 2000-2009 Year 2000 2001 2002 2003 2004

No. of Deals 311 172 187 197 366

% of all Deals 3.5% 2.5% 3.1% 3.0% 4.7%

2005 2006 2007 2008 2009 2010

520 754 815 576 287 438

6.1% 7.8% 7.8% 6.8% 4.9% 6.4%

Source: Mergers and Acquisitions February 2009, 2010, 2011

Chapter 2 VI.

IFRS versus U.S. GAAP

Illustration 2-6 Comparison of Business Combinations and Consolidations under U.S. GAAP and IFRS 1 U.S. GAAP 1. Fair value of contingent consideration recorded at acquisition date, with subsequent adjustments recognized through earnings if contingent liability (no adjustment for equity). 2. Contingent assets and liabilities assumed (such as warranties) are measured at fair value on the acquisition date if they can be reasonable estimated. If not, they are treated according to SFAS No. 5. 3. Noncontrolling interest is recorded at fair value and is presented in equity. 4. Special purpose entities (SPEs) are consolidated if the most significant activities of the SPE are controlled. Qualified SPE (QSPEs) are no longer exempted from consolidation rules. 5. Direct acquisition costs (excluding the costs of issuing debt or equity securities) are expenses. 6. Goodwill is not amortized, but is tested for impairment using a two-step process 7. Negative goodwill in an acquisition is recorded as an ordinary gain in income (not extraordinary). 8. Fair value is based on exit prices, i.e. the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. 9. Purchased in-process R&D is capitalized with subsequent expenditures expensed. The capitalized portion is then amortized. 10. Parent and subsidiary accounting policies do not need to conform. 11. Restructuring plans are accounted for separately from the business combination and generally expensed (unless conditions in SFAS No. 146 [ASC 420] are met). 12. Measurement period ends at the earlier of a) one year from the acquisition date, or b) the date when the acquirer receives needed information to consummate the acquisition. 13. For step acquisitions, all previous ownership interests are adjusted to fair value, with any gain or loss recorded in earnings. 14 Reporting dates for the parent and subsidiary can be different up to three months. Significant events in that time must be disclosed.

15. Potential voting rights are generally not considered in determining control

IFRS GAAP 1. IFRS 3R uses the same approach

2. Under IFRS 3R a contingent liability is recognized at the acquisition date if its fair value can be reliably measured. 3. Noncontrolling interest can be recorded either at fair value or at the proportionate share of the net assets acquired. Also presented in equity. 4. Special purpose entities (SPEs) are consolidated if controlled. QSPEs are not addressed. 5. IFRS 3R uses the same approach. 6. Goodwill is not amortized, but is tested for impairment using a one-step process. 7. IAS 36 uses the same approach. 8. Fair value is the amount for which an asset could be exchanged or a liability settled between knowledgeable, willing parties in an arm’s length transaction. 9. Purchased in-process R&D is capitalized with the potential for subsequent expenditures to be capitalized. The capitalized portion is then amortized. 10. Parent and subsidiary accounting policies do need to conform. 11. Similar accounting under IFRS 3 and amended IAS 27 12. Similar to U.S. GAAP

13. Similar to U.S. GAAP

14. Permits a three-month difference if impractical to prepare the subsidiary’s statements on the same date; however, adjustments are required for significant events in that period. 15. Potential voting rights are considered if currently exercisable.

Chapter 2

APPENDIX A: Deferred Taxes in Business Combinations A. B.

Motivation for selling firm: structure the deal so that any gain resulting is tax-free at the time of the combination. Deferred tax liability (or asset) needs to be recognized by purchaser when the book value of the assets is used (inherited) for tax purposes, but the fair value is recognized in the accounting books under acquisition accounting rules.

CHAPTER 3 Note: The letter A or B indicated for a question, exercise, or problem means that the question, exercise, or problem relates to a chapter appendix. ANSWERS TO QUESTIONS 1. (1) Stock acquisition is greatly simplified by avoiding the lengthy negotiations required in an exchange of stock for stock in a complete takeover. (2) Effective control can be accomplished with more than 50% but less than all of the voting stock of a subsidiary; thus the necessary investment is smaller. (3) An individual affiliate’s legal existence provides a measure of protection of the parent’s assets from attachment by creditors of the subsidiary. 2. The purpose of consolidated financial statements is to present, primarily for the benefit of the shareholders and creditors of the parent company, the results of operations and the financial position of a parent company and its subsidiaries essentially as if the group were a single company with one or more branches or divisions. The presumption is that these consolidated statements are more meaningful than separate statements and necessary for fair presentation. Emphasis then is on substance rather than legal form, and the legal aspects of the separate entities are therefore ignored in light of economic aspects. 3. Each legal entity must prepare financial statements for use by those who look to the legal entity for analysis. Creditors of the subsidiary will use the separate statements in assessing the degree of protection related to their claims. Noncontrolling shareholders, too, use these individual statements in determining risk and the amounts available for dividends. Regulatory agencies are concerned with the net resources and results of operations of the individual legal entities. 4. (1) Control should exist in fact, through ownership of more than 50% of the voting stock of the subsidiary. (2) The intent of control should be permanent. If there are current plans to dispose of a subsidiary, then the entity should not be consolidated. (3) Majority owners must have control. Such would not be the case if the subsidiary were in bankruptcy or legal reorganization, or if the subsidiary were in a foreign country where political forces were such that control by majority owners was significantly curtailed. 5. Consolidated workpapers are used as a tool to facilitate the preparation of consolidated financial statements. Adjusting and eliminating entries are entered on the workpaper so that the resulting consolidated data reflect the operations and financial position of two or more companies under common control. 6. Noncontrolling interest represents the equity in a partially owned subsidiary by those shareholders who are not members in the affiliation and should be accounted and presented in equity, separately from the parents’ shareholders equity. Alternative views have included: presenting the noncontrolling interest as a liability from the perspective of the controlling shareholders; presenting the noncontrolling interest between liabilities and shareholders’ equity to acknowledge its hybrid status; presenting it as a contra-asset so that total assets reflect only the parent’s share; and

3-1

presenting it as a component of owners’ equity (the choice approved by FASB in its most recent exposure drafts). 7. The fair, or current, value of one or more specific subsidiary assets may exceed its recorded value, or specific liabilities may be overvalued. In either case, an acquiring company might be willing to pay more than book value. Also, goodwill might exist in the form of above normal earnings. Finally, the parent may be willing to pay a premium for the right to acquire control and the related economic advantages gained. 8. The determination of the percentage interest acquired, as well as the total equity acquired, is based on shares outstanding; thus, treasury shares must be excluded. The treasury stock account should be eliminated by offsetting it against subsidiary stockholder equity accounts. The accounts affected as well as the amounts involved will depend upon whether the cost or par method is used to account for the treasury stock. 9. None. The full amount of all intercompany receivables and payables is eliminated without regard to the percentage of control held by the parent. 10A. The decision in SFAS No. 109 and SFAS No. 141R [topics 740 and 805] is primarily a display issue and would only affect the calculation of consolidated net income if there were changes in expected future tax rates that resulted in an adjustment to the balance of deferred tax assets or deferred tax liabilities. Prior to SFAS No. 109 and SFAS No. 141R, purchased assets and liabilities were displayed at their net of tax amounts and related figures for amortization and depreciation were based on the net of tax amounts. With the adoption of SFAS No. 109 and SFAS No. 141R, assets and liabilities are displayed at fair values and the tax consequences for differences between their assigned values and their tax bases are displayed separately as deferred tax assets or deferred tax liabilities. Although the amounts shown for depreciation, amortization and income tax expense are different under SFAS No. 109 and SFAS No. 141R, absent a change in expected future tax rates, the amount of consolidated net income will be the same.

ANSWERS TO BUSINESS ETHICS CASE Part 1 Even though the suggested changes by the CFO lie within GAAP, the proposed changes will unfairly increase the EPS of the company, misleading the common investors and other users. It is evident that the CFO is doing it for his or her personal gain rather than for the transparency of financial reporting. Thus, manipulating the reserve in this case comes under the heading of unethical behavior. Taking a stand in such a situation is a difficult and challenging test for an employee who reports to the CFO. Part 2 The tax laws permit individuals to minimize taxes by means that are within the law like using tax deductions, changing one's tax status through incorporation, or setting up a charitable trust or foundation. In the given case the losses reported were phony and the whole scheme was fabricated to illegally benefit certain individuals; hence there appears to be a criminal intent in the scheme. Although there is no reason to pay more tax than necessary, the lack of risk in these types of shelters makes participation in such schemes of questionable ethics, at the best.

3-2

ANSWERS TO ANALYZING FINANCIAL STATEMENTS EXERCISES AFS3-1 eBay’s Acquisitions 1. Acquisition-related costs are costs the acquirer incurs to effect a business combination. Those costs include finder’s fees; advisory, legal, accounting, valuation, and other professional or consulting fees; general administrative costs, including the costs of maintaining an internal acquisitions department; and costs of registering and issuing debt and equity securities. The acquirer shall account for acquisition-related costs as expenses in the periods in which the costs are incurred and the services are received, with one exception. The costs to issue debt are recognized as a deferred charge while the costs to issue equity securities are recognized either as a reduction in paid-in-capital or as an organizational cost and amortized over time. 2. Ratio of acquisition-related costs to purchase price. Purchase Rent.com $435,365 International Websites 81,584 Shopping.com 685,285

Acquisition-related costs $2,000 1,300 7,600

Ratio 0.46% 1.59% 1.11%

3. Journal entry to acquire Rent.com Investment in Rent.com Acquisition expenses Cash (or stock accounts)

435,365 2,000 437,365

4. Since eBay acquired Skype on October 15, 2005 and its yearend is December 31, 2005, eBay can only include income for the last two and a half months (October 15 to December 31). 5. International Classified Websites acquisition: Purchase price Fair value of net tangible and identifiable Intangible assets (81,584-71,771) Goodwill

$81,584 9,813 71,771

Most internet companies do not have a significant amount of physical assets. The value of such businesses tends to be derived from the expected future cash flows to be earned by the business. Thus the value of most internet companies will be recorded in goodwill.

3-3

AFS3-2 eBay’s Acquisitions 1. The growth rates for revenues and profits, including the profit margin ratio (net income divided by net revenues) under the two scenarios are as follows:

Assumed combined

Net Revenue - proforma Net Income - proforma Profit margin %

As reported by eBay Net Revenue- actual Net Income- actual Profit margin %

2004

$3,277,534 684,905 20.9% 2004 3,271,309 778,223 23.8%

Growth 2005 Rates $4,594,954 40.2% 944,057 37.8% 20.5% Growth Rates 4,552,401 39.2% 1,082,043 39.0% 23.8% 2005

Assuming that the results for 2004 and 2005 included Skype, the profit margins would be approximately 3% lower and the growth rate in net income would be slightly more than one percent lower. The growth rate in net revenues would be slightly higher by one percent. It appears that to acquire a one percent increase in revenues, that profits would be lowered by 3 percent of revenues. These numbers raise doubts about the wisdom of the acquisition. However, they reflect past rather than future periods, and the possibility existed at the time of the acquisition that growth in revenues would eventually translate into growth in profits. 2. Sixty percent of Skype’s shareholders opted for a lower cash price in favor of receiving a future contingent payment based on the performance of Skype. Shareholders are offered such payments when they believe that the consideration offered in the acquisition is too low. Ex post we know that Skype never met any of the performance goals and eBay eventually settled the contingent payment for approximately 1/3 of the maximum payment ($1.3 billion). Other factors involved include the shareholders’ tolerance for risk, and the quality of the information presented to them at the time.

3-4

ANSWERS TO EXERCISES Exercise 3-1 a. Common Stock – Saltez Other Contributed Capital - Saltez Retained Earnings - Saltez Property,Plant, and Equipment Investment in Saltez

160,000 92,000 43,000 56,000

b. Common Stock – Saltez Other Contributed Capital – Saltez Property, Plant, and Equipment ($232,000/0.9-[$190,000+$75,000-$29,000]) Retained Earnings – Saltez Investment in Saltez Noncontrolling Interest

190,000 75,000 21,778

351,000

29,000 232,000 25,778

c. Common Stock – Saltez 180,000 Other Contributed Capital – Saltez 40,000 Retained Earnings – Saltez Investment in Saltez Gain on Purchase of Business – Prancer ** Noncontrolling Interest (.2) ($198,750) + $3,450*

4,000 159,000 13,800 43,200

** The ordinary gain to Prancer is $159,000 – (.80)($216,000) = $13,800 * Noncontrolling interest reflects the noncontrolling share of implied value (.20 x $198,750, or $39,750), plus the NCI portion of the bargain (.20 x $17,250) NOTE: We know this is a bargain acquisition in part c because the investment cost of $159,000 implies a total value of $198,750. Since this value is less than the book value of equity of $216,000 [$180,000+$40,000-$4,000], the difference is a bargain of $17,250. This bargain is allocated between the parent (this portion is reflected as a gain) and the NCI. Exercise 3-2 Part A Investment in Save (40,000  $17.50) 700,000 Common Stock Other Contributed Capital ($700,000 – $20,000 – $400,000) Cash

400,000 280,000 20,000

Part B Common Stock – Save Other Contributed Capital – Save Retained Earnings –Save Investment in Save

700,000

320,000 175,000 205,000

3-5

Exercise 3-3 Part A Investment in Sun Company Cash Part B

192,000 192,000

PRUNCE COMPANY AND SUBSIDIARY Consolidated Balance Sheet January 2, 2011 Assets Cash ($260,000 + $64,000 – $192,000) Accounts Receivable Inventory Plant and Equipment (net) Land ($63,000 + $32,000 + $28,333*) Total Assets

$132,000 165,000 171,000 484,000 123,333 $1,075,333

Liabilities and Stockholders’ Equity Accounts Payable Mortgage Payable Total Liabilities

$151,000 111,000 262,000

Noncontrolling Interest ($192,000/0.9  0.1) Common Stock Other Contributed Capital Retained Earnings Total Stockholders’ Equity Total Liabilities and Stockholders’ Equity

$21,333 400,000 208,000 184,000 813,333 $1,075,333

* [$192,000/0.9 – ($70,000 + $20,000 + $95,000)] = $28,333 Exercise 3-4 Part A Investment in Swartz Company ($60  1,500) Common Stock ($20  1,500) Other Contributed Capital ($40  1,500)

90,000

Other Contributed Capital Cash Part B Computation and Allocation of Difference

1,700

30,000 60,000

1,700 Parent Share

Purchase price and implied value Less: Book value of equity acquired Difference between implied and book value Goodwill Balance * $40,000 + $24,000 + $19,000 = $83,000

NonControlling Share $90,000 0 83,000* 0 7,000 0 (7,000) (0) -0-0-

3-6

Entire Value 90,000 83,000 7,000 (7,000) -0-

Exercise 3-4 (continued) Part C

Peach Company and Subsidiary Consolidated Balance Sheet January 1, 2010

Assets Cash ($73,000 + $13,000 - $1,700) Accounts Receivable Inventory Plant and Equipment Land Goodwill* Total Assets Liabilities and Stockholders’ Equity Accounts Payable Notes Payable Total Liabilities

$ 84,300 114,000 83,000 138,000 48,000 7,000 $ 474,300 $84,000 103,000 $187,000

Common Stock ($100,000 + $30,000) Other Contributed Capital ($60,000 + $60,000 - $1,700) Retained Earnings Total Stockholders’ Equity Total Liabilities and Stockholders’ Equity

$130,000 118,300 39,000 287,300 $ 474,300

* Cost of investment less fair value acquired equals goodwill or ($90,000 – $83,000 = $7,000). Recall that the book value of net assets equals the fair value of net assets in this problem. Exercise 3-5 (1) Common Stock–Spruce 900,000 Other Contributed Capital–Spruce 440,000 Retained Earnings–Spruce 150,000 Land [$1,400,000/.90 – ($900,000 + $440,000 + $150,000 - $100,000)] 165,556 Investment in Spruce Company 1,400,000 Treasury Stock 100,000 Noncontrolling Interest ($1,400,000/.90  .10) 155,556 (2) Common Stock–Spruce 900,000 Other Contributed Capital–Spruce 440,000 Retained Earnings–Spruce 150,000 Land 10,000 Investment in Spruce Company 1,160,000 Treasury Stock 100,000 Gain on Purchase of Business - Pool ** 100,000 Noncontrolling Interest # 140,000 ** [$1,160,000 – ($1,050,000 + $990,000 + $180,000 – $820,000) x 90%]= $100,000 # ($1,160,000/.9 = $1,288,889 implied value; NCI=10% x $1,288,889 + $11,111* * 11,111 represents the NCI (10%) share of the bargain gain, which is in total $1,390,000 $1,288,889 + $10,000 (where $10,000 is the write-up of the land).

3-7

Exercise 3-6 Part A

$37,412 Noncontrolling Interest = 15% Noncontrolling Interest $249,412 Implied Value* * Implied Value = Parent’s value $212,000 + NCI $37,412 = $249,412 Common Stock-Shipley Other Contributed Capital-Shipley Retained Earnings-Shipley Land $249,412 - $236,000 Investment in Shipley Company Noncontrolling Interest

Part B

90,000 90,000 56,000 13,412 212,000 37,412

SHIPLEY COMPANY Balance Sheet December 31, 2010 Cash Accounts Receivable Inventory Plant and Equipment Land ($220,412 - $13,412 - $120,000) Total Assets

$ 15,900 22,000 34,600 147,000 87,000 $ 306,500

Accounts Payable Common Stock Other Contributed Capital Retained Earnings Total Equities

$ 70,500 90,000 90,000 56,000 $ 306,500

Exercise 3-7 Part A. Long-term receivable from subsidiary $500,000 Current assets: interest receivable from subsidiary $50,000 Part B. None Exercise 3-8 Investment in Shy Inc. [$2,500,000 + (15,000  $40)] Cash Common Stock Other Contributed Capital ($40 - $2)  15,000

3-8

3,100,000 2,500,000 30,000 570,000

Exercise 3-9 Investment in Shy Inc. [$2,500,000 + (15,000  $40)] Cash Common Stock Other Contributed Capital ($40 - $2)  15,000

Other Contributed Capital Acquisition Expense Deferred Acquisition Charges Acquisition Costs Payable

3,100,000 2,500,000 30,000 570,000

30,000 67,000 90,000 7,000

Exercise 3-10A Note: This solution assumes a difference between the basis of acquired assets for accounting and tax purposes for this stock acquisition. Part A Investment in Seely Company Common Stock*** Additional Paid-in-Capital

570,000 95,000 475,000

***Note: Depending on the wording of this exercise, the credit may be cash instead of common stock and additional paid-in-capital. If cash is paid, the credit to cash is $570,000. Part B Common Stock - Seely Other Contributed Capital – Seely Retained Earnings - Seely Difference between Implied and Book Value* Investment in Seely Company Noncontrolling Interest [($570,000/.95) x .05]

80,000 132,000 160,000 228,000 570,000 30,000

* [$570,000/.95 – ($80,000 + $132,000 + $160,000)] Inventory Land Plant Assets Discount on Bonds Payable Goodwill** Deferred Income Tax Liability* Difference between Cost and Book Value *(.40  ($52,000 + $25,000 + $71,000 + $20,000)) **228,000 – [($52,000 + $25,000 + $71,000 + $20,000) x 60%]

3-9

52,000 25,000 71,000 20,000 127,200 67,200 228,000

Exercise 3-11A Investment in Starless Company Common Stock Other Contributed Capital (($70 – $5)  10,000)

700,000 50,000 650,000

Because the combination is consummated as a stock acquisition, the entry on the books of the acquirer is no different than in the absence of deferred taxes. However, in the elimination entries, a deferred tax liability will be recognized and the amount of goodwill will be altered accordingly.

ANSWERS TO ASC (Accounting Standards Codification) EXERCISES ASC3-1 Presentation A company considered displaying negative amounts using red print in a manner that clearly distinguishes the negative attribute. When determining methods of display, does the company need to give consideration to the limitations of reproduction and microfilming processes? Alternative one: Step 1: Below the search box on the home page, click on ‘advanced search.’ Enter ‘display’ in the text/keyword box and choose ‘Presentation’ in the Area pull-down menu. Step 2: Six results are obtained. Scrolling through the results you find the solution as the 4th returned result. Alternative one: Step 1: Below the search box on the home page. Enter ‘negative amounts’ in the text/keyword box and choose ‘Presentation’ in the Area pull-down menu. Step 2: 45 results are obtained. Narrow the search by clicking the box next to presentation in the ‘By Area’. Six results are obtained and scrolling through the results you find the solution as the 3rd returned result. FASB ASC subparagrpah 205-10-S99-1(c) ASC3-2 Cross-Reference Accounting for contingencies was originally addressed in SFAS No. 5. Where is this information included in the Codification? Is all the guidance listed within one topic? Step 1: Choose the cross reference tab on the opening page of the Codification. Step 2: Use the ‘By Standard’ drop down menu. Choose FAS as the standard type and 5 as the standard number. Click on ‘Generate Report.’ SFAS No. 5 is located primarily in ASC Topic 450 Contingencies, but some paragraphs are included in Topics 310 Receivables, 460 Guarantees, 505 Equity, 730 Research and Development, 720 Other expenses, and 944 Financial Services-Insurance. ASC3-3 Disclosure There are two specific operating cash payments that are required to be disclosed as supplemental information to the statement of cash flows (if not presented as line items under the direct method). What are they and where is this located in the Codification?

3 - 10

Step 1: Use the drop-down menus under the ‘Presentation’ general topic on the homepage and choose ‘230-Statement of Cash Flows’; then under the second drop-down menu, choose ’10-overall’. Step 2: Click on section 50 Disclosure. Scroll through the paragraphs. FASB ASC paragraph 230-10-50-2 states that if the indirect method is used, the amounts of interest paid and income taxes paid shall be disclosed. ASC3-4 Measurement Can treasury stock be listed as an asset on the balance sheet? While the problem states that this is a measurement issue, it is really a presentation issue. Step 1: Use the drop-down menus under the ‘Equity’ general topic on the homepage and choose ‘30Treasury Stock’. Step 2: Clicking on recognition does not solve the problem. Clicking on ’45 other presentation matters’ finds the correct answer. FASB ASC paragraph 505-30-45-1 requires that the cost of treasury stock be shown as a deduction from the total of capital stock, additional paid-in-capital, and retained earnings. However in FASB ASC paragraph 505-30-25-1 it is noted that some states govern the accounting treatment of treasury stock and FASB states that the entity shall follow the accounting treatment conforming to the applicable law. ASC3-5 Measurement Suppose a firm purchases treasury stock but pays an amount significantly larger than the market value of the stock. Describe the appropriate accounting for the treasury stock. Step 1: Use the drop-down menus under the ‘Equity’ general topic on the homepage and choose ‘30Treasury Stock’. Step 2: Click on “30 initial measurement’. Scroll through the paragraphs. FASB ASC paragraphs 505-30-30-2 through 4 states that if the purchase of treasury shares includes the receipt of stated or unstated rights, privileges, or agreements in addition to the capital stock, only the amount representing the fair value of the treasury shares at the date the major terms of the agreement to purchase the shares are reached shall be accounted for as the cost of the shares acquired. The price paid in excess of the amount accounted for as the cost of treasury shares shall be attributed to the other elements of the transaction and accounted for according to their substance. ASC3-6 Cross-Reference Variable interest entities (VIEs) are discussed in FASB Interpretation No. 46R. List all the topics in the Codification where this information can be found (i.e., ASC XXX). (Hint: There are three main topics.) Step 1: Choose the cross reference tab on the opening page of the Codification. Step 2: Use the ‘By Standard’ drop down menu. Choose FIN as the standard type and 46(R) as the standard number. Click on ‘Generate Report.’ There are many topics related to FIN 46(R) but the ones related to VIEs are the following. The main topic is FASB ASC Topic 810 Consolidation, but paragraphs are also included in Topics 860 Transfer and Servicing, 954 Healthcare Entities and 958 Not-For-Profit Entities.

3 - 11

ANSWERS TO PROBLEMS Problem 3-1 Part A

P COMPANY AND SUBSIDIARY Consolidated Balance Sheet Workpaper November 30, 2011

Case I Current Assets Investment in S Company Difference between Implied and Book Value Long-term Assets Other Assets Total Assets Current Liabilities Long-term Liabilities Common Stock: P Company S Company Retained Earnings P Company S Company Noncontrolling Interest Total Liabilities and Equity Case II Current Assets Investment in S Company Difference between Implied & Book Value Long-term Assets Other Assets Total Assets

P S Company Company 880,000 260,000 190,000

Eliminations Dr. Cr.

(1) 1,400,000 90,000 2,560,000 640,000 850,000

400,000 (2) 40,000 700,000

Noncontrolling Consolidated Interest Balance 1,140,000

(1) 190,000 71,111 (2) 71,111 71,111

1,871,111 130,000 3,141,111

270,000 290,000

910,000 1,140,000

600,000

600,000 180,000 (1) 180,000

470,000

470,000 (40,000)

2,560,000

700,000

780,000 190,000

280,000

(1) 40,000 (1) 21,111 322,222 322,222

400,000 70,000 750,000

21,111 3,141,111

1,060,000 (2)

1,200,000 70,000 2,240,000

21,111

(1) 190,000 8,889 (1) 8,889 8,889

1,591,111 140,000 2,791,111

Current Liabilities 700,000 260,000 Long-term Liabilities 920,000 270,000 Common Stock: P Company 600,000 S Company 180,000 (1) 180,000 Retained Earnings P Company 20,000 S Company 40,000 (1) 40,000 Noncontrolling Interest (1) 21,111 Total Liabilities and Equity 2,240,000 750,000 228,889 228,889 (1) To eliminate investment account and create noncontrolling interest account (2) To allocate the difference between implied value and book value to long-term assets.

960,000 1,190,000

3 - 12

(2)

600,000

20,000 21,111

21,111 2,791,111

Problem 3-1 (continued) Computation and Allocation of Difference (Case I) Parent Share Purchase price and implied value Less: Book value of equity acquired

190,000 126,000

NonControlling Share 21,111 14,000

Entire Value

Difference between implied and book value Increase long-term assets to fair value Balance

64,000 (64,000) -0-

7,111 (7,111) -0-

71,111 (71,111) -0–

Parent Share

Entire Value

190,000 198,000

NonControlling Share 21,111 22,000

211,111* 220,000

(8,000) 8,000 -0-

(889) 889 -0-

(8,889) 8,889 -0–

Parent Share

Entire Value 223,750 140,000 83,750 (83,750) -0–

211,111* 140,000

* $190,000/.90 Computation and Allocation of Difference (Case II)

Purchase price and implied value Less: Book value of equity acquired Difference between implied and book value Decrease long-term assets to fair value Balance * $190,000/.90 Part B Computation and Allocation of Difference

Purchase price and implied value ** Less: Book value of equity acquired

202,500 126,000

NonControlling Share 21,250 14,000

Difference between implied and book value Increase long-term assets to fair value Balance

76,500 (76,500) -0-

7,250 (7,250) -0-

** Parent share = .90*50,000*$4.50 = $202,500 Non-controlling share = .10*50,000*$4.25 = $21,250. This assumes that there was a $0.25 per share control premium paid to acquire the 90% interest.

3 - 13

Problem 3-2 Part A $100,000 Soho Total Par/$10 Par per share = 10,000 shares of Soho issued 8,000 shares acquired/10,000 total shares = 80% Implied Value of Soho (100%) = $120,000/80% = $150,000. Implied Value of Noncontrolling share = $150,000 x 20% = $30,000. Computation and Allocation of Difference Schedule Parent Share Purchase price and implied value Less: Book value of equity acquired: Common stock Other contributed capital Retained earnings Total book value

120,000

NonControlling Share 30,000

150,000*

80,000 13,200 18,800 112,000

20,000 3,300 4,700 28,000

100,000 16,500 23,500 140,000

8,000 (8,000) -0-

2,000 (2,000) -0-

10,000 (10,000) -0-

Difference between implied and book value Plant Assets Balance

Entire Value

*$120,000/.80 Part C $100,000 Soho Total Par/$10 Par per share = 10,000 shares of Soho issued 8,000 shares acquired/10,000 total shares = 80% Implied Value of Soho (100%) = $120,000/80% = $150,000. Implied Value of Noncontrolling share = $150,000 x 20% = $30,000. Computation and Allocation of Difference Schedule Parent Share 160,000

NonControlling Share 30,000

190,000*

80,000 13,200 18,800 112,000

20,000 3,300 4,700 28,000

100,000 16,500 23,500 140,000

Difference between implied and book value 48,000 Plant Assets (48,000) Balance -0-

2,000 (2,000) -0-

50,000 (50,000) -0-

Purchase price and implied value Less: Book value of equity acquired: Common stock Other contributed capital Retained earnings Total book value

8,000 shares at $20 per share plus 2,000 shares at $15 equals $190,000

3 - 14

Entire Value

Problem 3-2 (continued) PERRY COMPANY AND SUBSIDIARY SOHO Part B Consolidated Balance Sheet Workpaper January 1, 2011 Perry Company

Soho Company

Cash Accounts Receivable Inventory Investment in Soho Difference between Implied and Book Value Plant Assets Accumulated Depreciation Total

39,000 53,000 42,000 120,000

19,000 31,000 25,000

160,000 (52,000) 362,000

110,500 (19,500) 166,000

Current Liabilities Mortgage Note Payable Common Stock: Perry Company Soho Company Other Contributed Capital Perry Company Soho Company Retained Earnings: Perry Company Soho Company Noncontrolling Interest Total

18,500 40,000

26,000

Eliminations Debit Credit

Noncontrolling Interest

58,000 84,000 67,000 (1) 120,000 (1) 10,000 (2) 10,000

(2) 10,000 280,500 (71,500) 418,000 44,500 40,000

120,000

120,000 100,000

(1) 100,000

16,500

(1) 16,500

135,000

48,500

48,500 23,500

362,000

Consolidated Balance

166,000

(1) 23,500 160,000

(1) To eliminate investment account and create noncontrolling interest account. (2) To allocate the difference between implied and book value to plant assets.

3 - 15

(1) 30,000 160,000

30,000

30,000 418,000

Problem 3-3

P COMPANY AND SUBSIDIARY Consolidated Balance Sheet Workpaper August 1, 2011 P S Company Company

Cash Receivables

165,500 366,000

Inventory 261,000 Investment in Bonds 306,000 Investment in S Company Stock 586,500 Difference between Implied and Book Value Plant and Equipment (net) 573,000 Land 200,000 Total Assets 2,458,000 Accounts Payable Accrued Expenses Bonds Payable, 8% Common Stock: P Company S Company Other Contributed Capital: P Company S Company Retained Earnings P Company S Company Noncontrolling Interest Total Advances from P Company Total Liabilities and Equity

174,000 32,400

Eliminations Noncontrolling Consolidated Interest Balance Dr. Cr. 106,000 (b) 35,000 306,500 126,000 (a) 800 (3) 800 457,000 (4) 35,000 108,000 369,000 (2) 40,000 266,000 (1) 586,500

320,000 300,000 960,000

(5) 24,333 (1) 24,333 (5) 24,333

868,667 500,000 2,767,167

58,000 26,000 (3) 800 200,000 (2) 40,000

232,000 57,600 160,000

1,500,000

1,500,000 460,000 (1) 460,000

260,000

260,000 60,000 (1) 60,000

491,600

(a)

800

492,400

156,000 (1) 156,000 (1) 65,167 2,458,000

65,167

960,000 (4) 35,000 (b) 35,000 811,933 811,933

2,767,167

(a) To establish reciprocity for interest receivable and payable and to recognize interest earned (b) To establish reciprocity for intercompany advances (1) To eliminate Investment in S Company and create noncontrolling interest account (2) To eliminate intercompany bondholdings (3) To eliminate intercompany interest receivable and payable (4) To eliminate intercompany advances (5) To allocate the difference between implied value and book value to plant and equipment

3 - 16

Problem 3-3 (continued) Computation and Allocation of Difference Parent Share Purchase price and implied value 586,500 Less: Book value of equity acquired ($676,000 x .9) 608,400

NonEntire Controlling Value Share 65,167 651,667* 67,600 676,000

Difference between implied and book value Decrease PPE to fair value Balance

(2,433) 2,433 -0-

(21,900) 21,900 -0-

* $586,500/.90

3 - 17

(24,333) 24,333 -0-

Problem 3-4

PHILLIPS COMPANY AND SUBSIDIARIES Consolidated Balance Sheet Workpaper January 2, 2011

Cash Account Receivable Note Receivable Interest Receivable Inventory Investment in Sanchez Company Investment in Thomas Company Equipment Land Total Assets Accounts Payable Note Payable Accrued Interest Payable Common Stock: Phillips Company Sanchez Company Thomas Company Other Contributed Capital: Phillips Company Sanchez Company Thomas Company Retained Earnings Phillips Company Sanchez Company Thomas Company

Phillips Company 7,000 28,000 120,000 225,000 168,000 60,000 180,000

Sanchez Company 43,700 24,000 10,000 300 96,000

Thomas Company 20,000 20,000

Eliminations Dr. Cr.

Noncontrolling Interest

Consolidated Balance 70,700 72,000

(1) 10,000 (2) 300 43,000

259,000 (3) 225,000 (4) 168,000

40,000 80,000

30,000 70,000

788,000

294,000

183,000

28,000

20,000

18,000 10,000

130,000 369,217

(3) 7,250 * * (4) 31,967 * **

900,917 66,000 (1) 10,000 (2) 300

(a)

300

300,000

300,000 120,000 75,000

(3) 120,000 (4) 75,000

40,000

(3) 90,000 (4) 40,000

300,000

300,000 90,000

160,000

160,000 64,000 40,000

(3) 64,000 (a) 300 (4) 39,700 *

Noncontrolling Interest (3)(4)74,917 * *** 74,917 Total Liabilities and Equity 788,000 294,000 183,000 478,517 478,517 * ($40,000 – $300); ** [$225,000/.80 – ($120,000 + $90,000 + $64,000)]; *** [$168,000/.90 – ($75,000 + $40,000 + $40,000 – $300)]; **** ($225,000/.80 x .20) + ($168,000/.90 x .10) (a) To establish reciprocity for interest receivable and payable and to recognize interest earned (1) To eliminate intercompany note receivable and payable (2) To eliminate intercompany interest receivable and payable (3) To eliminate the investment in Sanchez Company and create noncontrolling interest account of $56,250 (4) To eliminate the investment in Thomas Company and create noncontrolling interest account $18,667

74,917 900,917

Problem 3-5 Part A Pat Company Cash balance, 12/31/2010 Less: Cash used in the acquisition of Solo Pat Company Cash balance after acquisition Consolidated Cash balance, 1/1/2011 Less: Pat Company Cash balance after acquisition Difference Less: Cash transfer unrecorded by Solo Solo's cash balance, 1/1/2011

$540,000 236,000 $304,000 $352,000 304,000 48,000 10,000 $38,000

Part B The noncontrolling interest of $28,500 on the consolidated balance sheet is equal to 10% of the total stockholders' equity of Solo Company. Thus, total stockholders' equity of Solo Company is  $28,500  $285,000 =    0.10  Part C Total stockholders’ equity of solo from (B) above $285,000 Add: Accounts payable of Solo Company $386,000 – $280,000 = $106,000 + $4,000 of intercompany payables eliminated in consolidation 110,000 Add: Long-term liabilities of Solo Company, $605,500 - $520,000 85,500 Total assets of Solo Company 1/1/2011 $480,500

3 - 19

Problem 3-6

PING COMPANY AND SUBSIDIARY Consolidated Balance Sheet Workpaper July 31, 2011

Ping Company

Santos Company

Cash 320,000 Accounts Receivable 600,000 Note Receivable 100,000 Inventory 1,840,000 Advance to Santos Company 60,000 Investment in Santos Company 2,010,000 Difference between Implied & Book Value Plant and Equipment 3,000,000 Land 90,000 Total Assets 8,020,000

150,000 300,000

Accounts Payable Notes Payable Common Stock: Ping Company Santos Company Other Contributed Capital: Ping Company Santos Company Retained Earnings Ping Company Santos Company Noncontrolling Interest Total Advance from Ping Company Interest Payable Interest Receivable Total Liabilities and Equity

800,000 900,000

Eliminations

(a)

Dr. 60,000

Noncontrolling Interest

Cr. 530,000 880,000

(2) 20,000 (5) 100,000

400,000

2,240,000 (1) 60,000 (3)2,010,000 (3) 40,333 * (6) 40,333

1,500,000 90,000 2,440,000

(6) 40,333

4,500,000 220,333 8,370,333

140,000 100,000

(2) 20,000 (5) 100,000

920,000 900,000

2,400,000

2,400,000 900,000

(3) 900,000

680,000

(3) 680,000

2,200,000

1,720,000

7,000

1,727,000

(b) 7,000 (3) 613,000 (3) 223,333

8,020,000

Consolidated Balance

223,333**

223,333

2,440,000 (1) 60,000 (4) 7,000 (c) 7,000 2,534,666 3-20

(a) 60,000 (b) 7,000 (4) 7,000 2,534,666

8,370,333

Problem 3-6 (continued) * [$2,010,000/.90 – ($900,000 + $680,000 + $620,000 - $7,000)] = $40,333; ** $2,010,000/.90 x .10 = 223,333 (a) To establish reciprocity for cash advances (b) To adjust for unrecorded interest expense and interest payable (c) To adjust for unrecorded interest income and interest receivable. (1) To eliminate intercompany advances (2) To eliminate intercompany accounts receivable and accounts payable (3) To eliminate investment in Santos Company and create noncontrolling interest account (4) To eliminate intercompany interest receivable and interest payable (5) To eliminate intercompany note receivable and note payable (6) To allocate the difference between implied and book value to land Problem 3-7

Cash ($700,000 – $594,000 + $ 111,000) Accounts Receivable (net) Inventory Property and Equipment (net) Land Total Assets

PREGO COMPANY AND SUBSIDIARY Consolidated Balance Sheet January 1, 2011 (Part A) $ 217,000 1,122,000 604,000 2,395,000 214,000 $4,552,000

Accounts Payable Notes Payable Long-term Debt Noncontrolling Interest ($500,000 + $80,000 + $80,000)  0.10) Common Stock Other Contributed Capital (part B, $543,000 + [($50 – $20)  11,880] Retained Earnings Total Equities Problem 3-8 Part A Investment in Sara Co. (13,400  $12) Common Stock (13,400  $10) Other Contributed Capital ($26,800 – $4,000) Cash

$ 454,000 649,000 440,000 66,000 1,800,000 543,000 600,000 $4,552,000 160,800 134,000 22,800 4,000

Investment in Rob Co. Cash

50,000 50,000 3-21

(Part B) $ 811,000 1,122,000 604,000 2,395,000 214,000 $5,146,000 $ 454,000 649,000 440,000 66,000 2,037,600 899,400 600,000 $5,146,000

Problem 3-8 (continued) Punto Company & Subsidiaries Consolidated Balance Sheet Workpaper at February 1, 2011 Part B Cash Account Receivable Notes Receivable Merchandise Inventory Prepaid Insurance Investment in Sara Company Investment in Rob Company Difference between Implied and Book Value Advances to Sara Company Advances to Rob Company Land Buildings (net) Equipment (net) Total Assets

Punto Company 111,000 35,000 18,000 106,000 13,500 160,800 50,000

Sara Company 45,000 35,000

Rob Company 17,000 26,000

35,500 2,500

14,000 500

10,000 5,000 248,000 100,000 35,000 892,300

43,000 27,000 10,000 198,000

15,000 16,000 2,500 91,000

Accounts Payable

25,500

20,000

10,500

Income Taxes Payable Notes Payable Bonds Payable Common Stock: Punto Company Sara Company Rob Company Other Contributed Capital: Punto Company Sara Company Rob Company Retained Earnings Punto Company Sara Company Rob Company Noncontrolling Interest Total Liabilities and Equity

30,000

10,000 6,000

Eliminations Dr. Cr. (a) 5,000 (2) 21,000 (3) 12,500

Noncontrolling Interest

(4) 160,800 (5) 50,000 (4) 7,263 ** (5) 11,176 (7) 11,176 (6) 7,263 6,900* (1) 10,000 (1) 5,000 (6) 7,263 (7) 11,176

(1) 15,000 (2) 21,000

313,263 131,824 47,500 923,087

100,000

25,000 40,000 4,000 100,000

434,000

10,500

144,000

(a)

Consolidated Balance 178,000 75,000 5,500 155,500 16,500

5,000

(3) 12,500

42,000

(4) 144,000 (5) 42,000

38,000

(4) 12,000 (5) 38,000

172,800

172,800 12,000

130,000

130,000 6,000

(4)

6,000

(10,000) 892,300

198,000

91,000

321,202

3-22

(5) 10,000 (4)(5)17,287 * 321,202

17,287

17,287 923,087

Problem 3-8 (continued) (a) To adjust for cash in transit from Punto to Rob (1) To eliminate intercompany advances (2) To eliminate intercompany accounts receivable and accounts payable (3) To eliminate intercompany notes receivable and notes payable (4) To eliminate investment in Sara Company and create noncontrolling interest account of $8,463 (5) To eliminate investment in Rob Company and create noncontrolling interest account of $8,824 (6) To allocate the difference between implied and book value to the under-valuation of Sara’s land (7) To allocate the difference between implied and book value to the over-valuation of Rob’s buildings * [$160,800/.95 x .05] = $8,463 $8,463 (entry 4) + $8,824 (entry 5) = $17,287 ** $160,800/.95 – ($144,000 + $12,000 + $6,000) Computation and Allocation of Difference Parent Share Purchase price and implied value Less: Book value of equity acquired

50,000 59,500

NonControlling Share 8,824 10,500

Difference between implied and book value Decrease buildings to fair value Balance

(9,500) 9,500 -0-

(1,676) 1,676 -0-

Entire Value 58,824* 70,000 (11,176) 11,176 -0-

* $50,000/.85 Part C

PUNTO COMPANY AND SUBSIDIARIES Consolidated Balance Sheet February 1, 2011 Assets Current Assets: Cash Accounts Receivable Notes Receivable Merchandise Inventory Prepaid Insurance Total Current Assets

$178,000 75,000 5,500 155,500 16,500 $ 430,500

Long-Term Assets: Land Buildings(net) Equipment(net) Total Assets

313,263 131,824 47,500 $ 923,087

3-23

Problem 3-8 (continued) Liabilities and Stockholders' Equity Current Liabilities: Accounts Payable Income Tax Payable Notes Payable Total Current Liabilities Bonds Payable Total Liabilities Stockholders’ Equity: Noncontrolling Interest in Subsidiaries Common Stock Other Contributed Capital Retained Earnings Total Stockholders’ Equity Total Liabilities and Stockholders’ Equity

$25,000 40,000 4,000 $ 69,000 100,000 169,000 17,287 434,000 172,800 130,000 754,087 $ 923,087

Problem 3-9 Part A Computation and Allocation of Difference Schedule Parent Share Purchase price and implied value Less: Book value of equity acquired: Common stock (5,250,000 x .90) Other contributed capital Retained earnings Less: Treasury stock Total book value

$5,800,000

NonTotal Controlling Value Share 644,444 6,444,444*

4,725,000 356,400 1,732,500 (1,080,000) 5,733,900

525,000 5,250,000 39,600 396,000 192,500 1,925,000 (120,000) (1,200,000) 637,100 6,371,000

Difference between implied and book value 66,100 Plant assets (66,100) Balance -0*$5,800,000/.90

3-24

7,344 (7,344) -0-

73,444 (73,444) -0-

Problem 3-9 (continued) Pope Company and Subsidiary Worksheet, January 1, 2009 Part B Pope Sun Eliminations Noncontrolling Consolidated Company Company Interest Balances Debit Credit Cash 297,000 165,000 462,000 Accounts Receivable 432,000 468,000 900,000 Notes Receivable 90,000 (1) 90,000 Inventory 1,980,000 1,447,000 3,427,000 Investment in Sun Company 5,800,000 (2) 5,800,000 Difference between Implied and & Book Value (2) 73,444 (3) 73,444 Plant and Equipment (net) 5,730,000 3,740,000 (3) 73,444 9,543,444 Land 1,575,000 908,000 2,483,000 Total $15,904,000 $6,728,000 $16,815,444 Accounts Payable Notes Payable Common Stock ($15 par): Pope Company Sun Company Other Contributed Capital Pope Company Sun Company Treasury Stock Held: Sun Company Retained Earnings Pope Company Sun Company Noncontrolling Interest Total

698,000 2,250,000

247,000 110,000

945,000 2,270,000

(1) 90,000

4,500,000

4,500,000 5,250,000 (2)5,250,000

5,198,000

5,198,000 396,000 (2) 396,000 (1,200,000)

(2)1,200,000

3,258,000

3,258,000 1,925,000 (2)1,925,000

$15,904,000 $6,728,000

7,807,888

(2) 644,444 7,807,888

(1) To eliminate intercompany note receivable and note payable (2) To eliminate Investment in Sun Company and create noncontrolling interest account (3) To allocate the difference between implied and book value to subsidiary plant and equipment.

3-25

644,444

644,444 $16,815,444

Problem 3-10A Part A Investment in Shah Company ($28  25,500) Common Stock ($2  25,500) Other Contributed Capital ($26  25,500)

714,000

Part B Common Stock - S Other Contributed Capital - S 1/1 Retained Earnings - S Difference between Implied and Book Value Investment in Shah Company Noncontrolling Interest [($714,000/.85) x .15]

120,000 164,000 267,000 289,000*

51,000 663,000

714,000 126,000

* ($714,000/.85) – ($120,000 + $164,000 + $267,000) Inventory Land Plant Assets Patents Deferred Tax Asset ($60,000 X .35) Goodwill Premium on Bonds Payable Deferred Tax Liability ($266,500 x .35) Difference between Implied and Book Value

28,000 33,500 100,000 105,000 21,000 154,775* 60,000 93,275 289,000

* ($289,000 +60,000-21,000)– [($28,000 + $33,500 + $100,000 + $105,000)  (−)]

3 - 26

Chapter 3 CHAPTER THREE – CONSOLIDATED FINANCIAL STATEMENTS – DATE OF ACQUISITION I.

DEFINITIONS OF SUBSIDIARY AND CONTROL A.

Subsidiary: Situation wherein a parent company (and/or parent’s other subsidiaries) owns a controlling financial interest in another company, whether that company is incorporated or not (such as a trust or partnership).

Control: Control, according to U.S. GAAP, is defined as the direct or indirect ability to determine the direction of management and policies through ownership, contract, or otherwise. FASB ASC paragraph 810-10-15-8 states that the usual condition for a controlling financial interest is ownership of a majority voting interest. 1. FASB developed a risk and reward model to determine who should consolidate a variable interest entity (VIE). 2. IRFS defines control to be the power to govern the entities’ financial and operating policies so as to obtain benefits from its activities. Figure 3-1 Definitions of Control U.S. GAAP

IFRS

Voting Interest Entities (Non-VIE)

Variable Interest Entities (VIEs)

All Entities

Control is the direct or indirect ability to determine the direction of management and policies through ownership, contract, or otherwise (usually a majority voting interest).

Control is the power to direct the activities that impact economic performance, the obligation to absorb the expected losses, and the right to receive expected residual returns.

Control is the power to govern the entities financial and operating policies as to obtain benefits from its activities.

Parent: When a stock acquisition occurs, the acquiring company is generally referred to as the parent.

Noncontrolling (minority) interest: Shareholders holding the remaining stock in a subsidiary outside of that held by the parent company.

Chapter 3 E.

II.

Affiliated companies: The related companies having a joint relationship. Each of the affiliated companies continues its separate legal existence.

REQUIREMENTS FOR THE INCLUSION OF SUBSIDIARIES IN THE CONSOLIDATED FINANCIAL STATEMENTS A.

Given the purpose that consolidated statements is to present for a single accounting entity the net resources and operating results of a group of companies under common control, also considering the problems related to off-balance-sheet financing, the FASB has taken the position that essentially all controlled corporations should be consolidated.

Under some circumstances, majority-owned subsidiaries should be excluded from the consolidated statements. Those circumstances include those where: 1. Control does not rest with the majority owner – e.g. as when the firm is in bankruptcy. 2. A foreign company is domiciled in a country with foreign exchange restrictions, controls, or governmentally imposed uncertainties that cast significant doubt on the parent’s ability to control the subsidiary. a. Majority owned investments that are not consolidated for one of the above reasons are normally reported as investments using the cost method (with fair value adjustments, if needed) because the subsidiaries are not controlled nor significantly influenced by the parent company.

Chapter 3 III.

REASONS FOR SUBSIDIARY COMPANIES A.

Stock acquisition is relatively simple in some cases. Mechanisms such as open market purchases and cash tender offers help avoid the often long & difficult negotiations of stock for stock exchange in complete takeovers.

Control of subsidiary’s operations can be accomplished with smaller investment – not all of the subsidiary’s stock must be acquired, but only a sufficient portion to achieve control.

Limited liability - separate legal existence of individual affiliates provides an element of protection of the parent’s assets from creditors of the subsidiary.

D. IV.

CONSOLIDATED FINANCIAL STATEMENTS A.

Statements prepared for a parent company and its subsidiaries. They represent the sum of assets, liabilities, revenues, and expenses of the affiliates after eliminating the effect of any transactions among the affiliated companies.

When a parent acquires controlling interest in a subsidiary, the parent makes an entry to debit Investment in Subsidiary and credit cash, debt, or stock (or combination) depending on medium of exchange. Assume the acquisition has a cash purchase price of $5 million. Entry in parent’s books is:

C. Investment in Subsidiary Cash C.

$5,000,000

The investment account represents the parent’s investment in the different asset and liability accounts of the subsidiary. The subsidiary continues to maintain detailed books based on historical book values, which are not as current as the market values assessed by the parent at the date of acquisition but are detailed as to classification. Consolidation process summarization: Investment Account on Asset and Liability the Parent’s Books Accounts on the Subsidiary’s Books Valuation in the financial statements MARKET VALUE HISTORICAL VALUE Classification in the financial statements

$5,000,000

ONE ACCOUNT

MULTIPLE ACCOUNTS

Process of preparing consolidated financial statements aims to achieve market value and multiple accounts characteristics (items in the diagonal (in bold) in part C above). Consolidated statements ignore the legal aspects of the separate entities and focus on the economic entity under the control of management, and thus focus on substance rather than

Chapter 3 form. Consolidated statements are not to be used as substitutes for the statements prepared by the separate subsidiaries.

VI.

INVESTMENTS AT THE DATE OF ACQUISITION A. Recording Investments at Cost (Parent’s Books) 1. Purchase or acquisition method – stock investment is recorded at its cost as measured by the fair value of the consideration given or received, whichever is more clearly evident. 2. Both direct and indirect costs (costs of maintaining an M&A dept, for example) should be expensed as incurred. B.

If cash is used for the acquisition, the investment is recorded at its cash cost, excluding broker's fees and other direct costs of the investment. The acquisition fee is recorded in a separate entry as an expense.

If the company acquires only part of shares and pays an acquisition fee, the investment is recorded at its cost of purchasing shares. The other direct costs of investment are recorded as an expense.

If the company issues stock in the acquisition, the investment is recorded at the fair value of the stock issued, giving effect to any costs of registering the stock issue.

If the company pays additional fees, such as a finder’s fee, the cost of that fee should be expensed under SFAS No. 141R [ASC 805-20].

CONSOLIDATED BALANCE SHEETS: THE USE OF WORKPAPERS A. The use of workpapers 1. Consolidated balance sheet reports the sum of the assets and liabilities of a parent and its subsidiaries as if they constituted a single company. 2. Assets and liabilities are summed in their entirety (whether 100% ownership or not). 3. Noncontrolling interests are reflected as a component of owner’s equity. 4. Eliminations must be made to cancel effects of transactions among the parent and its subsidiaries, as shown in the table below. 5. A workpaper is used to summarize the effects of the various additions, eliminations, etc.

Chapter 3

Intercompany Accounts to be Eliminated Parent’s Accounts Investment in subsidiary Intercompany receivable (payable) Advances to subsidiary (from subsidiary) Interest revenue (interest expense) Dividend revenue (dividends declared)

Against

Management fee paid to parent

Against

Purchases of inventory from parent (sales to parent)

Against Against

Management fee received from subsidiary Sales to subsidiary (purchases of inventory from subsidiary) B.

Against

Subsidiary’s Accounts Equity accounts Intercompany payable (receivable) Advances from parent (to parent) Interest expense (interest revenue) Dividends declared (dividend revenue)

Against Against

Investment elimination 1. An important basic elimination in the preparation of consolidated statements is the elimination of the investment account and the related subsidiary's stockholders' equity. 2.

To start the process of combining the individual assets and liabilities of a parent company and its subsidiary at the date of acquisition, the first step is to prepare a “Computation and Allocation of Difference between Implied and Book Value” schedule (CAD). Preparation of this schedule requires us to address two basic issues. a. Determine the percentage of stock acquired in the subsidiary (Is it a 100% acquisition, or a smaller percentage?) and calculate Implied Value (IV) by dividing the purchase price by the percentage acquired. b. Compare the IV to the book value of the equity of the subsidiary. If a difference between implied and book value exists, we must then allocate that difference to adjust the underlying assets and/or liabilities of the acquired company. c. Book value of the equity = sum of all equity accounts (common stock, additional contributed capital, retained earnings, etc.) which equals the book value of the acquired firm’s assets minus liabilities at the date of acquisition. d. Note that the comparison is implied value (IV) to book value, rather than market value of the acquired entity. e. The steps above lead to the following possible cases:

Chapter 3

CASE 1. The value of the subsidiary (IV), as implied by the purchase price, is equal to the book value of the subsidiary company's equity, and (a) The parent company acquires 100% of the subsidiary company's stock; or (b) The parent company acquires less than 100% of the subsidiary company's stock. CASE 2. The IV exceeds the book value of the subsidiary company's equity, and (a) The parent company acquires 100% of the subsidiary company's stock; or (b) The parent company acquires less than 100% of the subsidiary company's stock. CASE 3. The IV is less than the book value of the subsidiary company's equity, and (a) The parent company acquires 100% of the subsidiary company's stock; or (b) The parent company acquires less than 100% of the subsidiary company's stock. D.

Illustration of the alternatives 1. Case 1(a): IV (implied value) Is Equal to Book Value of Subsidiary Stock– Total Ownership (100% of Subsidiary Stock Acquired) P acquires all outstanding stock (5,000 shares) of S Company for a cash payment of $80,000 Journal entry: Investment in S Company Cash

$80,000 $80,000

P company's cash balance drops to $20,000 and an investment of $80,000 is recognized Computation and allocation of difference between implied and book value: Cost of investment (purchase price) = IV $80,000 Book value of equity $80,000 Difference between implied and book value 0 Note: Eliminating entries are made to cancel the effects of intercompany transactions and are made on workpapers only Eliminating entry in this example: Common Stock - S Company Other Contributed Capital - S Company Retained Earnings - S Company Investment in S Company

$50,000 $10,000 $20,000 $80,000

Chapter 3 A workpaper for the preparation of a consolidated balance sheet for P and S Companies on January 1, 2013, the date of acquisition, is presented in Illustration 3-2 (see textbook, page 112). 2.

CASE 1(b): IV Is Equal to Book Value of Subsidiary Company's Stock– Partial Ownership (Less than 100% of Subsidiary Stock Acquired) P acquires 90% of outstanding stock (4,500 shares) of S Company for a cash payment of $72,000 In this case, consideration must be given to a noncontrolling interest because P owns less than 100% of S Company. Journal entry: Investment in S Company Cash

$72,000 $72,000

P Company's cash balance drops to $28,000 and an investment of $72,000 is recognized

Computation and Allocation of Difference Schedule Parent Share Purchase price and implied value Less: Book value of equity acquired: Common stock Other contributed capital Retained earnings

$72,000

NonControlling Share 8,000

45,000 9,000 18,000

5,000 1,000 2,000

50,000 10,000 20,000

Total book value

72,000

8,000

80,000

Difference between implied and book value

Total Value 80,000

Eliminating entry in this example: Common Stock - S Company $50,000 Other Contributed Capital - S Company $10,000 Retained Earnings - S Company $20,000 Investment in S Company $72,000 Noncontrolling Interest in Equity (NCI) 8,000 Illustration 3-3 (textbook, page 114) shows the balance sheets of S and P Company before the consolidation, the eliminating entries, as well as the consolidated balance sheet. Note that the investment by P in S reflects only its percentage of S 7

Chapter 3 Company’s equity. Thus, when eliminating the equity accounts of S, we must recognize the emergence of a noncontrolling interest (NCI). Nonetheless, all the assets and liabilities of S Company and P Company are used to make up the consolidated balance sheet because the purpose of the latter is to show the resources that are under control of a single management, not owned! The noncontrolling interest represents the ownership of other shareholders in the net assets of S Company. And last, note that the assets are $8,000 greater than in the example before because P Company has $8,000 more left in cash (on the equity side of the balance sheet this difference is made up by the noncontrolling interest). 3.

CASE 2(b): Implied Value (IV) Exceeds Book Value of Subsidiary Company's Stock Acquired – Partial Ownership (Less than 100% of the Subsidiary Company's Stock Acquired) [Note that Case 2(a) is omitted here, as it is relatively easy to understand once Case 2(b) is grasped.] P acquires 80% of outstanding stock (4,000 shares) of S Company for a cash payment of $74,000 Again, consideration must be given to a noncontrolling interest because P owns less than 100% of S Company. At the same time, the amount by which IV exceeds the book value of S Company equity must be allocated to an asset or assets in the workpaper entries. Journal entry: Investment in S Company Cash

$74,000 $74,000

P Company's cash balance is to $26,000 and an investment of $74,000 is recognized. We assume in this case that the difference between the book value of the equity and the implied value is attributable to undervalued land.

Computation and Allocation of Difference Schedule Parent Share Purchase price and implied value Less: Book value of equity acquired: Common stock Other contributed capital Retained earnings

$74,000

NonControlling Share 18,500

40,000 8,000 16,000

10,000 2,000 4,000

50,000 10,000 20,000

Total book value

64,000

16,000

80,000

Difference between implied and book value 10,000 Adjust land upward (mark to market) (10,000) Balance -0-

2,500 (2,500) -0-

12,500 (12,500) -0-

Total Value 92,500

Chapter 3

Eliminating entry in this example: Common Stock - S Company $50,000 Other Contributed Capital - S Company $10,000 Retained Earnings - S Company $20,000 Difference between Iimplied and Book Value $12,500 Investment in S Company $74,000 Noncontrolling Interest (NCI) 18,500 Land

$12,500 Difference between Implied and Book Value $12,500

As one can see, the account “Difference between Implied and Book Value” is only a temporary account; the debit to land could also have been made in the early journal entry when the equity accounts of S Company were eliminated. Illustration 3-4 (textbook, page 117) shows the balance sheets of S and P Company before the consolidation, the eliminating entries, as well as the consolidated balance sheet. Note the adjustment of land. Reasons for paying for more than the book value: a. Conservative accounting principles were applied b. Unrecorded goodwill c. Overvaluation of liabilities d. Bidding war over company to be acquired drives the price up 4.

CASE 3(b): Implied Value (IV) Is Less than Book Value of Subsidiary Stock– Partial Ownership (Less than 100% of Subsidiary Stock Acquired) [Note that Case 3(a) is omitted here, as it is relatively easy to understand once Case 3(b) is grasped.] P acquires 80% of outstanding stock (4,000 shares) of S Company for a cash payment of $60,000 Again, consideration must be given to a noncontrolling interest because P owns less than 100% of S Company. At the same time, the amount that exceeds the book value of S Company equity must be allocated to an asset (or a gain may be recognized, if no market value adjustments are warranted); however this time, the value of the asset is written down rather than up. Journal entry: Investment in S Company Cash

$60,000 $60,000

P Company's cash balance is to $40,000 and an investment of $60,000 is recognized. We assume in this case that the difference between the book value of the equity and the implied value is attributable to overvalued land. 9

Chapter 3

Computation and Allocation of Difference Schedule Parent Share Purchase price and implied value Less: Book value of equity acquired: Common stock Other contributed capital Retained earnings Total book value

$60,000

NonTotal Controlling Value Share 15,000 $75,000

40,000 8,000 16,000 64,000

10,000 2,000 4,000 16,000

50,000 10,000 20,000 $80,000

Difference between implied and book value (4,000) Land, adjust downward 4,000 Balance -0-

(1,000) 1,000 -0-

(5,000) 5,000 -0-

Chapter 3 Eliminating entry in this example: Common Stock - S Company Other Contributed Capital - S Company Retained Earnings - S Company Difference between Implied and Book Value Investment in S Company Noncontrolling Interest (NCI) Difference between Implied and Book Value Land

$50,000 $10,000 $20,000 $ 5,000 $60,000 $15,000 $5,000 $5,000

Illustration 3-5 (textbook, page 120) shows the balance sheets of S and P Company before the consolidation, the eliminating entries, as well as the consolidated balance sheet. Note the (downward) adjustment of land. E.

Subsidiary Treasury Stock Holdings Treasury stock is excluded from the computation of the percentage of interest acquired because the latter is based on stock outstanding Example: P Company acquires 18,000 of S Company’s shares for $320,000 S Company’s equity section appears as follows: Common Stock, $10 par, 25,000 shares issued $250,000 Other Contributed Capital $50,000 Retained Earnings $125,000 $425,000 Less: Treasury Stock at cost, 1,000 shares $20,000 $405,000 P Company’s interest in S Company is 18,000/24,000 = 75%. Implied Value (IV) = $320,000/75%, or $426,667. The NCI is 25% x $426,667, or $106,667. Since treasury stock is a contra account, P Company’s share must be reduced accordingly. Eliminating entry: Common Stock - S Company $250,000 Other Contributed Capital - S Company $ 50,000 Retained Earnings - S Company $ 125,000 Difference between IV and Book Value $ 21,667 Treasury stock $ 20,000 Investment in S Company $320,000 Noncontrollling Interest in Equity (NCI) $106,667

Chapter 3

Other Intercompany Balance Sheet Eliminations All receivables or payables as well as cash advances must be eliminated against the reciprocal accounts of the other company. A $25,000 cash advance by P Company to S Company: Advance from P Company $25,000 Advance to S Company

VII.

$25,000

Adjusting Entries Prior to Eliminating Entries In case certain transactions are not completed, adjusting entries must be made.

A COMPREHENSIVE ILLUSTRATION - MORE THAN ONE SUBSIDIARY COMPANY (Illustration 3-6, 3-7—pages 125-126) Parent company owns a direct controlling interest in more than one subsidiary A. Balance sheet of each affiliate is entered on the workpaper. B. Any adjustments are prepared. C. All related intercompany accounts, including those between subsidiary companies, are eliminated. D. Remaining balances are combined, constituting a consolidated balance sheet. E. Formal consolidated balance sheet is prepared from the detail in the consolidated balance sheet columns of the workpaper. F. Balance sheet data are classified according to normal balance sheet arrangements. G. Noncontrolling interest in consolidated net assets is reported as a component of stockholders’ equity.

VIII. LIMITATIONS OF CONSOLIDATED STATEMENTS: A. Noncontrolling stockholders and regulatory agencies – consolidated statements contain insufficient detail about individual subsidiaries. B. Creditors – have claims only against the resources of particular subsidiary, unless the parent guarantees the claims. C. Financial analysts – difficult to analyze or compare diversified companies operating across several industries.

Chapter 3

Appendix A: Deferred Taxes on the Date of Acquisition A. If a purchase acquisition is tax-free to the seller, the tax bases of the acquired assets and liabilities are carried forward at book value. B. The assets and liabilities of the acquired company are recorded on the consolidated books at adjusted fair value. C. The difference between the tax bases and the recorded values gives rise to deferred taxes. Appendix B: Consolidation of Variable Interest Entities (VIEs) A. An entity is considered a VIE and is subject to consolidation under FASB Interpretation No. 46 if: 1. Its total equity at risk is not adequate to allow the entity to finance its own activities without additional subordinated financial support, 2. If the voting rights of the equity investors do not reflect their economic interests, or 3. If the equity investors lack one or more of the following three characteristics: a. Direct or indirect ability to make decisions that control the entity, b. The obligation to absorb the expected losses of the entity, or c. The right to receive the expected residual returns of the entity. B. The primary beneficiary of a VIE must disclose: 1. The nature, purpose, size, and activities of the VIE, 2. The carrying amount and classification of consolidated assets that are collateral for the obligations of the VIE, 3. Any lack of recourse by creditors of a consolidated VIE to the general credit of the primary beneficiary.

CHAPTER 4 Note: The letter A or B indicated for a question, exercise, or problem means that the question, exercise, or problem relates to a chapter appendix. ANSWERS TO QUESTIONS 1

Nonconsolidated subsidiaries are expected to be relatively rare. In those situations where a subsidiary is not consolidated, the investment in the subsidiary should be reported in the consolidated statement of financial position at cost, along with other long-term investments.

A liquidating dividend is a return of investment rather than a return on investment. Consequently, the amount of a liquidating dividend should be credited to the investment account rather than to dividend income when the cost method is used, whereas regular dividends are recorded as dividend income under the cost method. If the equity method is used, all dividends are credited to the investment account.

When the parent company uses the cost method, the workpaper elimination of intercompany dividends is made by a debit to Dividend Income and a credit to Dividends Declared. This elimination prevents the double counting of income since the subsidiary's individual revenue and expense items are combined with the parent company's in the determination of consolidated net income. When the parent company uses the equity method, the workpaper elimination for intercompany dividends is made by a debit to the investment account and a credit to Dividends Declared.

When the parent company uses the cost method, dividends received are recorded as dividend income. When the parent company uses the partial equity method, the parent company recognizes equity income on its books equal to its ownership percentage times the investee company’s reported net income. When the parent company uses the complete equity method, the parent recognizes income similar to the partial equity method, but adjusts the equity income for additional charges or credits when the purchase price differs from the fair value of the investee company’s net assets, and for intercompany profits (addressed in chapters 6 and 7).

Consolidated net income consists of the parent company's net income from independent operations plus (minus) any income (loss) earned (incurred) by its subsidiaries during the period, adjusted for any intercompany transactions during the period and for any excess depreciation or amortization implied by a purchase price in excess of book values. Consolidated retained earnings consist of the parent company's retained earnings from its independent operations plus (minus) the parent company's share of the increase (decrease) in its subsidiaries' retained earnings from the date of acquisition.

Investment in S Company 1/1 Retained Earnings, P Company 80%  ($461,430 - $16,250)]

356,144 356,144

This adjustment recognizes that P Company's share of S Company's undistributed profits from the date of acquisition to the beginning of the current year is properly a part of beginning-of-year 4-1

consolidated retained earnings. It also enhances the elimination of the investment account. This entry is only needed if the parent company uses the cost method. If the equity method is used, the parent’s retained earnings already reflect the undistributed earnings of the subsidiary. 7.

The noncontrolling interest column accumulates the noncontrolling stockholders' share of subsidiary income, less their share of excess depreciation or amortization implied by fair value adjustments (addressed in detail in chapter 5), dividends (as a reduction), and the beginning noncontrolling interest in equity carried forward from the previous period.

The method used to record the investment on the books of the parent company (cost method, partial equity method, or complete equity method) has no effect on the consolidated financial statements. Only the workpaper elimination procedures are affected.

The two methods for treating the preacquisition revenue and expense items of a subsidiary purchased during a fiscal year are (1) including the revenue and expense items of the subsidiary for the entire period with a deduction at the bottom of the consolidated income statement for the net income earned prior to acquisition (this is the preferred method), and (2) including in the consolidated income statement only the subsidiary's revenue earned and expenses incurred subsequent to the date of purchase.

10. (a) Readers of consolidated financial statements will be unable to evaluate the financial position and results of operations (neither of which is shown separately from the parent's) of the subsidiaries. (b) Because consolidated assets are not generally available to meet the claims of the creditors of a subsidiary, creditors will have to look to the financial statements of the debtor (subsidiary) corporation. Similarly, the creditors of the parent company are most interested in only the assets of the parent company, although large creditors are likely to gain control over or have indirect access to the assets of subsidiaries in the case of parent company default. (c) Because consolidated financial statements are a composite, it is impossible to distinguish a financially weak subsidiary from financially strong ones. (d) Ratio analyses based on consolidated data are not reliable guides, especially when the related group produces a conglomerate of unrelated product lines and services. (e) Consolidated financial statements often do not disclose data about subsidiaries that are not consolidated. (f) A reader of consolidated financial statements cannot assume that a certain amount of unrestricted consolidated retained earnings will be available for dividends. Data on the ability of the individual subsidiaries to pay dividends are frequently unavailable. 11. A consolidated statement of cash flows contains two adjustments that result from the existence of a noncontrolling interest: (1) an adjustment for the noncontrolling interest in net income or loss of the subsidiary in the determination of net cash flow from operating activities, and (2) subsidiary dividend payments to the noncontrolling stockholders must be included with parent company dividends paid in determining cash paid as dividends because the entire amount of the

4-2

noncontrolling interest in net income (loss) is added back (deducted) in determining net cash flows from operating activities. 12. Potential voting rights refer to the rights associated with potentially dilutive securities such as convertible bonds or stocks, or stock options, rights, or warrants that are currently exercisable. These are considered under international standards in determining the applicability of the equity method for investments where the investor may be considered to have significant influence. They are generally not considered under U.S. GAAP. International standards (IFRS) refer to investments that are accounted for under the equity method as “investments in associates.” 13B.

No. The recognition and display of a deferred tax asset or deferred tax liability relating to the assignment of the difference between implied value and book value is necessary without regard to whether the affiliates file consolidated income tax returns or separate income tax returns.

14B

An assumption must be made as to whether the undistributed income will be realized in a future dividend distribution or as a result of the sale of the subsidiary. This is necessary because the calculation of the tax consequences differs depending on the assumption made. Dividend distributions are subject to a dividends received exclusion, whereas gains or losses on disposal are not. In addition, gains or losses on disposal may be taxed at different tax rates than dividend distributions. Although capital gains are currently taxed at the same rates as ordinary income, the rates have been different in the past and may be again in the future.

15B

The amounts calculated under these two approaches would be different (1) if the affiliates had different marginal tax rates, (2) if the affiliates were in different tax jurisdictions, or (3) when expected future tax rates differ from the tax rate used in determining the tax paid or accrued by the selling affiliate.

16B

When the affiliates file separate returns, two types of temporary differences may arise: 1. Deferred income tax consequences that arise in the consolidated financial statements because of undistributed subsidiary income, and 2. Deferred income tax consequences that arise in the consolidated financial statements because of the elimination of unrealized intercompany profit.

ANSWERS TO BUSINESS ETHICS CASE Surreptitiously installing spyware on computers can be an unethical practice (the word surreptitious implies that the customer is unaware of the activity). The programs run in the background and can significantly slow down the computer’s operating performance. Sometimes these programs are used to pass on the consumer browsing history and may leak personal information to the advertising firm.

4-3

ANSWERS TO FINANCIAL STATEMENT ANALYSIS EXERCISES AFS4-1 GE Financial Statements A. GE uses the equity method to account for the investment in GECS. The investment account on GE’s books has a balance of $68,984 and $70,833 for the years 2010 and 2009 respectively. Notice that the balance in the investment account equals the ending balance of stockholders’ equity for GECS for the same years. Thus the investment account changes exactly by the amount that the subsidiary equity accounts change. Because GE owns 100% of GECS (and created this subsidiary), the equity method is the only method that would keep these two amounts equal. In essence, the parent’s investment account mirrors the activity in the subsidiary’s equity. B.

The 2010 consolidated balances for assets and liabilities are $751,216 and $781,901, which differ from the balances for GE’s assets and liabilities of $218,763 and $209,942. On the other hand, the 2005 consolidated balance for equity (excluding noncontrolling interests) equals the equity balance of GE’s equity at $118,936. On GE’s books, the assets and liabilities of GECS are recorded net in the investment account (i.e. the investment account represents the net assets of GECS). When the firm prepares consolidated financial statements, the investment account is eliminated and replaced by the individual assets and liabilities of GECS. While some consolidated amounts are simply the sum of GE’s and GECS’s individual accounts (such as inventories), other accounts do not simple add across (such as short-term borrowings, receivables, and payables). One reason these accounts may not add across is due to the elimination of intercompany transactions. The equity accounts of GECS disappear altogether in the consolidated totals.

None of this minority interest is related to GE’s investment in GECS since GE owns 100%. Under current GAAP, minority interest (or noncontrolling interest) is also recorded at fair value. In the past, the minority interest was maintained at historical cost. The current standard does not require previously recorded minority interest to be adjusted to fair value. Under IFRS, there is more flexibility with respect to recording the noncontrolling interest at fair value, at historical cost, or at a hybrid reflecting fair value for identifiable assets but not for goodwill. As U.S. GAAP and IFRS converge, this is one issue that needs to be resolved or clarified.

The current presentation that GE uses is very informative because it shows financial statements for each company (GE and GECS separately). This allows the user to see the nature of the types of accounts that GECS is involved in, as well as their magnitude (financing receivables and long-term borrowings, for example). In addition, it is crucial that the reader is able to see the accounts for the consolidated entity. For instance, if GE simply used the equity method to record GECS (without consolidation), it would appear that GE is only responsible for $95,729 of liabilities (see GE’s unconsolidated columns), when in reality, GECS has debt of $538,530. This debt is reflected in the consolidated columns. GECS's debt is not recorded as a line item on GE's books if the equity method is used and consolidation does not occur. It would be considered 'off balance sheet' debt. If undisclosed, this might be viewed in some respects as similar to the type of off-balance sheet debt in some of the partnerships that got Enron into so much trouble.

4-4

AFS4-2 eBay Acquires Skype This problem can be used to discuss the changes in GAAP regarding contingent payments. At the time of the Skype acquisition, contingent payments were only recorded if the contingency was already met. Otherwise, when the payment was made, the additional consideration was considered an increase in consideration (increase in goodwill). However, under current rules, the fair value of the contingency is recorded on the date of acquisition with subsequent changes in the contingent payment recognized in income. A. Journal entry to record the investment in Skype (using former GAAP): Investment in Skype ($ millions) Cash Capital stock

2,600 1,300 1,300

Journal entry to record the investment in Skype (using current GAAP): Expected fair value assumes that the full expected contingency will be settled. Investment in Skype ($ millions) 3,900 Cash 1,300 Capital stock 1,300 Liability for contingent consideration 1,300 B. The $1.3 billion cash component is listed under Cash from Investing Activities on the Statement of Cash Flows. The remaining two items are footnote disclosures. The amount of the investment acquired by issuing common stock is disclosed in the notes under ‘supplemental cash flow information.’ The expected contingent payment would also be disclosed under ‘supplemental cash flow information.’ AFS4-3 Various Acquisitions A. Income is only recognized on the parent’s books from the date of acquisition.

Company Acquired Rent.com International classified websites Shopping.com Skype Total Income

Fraction Date Acquired of year February 1, 2005 11/12 April 1, 2005 September 1, 2005 October 14, 2005

9/12 4/12 2.5/12

Total Income Acquired

Income 2005 Income Acquired 12,000 11,000 5,000 20,000 120,000 $ 157,000

3,750 6,667 25,000 $ 46,417

B. All of the following must be disclosed: FASB ASC sub-paragraph 805-10-50-2(h) 1. The amounts of revenue and earnings of the acquiree since the acquisition date included in the consolidated income statement for the reporting period ($46,417 in the problem).

4-5

AFS4-3 Various Acquisitions (continued) 2. The revenue and earnings of the combined entity for the current reporting period as though the acquisition date for all business combinations that occurred during the year had been as of the beginning of the annual reporting period (supplemental pro forma information), or $157,000 in the example. 3. If comparative financial statements are presented, the revenue and earnings of the combined entity for the comparable prior reporting period as though the acquisition date for all business combinations that occurred during the current year had occurred as of the beginning of the comparable prior annual reporting period (supplemental pro forma information). No information was provided in the problem to determine the amounts.

4-6

Answers to Exercises Exercise 4-1 Part A – Cost Method 2009 Investment in Song Company Cash

387,000 387,000

Cash Dividend Income (.8  $25,000)

20,000 20,000

2010 Cash Dividend Income (.8  $50,000)

40,000 40,000

2011 Cash Investment in Song Company (.8  $35,000) (liquidating dividend) Part B – Partial Equity Method 2009 Investment in Song Company Cash

28,000 28,000

387,000 387,000

Investment in Song Company Equity Income (.8  $63,500)

50,800

Cash Investment in Song Company

20,000

50,800

20,000

2010 Investment in Song Company Equity Income (.8  $52,500)

42,000 42,000

Cash Investment in Song Company

40,000 40,000

2011 Equity Loss (.8 x $55,000) Investment in Song Company

44,000 44,000

Cash Investment in Song Company (.8  $35,000)

4-7

28,000 28,000

Exercise 4-1 (continued) Part C – Complete Equity Method Parent Share Cost of investment Book value acquired($475,000 x .80) Difference between Implied and Book value Allocated to undervalued depreciable assets Balance

Noncontrolling Entire Share Value

387,000 380,000 7,000 (7,000) -0-

96,750 95,000 1,750 (1,750) -0-

483,750 * 475,000 8,750 (8,750) -0-

* $387,000/.80 Amortization per year Parent ($7,000/10) = $700 2009 Investment in Song Company Cash

387,000 387,000

Investment in Song Company Equity Income (.8  $63,500)

50,800

Equity Income ($7,000/10) Investment in Song Company

700

Cash Investment in Song Company

20,000

50,800

700

20,000

2010 Investment in Song Company Equity Income (.8  $52,500)

42,000 42,000

Equity Income ($7,000/10) Investment in Song Company

700

Cash Investment in Song Company

40,000

700

40,000

2011 Equity Loss (.8 x $55,000) Investment in Song Company

44,000 44,000

Equity Income ($7,000/10) Investment in Song Company

700 700

Cash Investment in Song Company (.8  $35,000)

4-8

28,000 28,000

Exercise 4-2 Workpaper entries 12/31/13 – Cost Method Investment in Salt Company Retained Earnings 1/1 - Park Company To establish reciprocity (.90  ($160,000 – $50,000))

99,000

Dividend Income Dividends Declared - Salt Company

9,000

99,000

9,000

Common Stock - Salt Company 450,000 Retained Earnings 1/1/13 - Salt Company 160,000 Land 16,667 Investment in Salt Company ($465,000 + $99,000) Noncontrolling Interest ($51,667 + .10 x ($160,000 – $50,000)

564,000 62,667

Computation and Allocation of Difference between Implied and Book Value Acquired Parent Share Purchase price and implied value Less: Book value of equity acquired: Difference between implied and book value Allocated to undervalued land Balance *$465,000/.90

465,000 450,000 15,000 (15,000) -0-

NonControlling Share 51,667 50,000 1,667 (1,667) -0-

Entire Value 516,667 * 500,000 16,667 (16,667) -0-

Exercise 4-3 Workpaper entries 12/31/17 – Equity Method The balance in the investment account at the beginning of the year is $532,000, which is computed as: [$494,000 + (.95 x ($160,000 – $120,000))] = $532,000 Common Stock - Succo Company Other Contributed Capital - Succo Company Retained Earnings 1/1/17 - Succo Company Investment in Succo Company Noncontrolling Interest*

300,000 100,000 160,000 532,000 28,000

* $520,000 x .05 + (.05 x ($160,000 - $120,000)) = 28,000 Equity Income ($40,000)(.95) Dividends Declared ($19,000)(.95) Investment in Succo Company

38,000 18,050 19,950

In this instance, the partial and complete equity methods result in the same entries because the amount paid for the acquisition of Succo is exactly 95% of Succo’s book value. Thus, there are no asset adjustments and no excess amortization or depreciation to consider. The equity income under the complete equity method is the same as under the partial equity method (95% of reported income of Succo). 4-9

Exercise 4-4 Parent Share Purchase price and implied value Less: Book value of equity acquired: Difference between implied and book value Goodwill Balance

310,000 293,250 16,750 (16,750) -0-

NonControlling Share 54,706 51,750 2,956 (2,956) -0-

Entire Value 364,706 * 345,000 19,706 (19,706) -0-

* $310,000/.85 Part A – Workpaper entries 12/31/12 - Equity Method Investment in Serena Company Dividends Declared - Serena Company (.85)($12,000) Equity Loss (.85)($10,000 loss)

18,700

Common Stock - Serena Company Other Contributed Capital - Serena Company Retained Earnings 1/1/12 - Serena Company Difference between Implied and Book Value (Goodwill) Investment in Serena Company ($310,000 – $6,375*) Noncontrolling Interest

240,000 55,000 42,500 a 19,706

10,200 8,500

303,625 53,581

* [($50,000 - $42,500) x .85] = 6,375; ** $54,706 - [($50,000 - $42,500) x .15] = $53,581 a

$42,500 = $20,500 at year-end plus 2012 loss of $10,000 plus 2012 dividends of $12,000

Goodwill Difference between Implied and Book Value

19,706 19,706

The partial equity and the complete equity methods result in the same entries because the excess of the cost over fair value of net assets is allocated to goodwill, a non-amortizable asset. If any of this excess is allocated to depreciable assets or intangible assets with limited lives (subject to amortization), additional expenses will be recorded under the complete equity method. Part B – Workpaper entries 12/31/12 - Cost Method Retained Earnings 1/1 - Poco Company Investment in Serena Company To establish reciprocity (.85  ($50,000 – $42,500))

6,375

Investment in Serena Company Dividends Declared - Serena Company

10,200

Common Stock - Serena Company Other Contributed Capital - Serena Company Retained Earnings 1/1/12 - Serena Company Difference between Implied and Book Value Investment in Serena Company ($310,000 – $6,375) Noncontrolling Interest

240,000 55,000 42,500 19,706

6,375

10,200

4 - 10

303,625 53,581

Exercise 4-4 (continued) Goodwill Difference between Implied and Book Value

19,706 19,706

Exercise 4-5 Workpaper Entries and Noncontrolling Interest Cost of investment Less: excess cost allocated to land Book value acquired (90%)

$ 650,000 20,000 $ 630,000

Total stockholders’ equity - Set Company ($630,000/.90) Less: Retained earnings, 1/1/09 Common stock, Set Company, 1/1/09

700,000 190,000 $ 510,000

$650,000 630,000 20,000 (2,222) -0-

NonControlling Share 72,222 70,000 2,222 (22,222) -0-

Entire Value 722,222 * 700,000 22,222 -0-

* $650,000/.90 Part A Eliminating entries – cost method Dividend Income (.90)($50,000) Dividends Declared - Set Company

45,000 45,000

Common Stock - Set Company ($700,000 – $190,000) Retained Earnings 1/1/09 - Set Company Difference between Implied and Book Value Investment in Salt Company Noncontrolling Interest

510,000 190,000 22,222

Land

22,222

650,000 72,222

Difference between Implied and Book Value

22,222

Part B Eliminating entries – equity method Equity Income (.90)($132,000) 118,800 Dividends Declared - Set Company (.90)($50,000) Investment in Set Company

45,000 73,800

Common Stock - Set Company Retained Earnings 1/1/09 - Set Company Difference between Implied and Book Value Investment in Salt Company Noncontrolling Interest 4 - 11

510,000 190,000 22,222 650,000 72,222

Exercise 4-5 (continued) Land

22,222 Difference between Implied and Book Value

22,222

Part C Noncontrolling Interest $72,222 + (.1  $132,000) - (.1  $50,000) = $80,422 The noncontrolling interest will be the same regardless of the method used to account for the investment on Plate Company’s books. Exercise 4-6 Journal and Workpaper Entries - Equity Method Part A Journal Entries Investment in Sales Cash

350,000 350,000

Investment in Sales ($148,000)(.85) Equity in Subsidiary Income

125,800

Cash ($50,000)(.85) Investment in Sales

42,500

125,800 42,500

Part B Workpaper Entries Equity in Subsidiary Income Dividends Declared - Sales Investment in Sales

125,800 42,500 83,300

Common Stock - Sales 100,000 Other Contributed Capital – Sales 40,000 Retained Earnings 1/1 – Sales 140,000 Difference between Implied and Book Value 131,765 Investment in Sales Noncontrolling Interest Land 131,765 Difference between Implied and Book Value

350,000 61,765 131,765

350,000 238,000 112,000 (19,765) -0-

* $350,000/.85

4 - 12

NonControlling Share 61,765 42,000 19,765 (131,765) -0-

Entire Value 411,765 * 280,000 131,765 -0-

Exercise 4-7 Journal and Workpaper Entries - Equity Method Part A Journal Entries Investment in Sales (.85)($190,000) Equity in Subsidiary Income

161,500 161,500

Cash

42,500 Investment in Sales (.85)($50,000)

Part B Workpaper Entries Equity in Subsidiary Income Dividends Declared - Sales Investment in Sales

42,500

161,500 42,500 119,000

Common Stock - Sales Other Contributed Capital – Sales Retained Earnings 1/1 – Sales* Difference between Implied and Book Value Investment in Sales ($350,000 + $83,300**) Noncontrolling interest ($61,765 + $14,700***) Land 131,765 Difference between Implied and Book Value * $140,000 + ($148,000 - $50,000) ** ($148,000 - $50,000) x .85 *** ($148,000 - $50,000) x .15

4 - 13

100,000 40,000 238,000 131,765 433,300 76,465 131,765

Exercise 4-8 Workpaper Entries and Consolidate Net Income - Cost Method Part A Workpaper Entries 2010 Dividend Income (.80  $2,000) Dividends Declared - Smith Company

1,600 1,600

Common Stock – Smith Other Contributed Capital – Smith Retained Earnings 1/1/10 - Smith Difference between Implied and Book Value Subsidiary Income Purchased * Investment in Smith Company Noncontrolling Interest

25,000 10,000 10,000 2,500 15,000

Land

2,500

50,000 12,500

Difference between Implied and Book Value

2,500

Computation and Allocation of Difference between Implied and Book Value Acquired Parent Share Purchase price and implied value Less: Book value of equity acquired: Equity Subsidiary Income purchased** Total book value Difference between implied and book value Land (2,000) Balance

50,000

NonControlling Share 12,500

36,000 12,000 48,000 2,000 (500) -0-

9,000 3,000 12,000 500 (2,500) -0-

Entire Value 62,500 * 45,000 15,000 60,000 2,500 -0-

* $50,000/.80 4  $45,000) = 15,000 12 Estimated Retained Earnings of Smith on date of acquisition** Retained earnings, 1/1 $ 10,000 Smith earnings to 5/1 = (4/12)($45,000) 15,000 Retained earnings, 5/1 $ 25,000

Subsidiary Income Purchased (

2011 Investment in Smith Retained Earnings 1/1 Peters To establish reciprocity (.80  ($53,000 – $25,000**)

22,400

Common Stock - Smith 25,000 Other Contributed Capital - Smith 10,000 Retained Earnings 1/1/11 - Smith 53,000 Land 2,500 Investment in Smith Company ($50,000 + $22,400) Noncontrolling Interest ($12,500+ .20 x ($53,000 – $25,000) 4 - 14

22,400

72,400 18,100

Exercise 4-8 (continued) Part B Consolidated Net Income Peters Company's reported net income Less: dividend income from Smith Peters' income from independent operations Plus: Peter's share of Smith's net income in 2010 since acquisition (.80)(8/12)($45,000) Less: Peter's share of Smith's net loss in 2010 (.80  $5,000) Consolidated net income Consolidated Retained Earnings Peter's 12/31 retained earnings ($80,000 + $64,000 - $15,000) Plus: Peter's share of the increase in Smith's retained earnings from the date of acquisition to the current date: (.80  ($53,000 – $25,000)) (.80  ($48,000 – $25,000))

2010 64,000 (1,600) 62,400 24,000 86,400

(4,000) 33,500

129,000

161,500

22,400 $151,400

Exercise 4-9 Workpaper Entries - Cost Method 2010 Dividend Income (.80)($2,000) Dividends Declared - Smith Company

1,600 1,600

Common Stock – Smith Other Contributed Capital – Smith Retained Earnings 5/1/10 – Smith * Difference between Implied and Book Value Investment in Smith Company Noncontrolling Interest [($50,000/.80) x .20]

25,000 10,000 25,000 2,500

Land

2,500

50,000 12,500

Difference between Implied and Book Value

2,500

* See previous problem to compute the balance of retained earnings on 5/1/10.

Exercise 4-10 Journal and Workpaper Entries - Equity Method Part A Journal Entries Investment in Star Cash

210,000 210,000

Investment in Star (0.90  (3/12)  $60,000) Equity in Subsidiary Income To account for prorated stake in equity

13,500

Cash (0.90  $10,000) 9,000 Investment in Star To account for reduction in equity due to dividends

4 - 15

2011 37,500 0 37,500

13,500

9,000

18,400 $179,900

Exercise 4-10 (continued) Part B Workpaper Entries Equity in Subsidiary Income (0.90)(3/12)($60,000) Dividends Declared – Star (.90)($10,000) Investment in Star

13,500 9,000 4,500

Common Stock - Star 70,000 Other Contributed Capital – Star 30,000 Retained Earnings – Star * 115,000 Difference between Implied and Book Value ** 18,333 Investment in Star Noncontrolling Interest Goodwill 18,333 Difference between Implied and Book Value * Retained earnings on 10/1/10 Retained earnings on 1/1/10 Income purchased to 10/1/10 (9/12 x $60,000) Retained earnings on 10/1/10

210,000 23,333 18,333

$ 70,000 45,000 $ 115,000

**Computation and Allocation of Difference between Implied and Book Value Acquired Parent Share Purchase price and implied value Less: Book value of equity acquired: Equity Subsidiary Income purchased Total book value Difference between implied and book value Goodwill Balance

210,000

NonControlling Share 23,333

233,333 *

153,000 40,500 193,500 16,500 (16,500) -0-

17,000 4,500 21,500 1,833 (1,833) -0-

170,000 45,000 ** 215,000 18,333 (18,333) -0-

* $210,000/.90 ** $60,000 x 9/12

4 - 16

Entire Value

Exercise 4-10 (continued) Part C Workpaper Entries- Full year reporting alternative Equity in Subsidiary Income (0.90)(3/12)($60,000) Dividends Declared – Star (.90)($10,000) Investment in Star Common Stock - Star Other Contributed Capital – Star Retained Earnings – Star Purchased Income Difference between Implied and Book Value Investment in Star Noncontrolling Interest

13,500 9,000 4,500 70,000 30,000 70,000 45,000 18,333

Goodwill 18,333 Difference between Implied and Book Value

4 - 17

210,000 $23,333

18,333

Exercise 4-11 Consolidated Statement of Cash Flows Part A Cash flows from operating activities - Direct Method Cash received from customers* Less cash paid for: Merchandise purchases** Selling expenses*** Administrative expenses**** Net cash flow from operating activities

$ 612,000 $323,000 138,000 102,000

* Beginning accounts receivable Plus: Sales Less: ending accounts receivable Cash received from customers

$229,000 701,000 (318,000) $612,000

** Cost of Sales Less: beginning inventory Plus: ending inventory Accrual basis purchases Plus: beginning accounts payable Less: ending accounts payable Cash paid for merchandise purchased

$263,000 (194,000) 234,000 303,000 99,000 (79,000) $323,000

***Accrual selling expenses Less: beginning prepaid selling expenses Plus: ending prepaid selling expenses Plus: beginning accrued selling expenses Less: ending accrued selling expenses Cash paid for administrative expenses

$122,000 (26,000) 30,000 96,000 (84,000) $138,000

**** Accrual administrative expenses Plus beginning accrued administrative expenses Less ending accrued administrative expenses Cash paid for administrative expenses

$85,000 56,000 (39,000) $102,000

Part B Cash flows from operating activities - Indirect Method Consolidated net income Adjustments to convert net income to net cash flows from operating activities: Depreciation expense Increase in accounts receivable Increase in inventory Increase in prepaid selling expenses Decrease in accounts payable Decrease in accrued selling expenses Decrease in accrued administrative expenses Net cash flow from operating activities

4 - 18

$ 155,000

76,000 (89,000) (40,000) (4,000) (20,000) (12,000) (17,000) $49,000

563,000 $ 49,000

Exercise 4-12 Part A **Computation and Allocation of Difference between Implied and Book Value Acquired Parent Share Purchase price and implied value Less: Book value of equity acquired: Difference between implied and book value Land Balance Goodwill Balance

$268,000 192,000

NonControlling Share 67,000 48,000

Entire Value 335,000 240,000

76,000 (16,000) 60,000 (60,000) -0-

19,000 (4,000) 15,000 (15,900) -0-

95,000 (20,000) 75,000 (75,000) -0-

Part B Investment in Sulfurst Cash

268,000 268,000

Part C (1) – Cost Method 2012 Cash Dividend Income (.8  $24,000)

19,200 19,200

2013 Cash Dividend Income (.8  $21,600)

17,280 17,280

(2) – Partial Equity Method 2012 Investment in Song Company Equity in Subsidiary Income (.8  $40,000)

32,000

Cash (.8  $24,000) Investment in Song Company

19,200

2013 Investment in Song Company Equity in Subsidiary Income (.8  $45,000)

36,000

32,000

19,200

Cash Investment in Song Company (.8  $21,600)

4 - 19

36,000 17,280 17,280

Exercise 4-12 (continued) (3) – Complete Equity Method

2012 Investment in Song Company Equity in Subsidiary Income (.8  $40,000)

32,000

Cash (.8  $24,000) Investment in Song Company

19,200

2013 Investment in Song Company Equity in Subsidiary Income (.8  $45,000)

36,000

32,000

19,200

Cash Investment in Song Company (.8  $21,600)

36,000* 17,280 17,280

*NOTE: There is no difference between the partial and complete equity methods in this exercise because the difference between implied value and book value was attributable to land and goodwill, and no impairment occurred. Had there been differences attributable to depreciable or amortizable assets, then the entries would have been adjusted under the complete equity method to reflect the impact of excess depreciation and/or amortization.

Exercise 4-13 1. Since the income statement includes the account ‘equity in net loss of subsidiary,’ we know that the equity method is being used. 2. Therefore, the controlling interest in consolidated income is the solution to the retained earnings T account, or $195,000. Retained Earnings - Pressing 1/1 380,000 Dividends 75,000 Controlling interest in consolidated income ? 12/31 500,000 Controlling interest in consolidated income = ($500,000 - $380,000 + $75,000) = $195,000. 3. From part 2, income from its independent operations is equal to consolidated income plus the equity loss, or ($195,000 + $55,000) = $250,000.

4 - 20

Exercise 4-13 (continued) 4. Since there is no difference between implied and book value, Pressing Inc.’s retained earnings will equal consolidated retained earnings under both the partial and complete equity methods. Therefore, the ending balance in consolidated retained earnings is $500,000. 5. Consolidated dividends equal Pressing Inc.’s dividends of $75,000. Because the subsidiary is wholly owned, all its dividends are eliminated. 6. The beginning balance in Stressing’s retained earnings is the solution to the following T-account. Retained Earnings - Stressing 1/1 Begin. Bal. -?Dividends 24,000 Loss 55,000 12/31 260,000 Therefore, the beginning balance is ($260,000 + $24,000 + $55,000) = $339,000 7. There is no difference between the implied and book value at acquisition. Workpaper entries Investment in Stressing Dividends Declared –Stressing Equity in Subsidiary Income (Loss) Common Stock – Stressing Other Contributed Capital – Stressing Retained Earnings – Stressing Difference between Implied and Book Value Investment in Stressing

79,000 24,000 55,000 20,000 380,000 339,000 0 739,000

8. Retained earnings would reflect only the income from its independent operations plus the dividend income from Stressing each year (instead of Stressing’s earnings). 9. A. The first entry from part 7 would be replaced by the following: Dividend Income Dividends Declared - Stressing Company

24,000 24,000

B. In addition, an entry would be needed to convert to equity/establish reciprocity in the amount of the change in Stressing’s retained earnings from acquisition to the beginning of the current year. C. After the reciprocity entry, the entry to eliminate the investment account is the same as shown in part 7.

4 - 21

Exercise 4-14 Cash flows from operating activities: Consolidated net income

$155,889

Adjustments to convert consolidated net income to net cash flow from operating activities Depreciation expense (($540,000 + $750,000 + $166,666*) – $1,385,555) Increase in inventories ($454,000 – $190,000 – $140,000) Decrease in accrued payables ($111,000 – $150,000 – $90,000) Net cash flow from operating activities

71,111 (124,000) (129,000)

Cash flows from investing activities: Acquired Lazytoo company (net of cash acquired)

(181,889) (26,000)

(590,000)

Cash flows from financing activities: Proceeds from the issuance of bonds Cash dividends paid ($10,000 + (.10)($5,000)) Net cash flow from financing activities Decrease in cash

300,000 (10,500) 289,500 ($326,500)

* $600,000/0.9 – [($200,000 + $300,000)] = $166,667; this is equivalent to doing a CAD Schedule, in which the purchase price is used to derive Implied Value of $666,667. Implied Value minus Book Value of Equity yields the Difference between IV and BV, which is allocated to mark up PPE of the sub. Exercise 4-15B Part A – Cost Method (1) Undistributed income is expected to be received as future dividend. Set Company net income $132,000 Set Company dividends 50,000 Undistributed income 82,000 Percent owned 70% Plenty Company’s share of undistributed income 57,400 Percent of dividends taxed 20% Future dividends that are taxed 11,480 Income tax rate 40% Deferred tax liability $ 4,592 Workpaper Entry Tax Expense Deferred Tax Liability

4,592 4,592

4 - 22

Exercise 4-15B (continued) (2) Undistributed income is expected to be received as future capital gain. Set Company net income Set Company dividends Undistributed income Percent owned Plenty Company’s share of undistributed income Capital gains tax rate Deferred tax liability Workpaper Entry Tax Expense Deferred Tax Liability Part B – Partial Equity Method

$132,000 50,000 82,000 70% 57,400 20% $11,480

11,480 11,480

(1) Undistributed income is expected to be received as future dividend. Set Company net income $132,000 Set Company dividends 50,000 Undistributed income 82,000 Percent owned 70% Plenty Company’s share of undistributed 57,400 Percent of dividends taxed 20% Future dividends that are taxed 11,480 Income tax rate 40% Deferred tax liability $4,592 Plenty Company’s Journal Entry Tax Expense Deferred Tax Liability

4,592 4,592

(2) Undistributed income is expected to be received as future capital gain. Set Company net income $132,000 Set Company dividends 50,000 Undistributed income 82,000 Percent owned 70% Plenty Company’s share of undistributed 57,400 Capital gains tax rate 20% Deferred tax liability $11,480 Plenty Company’s Journal Entry Tax Expense Deferred Tax Liability

11,480 11,480

Part C – Complete Equity Method The answer is the same as the partial equity method since the difference between implied and book value relates to land. 4 - 23

ANSWERS TO ASC (Accounting Standards Codification) EXERCISES ASC4-1 Presentation A company reported net income of $15,000, including an extraordinary loss of $3,000. Another company owns 40% of this company and uses the equity method to account for the investment. On the investee company’s books, does the investee report the net income of $15,000 as a single amount on its income statement? Alternative 1 Step 1: Use the drop-down menus under the ‘Presentation’ general topic on the homepage and choose ‘225-Income Statement; then using the second pull-down menu choose ‘Extraordinary and Unusual Items’. Step 2: Click on the red ‘join all sections’ button. Scroll through the paragraphs for guidance on investees reporting extraordinary items. Under section 60 for relationships, paragraph 60-1 states that the guidance for investee extraordinary items is found in paragraph 323-10-45-1. Equity investments in common stock shall be shown on the balance sheet as a single amount. However, the investor’s share of extraordinary items is classified with extraordinary items on the investor’s income statement (FASB ASC paragraph 323-10-45-2) Alternative 2 Step 1: in the search box, enter ‘equity method extraordinary.’ Step 2: 13 results are returned. The first option is the correct guidance. ASC4-2 Glossary Is a correction of an error in the financial statements considered an accounting change? On the Codification homepage, click on ‘Master Glossary’ in the left-hand column. In the ‘glossary term quick find’ menu type ‘accounting change’ and hit return. The correction of an error is not an accounting change and is addressed separately from accounting changes in Topic 250 Accounting Changes and Error Corrections. ASC4-3 Presentation A company changed its method of accounting for inventory and determined that it was impractical to determine the cumulative effect for all prior periods. The company decided to use the new method on a prospective basis. Is this acceptable under current GAAP? Step 1: Use the drop-down menus under the ‘presentation’ general topic on the homepage and choose ‘250 Accounting Changes and Error Corrections;’ then under the second drop-down menu, choose ’10overall’. Step 2: Click on the ‘Expand’ option. Under accounting changes is a subject called ‘impracticability.’ This paragraph (45-9) defines what impracticability means, but does not answer the question. If you scroll one paragraph earlier, you find the correct answer in paragraph 45-7. You apply to new method on a prospective basis at the earliest date practicable. ASC4-4 Scope Describe the equity method for accounting for investments. In order to qualify for the equity method, describe the conditions that must be met. Step 1: Use the drop-down menus under the ‘assets’ general topic on the homepage and choose ‘323 – Equity Method and Joint Ventures;’ then under the second drop-down menu, choose ’10-overall’.

4 - 24

Step 2: Click on section 15 which is always the ‘Scope and Scope exceptions’ for the guidance in that section. In FASB ASC paragraph 323-10-15-3 states that the guidance in Topic 323 apply to investments in common stock that give the investor the ability to exercise significant influence over the operating and financial policies of an investee even if the investor holds 50% or less of the common stock of the investee. . ASC4-5 Measurement Suppose that a company accounts for an investment using the equity method. Describe the appropriate accounting if the combined loss reported by the investee exceeds the investor’s balance in the investment account. Step 1: Use the drop-down menus under the ‘assets’ general topic on the homepage and choose ‘323 – Equity Method and Joint Ventures;’ then under the second drop-down menu, choose ’10-overall’. Step 2: Click on section 35 which is always the ‘Subsequent Measurement’ for the guidance in that section. Scroll though the paragraphs until you find ‘Equity Method Losses.’ FASB ASC paragraphs 323-10-35-19, 20, 21, and 22 provide the appropriate guidance. In general the investor will discontinue applying the equity method if the investment account is reduced to zero and shall not provide for additional losses. If the investee subsequently reports net income, the investor shall resume the equity method only after the share of unrecognized losses equals newly earned income. ASC4-6 Recognition Can a firm choose a fair value option for reporting some of its investments on the balance sheet? If so, describe the conditions that must be met. The answer to this exercise requires that the student be familiar with Fair Value accounting in Topic 825 Financial Instruments. Alternative 1: In the search box, enter ‘fair value option.’ Even though 158 results are returned, the third option is the correct solution. FASB ASC paragraphs 825-10-25-1 through 4. An entity may choose to elect the fair value option only on the date the one of the following occurs: the entity first recognizes the eligible item or the accounting treatment for the investment in another company changes because the investment becomes subject to the equity method of accounting or the investor ceases to consolidate a subsidiary because the investor no longer holds a majority interest. Alternative 2: Using this alternative, you are less certain about how to start your search. Step 1: Use the drop-down menus under the ‘assets’ general topic on the homepage and choose ‘323 – Investments – Debt and Equity Securities;’ then under the second drop-down menu, choose ’10overall’. Step 2: Click on section 15 which is always the ‘Scope’ section for the guidance in that section. Scrolling through the scope paragraphs, you will find subparagraph 15-7(c) which discusses the fair value option in paragraph 825-10-25-1

4 - 25

Answers to Problems Problem 4-1 Journal Entries - Cost Method Year 2009 2010 2011 2012

Net Income Cumulative Net Cumulative (Loss) Income Dividends 1,997,800 1,997,800 500,000 476,000 2,473,800 1,000,000 (179,600) 2,294,200 1,500,000 (323,800) 1,970,400 2,000,000

Part A – Cost Method 2009 Investment in Singer Co. Cash

Undistributed Income 1,497,800 1,473,800 794,200 (29,600)

4,972,000 4,972,000

Cash (.90)($500,000) Dividend Income

450,000

Cash (.90)($500,000) Dividend Income

450,000

Cash (.90)($500,000) Dividend Income

450,000

2010 450,000

2011 450,000

2012 Cash (.90)($500,000) 450,000 Dividend Income Investment in Singer Co. (.90  $29,600) To account for liquidating dividend Part B – Partial Equity Method 2009 Investment in Singer Co. Cash Cash (.90)($500,000) Investment in Singer Co. Investment in Singer Co. Equity in Subsidiary Income (.90)($1,997,800)

423,360 26,640

4,972,000 4,972,000 450,000 450,000 1,798,020 1,798,020

2010 Cash (.90)($500,000) Investment in Singer Co.

450,000

Investment in Singer Co. Equity in Subsidiary Income (.90)($476,000)

428,400

450,000 428,400

4 - 26

Problem 4-1 (continued) 2011 Cash (.90)($500,000) Investment in Singer Co.

450,000 450,000

Equity in Subsidiary Income (.90)($179,600) 161,640 Investment in Singer Co.

161,640

Cash (.90)($500,000) Investment in Singer Co.

450,000

2012 450,000

Equity in Subsidiary Income (.90)($323,800) 291,420 Investment in Singer Co.

291,420

Part C – Complete Equity Method Computation and Allocation of Difference between Implied and Book Value Acquired Parent Share Purchase price and implied value Less: Book value of equity acquired: Difference between implied and book value Undervalued depreciable assets (15 year life) Balance

4,972,000 4,961,160 10,840 (10,840) -0-

NonEntire Controlling Value Share 552,444 5,524,444 * 551,240 5,512,400 1,204 12,044 (1,204) (12,044) -0-0-

* $4,972,000/.90 2009 Investment in Singer Co. Cash Cash (.90)($500,000) Investment in Singer Co. Investment in Singer Co. Equity Income (.90)($1,997,800)

4,972,000 4,972,000 450,000 450,000 1,798,020 1,798,020

Equity in Subsidiary Income ($10,840/15 years) Investment in Singer Co.

723 723

2010 Cash (.90)($500,000) Investment in Singer Co.

450,000

Investment in Singer Co. Equity Income (.90)($476,000)

428,400

450,000 428,400

Equity in Subsidiary Income ($10,840/15 years) Investment in Singer Co.

4 - 27

723 723

2011 Cash (.90)($500,000) Investment in Singer Co.

450,000 450,000

Equity in Subsidiary Income (.90)($179,600) 161,640 Investment in Singer Co. Equity in Subsidiary Income ($10,840/15 years) Investment in Singer Co.

161,640

723 723

2012 Cash (.90)($500,000) Investment in Singer Co.

450,000 450,000

Equity in Subsidiary Income (.90)($323,800) 291,420 Investment in Singer Co. Equity in Subsidiary Income ($10,840/15 years) Investment in Singer Co.

4 - 28

291,420

723 723

Problem 4-2 Part A – Parry Corporation uses the cost method. If the cost method is used, Parry Corporation recognizes dividends received as income. Part B Workpaper - Cost Method

Parry Corporation and Subsidiary Consolidated Statements Workpaper For the Year Ended December 31, 2009 Parry Sent Eliminating Entries Consolidated Corp. Company Balances Dr. Cr.

Income Statement Sales Dividend Income Total Revenue Cost of Goods Sold Other Expenses Total Cost and Expense Net Income to Retained Earnings

Retained Earnings Statement Retained Earnings 1/1 Parry Corporation Sent Company Net Income from above Dividend Declared Parry Corporation Sent Company Retained Earnings 12/31 Balance Sheet Cash Accounts Receivable Inventory 12/31 Investment in Sent Company Difference between Implied and Book Value Land Total Assets Accounts Payable Common Stock: Parry Corporation Sent Company Retained Earnings from above Total Liabilities and Equity

476,000 154,500 630,500 3,500 (1) 3,500 479,500 154,500 630,500 285,600 121,000 406,600 45,500 29,500 75,000 331,100 150,500 481,600 148,400 4,000 3,500 148,900 Parry Sent Eliminating Entries Consolidated Dr. Cr. Corp. Company Balances

76,000 148,400

76,000 19,500 (2) 19,500 4,000 3,500

148,900

(3,500) 20,000

(17,500) 0 207,400

(17,500) 206,900 84,400 76,000 49,500 140,000

(1) 23,000

3,500 3,500

29,000 56,500 36,500

113,400 132,500 86,000

(2) 140,000 (2) 20,500 (3) 20,500 4,000 12,000 (3) 20,500 353,900 134,000 27,000 14,000

36,500 368,400 41,000

120,000

100,000 (2) 100,000 206,900 20,000 23,000 353,900 134,000 164,000

4 - 29

3,500 164,000

207,400 368,400

Problem 4-2 (continued) (1) To eliminate intercompany dividends (2) To eliminate investment in Sent Company (3) To eliminate difference between implied and book value

140,000 119,500 20,500 (20,500) -0-

4 - 30

NonControlling Share 0 0 0 (0) -0-

Entire Value 140,000 119,500 20,500 (20,500) -0-

Problem 4-3 Part A – Perkins Company uses the equity method. If the equity method is used, Perkins Company recognizes investment income from the investment based on the percentage owned times the investee net income. Part B Perkins Company and Subsidiary Consolidated Statements Workpaper Workpaper - Equity Method For the Year Ended December 31, 2010 Perkins Schultz Company Company Income Statement Sales Equity in Subsidiary Income Total Revenue Cost of Goods Sold Other Expenses Total Cost and Expense Net Income to Retained Earnings Retained Earnings Statement Retained Earnings 1/1 Perkins Company Schultz Company Net Income from Above Dividends Declared Perkins Company Schultz Company Retained Earnings 12/31 Balance Sheet Cash Inventory 12/31 Investment in Schultz

380,000 70,500 450,500 225,000 40,000 265,000 185,500

170,000

185,500

(1) 70,500 170,000 59,500 40,000 99,500 70,500

550,000 284,500 80,000 364,500 185,500

70,500

25,000 54,000 (3) 54,000 70,500 70,500

185,500

(15,000) 195,500 25,000 105,000 222,000

72,500

Consolidated Balances 550,000

25,000

Difference between Implied & Book Value Land 111,000 Goodwill Total 463,000 Accounts Payable Common Stock Perkins Company Schultz Company Other Contributed Capital Perkins Company Schultz Company Retained Earnings from above Total

Eliminating Entries Dr. Cr.

(15,000) (10,000) 114,500

(2) 10,000 124,500 10,000

30,000 97,500

195,500 55,000 202,500

(2) 10,000 (1) 70,500 (3) 161,500 (3) 15,000 (4) 15,000

97,000 224,500

208,000 15,000 480,500

17,500

90,000

(4) 15,000

160,000

160,000 75,000 (3) 75,000

35,000 195,500 463,000 4 - 31

35,000 17,500 (3) 17,500 114,500 124,500 224,500 257,000

10,000 257,000

195,500 480,500

Problem 4-3 (continued) (1) To eliminate equity in subsidiary income (2) To eliminate intercompany dividends (3) To eliminate investment in Schultz Company (4) To eliminate difference between implied and book value

161,500 146,500 15,000 (15,000) -0-

4 - 32

NonControlling Share 0 0 0 (0) -0-

Entire Value 161,500 146,500 15,000 (15,000) -0-

Problem 4-4 Workpaper - Cost Method Income Statement Sales Dividend Income ($22,000  .92) Total Revenue Cost of Goods Sold: Inventory, 1/1 Purchases Available for Sale Inventory, 12/31 Cost of Goods Sold Selling Expenses Other Expenses Total Cost and Expense Net/Consolidated Income Noncontrolling Interest in Consol. Inc. Net Income to Retained Earnings Retained Earnings Statement 1/1 Retained Earnings: Place Company Shaw Inc. Net Income from Above Dividends Declared Place Company Shaw Inc. 12/31/ Retained Earnings to Balance Sheet

Place Company

Shaw

Inc.

Eliminations Noncontrolling Consolidated Debit Credit Interest Balances

550,000 280,000 20,240 (1) 20,240 570,240 280,000

830,000

70,000 240,000 310,000 25,000 285,000 28,000 15,000 328,000 242,240

120,000 390,000 510,000 40,000 470,000 48,000 28,000 546,000 284,000 (4,960) 279,040

242,240

830,000

50,000 150,000 200,000 15,000 185,000 20,000 13,000 218,000 62,000 62,000

4,960 * 4,960

20,240

225,000

170,000 (2) 170,000 242,240 62,000 20,240

4,960

(35,000)

(35,000) (22,000)

432,240 210,000

190,240

(1) 20,240

(1,760)

20,240

3,200

Balance Sheet Cash 80,350 87,000 Accounts and Notes Receivable 200,000 210,000 (4) 15,000 Inventory 25,000 15,000 Investment in Shaw Inc. 400,000 (2) 400,000 Difference b/w Implied & Book Value (2) 15,783 (3) 15,783 Plant Assets 300,000 200,000 (3) 15,783 Total 1,005,350 512,000 Accounts and Notes Payable Other Liabilities Common Stock: Place Company Shaw Inc. Other Contributed Capital Place Company Shaw Inc. Retained Earnings from above 1/1 Noncontrolling Interest 12/31 Noncontrolling Interest Total

99,110 45,000

279,040

469,040 167,350 395,000 40,000

515,783 1,118,133

38,000 (4) 15,000 15,000

122,110 60,000

150,000

150,000 100,000 (2) 100,000

279,000

149,000 (2) 149,000 432,240 210,000 190,240

1,005,350 512,000

*(.08  $62,000) = $4,960

4 - 33

485,806

20,240 (2) 34,783 485,806

3,200 34,783 37,983

469,040 37,983 1,118,133

Problem 4-4 (continued) (1) To eliminate intercompany dividends. (2) To eliminate Investment in Shaw and establish noncontrolling interest account. (3) To allocate the difference between implied and book value. (4) To eliminate intercompany receivables and payables.

400,000 385,480 14,520 (14,520) -0 -

* $400,000/.92

4 - 34

NonControlling Share 34,783 33,520 1,263 (1,263) -0-

Entire Value 434,783 * 419,000 15,783 (15,783) -0-

Problem 4-5 Part A – Perez Company uses the cost method. If the cost method is used, Perez Company recognizes dividends received as income. Part B Workpaper – Cost Method

Perez Company and Subsidiary Consolidated Statements Workpaper For the Year Ended December 31, 2014 Perez Sanchez Company Company

Income Statement Sales 110,000 Dividend Income 10,800 Total Revenue 120,800 Cost of Goods Sold Inventory 1/1 14,000 Purchases 84,000 Available for Sale 98,000 Inventory 12/31 40,000 Cost of Goods Sold 58,000 Other Expenses 10,000 Total Cost and Expense 68,000 Net Income 52,800 Noncontrolling Interest Net Income to Retained Earnings 52,800 Retained Earnings Statement Retained Earnings 1/1 Perez Company Sanchez Company Net Income from above Dividends Declared Perez Company Sanchez Company Retained Earnings 12/31

Eliminating Entries Dr. Cr.

42,000

152,000 (3) 10,800

42,000

152,000

8,000 20,000 28,000 15,000 13,000 16,000 29,000 13,000

22,000 104,000 126,000 55,000 71,000 26,000 97,000 55,000 (1,300) 53,700

13,000

1,300 * 1,300

10,800

50,000 52,800

Noncontrolling Consolidated Interest Balance

(1) 16,200

66,200

30,000 (4) 30,000 13,000 10,800

1,300

(12,000) 31,000

(1,200) 100

(10,000) 92,800

53,700 (10,000)

* ($13,000  .10) = $1,300

4 - 35

(3) 10,800 40,800 27,000

109,900

Problem 4-5 (continued) Perez Sanchez Company Company Balance Sheet Cash Accounts Receivable Inventory 12/31 Advance to Sanchez Investment in Sanchez Difference b/w Implied & Book Value Plant and Equipment Land Goodwill Total Accounts Payable Other Liabilities Advances from Perez Common Stock: Perez Company Sanchez Company Retained Earnings from above Noncontrolling Interest 1/1 Noncontrolling Interest 12/31

13,000 22,000 40,000 8,000 85,000

14,000 36,000 15,000

50,000 17,800

44,000 6,000

Eliminating Entries Dr. Cr.

Noncontrol. Consolidated Interest Balance 27,000 58,000 55,000

(2) 8,000 16,200 (4) 101,200 12,444 (5) 12,444

(1) (4)

235,800 115,000

94,000 23,800 12,444 270,244

6,000 37,000

12,000 37,000

(5)

12,444

6,000 8,000 (2)

8,000

100,000 92,800

100,000 70,000 (4) 31,000

70,000 40,800 (4)

235,800 115,000 ** $9,444 + [($30,000 – $12,000) x .10] = $11,244

159,888

27,000 11,244 **

100 11,244 11,344

159,888

(1) To establish reciprocity/convert to the equity method (2) To eliminate intercompany advances (3) To eliminate intercompany dividends (4) To eliminate investment in Sanchez Company and establish noncontrolling interest account (5) To allocate the difference between implied and book value Computation and Allocation of Difference between Implied and Book Value Acquired Parent Share Purchase price and implied value Less: Book value of equity acquired: Difference between implied and book value Goodwill Balance

85,000 73,800 11,200 (11,200) -0-

*85,000/.90

4 - 36

NonControlling Share 9,444 8,200 1,244 (1,244) -0-

Entire Value 94,444 * 82,000 12,444 (12,444) -0-

109,900 11,344 270,244

Problem 4-6 Part A – Plank Company uses the equity method. If the equity method is used, Plank Company recognizes investment income from the investment based on the percentage owned times the investee net income. Part B

53,000 51,200 1,800 (1,800) -0-

NonControlling Share 13,250 12,800 450 (450) -0-

Entire Value 66,250 * 64,000 2,250 (2,250) -0-

* $53,000/.80 Journal entries for the worksheet on the following page (1) To eliminate intercompany receivables and payables (2) To eliminate intercompany dividends and equity in subsidiary income (3) To eliminate investment in Scoba Company and establish noncontrolling interest account** (4) To allocate the difference between implied and book value ** $13,250 + [($15,000 – $4,000) x .20) = $15,450

4 - 37

Problem 4-6 (continued)

Plank Company and Subsidiary Consolidated Statements Workpaper Workpaper - Equity Method For the Year Ended December 31, 2013 Plank Scoba Company Company Income Statement Sales 105,000 Equity in Subsidiary Income 14,400 Total Revenue 119,400 Cost of Goods Sold 85,400 Other Expenses 10,000 Total Cost and Expense 95,400 Net Income 24,000 Noncontrolling Interest ($18,000  .2) Net Income to Retained Earnings 24,000 Retained Earnings Statement Retained Earnings 1/1 Plank Company Scoba Company Net Income from above Dividends Declared Plank Company Scoba Company Retained Earnings 12/31

Noncontrolling Consolidated Interest Balance

50,000

155,000 (2) 14,400

50,000 20,000 12,000 32,000 18,000 18,000

3,600 3,600

14,400

48,800 24,000

62,800

12,000 5,000

15,000 18,000

(3) 15,000 14,400

3,600

(8,000) 25,000

(2) 29,400

22,000 17,000 8,000

6,400 6,400

(1)

3,000

(3) (4)

(2) (3) 2,250 (4) 2,250

8,000 61,800 2,250

6,000 4,000

(1)

3,000

55,000

(3) 55,000

5,000 25,000

(3)

48,000 95,000

(1,600) 2,000

62,800 64,000 35,000 23,000

102,250 224,250 15,000 9,000 100,000

20,000

20,000 5,000 29,400 (3)

199,800

24,000 (10,000)

100,000

62,800

155,000 105,400 22,000 127,400 27,600 (3,600) 24,000

48,800

(10,000)

Balance Sheet Cash 42,000 Accounts Receivable 21,000 Inventory 12/31 15,000 Investment in Scoba 69,800 ($61,800 +$14,400 - $6,400) Difference b/w Implied & Bk Value Land 52,000 Total assets 199,800 Accounts Payable Other Liabilities Common Stock Plank Company Scoba Company Other Contributed Capital Plank Company Scoba Company Retained Earnings from above Noncontrolling Interest 1/1 Noncontrolling Interest 12/31 Total liabilities and equity

Eliminating Entries Dr. Cr.

95,000

4 - 38

96,900

6,400 15,450 96,900

2,000 15,450 17,450

62,800 17,450 224,250

Problem 4-7

Workpaper - Cost Method

Price Company and Subsidiary Consolidated Statements Workpaper For the Year Ended December 31, 2013 Price Score Company Company

Income Statement Sales Dividend and Interest Income Total Revenue Cost of Goods Sold Other Expenses Total Cost and Expense Net Income Noncontrolling Interest Net Income to Retained Earnings Retained Earnings Statement Retained Earnings 1/1 Price Company Score Company Net Income from above Dividends Declared Price Company Score Company Retained Earnings 12/31

Eliminating Entries Noncontrolling Consolidated Interest Balance Dr. Cr.

1,420,000 52,500

500,000

1,472,500

500,000

1,920,000

822,000 250,500 1,072,500 400,000

242,000 124,000 366,000 134,000

1,064,000 367,000 1,431,000 489,000 (13,400) 475,600

400,000

1,920,000 (3) 45,000 (4) 7,500

134,000

(4)

52,500

687,000 400,000

7,500

13,400 * 13,400

(1) 108,000 210,000 (5) 210,000 134,000 52,500

795,000

7,500

13,400

45,000 160,500

(5,000) 8,400

(70,000 ) 1,017,000

475,600 (70,000)

(50,000 ) 294,000

* $134,000  .10 = $13,400.

4 - 39

(3) 262,500

1,200,600

Problem 4-7 (continued)

Price Score Company Company

Eliminating Entries Noncontrolling Consolidated Interest Balance Dr. Cr.

Balance Sheet Cash 109,000 78,000 Accounts Receivable 166,000 94,000 Note Receivable 75,000 (2) 75,000 Inventory 12/31 309,000 158,000 Investment in Score Company 450,000 (1) 108,000 (5) 558,000 Difference b/w Implied & Book Value (5) 50,000 (6) 50,000 Plant and Equipment 940,000 420,000 Land 160,000 70,000 Goodwill (6) 50,000 Total 2,209,000 820,000 Accounts Payable Notes Payable Common Stock: Price Company Score Company Other Contributed Capital Price Company Score Company Retained Earnings from above Noncontrolling Interest 1/1 Noncontrolling Interest 12/31

187,000 260,000 467,000

1,360,000 230,000 50,000 2,554,000

132,000 46,000 300,000 120,000 (2) 75,000

178,000 345,000

500,000

500,000 200,000 (5) 200,000

260,000

160,000 (5) 160,000 1,017,000 294,000 262,500

2,209,000 820,000

905,500

160,500 8,400 (5) 62,000 ** 62,000 70,400 905,500

** $50,000 + [($210,000 – $90,000) x .10] = $62,000

(1) To establish reciprocity/convert to the equity method ($210,000 - $90,000)  .90 (2) To eliminate intercompany receivables and payables (3) To eliminate intercompany dividends (4) To eliminate intercompany interest expense and income (5) To eliminate investment in Score Company and create noncontrolling interest account (6) To allocate the difference between implied and book value

4 - 40

1,200,600 70,400 2,554,000

Problem 4-7 (continued) Computation and Allocation of Difference between Implied and Book Value Acquired Parent Share Purchase price and implied value Less: Book value of equity acquired: Difference between implied and book value Goodwill Balance

450,000 405,000 45,000 (45,000) -0-

*$450,000/.90

4 - 41

NonControlling Share 50,000 45,000 5,000 (5,000) -0-

Entire Value 500,000 * 450,000 50,000 (50,000) -0-

Problem 4-8 Workpaper - Cost Method

Parker Company and Subsidiary Consolidated Statements Workpaper For the Year Ended December 31, 2010

Part A – 2010 Income Statement Sales Dividend Income Total Revenue Cost of Goods Sold Other Expenses Total Cost and Expense Net Income Noncontrolling Interest Net Income to Retained Earnings Retained Earnings Statement Retained Earnings 1/1 Parker Company Sid Company Net Income from above Dividends Declared Parker Company Sid Company Retained Earnings 12/31 Balance Sheet Cash Accounts Receivable Inventory 12/31 Investment in Sid Company Difference b/w Implied & Book Value Plant and Equipment Land Goodwill Total Accounts Payable Other Liabilities Common Stock Parker Company Sid Company Other Contributed Capital Parker Company Sid Company Retained Earnings from above Noncontrolling Interest 1/1 Noncontrolling Interest 12/31

Parker Sid Company Company 260,000 19,000 279,000 130,000 20,000 150,000 129,000 129,000

Eliminating Entries Dr. Cr.

Noncontrolling Consolidated Interest Balance

80,000

340,000 (1) 19,000

80,000 40,000 14,000 54,000 26,000 26,000

1,300 1,300

19,000

40,000 129,000

40,000 23,000 (2) 23,000 26,000 19,000

1,300

(20,000) 29,000

(1,000) 300

(20,000) 149,000

340,000 170,000 34,000 204,000 136,000 (1,300) 134,700

134,700 (20,000)

62,000 32,000 30,000 160,000

30,000 29,000 16,000

105,000 29,000

82,000 34,000

(1) 19,000 42,000 19,000

154,700

92,000 61,000 46,000 (2) 160,000 (2) 15,421 (3) 15,421

418,000 191,000

187,000 63,000 15,421 464,421

19,000 10,000

31,000 30,000

(3) 15,421

12,000 20,000

180,000

180,000 120,000 (2) 120,000

60,000 149,000

60,000 10,000 (2) 10,000 29,000 42,000

418,000 191,000

4 - 42

202,842

19,000 (2) 8,421 202,842

300 8,421 8,721

154,700 8,721 464,421

Problem 4-8 (continued) (1) To eliminate intercompany dividends (2) To eliminate investment in Sid Company and create noncontrolling interest account (3) To allocate the difference between implied and book value Computation and Allocation of Difference between Implied and Book Value Acquired Parent Share Purchase price and implied value Less: Book value of equity acquired: Difference between implied and book value Goodwill Balance

160,000 145,350 14,650 (14,650) -0-

NonControlling Share 8,421 7,650 771 (771) -0-

Entire Value 168,421 * 153,000 15,421 (15,421) -0-

*$160,000/.95 Part B – 2011 Workpaper –Cost Method

Parker Company and Subsidiary Consolidated Statements Workpaper For the Year Ended December 31, 2011 Parker Sid Eliminating Entries Company Company Dr. Cr.

Income Statement Sales Dividend Income Total Revenue Cost of Goods Sold Other Expenses Total Cost and Expense Net Income Noncontrolling Interest Net Income to Retained Earnings Retained Earnings Statement Retained Earnings 1/1 Parker Company Sid Company Net Income from above Dividends Declared Parker Company Sid Company Retained Earnings 12/31

240,000 19,000 259,000 155,000 30,000 185,000 74,000 74,000

120,000

360,000 (2) 19,000

120,000 52,000 18,000 70,000 50,000 50,000

2,500 * 2,500

19,000

149,000 74,000

Noncontrolling Consolidated Interest Balance

(1)

5,700

154,700

29,000 (3) 29,000 50,000 19,000

2,500

(20,000) 59,000

(1,000) 1,500

(20,000) 203,000

360,000 207,000 48,000 255,000 105,000 (2,500) 102,500

102,500 (20,000)

* ($50,000  .05) = $2,500.

4 - 43

(2) 19,000 48,000 24,700

237,200

Problem 4-8 (continued) Parker Sid Company Company Balance Sheet Cash Accounts Receivable Inventory 12/31 Investment in Sid Difference b/w Implied & Book Value Plant and Equipment Land Goodwill Total Accounts Payable Other Liabilities Common Stock: Parker Company Sid Company Other Contributed Capital Parker Company Sid Company Retained Earnings from above Noncontrolling Interest 1/1 Noncontrolling Interest 12/31

67,000 56,000 38,000 160,000

16,000 32,000 48,500

124,000 29,000

80,000 34,000

Eliminating Entries Dr. Cr.

Noncontroll- Consolidated ing Balance Interest 83,000 88,000 86,500

(1) 5,700 (3) (3) 15,421 (4)

165,700 15,421

474,000

210,500

204,000 63,000 15,421 539,921

16,000 15,000

7,000 14,500

23,000 29,500

(4) 15,421

180,000

180,000 120,000 (3) 120,000

60,000

60,000 10,000 (3) 10,000 59,000 48,000

203,000

(3) 474,000

210,500

214,542

24,700 1,500 8,721 ** 8,721 10,221 214,542

** $8,421 + [($29,000 – $23,000) x .05) = $8,721

(1) To establish reciprocity/convert to the equity method ($29,000 – $23,000 )  .95 = $5,700 (2) To eliminate intercompany dividends (3) To eliminate investment in Sid Company and create noncontrolling interest account (4) To allocate the difference between implied and book value

4 - 44

237,200 10,221 539,921

Problem 4-9 Workpaper - Cost Method

Pledge Company and Subsidiary Consolidated Statements Workpaper For the Year Ended December 31, 2012 Pledge Stom Company Company

Income Statement Sales Dividend and Interest Income Total Revenue Cost of Goods Sold Other Expenses Total Cost and Expense Net Income Noncontrolling Interest Net Income to Retained Earnings Retained Earnings Statement Retained Earnings 1/1 Pledge Company Stom Company Net Income from above Dividends Declared Pledge Company Stom Company Retained Earnings 12/31 Balance Sheet Cash and Marketable Securities Accounts Receivable

880,000 30,600

Eliminating Entries Dr. Cr.

910,600 460,000 225,000 685,000 225,600

340,000 3,000 (3) 24,000 (4) 6,600 343,000 185,000 65,000 (4) 250,000 93,000

225,600

93,000

30,600

422,000 225,600

1,220,000 3,000

6,600

(1) 320,000 (6) 320,000 93,000 30,600

Noncontrolling Consolidated Interest Balance

18,600 * 18,600

128,000

1,223,000 645,000 283,400 928,400 294,600 (18,600) 276,000

550,000

6,600

18,600

24,000 158,600

(6,000) 12,600

(50,000)

276,000 (50,000)

597,600

(30,000) 383,000

184,600 182,000

72,000 180,000

(3) 350,600

776,000

256,600 (2) (5)

55,000 6,600

(1) 128,000 (6) (6) 55,000 (7)

428,000 55,000

300,400 426,000

Inventory 12/31 214,000 Investment in Stom 300,000 Difference b/w Implied & Bk Value Plant and Equipment 309,000 Land 85,000 Total 1,274,600

212,000

301,000 75,000 (7) 55,000 840,000

610,000 215,000 1,808,000

Accounts Payable Accrued Expenses Notes Payable Common Stock: Pledge Company Stom Company Other Contributed Capital Pledge Company Stom Company Treasury Stock Retained Earnings from above Noncontrolling Interest 1/1 Noncontrolling Interest 12/31 Total

79,000 18,000 (5) 6,600 200,000 (2) 55,000

175,000 42,400 245,000

96,000 31,000 100,000 300,000

300,000 100,000 (6) 100,000

150,000

597,600

1,274,600

150,000 80,000 (6) 80,000 (20,000) (6) 383,000 350,600 (6) 840,000

4 - 45

830,200

20,000 158,600 12,600 107,000 ** 107,000 119,600 830,200

776,000 119,600 1808,000

Problem 4-9 (continued) * ($93,000  .20) = $18,600. ** $75,000 + [($320,000 – $160,000) x .20) = $107,000 (1) To establish reciprocity/convert to the equity method ($320,000 - $160,000)  .80 (2) To eliminate intercompany note receivables and payables (3) To eliminate intercompany dividends (4) To eliminate intercompany interest expense and income (5) To eliminate intercompany interest receivables and payables (6) To eliminate investment in Stom Company and create noncontrolling interest account (7) To allocate the difference between implied and book value

300,000 256,000 44,000 (44,000) -0-

*$300,000/.80

4 - 46

NonControlling Share 75,000 64,000 11,000 (11,000) -0-

Entire Value 375,000 * 320,000 55,000 (55,000) -0-

Problem 4-10 Workpaper - Partial Equity Method

Poco Company and Subsidiary Consolidated Statements Workpaper For the Year Ended December 31, 2010

Poco Solo Company Company Income Statement Sales Equity in Subsidiary Income Total Revenue Cost of Goods Sold Other Expenses Total Cost and Expense Net Income Noncontrolling Interest Net Income to Retained Earnings Retained Earnings Statement Retained Earnings 1/1 Poco Company Solo Company Net Income from above Dividends Declared Poco Company Solo Company Retained Earnings 12/31 Balance Sheet Cash Inventory Investment in Solo Difference b/w Implied & Book Value Land Goodwill Total Accounts Payable Common Stock: Poco Company Solo Company Other Contributed Capital Poco Company Solo Company Retained Earnings from above Noncontrolling Interest 1/1 Noncontrolling Interest 12/31

760,000 164,000 924,000 410,000 100,000 510,000 414,000

410,000

414,000

205,000

Eliminating Entries Noncontrolling Consolidated Dr. Cr. Interest Balance 1,170,000 (1) 164,000

410,000 125,000 80,000 205,000 205,000 41,000 * 41,000

164,000

50,000 414,000

50,000 60,000 205,000

(2) 60,000 164,000

41,000

(30,000) 434,000

1,170,000 535,000 180,000 715,000 455,000 (41,000) 414,000

414,000 (30,000)

(15,000) 250,000

161,500 210,000 402,000

125,000 195,000

75,000

150,000

(1) 12,000 224,000 12,000

(3,000) 38,000

434,000

286,500 405,000 (1) 152,000 (2) 250,000 (2) 67,500 (3) 67,500

848,500

470,000

225,000 67,500 984,000

154,500

35,000

189,500

(3) 67,500

200,000

200,000 150,000

(2) 150,000

434,000

35,000 250,000

(2) 35,000 224,000

848,500

470,000

544,000

60,000

* $205,000  .20 = $41,000

4 - 47

12,000 (2) 62,500 544,000

38,000 62,500 100,500

434,000 100,500 984,000

Problem 4-10 (continued) (1) To eliminate intercompany income and dividends (2) To eliminate investment in Solo Company and create noncontrolling interest account (3) To allocate the difference between implied and book value Computation and Allocation of Difference between Implied and Book Value Acquired Parent Share Purchase price and implied value Less: Book value of equity acquired: Difference between implied and book value Goodwill Balance

250,000 196,000 54,000 (54,000) -0-

NonControlling Share 62,500 49,000 13,500 (13,500) -0-

Entire Value 312,500 * 245,000 67,500 (67,500) -0-

*$250,000/.80 Problem 4-11 Workpaper - Equity Method

Price Company and Subsidiary Consolidated Statements Workpaper For the Year Ended December 31, 2013 Price Score Company Company

Income Statement Sales Equity in Subsidiary Income Interest Income Total Revenue Cost of Goods Sold Other Expenses Total Cost and Expense Net Income Noncontrolling Interest Net Income to Retained Earnings Retained Earnings Statement Retained Earnings 1/1 Price Company Score Company Net Income from above Dividends Declared Price Company Score Company Retained Earnings 12/31

1,420,000 120,600 7,500 1,548,100 822,000 250,500 1,072,500 475,600

Eliminating Entries Noncontrolling Consolidated Interest Balance Dr. Cr.

500,000

1,920,000 (1) 120,600 (3) 7,500

500,000 242,000 124,000 366,000 134,000

475,600 134,000

(3)

128,100

7,500

13,400 * 13,400

795,000

1,920,000 1,064,000 367,000 1,431,000 489,000 (13,400) 475,600

795,000

210,000 (4) 210,000 475,600 134,000 128,100

7,500

13,400

(1) 45,000 338,100 52,500

(5,000) 8,400

(70,000)

475,600 (70,000)

(50,000) 1,200,600 294,000

* $134,000  .10 = $13,400.

4 - 48

1,200,600

Problem 4-11 (continued) Balance Sheet Cash Accounts Receivable Note Receivable Inventory 12/31 Investment in Score Difference b/w Implied & Book Value Plant and Equipment Land Goodwill Total Accounts Payable Notes Payable Common Stock: Price Company Score Company Other Contributed Capital Price Company Score Company Retained Earnings from above Noncontrolling Interest 1/1 Noncontrolling Interest 12/31 Total

Price Score Company Company 109,000 166,000 75,000 309,000 633,600

940,000 160,000

Eliminating Entries Noncontrolling Consolidated Interest Balance Dr. Cr.

78,000 94,000

187,000 260,000 (2)

75,000

(4) (1) (4) 50,000 (5)

558,000 75,600 50,000

158,000

467,000

420,000 70,000

1,360,000 230,000 50,000 2,554,000

(5) 50,000 2,392,600 820,000 132,000 300,000

46,000 120,000 (2) 75,000

178,000 345,000

500,000

500,000 200,000 (4) 200,000

260,000

160,000 (4) 160,000 1,200,600 294,000 338,100 (4) 2,392,600 820,000

873,100

52,500 8,400 62,000 ** 62,000 70,400 873,100

** $50,000 + [($210,000 – $90,000) x .10] = $62,000

(1) To eliminate intercompany income and dividends (2) To eliminate intercompany receivables and payables (3) To eliminate intercompany interest expense and income (4) To eliminate investment in Score company and create noncontrolling interest account (5) To allocate the difference between implied and book value Computation and Allocation of Difference between Implied and Book Value Acquired Parent Share Purchase price and implied value Less: Book value of equity acquired: Difference between implied and book value Goodwill Balance

450,000 405,000 45,000 (45,000) -0-

*$450,000/.90

4 - 49

NonControlling Share 50,000 45,000 5,000 (5,000) -0-

Entire Value 500,000 * 450,000 50,000 (50,000) -0-

1,200,600 70,400 2,554,000

Problem 4-12 Part A - 2010

Parker Company and Subsidiary Consolidated Statements Workpaper Workpaper - Equity Method For the Year Ended December 31, 2010 Parker Sid Company Company Income Statement Sales Equity in Subsidiary Income Total Revenue Cost of Goods Sold Operating Expenses Total Cost and Expense Net Income Noncontrolling Interest Net Income to Retained Earnings Retained Earnings Statement Retained Earnings 1/1 Parker Company Sid Company Net Income from above Dividends Declared Parker Company Sid Company Retained Earnings 12/31

300,000 18,000 318,000 150,000 35,000 185,000 133,000

95,000

133,000

20,000

Eliminating Entries Noncontrolling Consolidated Interest Balance Dr. Cr. 395,000 (1) 18,000

95,000 60,000 15,000 75,000 20,000 2,000 * 2,000

18,000

55,000 133,000

55,000 25,000 (2) 25,000 20,000 18,000

2,000

(15,000) 30,000

(1,500) 500

(20,000) 168,000

395,000 210,000 50,000 260,000 135,000 (2,000) 133,000

133,000 (20,000)

(1) 13,500 43,000 13,500

168,000

Balance Sheet Cash Accounts Receivable Inventory 12/31 Investment in Sid Company

65,000 40,000 25,000 184,500

35,000 30,000 15,000

Difference b/w Implied & Book Value Plant and Equipment Land Total

110,000 48,500 473,000

85,000 45,000 (3) 35,000 210,000

195,000 128,500 533,500

20,000 15,000

15,000 25,000

35,000 40,000

Accounts Payable Other Liabilities Common Stock Parker Company Sid Company Other Contributed Capital Parker Company Sid Company Retained Earnings from above Noncontrolling Interest 1/1 Noncontrolling Interest 12/31

100,000 70,000 40,000 (1) 4,500 (2) 180,000 (2) 35,000 (3) 35,000

200,000

200,000 120,000 (2) 120,000

70,000 168,000

473,000

70,000 20,000 (2) 20,000 30,000 43,000

210,000

*($20,000  .10) = $2,000

4 - 50

253,000

13,500 (2) 20,000 253,000

500 20,000 20,500

168,000 20,500 533,500

Problem 4-12 (continued) (1) To eliminate intercompany dividends and income (2) To eliminate investment in Sid Company and create noncontrolling interest account (3) To allocate the difference between implied and book value Computation and Allocation of Difference between Implied and Book Value Acquired Parent Share Purchase price and implied value Less: Book value of equity acquired: Difference between implied and book value Undervalued land Balance

180,000 148,500 31,500 (31,500) -0-

*$180,000/.90

4 - 51

NonControlling Share 20,000 16,500 3,500 (3,500) -0-

Entire Value 200,000 * 165,000 35,000 (35,000) -0-

Problem 4-12 (continued) Part B - 2011

Parker Company and Subsidiary Consolidated Statements Workpaper For the Year Ended December 31, 2011 Parker Sid Company Company

Income Statement Sales Equity in Subsidiary Income Total Revenue Cost of Goods Sold Operating Expenses Total Cost and Expense Net Income Noncontrolling Interest Net Income to Retained Earnings Retained Earnings Statement Retained Earnings 1/1 Parker Company Sid Company Net Income from above Dividends Declared Parker Company Sid Company Retained Earnings 12/31

260,000 22,500 282,500 160,000 35,000 195,000 87,500 87,500

Eliminating Entries Noncontrolling Consolidated Interest Balance Dr. Cr.

110,000

370,000 (1) 22,500

110,000 65,000 20,000 85,000 25,000 25,000

2,500 * 2,500

22,500

168,000 87,500

168,000 30,000 (2) 30,000 25,000 22,500

2,500

(20,000) 235,500

370,000 225,000 55,000 280,000 90,000 (2,500) 87,500

87,500 (20,000)

(15,000) 40,000

(1) 52,500

13,500 13,500

(1,500) 1,000

235,500

Balance Sheet Cash Accounts Receivable Inventory 12/31 Investment in Sid Company

70,000 60,000 40,000 193,500

20,000 35,000 30,000

Difference b/w Implied & Book Value Plant and Equipment Land Total

125,000 48,500 537,000

90,000 45,000 (3) 35,000 220,000

215,000 128,500 598,500

16,500 15,000

16,000 24,000

32,500 39,000

Accounts Payable Other Liabilities Common Stock: Parker Company Sid Company Other Contributed Capital Parker Company Sid Company Retained Earnings from above Noncontrolling Interest 1/1 Noncontrolling Interest 12/31

90,000 95,000 70,000 (1) 9,000 (2) 184,500 (2) 35,000 (3) 35,000

200,000

200,000 120,000 (2) 120,000

70,000 235,500

70,000 20,000 (2) 20,000 40,000 52,500 (2)

13,500 20,500 **

537,000 220,000 262,500 262,500 * ($25,000  .10) = $2,500; ** $20,000 + [($30,000 – $25,000) x .10] = $20,500

(1) To eliminate intercompany dividends and income (2) To eliminate investment in Sid company and create noncontrolling interest account (3) To allocate the difference between implied and book value 4 - 52

1,000 20,500 21,500

235,500 21,500 598,500

Problem 4-13 Workpaper - Equity Method Income Statement Sales Equity in Subsidiary Income Interest Income Total Revenue Cost of Goods Sold Operating Expenses Total Cost and Expense Net Income Noncontrolling Interest Net Income to Retained Earnings Retained Earnings Statement Retained Earnings 1/1 Pledge Company Stom Company Net Income from above Dividends Declared Pledge Company Stom Company Retained Earnings 12/31 Balance Sheet Cash and Marketable Securities Accounts Receivable Inventory 12/31 Investment in Stom

Pledge Company and Subsidiary Consolidated Statements Workpaper For the Year Ended December 31, 2012 Pledge Stom Eliminating Entries Noncontroll- Consolidated Company Company ing Interest Balance Dr. Cr. 880,000 340,000 1,220,000 74,400 (1) 74,400 6,600 3,000 (3) 6,600 3,000 961,000 343,000 1,223,000 460,000 185,000 645,000 225,000 65,000 (3) 6,600 283,400 685,000 250,000 928,400 276,000 93,000 294,600 18,600 * (18,600) 276,000 93,000 81,000 6,600 18,600 276,000

550,000 276,000

6,600

18,600

(50,000) (30,000) 383,000

184,600 182,000

72,000 180,000

214,000 478,400

96,000 31,000 100,000

276,000 (50,000)

776,000

Difference b/w Implied & Book Value Plant and Equipment 309,000 Land 85,000 Total 1,453,000 Accounts Payable Accrued Expenses Notes Payable Common Stock: Pledge Company Stom Company Other Contributed Capital Pledge Company Stom Company Treasury Stock Retained Earnings from above Noncontrolling Interest 1/1 Noncontrolling Interest 12/31 Total

550,000 320,000 (5) 320,000 93,000 81,000

(1) 401,000

24,000 30,600

(6,000) 12,600

776,000 256,600

(2) (4)

55,000 6,600

(1) (5) (5) 55,000 (6)

50,400 428,000 55,000

212,000

300,400 426,000

301,000 75,000 (6) 55,000 840,000

610,000 215,000 1,808,000

79,000 18,000 (4) 6,600 200,000 (2) 55,000

175,000 42,400 245,000

300,000

300,000 100,000 (5) 100,000

150,000

776,000

1,453,000

150,000 80,000 (5) 80,000 (20,000) (5) 383,000 401,000 (5) 840,000

4 - 53

752,600

20,000 30,600 12,600 107,000 ** 107,000 119,600 752,600

776,000 119,600 1,808,000

Problem 4-13 (continued) * $93,000  .20 = $18,600. ** $75,000 + [($320,000 – $160,000) x .20) = $107,000 (1) To eliminate intercompany dividends and income (2) To eliminate intercompany note receivables and payables (3) To eliminate intercompany interest expense and income (4) To eliminate intercompany interest receivables and payables (5) To eliminate investment in Stom company and create noncontrolling interest account (6) To allocate the difference between implied and book value

300,000 256,000 44,000 (44,000) -0-

*$300,000/.80 (72,000/90,000 shares = 80%)

4 - 54

NonControlling Share 75,000 64,000 11,000 (11,000) -0-

Entire Value 375,000 * 320,000 55,000 (55,000) -0-

Problem 4-14

Punca Company and Subsidiary Consolidated Statements Workpaper For the Year Ended December 31, 2010

Workpaper - Cost Method

Punca Surrano Company Company Income Statement Sales Dividend Income Total Revenue Cost of Goods Sold Other Expenses Total Cost and Expense Net Income Net Income Purchased* Noncontrolling Interest** Net Income to Retained Earnings Retained Earnings Statement Retained Earnings 1/1 Punca Company Surrano Company Net Income from above Dividends Declared Punca Company Surrano Company Retained Earnings 12/31 Balance Sheet Current Assets Investment in Surrano Difference b/w Implied & Book Value Plant and Equipment Total Accounts and Notes Payable Dividends Payable Common Stock: Punca Company Surrano Company Other Contributed Capital Punca Company Surrano Company Treasury Stock Retained Earnings from above Noncontrolling Interest 1/1 Noncontrolling Interest 12/31 Total

Eliminating Entries Dr. Cr.

Noncontroll Consolidated ing Balance Interest

2,100,000 1,300,000 42,500 6,000 (1) 42,500 2,142,500 1,306,000 1,540,000 759,000 415,000 250,000 1,955,000 1,009,000 187,500 297,000 (3) 148,500 187,500

297,000

22,275 22,275

191,000

355,000 187,500

3,400,000 6,000 3,406,000 2,299,000 665,000 2,964,000 442,000 (148,500) (22,275) 271,225

355,000 241,000 (3) 241,000 297,000 191,000

22,275

271,225

(7,500) 14,775

626,225

0 542,500 150,000 590,000

(50,000) 488,000 180,000

432,000

(1)

42,500 42,500

(2) (3) (3) 62,618 (4)

42,500 590,000 62,618

287,500

1,250,000 1,990,000

750,000 (4) 62,618 930,000

2,062,618 2,350,118

277,500

150,000 50,000 (2) 42,500

427,500 7,500

270,000

270,000 40,000 (3) 40,000

900,000

542,500

1,990,000

900,000 250,000 (3) 250,000 (48,000) (3) 488,000 432,000 (3) 930,000

889,736

48,000 42,500 104,118

14,775 104,118 118,893

889,736

*Alternate account title – Subsidiary Income Before Acquisition **$148,500 x .15 = $22,275

4 - 55

626,225 118,893 2,350,118

Problem 4-14 (continued) (1) To eliminate intercompany dividends (2) To eliminate intercompany dividends receivable and payable (3) To eliminate investment in Surrano company and create noncontrolling interest account (4) To allocate the difference between implied and book value Computation and Allocation of Difference between Implied and Book Value Acquired Parent Share Purchase price and implied value Less: Book value of equity acquired: Equity ($531,000 - $48,000) Subsidiary Income purchased (6/12)($297,000) Total book value Difference between implied and book value Undervalued land Balance

590,000

NonControlling Share 104,118

694,118 *

410,550

72,450

483,000

126,225 536,775 53,225 (53,225) -0-

22,275 94,725 9,393 (9,393) -0-

148,500 631,500 62,618 (62,618) -0-

*$590,000/.85

4 - 56

Entire Value

Problem 4-15 Workpaper - Cost Method

Punca Company and Subsidiary Consolidated Statements Workpaper For the Year Ended December 31, 2010 Punca Surrano Company Company

Income Statement Sales Dividend Income Total Revenue Cost of Goods Sold Other Expenses Total Cost and Expense Net Income Noncontrolling Interest* Net Income to Retained Earnings Retained Earnings Statement Retained Earnings Punca Company 1/1 Surrano Company 7/1 Net Income from above Dividends Declared Punca Company 1/1 Surrano Company 7/1 Retained Earnings 12/31 Balance Sheet Current Assets Investment in Surrano Difference b/w Implied & Book Value Plant and Equipment Total Accounts and Notes Payable Dividends Payable Common Stock: Punca Company 1/1 Surrano Company 7/1 Other Contributed Capital Punca Company 1/1 Surrano Company 7/1 Treasury Stock Retained Earnings from above Noncontrolling Interest 1/1 Noncontrolling Interest 12/31 Total

2,100,000 42,500 2,142,500 1,540,000 415,000 1,955,000 187,500 187,500

Eliminating Entries Noncontrolling Consolidated Interest Balance Dr. Cr.

650,000 3,000 (1) 42,500 653,000 379,500 125,000 504,500 148,500 148,500

22,275 22,275

42,500

355,000 187,500

2,750,000 3,000 2,753,000 1,919,500 540,000 2,459,500 293,500 (22,275) 271,225

355,000 389,500 (3) 389,500 148,500 42,500

22,275

271,225

(7,500) 14,775

626,225

0 542,500

150,000 590,000

(50,000) 488,000

180,000

432,000

(1) 42,500 42,500

(2) 42,500 (3) 590,000 (3) 62,618 (4) 62,618

287,500

1,250,000 1,990,000

750,000 (4) 62,618 930,000

2,062,618 2,350,118

277,500

150,000 50,000 (2) 42,500

427,500 7,500

270,000

270,000 40,000 (3) 40,000

900,000

542,500

1,990,000

900,000 250,000 (3) 250,000 (48,000) (3) 48,000 488,000 432,000 42,500 (3) 104,118 930,000

*$148,500 x .15 = $22,275

4 - 57

889,736

14,775 104,118 118,893

626,225 118,893 2,350,118

Problem 4-15 (continued) (1) To eliminate intercompany dividends (2) To eliminate intercompany dividends receivable and payable (3) To eliminate investment in Surrano company and create noncontrolling interest account (4) To allocate the difference between implied and book value

Computation and Allocation of Difference between Implied and Book Value Acquired Parent Share Purchase price and implied value Less: Book value of equity acquired: Equity ($531,000 - $48,000) Subsidiary Income purchased (6/12)($297,000) Total book value Difference between implied and book value Undervalued land Balance

590,000

NonControlling Share 104,118

694,118 *

410,550

72,450

483,000

126,225 536,775 53,225 (53,225) -0-

22,275 94,725 9,393 (9,393) -0-

148,500 631,500 62,618 (62,618) -0-

*$590,000/.85

4 - 58

Entire Value

Problem 4-16 Workpaper Partial Equity Method

Pillow Company and Subsidiary Consolidated Statements Workpaper For the Year Ended December 31, 2009 Pillow Satin Company Company

Income Statement Sales Equity in Subsidiary Income Total Revenue Cost of Goods Sold Other Expenses Total Cost and Expense Net Income Net Income Purchased Noncontrolling Interest * Net Income to Retained Earnings Retained Earnings Statement Retained Earnings 1/1 Pillow Company Satin Company Net Income from above Dividends Declared Pillow Company Satin Company Retained Earnings 12/31 Balance Sheet Current Assets Investment in Satin Difference b/w Implied & Book Value Plant and Equipment Total

1,940,000 90,000 2,030,000 1,261,000 484,000 1,745,000 285,000

Eliminating Entries Dr. Cr.

Noncontrolling Consolidated Interest Balance

976,000

2,916,000 (1) 90,000

976,000 584,000 242,000 826,000 150,000 (3) 45,000

285,000

150,000

15,000 15,000

135,000

315,360 285,000

2,916,000 1,845,000 726,000 2,571,000 345,000 (45,000) (15,000) 285,000

315,360 209,200 (3) 209,200 150,000 135,000

15,000

285,000

(6,000 ) 9,000

600,360

0 600,360 390,600 510,000

(60,000 ) 299,200 179,200

(3) 1,334,000 2,234,600

562,000 (4) 741,200

(1) 344,200 (2) (3) (1) 9,467 (4)

54,000 54,000 54,000 474,000 36,000 9,467

9,467

Accounts and Notes Payable 270,240 124,000 Dividends Payable 60,000 (2) 54,000 Common Stock: Pillow Company 1,000,000 Satin Company 200,000 (3) 200,000 Other Contributed Capital Pillow Company 364,000 Satin Company 90,000 (3) 90,000 Treasury Stock (32,000 ) (3) 32,000 Retained Earnings from above 600,360 299,200 344,200 54,000 Noncontrolling Interest 1/1 (3) 47,667 ** Noncontrolling Interest 12/31 Total 2,234,600 741,200 707,134 707,134 * ($150,000  .10) = $15,000 (noncontrolling interest in income after acquisition) **$52,667 - $5,000 = $47,667

4 - 59

515,800

1,905,467 2,421,267 394,240 6,000 1,000,000

364,000

9,000 47,667 56,667

600,360 56,667 2,421,267

Problem 4-16 (continued) (1) To eliminate intercompany dividends and income (2) To eliminate intercompany receivables and payables (3) To eliminate investment in Satin Company and create noncontrolling interest account (4) To allocate the difference between implied and book value

Computation and Allocation of Difference between Implied and Book Value Acquired Parent Share Purchase price and implied value Less: Book value of equity acquired: Equity ($499,200 - $32,000) Subsidiary Income purchased (4/12)($150,000) Total book value Difference between implied and book value Undervalued land Balance

474,000

NonControlling Share 52,667

526,667 *

420,480

46,720

467,200

45,000 465,480 8,520 (8,520) -0-

5,000 51,720 947 (947) -0-

50,000 517,200 9,467 (9,467) -0-

$474,000/.90

4 - 60

Entire Value

Problem 4-17

Pillow Company and Subsidiary Consolidated Statements Workpaper Workpaper - Partial Equity Method For the Year Ended December 31, 2009 Pillow Satin Company Company Income Statement Sales 1,940,000 Equity in Subsidiary Income 90,000 Total Revenue 2,030,000 Cost of Goods Sold 1,261,000 Other Expenses 484,000 Total Cost and Expense 1,745,000 Net Income 285,000 Noncontrolling Interest ($10,000.10) Net Income to Retained Earnings 285,000

Eliminating Entries Noncontrolling Consolidated Dr. Cr. Interest Balance

650,666

2,590,666 (1) 90,000

650,666 389,333 161,333 550,666 100,000 100,000

Pillow Satin Company Company Retained Earnings Statement Retained Earnings 1/1 Pillow Company Satin Company Net Income from above Dividends Declared Pillow Company Satin Company Retained Earnings 12/31 Balance Sheet Current Assets Investment in Satin Difference b/w Implied & Book Value Plant and Equipment Total Accounts and Notes Payable Dividends Payable Common Stock Pillow Company Satin Company Other Contributed Capital Pillow Company Satin Company Treasury Stock Retained Earnings from above Noncontrolling Interest 1/1 Noncontrolling Interest 12/31 Total *$52,667 + $4,000 = $56,667

10,000 10,000

90,000

Eliminating Entries Noncontrolling Consolidated Dr. Cr. Interest Balance

315,360 285,000

2,590,666 1,650,333 645,333 2,295,666 295,000 (10,000) 285,000

315,360 259,200 (3) 259,200 100,000 90,000

10,000

285,000

(6,000) 4,000

600,360

0 600,360

390,600 510,000

(60,000) 299,200

349,200

179,200

(3) 1,334,000 562,000 (4) 2,234,600 741,200 270,240

(1) 54,000 54,000

(2) 54,000 (3) 474,000 (1) 36,000 9,467 (4) 9,467

515,800

9,467

1,905,467 2,421,267

124,000 60,000 (2) 54,000

394,240 6,000

1,000,000

1,000,000 200,000 (3) 200,000

364,000

600,360

364,000 90,000 (3) 90,000 (32,000) (3) 32,000 299,200 349,200 54,000 (3) 52,667 *

2,234,600 741,200

4 - 61

712,134

4,000 52,667 56,667

600,360 56,667 2,421,267

Problem 4-17 (continued) (1) To eliminate intercompany dividends (2) To eliminate intercompany receivables and payables (3) To eliminate investment in Satin Company and create noncontrolling interest account (4) To allocate the difference between implied and book value Computation and Allocation of Difference between Implied and Book Value Acquired Parent Share Purchase price and implied value Less: Book value of equity acquired: Equity ($499,200 - $32,000) Subsidiary Income purchased (4/12)($150,000) Total book value Difference between implied and book value Undervalued land Balance

474,000

NonControlling Share 52,667

526,667 *

420,480

46,720

467,200

45,000 465,480 8,520 (8,520) -0-

5,000 50,000 51,720 517,200** 947 9,467 (947) (9,467) -0-0-

*$474,000/.90 ** ($200,000 + $90,000 - $32,000 + $209,200 + $50,000)

4 - 62

Entire Value

Problem 4-18 Consolidated Statement of Cash Flows - Indirect Method P Company and Subsidiary Consolidated Statement of Cash Flows For the Year Ended December 31, 2011 Cash flows from operating activities: Consolidated net income

$330,000

Adjustments to convert consolidated net income to net cash flow from operating activities Depreciation expense Increase in accounts receivable Increase in inventories Decrease in accounts payable Increase in accrued payable Net cash flow from operating activities

95,000 (110,000) (20,000) (232,000) 60,000

Cash flows from investing activities: Purchases of plant assets

(207,000) 123,000

(545,000)

Cash flows from financing activities: Proceeds from the issuance of bonds Proceeds from the issuance of common stock * Cash dividends paid ** Net cash flow from financing activities Decrease in cash * ($600,000 + $275,000) – ($450,000 + $225,000) = $200,000 ** ($60,000 + ($40,000  .20)) = $68,000.

4 - 63

240,000 200,000 (68,000) 372,000 ($50,000)

Problem 4-19 Parks Company and Subsidiary Consolidated Statement of Cash Flows – Direct Method For the Year Ended December 31, 2012 Cash flows from operating activities: Cash received from customers (1) Cash received from investment income Total cash provided by operating activities Less cash paid for: Merchandise purchases (2) Operating expenses (3) Net cash flow from operating activities

$274,000 4,500 $278,500 $159,000 83,000

Cash flows from investing activities: Purchase of plant assets (4)

242,000 $36,500

(33,000)

Cash flows from financing activities: Proceeds from the issuance of common stock Retirement of bonds payable Cash dividends paid (5) Net cash flow from financing activities Increase in cash

$ 87,500 (50,000) (20,300) 17,200 $20,700

(1) Accrual basis sales Plus: beginning accounts receivable Less: ending accounts receivable Cash received from customers

$239,000 90,000 (55,000) $274,000

(2) Accrual basis cost of goods sold Less: beginning inventory Plus: ending inventory Plus: beginning accounts payable Less: ending accounts payable Cash paid for merchandise purchases

$104,000 (92,000) 126,000 88,500 (67,500) $159,000

(3) Operating expenses Plus: beginning accrued expenses Less: ending accrued expenses Cash paid for operating expenses

$72,000 41,000 (30,000) $83,000

(4) Increase in property, plant, and equipment Add: Depreciation Cash paid for purchases of plant assets

$6,000 27,000 $33,000

(5) Beginning retained earnings Plus: consolidated net income Total Less: ending retained earnings Dividends paid by Parks Company Plus: dividends paid by SCR, Inc. to noncontrolling interest ($8,000  .10) Cash paid for dividends

$112,500 37,500 150,000 130,500 19,500 800 $20,300

4 - 64

Chapter 4 CHAPTER FOUR – CONSOLIDATED FINANCIAL STATEMENTS AFTER ACQUISITION I.

THREE METHODS OF REPORTING ON PARENT’S BOOKS A. Investments in voting stock of other companies may be consolidated, or they may be separately reported in the financial statements at cost, at fair value, or carrying value of equity. The method of reporting adopted depends on a number of factors including the size of the investment, the extent to which the investor exercises control over the activities of the investee, and the marketability of the securities. B.

Generally speaking, there are three levels of influence or control by an investor over an investee, which determine the appropriate accounting treatment. There are no absolute percentages to distinguish among these levels, but there are guidelines. The three levels and the corresponding accounting treatment are summarized as follows:

Level No significant influence

Guideline Percentages Less than 20%

Significant influence (no control)

20 to 50%

Effective control

Greater than 50%

Usual Accounting Treatment Investment carried at fair value at current yearend (trading or available for sale securities) – method traditionally referred to as “Cost” method with an adjustment for market changes. Investment measured under the equity method; may be elected to be carried at fair value under an irrevocable option (FASB ASC paragraph 825-10-25-4) Consolidated statements required (investment eliminated, combined financial statements): investment recorded under cost, partial equity, or complete equity method.

Differences among the three methods in accounting for the investment on the books of the parent are also summarized in Figure 4-1 (see textbook, page 157).

Cost Method on Books of Investor P Company acquired 90% of the outstanding voting stock of S Company at the beginning of Year 1 for $800,000. Income (loss) of S Company and dividends declared by S Company during the next three years (as shown below): During the third year, the firm pays a liquidating dividend (i.e. the cumulative dividends declared exceeds the cumulative income earned).

Year 1 2 3 P’s books

Income (Loss) $90,000 (20,000) 10,000

Dividends Declared $30,000 30,000 30,000

Year 1 – P’s Books 1

Cumulative Income Over (Under) Dividends $60,000 10,000 (10,000)

Chapter 4 Investment in S Company 800,000 Cash To record the initial investment Cash 7,000 Dividend Income To record dividends received .9($30,000). Year 2 – P’s Books Cash Dividend Income To record dividends received .9($30,000).

800,000

27,000

7,000 27,000

Year 3 – P’s Books Cash 7,000 Dividend Income 18,000 Investment in S Company 9,000 To record dividends received, $9,000 of which represents a return of investment. After these entries are posted, the investment account will appear as follows: Investment in S company (Cost Method) 800,000 Year 3 Liquidating dividend Year 3 Balance 791,000 Year 1 Cost

9,000

Year 1 entries record the initial investment and the receipt of dividends from S Company. In Year 2, although S Company incurred a $20,000 loss, there was a $60,000 excess of earnings over dividends in Year 1. Consequently, the dividends received are recognized as income by P Company. In Year 3, however, a liquidating dividend occurs. From the point of view of a parent company, a purchased subsidiary is deemed to have distributed a liquidating dividend when the cumulative amount of its dividends declared exceeds its cumulative reported earnings after its acquisition. Such excess dividends are treated as a return of capital, and are recorded as a reduction of the investment account rather than as dividend income. The liquidating dividend is 90% of the excess of dividends paid over cumulative earnings since acquisition (90% of $10,000).

Partial Equity Method on Books of Investor P Company has elected to use the partial equity method to record the investment in S Company above. The entries for the first three years would appear as follows: Year 1 – P’s Books Investment in S Company Cash To record the initial investment.

800,000

Investment in S Company

81,000

800,000

Chapter 4 Equity in Subsidiary Income .9($90,000) To record P’s share of subsidiary income. Cash Investment in S Company To record dividends received .9($30,000).

81,000

27,000 27,000

Note: The entries to record equity in subsidiary income and dividends received may be combined into one entry, if desired. Year 2 – P’s Books Equity in Subsidiary Loss 18,000 Investment in S Company To record equity in subsidiary loss .9($20,000).

18,000

Cash Investment in S Company To record dividends received .9($30,000).

27,000

Year 3 - P’s Books Investment in S Company 9,000 Equity in Subsidiary Income To record equity in subsidiary income .9($10,000).

9,000

Cash Investment in S Company To record dividends received .9($30,000).

27,000

After these entries are posted, the investment account will appear as follows: Investment in S company (partial equity method) Year 1 Cost 800,000 Year 1 Equity in 81,000 Year 1 Share of dividends declared subsidiary income Year 1 Balance 854,000 Year 2 Equity in subsidiary loss Year 2 Share of dividends declared Year 2 Balance 809,000 Year 3 Equity in 9,000 Year 3 Share of dividends declared subsidiary income Year 3 Balance 791,000 F.

Complete Equity Method on Books of Investor

27,000

18,000 27,000 27,000

Chapter 4 The complete equity method is usually required to report common stock investments in the 20% to 50% range, assuming the investor has the ability to exercise significant influence over the operating activities of the investee. In addition, a parent company may use, in its own books, the complete equity method to account for investments in subsidiaries that will be consolidated. This method is similar to the partial equity method up to a point, but it requires additional entries in most instances. Continuing the illustration above, assume additionally that the $800,000 purchase price exceeded the book value of the underlying equity of S Company by $100,000; and that the difference was attributed half to goodwill ($50,000) and half to an excess of market over book values of depreciable assets ($50,000). Under current FASB rules, goodwill would not be amortized. The additional depreciation expense implied by the difference between market and book values of depreciable assets, however, must be accounted for. The excess depreciation of those assets, if spread over a life of 10 years, would result in a charge to earnings of $5,000 per year. This charge has the impact of lowering the equity in subsidiary income, or increasing the equity in subsidiary loss, recorded by the parent. The entries for the first three years under the complete equity method are: Year 1 – P’s Books Investment in S Company Cash To record the initial investment.

800,000 800,000

Investment in S Company Equity in Subsidiary Income .9($90,000) To record equity in subsidiary income.

81,000 81,000

Equity in Subsidiary Income 5,000 Investment in S Company 5,000 (50,000/10 years) To adjust equity in subsidiary income for the excess depreciation. Cash 27,000 Investment in S Company To record dividends received .9($30,000).

27,000

5,000

18,000

Chapter 4 years) Investment in S Company

5,000

Year 2 (Continued) P’s Books To adjust equity in subsidiary loss for the excess depreciation. Cash Investment in S Company To record dividends received .9($30,000).

27,000 27,000

Year 3 – P’s Books Investment in S Company 9,000 Equity in Subsidiary Income To record equity in subsidiary income .9($10,000).

9,000

Equity in Subsidiary Income ($50,000/10 5,000 years) Investment in S Company 5,000 To adjust equity in subsidiary income for the excess depreciation. Cash Investment in S Company To record dividends received .9($30,000).

27,000 27,000

After these entries are posted, the investment account will appear as follows: INVESTMENT IN S COMPANY (COMPLETE EQUITY METHOD)

Year 1 Cost Year 1 Equity in subsidiary income Year 1 Balance

800,000 81,000

Year 1 Excess depreciation Year 1 Share of dividends declared

5,000 27,000

849,000 Year 2 Equity in Subsidiary Loss 18,000 Year 2 Excess depreciation 5,000 Year 2 Share of dividends Declared 27,000

Year 2 Balance Year 3 Equity in Subsidiary Income Year 3 Balance

799,000 9,000

Year 3 Excess depreciation 5,000 Year 3 Share of Dividends Declared 27,000

776,000

The additional entry to adjust the equity in subsidiary income for the excess depreciation in Year 1 may be viewed as reversing out a portion of the income recognized; the result is a net equity in subsidiary income for Year 1 of $76,000 ($81,000 minus $5,000). In Year 2, however, since the subsidiary showed a loss for the period, the excess depreciation has 5

Chapter 4 the effect of increasing the loss from the amount initially recorded ($18,000) to a larger loss of $23,000. A solid understanding of the entries made on the books of the investor (presented above) will help greatly in understanding the eliminating entries presented in the following sections. In some sense these entries may be viewed as “undoing” the above entries. It is important to realize, however, that the eliminating entries are not “parent only” entries. In many cases an eliminating entry will affect certain accounts of the parent and others of the subsidiary. For example, the entry to eliminate the investment account (a parent company account) against the equity accounts of the subsidiary affects both parent and subsidiary accounts. Some accounts do not need eliminating because the effects on parent and subsidiary are offsetting. For example, in the entries above, we saw that the parent debited cash when dividends were received from the subsidiary. We know that cash on the books of the subsidiary is credited when dividends are paid. The net effect on cash of the consolidated entry is thus zero. No entry is made to the cash account in the consolidating process. See Figure 4-1 (see page 157 in textbook) for a comparison of the three methods on the books of the parent. II.

CONSOLIDATED STATEMENTS AFTER ACQUISITION—COST METHOD A. The preparation of consolidated financial statements after acquisition, relative to that at the acquisition date, is more complex. B.

Workpaper format 1. Accounting workpapers are used to accumulate, classify, and arrange data for a variety of accounting purposes, including the preparation of financial reports and statements. Although workpaper style and technique vary among firms and individuals, we have adopted a three-section workpaper for illustrative purposes in this book. The format includes a separate section for each of three basic financial statements -- income statement, retained earnings statement, and balance sheet 2. An alternative format to preparing the workpaper is provided in Appendix A (page 203) in this chapter (using the information in Illustration 4-4, see textbook, page 167). 3. The fourth statement, the statement of cash flows, is prepared from the information in the consolidated income statement and from two comparative consolidated balance sheets.

Example of at Year of Acquisition – Cost Method 1. A workpaper for the preparation of consolidated financial statements at December 31, 2010, the end of the year of acquisition, is presented in Illustration 4-2 (see textbook, page 162. 2. Begin the consolidating process, as always, by preparing a Computation and Allocation Schedule. 3. Data from the trial balances are arranged in statement form and entered on the workpaper. Consolidated financial statements should include only balances resulting from transactions with outsiders. Eliminating techniques are designed to accomplish this end. The consolidated income statement is essentially a combination of the revenue, expense, gain, and loss accounts of all consolidated 6

Chapter 4 affiliates after elimination of amounts representing the effect of transactions among the affiliates. The consolidated net income of the affiliates is allocated to the controlling and noncontrolling interests. On the workpaper, the allocation to the noncontrolling interest (NCI) appears as a reduction to calculate the controlling interest's share of the consolidated net income. The controlling interest in consolidated net income consists of parent company net income plus (minus) its share of the affiliate's income (loss) resulting from transactions with outside parties. The consolidated retained earnings statement consists of beginning consolidated retained earnings plus (minus) the controlling interest in consolidated net income (net loss), minus parent company dividends declared. The net balance represents consolidated retained earnings at the end of the period. Note that the noncontrolling interest in consolidated net income appears as a component of the noncontrolling interest in net assets at the end of the period. The noncontrolling interest in net assets is reflected as a separate component of equity. D.

Workpaper Observations Several observations should be noted concerning the workpaper presented in Illustration 4-2, including the following: 1. Each section of the workpaper represents one of three consolidated financial statements. 2. Elimination of the Investment Account 3. Allocation of the Difference between Implied and Market Value 4. Intercompany Dividends 5. Noncontrolling Interest in Consolidated Net Income 6. Consolidated Retained Earnings 7. The eliminations columns in each section do not balance, but balance in total. 8. Noncontrolling interest in consolidated net assets can be determined directly by multiplying the noncontrolling interest percentage times the implied value of the subsidiary's net assets at the date of acquisition. After that date, it changes to reflect the noncontrolling share of adjusted income and dividends paid by the subsidiary to the noncontrolling shareholders.

Example: After Year of Acquisition – Cost Method 1. A workpaper for the preparation of consolidated financial statements for P and S Companies for the year ended December 31, 2014, is presented in Illustration 4-4. Note that the detail comprising cost of goods sold is provided in Illustration 4-2 (beginning inventory plus purchases minus ending inventory). In Illustration 4-4 and subsequent illustrations in this chapter, the detail will be collapsed into one item, “Cost of Goods Sold.'' See Illustration 4-3, 4-4 (textbook, pages 166-167) 2.

The workpaper entries in years after the year of acquisition are essentially the same as those made for the year of acquisition (Illustration 4-2) with one major exception. Before the elimination of the investment account, a workpaper entry, (1) in Illustration 4-4, is made to the investment account and P Company's beginning retained earnings to recognize P Company's share of the cumulative undistributed income or loss of S Company from the date of acquisition to the beginning of the current year. This entry may be viewed as either the entry to 7

Chapter 4 convert from the Cost method to the Equity method or the entry to establish reciprocity.

III.

The amount needed for the workpaper entry to establish reciprocity can be most accurately computed by multiplying the parent company's percentage of ownership times the increase or decrease in the subsidiary's retained earnings from the date of stock acquisition to the beginning of the current year.

After the investment account is adjusted by workpaper entry (1), S Company's equity is eliminated against the adjusted investment account, and the NCI is recognized (if any). In addition, an account is created to reflect the difference between implied value (IV) and book value (BV).

The next entry distributes the difference between implied and book values.

Next, intercompany dividend income is eliminated

Consolidated balances are then determined in the same manner as in previous illustrations.

An example of a consolidated statement of income and retained earnings and a consolidated balance sheet (based on Illustration 4-4) is presented in Illustration 45. Notice that all (100%) of S Company's revenues and expenses are included in the consolidated income statement. The noncontrolling interest's share of the subsidiary's income is then deducted as a separate item in determining the controlling interest in consolidated net income. Likewise, all of S Company's assets and liabilities are included with those of P Company in the consolidated balance sheet. The noncontrolling interest's share of the net assets is then included as a separate item within the stockholders' equity section of the consolidated balance sheet.

RECORDING INVESTMENTS IN SUBSIDIARIES — EQUITY METHOD (PARTIAL OR COMPLETE) A. Companies may elect to use the equity method to record their investments in subsidiaries. This method may be preferred to the cost method if they wish to estimate the operating effects of their investments for internal decision-making purposes. As with the cost method, the investment is recorded initially at its cost under the equity method. Subsequent to acquisition, the major differences between the cost and equity methods pertain to the period in which subsidiary income is formally recorded on the books of the parent company and the amount of income recognized. Under the assumptions of this chapter, partial and complete equity methods are indistinguishable. Thus, the differences between the two do not become important until Chapter 5 (a need for amortization, depreciation, or impairment adjustments exists). B.

Under the equity method, income is recorded in the books of the parent company in the same accounting period that it is reported by the subsidiary company, whether or not such 8

Chapter 4 income is distributed to the parent company. C.

P Company would record income in the first year based not on dividends received, but on its share of the subsidiary's income. Under the partial equity method, this amount will be based upon income reported by the subsidiary. Under the complete equity method, the subsidiary’s reported income will be adjusted under certain circumstances (elaborated upon in subsequent chapters).

Example of Investment Carried at Equity—Year of Acquisition 1. Begin the consolidating process, as always, by preparing a Computation and Allocation Schedule. Because the difference between implied and book values is established only at the date of acquisition, this schedule will not change in future periods. 2. Note that the trial balance data in Illustration 4-6 reflect the effects of the investment, equity in subsidiary income, and dividend transactions presented above. These balances are next arranged into income statement, retained earnings statement, and balance sheet statement sections as they are entered into the first two columns of the consolidated workpaper presented in Illustration 4-7. 3. When the investment account is carried on the equity basis, it is necessary to make a workpaper entry reversing the effects of the parent company's entries to the investment account for subsidiary income and dividends during the current year (this may be done as two separate entries or as one combined entry): a. Entry to eliminate intercompany dividends under the equity method. b. Entry to eliminate equity in subsidiary income against the investment account. 4. A third eliminating entry must then be made to eliminate the Investment account against subsidiary equity and to create an account for NCI, if any, and the fourth entry distributes the difference between implied and book value of equity acquired. 5. Next steps relate to basic workpaper concepts that do not differ between the Cost and Equity methods. 6. Comparison of Illustrations 4-2 (textbook, page 162) and 4-7 (textbook, page 173) brings out an important observation. The consolidated column of the workpaper is the same under the cost and equity methods. Thus, the decision to use the cost or equity method to record investments in subsidiaries that will be consolidated has no impact on the consolidated financial statements. Only the elimination process is affected.

Example of Investment Carried at Equity—After Year of Acquisition 1. The preparation of the Computation and Allocation Schedule is the same as it was in the year of acquisition; that is, it does not need to be prepared again. The elimination process also follows the same procedures as in the year of acquisition (with current year amounts). A consolidated statements workpaper in this case is presented in Illustration 4-9 (textbook, page 179). We next review the workpaper entries in general journal entry form. Note that although the Computation and Allocation Schedule does not change, the third eliminating entry (to eliminate the Investment account against the equity accounts of the subsidiary) will change to reflect the Retained Earnings balance of the subsidiary at the beginning of the current year and the corresponding change in the Investment account and in the NCI. 9

Chapter 4 2. 3. 4.

5. 6.

As in the year of acquisition, the equity in subsidiary account must be eliminated against the Investment in Subsidiary account. Next, eliminate intercompany dividends against the Investment account under the equity method. This entry may, if desired, be combined with that in #2 above. A third eliminating entry must then be made to eliminate the Investment account against subsidiary equity, and the fourth entry distributes the difference between implied and book value of equity acquired. The only differences in the affiliates' account data as compared to the cost method workpaper appear in P Company's statements (and in the elimination columns). Observe that the consolidated columns in Illustrations 4-4 and 4-9 are the same; regardless of the method used (cost or equity), the consolidated results are unaffected. Note that there is no need for a “reciprocity entry” under the equity method.

Investment Carried at Complete Equity 1. Under the assumptions of the preceding illustration, the complete equity method and the partial equity method are identical, not only in the end result but also in the steps to consolidate. Under other assumptions, however, the two may differ in the steps (though not in the end result). Recall that the complete equity method is quite similar to the partial equity method, but involves additional entries to the investment account on the books of the parent. These additional adjustments are made to the investment account for the amortization or depreciation of differences between market and book values, the effects of unrealized intercompany profits, and stockholders' equity transactions undertaken by the subsidiary. In the absence of these types of transactions, the complete equity method is identical to the partial equity method, both on the books of the parent and in the workpaper eliminating entries, as in the preceding illustration.

Summary of Workpaper Eliminating Entries 1. Basic workpaper consolidating (eliminating/adjusting) entries depend on whether (1) the cost method or equity method is used to record the investment on the books of the parent company, and (2) the workpaper is being prepared at the end of the year of acquisition or at the end of periods after the year of acquisition. Workpaper eliminating entries for the alternatives are summarized in Illustration 4-10.

IV.

ELIMINATION OF INTERCOMPANY REVENUE AND EXPENSE ITEMS Several types of intercompany revenue and expense items must be eliminated in the preparation of a consolidated income statement.

INTERIM ACQUISITIONS OF SUBSIDIARY STOCK. A. For example, suppose that P Company acquires 90% of the outstanding common stock of S Company on April 1, 2013. Both companies close their books on December 31. Consider S’s Income Statement in Illustration 4-11. In this illustration, the revenues and expenses for S Company are presented in total and also separately for the periods before and after the acquisition. S Company earns $36,000 of income for the entire year. P Company is entitled to 90% of the income earned since April (90% of $27,000 or 10

Chapter 4 $24,300). Consolidated net income will reflect $27,000 earned subsequent to acquisition. B.

Two acceptable alternatives for presenting the subsidiary’s revenue and expense items in the consolidated income statement in the year of acquisition are allowed under current generally accepted accounting principles. Although the authoritative standard [FASB ASC paragraph 810-10-45-4] expresses a preference for one of the two, this preference is not a requirement. Both alternatives result in the same consolidated income; the difference lies in the detail included in the statement.

Full-year reporting alternative, includes the subsidiary’s revenues and expenses in the consolidated income statement for the entire year (as though S has been acquired at the beginning of the year). These revenues and expenses are shown in the first column of Illustration 4-11. Then a deduction is needed at the bottom of the consolidated income statement for the applicable pre-acquisition earnings and noncontrolling interest in income.

The partial-year reporting alternative, includes presentation of the subsidiary's revenue and expenses from the date of acquisition only. To accomplish this, the subsidiary closes the books on the date of acquisition (i.e. pre-acquisition income is closed to retained earnings).

Interim Acquisition under the Cost Method—Full-Year Reporting Alternative 1. The first step is to prepare a Computation and Allocation Schedule. For an interim acquisition, this schedule will include one or two additional amounts in the calculation of equity acquired: one for the income earned prior to acquisition, and one for dividends declared (if any) by the subsidiary during the current year prior to acquisition. 2. Next, the workpaper entry to eliminate the investment account is made. 3. There is no need for a reciprocity/conversion entry in year 1 because the retained earnings account has not changed on the books of the subsidiary since acquisition. 4. If S Company earns its income unevenly throughout the year, because of the seasonal nature of its business, for example, this should be taken into consideration. 5. Noncontrolling interest in consolidated net income is represented by the year end noncontrolling interest percentage times the reported subsidiary income, with adjustments made to reflect excess depreciation, amortization, or impairment, if any (see Chapter 5 for details). 6. In subsequent years, the establishment of reciprocity is based on the parent company's share of the change in subsidiary retained earnings from the date of acquisition to the beginning of the appropriate year

Interim Acquisition under the Cost Method—Partial-Year Reporting Alternative 1. Another method of prorating income is to include in the consolidated income statement only the subsidiary's revenue and expenses after the date of acquisition. Thus, assuming the interim purchase situation discussed earlier, in which the purchase of stock took place on April 1, only three-fourths of S Company's sales, cost of goods sold, and other expense is included in the consolidated income 11

Chapter 4

3. 4.

Interim Acquisition under the Equity Method—Full-Year Reporting Alternative 1. If the equity method had been used, P Company would have recognized (in actual entries posted to the general ledger) its share of subsidiary income earned after acquisition. On the books of the parent company, dividends would be treated as usual as a reduction in the investment account. 2. For an interim acquisition assuming the use of the full-year reporting alternative, the Computation and Allocation Schedule will include one or two additional amounts in the calculation of equity acquired: one for the income earned prior to acquisition, and one for dividends declared (if any) by the subsidiary during the current year prior to acquisition. 3. The new amount(s) included in the Computation and Allocation Schedule are for income and dividends of the subsidiary for the period from the beginning of the current year (1/1) to the date of acquisition (4/1). These are amounts that would have been included in retained earnings of the subsidiary if closing procedures had been performed on April 1 (not a normal date for closing entries, which usually are made at year-end). Note, also, that dividends declared by the subsidiary for the period from 1/1 to 4/1 are listed as zero because the subsidiary’s dividends were not declared until 11/1 in our example

Interim Acquisition under the Equity Method—Partial-Year Reporting Alternative 1.

VI.

statement as if S Company's books had been closed on April 1, 2013. These are the amounts shown in the column 3 of Illustration 4-11 (textbook, page 182). Prepare a Computation and Allocation Schedule. For an interim acquisition, the retained earnings of the subsidiary reflect the changes from the beginning of the current year to the date of acquisition (income earned and dividends declared). Next, the workpaper entry to eliminate the investment account is made. Note that consolidated net income, consolidated retained earnings, and the consolidated balance sheet are identical to those in Illustration 4-12 (textbook, page 185). Only the details included in the consolidated income statement, such as S Company's beginning retained earnings, the noncontrolling interest in net income included in consolidated net income income and the noncontrolling interest's share of beginning equity of S company are different.

If the partial year reporting alternative is used in conjunction with the equity method, P Company would recognize its share of S Company's income after acquisition in its general ledger accounts (as always with the equity method). S Company would, however, close its revenue and expense accounts at 4/1 into retained earnings. The 12/31 trial balance includes only the period from 4/1 to 12/31, or three-fourths of S Company's revenue and expense items for the year. These amounts are reflected in the third column of Illustration 4-11. This is the portion to itemize in the consolidated income statement under the partial year reporting alternative as well. Thus, there is no need to subtract any “income prior to acquisition” at the bottom of the consolidated income statement.

CONSOLIDATED STATEMENT OF CASH FLOWS A. When the company is reporting on a consolidated basis, the statement of cash flows must also be presented on a consolidated basis. The starting point for the consolidated cash 12

Chapter 4 flow statement is the consolidated income statement and comparative consolidated balance sheets (beginning and end of current year). Thus the preparation of the consolidated statement of cash flows will be the same, regardless of how the parent accounts for its investment (cost method, partial equity method, or complete equity method). B.

In years subsequent to the year of acquisition, a consolidated balance sheet should be available for both the beginning and end of the current year. The consolidated statement of cash flows reflects all cash outlays and inflows of the consolidated entity except those between parent and subsidiary.

The preparation of a consolidated statement of cash flows is different in three aspects: 1. Begin with consolidated net income. Because this amount includes the noncontrolling interest in consolidated income, there is no need to add back the noncontrolling interest in consolidated net income (or to subtract the non-controlling interest's share of a loss). If, for some reason, the statement should begin with the controlling interest in consolidated net income, then the noncontrolling interest would need to be added back. 2. Subsidiary Dividends Paid: Any subsidiary dividends paid to the noncontrolling stockholders must be included with dividends paid by the parent company when calculating cash outflow from financing activities. The dividends paid by the subsidiary to the parent do not involve cash flows to or from outsiders and thus are not reported on the consolidated statement of cash flows. 3. Parent Company Acquisition of Additional Subsidiary Shares: The cost of the acquisition of additional shares in a subsidiary by the parent company may or may not constitute a cash outflow from investing activities. If the acquisition is an open market purchase, it does represent such an outflow. If it is an acquisition directly from the subsidiary, however, it represents an intercompany cash transfer that does not affect the total cash balance of the consolidated group.

Illustration of Preparation of a Consolidated Statement of Cash Flows: After Acquisition 1. Under indirect method 2. Under direct method See Illustration 4-17 (textbook pages 196 – 197). E.

Illustration of Preparation of a Consolidated Statement of Cash Flows: Year of Acquisition 1. The balance sheet at the end of the year of acquisition reflects consolidated balances, while the beginning of the year reflects parent-only balances. Thus the net change in cash that investors wish to interpret is the change from the parent’s beginning-of-year balance to the combined (consolidated) end-of-year cash balance. To accomplish this reconciliation, two realizations are important. a. Any cash spent or received in the acquisition itself should be reflected in the Investing activities section of the consolidated statement of cash flows. b. To explain the change in cash successfully, the assets and liabilities of the subsidiary at the date of acquisition must be added to those of the parent at the beginning of the current year. 13

Chapter 4 2.

For an example of the preparation of a Consolidated Statement of Cash Flows in the year of acquisition, see Illustration 4-20 (textbook, page 200).

Chapter 4 VII.

Compare U.S. GAAP and IFRS Regarding the Equity Method

The Equity Method

Issue Relevant Standards

U.S. GAAP FASB ASC 323 [Investments – Equity Method and ASC 825 [Financial Instruments] Equity method investments.

IFRS IAS 28

Requirement to apply equity method

Corporate entities can exert significant influence (but not control) must use the equity method (unless the investor has elected to use the fair value option).

Significant influence

Presumed if the investor has 20% or more of the voting rights in a corporate investee. Generally not considered.

An associate is an entity in which the investor has significant influence (excluding subsidiaries and joint ventures). Investments in associates are accounted for using the equity method. Same as in the U.S.

Terminology

Potential voting rights

Joint ventures

Equity method is required for jointly controlled entities.

Limited partnerships

The equity method is applied to investments of more than 3 to 5%.

Carrying value of the investment

Increased (decreased) with the investor’s share of profit (loss) of the investee after the date of acquisition. Not required.

Uniform accounting policies Different reporting dates

Permits a three month difference (and disclose significant events).

Exemptions from the equity method

FASB ASC 825-10-25-1 gives entities the option to account for equity investments at fair value.

Investments in associates.

Consider the existence and effects of potential voting rights on currently exercisable or convertible instruments. Use proportionate consolidation. The equity method may be used, but is not recommended. (there is a current proposal to eliminate proportionate consolidation). Equity method is applied to investments using the ‘significant influence’ principle. Same as in the U.S.

Uniform accounting policies are required. (use top-side adjustments when policies are different). Permits a three month difference if it is impractical to change; however, investors must adjust for significant events. Associates classified as held for sale.

Chapter 4 APPENDIX A

ALTERNATIVE WORKPAPER FORMAT

A variety of workpaper formats may be used in the preparation of consolidated financial statements. They may be classified generally into two categories, the three-division workpaper format used in this text, and the trial balance format. In the three-divisional format the account balances of the individual firms are first arranged into financial statement format. In contrast, in the trial balance format, columns are provided for the trial balances, the elimination entries, and normally, each financial statement to be prepared, except for the statement of cash flows.

APPENDIX B

DEFERRED TAX CONSEQUENCESS WHEN AFFILIATES FILE SEPARATE INCOME TAX RETURNS – UNDISTRIBUTED INCOME

Consolidated Tax Returns - Affiliated Companies (80% or more Ownership Levels)

Separate Tax Returns - Deferred Tax Consequences Arising Because of Undistributed Subsidiary Income

The Cost Method – Separate Tax Returns

Workpaper Entry – Cost Method – Year of Acquisition (2014) Undistributed Income Expected to be Received as Future Dividend

Workpaper Entry – Cost Method – Year Subsequent to Acquisition (2015) Undistributed Income Expected to be Received as Future Dividend

Undistributed Income is Expected to be Realized when the Subsidiary is Sold

Workpaper Entry – Cost Method – Year of Acquisition and Year Subsequent to Acquisition (2014 and 2015) Undistributed Income Expected to be Received as Gain Upon Sale of Subsidiary

The Partial and Complete Equity Methods – Separate Tax Returns

CHAPTER 5 ANSWERS TO QUESTIONS 1. a. The “difference between implied and book value” is the total difference between the value of the subsidiary in total, as implied by the acquisition cost of an investment in that subsidiary, and the book value of the subsidiary’s equity on the date of the acquisition (note that equity is the same as net assets). b. The excess of implied value over fair value, or “Goodwill,” is the excess of the value of the subsidiary, as implied by the amount paid by the parent, over the fair value of the identifiable net assets of that subsidiary on the date of acquisition. c. The “excess of fair value over implied value” is the excess of the fair value of the identifiable net assets of a subsidiary (all assets other than goodwill minus liabilities) on the acquisition date over the value of the subsidiary as implied by the amount paid by the parent. This may be referred to as a bargain acquisition. d. An excess of book value over fair value describes a situation where some (or all) of the subsidiary’s assets need to be written down rather than up (or liabilities need to be increased, or both). It does not, however, tell us whether the acquisition results in the recording of goodwill or an ordinary gain (in a bargain acquisition). That determination depends on the comparison of fair value of identifiable net assets and the implied value (purchase price divided by percentage acquired), referred to in parts (b) and (c) above. 2. The “difference between implied and book value” and the “Goodwill” are a part of the cost of an investment and are included in the amount recorded in the investment account. Although not recorded separately in the records of the parent company, these amounts must be known in order to prepare the consolidated financial statements. 3. In allocating the difference between implied and book value to specific assets of a less than wholly owned subsidiary, the difference between the fair value and book value of each asset on the date of acquisition is reflected by adjusting each asset upward or downward to fair value (marked to market) in its entirety, regardless of the percentage acquired by the parent company. 4. If the parent’s share of the fair value exceeds the cost, then the entire fair value similarly exceeds the implied value of the subsidiary. This constitutes a bargain acquisition, and under proposed GAAP (ED No. 1204-001), the excess is recorded as an ordinary gain in the period of the acquisition. Current GAAP requires that the acquirer recognize this gain in earnings on the acquisition date. (FASB ASC 805-30-25 paragraphs 1-4). Past GAAP (APB Opinion No. 16) differed in that it provided that the excess of fair value over cost should be allocated to reduce proportionally the values assigned to noncurrent assets with certain exceptions. If such noncurrent assets were reduced to zero (or to the noncontrolling percentage, if there was one) by this allocation, any remaining excess was recorded as an extraordinary gain. 5. The recording of an ordinary (or extraordinary gain) on an acquisition flies in the face of the rules of revenue recognition because no earnings process has been completed. On the other hand, a decision to record certain assets below their fair values is arbitrary, and also rather confusing (how far should they be reduced?) The reason that bargain acquisitions are unlikely to occur very often 5–1

is because they suggest that the usual assumptions of an arm’s length transaction have been violated. In most accounting scenarios, we assume that both parties are negotiating for a reasonable exchange price and that price, once established, represents fair value both for the item given up and the item received. In the case of a business combination, there is not a single item being exchanged but rather a number of assets and liabilities. Nonetheless, the assumption is still that both parties are negotiating for a fair valuation. If one party is able to obtain a bargain, it most likely indicates that the other party was being influenced by non-quantitative considerations, such as a wish to retire quickly, health concerns, etc. 6. If P Company acquires a 100 percent interest in S Company the land will be included in the consolidated financial statements at its fair value on the date of acquisition of $1,500,000. If P Company acquires an 80 percent interest in S Company, the land will still be included in the consolidated financial statements at $1,500,000, and the noncontrolling interest would be charged with its share of the fair value adjustment. 7. (d). Once the determination is made that none of the assets are over-valued (and none of the liabilities under-valued), the bargain is reflected as an ordinary gain of $10,000 in the year of acquisition. 8. (b). The “excess of fair value over implied value” is reported as an ordinary gain under (FASB ASC 805-30-25 paragraphs 1-4). 9. Under the entity theory, the noncontrolling interest shares in the adjustment of consolidated net assets for the difference between implied and book value. The noncontrolling interest is also affected by the amortization or depreciation in the consolidated workpapers of the difference between implied and book value. Assuming that implied value exceeds book value, the effect will generally be to lower the noncontrolling interest in reported earnings because of its (the noncontrolling interest’s) share of the excess depreciation and amortization charges, additional cost of goods sold, impairment of goodwill, etc.

ANSWERS TO BUSINESS ETHICS CASE This case brings an interesting question to the table for discussion. As the article by Mano points out, each individual must decide for himself or herself how to respond to the gray issues that are bound to arise in life. Ultimately life is more about being at peace with ourselves and leaving a legacy of a life well-lived and values taught through our example to the generations that we leave behind us than it is about accumulating wealth (that we cannot take to the grave). The individual, had he acted on the advice, may have been guilty of insider trading as the information available to him was, apparently, not available publicly. Although there is no clear-cut definition of what constitutes insider trading, the gray area implies uncertainty; and this uncertainty can in many cases result in decisions that have severe implications both professionally and personally.

5–2

ANSWERS TO FINANCIAL STATEMENT ANALYSIS EXERCISES AFS5-1 eBay acquires Rent.com In order to answer this question, additional information can either be provided to the students, or the students can be instructed to state their assumptions. The footnotes describing the acquisition do not disclose the book value of the acquisition, but only report how the purchase price was allocated. Thus one option is to assume that the cash and investments mentioned specifically (i.e. $18,050) represent the only recorded net assets on the books of Rent.com, and thus equal the book value of equity for Rent.com. We have chosen this assumption in the solution reported below. Other assumptions, however, may clearly be justified. A. Journal entry for the acquisition of Rent.com Investment in Rent.com Acquisition-related expenses Cash

435,365 2,000 437,365

B. Worksheet eliminating entry. (The book value of rent.com is assumed to be equal to the cash and investment amount of $18,050.) Beginning retained earnings (Rent.com) Capital stock – Rent.com 18,050 * Difference between implied and book value 417,315 Investment in Rent.com 435,365 * not enough information to allocate the amount between the two accounts. Identifiable intangible assets 61,800 Goodwill 380,439 Deferred tax liability Difference between implied and book value

24,924 417,315

C. Amortization journal entries. Amortization expense over the next six years. Amort. Amort. Identifiable Estimated Amortization Amort. (yrs. 2-3) (yrs. 4-5) (yr. 6) Intangibles Life (yrs) (yr. 1) $ 5,750 $ 5,750 Customer lists $ 34,500 6 yrs. $ 5,750 $ 5,750 3,600 Trade name 18,000 5 yrs. 3,600 3,600 Developed technology 8,200 3 yrs. 2,733 2,733 User base 1,100 1 yr. 1,100 12,083 9,300 $5,750 Total 61,800 13,183 Year One: Amortization expense 13,183 Identifiable intangible assets 13,183 Worksheet. If the complete equity method were used, the entry would be reflected on the books of eBay as an adjustment to equity in subsidiary income and a reduction in the Investment account. Thus, earnings and consolidated retained earnings do not require adjustment for this amount. However, it is still necessary to make a worksheet entry to reflect the proper amount in the amortization expense and identifiable intangible asset accounts. If the cost or partial equity methods are used, the entry would be

5–3

recorded on the consolidated workpaper, and would also lead to a reduction in consolidated income and equity. D. Since the Rent.com was acquired using cash, the acquisition will be accretive if the additional earnings from Rent.com exceed the additional amortization expense of $13,183. AFS5-2 LoJack Corporation A. The FASB has changed the rules regarding amortization of goodwill over time. Initially, goodwill was required to be amortized over time for financial reporting purposes. However, when the FASB eliminated the pooling-of-interests method against the wishes of many entities, the FASB decided to eliminate goodwill amortization in favor of goodwill impairment tests. Since it is questionable whether goodwill possesses a determinable useful life or is a wasting asset, goodwill is treated as an asset with indefinite life and is not currently amortized. In ASU 2011-08 FASB addresses the testing for goodwill impairment. The amendments in the Update permit an entity to first assess qualitative factors to determine whether it is more likely than not that the fair value of a reporting unit is less than its carrying amount as a basis for determining whether it is necessary to perform the two-step goodwill impairment test described in Topic 350. The more-likely-than-not threshold is defined as having a likelihood of more than 50 percent. Previous guidance under Topic 350 required an entity to test goodwill for impairment, on at least an annual basis, by comparing the fair value of a reporting unit with its carrying amount, including goodwill (step one). If the fair value of a reporting unit is less than its carrying amount, then the second step of the test must be performed to measure the amount of the impairment loss, if any. Under the amendments in this Update, an entity is not required to calculate the fair value of a reporting unit unless the entity determines that it is more likely than not that its fair value is less than its carrying amount. An entity has the option to first assess qualitative factors to determine whether the existence of events or circumstances leads to a determination that it is more likely than not that the fair value of a reporting unit is less than its carrying amount. If, after assessing the totality of events or circumstances, an entity determines it is not more likely than not that the fair value of a reporting unit is less than its carrying amount, then performing the two-step impairment test is unnecessary. However, if an entity concludes otherwise, then it is required to perform the first step of the two-step impairment test by calculating the fair value of the reporting unit and comparing the fair value with the carrying amount of the reporting unit, as described in FASB ASC paragraph 350-20- 35-4. If the carrying amount of a reporting unit exceeds its fair value, then the entity is required to perform the second step of the goodwill impairment test to measure the amount of the impairment loss, if any, as described in FASB ASC paragraph 35020-35-9. Under the amendments ASU 2011-08, an entity has the option to bypass the qualitative assessment for any reporting unit in any period and proceed directly to performing the first step of the two-step goodwill impairment test. An entity may resume performing the qualitative assessment in any subsequent period. B. In 2008, the goodwill impairment charge of $36,830 lowered the reported performance for Boomerang from an operating profit of $9,927 to a net operating loss. In 2009, the goodwill impairment charge reduced income by $13,627. Without the impairment charge the firm would still have recognized a loss for the year of $30,559. Writing down assets should have a positive impact on future return on asset (ROA) computations since it lowers the denominator. C. Typically one would expect a negative stock market impact from goodwill impairment charges. Goodwill is recorded when the purchase price exceeds the fair value of the net identifiable tangible and intangible assets. The firm is willing to pay this amount because of the expected excess cash to be 5–4

received in the future from the acquisition. A goodwill impairment is a signal that these future cash flows are no longer expected, and is sometimes viewed as an admission that management paid too much for the target. ANSWERS TO EXERCISES Exercise 5-1 Part A Computation and Allocation of Difference Schedule Parent Share Purchase price and implied value $540,000 Less: Book value of equity acquired: Common stock 340,000 Retained earnings 119,000 Total book value 459,000 Difference between implied and book value 81,000 Marketable Securities ($45,000 – $20,000) (21,250) Equipment ($140,000 – $120,000) (17,000) Balance 42,750 Goodwill (42,750) Balance -0-

NonControlling Share 95,294

Entire Value 635,294 *

60,000 21,000 81,000 14,294 (3,750) (3,000) 7,544 (7,544) -0-

400,000 140,000 540,000 95,294 (25,000) (20,000) 50,294 (50,294) -0-

*$540,000/.85 Part B Marketable securities Equipment (net) Goodwill

$ 45,000 140,000 50,294

Exercise 5-2 Computation and Allocation of Difference Schedule Parent Share Purchase price and implied value Less: Book value of equity acquired Difference between implied and book value Equipment ($705,000 – $525,000) Balance

$585,000 450,000 135,000 (135,000) -0-

NonEntire Controlling Value Share 195,000 780,000 * 150,000 600,000 45,000 180,000 (45,000) (180,000) -0-0-

*$585,000/.75 Part A Equipment Difference between Implied and Book Value 5–5

180,000 180,000

Depreciation Expense ($180,000/10) Accumulated Depreciation

18,000 18,000

Exercise 5-2 (continued) Part B The asset has a value of $180,000 with 10 years of a 15 year life (i.e. 2/3). Therefore, the implied gross value of the asset is $270,000 (or $180,000  2/3). Equipment ($180,000  2/3) Accumulated Depreciation (1/3  $270,000) Difference between Implied and Book Value

270,000

Depreciation Expense ($180,000/10) Accumulated Depreciation

18,000

90,000 180,000

18,000

Exercise 5-3 Part A Investment in Saddler Corporation Cash

525,000 525,000

Part B Computation and Allocation of Difference Schedule Parent Share Purchase price and implied value $525,000 Less: Book value of equity acquired 480,000 Difference between implied and book value 45,000 Inventory (16,000) Marketable Securities (20,000) Plant and Equipment (24,000) Balance (excess of FV over implied value) (15,000) Gain 15,000 Increase Noncontrolling interest to fair value of assets Total allocated bargain Balance -0*$525,000/.80

5–6

NonControlling Share 131,250 120,000 11,250 (4,000) (5,000) (6,000) (3,750)

Entire Value 656,250 * 600,000 56,250 (20,000) (25,000) (30,000) (18,750)

3,750 -0-

18,750 -0-

Exercise 5-4 Part A Computation and Allocation of Difference Schedule Parent Share Purchase price and implied value $260,000 Less: Book value of equity acquired 270,000 Difference between implied and book value (10,000) Inventory (4,000) Current Assets (4,000) Equipment (net) (40,000) Balance (excess of FV over implied value) (58,000) Gain 58,000 Increase Noncontrolling interest to fair value of assets Total allocated bargain Balance -0-

NonControlling Share 65,000 67,500 (2,500) (1,000) (1,000) (10,000) (14,500)

Entire Value 325,000 * 337,500 (12,500) (5,000) (5,000) (50,000) (72,500)

14,500 -0-

72,500 -0-

*$260,000/.80 Part B (1) Capital Stock- Salem Company Beginning Retained Earnings-Salem Company Difference between Implied and Book Value Investment in Salem Company Noncontrolling Interest (2) Difference between Implied and Book Value Inventory Current Assets Equipment (net) Gain on Acquisition Noncontrolling interest

207,000 130,500 12,500 260,000 65,000 12,500 5,000 5,000 50,000 58,000 14,500

Exercise 5-5 Noncontrolling Interest in Consolidated Income Amortization of the difference between implied and book value related to patent amortization ($100,000*/10)

Net income reported by S

$ 100,000

10,000 Adjusted net income of S Noncontrolling Ownership percentage interest Noncontrolling Interest in Consolidated Net Income

* (600,000/.80) – ($300,000 + $350,000)

5–7

90,000 20% $ 18,000

Exercise 5-5 (continued) Controlling Interest in Consolidated Income P Company's net income from its independent operations

$ 200,000

P Company's share of the adjusted income of S Company (.8 X $90,000)

72,000

Controlling Interest in Consolidated Net Income

$ 272,000

Parent Share Purchase price and implied value $600,000 Less: Book value of equity acquired 520,000 Difference between implied and book value (patent) 80,000 Patent (80,000) Balance -0-

NonEntire Controlling Value Share 150,000 750,000 130,000 650,000 20,000 100,000 (20,000) (100,000) -0-0-

*$600,000/.80 Exercise 5-6 2012 1/1 Retained Earnings-Park Co.* (12,000 x .85) Noncontrolling Interest Depreciation Expense ($120,000/10) Equipment [$120,000/(10/15)] Accumulated Depreciation Difference between Implied and Book Value

2013 10,200 1,800 12,000 180,000

12,000 180,000 72,000a 120,000

84,000b 120,000

* If the complete equity method is used, the debit to 1/1 Retained Earnings – Park Co. would be replaced with a debit to Investment in Sunland Company a ($180,000)(6/15)= $72,000 b ($180,000)(7/15)= $84,000 Alternative entries Equipment [$120,000/(10/15)] Accumulated Depreciation ($180,000  5/15) Difference between Implied and Book Value 1/1 Retained Earnings-Park Co*. Noncontrolling Interest Depreciation Expense ($120,000/10) Accumulated Depreciation

2012 180,000 60,000 120,000

2013 180,000 60,000 120,000

12,000

10,200 1,800 12,000 12,000

24,000b

* If the complete equity method is used, the debit to 1/1 Retained Earnings – Park Co. would be replaced with a debit to Investment in Sunland Company 5–8

Exercise 5-7

2011

1/1 Retained Earnings - Packard Co.* 1/1 Noncontrolling Interest Depreciation Expense ($200,000/5) Equipment [$200,000/(5/10)] Accumulated Depreciation Difference between Implied and Book Value

2012 32,000 8,000 40,000 400,000

40,000 400,000 240,000a 200,000

280,000 200,000

* If the complete equity method is used, the debit to 1/1 Retained Earnings – Packard Co. would be replaced with a debit to Investment in Sage Company a

$400,000  (6/10) = $240,000 $400,000  (7/10) = $280,000

Computation and Allocation of Difference Schedule Parent Share Purchase price and implied value Less: Book value of equity acquired Difference between implied and book value Equipment ($705,000 – $525,000) Balance

$600,000 440,000 160,000 (160,000) -0-

NonEntire Controlling Value Share 150,000 750,000 * 110,000 550,000 40,000 200,000 (40,000) (200,000) -0-0-

*$600,000/.80 Alternative entries Equipment [$200,000/(5/10)] Accumulated Depreciation Difference between Implied and Book Value 1/1 Retained Earnings - Packard Co. 1/1 Noncontrolling Iinterest Depreciation Expense ($200,000/5) Accumulated Depreciation

2011 400,000 200,000 200,000

2012 400,000 200,000 200,000

40,000

32,000 8,000 40,000 40,000

80,000

* If the complete equity method is used, the debit to 1/1 Retained Earnings – Packard Co. would be replaced with a debit to Investment in Sage Company

5–9

Exercise 5-8 Part A Land ($31,000/0.8) Difference between Implied and Book Value

38,750

Part B Gain on subsidiary books Reduction for consolidated adjustment to fair market value Consolidated gain

$50,000 (38,750) $11,250

Part C Cost or Partial Equity 1/1 Retained Earnings - Padilla Co. 1/1 NCI (38,750 x 20%) Difference between Implied and Book Value

$31,000 7,750

Complete Equity Investment in Sanoma Company ($38,750 x 80%) 1/1 NCI (38,750 x 20%) Difference between Implied and Book Value

$31,000 7,750

38,750

Exercise 5-9 Part A Computation and Allocation of Difference Schedule Parent Share Purchase price and implied value Less: Book value of equity acquired Difference between implied and book value Land ($100,000 – $ 80,000) Premium on Bonds Payablea Balance Goodwill Balance

$2,000,000 1,760,000 240,000 (16,000) 31,941 255,941 (255,941) -0-

NonEntire Controlling Value Share 500,000 2,500,000 * 440,000 2,200,000 60,000 300,000 (4,000) (20,000) 7,985 39,926 63,985 319,926 (63,985) (319,926) -0-0-

*$2,000,000/.80 a

Present Value on 1/1/2010 of 10% Bonds Payable Discounted at 8% over 5 periods Principal ($500,000  0.68058) Interest ($50,000  3.99271) Fair value of bond Face value of bond Bond premium

5 – 10

$340,290 199,636 $539,926 500,000 39,926

Exercise 5-9 (continued) Part B Land Goodwill Interest Expense ($50,000 – ($539,926  0.08)) Unamortized Premium on Bonds Payable ($39,926 – $6,806) Difference between Implied and Book Value Alternative entries Land Goodwill Unamortized Premium on Bonds Payable Difference between Implied and Book Value

Unamortized Premium on Bonds Payable Interest Expense ($50,000 – ($539,926  0.08))

20,000 319,926 6,806 33,120 300,000

20,000 319,926 39,926 300,000

6,806 6,806

Exercise 5-10 Part A Computation and Allocation of Difference Schedule Parent Share Purchase price and implied value Less: Book value of equity acquired Difference between implied and book value Land ($200,000 - $ 120,000) Premium on Bonds Payablea Balance Goodwill Balance

$3,500,000 3,150,000 350,000 (72,000) 56,867 334,867 (334,867) -0-

NonEntire Controlling Value Share 388,889 3,888,889 * 350,000 3,500,000 38,889 388,889 (8,000) (80,000) 6,319 63,186 37,208 372,075 (37,208) (372,075) -0-0-

*$3,500,000/.90 a

Present Value on 1/2/2010 of 9% Bonds Payable Discounted at 6% for 5 periods Principal ($500,000  0.74726) Interest ($45,000  4.21236) Fair value of bond Face value of bond Premium on bond payable

5 – 11

$373,630 189,556 $563,186 500,000 63,186

Exercise 5-10 (continued) Part B Land Goodwill Interest Expense Unamortized Premium on Bonds Payable ($63,186 – $11,209) Difference between Implied and Book Value

80,000 372,075 11,209a 51,977 388,889 Year 2010 $(33,791) 45,000 11,209

Effective Interest (0.06  $563,186) Nominal Interest (0.09  $500,000) Difference

Alternative entries Land Goodwill Unamortized Premium on Bonds Payable Difference between Implied and Book Value Unamortized Premium on Bonds Payable Interest Expense

80,000 372,075 63,186 388,889 11,209 11,209a

Exercise 5-11 Part 1 – Cost Method Computation and Allocation of Difference Schedule Parent Share Purchase price and implied value Less: Book value of equity acquired Difference between implied and book value Inventory Equipment Balance Goodwill Balance

$2,276,000 2,000,000 276,000 (36,000) (40,000) 200,000 (200,000) -0-

NonEntire Controlling Value Share 569,000 2,845,000 * 500,000 2,500,000 69,000 345,000 (9,000) (45,000) (10,000) (50,000) 50,000 250,000 (50,000) (250,000) -0-0-

*$2,276,000/.80 2010 (1) Dividend Income Dividends Declared (0.80  $20,000) To eliminate intercompany dividends

16,000 16,000

5 – 12

Exercise 5-11 (continued) (2) Beginning Retained Earnings-Sand Capital Stock-Sand Difference between Implied and Book Value Investment in Sand Company Noncontrolling Interest (3) Cost of Goods Sold (Beginning Inventory) Depreciation Expense ($50,000/8) Equipment (net) ($50,000 – $6,250) Goodwill Difference between Implied and Book Value To allocate and depreciate the difference between implied and book value Alternative to entry (3) (3a) Cost of Goods Sold (Beginning Inventory) Equipment (net) Goodwill Difference between Implied and Book Value (3b) Depreciation Expense ($50,000/8) Equipment (net)

700,000 1,800,000 345,000 2,276,000 569,000 45,000 6,250 43,750 250,000 345,000

45,000 50,000 250,000 345,000 6,250 6,250

2011 (1) Investment in Sand Company ($80,000  0.80) Beginning Retained Earnings - Piper Company To establish reciprocity/convert to equity method as of 1/1/2011

64,000

(2) Dividend Income ($30,000  0.80) Dividends Declared To eliminate intercompany dividends

24,000

64,000

24,000

(3) Beginning Retained Earnings-Sand Company ($700,000 + $100,000 – $20,000) 780,000 Capital Stock-Sand Company 1,800,000 Difference between Implied and Book Value 345,000 Investment in Sand Company ($2,276,000 + $64,000) 2,340,000 Noncontrolling Interest ($569,000 + ($780,000 – $700,000) x 0.20) 585,000 To eliminate investment account and create noncontrolling interest account (4) Beginning Retained Earnings-Piper Company ($36,000 + $5,000) Noncontrolling Interest ($9,000 + $1,250) Depreciation Expense Equipment (net) ($50,000 – $6,250 – $6,250) Goodwill Difference between Implied and Book Value To allocate and depreciate the difference between implied and book value

5 – 13

41,000 10,250 6,250 37,500 250,000 345,000

Exercise 5-11 (continued) Alternative to entry (4) (4a) Beginning Retained Earnings-Piper Company Noncontrolling Interest Equipment (net) Goodwill Difference between Implied and Book Value (4b) Beginning Retained Earnings-Piper Company Noncontrolling Interest Depreciation Expense ($50,000/8) Equipment (net) 2012 (1) Investment in Sand Company ($200,000  0.80) Beginning Retained Earnings-Piper Company To establish reciprocity/convert to equity method as of 1/1/2012 (2) Dividend Income ($15,000  0.80) Dividends Declared To eliminate intercompany dividends

36,000 9,000 50,000 250,000 345,000 5,000 1,250 6,250 12,500

160,000 160,000

12,000 12,000

(3) Beginning Retained Earnings-Sand ($780,000 + $150,000 – $30,000) Capital Stock- Sand Company Difference between Implied and Book Value Investment in Sand Company ($2,276,000 + (.80 x $200,000)) Noncontrolling Interest ($569,000 + ($900,000 – $700,000) x 0.20) To eliminate investment account and create noncontrolling interest account

900,000 1,800,000 345,000

(4) Beginning Retained Earnings-Piper Company ($41,000 + $5,000) Noncontrolling Interest ($10,250 +$1,250) Depreciation Expense Equipment (net) Goodwill Difference between Implied and Book Value To allocate and depreciate the difference between implied and book value

46,000 11,500 6,250 31,250 250,000

Alternative to entry (4) (4a) Beginning Retained Earnings-Piper Company Noncontrolling Interest Equipment (net) Goodwill Difference between Implied and Book Value (4b) Beginning Retained Earnings-Piper Company ($5,000 x 2) Noncontrolling Interest ($1,250 x 2) Depreciation Expense ($50,000/8) Equipment (net) ($6,250 x 3) 5 – 14

2,436,000 609,000

345,000

36,000 9,000 50,000 250,000 345,000 10,000 2,500 6,250 18,750

Exercise 5-11 (continued) Part 2 – Partial Equity Method Computation and Allocation of Difference Schedule Parent Share Purchase price and implied value Less: Book value of equity acquired Difference between implied and book value Inventory Equipment Balance Goodwill Balance Cost of investment

$2,276,000 2,000,000 276,000 (36,000) (40,000) 200,000 (200,000) -0-

NonEntire Controlling Value Share 569,000 2,845,000 500,000 2,500,000 69,000 345,000 (9,000) (45,000) (10,000) (50,000) 50,000 250,000 (50,000) (250,000) -0-0-

Investment in Sand Corporation (Partial Equity) 2,276,000P

2010 equity income (.8)($100,000) Balance 2010

80,000 2,340,000

2010 Dividends (.8)($20,000)

16,000

2011 equity income (.8)($150,000)

120,000

2011 Dividends (.8)($30,000)

24,000

2012 Dividends (.8)($15,000)

12,000

Balance 2011 2012 equity income (.8)($80,000) Balance 2012

2,436,000 64,000 2,488,000

2010 (1) Equity in Subsidiary Income (0.80  $100,000) Dividends Declared (0.80  $20,000) Investment in Sand Company To eliminate intercompany dividends and income (2) Beginning Retained Earnings-Sand Capital Stock-Sand Difference between Implied and Book Value Investment in Sand Company Noncontrolling Interest (3) Cost of Goods Sold (Beginning Inventory) Depreciation Expense ($50,000/8) Equipment (net) ($50,000 – $6,250) Goodwill Difference between Implied and Book Value To allocate and depreciate the difference between implied and book value

5 – 15

80,000 16,000 64,000 700,000 1,800,000 345,000 2,276,000 569,000 45,000 6,250 43,750 250,000 345,000

Exercise 5-11 (continued) Alternative to entry (3) (3a) Cost of Goods Sold (Beginning Inventory) Equipment (net) Goodwill Difference between Implied and Book Value (3b) Depreciation Expense ($50,000/8) Equipment (net)

45,000 50,000 250,000 345,000 6,250 6,250

Part 2 – Partial Equity Method 2011 (1) Equity in Subsidiary Income (0.80  $150,000) Dividends Declared (0.80  $30,000) Investment in Sand Company To eliminate intercompany dividends and income

120,000 24,000 96,000

(2) Beginning Retained Earnings-Sand Company Capital Stock- Sand Company Difference between Implied and Book Value Investment in Sand Company ($2,276,000 + $64,000) Noncontrolling Interest ($569,000 + ($780,000 – $700,000) x 0.20) To eliminate investment account and create noncontrolling interest account

780,000 1,800,000 345,000

(3) Beginning Retained Earnings-Piper Company ($36,000 + $5,000) Noncontrolling Interest ($9,000 + $1,250) Depreciation Expense Equipment (net) ($50,000 – $6,250 – $6,250) Goodwill Difference between Implied and Book Value To allocate and depreciate the difference between implied and book value

41,000 10,250 6,250 37,500 250,000

Alternative to entry (3) (3a) Beginning Retained Earnings-Piper Company Noncontrolling Interest Equipment (net) Goodwill Difference between Implied and Book Value (3b) Beginning Retained Earnings-Piper Company Noncontrolling Interest Depreciation Expense ($50,000/8) Equipment (net)

5 – 16

2,340,000 585,000

345,000

36,000 9,000 50,000 250,000 345,000 5,000 1,250 6,250 12,500

Exercise 5-11 (continued) 2012 (1) Equity in Subsidiary Income (0.80  $80,000) Dividends Declared (0.80  $15,000) Investment in Sand Company To eliminate intercompany dividends and income

64,000 12,000 52,000

Part 2 – Partial Equity Method (2) Beginning Retained Earnings-Sand Common Stock- Sand Company Difference between Implied and Book Value Investment in Sand Company ($2,276,000 + $160,000) Noncontrolling Interest ($569,000 + ($900,000 – $700,000) x 0.20) To eliminate investment account and create noncontrolling interest account

900,000 1,800,000 345,000

(3) Beginning Retained Earnings-Piper Company ($41,000 + $5,000) Noncontrolling Interest ($10,250 + $1,250) Depreciation Expense Equipment (net) Goodwill Difference between Implied and Book Value To allocate and depreciate the difference between implied and book value

46,000 11,500 6,250 31,250 250,000

5 – 17

2,436,000 609,000

345,000

36,000 9,000 50,000 250,000 345,000 10,000 2,500 6,250 18,750

Exercise 5-11 (Continued) Part 3 – Complete Equity Method Computation and Allocation of Difference Schedule Parent Share Purchase price and implied value Less: Book value of equity acquired Difference between implied and book value Inventory Equipment Balance Goodwill Balance

Cost of investment

Investment in Sand Corporation (Complete Equity) 2,276,000 P

2010 equity income (.8)($100,000)

Balance 2010 2011 equity income (.8)($150,000)

Balance 2011 2012 equity income (.8)($80,000)

Balance 2012

$2,276,000 2,000,000 276,000 (36,000) (40,000) 200,000 (200,000) -0-

NonEntire Controlling Value Share 569,000 2,845,000 500,000 2,500,000 69,000 345,000 (9,000) (45,000) (10,000) (50,000) 50,000 250,000 (50,000) (250,000) -0-0-

80,000

2010 Dividends (.8)($20,000) 2010 depreciation and cost of goods sold

16,000

2011 Dividends (.8)($30,000) 2011 depreciation and cost of goods sold

24,000

2012 Dividends (.8)($15,000) 2012 depreciation and cost of goods sold

12,000

41,000

2,299,000 120,000

5,000

2,390,000 64,000

5,000

2,437,000

2010 (1) Equity in Subsidiary Income ((0.80  $100,000) – $41,000) Dividends Declared (0.80  $20,000) Investment in Sand Company To eliminate intercompany dividends and income (2) Beginning Retained Earnings-Sand Capital Stock- Sand Difference between Implied and Book Value Investment in Sand Company Noncontrolling Interest

5 – 18

39,000 16,000 23,000 700,000 1,800,000 345,000 2,276,000 569,000

Exercise 5-11 (continued) (3) Cost of Goods Sold (Beginning Inventory) Depreciation Expense ($50,000/8) Equipment (net) ($50,000 – $6,250) Goodwill Difference between Implied and Book Value To allocate and depreciate the difference between implied and book value

45,000 6,250 43,750 250,000 345,000

Part 3 – Complete Equity Method Alternative to entry (3) (3a) Cost of Goods Sold (Beginning Inventory) Equipment (net) Goodwill Difference between Implied and Book Value (3b) Depreciation Expense ($50,000/8) Equipment (net)

45,000 50,000 250,000 345,000 6,250 6,250

2011 (1) Equity in Subsidiary Income ((0.80  $150,000) – $-5,000) Dividends Declared (0.80  $30,000) Investment in Sand Company To eliminate intercompany dividends and income

115,000 24,000 91,000

780,000 1,800,000 345,000

(3) Investment in Sand Company ($36,000 + $5,000) Noncontrolling interest ($9,000 + $1,250) Depreciation expense Equipment (net) ($50,000 – $6,250 – $6,250) Goodwill Difference between Implied and Book Value To allocate and depreciate the difference between implied and book value

41,000 10,250 6,250 37,500 250,000

Alternative to entry (4) (3a) Investment in Sand Company Noncontrolling Interest Equipment (net) Goodwill Difference between Implied and Book Value

5 – 19

2,340,000 585,000

345,000

36,000 9,000 50,000 250,000 345,000

Exercise 5-11 (continued)

(3b) Investment in Sand Company Noncontrolling interest Depreciation Expense ($50,000/8) Equipment (net)

5,000 1,250 6,250 12,500

Part 3 – Complete Equity Method

2012 (1) Equity in Subsidiary Income ((0.80  $80,000) – $5,000) Dividends Declared (0.80  $15,000) Investment in Sand Company To eliminate intercompany dividends and income

59,000 12,000 47,000

(2) Beginning Retained Earnings-Sand Common Stock- Sand Company Difference between Implied and Book Value Investment in Sand Company ($2,276,000 + $160,000) Noncontrolling Interest ($569,000 + ($900,000 – $700,000) x 0.20) To eliminate investment account and create noncontrolling interest account

900,000 1,800,000 345,000

(3) Investment in Sand Company ($41,000 + $5,000) Noncontrolling Interest ($10,250 + $1,250) Depreciation Expense Equipment (net) Goodwill Difference between Implied and Book Value To allocate and depreciate the difference between implied and book value

46,000 11,500 6,250 31,250 250,000

Alternative to entry (3) (3a) Investment in Sand Company Noncontrolling Interest Equipment (net) Goodwill Difference between Implied and Book Value (3b) Investment in Sand Company Noncontrolling Interest Depreciation Expense ($50,000/8) Equipment (net)

2,436,000 609,000

345,000

36,000 9,000 50,000 250,000 345,000 10,000 2,500 6,250 18,750

5 – 20

Exercise 5-12 Part A (1) Investment in Saxton Corporation 225,000 Beginning Retained Earnings-Palm Inc. 225,000 To establish reciprocity/convert to equity (0.90  ($1,250,000 – $1,000,000))

Computation and Allocation of Difference Schedule Parent Share Purchase price and implied value $3,750,000 Less: Book value of equity acquired 3,600,000 Difference between implied and book value 150,000 Inventory (90,000) Land (360,000) Balance (excess of FV over implied value) (300,000) Gain 300,000 Increase Noncontrolling interest to fair value of assets Total allocated bargain Balance -0-

NonEntire Controlling Value Share 416,667 4,166,667 * 400,000 4,000,000 16,667 166,667 (10,000) (100,000) (40,000) (400,000) (33,333) (333,333) 33,333 -0-

333,333 -0-

*$3,750,000/.90 (2) Beginning Retained Earnings-Saxton Co. 1,250,000 Capital Stock- Saxton Co. 3,000,000 Difference between Implied and Book Value 166,667 Investment in Saxton Co. ($3,750,000 + $225,000) 3,975,000 Noncontrolling Interest [$416,667 + ($1,250,000 – $1,000,000) x .10] 441,667 To eliminate the investment amount and create noncontrolling interest account (3) Beginning Retained Earnings-Palm Inc. Noncontrolling Interest Land Difference between Implied and Book Value Gain on Acquisition Noncontrolling Interest To allocate and depreciate the difference between implied and book value

5 – 21

90,000 10,000 400,000 166,667 300,000 33,333

Exercise 5-12 (continued) Part B Palm Incorporated's Retained Earnings on 12/31/2012 Palm Incorporated's share of the increase in Saxton Corporation's Retained Earnings from acquisition date to 12/31/2012 ($1,550,000 - $1,000,000)  0.9 Less the cumulative effect to 12/31/2012 of the amortization of the difference between implied and book value 2011 2012 Current Assets (inventory) $90,000 $0 Gain (300,000) (0) Total $(210,000) $(0) Consolidated Retained Earnings on 12/31/2012

$2,000,000 495,000

210,000 $2,705,000

Exercise 5-13 Imputed Value ($2,070,000/0.9) Recorded Value ($1,200,000 + $600,000) Unrecorded Values Allocated to identifiable assets Inventory ($725,000 - $600,000) Equipment ($1,075,000 - $900,000) Goodwill Inventory Equipment Goodwill Revaluation Capital

Net Assets $2,300,000 1,800,000 $500,000 $125,000 175,000

300,000 $200,000

125,000 175,000 200,000 500,000

5 – 22

Exercise 5-14 Part A Computation and Allocation of Difference Schedule Parent Share Purchase price and implied value $3,750,000 Less: Book value of equity acquired 3,600,000 Difference between implied and book value 150,000 Inventory (90,000) Land (360,000) Balance (excess of FV over implied value) (300,000) Gain 300,000 Increase Noncontrolling interest to fair value of assets Total allocated bargain Balance -0-

NonEntire Controlling Value Share 416,667 4,166,667 * 400,000 4,000,000 16,667 166,667 (10,000) (100,000) (40,000) (400,000) (33,333) (333,333) 33,333 -0-

333,333 -0-

*$3,750,000/.90

Cost of investment

Investment in Saxton Corporation (Partial Equity) 3,750,000P

2011 equity income (.9)($250,000) Balance 2011

225,000 3,975,000

2011 Dividends

2012 equity income (.9)($300,000)

270,000

2012 Dividends

Balance 2012

4,245,000

(1) Equity in Subsidiary Income Investment in Saxton Corporation. To eliminate subsidiary income ($270,000)

270,000 270,000

(2) Beginning Retained Earnings-Saxton Co. 1,250,000 Capital Stock- Saxton Co 3,000,000 Difference between Implied and Book Value 166,667 Investment in Saxton Co. ($3,750,000 + $225,000) 3,975,000 Noncontrolling Interest $416,667 + [($1,250,000 – $1,000,000) x .10] 441,667 To eliminate the investment amount and create noncontrolling interest account (3) Beginning Retained Earnings-Palm Inc. 90,000 Noncontrolling Interest 10,000 Land 400,000 Difference between Implied and Book Value Gain on Acquisition Noncontrolling Interest To allocate and depreciate the difference between implied and book value 5 – 23

166,667 300,000 33,333

Exercise 5-14 (continued) Part B Palm Incorporated's Retained Earnings on 12/31/2012 Less the cumulative effect to 12/31/2012 of the amortization of the difference between implied and book value 2011 2012 Current Assets (inventory) $90,000 $0 Gain (300,000) (0) Total $(210,000) $(0) Consolidated Retained Earnings on 12/31/2012

$2,705,000

210,000 $2,495,000

Exercise 5-15 Part A Computation and Allocation of Difference Schedule Parent Share Purchase price and implied value $3,750,000 Less: Book value of equity acquired 3,600,000 Difference between implied and book value 150,000 Inventory (90,000) Land (360,000) Balance (excess of FV over implied value) (300,000) Gain 300,000 Increase Noncontrolling interest to fair value of assets Total allocated bargain Balance -0-

NonEntire Controlling Value Share 416,667 4,166,667 * 400,000 4,000,000 16,667 166,667 (10,000) (100,000) (40,000) (400,000) (33,333) (333,333) 33,333 -0-

333,333 -0-

*$3,750,000/.90

Cost of investment 2011 equity income (.9)($250,000) Balance 2011 2012 equity income (.9)($300,000) Balance 2012

Investment in Saxton Corporation 3,750,000 P 225,000

2011 Dividends 2011 amortization (equity income)

0 90,000

2012 Dividends 2012 amortization (equity income)

3,885,000 270,000 4,155,000

5 – 24

Exercise 5-15 (continued) (1) Equity in Subsidiary Income Investment in Saxton Corporation. To eliminate subsidiary income ((.90)($300,000))

270,000 270,000

(2) Beginning Retained Earnings-Saxton Co. 1,250,000 Capital Stock- Saxton Co. 3,000,000 Difference between Implied and Book Value 166,667 Investment in Saxton Co. ($3,750,000 + $225,000) 3,975,000 Noncontrolling Interest [$416,667 + ($1,250,000 – 1,000,000) x .10] 441,667 To eliminate the investment amount and create noncontrolling interest account (3) Investment in Saxton Co. Noncontrolling Interest Land Difference between Implied and Book Value Beginning Retained Earnings-P (gain on acquisition) Noncontrolling Interest To allocate and depreciate the difference between implied and book value

90,000 10,000 400,000 166,667 300,000 33,333

Part B Palm Incorporated's Retained Earnings on 12/31/2012 Consolidated Retained Earnings on 12/31/2012

$2,705,000 $2,705,000

Under the complete equity method, Palm’s retained earnings will equal consolidated retained earnings. Exercise 5-16 Part A. 2011: Step 1: Fair value of the reporting unit Carrying value of unit: Carrying value of identifiable net assets Carrying value of goodwill ($450,000 - $375,000)

$400,000 $330,000 75,000

Excess of carrying value over fair value

405,000 $ 5,000

5 – 25

$400,000 340,000 60,000 75,000 $ 15,000

Exercise 5-16 (continued) 2012: Step 1: Fair value of the reporting unit Carrying value of unit: Carrying value of identifiable net assets Carrying value of goodwill ($75,000 - $15,000)

$400,000 $320,000 60,000 380,000 $ 20,000

Excess of fair value over carrying value

$350,000 $300,000 60,000 360,000 $ 10,000

Part B. 1. 2011: Impairment Loss—Goodwill Goodwill

$350,000 325,000 25,000 60,000 $ 35,000

15,000 15,000

2012: Retained Earnings-Porsche Goodwill

15,000

2013: Impairment Loss—Goodwill Retained Earnings – Porsche Goodwill

35,000 15,000

2. 2011: Impairment Loss—Goodwill Goodwill

15,000

50,000

15,000

2012: Investment in Saab Goodwill

15,000

2013: Impairment Loss—Goodwill Investment in Saab Goodwill

35,000 15,000

15,000

50,000

5 – 26

ANSWERS TO ASC (Accounting Standards Codification) EXERCISES ASC5-1 Presentation You are writing a research paper on the accounting for treasury stock. You wonder if it is possible to treat treasury stock as an asset. If not, you wonder if, over the history of GAAP, it has ever been acceptable for treasury stock to be classified as an asset (you vaguely recall reading something in FASB Statement No. 135, paragraph 4). Try to find statement 135 using the cross-reference tab. Step 1: Choose the cross reference tab on the opening page of the Codification. Step 2: Use the ‘By Standard’ drop down menu. Choose FAS as the standard type. Notice that 135 is not included in the Codification. Therefore, click on ‘Pre-Codification Standards’ on the left-hand column. Step 3: choose FASB Pronouncement categories [126-150]. Click on Statement No. 135, as issued and look for paragraph 4 (which list the pronouncements amended by Statement No. 135). APB Opinion No. 6, Status of Accounting Research Bulletins. In the first sentence of paragraph 12(b), or in some circumstances may be shown as an asset in accordance with paragraph 4 of Chapter 1A of ARB 43 is deleted (to reflect current established practice that it is no longer acceptable to show stock of a corporation held in its own treasury as an asset). ASC5-2 Presentation Management changed an accounting method. Several executives would have qualified for additional bonuses totaling $50,000 in the prior year under the new method. Can the firm restate the previous year’s income statement to include this expense? Step 1: Use the drop-down menus under the ‘presentation’ general topic on the homepage and choose ‘Accounting Changes and Error Corrections.’ Step 2: Click on the ‘Expand’ option and scroll through the topics looking for ‘accounting changes’. Click on section 45 Other Presentation Matters. Read through the paragraphs. FASB ASC paragraph 250-10-45-8: Retrospective application shall include only the direct effects of a change in accounting principle, including any related income tax effects. Indirect effects that would have been recognized if the newly adopted accounting principle had been followed in prior periods shall not be included in the retrospective application. If indirect effects are actually incurred and recognized, they shall be reported in the period in which the accounting change is made. ASC5-3 Objective What is the objective of the statement of cash flows? Step 1: Use the drop-down menus under the ‘Presentation’ general topic on the homepage and choose ‘230-Statement of Cash Flows’; then under the second drop-down menu, choose ’10-overall’. Step 2: Click on section 10 Objectives. FASB ASC paragraph 230-10-10-1 states that the primary objective of a statement of cash flows is to provide relevant information about the cash receipts and cash payments of an entity during a period. In paragraph 2, the FASB states that the information provided in a statement of cash flows, should help investors, creditors, and others to do all of the following: a. Assess the entity's ability to generate positive future net cash flows b. Assess the entity's ability to meet its obligations, its ability to pay dividends, and its needs for external financing 5 – 27

c. Assess the reasons for differences between net income and associated cash receipts and payments d. Assess the effects on an entity's financial position of both its cash and noncash investing and financing transactions during the period. ASC5-4 Cross-Reference FASB Statement No. 142 changed the guidance for goodwill and other intangibles. List all the topics in the Codification where this information can be found (i.e., ASC XXX). (Hint: There are two general topics.) Step 1: Choose the cross reference tab on the opening page of the Codification. Step 2: Use the ‘By Standard’ drop down menu. Choose FAS as the standard type and 142 as the standard number. Click on ‘Generate Report.’ The two general topics are Asset and Presentation. The specific topics are FASB ASC Topic 350 [Intangibles – Goodwill and other], Topic 323 [Investments – Equity Method and Joint Ventures], and Topic 205 [Presentation of Financial Statements], and Topic 280 [Segment Reporting]. ASC5-5 Measurement What is a reverse acquisition? How should the consideration transferred in a reverse acquisition be measured? (ASC 805-40-30-2 and ASC 805-40-20) Alternative 1: In the master glossary, find the definition of ‘reverse acquisition.’ A reverse acquisition is an acquisition in which the entity that issues securities (the legal acquirer) is identified as the acquiree for accounting purposes. The entity whose equity interests are acquired (the legal acquiree) must be the acquirer for accounting purposes for the transaction to be considered a reverse acquisition. This definition points you to paragraph 805-10-55-12, which identifies the guidance for reverse acquisition in Subtopic 805-40. In that subtopic, click on initial measurement and find paragraph 2. Alternative 2: In the search box, type ‘reverse acquisition.’ Twenty-five results are found. The answer is the first result. FASB ASC paragraph 805-40-30-2: In a reverse acquisition, the accounting acquirer usually issues no consideration for the acquiree. Instead, the accounting acquiree usually issues its equity shares to the owners of the accounting acquirer. Accordingly, the acquisition-date fair value of the consideration transferred by the accounting acquirer for its interest in the accounting acquiree is based on the number of equity interests the legal subsidiary would have had to issue to give the owners of the legal parent the same percentage equity interest in the combined entity that results from the reverse acquisition. The fair value of the number of equity interests calculated in that way can be used as the fair value of consideration transferred in exchange for the acquiree. ASC5-6 Disclosure When does the SEC staff believe that push down accounting should be applied? (ASC 805-50-S99-2) Alternative 1: Step one: In the master glossary, find the definition of ‘pushdown accounting.’ You learn that it is covered in Topic 805, but you can also click on the incoming links to see specific links in the standards. 5 – 28

Step two; after clicking on incoming links, click on ‘805 Business Combinations > 50 Related Issues > 25 Recognition,’ This finds the paragraph concerning the SEC’s views on push-down basis of accounting, FASB ASC paragraph 805-50-S99-2. The SEC staff indicated that it believes push-down accounting is required in "purchase transactions that result in an entity becoming substantially wholly owned." The SEC staff has stated that push-down accounting would be required if 95 percent or more of the company has been acquired (unless the company has outstanding public debt or preferred stock that may impact the acquirer's ability to control the form of ownership of the company), permitted if 80 percent to 95 percent has been acquired, and prohibited if less than 80 percent of the company is acquired.

5 – 29

ANSWERS TO PROBLEMS Problem 5-1 Calculations: Computation and Allocation of Difference Schedule Parent Share Purchase price and implied value Less: Book value of equity acquired Difference between implied and book value Equipment (net) ($1,500,000 - $600,000) Balance Goodwill Balance

$2,800,000 1,200,000 1,600,000 (720,000) 880,000 (880,000) -0-

NonEntire Controlling Value Share 700,000 3,500,000 * 300,000 1,500,000 400,000 2,000,000 (180,000) (900,000) 220,000 1,100,000 (220,000) (1,100,000) -0-0-

*$2,800,000/.80 Depreciation of difference allocated to Palmero ($720,000/10) Depreciation of difference allocated to Santos ($180,000/10)

$72,000 $18,000

Part A 2011 (1) Beginning Retained Earnings-Santos Co. 1,000,000 Capital Stock- Santos Co. 500,000 Difference between Implied and Book Value 2,000,000 Investment in Santos Co. 2,800,000 Noncontrolling Interest 700,000 To eliminate investment account and create noncontrolling interest account (2) Depreciation Expense 90,000 Property and Equipment (net) ($900,000 - $90,000) 810,000 Goodwill 1,100,000 Difference between Implied and Book Value 2,000,000 To allocate and depreciate the difference between implied and book value Alternative to entry (2) (2a) Property and Equipment (net) Goodwill Difference between Implied and Book Value (2b) Depreciation Expense Property and Equipment (net)

900,000 1,100,000 2,000,000 90,000 90,000

5 – 30

Problem 5-1 (continued) 2012 (1) Investment in Santos Company ($300,000  0.80) Beginning Retained Earnings-Palmero Co. To establish reciprocity/convert to equity as of 1/1/2012

240,000 240,000

(2) Beginning Retained Earnings-Santos Company 1,300,000 Capital Stock-Santos Company 500,000 Difference between Implied and Book Value 2,000,000 Investment in Santos Company ($2,800,000 + $240,000) 3,040,000 Noncontrolling Interest $700,000 + [($1,300,000 – $1,000,000) x 0.20] 760,000 To eliminate investment account. (3) Beginning Retained Earnings-Palmero Co. 72,000 Noncontrolling Interest 18,000 Depreciation Expense 90,000 Property and Equipment (net) ($900,000 - $90,000 - $90,000) 720,000 Goodwill 1,100,000 Difference between Implied and Book Value 2,000,000 To allocate and depreciate the difference between implied and book value Alternative to entry (3) (3a) Property and Equipment (net) Goodwill Difference between Implied and Book Value (3b) Beginning Retained Earnings-Palmero Co. Noncontrolling Interest Depreciation Expense Property and Equipment (net)

5 – 31

900,000 1,100,000 2,000,000 72,000 18,000 90,000 180,000

Problem 5-1 (continued) Part B Controlling Interest in Consolidated Net Income 2011 Palmero Company's Net Income from Independent Operations $400,000 Palmero Company's Share of Reported Income of Santos Company 240,000 Less: Depreciation of Difference between Implied and Book Value Allocated to: Property and Equipment (72,000) Controlling Interest in Consolidated Net Income $568,000

2012 $425,000 320,000

(72,000) $673,000

Noncontrolling Interest in Consolidated Income (2011) Amortization of the difference between implied and book value related to equipment ($900,000/10)

Net income reported by Santos

$ 300,000

90,000 Adjusted net income of Santos Noncontrolling Ownership percentage interest

210,000 20%

Noncontrolling Interest in Consolidated Net Income

$ 42,000

Controlling Interest in Consolidated Income (2011) Palmero Company's net income from its independent operations $ 400,000 Palmero Company's share of the adjusted income of Santos Company (.8 X $210,000)

Controlling Interest in Consolidated Net Income

168,000

$ 568,000

Noncontrolling Interest in Consolidated Income (2012) Amortization of the difference between implied and book value related to equipment ($900,000/10)

Net income reported by Santos

$ 400,000

90,000 Adjusted net income of Santos Noncontrolling Ownership percentage interest

310,000 20%

Noncontrolling Interest in Consolidated Net Income

$ 62,000

5 – 32

Problem 5-1 (continued) Controlling Interest in Consolidated Income (2012) Palmero Company's net income from its independent operations $ 425,000 Palmero Company's share of the adjusted income of Santos Company (.8 X $310,000)

Controlling Interest in Consolidated Net Income

248,000

$ 673,000

Problem 5-2 Computation and Allocation of Difference Schedule Parent Share Purchase price and implied value Less: Book value of equity acquired Difference between implied and book value Unamortized Discount on Bonds Payable Balance Goodwill Balance

$1,300,000 1,050,000 250,000 (106,143) 143,857 (143,857) -0-

NonEntire Controlling Value Share 557,143 1,857,143 * 450,000 1,500,000 107,143 357,143 (45,490) (151,633) 61,653 205,510 (61,653) (205,510) -0-0-

*$1,300,000/.70 Present Value on 1/1/2011 of 6% Bonds Payable Discounted at 10%, 5 periods Principal ($1,000,000  0.62092) Interest ($60,000  3.79079) Fair value of bonds Face value of bonds Total Discount

$620,920 227,447 $848,367 1,000,000 $151,633

Amortization of amount of difference between implied and book value allocated to unamortized discount on bonds payable (1) Year 2011 2012

(2) Carrying Value (1/1) $848,367 $873,204

(3) Interest at 10% of Carrying Value $84,837 $87,320

(4) Interest at 6% of Par Value $60,000 $60,000

5 – 33

(5) Difference [(3)-(4)] $24,837 $27,320

Problem 5-2 (continued) Part A 2011 (1) Equity in Subsidiary Income (.70)($100,000) Investment in Sagon Co. To eliminate subsidiary income

70,000 70,000

(2) Beginning Retained Earnings-Sagon Co. 500,000 Capital Stock- Sagon Co. 1,000,000 Difference between Implied and Book Value 357,143 Investment in Sagon Co. 1,300,000 Noncontrolling Interest 557,143 To eliminate investment amount and create noncontrolling interest account (3) Interest Expense Unamortized Discount on Bonds Payable ($151,633 - $24,837) Goodwill Difference between Implied and Book Value To allocate and amortize the difference between Implied and book value Alternative to entry (3) (3a) Unamortized Discount on Bonds Payable Goodwill Difference between Implied and Book Value (3b) Interest Expense Unamortized Discount on Bonds Payable 2012 (1) Equity in Subsidiary Income (.70)($120,000) Investment in Sagon Co. To eliminate subsidiary income

24,837 126,796 205,510 357,143

151,633 205,510 357,143 24,837 24,837 84,000 84,000

(2) Beginning Retained Earnings-Sagon Company 600,000 Common Stock- Sagon Company 1,000,000 Difference between Implied and Book Value 357,143 Investment in Sagon Company ($1,300,000 + $70,000) 1,370,000 Noncontrolling Interest ($557,143 + ($600,000 – $500,000) x 0.30) 587,143 To eliminate the investment account and create noncontrolling interest account (3) Beginning Retained Earnings-Paxton Company 17,386 * Noncontrolling Interest 7,451 Interest Expense 27,320 Unamortized Discount on Bonds Payable ($151,633 - $24,837 - $27,320) 99,476 Goodwill 205,510 Difference between Implied and Book Value 357,143 To allocate and amortize the difference between implied and book value *$24,837 x 70% = $17,386

Alternative to entry (3) 5 – 34

Problem 5-2 (continued) (3a) Unamortized Discount on Bonds Payable Goodwill Difference between Implied and Book Value

151,633 205,510

(3b) Beginning Retained Earnings-Paxton Company Noncontrolling Interest Interest Expense Unamortized Discount on Bonds Payable

17,386 7,451 27,320

357,143

52,157

(4) Impairment Loss – Goodwill** Goodwill

25,510 25,510

**Step 1: Fair value of the reporting unit Carrying value of unit: Carrying value of identifiable net assets Carrying value of goodwill

$1,500,000 $1,409,000 205,510

Excess of carrying value over fair value

1,614,510 $ 114,510

The excess of carrying value over fair value means that step 2 is required. Step 2:Fair value of the reporting unit Fair value of identifiable net assets Implied value of goodwill Recorded value of goodwill Impairment loss

$1,500,000 1,320,000 180,000 205,510 $ 25,510

Part B Controlling Interest in Consolidated Net Income 2011 Paxton Company's Net Income from Independent Operations $300,000 Paxton Company's Share of Reported Income of Sagon Company 70,000 Less: Amortization of Difference between Implied and Book Value Allocated to: Bonds Payable (17,386) Controlling Interest in Consolidated Net Income $352,614 * $27,320 x 70% = $19,124

5 – 35

2012 $250,000 84,000

(19,124)* $314,876

Problem 5-2 (continued) Noncontrolling Interest in Consolidated Income (2011) Amortization of the difference between implied and book value related to bonds payable

Net income reported by Sagon

$ 100,000

24,837 Adjusted net income of Sagon Noncontrolling Ownership percentage interest Noncontrolling Interest in Consolidated Net Income

75,163 30% $ 22,549

Controlling Interest in Consolidated Income (2011) Paxton Company's net income from its independent operations $ 300,000 Paxton Company's share of the adjusted income of Sagon Company (.7 X $75,163)

Controlling interest in Consolidated Net Income

52,614

$ 352,614

Noncontrolling Interest in Consolidated Income (2012) Amortization of the difference between implied and book value related to bonds payable Goodwill Impairment

Net income reported by S

$ 120,000

27,320 25,510 Adjusted net income of S Noncontrolling Ownership percentage interest Noncontrolling Interest in Consolidated Net Income

67,170 30% $ 20,151

Controlling Interest in Consolidated Income (2012) Paxton Company's net income from its independent operations $ 250,000 Paxton Company's share of the adjusted income of Sagon Company (.7 X $67,170)

Controlling interest in Consolidated Net Income

5 – 36

47,019

$ 297,019

Problem 5-3 Computation and Allocation of Difference Schedule Parent Share $1,970,000 1,440,000 530,000 (100,000) (140,000) 290,000 (290,000) -0-

NonControlling Share 492,500 360,000 132,500 (25,000) (35,000) 72,500 (72,500) -0-

2,462,500 * 1,800,000 662,500 (125,000) (175,000) 362,500 (362,500) -0-

2012 Amortization Schedule Inventory (60% in 2012) Equipment ($175,000/7) Total

60,000 20,000 80,000

15,000 5,000 20,000

75,000 25,000 100,000

2013 Amortization Schedule Inventory (40% in 2013) Equipment ($175,000/7) Total

40,000 20,000 60,000

10,000 5,000 15,000

50,000 25,000 75,000

Purchase price and implied value Less: Book value of equity acquired Difference between implied and book value Inventory ($725,000 - $600,000) Equipment ($1,075,000 - $900,000) Balance Goodwill Balance

Entire Value

*$1,970,000/.80

Part A 2012 Investment in Superstition Company Cash

1,970,000 1,970,000

Cash (0.8  $150,000) Investment in Superstition Company

120,000

Investment in Superstition Company Equity in Subsidiary Income (.80)($750,000)

600,000

Equity in Subsidiary Income Investment in Superstition Company

80,000

2013 Cash (0.8  $225,000) Investment in Superstition Company

120,000

600,000

80,000 180,000 180,000

Investment in Superstition Company Equity in Subsidiary Income (.80)($900,000)

720,000

Equity in Subsidiary Income Investment in Superstition Company

60,000

5 – 37

720,000

60,000

Problem 5-3 (continued) Part B 2012 (1) Equity in Subsidiary Income ((.80)($750,000) - $80,000) Dividends Declared (0.80  $150,000) Investment in Superstition Company To eliminate intercompany income and dividends

520,000 120,000 400,000

(2) Beginning Retained Earnings - Superstition Company 600,000 Common Stock- Superstition Company 1,200,000 Difference between Implied and Book Value 662,500 Investment in Superstition Company 1,970,000 Noncontrolling Interest 492,500 To eliminate the investment account and create noncontrolling interest account (3) Inventory ($125,000 - $75,000) 50,000 Cost of Goods Sold 75,000 Depreciation Expense 25,000 Equipment (net) ($175,000 - $25,000) 150,000 Goodwill 362,500 Difference between Implied and Book Value 662,500 To allocate and depreciate the difference between implied and book value Alternative to entry (3) (3a) Inventory Cost of Good Sold Equipment (net) Goodwill Difference between Implied and Book Value (3b) Depreciation Expense Equipment (net)

50,000 75,000 175,000 362,500 662,500 25,000 25,000

2013 (1) Equity in Subsidiary Income ((.80)($900,000) - $60,000) Dividends Declared (0.80  $225,000) Investment in Superstition Company To eliminate intercompany income and dividends

660,000 180,000 480,000

(2) Beginning Retained Earnings-Superstition Company 1,200,000 Common Stock - Superstition Company. 1,200,000 Difference between Implied and Book Value 662,500 Investment in Superstition Company ($1,970,000 + $480,000) 2,450,000 Noncontrolling Interest ($492,500 + ($1,200,000 – $600,000) x .20) 612,500 To eliminate investment account and create noncontrolling interest account

5 – 38

Problem 5-3 (continued) (3)

Investment in Superstition Company ($60,000 + $20,000) 80,000 Noncontrolling Interest ($15,000 + $5,000) 20,000 Cost of Good Sold 50,000 Depreciation Expense 25,000 Equipment (net) ($175,000 – $25,000 – $25,000) 125,000 Goodwill 362,500 Difference between Implied and Book Value 662,500 To allocate and depreciate the difference between implied and book value

Alternative to entry (3) (3a) Investment in Superstition Company Noncontrolling Interest Cost of Good Sold Equipment (net) Goodwill Difference between Implied and Book Value (3b) Investment in Superstition Company Noncontrolling Interest Depreciation Expense Equipment (net)

60,000 15,000 50,000 175,000 362,500 662,500 20,000 5,000 25,000 50,000

Part C Perke Corporation's Net Income from Independent Operations ($1,000,000 - $120,000) $880,000 Perke Corporation's Share of Superstition Company's net income (0.8  $750,000) 600,000 Less: Assignment, amortization, and depreciation of: Inventory (60,000) Equipment (20,000) Controlling Interest in Consolidated Net Income $1,400,000

5 – 39

Problem 5-4 Part A Computation and Allocation of Difference Schedule Parent Share Purchase price and implied value Less: Book value of equity acquired Difference between implied and book value Equipment Land Inventory Balance Goodwill Balance

$850,000 504,000 346,000 (104,000) (52,000) (32,000) 158,000 (158,000) -0-

NonControlling Share 212,500 126,000 86,500 (26,000) (13,000) (8,000) 39,500 (39,500) -0-

Entire Value 1,062,500 * 630,000 432,500 (130,000) (65,000) (40,000) 197,500 (197,500) -0-

*$850,000/.80

Part B and C – Worksheet Entries Cost Method Workpaper entries – Year 2010 (1) Dividend Income ($25,000  .80) Dividends Declared To eliminate intercompany dividends

20,000 20,000

(2) Beginning Retained Earnings - Salem Co. Common Stock - Salem Difference between Implied and Book Value Investment in Salem Company Noncontrolling Interest To eliminate investment account and create noncontrolling interest account

80,000 550,000 432,500

(3) Cost of Goods Sold Land Plant and Equipment (5 year life) Goodwill Difference between Implied and Book Value To allocate the difference between implied and book value

40,000 65,000 130,000 197,500

(4) Depreciation Expense ($130,000/5) Plant and Equipment

26,000

850,000 212,500

432,500

26,000

5 – 40

Problem 5-4 (continued) Cost Method – Worksheet Entries – Year 2011 (1) Investment in Salem Company (.80  ($100,000 - $25,000)) Beginning Retained Earnings - Porter Co. To establish reciprocity/convert to equity as of 1/1/2011

60,000

(2) Dividend Income ($35,000  .80) Dividends Declared To eliminate intercompany dividends

28,000

(3) Beginning Retained Earnings - Salem Co.($80,000 + $100,000 – $25,000) Common Stock - Salem Difference between Implied and Book Value Investment in Salem Company ($850,000 + $60,000) Noncontrolling Interest ($212,500 + ($155,000 – $80,000)  .2) To eliminate investment account and create noncontrolling interest account

155,000 550,000 432,500

(4) 1/1 Retained Earnings – Porter Company Noncontrolling Interest Land Plant and Equipment (5 year life) Goodwill Difference between Implied and Book Value To allocate the difference between implied and book value

32,000 8,000 65,000 130,000 197,500

(5) 1/1 Retained Earnings – Porter Company (previous year’s amount) Noncontrolling Interest Depreciation Expense ($130,000/5) Plant and Equipment

20,800 5,200 26,000

60,000

28,000

Partial Equity Method Workpaper entries – Year 2010 (1) Equity in Subsidiary Income ($100,000)(.80) Dividends Declared ($25,000  .80) Investment in Salem Company To eliminate intercompany dividends (2) Beginning Retained Earnings - Salem Co. Common Stock - Salem Difference between Implied and Book Value Investment in Salem Company Noncontrolling Interest To eliminate investment account and create noncontrolling interest account

5 – 41

910,000 227,500

432,500

52,000

80,000 20,000 60,000

80,000 550,000 432,500 850,000 212,500

Problem 5-4 (continued) (3) Cost of Goods Sold Land Plant and Equipment (5 year life) Goodwill Difference between Implied and Book Value To allocate the difference between implied and book value (4) Depreciation Expense ($130,000/5) Plant and Equipment

40,000 65,000 130,000 197,500 432,500

26,000 26,000

Partial Equity Method – Worksheet Entries – Year 2011 (1) Equity in Subsidiary Income ($110,000)(.80) Dividends Declared ($35,000  .80) Investment in Salem Company To eliminate intercompany dividends and income

88,000

(2) Beginning Retained Earnings - Salem Co. Common Stock - Salem Difference between Implied and Book Value Investment in Salem Company ($850,000 + $80,000 – $20,000) Noncontrolling Interest ($212,500 + ($155,000 – $80,000)  .2) To eliminate investment account and create noncontrolling interest account

155,000 550,000 432,500

(3) 1/1 Retained Earnings – Porter Company Noncontrolling Interest Land Plant and Equipment (5 year life) Goodwill Difference between Implied and Book Value To allocate the difference between implied and book value

32,000 8,000 65,000 130,000 197,500

(4) 1/1 Retained Earnings – Porter Company (previous year’s amount) Noncontrolling Interest Depreciation Expense ($130,000/5) Plant and Equipment

20,800 5,200 26,000

Complete Equity Method Workpaper entries – Year 2010 (1) Equity in Subsidiary Income ($100,000)(.80) – $32,000 – $20,800 Dividends Declared ($25,000  .80) Investment in Salem Company To eliminate intercompany dividends

5 – 42

28,000 60,000

910,000 227,500

432,500

52,000

27,200 20,000 7,200

Problem 5-4 (continued) (2) Beginning Retained Earnings - Salem Co. Common Stock - Salem Difference between Implied and Book Value Investment in Salem Company Noncontrolling Interest To eliminate investment account and create noncontrolling interest account

80,000 550,000 432,500

(3) Cost of Goods Sold Land Plant and Equipment (5 year life) Goodwill Difference between Implied and Book Value To allocate the difference between implied and book value

40,000 65,000 130,000 197,500

(4) Depreciation Expense ($130,000/5) Plant and Equipment

26,000

850,000 212,500

432,500

26,000

Complete Equity Method – Worksheet Entries – Year 2011 (1) Equity in Subsidiary Income ($110,000)(.80) - $20,800 Dividends Declared ($35,000  .80) Investment in Salem Company To eliminate intercompany dividends and income

67,200

(2) Beginning Retained Earnings - Salem Co. ($80,000 + $75,000) Common Stock - Salem Difference between Implied and Book Value Investment in Salem Company ($850,000 + $80,000 – $20,000) Noncontrolling Interest ($212,500 + ($155,000 – $80,000)  .2) To eliminate investment account and create noncontrolling interest account

155,000 550,000 432,500

(3) Investment in Salem Company Noncontrolling Interest Land Plant and Equipment (5 year life) Goodwill Difference between Implied and Book Value To allocate the difference between implied and book value

32,000 8,000 65,000 130,000 197,500

(4) Investment in Salem Company Noncontrolling Interest Depreciation Expense ($130,000/5) Plant and Equipment

20,800 5,200 26,000

28,000 39,200

910,000 227,500

432,500

52,000

5 – 43

Problem 5-4 (continued) Part D Income Statement

Porter Company

Salem Company

Sales Dividend Income Total Revenue Cost of Goods Sold Depreciation Expense Impairment loss Other Expenses Total Cost and Expense Net/Consolidated Income

$1,100,000 $450,000 48,000 (2) 1,148,000 450,000 900,000 200,000 40,000 30,000 (4b) (5) 60,000 50,000 1,000,000 280,000 148,000 170,000

Noncontrolling Interest in Consolid. Income* Net Income to Retained Earnings

$148,000 $170,000

Retained Earnings Statement 1/1 Retained Earnings: Porter Company

$500,000

Salem Company Net Income from Above Dividends Declared: Porter Company Salem Company 12/31 Retained Earnings to Balance Sheet

148,000

Eliminations Debit Credit

$1,550,000 48,000 1,550,000 1,100,000 96,000 47,500 110,000 1,353,500 196,500

26,000 47,500

19,300 $19,300

$121,500

(4a) (4b)

Noncontrolling Consolidated Interest Balances

32,000 41,600

(1) $120,000

230,000 (3) 230,000 170,000 121,500

(19,300) $177,200

$546,400

19,300

(90,000)

177,200 (90,000)

(60,000) $558,000 $340,000

5 - 44

(2) $425,100

48,000 $168,000

(12,000) $7,300

$633,600

Problem 5-4 (continued) Porter Salem Balance Sheet Company Company Cash $70,000 $65,000 Accounts Receivable 260,000 190,000 Inventory 240,000 175,000 Investment in Salem Company 850,000 (1) Difference between Implied and Book Value (3) Land 320,000 (4a) Plant and Equipment 360,000 280,000 (4a) Goodwill (4a) Total Assets $1,780,000 $1,030,000 Accounts Payable Notes Payable Common Stock: Porter Company Salem Company Retained Earnings from above 1/1 Noncontrolling Interest in Net Assets 12/31 Noncontrolling Interest in Net Assets Total Liabilities and Equity

$132,000 90,000

Eliminations Debit Credit

120,000 (3) 432,500 (4a) 65,000 130,000 (4b) 197,500 (5)

Noncontrolling Consolidated Interest Balances $135,000 $450,000 $415,000

970,000 432,500 385,000 692,000 150,000 $2,227,000

78,000 47,500

$110,000 30,000

$242,000 120,000

1,000,000 558,000

1,000,000 550,000 340,000

(3) (4a) (4b)

$1,780,000 $1,030,000

550,000 425,100 8,000 (3) 10,400

$1,938,500

168,000 242,500 **

$1,938,500

* Noncontrolling Interest in Income =.2  $170,000 – (.2 x $26,000) – (.2 x $47,500) = $19,300 ** $212,500 + ($230,000 – $80,000) x .20 = $242,500 Explanations of workpaper entries are on the following page.

5 - 45

7,300 224,100

633,600

$231,400

231,400 $2,227,000

Problem 5-4D explanation Computation and Allocation of Difference Schedule Parent Share Purchase price and implied value Less: Book value of equity acquired Difference between implied and book value Equipment Land Inventory Balance Goodwill Balance

$850,000 504,000 346,000 (104,000) (52,000) (32,000) 158,000 (158,000) -0-

NonControlling Share 212,500 126,000 86,500 (26,000) (13,000) (8,000) 39,500 (39,500) -0-

Entire Value 1,062,500 630,000 432,500 (130,000) (65,000) (40,000) 197,500 (197,500) -0-

Explanations of Workpaper entries: (1) Investment in Salem Company [.80  ($230,000 - $80,000)] Beginning Retained Earnings - Porter Co. To establish reciprocity/convert to equity method as of 1/1/12

120,000

(2) Dividend Income ($60,000  .80) Dividends Declared To eliminate intercompany dividends

48,000

(3) Beginning Retained Earnings - Salem Co. Common Stock - Salem Difference between Implied and Book Value Investment in Salem Company ($850,000 + $120,000) Noncontrolling Interest To eliminate the investment account and create noncontrolling interest account

230,000 550,000 432,500

(4a) Beginning Retained Earnings- Porter Company Noncontrolling Interest Land Plant and Equipment Goodwill Difference between Implied and Book Value

32,000 8,000 65,000 130,000 197,500

(4b) Beginning Retained Earnings - Porter Company (two years) Noncontrolling Interest (two years) Depreciation Expense Plant and Equipment

41,600 10,400 26,000

120,000

48,000

5 - 46

970,000 242,500

432,500

78,000

Problem 5-4D explanation Alternative to entries (4a) and (4b) (4) Beginning Retained Earnings - Porter Company a Noncontrolling Interest b Depreciation Expense Land Plant and Equipment c Goodwill Difference between Implied and Book Value To allocate and depreciate the difference between implied and book value a ($32,000 + $20,800) + ($20,800) = $73,600 b ($8,000 + $5,200) + ($5,200) = $18,400 c ($130,000 - [3  $26,000]) = $52,000 (5) Impairment Loss ($197,500 - $150,000) Goodwill To record goodwill impairment

Part E

73,600 18,400 26,000 65,000 52,000 197,500 432,500

47,500 47,500

PORTER COMPANY AND SUBSIDIARY Consolidated Financial Statements For the Year Ended December 31, 2012 Consolidated Income Statement Sales Cost of Goods Sold Gross Profit Expenses: Depreciation Expense Impairment Loss Other Expenses Consolidated Income Noncontrolling Interest in Consolidated Income Net Income Consolidated Statement of Retained Earnings Retained Earnings - Beginning of Year Add: Net Income Less Dividends Retained Earnings - End of Year

5 - 47

$1,550,000 1,100,000 450,000 $96,000 47,500 110,000

253,500 196,500 19,300 $177,200 $546,400 177,200 723,600 90,000 $633,600

Problem 5-4 (continued) Part E PORTER COMPANY AND SUBSIDIARY Consolidated Statement of Financial Position December 31, 2012 Assets Current Assets: Cash Accounts Receivable Inventory Noncurrent Assets: Plant and Equipment (net) Land Goodwill Total Assets

$135,000 450,000 415,000 692,000 385,000 150,000

Liabilities And Stockholders' Equity Liabilities: Accounts Payable Notes Payable Total Liabilities Stockholders' Equity Noncontrolling Interest in Net Assets Capital Stock Retained Earnings Total Liabilities and Stockholders' Equity

$1,000,000

1,227,000 $2,227,000

$242,000 120,000 362,000 231,400 1,000,000 633,600

1,865,000 $2,227,000

Part F Ending inventory would be higher by $40,000 if LIFO is assumed because it would not have been sold. Beginning controlling retained earnings and noncontrolling interest would also be $32,000 and $8,000 higher, because cost of goods sold in the year of acquisition was lower. Part G Porter Company's Retained Earnings on 12/31/12 Porter Company's Share of the Increase in Salem Company's Retained Earnings from January 1, 2010 to December 31, 2012 ($340,000 – $80,000)  .8 Cumulative Effect to December 31, 2012 of the Allocation and Depreciation of the Difference between Implied and Book value (Parent’s share) Allocated to: 2010 2011 2012 Inventory $32,000 $0 $0 Equipment 20,800 20,800 20,800 $52,800 $20,800 $20,800 Goodwill Impairment (2012) Controlling Interest in Consolidated Retained Earnings on 12/31/12

5 - 48

$558,000

208,000

(94,400) (38,000) $633,600

Problem 5-5 Part A – The firm uses the cost method because the firm recognizes dividend income from the investment. Computation and Allocation of Difference Schedule Parent Share Purchase price and implied value $1,000,000 Less: Book value of equity acquired 621,000 Difference between implied and book value 379,000 Equipment ($390,000 – $300,000) (81,000) Less:Accumulated Depreciation ($130,000 – $100,000) 27,000 Inventory ($210,000 – $160,000) (45,000) Land ($290,000 – 190,000) (90,000) Bond Discount ($205,556 – $150,000) (50,000) Balance 140,000 Goodwill (140,000) Balance -0-

NonControlling Share 111,111 69,000 42,111 (9,000) 3,000 (5,000) (10,000) (5,556) 15,555 (15,555) -0-

Entire Value 1,111,111 * 690,000 421,111 (90,000) 30,000 (50,000) (100,000) (55,556) 155,555 (155,555) -0-

*$1,000,000/.90 2011 Amortization Schedule Equipment (10 year life) Inventory (sold in 2011) Bond Discount Total

5,400 45,000 50,000 100,400

600 5,000 5,556 11,156

6,000 50,000 55,556 111,556

2012 Amortization Schedule Equipment (10 year life) Inventory (sold in 2011) Bond Discount Total

5,400 0 0 5,400

600 0 0 600

6,000 0 0 6,000

*The goodwill may also be calculated analytically as follows: Cost of Investment ($1,000,000/0.9) Fair value acquired Goodwill

$1,111,111 (955,556) $155,555

5 - 49

Problem 5-5 (Continued) Part B 2011 Cost of Goods Sold Gain on Early Extinguishment of Debt Land Equipment Goodwill Accumulated Depreciation Difference between Implied and Book Value Depreciation Expense ($60,000/10) Accumulated Depreciation

50,000 55,556 100,000 90,000 155,555 30,000 421,111 6,000 6,000

Treatment of the Amount of the Difference Assigned to Bond Discount Date of Acquisition Unamortized Discount on Bonds Payable Difference between Implied And Book Value

55,556 55,556

2011 Book entry to record retirement in 2011 on Stevens books Bonds Payable Cash Gain on Retirement of Debt

205,556 150,000 55,556

But from consolidated point of view the gain should be $0 Bonds Payable Unamortized Discount on Bonds Payable Cash

205,556 55,556 150,000

So entry in Consolidated Statements Workpaper for year ended December 31, 2011 is: Gain on Early Extinguishment of Debt Difference between Implied And Book Value

55,556 55,556

Workpaper entries in years after 2011: Beginning Retained Earnings-Palmer Noncontrolling Interest Difference between Implied And Book Value

5 - 50

50,000 5,556 55,556

Problem 5-5 (continued) Part C

Income Statement Sales Cost of Goods Sold Gross Margin Depreciation Expense

PALMER COMPANY AND SUBSIDIARY Consolidated Statement Workpaper For the Year Ended December 31, 2013 Palmer Company

Stevens Company

$620,000 430,000 190,000 30,000

$340,000 240,000 100,000 20,000

60,000 100,000 31,500 131,500

35,000 45,000

Other Expenses Income from Operations Dividend Income Net/Consolidated Income Noncontrolling Interest in Income * Net Income to Retained Earnings

$131,500

Statement of Retained Earnings 1/1Retained Earnings Palmer Company

$297,600

Stevens Company Net Income from above Dividends Declared Palmer Company Stevens Company 12/31Retained Earnings to Balance Sheet * ($45,000  .10) - $600 = $3,900.

131,500

Eliminations Dr. Cr.

(4b)

Noncontrolling Consolidated Interest Balances $960,000 670,000 290,000 56,000

6,000

95,000 139,000 (2)

31,500

45,000 $45,000

210,000 45,000

$37,500

(4a) 95,000 (4b) 10,800

(1) 18,000

(3) 210,000 37,500

3,900 $3,900

$209,800

3,900

(120,000) $309,100

139,000 (3,900) $135,100

135,100 (120,000)

(35,000) $220,000

5 - 51

$353,300

(2) 31,500 $49,500

(3,500) $400

$224,900

Problem 5-5 (continued) Part C

Palmer Company

Balance Sheet Cash $201,200 Accounts Receivable 221,000 Inventory 100,400 Investment in Stevens Company 1,000,000 Difference between Implied & Bk Value Equipment 450,000 Accumulated Depreciation (300,000)

Stevens Company

Eliminations Cr.

Noncontrolling Interest

$151,000 173,000 81,000

360,000

290,000

$2,032,600

$855,000

Accounts Payable Bonds Payable

$323,500 400,000

$135,000

(1) 18,000 (3) 1,018,000 (3) 421,111 (4a) 421,111 (4a) 90,000 (4a) 30,000 (4b) 18,000 (4a) 100,000 (4a) 155,555

840,000 (488,000) 750,000 155,555 $2,185,155 $458,500 400,000

1,000,000 309,100

$2,032,600

Consolidated Balances $352,200 394,000 181,400

300,000 (140,000)

Land Goodwill Total Assets

Capital Stock: Palmer Company Stevens Company Retained Earnings from above 1/1 Noncontrolling Interest in Net Assets 12/31 Noncontrolling Interest in Net Assets Total Liabilities & Equity

Dr.

1,000,000 500,000 220,000

(3) 500,000 353,300 (4a) 10,556 (4b) 1,200

$855,000

$1,649,722

Noncontrolling Interest in Income = 0.10  $45,000 – $600 = $3,900 Explanations of workpaper entries are on separate page

5 - 52

49,500 (3) 113,111

$1,649,722

400 101,355

224,900

$101,755

101,755 $2,185,155

Problem 5-5 (continued) Explanations of workpaper entries Explanation of workpaper entries – Year 2013 (1) Investment in Stevens Company [0.9  ($210,000 - $190,000)] Beginning Retained Earnings-Palmer Company To establish reciprocity/convert to equity as of 1/1/2013

18,000

(2) Dividend Income ($35,000  0.90) Dividends Declared To eliminate intercompany dividends

31,500

18,000

31,500

(3) Beginning Retained Earnings - Stevens Company 210,000 Common Stock-Stevens Company 500,000 Difference between Implied and Book Value 421,111 Investment in Stevens Company ($1,000,000 + $18,000) 1,018,000 Noncontrolling Interest ($111,111 + ($210,000 – $190,000) x .10) 113,111 To eliminate investment account and create noncontrolling interest account (4) Beginning Retained Earnings-Palmer Company [$45,000 + $50,000 + (2  $5,400)] 105,800 Noncontrolling Interest [$5,000 + $5,556 + (2 x $600)] 11,756 Depreciation Expense ($60,000/10) 6,000 Plant and Equipment 90,000 Land 100,000 Goodwill 155,555 Accumulated Depreciation [$30,000 + (3  $6,000)] 48,000 Difference between Implied and Book Value 421,111 To allocate and depreciate the difference between implied and book value Alternative to entry (4) (4a) Beginning Retained Earnings-Palmer Company [$45,000 + $50,000] Noncontrolling Interest [$5,000 + $5,556] Plant and Equipment Land Goodwill Accumulated Depreciation Difference between Implied and Book Value (4b) Beginning Retained Earnings-Palmer Company Noncontrolling Interest ($600 x 2) Depreciation Expense ($60,000/10) Accumulated Depreciation [(3  $6,000)]

5 - 53

95,000 10,556 90,000 100,000 155,555 30,000 421,111 10,800 1,200 6,000 18,000

Problem 5-5 Part D Palmer Company's net income from its own operations Palmer Company's share of Stevens Company's income (0.90  $45,000) Less: Depreciation Controlling Interest in Consolidated Net Income

$100,000 40,500 (5,400) $135,100

Noncontrolling Interest in Consolidated Income (2013) Amortization of the difference between implied and book value related to Property and equipment ($60,000/10)

Net income reported by Stevens

$ 45,000

6,000 Adjusted net income of Stevens Noncontrolling Ownership percentage interest Noncontrolling Interest in Consolidated Net Income

39,000 10% $

3,900

Controlling Interest in Consolidated Income (2013) Palmer Company's net income from its independent operations

$ 100,000

Palmer Company's share of the adjusted income of Stevens Company (.9 X $39,000)

35,100

Controlling interest in Consolidated Net Income

Problem 5-6 Computation and Allocation of Difference Schedule Parent Share Purchase price and implied value Less: Book value of equity acquired Difference between implied and book value Equipment* Less:Accumulated Depreciation* Balance Goodwill Balance

$400,000 255,000 145,000 (76,500) 25,500 94,000 (94,000) -0-

*$400,000/.85

5 - 54

NonControlling Share 70,588 45,000 25,588 (13,500) 4,500 16,588 (16,588) -0-

Entire Value 470,588 * 300,000 170,588 (90,000) 30,000 110,588 (110,588) -0-

$ 135,100

Problem 5-6 (continued) *Schedule of Book Value and Fair Value on Date of Acquisition

Equipment Accumulated Depreciation Equipment (net)

Fair Value $450,000 1 150,000 2 $300,000

Book Value $360,000 120,000 $240,000

Fair Value Minus Book Value $90,000 3 30,000 4 $60,000

$300,000/($240/$360) = $450,000 $450,000  ($120/$360) = $150,000 3 $60,000/($240/$360) = $90,000 4 $90,000  ($120/$360) = $30,000 2

Allocation of Difference between Implied and Book Value Equipment (net) Goodwill Difference between Implied and Book Value

Annual Amount Amortization $60,000/6 yr $10,000 110,588 0 $170,588 $10,000

Part A Part 1 – Cost Method (1) Dividend Income ($30,000  0.85) Dividends Declared

25,500 25,500

(2) Beginning Retained Earnings - Silvas Company Common Stock - Silvas Company Difference between Implied and Book Value Investment in Silvas Company Noncontrolling Interest

210,000 90,000 170,588

(3) Depreciation Expense Equipment Goodwill Accumulated Depreciation - Equipment ($30,000 + $10,000) Difference between Implied and Book Value

10,000 90,000 110,588

Alternative to entry (3) (3a) Equipment Goodwill Accumulated Depreciation - Equipment Difference between Implied and Book Value

Depreciation Expense Accumulated Depreciation - Equipment

5 - 55

400,000 70,588

40,000 170,588

90,000 110,588 30,000 170,588

10,000 10,000

Problem 5-6 (continued) Part 2 – Partial Equity Method (1) Equity in Subsidiary Income ($40,000  0.85) Dividends Declared ($30,000  0.85) Investment in Silvas Company To eliminate intercompany dividends and income

34,000 25,500 8,500

(2) Beginning Retained Earnings - Silvas Company Common Stock - Silvas Company Difference between Implied and Book Value Investment in Silvas Company Noncontrolling Interest

210,000 90,000 170,588

(3) Depreciation Expense Equipment Goodwill Accumulated Depreciation - Equipment ($30,000 + $10,000) Difference between Implied and Book Value

10,000 90,000 110,588

400,000 70,588

Alternative to entry (3) (3a) Equipment Goodwill Accumulated Depreciation - Equipment Difference between Implied and Book Value

40,000 170,588

90,000 110,588 30,000 170,588

(3b) Depreciation Expense Accumulated Depreciation - Equipment

10,000 10,000

Part B Part 1 – Cost Method Cost Accumulated Depreciation Undepreciated Basis Sales Proceeds Gain (Loss)

Silvas Company $360,000 160,000 200,000 220,000 $ 20,000

Difference $90,000 40,000 50,000 $50,000

Consolidated $450,000 200,000 250,000 220,000 $(30,000)

(1) Investment in Silvas Company ($10,000  0.85) Beginning Retained Earnings - Perini Company To establish reciprocity/convert to equity as of 1/1/2012

8,500

(2) Dividend Income ($30,000  0.85) Dividends Declared-Silvas Company To eliminate intercompany dividends

25,500

5 - 56

8,500

25,500

Problem 5-6 (continued) (3) Beginning Retained Earnings-Silvas Co. 220,000 Common Stock -Silvas Company 90,000 Difference between Implied and Book Value 170,588 Investment in Silvas Company ($400,000 + $8,500) 408,500 Noncontrolling Interest ($70,588 + ($220,000 – $210,000) x .15) 72,088 To eliminate investment account and create noncontrolling interest account

(4) Beginning Retained Earnings-Perini Company Noncontrolling Interest Gain on Disposal of Equipment Loss on Disposal of Equipment Goodwill Difference between Implied and Book Value To allocate and depreciate difference between Implied and book value

8,500 1,500 20,000 30,000 110,588

Note: $20,000 Dr. to Gain + $30,000 Dr. to Loss = Unamortized difference associated with equipment on date sold to outsiders equals $60,000 - $10,000 =

$50,000

170,588

$50,000

Part B Part 2 – Partial Equity Method Cost Accumulated Depreciation Undepreciated Basis Sales Proceeds Gain (Loss)

Silvas Company $360,000 160,000 200,000 220,000 $20,000

Difference $90,000 40,000 50,000 $50,000

Consolidated $450,000 200,000 250,000 220,000 $(30,000)

(1) Equity in Subsidiary Income ($40,000  0.85) Investment in Silvas Company To eliminate intercompany dividends and income

34,000

(2) Investment in Silvas Company Dividends Declared-Silvas Company ($30,000  0.85) To eliminate intercompany dividends

25,500

34,000

25,500

(3) Beginning Retained Earnings-Silvas Co. 220,000 Common Stock -Silvas Company 90,000 Difference between Implied and Book Value 170,588 Investment in Silvas Company ($400,000 + $8,500) 408,500 Noncontrolling Interest ($70,588 + ($220,000 – $210,000) x .15) 72,088 To eliminate investment account and create noncontrolling interest account

5 - 57

Problem 5-6 (continued) (4)

Beginning Retained Earnings-Perini Company Noncontrolling Interest Gain on Disposal of Equipment Loss on Disposal of Equipment Goodwill Difference between Implied and Book Value To allocate and depreciate difference between implied and book value

8,500 1,500 20,000 30,000 110,588

Note: $20,000 Dr. to Gain + $30,000 Dr. to Loss = Unamortized difference associated with equipment on date sold to outsiders equals $60,000 - $10,000 =

$50,000

170,588

$50,000

Problem 5-7 Computation and Allocation of Difference Schedule Parent Share Purchase price and implied value Less: Book value of equity acquired Difference between implied and book value Equipment (net) Balance Goodwill Balance

$900,000 506,250 393,750 (135,000) 258,750 (258,750) -0-

NonControlling Share 300,000 168,750 131,250 (45,000) 86,250 (86,250) -0-

Entire Value 1,200,000 * 675,000 525,000 (180,000) 345,000 (345,000) -0-

*$900,000/.75 Amount of Difference Between Implied and Book Value Allocated to Equipment

Equipment Accumulated Depreciation Net

Fair Value $990,000 1 330,000 2 $660,000

Book Value $720,000 (240,000) $480,000

$660,000/($480/$720) = $990,000 $990,000  ($240/$720) = $330,000 3 $180,000/($480/$720) = $270,000 4 $270,000  ($240/$720) = $90,000 2

Annual Depreciation of Difference Equipment ($180,000/10)) = $18,000

5 - 58

Fair Value Minus Book Value $270,000 3 (90,000)4 $180,000

Problem 5-7 (Continued) Part A Investment in Sanchez Company Dividend Declared-Sanchez Co. ($120,000  0.75)

90,000 90,000

(1) Equity in Subsidiary Income (($123,000  0.75) – $13,500) Investment in Sanchez Company

78,750

(2) Beginning Retained Earnings-Sanchez Company Common Stock-Sanchez Company Difference between Implied and Book Value Investment in Sanchez Company Noncontrolling Interest To eliminate investment and create noncontrolling interest account

375,000 300,000 525,000

(3) Depreciation Expense Equipment Goodwill Accumulated Depreciation-Equipment ($90,000 + $18,000) Difference between Implied and Book Value To allocate and depreciate the difference between implied and book value

18,000 270,000 345,000

Alternative to entry (3) (3a) Equipment Goodwill Accumulated Depreciation-Equipment Difference between Implied and Book Value

78,750

900,000 300,000

108,000 525,000

270,000 345,000 90,000 525,000

(3b) Depreciation Expense Accumulated Depreciation-Equipment

18,000 18,000

Part B (1) & (2) Equipment Accumulated Depreciation Carrying Value 1/1/2011 Carrying Value 1/1/2013 Proceeds from Sale (Gain) Loss on Sale

Book Value $720,000 (240,000) $480,000  8/10 384,000 (450,000) $(66,000)

(3) Investment in Sanchez Company Noncontrolling interest Gain on Disposal of Equipment - Sanchez Loss on Disposal of Equipment Difference between Implied and Book Value

Difference $270,000 3 (90,000) $180,000

Consolidated $990,000 1 (330,000) $660,000  8/10 528,000 (450,000) $78,000 27,000 9,000 66,000 78,000 180,000

(4) In subsequent years, the $180,000 difference between implied and book value that was allocated to the equipment that was disposed of will be allocated between the controlling and noncontrolling interests, and debited to Investment in Sanchez Company (75%) and Noncontrolling Interest (25%). . 5 - 59

Problem 5-7 (continued) Note: The $66,000 reduction of the gain plus the $78,000 loss equals $144,000, which is equal to the unamortized difference associated with the equipment on the date it was sold to outsiders ($180,000 - $18,000 - $18,000 = $144,000)

Problem 5-8 Part A Computation and Allocation of Difference Schedule Parent Share Purchase price and implied value $3,100,000 Less: Book value of equity acquired 2,295,000 Difference between implied and book value 805,000 Inventory (42,500) Plant and Equipment (340,000) Land (425,000) Balance (excess of FV over implied value) (2,500) Gain 2,500 Increase Noncontrolling interest to fair value of assets Total allocated bargain Balance -0-

NonEntire Controlling Value Share 547,059 3,647,059 * 405,000 2,700,000 142,059 947,059 (7,500) (50,000) (60,000) (400,000) (75,000) (500,000) (441) (2,941) 441 -0-

2,941 -0-

*$3,100,000/.85 Amortization Schedule - Parent Inventory Plant and Equipment ($400,000/10 x .85) Gain Total

2011 $42,500 34,000 2,500 $79,000

2012 $0 34,000 0 $34,000

2011 $7,500 6,000 441 $13,941

2012 $0 6,000 0 $6,000

Amortization Schedule – Noncontrolling interest Inventory Plant and Equipment ($400,000/10 x .15) FV adjustment Total

5 - 60

Problem 5-8 (continued) Part B (1) - Cost method (1)

Investment in Savage ($110,000  .85) Beginning Retained Earnings – Patten

2011

2012 93,500 93,500

(2)

Beginning Retained Earnings – Savage 700,000 810,000 Common Stock – Savage 2,000,000 2,000,000 Difference between Implied and Book Value 947,059 947,059 Investment in Savage 3,100,000 3,193,500 Noncontrolling Interest [$547,059 + ($110,000 x .15)] 547,059 563,559

(3)

Beginning Retained Earnings – Patten ($42,500 + $34,000) Noncontrolling Interest ($7,500 + $6,000) Cost of Goods Sold 50,000 Depreciation Expense 40,000 Plant and Equipment ($400,000 – $40,000) 360,000 Land 500,000 Difference between Implied and Book Value 947,059 Gain on Acquisition (P’s share) 2,500 Beginning Retained Earnings – Patten (gain) Noncontrolling Interest 441

Alternative to entry (3) (3a) Beginning Retained Earnings – Patten Noncontrolling Interest Cost of Goods Sold Plant and Equipment Land Difference between Implied and Book Value Gain on Acquisition (P’s share) Beginning Retained Earnings – Patten (gain) Noncontrolling Interest (3b)

Beginning Retained Earnings – Patten Noncontrolling Interest Depreciation Expense Plant and Equipment (net)

76,500 13,500 40,000 320,000 500,000 947,059 2,500 441

42,500 7,500 50,000 400,000 500,000

400,000 500,000 947,059 2,500

947,059 2,500 441

441 34,000 6,000 40,000

40,000 40,000

80,000

Part B (2) – Partial Equity Method (1)

(2)

Equity in Sub. Income ($110,000)(.85), ($180,000)(.85) Investment in Savage Beginning Retained Earnings – Savage Common Stock – Savage Difference between Implied and Book Value Investment in Savage Noncontrolling Interest 5 - 61

2011 93,500 93,500 700,000 2,000,000 947,059

2012 153,000 153,000 810,000 2,000,000 947,059

3,100,000 547,059

3,193,500 563,559

Problem 5-8 (continued) (3) Beginning Retained Earnings – Patten Noncontrolling Interest ($7,500 + $6,000) Cost of Goods Sold Depreciation Expense Plant and Equipment Land Difference between Implied and Book Value Gain on Acquisition (P’s share) Beginning Retained Earnings – Patten (gain) Noncontrolling Interest Alternative to entry (3) (3a) Beginning Retained Earnings – Patten Noncontrolling Interest Cost of Goods Sold Plant and Equipment Land Difference between Implied and Book Value Gain on Acquisition (P’s share) Beginning Retained Earnings – Patten (gain) Noncontrolling Interest (3b)

Beginning Retained Earnings – Patten Noncontrolling Interest Depreciation Expense Plant and Equipment (net)

76,500 13,500 50,000 40,000 360,000 500,000

40,000 320,000 500,000 947,059 2,500

947,059 2,500 441

441

42,500 7,500 50,000 400,000 500,000

400,000 500,000 947,059 2,500

947,059 2,500 441

441 34,000 6,000 40,000

40,000 40,000

80,000

Part B (3) – Complete Equity Method 2011 17,000*

(1)

Equity in Subsidiary Income Investment in Savage *($110,000)(.85) – $42,500 – $34,000 **($180,000)(.85) – $34,000

(2)

Beginning Retained Earnings – Savage Common Stock – Savage Difference between Implied and Book Value Investment in Savage Noncontrolling Interest

(3)

Investment in Savage Noncontrolling Interest ($7,500 + $6,000) Cost of Goods Sold Depreciation Expense Plant and Equipment Land Difference between Implied and Book Value 5 - 62

2012 119,000** 17,000 119,000

700,000 2,000,000 947,059

810,000 2,000,000 947,059 3,100,000 547,059

3,193,500 563,559 76,500 13,500

50,000 40,000 360,000 500,000

40,000 320,000 500,000 947,059

947,059

Gain on Acquisition (P’s share) Beginning Retained Earnings – Patten (gain) Noncontrolling Interest Alternative to entry (3) (3a) Investment in Savage Noncontrolling Interest Cost of Goods Sold Plant and Equipment Land Difference between Implied and Book Value Gain on Acquisition (P’s share) Beginning Retained Earnings – Patten (gain) Noncontrolling Interest (3b)

Investment in Savage Noncontrolling Interest Depreciation Expense Plant and Equipment (net)

2,500 2,500 441

441

42,500 7,500 50,000 400,000 500,000

400,000 500,000 947,059 2,500

947,059 2,500 441

441 34,000 6,000 40,000

40,000 40,000

80,000

Part C Patten Corporation’s Income from its own operations Patten Corporation’s share of Savage Company’s Income (85%) Less: amortization/depreciation: Inventory Plant and Equipment Gain Consolidated Net Income

5 - 63

2011 $950,000 93,500

2012 $675,000 153,000

(42,500) (34,000) 2,500 $969,500

(34,000) 0 $794,000

Problem 5-9 Computation and Allocation of Difference Schedule Parent Share Purchase price and implied value 556,000 Less: Book value of equity acquired 294,000 Difference between implied and book value 262,000 Receivables 10,690 Inventory (48,000) Building (44,000) Accumulated Depreciation 35,200 Equipment 15,000 Accumulated Depreciation (11,250) Land (270,000) Bonds Payable * (49,640) Balance (excess of FV over implied value) (100,000) Gain 100,000 Increase Noncontrolling interest to fair value of assets Total allocated bargain Balance -0-

NonEntire Controlling Value Share 0 556,000 0 294,000 0 262,000 0 10,690 (0) (48,000) (0) (44,000) (0) 35,200 (0) 15,000 (0) (11,250) (0) (270,000) (0) (49,640) (0) (100,000) 0 -0-

100,000 -0-

Fair value of $300,000, 8%, Bonds Present Value of annuity of 1, 5%, 36 periods = 16.54685  $12,000 = $198,562 Present Value of annuity of 1, 5%, 36 periods = .17266  $300,000 = $51,798 $250,360 Part A (1) Beginning Retained Earnings-Sound Company 14,000 Common Stock-Sound Company 200,000 Premium on Common Stock-Sound Company 80,000 Difference Between Implied and Book Value 262,000 Investment in Sound Company 556,000 (2) Buildings Accumulated Depreciation-Equipment Land Cost of Goods Sold Interest Expense Unamortized Discount on Bonds Payable Depreciation Expense Equipment Loss on Write-down of Receivables Accumulated Depreciation-Buildings Gain on Acquisition Difference between Implied and Book Value

5 - 64

44,000 17,250a 270,000 48,000 1,062 b 48,578 c 1,600d 15,000 10,690 39,600e 100,000 262,000

Alternative to entry (2) (2a) Buildings Accumulated Depreciation-Equipment Land Cost of Goods Sold Unamortized Discount on Bond Payable Equipment Loss on Write-down of Receivables Accumulated Depreciation-Buildings Gain on Acquisition Difference between Implied and Book Value (2b) Depreciation Expense ($44,000/10) Accumulated Depreciation – Building Accumulated Depreciation – Equipment (15,000/2.5) Depreciation Expense (2c) Interest Expense Unamortized Discount on Bonds Payable

44,000 11,250 270,000 48,000 49,640 15,000 10,690 35,200 100,000 262,000 4,400 4,400 6,000 6,000 1,062 1,062

$11,250 +$6,000 = $17,250 [($250,360  0.05) – $12,000 + ($250,878  0.05) – $12,000] = $1,062 c $49,640 – $1,062 = $48,578 d (15,000/2.5) – ($44,000/10) = $1,600 e $35,200 + $4,400 = $39,600 b

Part B Pump Company's net income from its independent operations Pump Company's share of the reported income of Sound Company Less allocation and depreciation of Difference between Implied and Book Value assigned to: Increase cost of goods sold Increase interest expense Decrease on asset write-down Decrease depreciation Consolidated Net Income - 2011

5 - 65

$500,000 80,000

(48,000) (1,062) 10,690 1,600 $543,228

Problem 5-10 Computation and Allocation of Difference Schedule Parent NonEntire Share Controlling Value Share Taylor Purchase price and implied value $1,300,000 144,444 1,444,444 * Less: Book value of equity acquired 990,000 110,000 1,100,000 Difference between implied and book value 310,000 34,444 344,444 Inventory (67,500) (7,500) (75,000) Plant and equipment 0 0 0 Land (67,500) (7,500) (75,000) Balance 175,000 19,444 194,444 Goodwill (175,000) (19,444) (194,444) Balance -0-0-0-

Sanders 100% 800,000 700,000 100,000 0 (50,000) 0 50,000 (50,000) -0-

*$1,300,000/.90 Amortization Schedule for 2011 Inventory Plant and Equipment ($50,000/10 yr) Land

Sanders $0 5,000

Taylor $50,000 ($75,000  2/3) 0

Part A Investment in Sanders Cash

800,000 800,000

Investment in Taylor Cash

1,300,000 1,300,000

Cash Dividend Income (Sanders)

100,000

Cash ($200,000  .90) Dividend Income (Taylor)

180,000

100,000

180,000

5 - 66

Problem 5-10 (continued) Part B (1) Dividend Income Dividends Declared-Sanders

100,000 100,000

(2) Capital Stock- Sanders Retained Earnings-Sanders Difference between Implied and Book Value Investment in Sanders

500,000 200,000 100,000

(3) Depreciation Expense Plant and Equipment Goodwill Difference between Implied and Book Value

5,000 45,000 50,000

(4) Dividend Income ($200,000  0.90) Dividends Declared-Taylor

180,000

(5) Common Stock – Taylor Retained Earnings – Taylor Difference between Implied and Book Value Investment in Taylor Noncontrolling Interest

800,000 300,000 344,444 1,300,000 144,444

(6) Inventory ($75,000  1/3) Cost of Goods Sold Land Goodwill Difference between Implied and Book Value

25,000 50,000 75,000 194,444

Problem 5-11 Part A - Partial Equity Method Workpaper entries – Year 2010 (1) Equity in Subsidiary Income ($100,000)(.80) Dividends Declared ($25,000  .80) Investment in Salem Company To eliminate intercompany dividends and equity income (2) Beginning Retained Earnings - Salem Co. Common Stock - Salem Difference between Implied and Book Value Investment in Salem Company Noncontrolling Interest To eliminate investment account and create noncontrolling interest account

5 - 67

800,000

100,000

180,000

344,444

80,000 20,000 60,000

80,000 550,000 432,500 850,000 212,500

Problem 5-11 (continued) (3) Cost of Goods Sold Land Plant and Equipment Goodwill Difference between Implied and Book Value To allocate the difference between implied and book value

40,000 65,000 130,000 197,500

(4) Depreciation Expense ($130,000/5) Plant and Equipment

26,000

432,500

26,000

Part B - Partial Equity Method – Worksheet Entries – Year 2011 (1) Equity in Subsidiary Income ($110,000)(.80) Dividends Declared ($35,000  .80) Investment in Salem Company To eliminate intercompany dividends and income

88,000

155,000 550,000 432,500

32,000 8,000 65,000 130,000 197,500

(4) 1/1 Retained Earnings – Porter Company (previous year’s amount) Noncontrolling Interest Depreciation Expense ($130,000/5) Plant and Equipment

20,800 5,200 26,000

5 - 68

28,000 60,000

910,000 227,500

432,500

52,000

Problem 5-11 (continued) Cost of investment

Investment in Salem Corporation (Partial Equity) 850,000

2010 equity income (.8)($100,000) Balance 2010

80,000 910,000

2010 Dividends (.8)($25,000)

20,000

2011 equity income (.8)($110,000)

88,000

2011 Dividends (.8)($35,000)

28,000

Balance 2011

970,000

2012 equity income (.8)($170,000)

136,000 2012 Dividends (.8)($60,000)

48,000

Balance 2012

1,058,000

Part C T-account Calculation of Controlling and Noncontrolling Interest in Consolidated Income For Year Ended December 31, 2012 Non-Controlling Interest in Consolidated Income Additional depreciation of the difference between implied and Net income reported by Salem Company book value related to: Depreciation Expense ($130,000/5) 26,000 Goodwill Impairment ($197,500 – $150,000) 47,500 Adjusted income of Salem

170,000

96,500

Noncontrolling Ownership percentage interest

20%

Noncontrolling Interest in Consolidated Income

19,300

Controlling Interest in Consolidated Income Porter Company's net income from its independent operations ($236,000 reported net income less $136,000 equity in subsidiary income included therein) $100,000 Porter Company's share of the adjusted income of Salem Company (.8 X $96,500)

77,200

Controlling interest in Consolidated Net Income

$177,200

5 - 69

Problem 5-11 (continued) Part D Income Statement

Porter Salem Company Company

Eliminations Noncontrolling Consolidated Debit Credit Interest Balances

Sales $1,100,000 $450,000 Equity in Subsidiary Income 136,000 (1) 136,000 Total Revenue 1,236,000 450,000 Cost of Goods Sold 900,000 200,000 Depreciation Expense 40,000 30,000 (4) 26,000 Impairment Loss (5) 47,500 Other Expenses 60,000 50,000 Total Cost and Expense 1,000,000 280,000 Net/Consolidated Income 236,000 170,000 Noncontrolling Interest in Consolid. Income Net Income to Retained Earnings $236,000 $170,000 $209,500 Retained Earnings Statement 1/1 Retained Earnings: Porter Company

Salem Company Net Income from above Dividends Declared: Porter Company Salem Company 12/31/ Retained Earnings to Balance Sheet

$620,000

236,000

(3) (4)

$1,550,000

19,300* $19,300

32,000 41,600

$230,000 (2) 230,000 170,000 209,500

1,550,000 1,100,000 96,000 47,500 110,000 1,353,500 196,500 (19,300) $177,200

$546,400

19,300

(1) 48,000 $513,100 $48,000

(12,000) $7,300

(90,000)

177,200 (90,000)

(60,000) $766,000 $340,000

5 - 70

$633,600

Problem 5-11 (continued) Balance Sheet Cash Accounts Receivable Inventory Investment in Salem Comp.

Porter Salem Company Company $70,000 $65,000 260,000 190,000 240,000 175,000 1,058,000

Difference between Implied and Book Value Land 320,000 Plant and Equipment 360,000 280,000 Goodwill Total Assets $1,988,000 $1,030,000 Accounts Payable Notes Payable Common stock: Porter Company Salem Company Retained Earnings from above 1/1 Noncontrolling Interest in Net Assets 12/31 Noncontrolling Interest in Net Assets Total Liabilities and Equity

$132,000 90,000

Eliminations Debit Credit

(2) (3) (3) (3)

(1) (2) 432,500 (3) 65,000 130,000 (4) 197,500 (5)

Noncontrolling Interest

88,000 970,000 432,500

385,000 692,000 150,000 $2,227,000

78,000 47,500

$110,000 30,000

$242,000 120,000

1,000,000 766,000

Consolidated Balances $135,000 450,000 415,000 0

1,000,000 550,000 (2) 340,000 (3) (4)

$1,988,000 $1,030,000

550,000 513,100 8,000 (2) 10,400

$1,906,500

48,000 242,500 **

$1,906,500

5 - 71

7,300 224,100

633,600

$231,400

231,400 $2,227,000

Problem 5-11 (continued) Computation and Allocation of Difference Schedule Parent Share Purchase price and implied value Less: Book value of equity acquired Difference between implied and book value Equipment Land Inventory Balance Goodwill Balance

$850,000 504,000 346,000 (104,000) (52,000) (32,000) 158,000 (158,000) -0-

NonControlling Share 212,500 126,000 86,500 (26,000) (13,000) (8,000) 39,500 (39,500) -0-

Entire Value 1,062,500 * 630,000 432,500 (130,000) (65,000) (40,000) 197,500 (197,500) -0-

*$850,000/.80 Explanations of workpaper entries: (1) Equity in Subsidiary Income Dividends Declared ($60,000  .8) Investment in Salem Company To reverse the effect of parent company entries during the year for subsidiary dividends and income

136,000

(2) Beginning Retained Earnings - Salem Co. Common Stock – Salem Difference between Implied and Book Value Investment in Salem Company Noncontrolling Interest To eliminate investment account and create noncontrolling interest account

230,000 550,000 432,500

(3) Beginning Retained Earnings - Porter Company Noncontrolling Interest Land Plant and Equipment Goodwill Difference between Implied and Book Value To allocate the difference between implied and book value

32,000 8,000 65,000 130,000 197,500

(4) Beginning Retained Earnings - Porter Company (2)($20,800) Noncontrolling Interest (2)($5,200) Depreciation Expense ($130,000/5) Plant and Equipment, net

41,600 10,400 26,000

(5) Impairment Loss ($197,500 – $150,000) Goodwill To record goodwill impairment

47,500

48,000 88,000

970,000 242,500

432,500

78,000

47,500

5 - 72

Problem 5-11 (continued) Part E PORTER COMPANY AND SUBSIDIARY Consolidated Financial Statements For the Year Ended December 31, 2012 Consolidated Income Statement Sales Cost of Sales Gross Profit Expenses: Depreciation Expense Impairment Loss Other Expenses Consolidated Net Income Noncontrolling Interest in Consolidated Income Controlling Interest in Consolidated Net Income

$1,550,000 1,100,000 450,000 $96,000 47,500 110,000

Consolidated Statement of Retained Earnings Retained Earnings - Beginning of Year Add: Net Income

253,500 196,500 19,300 $177,200 $546,400 177,200 723,600 90,000 $633,600

Less Dividends Retained Earnings - End of Year PORTER COMPANY AND SUBSIDIARY Consolidated Statement of Financial Position December 31, 2012 Assets Current Assets: Cash Accounts Receivable Inventory Noncurrent Assets: Plant and Equipment (net) Land Goodwill Total Assets

$135,000 450,000 415,000 692,000 385,000 150,000

5 - 73

$1,000,000

1,227,000 $2,227,000

$242,000 120,000 362,000 231,400 1,000,000 633,600

1,865,000 $2,227,000

Problem 5-11 (continued) Part F If the subsidiary uses the LIFO assumption in pricing its inventory, a workpaper entry would be made each year debiting Inventory and crediting the Difference between Implied and Book Value, so long as there was no reduction in inventory quantities. The effect on the consolidated balances would be an additional $40,000 in inventory, with a corresponding additional $32,000 and $8,000 in beginning consolidated retained earnings and noncontrolling interest. The increase in inventory results from the additional amount assigned to the inventory account at acquisition, and will remain there because of the LIFO assumption. Beginning consolidated retained earnings and noncontrolling interest accounts are increased because under the LIFO assumption the $40,000 additional inventory has not passed through cost of goods sold. Part G Porter Company's retained earnings on 12/31/2012 Less Cumulative Effect to December 31, 2012 of the Assignment and Depreciation of the Difference between Implied and Book Value Assigned to: 2010 2011 2012 Inventory $32,000 $0 $0 Equipment 20,800 20,800 20,800 Goodwill 0 0 0 $52,800 $20,800 $20,800 Goodwill Impairment (2012) Controlling Retained Earnings on 12/31/2012

$766,000

(94,400) (38,000) $633,600

Problem 5-12 Computation and Allocation of Difference Schedule Parent Share Purchase price and implied value $1,000,000 Less: Book value of equity acquired 621,000 Difference between implied and book value 379,000 Equipment ($390,000 - $300,000) (81,000) Less: Accumulated Depreciation ($130,000 – $100,000) 27,000 Inventory ($210,000 - $160,000) (45,000) Land ($290,000 – $190,000) (90,000) Bond Discount ($205,556 – $150,000) (50,000) Balance 140,000 Goodwill (140,000) Balance -0-

*$1,000,000/.90

5 - 74

NonControlling Share 111,111 69,000 42,111 (9,000) 3,000 (5,000) (10,000) (5,556) 15,555 (15,555) -0-

Entire Value 1,111,111 * 690,000 421,111 (90,000) 30,000 (50,000) (100,000) (55,556) 155,555 (155,555) -0-

Problem 5-12 (continued) 2011 Amortization Schedule Equipment (10 year life) Inventory (sold in 2011) Bond Discount Total

5,400 45,000 50,000 100,400

600 5,000 5,556 11,156

6,000 50,000 55,556 111,556

2012 Amortization Schedule Equipment (10 year life) Inventory (sold in 2011) Bond Discount Total

5,400 0 0 5,400

600 0 0 600

6,000 0 0 6,000

*The Goodwill may also be calculated analytically as follows: Cost of Investment ($1,000,000/0.9) Fair value acquired Goodwill

$1,111,111 (955,556) $155,555

Part A 2011 Cost of Goods Sold Gain on Early Extinguishment of Debt Land Equipment Goodwill Accumulated Depreciation Difference between Implied and Book Value Depreciation Expense ($60,000/10) Accumulated Depreciation

50,000 55,556 100,000 90,000 155,555 30,000 421,111 6,000 6,000

To allocate and depreciate the difference between implied and book value Treatment of the Amount of the Difference Assigned to Bond Discount Date of Acquisition Unamortized Discount on Bonds Payable Difference between Implied and Book Value

5 - 75

55,556 55,556

Problem 5-12 (continued) 2011 Book entry to record retirement in 2011 on Stevens books Bonds Payable Cash Gain on Retirement of Debt

205,556 150,000 55,556

But from a consolidated point of view the gain should be $0: Bonds Payable Unamortized Discount on Bonds Payable Cash

205,556 55,556 150,000

So entry in Consolidated Statements Workpaper for year ended December 31, 2011 is: Gain on Retirement of Debt 55,556 Difference between Implied and Book Value 55,556 Workpaper entries in years after 2011: Beginning Retained Earnings-Palmer Noncontrolling Interest Difference between Implied and Book Value

5 - 76

50,000 5,556 55,556

Problem 5-12 (continued) Part B

Income Statement Sales Cost of Good Sold Gross Margin Depreciation Expense

PALMER COMPANY AND SUBSIDIARY Consolidated Statement Workpaper For the Year Ended December 31, 2013 Palmer Company

Stevens Company

$620,000 430,000 190,000 30,000

$340,000 240,000 100,000 20,000

60,000 100,000 40,500 140,500

35,000 45,000

Other Expenses Income from Operations Equity in Subsidiary Income Net/Consolidated Income Noncontrolling Interest in Income Net Income to Retained Earnings

$140,500

Statement of Retained Earnings 1/1Retained Earnings Palmer Company

$315,600

Stevens Company Net Income from above Dividends Declared Palmer Company Stevens Company 12/31Retained Earnings to Balance Sheet

140,500

Eliminations Dr. Cr.

(3b)

Noncontrolling Interest

$960,000 670,000 290,000 56,000

6,000

95,000 139,000 (1) 40,500

45,000 $45,000

3,900 * 3,900

46,500

(3a) 95,000 (3b) 10,800 $210,000 45,000

139,000 (3,900)* $135,100

$209,800

(2) 210,000 46,500

3,900

(120,000) $336,100

Consolidated Balances

135,100 (120,000)

(35,000) $220,000

5 - 77

362,300

(1) 31,500 31,500

(3,500) $400

$224,900

Problem 5-12 (continued)

Balance Sheet Cash Accounts Receivable Inventory Investment in Stevens Company Difference between Implied & Book Value Equipment Accumulated Depreciation

Palmer Company

Stevens Company

$201,200 221,000 100,400 1,027,000

$151,000 173,000 81,000

Noncontrolling Interest

450,000 300,000 (300,000) (140,000) 360,000

290,000

2,059,600

855,000

Accounts Payable Bonds Payable

$323,500 400,000

$135,000

$352,200 394,000 181,400

(2) 421,111 (3a) 90,000

(3) 421,111 840,000 (488,000)

(3a) 30,000 (3b) 18,000 (3a)100,000 (3a)155,555

750,000 155,555 2,185,155 $458,500 400,000

1,000,000 336,100

$2,059,600

Consolidated Balances

(1) 9,000 (2) 1,018,000

Land Goodwill Total Assets

Capital Stock: Palmer Company Stevens Company Retained Earnings from above 1/1 Nonconntrolling Interest in Net Assets 12/31 Noncontrolling Interest In Net Assets Total Liabilities and Equity

Eliminations Dr. Cr.

1,000,000 500,000 220,000

$855,000

(2) 500,000 362,300 (3a) 10,556 (3b) 1,200

$1,640,722

*Noncontrolling Interest in Consolidated Income = 0.10  $45,000 – $600 = $3,900 Explanations of workpaper entries are on separate page.

5 - 78

31,500 (2) 113,111

$1,640,722

400 101,355

224,900

$101,755

$101,755 $2,185,155

Problem 5-12 (continued) Explanations of workpaper entries: (1) Equity in Subsidiary Income 40,500 Dividends Declared ($35,000  .90) 31,500 Investment in Stevens Company 9,000 To reverse effect of parent company entries during the year for subsidiary dividends and income (2) Beginning Retained Earnings-Stevens Company 210,000 Common Stock-Stevens Company 500,000 Difference between Implied and Book Value 421,111 Investment in Stevens Company ($1,027,000 – $9,000) 1,018,000 Noncontrolling Interest ($111,111 + ($210,000 – $190,000) x .10) 113,111 To eliminate investment account and create noncontrolling interest account (3) Beginning Retained Earnings-Palmer Company [$45,000 + $50,000 + (2  $5,400)] 105,800 Noncontrolling Interest [$5,000 + $5,556 + (2 x $600)] 11,756 Depreciation Expense ($60,000/10) 6,000 Plant and Equipment 90,000 Land 100,000 a Goodwill 155,555 Accumulated Depreciation [$30,000 + (3  $6,000)] 48,000 Difference between Implied and Book Value 421,111 To allocate and depreciate the difference between implied and book value Alternative to entry (3) (3a) Beginning Retained Earnings-Palmer Company [$45,000 + $50,000 ] Noncontrolling Interest [$5,000 + $5,556] Equipment Land Goodwill Accumulated Depreciation Difference between Implied and Book Value (3b) Beginning Retained Earnings-Palmer Company Noncontrolling Interest ($600 x 2) Depreciation Expense ($60,000/10) Accumulated Depreciation [(3  $6,000)]

Part C Palmer Company's net income from its own operations Palmer Company's share of Stevens Company’s income (0.90  $39,000*) Controlling interest in consolidated net income *$45,000 – ($60,000/10) = $39,000 5 - 79

95,000 10,556 90,000 100,000 155,555 30,000 421,111 10,800 1,200 6,000 18,000

$100,000 35,100 $135,100

Problem 5-13 Part A Equipment Land Patents Revaluation Capital

61,467 40,978 102,444 204,889

Implied fair value ($800,000/0.9) Book Value ($300,000 + $164,000 + $220,000) Amount to push down Adjustment to: Equipment Land Patents

$204,889  0.30 $204,889  0.20 $204,889  0.50

$888,889 684,000 $204,889

= $61,467 = $40,978 = $102,444

Part B Worksheet entries (1) Common Stock - Sensor Other Contributed Capital - Sensor Retained Earnings – Sensor Revaluation Capital Investment in Sensor Noncontrolling Interest ($800,000/0.9 x 0.1)

5 - 80

300,000 164,000 220,000 204,889 800,000 88,889

Problem 5-13 (continued) Part B

Cash Receivables Inventory Investment in Sensor Company Buildings Equipment Land Patents Total Assets

PRESS COMPANY AND SUBSIDIARY Consolidated Balance Sheet Workpaper January 1, 2011 Press Sensor Company Company $265,000 $38,000 422,500 76,000 216,500 124,000 800,000 465,000 322,000 229,000 246,467 188,000 140,978 167,500 190,444 $2,753,500 $1,137,889

Liabilities: $667,000 $249,000 Common Stock: Press Company 700,000 Sensor Company 300,000 Other Contributed Capital: Press Company 846,000 Sensor Company 164,000 Retained Earnings: Press Company 540,500 Sensor Company 220,000 Revaluation Capital 204,889 Noncontrolling Interest in Net Assets Total Liabilities and Equity $2,753,500 $1,137,889

Eliminations Dr. Cr.

Noncontrolling Consolidated Interest Balances $303,000 498,500 340,500

(1) 800,000 787,000 475,467 328,978 357,944 $3,091,389 $916,000 700,000 (1) 300,000 846,000 (1) 164,000 540,500 (1) 220,000 (1) 204,889 $888,889

(1) 88,889 $888,889

(1) To eliminate the investment account and create noncontrolling interest account.

$88,889

88,889 $3,091,389

Problem 5-14 Net Assets $1,025,000 600,000 $425,000

Part A Imputed Fair Value ($820,000/0.8) Recorded Book Value ($100,000 + $500,000) Unrecorded Values Allocated to Identifiable Assets: Equipment Land Inventory Goodwill

$125,000 62,500 37,500

Entry on Books of WayDown Company, January 2, 2009: Inventory Equipment Land Goodwill Revaluation Capital

225,000 $200,000

37,500 125,000 62,500 200,000 425,000

Additional expense recorded on books of WayDown Company because of push down of values based on fair value of WayDown Company as a whole implied by the transaction 2009 $37,500 25,000 $62,500

Cost of Goods Sold Depreciation Expense ($125,000/5)

5 - 82

2010 $0 25,000 $25,000

2011 $0 25,000 $25,000

Problem 5-14 (continued) Part B

Income Statement Sales Dividend Income Total Revenue Cost of Goods Sold Expense Depreciation Expense Other Expenses Total Cost & Expense Net/Consolidated income Noncontrolling Interest In Income Net Income to Retained Earnings Statement of Retained Earnings 1/1Retained Earnings Push Company WayDown Company Net Income from above Dividends Declared Push Company WayDown Company 12/31Retained Earnings to Balance Sheet

PUSH COMPANY AND SUBSIDIARY Consolidated Statement Workpaper For the Year Ended December 31, 2009 Push Company

WayDown Company

Eliminations Dr. Cr.

$1,050,000 40,000 1,090,000

$400,000 400,000

1,450,000

$850,000 35,000 65,000 950,000 140,000

180,000 50,000 50,000 280,000 120,000

$140,000

$120,000

1,030,000 85,000 115,000 1,230,000 220,000 (24,000)* $196,000

$1,450,000

24,000 $24,000

$40,000

(1) 2,000 $102,500 120,000

(3) 102,500 40,000

$482,000 24,000

(100,000) $520,000

Consolidated Balances

(2) 40,000

$480,000 140,000

Noncontrolling Interest

196,000 (100,000)

(50,000) $172,500

5 - 83

(2) 40,000 $142,500 $42,000

(10,000) $14,000

$578,000

Problem 5-14 (continued) Balance Sheet Cash Accounts Receivable Inventory Investment in WayDown Company Land Plant and Equipment Goodwill Total assets Accounts Payable Notes Payable Revaluation Capital-WayDown Co. Capital Stock: Push Company WayDown Company Retained Earnings from above 1/1 Noncontrolling Interest in Net Assets 12/31 Noncontrolling Interest Total liabilities & equity

Push Company

WayDown Company

$ 80,000 250,000 230,000 820,000

$ 35,000 170,000 150,000

350,000 $1,730,000 $ 160,000 50,000

Eliminations Dr. Cr.

Noncontrolling Interest

$115,000 420,000 380,000 (1)

2,000

(3) 822,000

362,500 300,000 200,000 $1,217,500

362,500 650,000 200,000 $2,127,500

$ 100,000 20,000 425,000 (3) 425,000

$260,000 70,000

1,000,000 520,000

$1,730,000

Consolidated Balances

1,000,000 500,000 (3) 500,000 172,500 142,500

$1,217,500

* Noncontrolling Interest in Income = 0.20  $120,000 = $24,000 Explanations of workpaper entries are on separate page

5 - 84

$1,069,500

42,000 (3) 205,500 $1,069,500

14,000 205,500 $219,500

578,000 219,500 $2,127,500

Problem 5-14 (continued) Explanations of workpaper entries: (1) Investment in WayDown Beginning Retained Earnings - Push To establish reciprocity/convert to equity (.80  ($102,500 – $100,000)]

2,000

(2) Dividend Income Dividends Declared (.80)($50,000) To eliminate intercompany dividends

40,000

2,000

40,000

(3) 1/1 Retained Earnings - WayDown 102,500 Capital Stock - WayDown 500,000 Revaluation Capital 425,000 Investment in WayDown Company ($820,000 + $2,000) 822,000 Noncontrolling Interest [($820,000/0.8 x 0.2) + ($102,500 – $100,000) x .2)] 205,500 To eliminate investment account and create noncontrolling interest account

Part C (1) Consolidated net incomes are the same (2) Consolidated retained earnings are the same (3) & (4) Consolidated net assets and noncontrolling interest in consolidated net assets are the same

5 - 85

Problem 5-15 Computation and Allocation of Difference Schedule Parent Share Purchase price and implied value Less: Book value of equity acquired Difference between implied and book value Equipment Land Inventory Balance Goodwill Balance

$850,000 504,000 346,000 (104,000) (52,000) (32,000) 158,000 (158,000) -0-

NonControlling Share 212,500 126,000 86,500 (26,000) (13,000) (8,000) 39,500 (39,500) -0-

Entire Value 1,062,500 * 630,000 432,500 (130,000) (65,000) (40,000) 197,500 (197,500) -0-

*$850,000/.80 Complete Equity Method Workpaper entries – Year 2010 (1) Equity in Subsidiary Income (($100,000)(.80) – $32,000 – $20,800) Dividends Declared ($25,000  .80) Investment in Salem Company To eliminate intercompany dividends

27,200 20,000 7,200

80,000 550,000 432,500

(3) Cost of Goods Sold Land Plant and Equipment (5 year life) Goodwill Difference between Implied and Book Value To allocate the difference between implied and book value

40,000 65,000 130,000 197,500

(4) Depreciation Expense ($130,000/5) Plant and Equipment

26,000

850,000 212,500

432,500

26,000

5 - 86

Problem 5-15 (continued) Complete Equity Method – Worksheet Entries – Year 2011 (1) Equity in Subsidiary Income ($110,000)(.80) - $20,800 Dividends Declared ($35,000  .80) Investment in Salem Company To eliminate intercompany dividends and income

67,200

(2) Beginning Retained Earnings - Salem Co. ($80,000 + $75,000) Common Stock - Salem Difference between Implied and Book Value Investment in Salem Company ($850,000 + $80,000 – $20,000) Noncontrolling Interest ($212,500 + ($155,000 - $80,000)  .2) To eliminate investment account and create noncontrolling interest account

155,000 550,000 432,500

32,000 8,000 65,000 130,000 197,500

(4) Investment in Salem Company Noncontrolling Interest Depreciation Expense ($130,000/5) Plant and Equipment

20,800 5,200 26,000

28,000 39,200

910,000 227,500

432,500

52,000

5 - 87

Problem 5-15 (continued) Part C T-account Calculation of Controlling and Noncontrolling Interest in Consolidated Income For Year Ended December 31, 2012 Noncontrolling Interest in Consolidated Income Additional depreciation of the difference between implied and Net income reported by Salem Company book value related to: Depreciation Expense ($130,000/5) 26,000 Goodwill Impairment ($197,500 - $150,000) 47,500 Adjusted income of Salem

170,000

96,500

Noncontrolling Ownership percentage interest

20%

Noncontrolling Interest in Consolidated Income

19,300

Controlling Interest in Consolidated Income Porter Company's net income from its independent operations ($177,200 reported net income less $77,200 equity in subsidiary income included therein) $100,000 Porter Company's share of the adjusted income of Salem Company (.8 X $96,500)

77,200

Controlling interest in Consolidated Net Income

$177,200

5 - 88

Problem 5-15 (continued) Part D Income Statement

Porter Salem Company Company

Eliminations Noncontrolling Consolidated Debit Credit Interest Balances

Sales $1,100,000 $450,000 Equity in Subsidiary Income 77,200 (1) 77,200 Total Revenue 1,177,200 450,000 Cost of Goods Sold 900,000 200,000 Depreciation Expense 40,000 30,000 (4) 26,000 Impairment Loss (5) 47,500 Other Expenses 60,000 50,000 Total Cost and Expense 1,000,000 280,000 Net/Consolidated Income 177,200 170,000 Noncontrolling Interest in Consolid. Income Net Income to Retained Earnings $177,200 $170,000 $150,700 Retained Earnings Statement 1/1 Retained Earnings: Porter Company Salem Company Net Income from Above Dividends Declared: Porter Company Salem Company 12/31/ Retained Earnings to Balance Sheet

$1,550,000

19,300* $19,300

$546,400

1,550,000 1,100,000 96,000 47,500 110,000 1,353,500 196,500 (19,300) $177,200

$546,400

$230,000 (2) 230,000 177,200 170,000 150,700

19,300

(90,000)

177,200 (90,000)

(60,000) $633,600 $340,000

5 - 89

(1) 48,000 $380,700 $48,000

(12,000) $7,300

$633,600

Problem 5-15 (continued) Balance Sheet Cash Accounts Receivable Inventory Investment in Salem Comp.

Porter Salem Company Company $70,000 $65,000 260,000 190,000 240,000 175,000 925,600 (3) (4)

Difference between Implied and Book Value Land 320,000 Plant and Equipment 360,000 280,000 Goodwill Total Assets $1,855,600 $1,030,000 Accounts Payable Notes Payable Common stock: Porter Company Salem Company Retained earnings from above 1/1 Noncontrolling Interest in Net Assets 12/31 Noncontrolling Interest in Net Assets Total Liabilities and Equity

$132,000 90,000

(2) (3) (3) (3)

Eliminations Debit Credit

32,000 (1) 41,600 (2)

29,200 970,000

432,500 (3) 65,000 130,000 (4) 197,500 (5)

432,500

Noncontrolling Consolidated Interest Balances $135,000 450,000 415,000

385,000 692,000 150,000 $2,227,000

78,000 47,500

$110,000 30,000

$242,000 120,000

1,000,000 633,600

1,000,000 550,000 (2) 340,000 (3) (4)

$1,855,600 $1,030,000

550,000 380,700 8,000 (2) 10,400

$1,847,700

48,000 242,500 **

$1,847,700

5 - 90

7,300 224,100

633,600

$231,400

231,400 $2,227,000

Problem 5-15 (continued) Computation and Allocation of Difference Schedule Parent Share Purchase price and implied value Less: Book value of equity acquired Difference between implied and book value Equipment Land Inventory Balance Goodwill Balance

$850,000 504,000 346,000 (104,000) (52,000) (32,000) 158,000 (158,000) -0-

NonControlling Share 212,500 126,000 86,500 (26,000) (13,000) (8,000) 39,500 (39,500) -0-

Entire Value 1,062,500 * 630,000 432,500 (130,000) (65,000) (40,000) 197,500 (197,500) -0-

77,200

230,000 550,000 432,500

(3) Investment in Salem Company Noncontrolling Interest Land Plant and Equipment Goodwill Difference between Implied and Book Value To allocate the difference between implied and book value

32,000 8,000 65,000 130,000 197,500

(4) Investment in Salem Company (2)($20,800) Noncontrolling Interest (2)($5,200) Depreciation Expense ($130,000/5) Plant and Equipment, net

41,600 10,400 26,000

(5) Impairment Loss ($197,500 - $150,000) Goodwill To record goodwill impairment

47,500

48,000 29,200

970,000 242,500

432,500

78,000

47,500

5 - 91

Problem 5-15 - Part E PORTER COMPANY AND SUBSIDIARY Consolidated Financial Statements For the Year Ended December 31, 2012 Consolidated Income Statement Sales Cost of Goods Sold Gross Profit Expenses: Depreciation Expense Impairment Loss Other Expenses Consolidated Income Noncontrolling Interest in Consolidated Income Net Income

$1,550,000 1,100,000 450,000 $96,000 47,500 110,000

Consolidated Statement of Retained Earnings Retained Earnings - Beginning of Year Add: Net Income

253,500 196,500 19,300 $177,200 $546,400 177,200 723,600 90,000 $633,600

$135,000 450,000 415,000 692,000 385,000 150,000

5 - 92

$1,000,000

1,227,000 $2,227,000

$242,000 120,000 362,000 231,400 1,000,000 633,600

1,865,000 $2,227,000

Problem 5-15 (continued) Part F If the subsidiary uses the LIFO assumption in pricing its inventory, a workpaper entry would be made each year debiting Inventory and crediting the Difference between Implied and Book Value, so long as there was no reduction in inventory quantities. The effect on the consolidated balances would be an additional $40,000 in inventory, with a corresponding additional $32,000 and $8,000 in consolidated Retained Earnings and in the noncontrolling interest, respectively. The increase in inventory results from the additional amount assigned to the inventory account at acquisition, and will remain there because of the LIFO assumption. Both consolidated retained earnings and noncontrolling interest accounts are increased because under the LIFO assumption the $40,000 additional inventory has not passed through cost of goods sold. Part G Porter Company's retained earnings on 12/31/2012

$633,600

Consolidated Retained Earnings on 12/31/2012

$633,600

Problem 5-16 Computation and Allocation of Difference Schedule Parent Share Purchase price and implied value $1,000,000 Less: Book value of equity acquired 621,000 Difference between implied and book value 379,000 Equipment ($390,000 – $300,000) (81,000) Less:Accumulated Depreciation ($130,000 – $100,000) 27,000 Inventory ($210,000 – $160,000) (45,000) Land ($290,000 – $190,000) (90,000) Bond Discount ($205,556 – $150,000) (50,000) Balance 140,000 Goodwill (140,000) Balance -0-

NonControlling Share 111,111 69,000 42,111 (9,000) 3,000 (5,000) (10,000) (5,556) 15,555 (15,555) -0-

Entire Value 1,111,111 * 690,000 421,111 (90,000) 30,000 (50,000) (100,000) (55,556) 155,555 (155,555) -0-

600 5,000 5,556 11,156

6,000 50,000 55,556 111,556

*$1,000,000/.90 2011 Amortization Schedule Equipment (10 year life) Inventory (sold in 2011) Bond Discount Total

5,400 45,000 50,000 100,400

5 - 93

Problem 5-16 (continued) 2012 Amortization Schedule Equipment (10 year life) Inventory (sold in 2011) Bond Discount Total

5,400 0 0 5,400

600 0 0 600

6,000 0 0 6,000

*The Goodwill may also be calculated analytically as follows: Cost of Investment ($1,000,000/0.9) Fair value acquired Goodwill

$1,111,111 (955,556) $155,555

50,000 55,556 100,000 90,000 155,555 30,000 421,111 6,000 6,000

Treatment of the Amount of the Difference Assigned to Bond Discount Date of Acquisition Discount on Bonds Payable Difference between Implied and Book Value

55,556

2011 Book entry to record retirement in 2011 on Stevens books Bonds Payable Cash Gain on Retirement of Debt

205,556

But from the consolidated point of view, the gain should be $0: Bonds Payable Discount on Bonds Payable Cash

5 - 94

55,556

150,000 55,556

205,556 55,556 150,000

Problem 5-16 (continued) So entry in Consolidated Statements Workpaper for year ended December 31, 2011 is: Gain on Retirement of Debt 55,556 Difference between Implied and Book Value 55,556 Workpaper entries in years after 2011: Investment in Stevens Noncontrolling Interest Difference between Implied and Book Value

5 - 95

50,000 5,556 55,556

Problem 5-16 (continued) Part B

Income Statement Sales Cost of Good Sold Gross Margin Depreciation Expense

PALMER COMPANY AND SUBSIDIARY Consolidated Statement Workpaper For the Year Ended December 31, 2013 Palmer Company

Stevens Company

$620,000 430,000 190,000 30,000

$340,000 240,000 100,000 20,000

60,000 100,000 35,100 135,100

35,000 45,000

Other Expenses Income from Operations Equity in Subsidiary Income Net/Consolidated Income Noncontrolling Interest in Income Net Income to Retained Earnings

$135,100

Statement of Retained Earnings 1/1Retained Earnings Palmer Company

$209,800

Stevens Company Net Income from above Dividends Declared Palmer Company Stevens Company 12/31Retained Earnings to Balance Sheet

135,100

Eliminations Dr. Cr.

(3b)

Noncontrolling Interest

$960,000 670,000 290,000 56,000

6,000

95,000 139,000 (1) 35,100

45,000 $45,000

3,900 3,900

41,100

139,000 (3,900)* $135,100

$209,800

$210,000 45,000

(2) 210,000 41,100

3,900

(120,000) $224,900

Consolidated Balance

135,100 (120,000)

(35,000) $220,000

5 - 96

251,100

(1) 31,500 31,500

(3,500) $400

$224,900

Problem 5-16 (continued) Palmer Company

Stevens Company

Balance Sheet Cash Accounts Receivable Inventory Investment in Stevens Company

$201,200 221,000 100,400 915,800

$151,000 173,000 81,000

Difference between Implied & Book Value Equipment Accumulated Depreciation

450,000 300,000 (300,000) (140,000)

Land Goodwill Total Assets

360,000

290,000

1,948,400

855,000

Accounts Payable Bonds Payable

$323,500 400,000

$135,000

Capital Stock: Palmer Company 1,000,000 Stevens Company Retained Earnings from above 224,900 1/1 Nonconntrolling Interest in Net Assets 12/31 Noncontrolling Interest In Net Assets Total Liabilities and Equity $1,948,400

Eliminations Dr. Cr.

Noncontrolling Interest

Consolidated Balance $352,200 394,000 181,400

(3a) 95,000 (3b) 10,800 (2) 421,111 (3a) 90,000

(1) 3,600 (2) 1,018,000 (3a) 421,111 840,000 (488,000)

(3a) 30,000 (3b) 18,000 (3a)100,000 (3a)155,555

750,000 155,555 2,185,155 $458,500 400,000

1,000,000 500,000 220,000

$855,000

(2) 500,000 251,100 (3a) 10,556 (3b) 1,200 $1,635,322

*Noncontrolling Interest in Consolidated Income = 0.10  $45,000 - $600 = $3,900 Explanations of workpaper entries are on separate page.

5 - 97

31,500 (2) 113,111

$1,635,322

400 101,355

224,900

$101,755

$101,755 $2,185,155

Problem 5-16 (continued) Explanations of workpaper entries: (1) Equity in Subsidiary Income Investment in Stevens Company Dividends Declared ($35,000  .90) To reverse effect of parent company entries during the year for subsidiary dividends and income

35,100 3,600 31,500

(2) Beginning Retained Earnings-Stevens Company. 210,000 Common Stock-Stevens Company 500,000 Difference between Implied and Book Value 421,111 Investment in Stevens Company * 1,018,000 Noncontrolling Interest ($111,111 + ($210,000 – $190,000) x .10) 113,111 To eliminate investment account and create noncontrolling interest account * $1,000,000 + [$210,000 - $190,000)  .90)] (3) Investment in Stevens Company [$45,000 + $50,000 + (2  $5,400)] 105,800 Noncontrolling Interest [$5,000 + $5,556 + (2 x $600)] 11,756 Depreciation Expense ($60,000/10) 6,000 Plant and Equipment 90,000 Land 100,000 Goodwill 155,555 Accumulated Depreciation [$30,000 + (3  $6,000)] 48,000 Difference between Implied and Book Value 421,111 To allocate and depreciate the difference between implied and book value Alternative to entry (3) (3a) Investment in Stevens Company [$45,000 + $50,000] Noncontrolling Interest [$5,000 + $5,556] Equipment Land Goodwill Accumulated Depreciation Difference between Implied and Book Value (3b) Investment in Stevens Company Noncontrolling Interest ($600 x 2) Depreciation Expense ($60,000/10) Accumulated Depreciation [(3  $6,000)] Part C Palmer Company's net income from its own operations Palmer Company's share of Stevens Company’s income (0.90  $39,000) Controlling interest in consolidated Net Income *$45,000 – ($60,000/10) = $39,000 5 - 98

95,000 10,556 90,000 100,000 155,555 30,000 421,111 10,800 1,200 6,000 18,000 $100,000 35,100 $135,100

Problem 5-17 Part A Yearly Amortization (1) Price with a P/E ratio of 10: (10)($15,000) $150,000 Book Value of Equity Acquired ($100,000 – $17,000 – $18,000) 65,000 Excess of cost over book value 85,000 Allocated to: In-process R&D $30,000 Assets to fair value ($105,000 – $65,000) 40,000 70,000 Goodwill $15,000 Yearly amortization Decrease in income In-process R&D Depreciation expense Amortization expense Total decrease

Year 1 $30,000 4,000 0 $34,000

$4,000 0 $4,000

Year 2-10

Year 11-20

$4,000 0 $4,000

0 0 Yearly Amortization

(2) Price with a P/E ratio of 12: (12)($15,000) $180,000 Book value of equity acquired ($100,000 - $17,000 - $18,000) 65,000 Excess of cost over book value 115,000 Allocated to: In-process R&D $30,000 Assets to fair value ($105,000 – $65,000) 40,000 70,000 Goodwill $45,000 Yearly amortization Decrease in income In-process R&D Depreciation expense Amortization expense Total decrease

Year 1 $30,000 4,000 0 $34,000

5 - 99

$ 4,000 0 $4,000

Years 2-10

Years 11-20

4,000 0 $4,000

0 0

Problem 5-17 (continued) Part B (1) Decrease in income In-process R&D ($30,000/20) Depreciation expense Amortization expense Total decrease

Years 1-10 $1,500 4,000 0 $5,500

Years 11-20 $1,500

Decrease in income In-process R&D Depreciation expense Amortization expense Total decrease

Years 1-10 $1,500 4,000 ____ $5,500

Years 11-20 $1,500

0 $1,500

(2)

_____ $1,500

Under all scenarios, the future profitability of the acquisition is decreased. If the in-process R&D is amortized over 20 years, the future profits are decreased even more. Many managers hope that one-time charges to income are ignored by the market. In general, a profitable acquisition is one that generates a return greater than the cost of capital.

5 - 100

Problem 5-18 Part A Investment in Shah Company ($28  ) Common Stock ($2  25,500) Other Contributed Capital ($26  25,500)

714,000

Part B Dividend Income (.85  $90,000) Dividends Declared – Shah Company

76,500

Common Stock - S Other Contributed Capital - S 1/1 Retained Earnings - S Difference between Implied and Book Value Investment in Shah Company Noncontrolling Interest ($714,000/.85 x .15)

51,000 663,000

76,500 120,000 164,000 267,000 289,000 * 714,000 126,000

*$714,000/.85 – ($120,000 + $164,000 + $267,000) Inventory 28,000 Land 33,500 Plant Assets 100,000 Patents 105,000 Deferred Tax Asset ($60,000 x .35) 21,000 Goodwill* 154,775 * Premium on Bonds Payable 60,000 Deferred Tax Liability ($266,500 x .35) 93,275 Difference between Implied and Book Value 289,000 * $289,000 – [($28,000 + $33,500 + $100,000 + $105,000 - $60,000)  (−)]

5 - 101

Problem 5-18 (continued) Cost of Goods Sold Depreciation Expense ($100,000/10) Amortization Expense – Patents ($105,000/8) Premium on Bonds Payable ($60,000/10) Inventory Plant Assets Patents Interest Expense

28,000 10,000 13,125 6,000

Deferred Tax Liability* Deferred Tax Asset (35%  $6,000) Income Tax Expense

17,894

28,000 10,000 13,125 6,000

2,100 15,794

*(35%  ($28,000 + $10,000 + $13,125)) Part C Dividend Income (.85  $100,000) Dividends Declared - Shah

85,000 85,000

Investment in Shah Company 1/1 Retained Earnings - Pruitt Company (85%  ($393,000* – $267,000))

107,100 107,100

* $267,000 + $216,000 - $90,000 = $393,000 Common Stock - Shah 120,000 Other Contributed Capital - Shah 164,000 1 / 1 Retained Earnings – Shah ($267,000 + $216,000 - $90,000) 393,000 Difference between Implied and Book Value 289,000 Investment in Shah Company ($714,000 + $107,100) Noncontrolling Interest [$126,000 + ($216,000 – $90,000) x .15]

821,100 144,900

Note: The next two entries may be combined into one or separated into various components. The two approaches presented are only two of various ways to split the effects: Alternative One: 1/1 Retained Earnings - Pruitt Company* Noncontrolling Interest** Land Depreciation Expense Plant Assets ($100,000 – ($10,000  2)) Amortization Expense - Patents Patents ($105,000 – ($13,125  2)) Goodwill* Deferred Tax Asset ($21,000 – $2,100) Interest Expense Premium on Bonds Payable ($60,000 – ($6,000  2)) Deferred Tax Liability ($93,275 – $17,894) Difference between Implied and Book Value 5 - 102

24,931 4,400 33,500 10,000 80,000 13,125 78,750 154,775 18,900 6,000 48,000 75,381 289,000

Problem 5-18 (concluded) * ($28,000 + $10,000 + $13,125 – $6,000 – $15,794) x .85 ** ($28,000 + $10,000 + $13,125 – $6,000 – $15,794) x .15 Deferred Tax Liability (35%  ($10,000 + $13,125)) Deferred Tax Asset (35%  $6,000) Income Tax Expense Alternative Two: 1/1 Retained Earnings - Pruitt Company* Noncontrolling Interest Land Plant Assets Patents Goodwill Deferred Tax Asset Premium on Bonds Payable Deferred Tax Liability Difference between Implied and Book Value

8,094 2,100 5,994 23,800 4,200 33,500 100,000 105,000 154,775 21,000 60,000 93,275 289,000

* Inventory sold in prior year and reflected in cost of goods sold and hence retained earnings

Depreciation Expense 1/1 Retained Earnings - Pruitt Noncontrolling Interest Plant Assets (net)

10,000 8,500 1,500

Amortization Expense - Patent 1/1 Retained Earnings – Pruitt Noncontrolling Interest Patents

13,125 11,156 1,969

Premium on Bonds Payable Interest Expense 1/1 Retained Earnings - Pruitt Noncontrolling Interest

12,000

20,000

26,250

6,000 5,100 900

Deferred Tax Liability [35%  ($10,000 + $13,125)] + $17,894 25,988 Deferred Tax Asset (35%  $6,000) + $2,100 Income Tax Expense (($10,000 + $13,125 – $6,000)  ) 1/1 Retained Earnings – Pruitt ($15,794 x .85) Noncontrolling Interest ($15,794 x .15)

5 - 103

4,200 5,994 13,425 2,369

Chapter 5 CHAPTER FIVE – ALLOCATION AND DEPRECIATION OF DIFFERENCES BETWEEN IMPLIED AND BOOK VALUES I.

ALLOCATION OF DIFFERENCE BETWEEN IMPLIED AND BOOK VALUES TO ASSETS AND LIABILITIES OF SUBSIDIARY: ACQUISITION DATE A.

When consolidated financial statements are prepared, asset and liability values must be adjusted by allocating the differences between implied and book values to specific recorded or unrecorded tangible and intangible assets and liabilities. In the case of a wholly owned subsidiary, the following two steps are taken. 1. Step One: The difference between the implied value and book value is used first to adjust the individual assets and liabilities to their fair values on the date of acquisition. 2. Step Two: If, after adjusting identifiable assets and liabilities to fair values, a residual amount of difference remains, it is treated as follows: a. When the implied value exceeds the aggregate fair values of identifiable assets less liabilities, the residual amount will be positive (a debit balance). A positive residual difference is evidence of an unspecified intangible and is accounted for as goodwill. b. When the implied value is below the aggregate fair value of identifiable assets less liabilities, the residual amount will be negative (a credit balance). A negative residual difference is evidence of a bargain purchase, with the difference between acquisition cost and fair value designating the amount of the bargain. When a bargain acquisition occurs, some of the acquired assets have, in the past, been reduced below their fair values (as reflected after step 1). However, under FASB Statement No. 141R,“Business Combinations,” [ASC 805–30–25–2], the negative (or credit) balance should be recognized as an ordinary gain in the year of acquisition. Under this standard, no assets should be recorded below their fair values.

CASE 1: Implied Value “in Excess of” Fair Value of Identifiable Net Assets of a Subsidiary 1. Adjustment of Assets and Liabilities: Wholly Owned Subsidiaries (textbook page, 239) 2. Adjustment of Assets and Liabilities: Less than Wholly Owned Subsidiaries (textbook page, 240)

CASE 2: Implied Value “Less Than” Fair Value of Identifiable Net Assets of a Subsidiary; Less than Wholly Owned Subsidiaries 1.

The Computation and Allocation Schedule is started as usual, but a negative balance requires a gain the recording of a gain after adjusting the identifiable assets and liabilities to their fair values. Implied Value less than Book Value less than Fair Value of Identifiable Net Assets 1

Chapter 5 It is possible for the value implied by the acquisition cost to be less than the book value as well as the fair value of the net assets of the subsidiary. In that case, the difference between the implied and book value initially will be credited in the investment elimination workpaper entry. Adjust the assets upward (as usual. II.

EFFECT OF ALLOCATION, AMORTIZATION, AND DEPRECIATION OF DIFFERENCES BETWEEN IMPLIED AND BOOK VALUES ON CONSOLIDATED NET INCOME: YEAR SUBSEQUENT TO ACQUISITION A.

Depreciation and amortization in the consolidated income statement should be based on the values allocated to depreciable and amortizable assets in the consolidated balance sheet. When any portion of the difference between implied value and book value is allocated to such assets, recorded income must be adjusted in determining consolidated net income in current and future periods. This adjustment is needed to reflect the difference between the amount of amortization and/or depreciation recorded by the subsidiary and the appropriate amount based on consolidated carrying values.

The worksheet entries needed to ensure that all balance sheet and income statement accounts reflect the correct consolidated balances differ depending on which method the parent company uses to account for its investment: complete equity, partial equity, or cost. The correct consolidated balances will not differ, only the means of arriving at them. Thus, after the worksheet entries are made, the resulting balances should be identical under the three methods.

Much of the consolidating process is the same for all three methods, but important differences exist. Each of the following stand-alone sections presents the entire process. For those who are interested in focusing on only one or two of the three methods, the other sections may be omitted without loss of continuity. First, though, it is worth nothing that there are only three basic accounts that are reported differently in the books of the parent. A brief review of the entries made by the parent under the three methods (see opening of Chapter 4) reveals two of these accounts: the investment account itself and the income recognized from the subsidiary (dividend income or equity in subsidiary income). Since the amount of income recognized from the subsidiary is added into retained earnings of the parent each year, it follows that the third important account that differs among these methods is retained earnings of the parent.

Under all three methods, the worksheet entries will separate current year effects from the effects of the previous years because the current year income statement accounts are open and need to be reported separately and correctly. Hence, worksheet entries to retained earnings and to the noncontrolling interest in net assets will always adjust the balance at the beginning of the current year (or the date of acquisition, if it is the first year) under the cost and partial equity methods. Under the complete equity method, beginning retained earnings of the parent is the same as beginning

Chapter 5 consolidated retained earnings and hence needs no adjustment. Noncontrolling interest, however, will need adjustment under all three methods. Figures 5-1 through 5-3 present three years of entries for a parent company and for a consolidating worksheet under all three methods. III.

CONSOLIDATED STATEMENTS WORKPAPER - INVESTMENT RECORDED USING THE COST METHOD A.

Year of Acquisition a. Depreciation in the consolidated income statement should be based on the value assigned to the equipment in the consolidated balance sheet. Since the depreciation recorded by S Company is based on the book value of the equipment on its records, consolidated depreciation must be increased by a workpaper entry. b. The amount of the difference between implied and book values not allocated to specific identifiable assets or liabilities is treated in the consolidated financial statements as goodwill and is not amortized, but may give rise to impairment losses in future years (it must be reviewed at least annually for potential impairment). c. In Illustration 5-6 (see textbook, page 250), the calculation of noncontrolling interest is now affected by its share of the amortization and/or depreciation of the differences between implied and book values. d. If inventory is part of the Computation and Allocation Schedule adjustments, by the end of the first year, under FIFO cost flow assumption, the inventory that necessitated a workpaper adjustment would have been sold. The entry to Cost of Goods Sold is appropriate only in the year of acquisition. In subsequent years, consolidated Cost of Goods Sold will have been reflected in the consolidated income for the year of acquisition and hence consolidated retained earnings at the end of that year.

Years Subsequent to Acquisition a. Under the Cost Method, the parent company makes no entry for the reported income of the subsidiary. b. Eliminate the investment account against the equity accounts of S Company using equity balances at the beginning of the current year. c. In the investment elimination entry, the amount debited or credited to the Difference between Implied and Book Values is equal to the amount of the difference between implied value (cost divided by parent’s percentage) and book value on the date of acquisition. The amount does not change

Chapter 5

IV.

subsequent to acquisition and may be obtained from the Computation and Allocation Schedule. Both the entry to Investment in S and Noncontrolling Interest reflect one year of change since acquisition. To allocate and depreciate or amortize the differences between implied and book values, beginning consolidated retained earnings must be adjusted each year for the cumulative amount of depreciation and other deductions that have been made from consolidated net income because of the differences between implied and book values in the consolidated statements workpapers of prior years. By reducing previously reported consolidated net income, these workpaper adjustments also reduce previously reported consolidated retained earnings. The reduction of beginning consolidated retained earnings and noncontrolling interest is accomplished by a debit to the beginning retained earnings of the parent company and to Noncontrolling Interest in Equity in the consolidating statements’ workpaper. e.

COST METHOD ANALYSIS OF CONTROLLING AND NONCONTROLLING INTERESTS IN CONSOLIDATED NET INCOME AND RETAINED EARNINGS A.

In the preceding chapter, a t-account approach to the calculation of the controlling and noncontrolling interests in consolidated net income was presented. This approach must now be refined to accommodate the effect of the allocation and depreciation or amortization of the differences between implied and book values.

Consolidated net income is the parent company's income from its independent operations plus (minus) reported subsidiary income (loss) plus or minus adjustments for the period relating to the depreciation, amortization, or impairment of the differences between implied and book values.

Consolidated retained earnings is the parent company's cost basis retained earnings plus (minus) the parent company's share of the increase (decrease) in reported subsidiary retained earnings from the date of acquisition to the current date plus or minus the cumulative effect of adjustments to date relating to the depreciation or amortization of the differences between implied and book values.

CONSOLIDATED STATEMENTS WORKPAPER - INVESTMENT RECORDED USING PARTIAL EQUITY METHOD A.

In the preparation of consolidated financial statements, the recorded balances of individual assets, liabilities, and expense accounts must be adjusted to reflect the allocation and depreciation, amortization, and potential impairment of the differences between implied and book values. Although the equity methods (partial and complete) reflect the effects of certain transactions more fully than the cost method on the books of the parent, the adjustments have not been made to individual underlying asset or income statement accounts. For example, under the partial equity method, the parent records its equity

Chapter 5 in subsidiary income in its books, but it does not record the underlying revenue and expense accounts that combine to form that total. Also, under this method, the parent does not record excess depreciation or amortization arising in the acquisition in its investment account. These adjustments must be accomplished through the use of workpaper entries in the preparation of the consolidated statements workpaper.

VI.

Entries on Books of P Company - Year of Acquisition (textbook, page 260)

Entries on Books of P Company - Year Subsequent to Acquisition (textbook, page 260)

Workpaper Entries - Year of Acquisition (textbook, page 261)

Workpaper Entries - Year Subsequent to Acquisition – Partial Equity Method (textbook, page 263)

Under the partial equity method, there is no need to establish reciprocity. That feature was unique to the cost method, and in fact may be viewed as a sort of conversion to the equity method. In the investment elimination entry, the amount debited or credited to the Difference between Implied and Book Value is equal to the amount of the Difference between Implied and Book value on the date of acquisition. The amount does not change subsequent to acquisition and may be obtained from the Computation and Allocation Schedule.

PARTIAL EQUITY METHOD ANALYSIS OF CONTROLLING AND NONCONTROLLING INTERESTS IN CONSOLIDATED NET INCOME AND RETAINED EARNINGS A.

The t-account calculation of the controlling interest in consolidated net income does not differ between the cost and partial equity methods. The controlling interest in consolidated net income is the parent company's income from its independent operations plus (minus) its share of reported subsidiary income (loss) plus or minus its share of the adjustments for the period relating to the depreciation or amortization of the difference between implied and book value. The remaining share of income (loss) of the subsidiary plus or minus adjustments represents the non-controlling interest in consolidated net income.

When the parent company uses the partial equity method to account for its investment, the parent company's share of subsidiary income since acquisition is already included in the parent company's reported retained earnings. Consequently, consolidated retained earnings are calculated as the parent company's recorded partial equity basis retained earnings plus or minus the cumulative effect of the adjustments to date relating to the depreciation or amortization of the differences between implied and book value.

Chapter 5 VII.

CONSOLIDATED STATEMENTS WORKPAPER - INVESTMENT RECORDED USING COMPLETE EQUITY METHOD A.

In the preparation of consolidated financial statements, the recorded balances of individual assets, liabilities, and expense accounts must be adjusted to reflect the allocation and depreciation or amortization of the differences between implied and book values. When the parent accounts for its investment using the complete equity method, the parent records excess depreciation , amortization, and impairmentarising in the acquisition in its investment account. The income statement effects are recorded as adjustments to the amount recognized as “equity in subsidiary income” each year. Even under this method, however, adjustments are needed to record the effects in the proper accounts for the consolidated entity. For example, the account “equity in subsidiary income” will be eliminated in the consolidated financial statements, and the effects need to be shown directly in “depreciation expense” (or “amortization expense,” in the case of intangibles). Similarly, the investment account will be eliminated and the NCI recognized, and the adjustments for any differences between implied and book values need to be shown directly in the appropriate asset (inventory, land, equipment, patents, etc.) and/or liability accounts. These adjustments must be accomplished through the use of workpaper entries in the preparation of the consolidated statements workpaper.

Entries on Books of P Company - Year of Acquisition (textbook, page 270)

Entries on Books of P Company - Year Subsequent to Acquisition (textbook, page 270)

Workpaper Entries - Year of Acquisition (textbook, page 271)

Entries on Workpapers - Year Subsequent to Acquisition (textbook, page 274)

VIII. COMPLETE EQUITY METHOD ANALYSIS OF CONTROLLING INTEREST IN CONSOLIDATED NET INCOME AND RETAINED EARNINGS A.

When the parent uses the complete equity method, its reported income equals the controlling interest in consolidated net income. As with the other methods, this amount is the parent company's income from its independent operations plus (minus) its share of subsidiary income (loss) plus or minus its share of adjustments for the period relating to the depreciation,amortization, and impairment of the difference between implied and book values. Note that consolidated income, as opposed to the controlling interest in consolidated income, includes both the parent’s share and the noncontrolling interest in subsidiary income (loss).

Chapter 5

IX.

ADDITIONAL CONSIDERATIONS RELATING TO TREATMENT OF DIFFERENCE BETWEEN IMPLIED VALUE AND BOOK VALUE A. The additional considerations relating to the treatment of the difference between implied value and book value include allocation of the difference between implied value and book value to liabilities and to assets with fair values less than book values; the separate disclosure of accumulated depreciation; premature disposals of long-lived assets by the subsidiary; and depreciable assets used in manufacturing. B.

Allocation of Difference between Implied Value and Book Value to Debt 1. Adjustment of Contingent Liabilities and Reserves. Often an acquiring firm reassesses the adequacy of the acquired firm’s accounting for contingent liabilities, purchase commitments, reserves, etc. prior to its allocation of any difference between implied and book values. If the accounting for these items falls into a gray area of GAAP, the purchaser may decide to allocate some of the difference between implied and book values to adjust or create liability accounts. For example, suppose that the purchaser assesses a contingent liability of the acquired firm’s to be both probable and reasonably estimable, whereas the acquired firm had previously disclosed it only in a note because it was deemed reasonably possible (but not probable). By adjusting liabilities upward, the difference to be allocated to assets (and potentially to goodwill) is increased. 2. Allocation of Difference between Implied and Book Values to Long-Term Debt. Notes payable, long-term debt, and other obligations of an acquired company should be valued for consolidation purposes at their fair values. Quoted market prices, if available, are the best evidence of the fair value of the debt. If quoted market prices are unavailable, then management’s best estimate of the fair value may be based on fair values of debt with similar characteristics or on valuation techniques such as the present value of estimated future cash flows. The present value should be determined using appropriate market rates of interest at the date of acquisition. 3.

Allocating the Difference to Assets (Liabilities) with Fair Values Less (Greater) than Book Values 1.

Sometimes the fair value of an asset on the date of acquisition is less than the amount recorded on the books of the subsidiary. In this case the allocation of the difference between the fair value and the book value of the asset will result in a reduction of the asset. If the asset is depreciable, this difference will be amortized over the life of the asset as a reduction of depreciation expense. Likewise, the fair value of the long-term debt may be greater rather than less than its recorded value on the date of acquisition. In this case, entries are necessary to allocate the difference between the fair value and

Chapter 5

2. 3.

book value of the debt to unamortized bond premium and to amortize it over the remaining life of the debt as a reduction of interest expense. End of first year after acquisition (worksheet entries) (textbook page 282) End of second year after acquisition (worksheet entries) (textbook, page 283)

Reporting Accumulated Depreciation in Consolidated Financial Statements as a Separate Balance 1. In previous illustrations, we have assumed that any particular classification of depreciable assets will be presented in the consolidated financial statements as a single balance net of accumulated depreciation. When accumulated depreciation is reported as a separate balance in the consolidated financial statements, the workpaper entry to allocate and depreciate the difference between implied and book value must be slightly modified.

Disposal of Depreciable Assets by Subsidiary 1. Cost or Partial Equity Method (textbook page, 287) 2. Complete Equity Method (textbook page, 287) In the year of sale, any gain or loss recognized by the subsidiary on the disposal of an asset to which any of the difference between implied and book value has been allocated must be adjusted in the consolidated statements workpaper.

Depreciable Assets Used in Manufacturing 1. When the difference between implied and book value is allocated to depreciable assets used in manufacturing, workpaper entries necessary to reflect additional depreciation may be more complex, because the current and previous years’ additional depreciation may need to be allocated among work in process, finished goods on hand at the end of the year, and cost of goods sold. In practice, such refinements are often ignored on the basis of materiality, and all the current year's additional depreciation is charged to cost of goods sold.

PUSH DOWN ACCOUNTING A. Push down accounting is the establishment of a new accounting and reporting basis for a subsidiary company in its separate financial statements based on the purchase price paid by the parent company to acquire a controlling interest in the outstanding voting stock of the subsidiary company. This accounting method is required for the subsidiary in some instances such as in the banking industry, an industry overwhelmed by the frequency and extent of merger activity in recent years. 1. The valuation implied by the price of the stock to the parent company is "pushed down" to the subsidiary and used to restate its assets (including goodwill) and liabilities in its separate financial statements. 2. If all the voting stock is purchased, the assets and liabilities of the subsidiary company are restated so that the excess of the restated amounts of the assets (including goodwill) over the restated amounts of the liabilities equals the purchase price of the stock.

Chapter 5 3.

Push down accounting is based on the notion that the basis of accounting for purchased assets and liabilities should be the same regardless of whether the acquired company continues to exist as a separate subsidiary or is merged into the parent company's operations. Under push down accounting, the parent company's cost of acquiring a subsidiary is used to establish a new accounting basis for the assets and liabilities of the subsidiary in the subsidiary's separate financial statements. Because push down accounting has not been addressed in authoritative pronouncements of the FASB or its predecessors, practice has been inconsistent.

Arguments For and Against Push Down Accounting 1. Proponents of push down accounting believe that a new basis of accounting should be required following an acquisition transaction that results in a significant change in the ownership of a company's outstanding voting stock. 2. Those who oppose push down accounting believe that, under the historical cost concept, a change in ownership of an entity does not justify a new accounting basis in its financial statements. 3. Push down accounting is an issue only if the subsidiary is required to issue separate financial statements for any reason, for example, because of the existence of noncontrolling interests or financial arrangements with nonaffiliates. Three important factors that should be considered in determining the appropriateness of push down accounting are: a. Whether the subsidiary has outstanding debt held by the public. b. Whether the subsidiary has outstanding, a senior class of capital stock not acquired by the parent company. c. The level at which a major change in ownership of an entity should be deemed to have occurred, for example, 100%, 90%, 51%.

Status of pushing down accounting 1. The Task Force on Consolidation Problems, Accounting Standards Division of the AICPA, released an issues paper entitled, "Push Down Accounting" in 1979. The paper discussed the issues related to push down accounting and cited related literature. The paper also presented the conclusions of the Accounting Standards Executive Committee on the issues discussed in the paper. The majority of the Committee recommended the use of push down accounting where there had been at least a 90% change in ownership. 2. The SEC believes that purchase transactions that result in an entity becoming substantially wholly owned (as defined in Regulation S-X) should establish a new basis of accounting for the purchased assets and liabilities. When the form of ownership is within the control of the parent company, the basis of accounting for purchased assets and liabilities should be the same regardless of whether the entity continues to exist or is merged into the parent company’s operations. As a general rule, the SEC requires push down accounting when the ownership change is greater than 95% and objects to push down accounting when the ownership change is less than 80%.

Chapter 5

XI.

IFRS VS. U.S. GAAP ON RESEARCH AND DEVELOPMENT COSTS As mentioned previously, Research & Development costs that are in process at the time of an acquisition are capitalized at their estimated fair value and expensed over their expected useful life. U.S. GAAP and IFRS are similar in this regard. However, for Research & Development projects undertaken apart from an acquisition or subsequent to the acquisition, IFRS distinguish between research costs and development costs while U.S. GAAP generally expense both as incurred. A. Under U.S. GAAP, development costs are generally expensed as incurred (as part of R&D expense) unless the costs relate to activities for which there is an alternative future use. B. Under IFRS, development costs are capitalized if all of the following criteria are demonstrated (research costs are expensed): 1. The technical feasibility of completing the intangible asset, 2. The intention to complete the intangible asset, 3. The ability to use or sell the intangible asset, 4. How the intangible asset will generate future economic benefits (the entity should demonstrate the existence of a market or, if for internal use, the usefulness of the intangible asset), 5. The availability of adequate resources to complete the development, 6. The ability to measure reliably the expenditure attributable to the intangible asset during its development.

CHAPTER 6 Note: The letter A indicated for a question, exercise, or problem means that the question, exercise, or problem relates to the chapter appendix. ANSWERS TO QUESTIONS 1. No. If all of the merchandise sold by one affiliate to another has subsequently been sold to outsiders, the only effect that the elimination of intercompany sales of merchandise will have on the consolidated financial statements is to reduce consolidated sales and consolidated cost of sales by an equal amount. Consolidated net income will be unaffected. 2. The effect of eliminating profit on intercompany sales after deducting selling and administrative expenses rather than gross profit is to include selling and administrative expenses associated with the intercompany sale in consolidated inventories. Support for the gross profit approach is based on the proposition that consolidated inventory balances should include manufacturing costs only and that generally accepted accounting standards normally preclude the capitalization of selling and administrative costs. 3. $10,000 in intercompany profit should be eliminated on the consolidated statements workpaper $100,000 ($60,000 – = $10,000). After this elimination the merchandise will be included in the 2 $100,000 consolidated statements at its cost to the affiliated group of $50,000 ( ). 2 4. Yes. Although 100 percent elimination of intercompany profit has long been required in the preparation of consolidated financial statements, the adjustments to the noncontrolling interest described in this text were discretionary prior to the current standard. The FASB requires that these adjustments be allocated between the noncontrolling and controlling interests. 5. When the subsidiary is the intercompany seller, the unrealized profit is shown in the accounts of the sub (S Company). These accounts provide the starting point for the calculation of the noncontrolling share of current year earnings. Failure to eliminate unrealized profit would result in the overstatement of the noncontrolling share in profits. However, when the parent is the intercompany seller, the unrealized profit is shown in the accounts of the parent (P Company). Since the noncontrolling interest does not share in the earnings of P Company, the noncontrolling interest is not affected by the unrealized profit therein. 6. Noncontrolling interest in consolidated net assets at the beginning of the year is adjusted by debiting or crediting the subsidiary’s beginning retained earnings in the consolidated statements workpaper. 7. The only procedural difference in the workpaper entries relating to the elimination of intercompany profits when the selling affiliate is a less than wholly owned subsidiary is that the noncontrolling interest in the amount of intercompany profit in beginning inventory must be recognized by debiting or crediting the noncontrolling shareholders’ percentage interest in such adjustments to the beginning retained earnings of the subsidiary. 8. Controlling interest in consolidated net income is equal to the parent company’s income from its independent operations that has been realized in transactions with third parties plus its share of reported subsidiary income that has been realized in transactions with third parties and adjusted for its share of the amortization of the difference between implied and book value for the period.

6-1

9. It is important to distinguish between upstream and downstream sales because the calculation of noncontrolling interest in the consolidated financial statements differs depending on whether the intercompany sale giving rise to unrealized intercompany profit is upstream or downstream. 10. Profit relating to the intercompany sale of merchandise is recognized in the consolidated financial statements in the period in which the merchandise is sold to outsiders. It is recognized in the consolidated financial statements by reducing cost of goods sold (thus increasing gross profit and net income).

6-2

ANSWERS TO BUSINESS ETHICS CASE 1.

•

Independence of the auditor is essential in maintaining effective audits. When auditors are involved in non-audit services, their independence may be impaired (in essence they may be viewed as auditing their own work).

•

Many times auditors have to rely on management representation when no supporting evidence is available. Auditors’ involvement in non-audit services can help them gain sufficient familiarity with their client’s business and operational activities to reduce such dependencies and perhaps to lower audit risk.

•

The growing importance of non-audit service fees to the audit firms over time may have increased the potential for the auditors to lose independence, even to the extent of financial fraud involvement.

•

The increasing effort to reduce costs (in a competitive marketplace for audit services) imposes limitations on the scope of the audit work involved-- to avoid operating at a loss. Subsidizing any shortfall between audit revenues and audit costs with non-audit fees can help in overcoming such limitations.

•

Audit fees would have to increase if auditors are held liable to a greater degree. The increased fees would cover both increased auditor effort to detect errors and to cover the increased litigation settlements/insurance premiums. The additional benefits would be weighed against the costs.

•

Timeliness and accuracy present constant tradeoffs in any audit. Time and budget constraints may potentially result in an audit staff not performing sufficient work to meet deadlines. Further, excessive cost-cutting may cause audit work to be inappropriately reduced, which leads to increased reliance by auditors on client presentations to document areas where the data are not easily available. Such reliance can cause audit judgments to be inappropriately influenced. When factors outside their control cause auditors to rely on the representations of others, they should not be solely responsible for resulting errors. Legislation aimed at protecting auditors to some extent also serves to keep audits from becoming prohibitively expensive.

6-3

ANSWERS TO FINANCIAL STATEMENT ANALYSIS EXERCISES AFS6-1 Medianet intercompany eliminations A. If intercompany sales of inventory are not eliminated, consolidated sales are overstated by $862,677 and cost of goods sold are overstated by $862,677. Thus there is no impact on net income. The correct entry should be: Sales Purchases (Income Statement) or cost of goods sold

862,677 862,677

Because the financial statements are presented from the standpoint of the consolidated entity, any intercompany transactions must be eliminated. The consolidated financial statements report on transactions with entities and individuals outside the consolidated entity. B. The journal entry to correct the error is as follows: Revenues (income statement) 2,934,794 Unearned revenues (current liability) 2,934,794 Revenues are overstated by $2,934,794. This error would have no impact on cash flows since the cash collected would be properly recorded in cash from operations (although the lines in the cash from operation section would differ). Income would be lower and in section reporting the working capital adjustments, there would be an adjustment for the increase in unearned revenues needed to reconcile between net income and cash flow from operating activities. Working capital would be lower by $2,934,794. Working capital would be 3,916,885 less 6,561,474 less 2,934,794= -5,579,383. (Technically, working capital would not decrease by the amount of the adjustment since there would be an increase in a deferred tax asset). The unadjusted current ratio would be (3,916,885/6,561,474) = 0.597, after adjusted for the increase in unearned revenues, the adjusted current ratio would be (3,916,885/(6,561,474+2,934,794) = 0.412. Equity is negative for the company so computing the ratio of total liabilities to equity would not make a lot of sense. It might be better to compute the total liabilities to total assets ratio. The unadjusted total liabilities to assets ratio would be (6,561,474/4,043,246) = 1.6228. The adjusted total liabilities to assets ratio would be ((6,561,474+2,934,794)/4,043,246) = 2.349

6-4

AFS6-2 Green Mountain Coffee Roasters A. The correcting workpaper entries (in thousands of dollars) Purchases (Income Statement)* Sales

15,200

Ending inventory (Income Statement)* Inventory (Balance sheet)

5,792

15,200 5,792

* both of the debits in these journal entries could be to ‘Cost of Goods Sold’ since on the workpaper, both of these entries increase cost of goods sold. B. As reported, EPS is $0.54 or $24,702/45,943 = $0.54; ignoring acquisition-related expenses, adjusted EPS (excluding acquisition-related expenses) is $0.604 or ($24,702+3,070)/45,943 which just barely beats analysts’ expectations. However, after the correcting entries are made the adjusted EPS is 0.257, or ($24,702+3,070 - 0.614*20,992)/45,943 = 11,813/45,943. The tax adjustment of 0.614 was computed using the tax adjustment for the acquisition related costs as follows: 3,070/5,000 = 0.614. Thus after the correcting entries are made, Green Mountain did not beat analysts’ expectations.

6-5

ANSWERS TO EXERCISES Exercise 6-1 Part A (1) Sales

2,700,000 2,700,000

Purchases (Cost of Goods Sold) To eliminate intercompany sales of 2011 (2) 12/31 Inventory-Income Statement (Cost of Goods Sold) 12/31 Inventory (Balance Sheet) To eliminate unrealized intercompany profit in inventory

487,500 487,500

Exercise 6-2 Reported Net Income- S Company Noncontrolling Interest Percentage Noncontrolling Interest in Net Income

$ 525,000 0.20 $ 105,000

Exercise 6-3 2011 Reported net income

$ 30,000

$20,800 Unrealized intercompany profit included therein = $5,200; $5,200  0.25 = 4 Profit included in consolidated income Percentage interest Noncontrolling interest in consolidated income

2012 (Rounded to nearest dollar) Reported net income Intercompany profit included in beginning inventory, now realized $25,000 Unrealized intercompany profit included therein = $6,250; $6,250  0.25 = 4 Profit included in consolidated income Percentage interest Noncontrolling interest in consolidated income

6-6

(1,300) 28,700 0.10 $ 2,870 $ 35,000 1,300 (1,563) 34,737 0.10 $ 3,474

Exercise 6-4 The $600,000 that could not be assigned to specific assets and liabilities is assumed to represent goodwill (the unidentifiable intangible asset), which is not amortized under current GAAP but is reviewed periodically for impairment. In contrast, identifiable intangible assets would be amortized if they have a definite life but not if the life is indefinite in duration. Thus, only if the $600,000 pertained to an identifiable intangible asset with a finite life would amortization be required. We assume that is not the case here. 2011 Pearce Company's net income from its independent operations $90,000 Amount of income not realized in transactions with third parties ($90,000 – ) 1.25 Pearce Company's income from its independent operations that has been realized in transactions with third parties Pearce's share of Searl Company adjusted income that has been realized in transactions with third parties ($412,500*  0.80) Controlling interest in consolidated net income for 2011

$1,500,000 (18,000) 1,482,000 330,000* $1,812,000

*[$600,000 – ($75,000 + $112,500)] x 0.80 = 330,000, where $75,000 = $375,000/5 Alternatively, Controlling Interest in Consolidated Income Net income internally generated by Pearce Company Unrealized profit on downstream sales to Searl Company (ending Inventory) ($90,000 – $90,000/1.25)

$1,500,000

Realized profit (downstream sales) from begin. inventory 18,000 Pearce Company's percentage of Searl Company's income realized from third parties, .80($412,500) Controlling interest in Consolidated Income

2012 Pearce Company's net income from its independent operations Less profit included therein that has not been realized in transactions with third parties ($105,000 – ($105,000/1.25)) Plus profit realized in 2012 ($90,000 – ($90,000/1.25)) Pearce Company's income from its independent operations that has been realized in transactions with third parties Pearce's share of Searl Company adjusted income that has been realized in transactions with third parties ($675,0000  .80) Controlling interest in consolidated net income for 2012 *[$750,000 – $75,000] x 0.80 = $540,000, where $75,000 = $375,000/5

6-7

330,000 $1,812,000

$1,800,000 (21,000) 18,000 1,797,000 540,000 $2,337,000

Exercise 6-4 (continued) Alternatively, Controlling Interest in Consolidated Income Net income internally generated by Pearce Company

$1,800,000

Unrealized profit on downstream Realized profit (downstream sales) from begin. inventory sales to Searl Company (ending Inventory) 21,000 Pearce Company's percentage of Searl Company's income realized from third parties, .80($675,000) Controlling interest in Consolidated Income

18,000

540,000 $2,337,000

Exercise 6-5 2011 Pearce Company's income from its independent operations Plus: Pearce Company's interest in the realized net income of Searl Company: Reported Net income Less Amortization of difference between implied and book value ($75,000 + $112,500) $90,000 Less unrealized profit included therein ($90,000 ) 1.25 Income realized in transaction with third parties Pearce Company's interest therein (0.8  $394,500) Controlling interest in consolidated net income 2012 Pearce Company's income from its independent operations Plus: Pearce Company's interest in the realized net income of Searl Company: Reported Net income Less amortization of difference between implied and book value Less profit included therein that has not been realized in transactions $105,000 with third parties ($105,000 ) 1.25 $90,000 Plus profit realized in 2012 ($90,000 ) 1.25 Income realized in transaction with third parties Pearce Company's interest therein (0.8  $672,000) Controlling interest in consolidated net income

6-8

$1,500,000

$600,000 (187,500) (18,000) $394,500 $315,600 $1,815,600 $1,800,000

$750,000 (75,000) (21,000) 18,000 $672,000 537,600 $2,337,600

Exercise 6-6 Part A Payne Company's net income from its independent operations Sierra Company's net income from its independent operations Plus: profit realized from beginning inventory Less: unrealized profit in ending inventory Sierra Company's net income realized in transactions with third parties Payne Company's share thereof (1.00  $171,000) Santa Fe Company's net income from its independent operations Plus: profit realized from beginning inventory Less: unrealized profit in ending inventory Santa Fe Company's net income realized in transactions with third parties Payne Company's share thereof (0.80  $122,300) Controlling interest in consolidated net income

$280,000 $172,000 3,800 (4,800) $171,000 171,000 $120,000 4,600 (2,300) $122,300 97,840 $548,840

Exercise 6-7 Part A 2011 (1) Sales

450,000

Purchases (Cost of Goods Sold) To eliminate intercompany sales

450,000

(2) Ending Inventory – Income Statement (CoGS) 12/31 Inventory (Balance Sheet)

25,000 25,000

To eliminate intercompany profit in ending inventory ($150,000 2012 (1) Sales

$150,000 ) 1.20

486,000

Purchases (Cost of Goods Sold) To eliminate intercompany sales

486,000

(2) Beginning Retained Earnings-Perkins 25,000 Beginning Inventory – Income Statement (CoGS) 25,000 To recognize intercompany profit included in beginning inventory and reduce beginning consolidated retained earnings for unrealized intercompany profit at the beginning of the year (3) Ending Inventory – Income Statement (CoGS) 12/31 Inventory (Balance Sheet)

27,000 27,000

$162,000 To eliminate intercompany profit in ending inventory ($162,000 ) 1.20

6-9

Exercise 6-8 2011 (1) Sales Purchases (Cost of Goods Sold)

450,000 450,000

(2) Ending Inventory – Income Statement (CoGS) 12/31 Inventory (Balance Sheet) To eliminate intercompany profit in ending inventory ($150,000 - $150,000/1.2) 2012 (1) Sales

25,000 25,000

486,000

Purchases (Cost of Goods Sold) To eliminate intercompany sales

486,000

(2) 1/1 Retained Earnings-Perkins Company (85%)($25,000) 21,250 1/1 Noncontrolling Interest (15%)($25,000) 3,750 Beginning Inventory – Income Statement (CoGS) 25,000 To recognize intercompany profit in beginning inventory realized during the year and reduce controlling and noncontrolling interests for their share of unrealized intercompany profit at beginning of year. (3) Ending Inventory – Income Statement (CoGS) 27,000 12/31 Inventory (Balance Sheet) 27,000 To eliminate intercompany profit in ending inventory. ($162,000 - $162,000/1.2)

6 - 10

Exercise 6-9

PEAT COMPANY AND SUBSIDIARY Consolidated Income Statement For the Year Ended December 31, 2012

Sales ($14,000,000 - $1,400,000) Cost of Goods Sold (a) Operating Expense Consolidated Income Less Noncontrolling Interest in Consolidated Income (b) Controlling Interest in Consolidated Net Income

$12,600,000 $7,900,000 1,800,000

(a) Reported Cost of Goods Sold Less intercompany sales in 2012

9,700,000 2,900,000 210,000 $2,690,000 $9,200,000 (1,400,000)

2  ($1,400,000 - $900,000)) 5 1 Less realized profit in beginning inventory (  ($1,800,000 - $1,500,000)) 3 Corrected cost of goods sold

Plus unrealized profit in ending inventory (

200,000 (100,000) $7,900,000

 $200 ,000  (b) Reported net income of subsidiary  $2,000,000   0.1  Plus unrealized profit on subsidiary sales in 2011 that is considered realized in 2012 1 (  ($1,800,000 - $1,500,000)) 100,000 3 Less unrealized profit on subsidiary sales in 2012 (there were no upstream sales in 2012) 0 Income realized in transactions with third parties 2,100,000  0.10 Noncontrolling interest in consolidated income $210,000

6 - 11

ANSWERS TO ASC (Accounting Standards Codification) EXERCISES ASC6-1 Presentation If a firm uses the LIFO method to account for inventories, is the firm required to disclose the excess of replacement or current cost over the stated LIFO value? Alternative One: Step 1: Use the drop-down menus under the ‘Assets’ general topic on the homepage and choose ‘330 Inventory’; then under the second drop-down menu, choose ’10-overall’. Step 2: Click on Section 50 disclosure. Find paragraph 330-10-S50-1 and click on the link to SEC disclosure requirements (after paragraph 50-6). Find FASB ASC 210-10-S99-1 item 6(c), which states that if the LIFO inventory method is used, the excess of replacement or current cost over stated LIFO value shall, if material, be stated parenthetically or in a note to the financial statements. Alternative Two: Step 1: Using the search box, type ‘LIFO disclosures.’ There are 14 results returned. The first result takes you to FASB ASC 330-10-50-1. Scrolling through the paragraphs, click on the link to SEC disclosure requirements (after paragraph 50-6). Find FASB ASC 210-10-S99-1 item 6(c), which states that if the LIFO inventory method is used, the excess of replacement or current cost over stated LIFO value shall, if material, be stated parenthetically or in a note to the financial statements. ASC6-2 Presentation Suppose that a firm would like to adopt the LIFO method to account for its inventories, but it is not practical to determine the amounts assigned to major classes of inventories. Can the firm use the LIFO method? If so, what option is available? Step 1: Use the drop-down menus under the ‘Assets’ general topic on the homepage and choose ‘330 Inventory’; then under the second drop-down menu, choose ’10-overall’. Step 2: Click to expand the table of contents. Scroll looking for presentation issues. Click on Section S45 Other Presentation Matters.’ Then click on S45-1 for SEC guidance. Find FASB ASC 210-10-S99-1 item 6(a), if the method of calculating a LIFO inventory does not allow for the practical determination of amounts assigned to major classes of inventory, the amounts of those classes may be stated under cost flow assumptions other that LIFO with the excess of such total amount over the aggregate LIFO amount shown as a deduction to arrive at the amount of the LIFO inventory. ASC6-3 Glossary Define an extraordinary item. On the Codification homepage, click on ‘Master Glossary’ in the left-hand column. In the ‘glossary term quick find’ menu type ‘extraordinary items’ and hit return.’ Extraordinary items are events and transactions that are distinguished by their unusual nature and by the infrequency of their occurrence. Thus, both of the following criteria should be met to classify an event or transaction as an extraordinary item: a. Unusual nature. The underlying event or transaction should possess a high degree of abnormality and be of a type clearly unrelated to, or only incidentally related to, the ordinary and typical activities of the entity, taking into account the environment in which the entity operates. b. Infrequency of occurrence. The underlying event or transaction should be of a type that would not reasonably be expected to recur in the foreseeable future, taking into account the environment in which the entity operates. 6 - 12

ASC6-4 SEC A company that manufactures and sells a product excludes depreciation expense from the computation of cost of goods sold. The company computes the gross margin by subtracting this cost-ofgoods-sold number from sales. Is this a violation of current GAAP? Step One: In the advanced search box, enter ‘exclude depreciation cost goods sold’ and choose the ‘all words’ option. Thirteen results are obtained. Step Two: Narrow the search by clicking on the box next to ‘presentation’ to narrow by area. Click on the ‘225 Income Statement’ result and scroll through the paragraphs. The last paragraph contains the answer. FASB ASC 225-10-S99-8: If cost of sales or operating expenses exclude charges for depreciation, depletion and amortization of property, plant and equipment, the description of the line item should read somewhat as follows: "Cost of goods sold (exclusive of items shown separately below)" or "Cost of goods sold (exclusive of depreciation shown separately below)." ASC6-5 SEC There are 21 required line items to be reported on the income statement as determined by the SEC. Is a firm required to report its gross margin on the income statement? Step 1: Use the drop-down menus under the ‘Presentation’ general topic on the homepage and choose ‘225- Income Statement; then under the second drop-down menu, choose ’10-overall’. Step 2: Click on Section 45 Other Presentation Matters, and scroll through the paragraphs. Click on the link in paragraph S45-2 which takes you to the answer. FASB ASC 225-10-S99-2 provides the essential line items as required by the SEC. The gross margin is not required.

6 - 13

ANSWERS TO PROBLEMS Problem 6-1 Part A 2011 (1) Sales

436,000

Purchases (Cost of Goods Sold) To eliminate intercompany sales

436,000

(2) 12/31 Inventory (Income Statement) Inventory (Balance Sheet)

18,167

(1) Sales

532,000

18,167 $109,000 To eliminate unrealized intercompany profit in ending inventory ($109,000 – ) 1.2

2012

Purchases (Cost of Goods Sold) To eliminate intercompany sales

532,000

(2) Beginning Retained Earnings-Peel Co. (0.9  $18,167) Noncontrolling Interest (0.10  $18,167) 1/1 Inventory (Income Statement) To recognize gross profit in beginning inventory realized in 2012

16,350 1,817

(3) 12/31 Inventory (Income Statement) Inventory (Balance Sheet) To eliminate unrealized intercompany profit in ending inventory ($133,000 – ($133,000/1.2))

22,167

18,167

Part B Reported subsidiary income Add: Realized profit in beginning inventory Less: Unrealized profit in ending inventory Subsidiary income included in consolidated income Noncontrollong interest ownership percentage Noncontrolling interest in consolidated income Part C Peel Company's net income from independent operations Reported income of Seacore Company Less: Unrealized profit on intercompany sales of 2012 Add: Profit on 2011 sales to Peel realized in transactions with third parties Subsidiary income realized in transactions with third parties Peel 's share of subsidiary income (0.90  $126,000) Controlling interest in consolidated net income

6 - 14

22,167

$130,000 18,167 (22,167) 126,000  0.10 $12,600 $300,000 $130,000 (22,167) 18,167 $126,000 113,400 $413,400

Problem 6-2 Part A 2011 (1) Sales

442,500

Purchases (Cost of Goods Sold) To eliminate intercompany sales

442,500

(2) 12/31 Inventory (Income Statement) 44,250 Inventory (Balance Sheet) 44,250 To eliminate unrealized intercompany profit in ending inventory ($221,250  0.2) 2012 (1) Sales

386,250

Purchases (Cost of Goods Sold) To eliminate intercompany sales

386,250

(2) 12/31 Inventory (Income Statement) 15,450 12/31 Inventory (Balance Sheet) To eliminate intercompany profit in ending inventory ($77,250  0.20) (3) Beginning Retained Earnings-Plaster Co. (0.85  $44,250) 37,612 Noncontrolling Interest (0.15  $44,250) 6,638 1/1 Inventory (Income Statement) To recognize realization of intercompany profit in beginning inventory Part B Reported subsidiary income Add: Intercompany profit in beginning inventory Deduct Unrealized intercompany profit in ending inventory Subsidiary income realized in transactions with third parties and included in consolidated income Noncontrolling interest percentage Noncontrolling interest in consolidated income Part C Plaster's income from independent operations Reported income of Shell Company Add: Intercompany profit in beginning inventory Deduct: Unrealized profit in ending inventory Subsidiary Income realized in transactions with third parties Plaster's share of subsidiary income ($364,200  0.85) Controlling interest in consolidated net income

6 - 15

15,450

44,250

$335,400 44,250 (15,450) 364,200  0.15 $54,630 $780,000 $335,400 44,250 (15,450) $364,200 309,570 $1,089,570

Problem 6-3 Part A 2011 (1) Sales

265,000

Purchases (Cost of Goods Sold) To eliminate intercompany sales (2) 12/31 Inventory (Income Statement) 12/31 Inventory (Balance Sheet) To eliminate unrealized profit in ending inventory ($125,000 – 2012 (1) Sales

265,000 25,000 25,000 $125,000 ) 1.25

475,000

Purchases (Cost of Goods Sold) To eliminate intercompany sales

475,000

(2) 12/31 Inventory (Income Statement) 12/31 Inventory (Balance Sheet) To eliminate intercompany profit in ending inventory ($170,000 – ($170,000/1.25))

34,000

(3) Beginning Retained Earnings-Peer Co. 1/1 Inventory (Income Statement) To recognize intercompany profit in beginning inventory realized during the year

25,000

34,000

25,000

2011

2012

$225,000 20% $45,000

$275,000 20% $55,000

Part B Reported subsidiary income Noncontrolling interest ownership percentage Noncontrolling interest in consolidated income Part C Peer Company's income from independent operations Less: Unrealized profit in ending inventory Add: Realized profit in beginning inventory Peer Company's income realized in transactions with third parties Peer Company's share of subsidiary income ($275,000  0.8) Controlling interest in consolidated net income

6 - 16

2012 $480,000 (34,000) 25,000 471,000 220,000 $691,000

Problem 6-4 Part A (1) Sales

225,000

Purchases (Cost of Goods Sold) To eliminate intercompany sales for 2012 (2) Ending Inventory – Income Statement (CoGS) 12/31 Inventory (Balance Sheet) To eliminate unrealized profit in ending inventory

225,000 21,000

(3) Beginning Retained Earnings-Pace Company ($7,000 + ($8,000  0.85) + $8,000) 21,800 Noncontrolling Interest ($8,000  0.15) 1,200 Beginning Inventory – Income Statement (CoGS) To recognize gross profit in beginning inventory realized in current year Part B Consolidated income (a) Noncontrolling interest in consolidated income (b) Controlling interest in consolidated net income (c)

21,000

23,000 $477,000 21,450 $455,550

(a) ($475,000* + $23,000 – $21,000) (b) (0.15  ($150,000 + $8,000 – $15,000) (c) ($200,000 + ($7,000 – $2,000) + (0.85  ($150,000 + $8,000 – $15,000)) + ($125,000 + $8,000 – $4,000)) * ($200,000 + $150,000 + $125,000)

6 - 17

Problem 6-5 Part A

PRUITT CORPORATION AND SUBSIDIARY For the Year Ended December 31, 2013

Pruitt Sedbrook Corporation Company Income Statement Sales Dividend Income Total Revenue Cost of Goods Sold: Inventory, 1/1 Purchases Cost of Available for Sale Inventory, 12/31 Cost of Goods Sold Other Expense Total Cost and Expense Net/Consolidated Income Noncontrolling Interest In Consolidated Income Net Income to Retained Earnings Retained Earnings Statement 1/1 Retained Earnings: Pruitt Corporation Sedbrook Company Net Income from above Dividends Declared Pruitt Corporation Sedbrook Company 12/31/ Retained Earnings to Balance Sheet

Eliminations Debit Credit

$1,210,000 $636,000 (2) $250,000 31,500 (5) 31,500 1,241,500 636,000 165,000 935,000 1,100,000 220,000 880,000 198,000 1,078,000 163,500

132,000 420,000 552,000 144,000 (3) 408,000 165,000 573,000 63,000

25,000 250,000

272,000 1,105,000 1,377,000 354,000 1,023,000 363,000 1,386,000 210,000

10,000

$63,000

$291,500

$598,400

(4) 144,000 (6) 63,000

25,000 144,000 291,500

$1,596,000 1,596,000

(4) (2)

$163,500

163,500

Noncontrolling Consolidated Interest Balances

$275,000

(1)

6,300 $6,300

44,100

(6,300) $203,700

$617,500

275,000

6,300

31,500 $350,600

(3,500) $2,800

(110,000)

203,700 (110,000)

(35,000) $651,900 $172,000

6 - 18

(5) $460,500

$711,200

Problem 6-5 (continued) Balance Sheet Cash Accounts Receivable Inventory Investment in Sedbrook Comp. Other Assets Total Accounts Payable Other Liabilities Common stock: Pruitt Corporation Sedbrook Company Retained Earnings from above 1/1 Noncontrolling Interest in Net Assets 12/31 Noncontrolling Interest Total

Pruitt Sedbrook Corporation Company 90,800 96,000 243,300 135,000 220,000 144,000 625,500 (1) 550,000 480,000 $1,729,600 $855,000 77,000 120,700

Eliminations Debit Credit

(3) 44,100 (6)

Noncontrolling Consolidated Interest Balances 186,800 378,300 10,000 354,000 669,600 1,030,000 $1,949,100

36,000 47,000

113,000 167,700

880,000 651,900

880,000 600,000 (6) 172,000

600,000 460,500 (6)

$1,729,600 $855,000

6 - 19

1,104,600

350,600 74,400 1,104,600

2,800 74,400 77,200

711,200 77,200 $1,949,100

Problem 6-5 (continued) Explanations of workpaper entries (1) Investment in Sedbrook Company (0.90  ($144,000 – $95,000)) Beginning Retained Earnings - Pruitt Co. To establish reciprocity/convert to equity as of 1/1/13 (2) Sales

44,100 44,100 250,000

Purchases (Cost of Goods Sold) To eliminate intercompany sales

250,000

(3) Ending Inventory - Income Statement (CoGS) Ending Inventory (Balance Sheet) To eliminate unrealized intercompany profit in ending inventory ($60,000 – ($60,000/1.2)

10,000

(4) Beginning Retained Earnings - Pruitt Co. Beginning Inventory (Income Statement) To recognize intercompany profit in beginning inventory realized during the year

25,000

(5) Dividend Income ($35,000  .90) Dividends Declared To eliminate intercompany dividends

31,500

10,000

25,000

(6) Beginning Retained Earnings - Sedbrook Co. 144,000 Common Stock - Sedbrook Co. 600,000 Investment in Sedbrook Co.($625,500 + $44,100) Noncontrolling Interest ($744,000 x .10) To eliminate investment account and create noncontrolling interest account

6 - 20

31,500

669,600 74,400

Problem 6-5 (continued) Part B Pruitt Corporation's Retained Earnings on 12/31/13 Amount of Pruitt Corporation Retained Earnings that have not been realized in transactions with third parties Pruitt Corporation's Retained Earnings that have been realized in transactions with third parties Increase in retained earnings of Sedbrook Company that have been realized in transactions with third parties from 1/1/09 to 12/31/13 ($172,000 – $95,000) $ 77,000 Pruitt Corporation's share x .90 Consolidated Retained Earnings as of 12/31/13

$651,900 10,000 641,900

69,300 $711,200

Consolidated Retained Earnings Pruitt Corporation's Retained Earnings on 12/31/13 Pruitt Corporation's share of the increase in Sedbrook Company's Retained Earnings since acquisition ($172,000 - $95,000).90 Unrealized profit on downstream sales to Sedbrook Company (in Sedbrook's ending Inventory

$651,900

69,300

10,000 Consolidated Retained Earnings

6 - 21

$711,200

Problem 6-6

PRUITT CORPORATION AND SUBSIDIARY Consolidated Statements Workpaper For the Year Ended December 31, 2013 Consolidated Pruitt Sedbrook Eliminations Income Corporation Company Dr. Cr. Statement

Consolidated Retained Noncontrolling Consolidated Earnings Interest Balances

Debits Cash Accounts Receivable (net) Inventory 1/1 Investment in Sedbrook Company Other Assets Dividends Declared Pruitt Corporation Sedbrook Company Purchases Other Expenses Total Inventory 12/31 Total Assets

$ 90,800 243,300 165,000 625,500 550,000

$ 96,000 135,000 132,000

$186,800 378,300 (1) 44,100

(4) 25,000 (6) 669,600

272,000

480,000

1,030,000

110,000

(110,000)

935,000 198,000 2,917,600

35,000 420,000 165,000 1,463,000

(5) 31,500 (2) 250,000

$ 220,000

$ 144,000

(3) 10,000

77,000 120,700

36,000 47,000

(3,500) 1,105,000 363,000 354,000 $1,949,100

Credits Accounts Payable Other Liabilities Common Stock: Pruitt Corporation Sedbrook Company Retained Earnings Pruitt Corporation Sedbrook Company Sales Dividend Income Totals

113,000 167,700

880,000

880,000 600,000

(6)600,000

144,000 636,000

(4) 25,000 (6)144,000 (2)250,000 (5) 31,500

598,400 1,210,000 31,500 $2,917,600

Inventory 12/31 $ 220,000 Net/Consolidated Income Noncontrolling Interest in Consolidated Net Income Controlling Interest in Consolidated Net Income Consolidated Retained Earnings 1/1 Noncontrolling Interest in Net Assets 12/31 Noncontrolling Interest in Net Assets

(1) 44,100

617,500 (1,596,000)

$1,463,000 $ 144,000

(3) 10,000

(6) 74,400 _______ __ $1,104,600 $1,104,600

Total Liabilities and Equity *Noncontrolling Interest in Consolidated Income = 0.10  $63,000 = $6,300 See solution to Problem 6-5 for explanation of Workpaper entries

6-22

(354,000) 210,000 (6,300) $203,700

6,300 203,700 $711,200

711,200 74,400 $77,200

77,200 $1,949,100

Problem 6-7 Part A

PAQUE CORPORATION AND SUBSIDIARY Consolidated Statement Workpaper For the Year Ended December 31, 2013 Paque Corporation

Income Statement Sales Dividend Income Total revenue Cost of Goods Aold: Beginning Inventory Purchases Cost of Goods Available Less Ending Inventory Cost of Goods Sold Other Expenses Total Cost & Expense Net/Consolidated Income Noncontrolling Interest in Income Net Income to Retained Earnings Statement of Retained Earnings 1/1 Retained Earnings Paque Corporation Segal Company Net Income from above Dividends Declared Paque Corporation Segal Company 12/31 Retained Earnings to Balance Sheet

Segal Company

Dr.

Eliminations Cr.

1,650,000 54,000 1,704,000

795,000 (2) 300,000 (5) 54,000 795,000

225,000 1,275,000 1,500,000 210,000 1,290,000 310,500 1,600,500 103,500

165,000 525,000 690,000 172,500 (3) 517,500 206,250 723,750 71,250

103,500

71,250

369,000

345,000

(4) 40,500 (6) 180,000

(1) 27,000

180,000 71,250

369,000

345,000

811,500

103,500

Noncontrolling Consolidated Interest Balances 2,145,000 2,145,000

(4) 45,000 (2) 300,000 15,000

10,125* 10,125

798,000

10,125

(150,000) 589,500

(5) 54,000 426,000

*Noncontrolling Interest in Consolidated Income = 0.10  ($71,250 + $45,000 – $15,000) = $10,125

6-23

140,625 (150,000)

(60,000) 191,250

765,000

345,000 1,500,000 1,845,000 367,500 1,477,500 516,750 1,994,250 150,750 (10,125) 140,625

(6,000) 4,125

788,625

Problem 6-7(continued) Balance Sheet Cash Accounts Receivable Inventory Investment in Segal Company Other Assets Total assets Accounts Payable Other Current Liabilities Capital Stock: Paque Corporation Segal Company Retained Earnings from above 1/1 Noncontrolling Interest 12/31 Noncontrolling Interest Total liabilities & equity

Paque Corporation

Segal Company

Eliminations Dr. Cr.

Noncontrolling Consolidated Interest Balances

93,000 319,500 210,000 810,000 750,000 2,182,500

75,000 168,750 172,500 630,000 1,046,250

1,380,000 2,403,750

105,000 112,500

45,000 60,000

150,000 172,500

168,000 488,250 367,500

(3) 15,000 (1) 27,000 (6) 837,000

1,200,000 765,000

2,182,500

1,200,000 750,000 (6) 750,000 191,250 589,500 (4) 4,500 1,046,250

1,371,000

Explanations of workpaper entries are on next page

6-24

426,000 (6) 93,000 1,371,000

4,125 88,500 92,625

788,625 92,625 2,403,750

Problem 6-7 (continued) Explanation of workpaper entries (1) Investment in Segal (0.90  ($180,000 – $150,000)) Beginning Retained Earnings-Paque Co. To establish reciprocity as of 1/1/2013 (2) Sales

27,000 27,000 300,000

Purchases (Cost of Goods Sold) To eliminate intercompany sales

300,000

(3) Ending Inventory - Income Statement (CoGS) Ending Inventory (Balance Sheet) To eliminate unrealized intercompany profit in ending inventory ($75,000  0.20)

15,000

(4) Beginning Retained Earnings - Paque Co. ($45,000  0.90) Noncontrolling Interest ($45,000  0.10) Beginning Inventory To recognize intercompany profit realized during the year and to reduce controlling and noncontrolling interests for their share of unrealized profit at beginning of year

40,500 4,500

(5) Dividend Income ($60,000  0.90) Dividends Declared To eliminate intercompany dividends

54,000

(6) Beginning Retained Earnings- Segal Co. Common Stock - Segal Company Investment in Segal Company ($810,000 + $27,000) Noncontrolling Interest ($750,000 + $180,000) x .10 To eliminate investment account and create noncontrolling interest account

180,000 750,000

15,000

45,000

54,000

6-25

837,000 93,000

Problem 6-7 (continued) Part B PAQUE CORPORATION AND SUBSIDIARY Calculation of Controlling Interest in Net Income For Year Ended December 31,2013 Paque's net income from its independent operations ($103,500 reported income less $54,000 in subsidiary dividend income) Less: unrealized profit on 2013 sales to Segal Plus: profit on prior year's sales to Segal realized in transactions with third parties in 2013 Paque's income from its independent operations that has been realized in transactions with third parties Reported income of Segal Less amortization of difference between implied and book value Less: unrealized profit on 2013 sales to Paque Plus: profit on prior year's sales to Paque realized in transactions with third parties in 2013 Income of Segal that has been realized in transactions with third parties Paque's share of Segal’s income Controlling interest in Consolidated net income

$49,500 -0-0$49,500 $71,250 0 (15,000) 45,000 $ 101,250 90%

91,125 $140,625

Noncontrolling Interest in Consolidated Income Unrealized profit on upstream

Net income reported by Segal Company

sales in ending inventory

$ 71,250

15,000 Realized profit (upstream sales) from beginning inventory

Amortization of the difference between implied and book value

45,000

0 Subsidiary Income included in Consolidated Income

$101,250

Controlling Interest in Consolidated Income Net income internally generated by Paque Corporation Paque Corporation's percentage of Segal Company's income realized from third parties, .90($101,250) Controlling Interest in Consolidated Income

6-26

$ 49,500

91,125 $140,625

Problem 6-8 Part A (1) Sales

1,140,000

Purchases (Cost of Goods Sold) ($950,000  1.2) To eliminate intercompany sales for 2011

1,140,000

(2) 12/31 Inventory (Income Statement) 96,000 12/31 Inventory (Balance Sheet) To eliminate unrealized profit in ending Inventory ($576,000 – ($576,000/1.2)) (3) Common Stock - Sterling Company 800,000 Beginning Retained Earnings - Sterling Company 425,000 Difference between Implied and Book Value ($1,400,000/.90 – $1,225,000) 330,556 Investment in Sterling Company Noncontrolling Interest [($1,400,000/.90) x .10] (4) Depreciation Expense ($200,000/10) Plant and Equipment (net) ($200,000 – $20,000) 1/1 Inventory (Income Statement) Goodwill Difference between Implied and Book Value Alternative to entry (4) (4a) Plant and Equipment (net) 1/1 Inventory (Income Statement) Goodwill Difference between Implied and Book Value (4b) Depreciation Expense ($200,000/10) Plant and Equipment (net)

6-27

96,000

1,400,000 155,556

20,000 180,000 41,667 88,889 330,556

200,000 41,667 88,889 330,556 20,000 20,000

Problem 6-8 (continued) Part B Patten Company and Subsidiary Sterling Company Analytical Calculation of Controlling Interest in Consolidated Net Income For the Year Ended December 31, 2011 Patten Company's net income from its independent operations ($2,000,000 reported income less $0 in subsidiary dividend income) Less: Unrealized profit on 2011 sales to Sterling Company Plus: Profit on prior year's sales to Sterling Company realized in transactions with third parties in 2011 Patten Company's income from its independent operations that has been realized in transactions with third parties Reported income of Sterling Company Less: Amortization of the difference between implied and book value ($20,000 + $41,667) Less: Unrealized profit on 2011 sales to Patten Company Plus: Profit on prior year's sales to Patten Company realized in transactions with third parties in 2011 Income of Sterling Company that has been realized in transactions with third parties Patten Company's share Controlling interest in consolidated net income

$ 2,000,000 -0-02,000,000 410,000 (61,667) (96,000) -0$252,333 90%

227,100 $ 2,227,100

Part C Noncontrolling Interest In Consolidated Income Reported income of Sterling Company Less: Amortization of the difference between implied and book value ($20,000 + $41,667) Less: Unrealized profit on 2011 sales to Patten Company Income of Sterling Company included in consolidated income

$410,000

Noncontrolling interest share thereof (.1  $252,333)

$25,233

6-28

(61,667) (96,000) $252,333

Problem 6-9

Part A

Income Statement Sales Dividend Income Total Revenue Cost of Goods Sold: Inventory, 1/1 Purchases Cost of Available for Sale Inventory, 12/31 Cost of Goods Sold Other Expense Total Cost and Expense Net/Consolidated Income Noncontrolling Interest In Consolidated Income Net Income to Retained Earnings Retained Earnings Statement 1/1 Retained Earnings: Perry Company

PERRY COMPANY AND SUBSIDIARY Consolidated Statements Workpaper For the Year Ended December 31, 2010

Perry Company

Selby Company

$1,400,000 20,000 1,420,000

$800,000 (2) $310,000 (5) 20,000 800,000

230,000 900,000 1,130,000 450,000 680,000 250,000 930,000 490,000

145,000 (7) 380,000 525,000 200,000 (3) 325,000 195,000 (8) 520,000 280,000

$490,000

$1,500,000

Selby Company Net Income from above Dividends Declared

490,000

Perry Company Selby Company 12/31/ Retained Earnings to Balance Sheet

(50,000) $1,940,000

Eliminations Debit Credit

Noncontrolling Interest

Consolidated Balances $1,890,000 1,890,000

25,000 (4) (2)

12,000 310,000

16,400 15,000

$280,000

$386,400

$322,000

(4) (7) (8) 480,000 (6)

$9,600 (1) $84,000 20,000 12,000 480,000

280,000

386,400

50,400 * $50,400

388,000 970,000 1,358,000 633,600 724,400 460,000 1,184,400 705,600 (50,400) $655,200

$1,542,400

322,000

50,400

20,000 $426,000

(5,000) $45,400

655,200 (50,000)

(25,000) $735,000

(5) $908,000

* Noncontrolling interest in income = .2  ($280,000 + $12,000 – $25,000 – $15,000) = $50,400 6-29

$2,147,600

Problem 6-9 (continued) Balance Sheet Cash Accounts Receivable Inventory Investment in Selby Comp. Difference between Implied & Book Value Plant and Equipment Goodwill Other Assets Total Assets Accounts Payable Other Liabilities Common stock: Perry Company Selby Company Retained Earnings from above 1/1 Noncontrolling Interest in Net Assets 12/31 Noncontrolling Interest in Net Assets Total Liabilities and Equity

Perry Company

Selby Company

Eliminations Noncontrolling Consolidated Debit Credit Interest Balances

$ 95,000 302,000 450,000 990,000

$ 70,000 90,000 200,000

$ 165,000 392,000 633,600

(1) (6) 850,000 585,000 (7) (7) 390,000 230,000 $3,077,000 $1,175,000 $ 75,000 102,000

(3) 16,400 84,000 (6) 1,074,000 512,500 (7) 512,500 150,000 (8) 30,000 312,500

1,555,000 312,500 620,000 $3,678,100

$ 30,000 60,000

$ 105,000 162,000

960,000

350,000 (6) 350,000 1,940,000 735,000 908,000 426,000 (4) 2,400 (6) 268,500 (7) 5,000 (8) 3,000 $3,077,000 $1,175,000 $2,327,400 $2,327,400

Explanations of workpaper entries are on next page

6-30

45,400 258,100

2,147,600

$303,500

303,500 $3,678,100

Problem 6-9 (continued) Explanations of workpaper entries Computation and Allocation of Difference Schedule Parent Share Purchase price and implied value Less: Book value of equity acquired Difference between implied and book value Inventory ($210,000 - $ 160,000) Equipment ($780,000 - $ 630,000) Balance Goodwill Balance

$990,000 580,000 410,000 (40,000) (120,000) 250,000 (250,000) -0-

NonEntire Controlling Value Share 247,500 1,237,500 * 145,000 725,000 102,500 512,500 (10,000) (50,000) (30,000) (150,000) 62,500 312,500 (62,500) (312,500) -0-0-

*$990,000/.80 (1) Investment in Selby Company (0.80  ($480,000 – $375,000)) Beginning Retained Earnings - Perry Co. To establish reciprocity/convert to equity as of 1/1/10

84,000

(2) Sales

310,000

84,000

Purchases (Cost of Goods Sold) To eliminate intercompany sales

310,000

(3) Ending Inventory - Income Statement (CoGS) Ending Inventory (Balance Sheet) To eliminate unrealized intercompany profit in ending inventory ($82,000  .2)

16,400

(4) Beginning Retained Earnings - Perry Co. ($12,000  .80) Noncontrolling Interest ($12,000  .20) Beginning Inventory (Income Statement) To recognize intercompany profit in beginning inventory realized during the year ($60,000 – ($60,000/1.25)) = $12,000

9,600 2,400

(5) Dividend Income ($25,000  .80) Dividends Declared To eliminate intercompany dividends

20,000

(6) Beginning Retained Earnings - Selby Co. Common Stock - Selby Co. Difference between Implied and Book Value Investment in Selby Co. ($990,000 + $84,000) Noncontrolling Interest [$247,500 +.2 x ($480,000 – $375,000)]

480,000 350,000 512,500

16,400

12,000

20,000

6-31

1,074,000 268,500

Problem 6-9 (continued) (7) Equipment Beginning Inventory (Income Statement) Beginning Retained Earnings - Perry Co. Noncontrolling Interest Goodwill Difference between Implied and Book value (8) Other Expenses (Depreciation) ($150,000/10) Beginning Retained Earnings - Perry Co. Noncontrolling Interest Equipment

150,000 25,000 20,000 5,000 312,500 512,500 15,000 12,000 3,000 30,000

Part B Perry Company's Retained Earnings on 12/31/10 Amount of Perry Company Retained Earnings that have not been realized in transactions with third parties Perry Company's Retained Earnings that have been realized in transactions with third parties Increase in retained earnings of Selby Company from date of acquisition to 12/31/10 ($735,000 – $375,000) Less: Cumulative effect of adjustments to date relating to amortization of the difference between implied and book value ($50,000 + $30,000) Less:Unrealized profit on sales to Perry in 2010 that has not been realized by sales to third parties Increase in retained earnings of Selby Company since acquisition that has been realized in transactions with third parties Perry Company's share (.80  $280,000) Consolidated Retained Earnings as of 12/31/10

$1,940,000 (16,400) 1,923,600 360,000

(80,000) 0 280,000 80%

224,000 $2,147,600

Consolidated Retained Earnings Perry 's Share of unrealized profit on Perry 's Retained Earnings on 12/31/10 $1,940,000 downstream sales to Selby (in Selby's ending inventory), Increase in Selby’s Retained Earnings .2($82,000) 16,400 since acquisition ($735,000 - $375,000) = $360,000 Less: cumulative amortization of difference between implied and book value 80,000 Adjusted Increase $280,000 Perry’s share thereof .80 224,000 Consolidated Retained Earnings

6-32

$2,147,600

Problem 6-10 Part A 2011 Reported net income Unrealized profit therein Income included in consolidated income Percentage interest Noncontrolling interest in consolidated income

Salvador $50,000 (6,000) 44,000 0.1 $4,400

Sencal $60,000 (5,000) 55,000 0.2 $11,000

$15,400

2012 Reported net income Unrealized profit therein Profit realized in 2012 Income included in consolidated income Percentage interest Noncontrolling interest in consolidated income

$45,000 (10,000) 6,000 41,000 0.1 $4,100

$75,000 (2,000) 5,000 78,000 0.2 $15,600

$19,700

Part B 2011 Penn Company's net income from its own operations Amount of income not realized in transactions with third parties ($8,000 + $4,000) Penn Company's realized net income Salvador Company's net income $50,000 Less unrealized profit included therein (6,000) Salvador Company's realized income $44,000 Penn Company's share (.90  $44,000) Sencal Company's net income $60,000 Less unrealized profit included therein (5,000) Sencal Company's realized income $55,000 Penn Company's share (.80  $55,000) Controlling interest in consolidated net income 2012 Penn Company's net income from its own operations Less unrealized profit included therein ($5,000 + $9,000) Plus profit realized in 2012 Penn Company's realized net income Salvador Company's net income Less unrealized profit included therein Plus profit realized in 2012 Salvador Company's realized income Penn Company's share (.90  $41,000) Sencal Company's net income Less unrealized profit included therein Plus profit realized in 2012 Sencal Company's realized income Penn Company's share (.80  $78,000) Controlling interest in consolidated net income 6 - 33

Total

$600,000 (12,000) 588,000

39,600

44,000 $671,600

$400,000 (14,000) 12,000 398,000 $45,000 (10,000) 6,000 $41,000 36,900 $75,000 (2,000) 5,000 $78,000 62,400 $497,300

Problem 6-11 Part A

PRUITT CORPORATION AND SUBSIDIARY Consolidated Statement Workpaper For the Year Ended December 31, 2013 Pruitt Corporation

Income Statement Sales 1,100,000 Equity in subsidiary income 47,250 Total revenue 1,147,250 Cost of goods sold: Beginning inventory 150,000 Purchases 850,000 Cost of goods available 1,000,000 Less ending inventory 200,000 Cost of goods sold 800,000 Other expenses 180,000 Total cost & expense 980,000 Net/consolidated income 167,250 Noncontrolling interest in income Net income to retained earnings 167,250 Statement of Retained Earnings 1/1 Retained earnings Pruitt Corporation 562,000 Sedbrook Company Net income from above 167,250 Dividends declared Pruitt Corporation (100,000) Sedbrook Company 12/31 Retained earnings to balance sheet 629,250 *Noncontrolling interest in income = 0.10  $52,500 = $5,250

Sedbrook Company 530,000

Eliminations Dr. Cr.

Noncontrolling Interest

(2) 200,000 (1) 47,250

1,430,000

530,000 110,000 350,000 460,000 120,000 340,000 137,500 477,500 52,500

Consolidated Balances

1,430,000 (4) 30,000 (2) 200,000 (3) 10,000

52,500

257,250

120,000 52,500

(4) 30,000 (5) 120,000 257,250

230,000

5,250 * 5,250

230,000 1,000,000 1,230,000 310,000 920,000 317,500 1,237,500 192,500 (5,250)* 187,250

532,000 230,000

5,250

187,250 (100,000)

(30,000) 142,500

6-34

(1) 407,250

27,000 257,000

(3,000) 2,250

619,250

Problem 6-11 (continued) Balance Sheet Cash Accounts receivable Inventory Investment in Sedbrook Company Other assets Total assets Accounts payable Other liabilities Capital Stock: Pruitt Corporation Sedbrook Company Retained earnings from above 1/1 Noncontrolling interest 12/31 Noncontrolling interest Total liabilities & equity

Pruitt Corporation

Sedbrook Company

83,000 213,000 200,000 578,250

80,000 112,500 120,000

500,000 1,574,250

400,000 712,500

900,000 1,698,500

70,000 75,000

30,000 40,000

100,000 115,000

Eliminations Dr. Cr.

Noncontrolling Interest

163,000 325,500 310,000

(3) 10,000 (5) 558,000 (1) 20,250

800,000 629,250

1,574,250

Consolidated Balances

800,000 500,000 142,500

(5) 500,000 407,250

712,500

907,250

Explanations of workpaper entries are on next page

6-35

257,000 (5) 62,000 907,250

2,250 62,000 64,250

619,250 64,250 1,698,500

Problem 6-11 (continued) Explanation of workpaper entries (1) Equity in Subsidiary Income ($52,000 x .90) Investment in Sedbrook Company Dividends Declared ($30,000  .90) To reverse the effect of parent company entries during the year for subsidiary dividends and income (2) Sales

47,250 20,250 27,000

200,000

Purchases (Cost of Goods Sold) To eliminate intercompany sales

200,000

(3) Ending Inventory - Income Statement (CoGS) Ending Inventory (Balance Sheet) To eliminate unrealized intercompany profit in ending inventory ($50,000 – ($50,000/1.25))

10,000

(4) Beginning Retained Earnings- Pruitt Corporation Beginning Inventory(Income Statement) To recognize intercompany profit in beginning inventory realized during the year

30,000

10,000

(5) Beginning Retained Earnings- Sedbrook Co. 120,000 Common Stock - Sedbrook Company 500,000 Investment in Sedbrook Company ($578,250 - $20,250) Noncontrolling Interest ($500,000 + $120,000) x .10 To eliminate investment account and create noncontrolling account Part B Pruitt Corporation's retained earnings on 12/31/2013 Unrealized profit on downstream sales included therein Unrealized profit on upstream sales included therein Consolidated retained earnings on 12/31/2013

30,000

558,000 62,000

$ 629,250 (10,000) 0 $ 619,250

Consolidated Retained Earnings Pruitt’s Retained Earnings on 12/31/13

$629,250

Consolidated Retained Earnings

$619,250

Unrealized profit on downstream sales to Sedbrook (in Sedbrook's ending Inventory) 10,000

6-36

Problem 6-12

Debits

Pruitt Corporation

Cash Accounts Receivable(net) Inventory 1/1 Investment in Sedbrook Company

83,000 213,000 150,000 578,250

Other Assets Dividends Declared Pruitt Corporation Sedbrook Company Purchases Other Expenses Total

500,000

Inventory 12/31 Total assets Credits Accounts Payable Other Liabilities Common Stock: Pruitt Corporation Sedbrook Company Retained Earnings Pruitt Corporation Sedbrook Company Sales Equity in Subsidiary Income Totals

PRUITT CORPORATION AND SUBSIDIARY Consolidated Statements Workpaper For the Year Ended December 31, 2013 Sedbrook Eliminations Consolidated Company Dr. Cr. Income Stat. 80,000 112,500 110,000 (4) 30,000 230,000 (5) 558,000 (1) 20,250 400,000

100,000

Consolidated Ret. Earnings

Noncontrolling Interest

Consolidated Balances 163,000 325,500

900,000 (100,000)

850,000 180,000 2,654,250

30,000 350,000 137,500 1,220,000

(1) 27,000 (2) 200,000

200,000

120,000

(3) 10,000

70,000 75,000

30,000 40,000

(3,000) 1,000,000 317,500 310,000 1,698,500 100,000 115,000

800,000

800,000 500,000

(5) 500,000

120,000 530,000

(4) 30,000 (5) 120,000 (2) 200,000 (1) 47,250

562,000 1,100,000 47,250 2,654,250

Inventory 12/31 200,000 Net/Consolidated Income Noncontrolling Interest in Income Control. Interest. in Consol. Income Consolidated Retained Earnings Noncontrolling Interest in Net Assets

532,000 (1,430,000)

1,220,000 120,000

(3) 10,000

(310,000) 192,500 (5,250) 187,250 (5) 62,000

907,250 Total liabilities and Equity *Noncontrolling Interest in Consolidated Income = 0.10  52,500 = $5,250

6-37

5,250 187,250 619,250

619,250 62,250 64,250

64,250

907,250 1,698,500 See solution to Problem 6-11 for explanation of Workpaper entries

Problem 6-13 Part A

PAQUE CORPORATION AND SUBSIDIARY Consolidated Statement Workpaper For the Year Ended December 31, 2013 Paque Corporation

Income Statement Sales Equity in subsidiary income Total revenue Cost of goods sold: Beginning inventory Purchases Cost of goods available Less ending inventory Cost of goods sold Other expenses Total cost & expense Net/consolidated income Noncontrolling interest in income Net income to retained earnings Statement of Retained Earnings 1/1Retained earnings Paque Corporation Segal Company Net income from above Dividends declared Paque Corporation Segal Company 12/31 Retained earnings to balance sheet

Segal Company

Eliminations Dr.

1,650,000 64,125 1,714,125

795,000

225,000 1,275,000 1,500,000 210,000 1,290,000 310,500 1,600,500 113,625

165,000 525,000 690,000 172,500 517,500 206,250 723,750 71,250

113,625

71,250

379,125

180,000

(4) 40,500 (5) 180,000

(2) 300,000 (1) 64,125

71,250

379,125

2,145,000 (4) 45,000 (2) 300,000 (3)

15,000

345,000

10,125 * 10,125

345,000 1,500,000 1,845,000 367,500 1,477,500 516,750 1,994,250 150,750 (10,125) 140,625

798,000

345,000

10,125

(150,000) 802,125

Consolidated Balances 2,145,000

795,000

838,500

113,625

Cr.

Noncontrolling Interest

140,625 (150,000)

(60,000) 191,250

6-38

(1) 599,625

54,000 399,000

(6,000) 4,125

788,625

Problem 6-13 (continued)

Paque Corporation

Segal Company

Eliminations Dr. Cr.

Noncontrolling Interest

Consolidated Balances

Balance Sheet Cash Accounts Receivable Inventory Investment in Segal Company

93,000 319,500 210,000 847,125

75,000 168,750 172,500

Other Assets

750,000

630,000

1,380,000

2,219,625

1,046,250

2,403,750

105,000 112,500

45,000 60,000

150,000 172,500

Total assets Accounts Payable Other Current Liabilities Capital Stock: Paque Corporation Segal Company Retained Earnings from above 1/1 Noncontrolling Interest 12/31 Noncontrolling Interest Total liabilities & equity

168,000 488,250 367,500

(3) 15,000 (5) 837,000 (1) 10,125

1,200,000 802,125

2,219,625

1,200,000 750,000 191,250

1,046,250

(5) 750,000 599,625 (4) 4,500 1,354,125

399,000 (5) 93,000 1,354,125

*Noncontrolling Interest in Consolidated Income = 0.10  ($71,250 + $45,000 – $15,000) = $10,125 Explanations of workpaper entries are on next page.

6-39

4,125 88,500 92,625

788,625 92,625 2,403,750

Problem 6-13 (continued) Explanation of workpaper entries (1) Equity in Subsidiary Income ($71,250 x .90) Investment in Segal Company Dividends Declared ($60,000  0.90) To reverse the effect of parent company entries during the year for subsidiary dividends and income (2) Sales

64,125 10,125 54,000

300,000

Purchases (Cost of Goods Sold) To eliminate intercompany sales

300,000

(3) Ending Inventory - Income Statement (CoGS) Ending Inventory (Balance Sheet) To eliminate unrealized intercompany profit in ending inventory ($75,000  0.2).

15,000

(4) Beginning Retained Earnings - Paque Corporation ($45,000  0.90) Noncontrolling Interest ($45,000  0.10) Beginning Inventory -Income Statement (CoGS) To recognize intercompany profit realized during the year and to reduce controlling and noncontrolling interests for their share of unrealized profit at beginning of year

40,500 4,500

(5) Beginning Retained Earnings- Segal Co. Common Stock - Segal Company Investment in Segal Company ($847,125 - $10,125) Noncontrolling Interest ($750,000 +$180,000) x .10

180,000 750,000

15,000

45,000

Part B Paque Corporation's Retained Earnings on 12/31/2013 Unrealized profit on downstream sales included therein Unrealized profit on upstream sales included therein (0.90  $15,000) Consolidated retained earnings on 12/31/2013

837,000 93,000

$802,125 0 (13,500) $ 788,625

Consolidated Retained Earnings Paque's Share of unrealized profit on Paque 's Retained Earnings on 12/31/13 upstream sales from S Company (in Paque's ending inventory), .9($15,000) 13,500

Consolidated Retained Earnings Part C – Balances are the same as in Problem 6-7.

6-40

$802,125

$788,625

Problem 6-14 Part A

PERRY COMPANY AND SUBSIDIARY Consolidated Statement Workpaper For the Year Ended December 31, 2011 Perry Company

Income Statement Sales Equity in subsidiary income Total revenue Cost of goods sold: Beginning inventory Purchases Cost of goods available Less ending inventory Cost of goods sold Other expenses Total cost & expense Net/consolidated income Noncontrolling interest in income* Net income to retained earnings Statement of Retained Earnings 1/1 Retained earnings Perry Company

Eliminations Dr. Cr.

Noncontrolling Interest

Consolidated Balances

1,385,000 208,000 1,593,000

720,000 (2) 300,000 (1) 208,000 720,000

1,805,000

210,000 875,000 1,085,000 400,000 685,000 225,000 910,000 683,000

155,000 (6a) 37,500 (4) 9,000 360,000 (2) 300,000 515,000 225,000 (3) 15,600 290,000 170,000 (6a) 20,000 460,000 260,000

393,500 935,000 1,328,500 609,400 719,100 415,000 1,134,100 670,900 (42,300)) 628,600

683,000

1,472,700

Selby Company Net income from above Dividends declared Perry Company Selby Company 12/31 Retained earnings to balance sheet

Selby Company

683,000

260,000

581,100

1,805,000

309,000

42,300 42,300

(4) 7,200 (6a) 46,000 450,000 (5) 450,000 260,000

581,100

1,419,500

309,000

42,300

(40,000) 2,115,700

628,600 (40,000))

(30,000) 680,000

1,084,300

6-41

(1) 24,000 333,000

(6,000 ) 36,300

2,008,100

Problem 6-14 (continued) Balance Sheet Cash Accounts Receivable Inventory Investment in Selby Company

Perry Company

Selby Company

90,000 297,000 400,000 1,184,000

65,000 85,000 225,000

Difference between Implied & Book Value Plant and Equipment 880,000 Goodwill Other Assets 384,000 Total assets 3,235,000 Accounts Payable Other liabilities Capital Stock: Perry Company Selby Company Retained Earnings from above 1/1 Noncontrolling Interest in Net Assets 12/31Noncontrolling Interest Total liabilities & equity

24,300 95,000

Eliminations Dr. Cr.

540,000

(5) 400,000 (6a) 160,000 (6a) 125,000

Noncontrolling Consolidated Interest Balances 155,000 382,000 609,400

(3) 15,600 (1) 184,000 (5)1,000,000 (6a) 400,000

230,000 1,145,000

1,580,000 125,000 614,000 3,465,400

25,000 40,000

49,300 135,000

1,000,000 2,115,700

3,235,000

1,000,000 400,000 680,000

(5) 400,000 1,084,300 (6a) 11,500 (4) 1,800

1,145,000

2,182,600

333,000 (5) 250,000

2,182,600

*Noncontrolling Interest in Consolidated Income = 0.20  ($260,000 + $9,000 - $37,500 - $20,000) = $42,300. Explanations of workpaper entries are on next page.

6-42

36,300 236,700

2,008,100

273,000

273,000 3,465,400

Problem 6-14 (continued) Computation and Allocation of Difference Schedule Parent Share Purchase price and implied value Less: Book value of equity acquired Difference between implied and book value Inventory ($230,000 - $ 155,000) Equipment ($800,000 - $ 600,000) Balance Goodwill Balance

$960,000 640,000 320,000 (60,000) (160,000) 100,000 (100,000) -0-

NonEntire Controlling Value Share 240,000 1,200,000 * 160,000 800,000 80,000 400,000 (15,000) (75,000) (40,000) (200,000) 25,000 125,000 (25,000) (125,000) -0-0-

*$960,000/.80 Explanation of workpaper entries (1) Equity in Subsidiary Income Dividends Declared ($30,000  0.80) Investment in Selby Company To reverse the effect of parent company entries during the year for subsidiary dividends and income (2) Sales

208,000 24,000 184,000

300,000

Purchases (Cost of Goods Sold) To eliminate intercompany sale

300,000

(3) Ending Inventory - Income Statement (CoGS) Ending Inventory (Balance Sheet) To eliminate unrealized intercompany profit in ending inventory ($78,000  0.2).

15,600

(4) Beginning Retained Earnings- Perry Co. ($9,000  0.80) Noncontrolling Interest ($9,000  0.20) Beginning Inventory –Income Statement (CoGS) *($54,000 - ($54,000/1.2)) To recognize intercompany profit realized during the year and to reduce the controlling and noncontrolling interests for their share of unrealized profit at beginning of year.

7,200 1,800

15,600

(5) Beginning Retained Earnings- Selby Company 450,000 Common Stock - Selby Company 400,000 Difference between Implied and Book Value 400,000 Investment in Selby Company [$960,000 + ($450,000 - $400,000) x .80] Noncontrolling Interest [$240,000 + ($450,000 - $400,000) x .20]

6-43

9,000*

1,000,000 250,000

Problem 6-14 (continued) (6) Beginning Inventory (Income Statement ) Beginning Retained Earnings- Perry Company Noncontrolling Interest ($37,500 x .20) Plant and Equipment Goodwill Difference between Implied and Book Value To allocate the difference between implied and book value a $75,000  (1/2) = $37,500 (7) Other Expenses Beginning Retained Earnings- Perry Company Noncontrolling Interest ($20,000 x .20) Plant and Equipment (2  $20,000))

37,500 30,000 7,500 200,000 125,000

400,000

20,000 16,000 4,000

40,000

Alternative to entries (6) and (7) (6a) Beginning Retained Earnings- Perry Company 46,000 c Noncontrolling Interest 11,500 d Beginning Inventory -Income Statement (CoGS) 37,500 a Other Expenses 20,000 b Plant and Equipment ($200,000 – (2  $20,000)) 160,000 Goodwill 125,000 Difference between Implied and Book Value 400,000 To allocate, amortize and depreciate the difference between implied and book value $75,000  (1/2) = $37,500 $200,000/10 = $20,000 c $30,000 + $16,000 = $46,000 – ($37,500 x .80 = $30,000) and ($20,000 x .80 = $16,000) d ($37,500 + $20,000) x .20 = $11,500 a

Part B Perry Company's Retained Earnings on 12/31/2011 Amount of Perry Company Retained Earnings that has not been realized in transactions with third parties Perry Company's Retained Earnings that have been realized in transactions with third parties Less cumulative effect of adjustments to date relating to amortization of the difference between implied and book value ($46,000 + $16,000 + $30,000) Consolidated Retained Earnings on 12/31/2011

6-44

$2,115,700 (15,600) 2,100,100

(92,000) $2,008,100

Problem 6-15 Part A 2012 (1) Sales

120,000

Purchases (Cost of Goods Sold) To eliminate intercompany sales ($50,000 + $70,000)

120,000

(2) Ending Inventory – Income Statement (CoGS) Inventory (Balance Sheet) To eliminate unrealized profit in ending inventories ($10,000 + $5,000)

15,000

(3) Beginning Retained Earnings – Paul Company ($20,000  0.8) Beginning Retained Earnings – Simon Company Beginning Inventory – Income Statement (CoGS) To recognize profit in beginning inventory (upstream sales) realized during year and to reduce the controlling and noncontrolling interests for their shares of the amount of unrealized upstream intercompany profit at beginning of year

16,000 4,000

(4) Beginning Retained Earnings – Paul Company. Beginning Inventory – Income Statement (CoGS) To recognize profit in beginning inventory (downstream sales) realized during the year and to reduce consolidated retained earnings at beginning of the year for the amount of unrealized downstream intercompany profit at the beginning of the year

30,000

15,000

20,000

30,000

Part B Calculation of 2012 Controlling interest in Consolidated Net Income Paul Company's net income from its independent operations Less unrealized intercompany profit on 2012 sales to Simon Company Plus profit on 2011 sales to Simon Company realized in transactions with third parties in 2012 Paul Company's net income from independent operations that has been realized in transactions with third parties Reported net income of Simon Company $270,000 Less amortization of the difference between implied and book value ($250,000*/25) (10,000) Less unrealized intercompany profit on 2012 sales to Paul Company (10,000) Plus profit on 2011 sales to Paul Company realized in transaction with third parties in 2012 20,000 Simon Company's net income that has been realized in transaction with third parties 270,000 Paul Company’s share 80% Controlling interest in consolidated net income * [$1,360,000/.80 – ($1,000,000 + $450,000)] = $250,000

6-45

$700,000 (5,000) 30,000 725,000

216,000 $941,000

Problem 6-15 (continued) Part C Calculation of 12/31/2012 Consolidated Retained Earnings Paul Company's Retained Earnings on 12/31/2012 $1,500,000 Less the amount of Paul's retained earnings that have not been realized in transactions with thirds parties (5,000) Paul Company's Retained Earnings that have been realized in transactions with third parties 1,495,000 Increase in retained earnings of Simon Company from date of acquisition to 12/31/2012 ($960,000 – $450,000) $510,000 Less cumulative amortization of the difference between implied and book value (4  $10,000) (40,000) Less unrealized profit included in Simon Company's retained earnings on 12/31/2012 (10,000) Increase in reported retained earnings of Simon Company since acquisition that has been realized in transactions with third parties $460,000 Paul Company's share 80% 368,000 Consolidated Retained Earnings 12/31/2012 $1,863,000 Part D

Calculation of Noncontrolling Interest in Consolidated Income For the Year Ended December 31,2012 Simon Company's reported income for 2012 Less: Amortization of difference between implied and book value Plus: Unrealized profit on 1/1/2012 Less: Unrealized profit on 12/31/2012 Amount included in 2012 consolidated income

$270,000 (10,000) 20,000 (10,000) $270,000

Noncontrolling interest share therein (0.20  $270,000)

$54,000

6-46

Problem 6-16 Part A

Income Statement Sales Equity in subsidiary income Total revenue Cost of goods sold: Beginning inventory Purchases Cost of goods available Less ending inventory Cost of goods sold Other expenses Total cost & expense Net/consolidated income Noncontrolling interest in income Net income to retained earnings Statement of Retained Earnings 1/1 Retained earnings Pruitt Corporation Sedbrook Company Net income from above Dividends declared Pruitt Corporation Sedbrook Company 12/31 Retained earnings to balance sheet

PRUITT CORPORATION AND SUBSIDIARY Consolidated Statement Workpaper For the Year Ended December 31, 2013 Pruitt Corporation

Sedbrook Company

1,100,000 67,250 1,167,250

530,000

150,000 850,000 800,000 200,000 1,000,000 180,000 980,000 187,250

110,000 350,000 460,000 120,000 340,000 137,500 477,500 52,500

187,250

Eliminations Dr.

Cr.

Noncontrolling Interest

(2) 200,000 (1) 67,250

1,430,000

530,000

52,500

1,430,000 (4) 30,000 (2) 200,000 (3) 10,000

277,250

230,000

5,250 * 5,250

532,000 187,250

230,000 1,000,000 1,230,000 310,000 920,000 317,500 1,237,500 192,500 (5,250)* 187,250

532,000 120,000 52,500

(5) 120,000 277,250

230,000

5,250

(100,000) 619,250

Consolidated Balances

187,250 (100,000)

(30,000) 142,500

6-47

(1) 397,250

27,000 257,000

(3,000) 2,250

619,250

Problem 6-16 (continued) Balance Sheet Cash Accounts receivable Inventory Investment in Sedbrook Company Other assets Total assets Accounts payable Other liabilities Capital stock: Pruitt Corporation Sedbrook Company Retained earnings from above 1/1 Noncontrolling interest 12/31 Noncontrolling interest Total liabilities & equity

Pruitt Corporation

Sedbrook Company

83,000 213,000 200,000 568,250

80,000 112,500 120,000

500,000 1,564,250

400,000 712,500

900,000 1,698,500

70,000 75,000

30,000 40,000

100,000 115,000

Eliminations Dr. Cr.

(4) 30,000

Noncontrolling Interest

163,000 325,500 310,000

(3) 10,000 (5) 558,000 (1) 40,250

800,000 619,250

1,564,250

Consolidated Balances

800,000 500,000 142,500

(5) 500,000 397,250

712,500

927,250

*Noncontrolling interest in income = 0.10  $52,500 = $5,250 Explanations of workpaper entries are on next page

6-48

257,000 (5) 62,000 927,250

2,250 62,000 64,250

619,250 64,250 1,698,500

Problem 6-16 (continued) Explanation of workpaper entries (1) Equity in Subsidiary Income Investment in Sedbrook Company Dividends Declared ($30,000  0.90) To reverse the effect of parent company entries during the year for subsidiary dividends and income * (.90)($52,500) + $30,000 - $10,000 = $67,250 (2) Sales

67,250* 40,250 27,000

200,000

Purchases (Cost of Goods Sold) To eliminate intercompany sales

200,000

(3) Ending Inventory - Income Statement (CoGS) Ending Inventory (Balance Sheet) To eliminate unrealized intercompany profit in ending inventory ($50,000 – ($50,000/1.25))

10,000

(4) Investment in Sedbrook Company Beginning Inventory (Income Statement) To recognize intercompany profit in beginning inventory realized during the year

30,000

10,000

(5) Beginning Retained Earnings- Sedbrook Co. 120,000 Common Stock - Sedbrook Company 500,000 Investment in Sedbrook Company ($568,250 - $40,250 + $30,000) Noncontrolling Interest ($500,00 + $120,000) x .10 To eliminate investment account and create noncontrolling interest account Part B Pruitt Corporation's retained earnings on 12/31/2013 Consolidated retained earnings on 12/31/2013 Part C The balances are the same as in Problem 6-11

6-49

30,000

558,000 62,000

$ 619,250 $ 619,250

Problem 6-17 Part A

PAQUE CORPORATION AND SUBSIDIARY Consolidated Statement Workpaper For the Year Ended December 31, 2013 Paque Corporation

Segal Company

Eliminations

1,650,000 91,125 1,741,125

795,000

225,000 1,275,000 1,500,000 210,000 1,290,000 310,500 1,600,500 140,625

165,000 525,000 690,000 172,500 517,500 206,250 723,750 71,250

140,625

71,250

406,125

180,000

(5) 180,000

71,250

406,125

Dr.

Cr.

Noncontrolling Interest

(2) 300,000 (1) 91,125

2,145,000

795,000

2,145,000 (4) 45,000 (2) 300,000 (3)

15,000

345,000

10,125 * 10,125

798,000

140,625

345,000 1,500,000 1,845,000 367,500 1,477,500 516,750 1,994,250 150,750 (10,125) 140,625

798,000

345,000

10,125

(150,000) 788,625

Consolidated Balances

140,625 (150,000)

(60,000) 191,250

6-50

(1) 586,125

54,000 399,000

(6,000) 4,125

788,625

Problem 6-17 (continued)

Paque Corporation

Segal Company

Balance Sheet Cash Accounts Receivable Inventory Investment in Segal Company

93,000 319,500 210,000 833,625

75,000 168,750 172,500

Other Assets

750,000

630,000

1,380,000

2,206,125

1,046,250

2,403,750

105,000 112,500

45,000 60,000

150,000 172,500

Eliminations Dr. Cr.

(4) 40,500

Noncontrolling Interest

168,000 488,250 367,500

(3) 15,000 (5) 837,000 (1) 37,125

1,200,000 788,625

2,206,125

Consolidated Balances

1,200,000 750,000 191,250

1,046,250

(5) 750,000 586,125 (4) 4,500 1,381,125

399,000 (5) 93,000 1,381,125

*Noncontrolling Interest in Consolidated Income = 0.10  ($71,250 + $45,000 – $15,000) = $10,125 Explanations of workpaper entries are on next page.

6-51

4,125 88,500 92,625

788,625 92,625 2,403,750

Problem 6-17 (continued) Explanation of workpaper entries (1) Equity in Subsidiary Income Investment in Segal Company Dividends Declared ($60,000  0.90) To reverse the effect of parent company entries during the year for subsidiary dividends and income * 0.90  ($71,250 + $45,000 – $15,000) = $91,125 (2) Sales

91,125* 37,125 54,000

300,000

Purchases (Cost of Goods Sold) To eliminate intercompany sales

300,000

(3) Ending Inventory - Income Statement (CoGS) Ending Inventory (Balance Sheet) To eliminate unrealized intercompany profit in ending inventory ($75,000  0.2).

15,000

(4) Investment in Segal Company (.90)($45,000) Noncontrolling Interest (.1)($45,000) Beginning Inventory -Income Statement (CoGS) To recognize intercompany profit realized during the year and to reduce controlling and noncontrolling interests for their share of unrealized profit at beginning of year

40,500 4,500

(5) Beginning Retained Earnings- Segal Co. Common Stock - Segal Company Investment in Segal Company ($833,625 - $37,125 + $40,500) Noncontrolling Interest ($750,000 + $180,000) x .10

180,000 750,000

Part B Paque Corporation's Retained Earnings on 12/31/2013 Consolidated retained earnings on 12/31/2013 Part C The balances are the same as in Problem 6-7 and Problem 6-13.

6-52

15,000

45,000

837,000 93,000

$ 788,625 $ 788,625

Problem 6-18 Part A

PERRY COMPANY AND SUBSIDIARY Consolidated Statement Workpaper For the Year Ended December 31, 2011 Perry Company

Eliminations Dr. Cr.

Noncontrolling Interest

Consolidated Balances

1,385,000 153,600 1,538,600

720,000 (2) 300,000 (1)153,600 720,000

1,805,000

210,000 875,000 1,085,000 400,000 685,000 225,000 910,000 628,600

155,000 (6) 37,500 (4) 9,000 360,000 (2) 300,000 515,000 225,000 (3) 15,600 290,000 170,000 (7) 20,000 460,000 260,000

393,500 935,000 1,328,500 609,400 719,100 415,000 1,134,100 670,900 (42,300) 628,600

628,600

260,000

526,700

1,805,000

309,000

42,300 42,300

1,419,500

Selby Company Net income from above Dividends declared Perry Company Selby Company 12/31 Retained earnings to balance sheet

Selby Company

1,419,500 450,000 (5) 450,000

628,600

260,000

526,700

309,000

42,300

(40,000) 2,008,100

628,600 (40,000)

(30,000) 680,000

976,700

6-53

(1) 24,000 333,000

(6,000 ) 36,300

2,008,100

Problem 6-18 (continued) Balance Sheet Cash Accounts Receivable Inventory Investment in Selby Company

Perry Company

Selby Company

90,000 297,000 400,000 1,076,400

65,000 85,000 225,000

Difference between Implied & Book Value Plant and Equipment 880,000 Goodwill Other Assets 384,000 Total assets 3,127,400 Accounts Payable Other Current Liabilities Capital Stock: Perry Company Selby Company Retained Earnings from above 1/1 Noncontrolling Interest in Net Assets

12/31 Noncontrolling Interest in Net Assets Total liabilities & equity

24,300 95,000

540,000

Eliminations Dr. Cr.

(4) 7,200 (6) 30,000 (7) 16,000 (5) 400,000 (6) 200,000 (6) 125,000

Noncontrolling Consolidated Interest Balances 155,000 382,000 609,400

(3) 15,600 (1) 129,600 (5)1,000,000 (6) 400,000 (7) 40,000

230,000 1,145,000

1,580,000 125,000 614,000 3,465,400

25,000 40,000

49,300 135,000

1,000,000 2,008,100

3,127,400

1,000,000 400,000 680,000

1,145,000

(5) 400,000 976,700 (4) 1,800 (6) 7,500 (7) 4,000

2,168,200

333,000 (5) 250,000

2,168,200

*Noncontrolling Interest in Consolidated Income = 0.20  ($260,000 + $9,000- $37,500- $20,000) = $42,300. Explanations of workpaper entries are on next page.

6-54

36,300 236,700

2,008,100

273,000

273,000 3,465,400

Problem 6-18 (continued) Computation and Allocation of Difference Schedule Parent Share Purchase price and implied value Less: Book value of equity acquired Difference between implied and book value Inventory ($230,000 - $ 155,000) Equipment ($800,000 - $ 600,000) Balance Goodwill Balance

$960,000 640,000 320,000 (60,000) (160,000) 100,000 (100,000) -0-

NonEntire Controlling Value Share 240,000 1,200,000 * 160,000 800,000 80,000 400,000 (15,000) (75,000) (40,000) (200,000) 25,000 125,000 (25,000) (125,000) -0-0-

*$960,000/.80 Explanation of workpaper entries (1) Equity in Subsidiary Income 153,600* Dividends Declared ($30,000  0.80) Investment in Selby Company To reverse the effect of parent company entries during the year for subsidiary dividends and income * [0.80  ($260,000 + $9,000)] - $15,600 – $16,000 - $30,000 = $153,600 (2) Sales

24,000 129,600

300,000

Purchases (Cost of Goods Sold) To eliminate intercompany sale

300,000

(3) Ending Inventory - Income Statement (CoGS) Ending Inventory (Balance Sheet) To eliminate unrealized intercompany profit in ending inventory ($78,000  0.2).

15,600

(4) Investment in Selby Company ($9,000  0.80) Noncontrolling Interest ($9,000  0.20) Beginning Inventory –Income Statement (CoGS) To recognize intercompany profit realized during the year and to reduce the controlling and noncontrolling interests for their share of unrealized profit at beginning of year.

7,200 1,800

15,600

6-55

9,000

1,000,000 250,000

Problem 6-18 (continued) (6) Beginning Inventory - Income Statement (CoGS) 37,500 Investment in Selby Company ($37,500 x .80) 30,000 Noncontrolling Interest 7,500 Plant and Equipment 200,000 Goodwill 125,000 Difference between Implied and Book Value To allocate the difference between implied and book value a $75,000  (1/2) = $37,500 (7) Other Expenses ($200,000/10) Investment in Selby Company ($20,000 x .80) Noncontrolling Interest Plant and Equipment (2  $20,000))

400,000

20,000 b 16,000 4,000 40,000

Alternative to entries (6) and (7) (6a) Investment in Selby Company 46,000 c Noncontrolling interest 11,500 d Beginning Inventory -Income Statement (CoGS) 37,500 a Other Expenses 20,000 b Plant and Equipment ($200,000 – (2  $20,000)) 160,000 Goodwill 125,000 Difference between Implied and Book Value 400,000 To allocate, amortize and depreciate the difference between implied and book value $75,000  (1/2) = $37,500 ($200,000/10) = $20,000 c $30,000 + $16,000 = $46,000 d $7,500 + $4,000 = $11,500 a

Part B Perry Company's Retained Earnings on 12/31/2011 Consolidated Retained Earnings on 12/31/2011 Part C The balances are the same as in Problem 6-14

6-56

$2,008,100 $2,008,100

Problem 6 – 19A Part A 2011 (1) Sales Purchases (Cost of Goods sold) To eliminate intercompany sales

265,000 265,000

(2) Ending Inventory – Income Statement (CoGS) 12/31 Inventory (Balance Sheet) To eliminate intercompany profit in ending inventory ($150,000 – ($150,000/1.25))

30,000

(3) Deferred Tax Asset Income Tax Expense To defer income tax paid or accrued by the selling affiliate on unrealized intercompany profit in ending inventory (.3  $30,000)

9,000

30,000

2012 (1) Sales

9,000

475,000

Purchases (Cost of Goods Sold) To eliminate intercompany sales

475,000

(2) Beginning Retained Earnings - Pearson Company 30,000 Beginning Inventory – Income Statement (CoGS) 30,000 To recognize intercompany profit realized during the year and to reduce controlling interest for unrealized intercompany profit at beginning of the year. (3) Income Tax Expense Beginning Retained Earnings - Pearson Company To recognize income tax expense on intercompany profit in beginning inventory considered to be realized during the current year and to adjust beginning consolidated retained earnings for the income tax consequences of unrealized profit at the beginning of the year

9,000

(4) Ending Inventory – Income Statement (CoGS) 12 /31 Inventory (Balance Sheet) To eliminate intercompany profit in ending inventory ($195,000 – ($195,000/1.25))

39,000

(5) Deferred Tax Asset Income Tax Expense To defer income tax paid or accrued by the selling affiliate on unrealized intercompany profit in ending inventory (.3  $39,000)

11,700

Part B Reported Subsidiary Income Noncontrolling Interest Ownership Noncontrolling Interest in Consolidated Income

6-57

9,000

39,000

11,700

2011 $225,000 20% $45,000

2012 $275,000 20% $55,000

Problem 6–19A (continued) Part C

Calculation of Controlling interest in consolidated income For Year Ended December 31, 2012 Pearson Company's net income from independent operations Less after-tax unrealized intercompany profit on 2012 sales to Sedbrook Company ( .7  $39,000 ) Plus after-tax profit on 2011 sales to Sedbrook Company realized in transactions with third parties in 2012 ( .7  $30,000 ) Pearson Company's net income from independent operations that has been realized in transactions with third parties Reported net income of Sedbrook Company Less after-tax unrealized intercompany profit on 2012 sales to Pearson Company Plus after-tax profit on 2011 sales to Sedbrook Company realized in transactions with third parties in 2012 Sedbrook Company's net income that has been realized in transactions with third parties Pearson Company's share Controlling interest in consolidated income

6-58

$480,000 (27,300) 21,000 473,700 $275,000 0 0 275,000 80%

220,000 $693,700

Problem 6 - 20A Part A

Income Statement Sales Dividend Income Total Revenue Cost of Goods Sold: Beginning Inventory Purchases Cost of Goods Available Less Ending Inventory Cost of Goods Sold: Income Tax Expense Other Expenses Total Cost and Expense Net /Combined Income Noncontrolling Interest in Income Net Income to Retained Earnings Statement Of Retained Earnings 1/1 Retained Earnings Peck Corporation

PECK CORPORATION AND SUBSIDIARY Consolidated Statements Workpaper For the Year Ended December 31, 2011 Peck Corporation 1,100,000 7,000 1,107,000

Seacrest Company 530,000

150,000 850,000 1,000,000 140,000 860,000 27,000

110,000 350,000 460,000 115,000 345,000 28,250

180,000 1,067,000 40,000

114,000 487,250 42,750

40,000

42,750

Net Income from Above Dividends Declared Peck Corporation Seacrest Company 12/31 Retained Earnings to Balance Sheet

120,000 40,000

Noncontrolling Interest

530,000

541,000

Seacrest Company

Eliminations Dr. Cr. (2) 100,000 (8) 7,000

42,750

1,530,000 (5) 10,000 (2) 100,000

3,200

250,000 1,100,000 1,350,000 247,000 1,103,000 57,591

120,901

113,200

294,000 1,454,951 75,049 (13,185)* 61,864

7,000 784 3,000 84,000 120,901

(1) 14,000 (6) 2,800 (6) 1,200

34,200

113,200

13,185

7,000 138,200

(3,000) 44,385

(3)

8,000

(6) (7)

4,000 1,901

(5) (7) (5) (9)

(4)

13,185 13,185

550,016

(100,000) 481,000

Consolidated Balances 1,530,000

61,864 (100,000)

(10,000) 152,750 6-59

(8) 215,685

511,880

Problem 6 - 20A (continued) Balance Sheet Cash Accounts Receivable (net) Inventory Investment in Seacrest Company Deferred Tax Assets Other Assets Total Assets

Peck Corporation

Seacrest Company

35,000 211,000 140,000 420,000

100,000 107,750 115,000

Eliminations Dr. Cr.

(1) (4)

14,000 3,200

Noncontrolling Interest

Consolidated Balances 135,000 318,750 247,000

(3) 8,000 (9) 434,000

500,000 1,306,000

400,000 722,750

3,200 900,000 1,603,950

70,000 55,000 20,000

30,000 35,000 5,000

100,000 90,000 27,685

Accounts Payable Other Liabilities Deferred Income Tax Liability Capital Stock Peck Corporation Seacrest Company Retained Earnings from Above Noncontrolling Interest in Net Assets

680,000

Total Liabilities & Equity

1,306,000

481,000

(7)

2,685

680,000 500,000 152,750

722,750

(9) 500,000 215,685

732,885

138,200 (9) 150,000

44,385 150,000 194,385

732,885

*Noncontrolling interest in consolidated income = .30  ($42,750 + (0.60  $10,000) – ( 0.60  $8,000)) = $13,185 Explanations of workpaper entries are on separate page

6-60

511,880 194,385 1,603,950

Problem 6 - 20A (Continued) Explanations of workpaper entries (1) Investment in Seacrest Company (.70  ($120,000 - $100,000)) 1/1 Retained Earnings - Peck Co. To establish reciprocity/convert to equity as of 1/1/2011 (2) Sales

14,000 14,000

100,000

Purchases (Cost of Goods sold) To eliminate intercompany sales.

100,000

(3) Ending Inventory - Income Statement (CoGS) Ending Inventory (Balance Sheet) To eliminate unrealized intercompany profit in ending inventory ($40,000 – ($40,000/1.25))

8,000

(4) Deferred Tax Asset Income Tax Expense To defer income tax paid or accrued by the selling affiliate on unrealized intercompany profit in ending inventory (.40  $8,000)

3,200

8,000

(5) 1/1 Retained Earnings - Peck Co. (.70  $10,000) 7,000 1/1 Retained Earnings - Seacrest Co. (.30  $10,000) 3,000 Beginning Inventory To recognize income tax expense on intercompany profit in beginning inventory considered to be realized during the current year and to adjust the controlling and the noncontrolling interests for their shares of the income tax consequences of unrealized profit at the beginning of the year (6) Income Tax Expense (.40  $10,000) 4,000 1/1 Retained Earnings - Peck Co. (.70  $4,000) 1/1 Retained Earnings - Seacrest Co. (.30  $4,000) To recognize income tax expense on intercompany profit in beginning inventory considered to be realized during the current year and to adjust the controlling and the noncontrolling interests for their shares of the income tax consequences of unrealized profit at the beginning of the year (7) 1/1 Retained Earnings - Peck Co. 1 784 Income Tax Expense 3 1,901 Deferred Income Tax Liability2 To recognize income tax consequences of undistributed subsidiary income $14,000  .70  .20  .40 = $784 $47,950  .70  .20  .40 = $2,685 3 $2,685 - $784 = $1,901 1 2

6-61

3,200

10,000

2,800 1,200

2,685

Problem 6 - 20A (Continued) (8) Dividend Income ($10,000  .70) Dividends Declared To eliminate intercompany dividends

7,000

(9) 1/1 Retained Earnings - Seacrest Co. Common Stock - Seacrest Co. Investment in Seacrest Co. To eliminate the investment accounts

84,000 350,000

7,000

434,000

Undistributed Income of Seacrest Company That Has Been Included in Consolidated Income From For From Acquisition Calendar Acquisition To 1/1/11 Year 2011 to 12/31/11 Seacrest Company Retained earnings 1/1/2011 Retained earnings 12/31/2011 Retained earnings date of acquisition Increase in retained earnings Net income 2011 Dividends 2011 After-tax unrealized profit on 1/1/2011 (.6  $10,000) After-tax unrealized profit on 12/31/2011 (.6  $8,000) Undistributed income that has been included in consolidated income

6-62

$120,000 $152,750 (100,000) 52,750

(100,000) 20,000 $ 42,750 (10,000) (6,000)

6,000

______

(4,800)

$14,000

$33,950

$47,950

Problem 6-20A (continued) Part B Calculation of Consolidated Net Income For year Ended December 31, 2011 Peck Corporation's net income from independent operations ($40,000 - $7,000) Less after-tax unrealized intercompany profit on 2011 sales to Seacrest Company Plus after-tax profit on 2010 sales to Seacrest Company realized in transactions with third parties in 2011 Peck Corporation's net income from independent operation that has been realized in transaction with third parties Reported net income of Seacrest Company $42,750 Less after-tax unrealized intercompany profit on 2011 sales to Peck Corporation (.6  $8,000) (4,800) Plus after-tax profit on 2010 sales to Peck Corporation realized in transactions with third parties in 2011 (.6  $10,000) 6,000 Seacrest Company's net income that has been realized in transactions with third parties 43,950 Peck Corporation's share 70% Less income tax consequence of undistributed income of Seacrest Company for 2011 that has been included in consolidated income ($33,950  .70  .20  .40) Less amortization of the difference between cost and book value Controlling interest in consolidated income

$33,000 0 0 33,000

30,765

(1,901) 0 $61,864

Calculation of Consolidated Retained Earnings December 31, 2011 Peck Corporation’s Retained Earnings on 12/31/2011 Unrealized after-tax profit on downstream sales included therein Unrealized after-tax profit on upstream sales included therein Less income tax consequence of undistributed income of Seacrest Company that has been included in consolidated income from date of acquisition to 12/31/2011 ($47,950  .70  .20  .40) Less cumulative effect to date of the amortization of the difference between cost and book value Consolidated Retained Earnings 12/31/2011

6-63

$517,925 0 (3,360)

(2,685) 0 $511,880

Problem 6 - 21A Part A

Income Statement Sales Equity in Subsidiary Income Total Revenue Cost of Goods Sold: Beginning Inventory Purchases Cost of Goods Available Less Ending Inventory Cost of Goods Sold: Income Tax Expense Other Expenses Total Cost and Expense Net /Consolidated Income Noncontrolling Interest in Income Net Income to Retained Earnings Statement Of Retained Earnings 1/1 Retained Earnings: Petra Corporation

PETRA CORPORATION AND SUBSIDIARY Consolidated Statements Workpaper For the Year Ended December 31, 2011 Petra Corporation

Swain Company

1,100,000 29,925 1,129,925

530,000

150,000 850,000 1,000,000 140,000 860,000 27,000

110,000 350,000 460,000 115,000 345,000 28,250

180,000 1,067,000 62,925

114,000 487,250 42,750

62,925

42,750

Net Income from Above Dividends Declared: Petra Corporation Swain Company 12/31/ Retained Earnings to Balance Sheet

120,000 62,925

Noncontrolling Interest

(2) 100,000 (1) 29,925

42,750

1,530,000 (5) 10,000 (2) 100,000 (3)

8,000

(6) (7)

4,000 (4) 1,901

143,826

(5) (7) (5) (8)

3,200

250,000 1,100,000 1,350,000 247,000 1,103,000 57,591

113,200

294,000 1,454,951 75,049 (13,185)* 61,864

7,000 784 (6) 2,800 3,000 (6) 1,200 84,000 143,826 113,200

13,185 13,185

550,016 34,200 13,185

(100,000) 517,925

Consolidated Balances 1,530,000

530,000

555,000

Swain Company

Eliminations Dr. Cr.

61,864 (100,000)

(100,000) 152,750 6-64

(1) 238,610

7,000 124,200

(3,000) 44,385

511,880

Problem 6 – 21A (continued) Balance Sheet Cash Accounts Receivable (net) Inventory Investment in Swain Company Deferred tax asset Other Assets Total Assets Accounts Payable Other Liabilities Deferred Income Tax Liability Capital Stock Petra Corporation Swain Company Retained Earnings from Above Noncontrolling Interest in Net Assets Total Liabilities & Equity

Petra Corporation

Swain Company

35,000 211,000 140,000 456,925

100,000 107,750 115,000

Eliminations Dr. Cr.

Noncontrolling Interest

135,000 318,750 247,000

(3) 8,000 (1) 22,925 (8) 434,000 (4)

Consolidated Balances

3,200

500,000 1,342,925

400,000 722,750

3,200 900,000 1,603,950

70,000 55,000 20,000

30,000 35,000 5,000

100,000 90,000 27,685

(7)

2,685

680,000 517,925

1,342,925

680,000 500,000 152,750

722,750

(8) 500,000 238,610

741,810

124,200 (8) 150,000 741,810

*Noncontrolling interest in consolidated income = .30  ($42,750 + (.60  $10,000) – (.60  $8,000) = $13,185 Explanation of workpaper entries on separate page

6-65

44,385 150,000 194,385

511,880 194,385 1,603,950

Problem 6 – 21A (continued) Explanations of workpaper entries (1) Equity in Subsidiary Income Dividends Declared Investment in Swain Company To reverse the effect of parent company entries during the year for subsidiary dividends and income

29,925

(2) Sales

100,000

7,000 22,925

Purchases (Cost of Goods sold) To eliminate intercompany sales (3) Ending Inventory – Income Statement (CoGS) Ending Inventory (Balance Sheet) To eliminate unrealized intercompany profit in ending inventory ($40,000 – ($40,000/1.25))

100,000

8,000 8,000

(4) Deferred Tax Asset 3,200 Income Tax Expense To defer income tax paid or accrued by the selling affiliate on unrealized intercompany profit in ending inventory (.40  $8,000) (5) 1/1 Retained Earnings – Petra Co. 1/1 Retained Earnings – Swain Co. Beginning Inventory To recognize intercompany profit realized during the year and to reduce the controlling and controlling interests for their share of unrealized intercompany profit at the beginning of the year

7,000 3,000

(6) Income Tax Expense (.40  $10,000) 1/1 Retained Earnings – Petra Co. 1/1 Retained Earnings – Swain Co. To recognize income tax expense on intercompany profit in beginning inventory considered to be realized during the current year and to adjust the controlling and the noncontrolling interests for their shares of the income tax consequences of unrealized profit at the beginning of the year

4,000

10,000

(7) 1/1 Retained Earnings – Petra Co. 1 784 Income Tax Expense 3 1,901 Deferred Income Tax Liability 2 To recognize income tax consequences of undistributed subsidiary income $14,000  .70  .20  .40 = $784 $47,950  .70  .20  .40 = $2,685 3 $2,685 – $784 = $1,901 1 2

6-66

3,200

2,800 1,200

2,685

Problem 6 – 21A (continued) (8) 1/1 Retained Earnings – Swain Co. Common Stock – Swain Co. Investment in Swain Co. To eliminate the investment accounts

84,000 350,000 434,000

Undistributed Income of Swain Company That Has Been Included in Consolidated Income

Swain Company Retained earnings 1/1/2011 Retained earnings 12/31/2011 Retained earnings date of acquisition Increase in retained earnings Net income 2011 Dividends 2011 After-tax unrealized profit on 1/1/2011 (.6  $10,000) After-tax unrealized profit on 12/31/2011 (.6  $8,000) Undistributed income that has been included in consolidated income

From Acquisition to 1/1/2011 $120,000

For Calendar From Year Acquisition 2011 to 12/31/2011 $152,750 (100,000) 52,750

(100,000) 20,000 $42,750 (10,000) (6,000)

6,000

_______

(4,800)

$14,000

$33,950

$47,950

Part B Calculation of Consolidated Net Income For year Ended December 31, 2011 Petra Corporation's net income from independent operations ($40,000 - $7,000) Less after-tax unrealized intercompany profit on 2011 sales to Swain Company Plus after-tax profit on 2010 sales to Swain Company realized in transactions with third parties in 2011 Petra Corporation's net income from independent operation that has been realized in transaction with third parties Reported net income of Swain Company Less after-tax unrealized intercompany profit on 2011 sales to Petra Corporation (.6  $8,000) Plus after-tax profit on 2010 sales to Petra Corporation realized in transactions with third parties in 2011 (.6  $10,000) Swain Company's net income that has been realized in transactions with third parties Petra Corporation's share (.70  $43,950) Less income tax consequence of undistributed income of Swain Company for 2011 that has been included in consolidated income ($33,950  .70  .20  .40) Less amortization of the difference between cost and book value Controlling interest in consolidated income 6-67

$33,000 0 0 33,000

$42,750 (4,800)

6,000 43,950 70%

30,765

(1,901) 0 $61,864

Problem 6-21A (Continued) Calculation of Consolidated Retained Earnings December 31, 2011 Petra Corporation’s Retained Earnings on 12/31/2011 Less after-tax amount of Petra Corporation's retained earnings that have not been realized in transactions with third parties Petra Corporation’s retained earnings that have been realized in transactions with third parties Increase in retained earnings of Swain Company from date of acquisition to 12/31/2011 ($152,700 - $100,000) Less after-tax unrealized profit included in Swain Company's retained earnings on 12/31/2011 (.6  $8,000) Increase in reported retained earnings of Swain Company since acquisition that has been realized in transactions with third parties Petra Corporation's share Less income tax consequence of undistributed income of Swain Company that has been included in consolidated income from date of acquisition to 12/31/2011 ($47,950  .70  .20  .40) Less cumulative amortization of the difference between cost and book value to 12/31/2011 Consolidated Retained Earnings 12/31/2011

6-68

$481,000 0 481,000 $52,750 (4,800) 47,950 70%

33,565

(2,685) 0 $511,880

Chapter 6 CHAPTER SIX -- ELIMINATION OF UNREALIZED PROFIT ON INTERCOMPANY SALES OF INVENTORY I.

DEFINITIONS A. Affiliated group refers to a parent and all subsidiaries for which consolidated financial statements are prepared; alternatively, this group may be referred to as the consolidated entity. B. Downstream sales: Sales from a parent company to one or more of its subsidiaries. C. Upstream sales: Sales from subsidiaries to the parent company. D. Horizontal sales: Sales from one subsidiary to another subsidiary. E. Unrealized intercompany profit (loss): Profit (loss) that has not been realized from the point of view of the consolidated entity through subsequent sales to third parties. It must be eliminated in the preparation of consolidated financial statements.

II.

EFFECTS OF INTERCOMPANY SALES OF MERCHANDISE ON THE DETERMINATION OF CONSOLIDATED BALANCES A. Objectives and Assumptions 1. The workpaper procedures illustrated in this chapter are designed to accomplish the following financial reporting objectives in the consolidated financial statements. a. Consolidated sales include only sales with parties outside the affiliated group. b. Consolidated cost of sales includes only the cost to the affiliated group, of goods that have been sold to parties outside the affiliated group. c. Consolidated inventory on the balance sheet is recorded at a value equal its cost to the affiliated group. 2.

Stated another way, the objective of eliminating the effects of intercompany sales of merchandise is to present consolidated balances for sales, cost of sales, and inventory as if the intercompany sale had never occurred. As a result, the recognition of income or loss on the intercompany transaction, including its allocation between the noncontrolling and controlling interests, is deferred until the profit or loss is confirmed by sales of the merchandise to nonaffiliates.

In order to concentrate on intercompany profit eliminations and adjustments, reporting complications relating to accounting for the difference between implied and book value are avoided in all chapter illustrations by assuming that all acquisitions are made at the book value of the acquired interest in net assets and that the book value of the subsidiary company's net assets equals their fair value on the date the parent company's interest is acquired. It is also assumed that the affiliates file consolidated income tax returns. If the affiliates file separate tax returns, deferred tax issues arise. These are addressed in the appendix to this chapter.

Chapter 6

Determination of Consolidated Sales, Cost of Sales, and Inventory Balances Assuming Downstream Sales Note: Depending on the accounting system used, a company may have a single account in its general ledger entitled “cost of sales” or “cost of goods sold” and a single line on its workpaper, or alternatively, separate accounts for the various components. In this chapter, we assume that the trial balance lists each component separately, and we present the workpaper entries accordingly. Using this approach, the cost of sales line on the income statement is replaced with lines for Beginning Inventory—Income Statement; Purchases; Ending Inventory—Income Statement; and Cost of Sales. Under this assumption, Ending Inventory—Income Statement requires an entry distinct from that to the balance sheet account Inventory. The account “Ending Inventory—Income Statement” has a normal credit balance because it is subtracted in computing Cost of Sales. We indicate in parentheses those entries that might be replaced by the use of a single account “cost of sales”. Follow the example on textbook, pages 322 – 328. 1.

Cost or Partial Equity Method: If the parent uses the cost or partial equity method of recording its investment in the subsidiary, the entry takes the following form: Beginning Retained Earnings – P Company XXXX Beginning Inventory – Income Statement (Cost of Sales) XXX To realize the gross profit in beginning inventory deferred from the prior period.

Complete Equity Method: For firms using the complete equity method, the debit to beginning retained earnings is not needed, assuming the parent correctly adjusted for all intercompany profits/losses in its “revenue from subsidiary” account in the preceding year. Under the complete equity method, consolidated retained earnings is identical to the parent’s reported retained earnings and thus no adjustment is needed. The debit to retained earnings is replaced by a debit to Investment in Subsidiary, which serves simply to facilitate the elimination of this account in the workpaper: Investment in Subsidiary XXXX Beginning Inventory – Income Statement (Cost of Sales) XXXX To realize the gross profit in beginning inventory deferred from the prior period.

Determination of Amount of Intercompany Profit 1. In the examples on textbook, pages 322 - 328, the amount of intercompany profit subject to elimination was calculated on the basis of the selling affiliate's gross profit rate. Gross profit may be stated either as a percentage

Commented [S1]: I am unable to indent ‘period’ so it is the same as in the next table.

Chapter 6 of sales or as a percentage of cost. When it is stated as a percentage of cost, it is often referred to as “markup.” To calculate the amount of intercompany gross profit to be eliminated from ending inventory, be careful to distinguish between percentages stated in terms of sales versus cost of sales.

III.

Inventory Pricing Adjustments When inventory adjustments (write-downs) have been made on the books of one of the affiliated firms due to market fluctuations, the workpaper entries are modified accordingly. The amount of intercompany profit subject to elimination should be reduced to the extent that the related goods have been written down by the purchasing affiliate.

Determination of Proportion of Intercompany Profit to Be Eliminated Two alternative views of the amount of intercompany profit that should be considered as “unrealized” exist. The elimination methods associated with these two points of view are generally referred to as 100% (total) elimination and partial elimination. Both current and past GAAP require 100% elimination of intercompany profit in the preparation of consolidated financial statements. Under 100% elimination, the entire amount of unconfirmed intercompany profit is eliminated from consolidated net income and the related asset balance.

Determination of the Noncontrolling Interest in Consolidated Net Income – Upstream or Horizontal Sales 1. Subsidiary as Intercompany Seller In the previous textbook example, the selling affiliate was the parent company (downstream sale). Accordingly, even though 100% of the unrealized profit was eliminated, no modification in the calculation of the noncontrolling interest in consolidated net income or consolidated net assets was necessary. If the selling affiliate is a less than wholly owned subsidiary (upstream sale), the controlling and the noncontrolling interests need to be adjusted to reflect their interest in the amount of unrealized intercompany profit eliminated. 2. The modification of the calculation of the noncontrolling interest is applicable only when the subsidiary is the selling affiliate (upstream or horizontal sales). Where the parent company is the selling affiliate (downstream sale), the amount of subsidiary income included in consolidated net income is not affected by the elimination of unrealized intercompany profit and no adjustment is necessary in the calculation of the noncontrolling interest in consolidated net income.

COST METHOD -CONSOLIDATED STATEMENTS WORKPAPER – UPSTREAM SALES (see textbook, pages 331 – 336) A. Entries on Books of P Company – Cost Method – Year of Acquisition B. Consolidated Statements Workpaper Entries - Year of Acquisition

Chapter 6 C. D.

IV.

Entry on Books of P Company – Cost Method Consolidated Statements Workpaper Entries - Year Subsequent to Acquisition – Cost Method

COST METHOD - ANALYSIS OF CONSOLIDATED NET INCOME AND CONSOLIDATED RETAINED EARNINGS A. The noncontrolling interest in consolidated net income is calculated after subtracting end-of-year unrealized intercompany profit and adding intercompany profit realized during the current year to the net income reported by the subsidiary. If the sale of merchandise had been downstream rather than upstream, the amount of subsidiary income included in consolidated income would not be affected by the workpaper entries related to unrealized intercompany profit, and no adjustment would be necessary in the calculation of the noncontrolling interest in consolidated net income. B.

Consolidated Net Income: Consolidated net income is the parent company's income from its independent operations that has been realized in transactions with third parties plus (minus) subsidiary income (loss) that has been realized in transactions with third parties plus or minus adjustments for the period relating to the depreciation, amortization, and impairment of differences between implied and book values.

Consolidated Retained Earnings: Consolidated retained earnings is the parent company's cost basis retained earnings that has been realized in transactions with third parties plus (minus) the parent company's share of the increase (decrease) in subsidiary retained earnings that has been realized in transactions with third parties from the date of acquisition to the current date plus or minus the cumulative effect of adjustments to date relating to the amortization, depreciation, and impairment of differences between implied and book values.

CONSOLIDATED STATEMENTS WORKPAPER – PARTIAL EQUITY METHOD The balances reported by the parent company in income, retained earnings, and the investment accounts differ depending on the method used by the parent company to record its investment. These differences are reflected in variations in the eliminating entries needed to arrive at the correct consolidated balances. Follow the example on textbook, pages 340 – 344.

VI.

PARTIAL EQUITY METHOD ANALYSIS OF CONSOLIDATED NET INCOME AND CONSOLIDATED RETAINED EARNINGS A. The t-account calculation of consolidated net income is independent of the method used by the parent company to record its investment. B. When the parent company uses the partial equity method to record its investment, the parent company's share of subsidiary income since acquisition is already included in the parent company's reported retained earnings. Consequently,

Chapter 6 consolidated retained earnings is calculated as the parent company's recorded partial equity basis retained earnings that has been realized in transactions with third parties plus or minus the cumulative effect of the parent’s share of the adjustments to date relating to the depreciation, amortization, and impairment of e differences between implied and book values.

VII.

COMPLETE EQUITY METHOD - ANALYSIS CONSOLIDATED NET INCOME AND CONSOLIDATED RETAINED EARNINGS A. Under the complete equity method, no formal calculation of the controlling interest in consolidated net income is needed. The parent company has already made adjustments for realized/unrealized gross profit depending upon whether or not such profit has been confirmed through transactions with outsiders. Thus, the controlling interest in consolidated net income equals the parent company's recorded income. Nonetheless, a t-account approach may be useful to establish the impact on both the controlling and noncontrolling interests of profits from intercompany sales and other adjustments. B. Consolidated net income may be verified as the sum of the following components: the parent company’s net income from its independent operations that has been realized in transactions with third parties plus (minus) reported subsidiary income (loss) that has been realized in transactions with third parties plus or minus adjustments for the period relating to the depreciation, amortization, and impairment of differences between implied and book values. C. When the parent company uses the complete equity method to record its investment, the parent company's share of subsidiary income (including any needed adjustments for intercompany profits) since acquisition is already included in the parent company's reported retained earnings. Consequently, consolidated retained earnings is equal to the parent company's recorded complete equity basis retained earnings.

VIII. SUMMARY OF WORKPAPER ENTRIES RELATING TO INTERCOMPANY SALES OF INVENTORY Consolidated statement workpaper eliminating entries for intercompany sales of inventory are the same whether the parent company uses the cost method or the partial equity method to record is investment. However, the form of the workpaper entry for unrealized profit in beginning inventories differs between upstream and downstream sales and between the complete equity method and the other two. Illustration 6-21 provides a summary of these workpaper elimination entries.

INTERCOMPANY PROFIT PRIOR TO PARENT--SUBSIDIARY AFFILIATION A. Generally accepted accounting principles (GAAP) are silent as to the appropriate treatment of unrealized profit on assets that result from sales between companies prior to affiliation (preaffiliation profit). The question is whether or not preaffiliation

Chapter 6 profit should be eliminated in consolidation. B.

If the selling company is the new subsidiary, the profit recognized by it prior to its acquisition is implicitly considered in determining the book value of the interest acquired by the parent company. Accordingly, such profit is automatically eliminated from consolidated retained earnings in the investment elimination entry.

If the selling company is the parent, the preaffiliation profit will ultimately be included in consolidated retained earnings in any case. However, a reduction of such profit from consolidated retained earnings on the date of affiliation simply results in the inclusion of the profit in the consolidated net income of subsequent years.

Chapter 6 APPENDIX: DEFERRED TAXES AND INTERCOMPANY SALES OF INVENTORY I.

II.

Deferred Tax Consequences Arising Because of Unrealized Intercompany Profit A. If the affiliated companies file consolidated income tax returns, the amount at which the asset is reported in the consolidated financial statements and its tax basis are the same, and it is not necessary to consider deferred tax consequences. B.

When the affiliates file separate income tax returns, the tax basis of the asset will differ from the amount reported for that asset in the consolidated financial statements.

Under FASB ASC topic 740 [ Income Taxes], the measurement of the tax benefit for temporary differences related to unrealized profit on intercompany sales is not subject to the basic principles that apply to other temporary differences that will result in deductible amounts in future years. This standard requires deferral of income taxes paid by the seller on intercompany profits on assets remaining within the consolidated group.

The balances reported by the parent company in income, retained earnings, and the investment account differ depending on the method used by the parent company to record its investment. However, the method used by the parent company to record its investment has no affect on the consolidated balances.

Workpaper entries to record deferred tax consequences of unrealized intercompany profit and undistributed subsidiary income are also the same when the parent company uses the partial equity method or the cost method to record its investment.

The Complete Equity Method – Intercompany Sales of Inventory A. When the parent uses the complete equity method to account for the investment, the parent accounts for deferred taxes related to undistributed adjusted subsidiary income on its own books. This occurs because there is a difference between taxable income (dividends received from the subsidiary) and equity income (reported on the income statement) on the books of the parent, necessitating parent company entries for deferred taxes. B.

Workpaper eliminating entries relating to the unrealized profit included in inventory of the purchasing affiliate differ in subsequent years, depending on whether the selling affiliate is the parent company (downstream sale) or the subsidiary (upstream or horizontal sale).

CHAPTER 7 Note: The letter A indicated for a question, exercise, or problem means that the question, exercise, or problem relates to a chapter appendix. ANSWERS TO QUESTIONS 1. Intercompany profit in depreciable asset transfers is realized as a result of the utilization of the asset in the generation of revenue. Such utilization is measured by depreciation and, accordingly, the recognition of the realization of intercompany profit is accomplished through depreciation adjustments in the periods following the intercompany transfers. When intercompany sales involve nondepreciable assets, any profit recognized by the selling affiliate will remain unrealized from the consolidated entity’s point of view for all subsequent periods or until the asset is disposed of. 2. Intercompany profit may be included in the selling affiliate’s carrying value of an asset that is sold to third parties. If the sales price in the sale to the third party is less that the inflated carrying value, the selling affiliate will recognize a loss on the sale. From the point of view of the consolidated entity, however, the carrying value of the asset is its cost to the affiliated group (selling affiliate’s cost less unrealized intercompany profit) and if this value is less than the selling price to the third party, the consolidated group will recognize a gain. In effect, previously unrecognized intercompany profit is realized upon the sale of the asset to a third party. 3. The only procedural difference in the workpaper entries relating to the elimination of unrealized intercompany profit in depreciable or nondepreciable assets when the selling affiliate is a less than wholly owned subsidiary is that the noncontrolling interest in the unrealized intercompany profit at the beginning of the year must be recognized by debiting or crediting the noncontrolling shareholders’ percentage interest in such adjustments to the beginning retained earnings of the subsidiary.

7-1

4. Consolidated income is equal to the parent company’s income from its independent operations that has been realized in transactions with third parties plus subsidiary income that has been realized in transactions with third parties and adjusted for the amortization, depreciation, or impairment of the differences between implied and book values (this total is then allocated to the controlling and noncontrolling interests). The controlling interest in consolidated income is equal to the parent company’s income from its independent operations that has been realized in transactions with third parties plus its share of subsidiary income that has been realized in transactions with third parties and adjusted for the amortization, depreciation, or impairment of the differences between implied and book values. Controlling Interest in Consolidated Income Unrealized gain on intercompany sale (downstream sales)

Net income internally generated by P Company Gain realized through usage (depreciation adjustment)

Unrealized profit on downstream sales to S Company (ending Inventory)

Realized profit (downstream sales) from beginning inventory P Company's percentage of S Company's adjusted income realized from third parties

Controlling interest in Consolidated Income

5. It is important to distinguish between upstream and downstream sales of property and equipment because calculation of the noncontrolling interest in the consolidated financial statements differs depending on whether the sale giving rise to the intercompany profit is upstream or downstream. 6. Profit relating to the intercompany sale of property and equipment is recognized in the consolidated financial statements over the useful life of the equipment. It is recognized in the consolidated financial statements by reducing depreciation expense (thus increasing consolidated income). 7. Consolidated retained earnings may be defined as the parent company’s cost basis retained earnings that has been realized in transactions with third parties plus (minus) the parent company’s share of the increase (decrease) in subsidiary retained earnings that has been realized in transactions with third parties from the date of acquisition to the current date and adjusted for the cumulative effect of amortization of the difference between implied and book values.

7-2

ANSWERS TO BUSINESS ETHICS CASE

1. The arguments against expensing options include the following: • Valuation is subjective, involves assumptions that may be unrealistic, and may yield numbers that time will prove to be of limited usefulness. • Disclosure is a reasonable substitute. • Companies may alter their reward systems with the result that lower level employees are most affected. • Options are not a “real” expense and may never be exercised. • Option valuation opens the door for manipulation as managers can alter their assumptions. • Diluted earnings per share are already disclosed, and expensing options amounts to double counting. • Expensing may destroy any advantage held by the U.S. as a world leader in technology, and distract corporate America from more important issues related to executive compensation and governance in general.

The arguments in favor of expensing options include the following: • Difficulty or subjectivity in valuation is not a reason for avoidance of recording other relevant financial statement items, such as deferred taxes, pension liabilities, etc. • Transparency is a major objective of financial reporting, and without proper expensing of executive compensation, transparency is lacking. • Not expensing options generates costs of misinformation. • If employees are over-compensated, the users need to be aware of that fact. • When options qualify as a “real” expense, as defined in the conceptual framework, based on the best available information at the balance sheet date, they should be reflected as such in the financial statements. 2.

Ideally the CEO or CFO should not be a past employee of the company’s audit firm, as such a relationship could jeopardize his or her independence. However, it is not unusual for a company to hire a former auditor, who might later be promoted to CEO or CFO, or might even be hired to such a position. If this happens, the company might want to consider switching auditors or taking other measures to make sure that the audit firm is viewed as sufficiently independent. Under the Sarbanes-Oxley Act of 2002 mandates that the audit firm’s independence is impaired if a former member of the audit engagement team accepts a supervisory accounting position, unless the individual observes a one-year ‘cooling off’ period.

The Sarbanes-Oxley Act of 2002 mandates that each member of the audit committee be a outside member of the board of directors of the issuer and to be independent. Independent means not receiving any consulting, advisory, or other compensatory fee from the issuer. At least one member must be a financial expert. The audit committee is responsible for appointment, compensation, retention, and oversight of the independent auditors.

7-3

ANSWERS TO FINANCIAL STATEMENT ANALYSIS EXERCISES AFS7-1 Green Mountain Coffee Roasters Acquisition In order to answer this question, additional information can either be provided to the students, or the students can be instructed to state their assumptions. The footnotes describing the acquisition do not disclose the book value of the acquisition, but only report how the purchase price was allocated. Among the options are; (1) assume that book values of the net tangible assets acquired (excluding deferred taxes and identifiable intangibles) are equal to their market values or (2) assume some asset’s book value is not equal to fair value (assume that inventory is undervalued by $1,800 thousand and no intangible assets or deferred taxes are recorded on the books). We provide alternative entries depending on these assumptions. Other assumptions, however, may clearly be justified and the problem can be modified for a variety of different scenarios. A. Worksheet eliminating entry in thousands of dollars. ( Assumption One: The book value of net tangible assets of Timothy’s Coffee is equal to their market value. None of the identifiable intangible assets or deferred taxes have been recorded on the books of Timothy’s Coffee. Beginning retained earnings (Rent.com) Capital stock – Rent.com 15,447 * Difference between implied and book value 140,293 Investment in Timothy’s Coffee 155,740 * not enough information to allocate the amount between the two accounts. Identifiable intangible assets 98,300 Goodwill 69,267 Difference between implied and book value Deferred taxes

140,293 27,274

Assumption Two: Assume that inventory is undervalued by $1,800 thousand and no intangible assets or deferred taxes are recorded on the books of Timothy’s Coffee. All other assets and liabilities have fair values equal to book values. Beginning retained earnings (Rent.com) Capital stock – Rent.com 13,647 * Difference between implied and book value 142,093 Investment in Timothy’s Coffee 155,740 * not enough information to allocate between the two accounts. Identifiable intangible assets 98,300 Inventory 1,800 Goodwill 69,267 Difference between implied and book value Deferred taxes

7-4

142,093 27,274

B. Accretive or dilutive? Whether the acquisition is accretive or dilutive is often a function of whether the acquisition was acquired using stock or cash. The 2009 EPS for Green Mountain is 0.45 per share ($54.439 million divided by 120.371 million shares). As long as the additional income from the acquisition less additional expenses from amortization of intangibles (and potential increased inventory expense) is positive, EPS should increase. However, this would ignore the opportunity value of the cash used to purchase Timothy’s Coffee. Cash of $155.74 million could be used to pay down debt or could be invested in other investments. If the cash could be invested at 3% interest, an additional $4.67 million could be earned. Additional amortization expense and additional cost of goods sold (the inventory that was increased in value is assumed sold) for the first year. Identifiable Estimated Amortization Intangible assets Intangibles Life (yrs) (first year) Customer relations $ 83,200 16 yrs. $ 5,200 Trade name 8,900 11 yrs. 809 Supply Agreements 6,200 11 yrs. 564 Total 61,800 6,573 Year One: Assumption One: The book value of net tangible assets of Timothy’s Coffee is equal to their market value. None of the identifiable intangible assets or deferred taxes have been recorded on the books of Timothy’s Coffee. Amortization expense Identifiable intangible assets

6,573 6,573

Since Timothy generated $15 million of income and the additional amortization is $6.573 million, the additional earnings are $8.427 million (which exceeds the opportunity cost of $4.67 million). Thus the acquisition should be accretive (should add an additional 0.07 a share). Assumption Two: Assume that inventory is undervalued by $1,800 thousand and no intangible assets or deferred taxes are recorded on the books of Timothy’s Coffee. All other assets and liabilities have fair values equal to book values. Amortization expense Identifiable intangible assets

6,573

Cost of goods sold Inventory

1,800

6,573

1,800

Since Timothy generated $15 million of income and the additional amortization is $6.573 million and the additional cost of goods sold is $1.8 million, the additional earnings are $6.627 million (which exceeds the opportunity cost of $4.67). Thus the acquisition should be accretive (should add an additional 0.055 a share).

7-5

ANSWERS TO EXERCISES Exercise 7-1 2011 Income of Paradise Company realized in transactions with third parties Paradise Company’s share of income of Sherwood Company realized in transactions with third parties 0.8  ($300,000 - $240,000 + $30,000) Controlling interest in consolidated net income

$550,000 72,000 $622,000

$840,000 - $600,000 = $240,000 $240,000 = $30,000 8 2012 Income of Paradise Company realized in transactions with third parties Paradise Company’s share of income of Sherwood Company realized in transactions with third parties 0.8  ($300,000 + $30,000) Controlling interest in consolidated net income

$550,000 264,000 $814,000

Exercise 7-2 2011 Income of Polar Company realized in transitions with third parties ($400,000 - $160,000 + $20,000) Polar Company’ share of income of Superior Company realized in transactions with third parties (.8  $200,000) Controlling interest in consolidated net income

$260,000 160,000 $420,000

$560,000 - $400,000 = $160,000 $160,000/8= $20,000 2012 Income of Polar Company realized in transactions with third parties ($400,000 + $20,000) Polar Company’s share of income of Superior Company realized in transactions with third parties (.8  $200,000) Controlling interest in consolidated net income

Exercise 7-3 Cost of equipment Accumulated Depreciation ($300,000    5 years) Book value 1/1 2011 Proceeds from sale Gain on sale

7-6

$420,000 160,000 $580,000

$ 300,000 150,000 150,000 200,000 $ 50,000

Exercise 7-3 (continued) Part A 2011 (1) Equipment ($300,000 - $200,000) Gain on Sale of Equipment Accumulated Depreciation($300,000)(5/10)

100,000 50,000 150,000

(2) Accumulated Depreciation – Equipment Depreciation Expense ($50,000/5)

10,000

2012 (1) Equipment Beginning Retained Earnings – Pearson (.9  $50,000) Noncontrolling Interest (.1  $50,000) Accumulated Depreciation – Equipment

100,000 45,000 5,000

(2) Accumulated Depreciation – Equipment Depreciation Expense Beginning Retained Earnings – Pearson (.9  $10,000) Noncontrolling Interest (.10  $10,000)

10,000

150,000 20,000 10,000 9,000 1,000

Part B Controlling interest in Consolidated Net Income for 2012 = $150,000 + .9($100,000 + $10,000) = $249,000 Exercise 7-4 Part A 2011 Land Cash

350,000 350,000

2012 None. No further entries are recorded on the books of Procter Company unless and until the land is sold to outsiders. Part B (1) 2011 Gain on Sale of Land Land ($350,000 - $200,000)

150,000 150,000

(2) 2012 Cost Method and Partial Equity Method Beginning Retained Earnings – Procter Company (.9  $150,000) Noncontrolling Interest (.10  $150,000) Land Complete Equity Method Investment in Silex Company (.9  $150,000) Noncontrolling Interest (.10  $150,000) Land 7-7

135,000 15,000 150,000

Exercise 7-5 Cost Method and Partial Equity Method Part A Upstream Sale Beginning Retained Earnings – Patterson Co. (.8  $300,000) Noncontrolling Interest (.2  $300,000) Land ($800,000 - $500,000) Part B Downstream Sale Beginning Retained Earnings – Patterson Co. Land Complete Equity Method Part A Upstream Sale Investment in Stevens Co. (.8  $300,000) Noncontrolling Interest (.2  $300,000) Land ($800,000 - $500,000) Part B Downstream Sale Investment in Stevens Co. Land

240,000 60,000 300,000 300,000 300,000 240,000 60,000 300,000 300,000 300,000

Exercise 7-6 Part A $700,000 - $600,000 = $100,000 Part B $700,000 - $400,000 = $300,000 Part C Cost Method and Partial Equity Method Beginning Retained Earnings – P Company (.9  $200,000) Noncontrolling Interest (.1  $200,000) Gain on Sale of Equipment ($300,000 - $100,000) Complete Equity Method Investment in S Company (.9  $200,000) Noncontrolling Interest (.1  $200,000) Gain on Sale of Equipment ($300,000 - $100,000)

180,000 20,000 200,000 180,000 20,000 200,000

Exercise 7-7 Part A (1) Sales

100,000 Cost of Sales (Purchases)

100,000

(2) Accounts Payable Accounts Receivable

17,500

(3) Cost of Sales (beginning inventory – income statement) Inventory ($20,000 – ($20,000/1.25))

4,000

(4) Beginning Retained Earnings – Price ($25,000 – ($25,000/1.25) Cost of Sales (beginning inventory – income statement)

5,000

17,500

7-8

4,000 5,000

Exercise 7-7 (continued) (5) Beginning Retained Earnings – Price ($5,500  .8) Noncontrolling Interest ($5,500  .2) Property Plant and Equipment

4,400 1,100

(6) Accumulated Depreciation Depreciation Expense ($5,500/5) Beginning Retained Earnings – Price ($1,100  .8) Noncontrolling Interest ($1,100  .2)

2,200

5,500 1,100 880 220

Part B Noncontrolling Interest in Consolidated Income .2  ($40,000 + $1,100) = $8,220

Exercise 7-8 P Company’s income realized in transactions with third parties ($300,000 - $40,000 + $10,000) P Company’s share of income of S Company realized in transactions with third parties (.9  ($120,000 - $15,000)) Controlling interest in consolidated net income $120,000 - $80,000 $40,000 4 $225,000  () $75,000 $75,000 – 1.25

$270,000 94,500 $364,500

= $40,000 = $10,000 = $75,000 = $15,000

Exercise 7-9 Sales

390,000 Cost of Goods Sold ($390,000/1.3) Selling Expense ($260,000 – ($260,000/1.3)) Administrative Expense ($130,000 – ($130,000/1.3))

300,000 60,000 30,000

Exercise 7-10 2010

2011

Architectural Fees Salary Expense Other Expense Building

700,000

Beginning Retained Earnings – Pier One Building

150,000

Accumulated Depreciation ($150,000/30) Depreciation Expense

5,000

400,000 150,000 150,000

7-9

150,000

5,000

Exercise 7-10 (continued) 2012 Beginning Retained Earnings – Pier One Accumulated Depreciation Building Accumulated Depreciation Depreciation Expense

145,000 5,000 150,000 5,000 5,000

Exercise 7-11 Part A

2011 (1) Sales

400,000 Equipment Cost of Sales

90,000 310,000

Accumulated Depreciation (($90,000/9) Depreciation Expense 2012 (2) Cost Method or Partial Equity Method Beginning Retained Earnings – Pinta Co. Equipment Accumulated Depreciation Depreciation Expense Beginning Retained Earnings – Pinta Co. Complete Equity Method Investment in Standard Co. Equipment

10,000

90,000 90,000 20,000 10,000 10,000

90,000 90,000

Accumulated Depreciation Depreciation Expense Investment in Standard Co. Part B 2011

10,000

20,000 10,000 10,000

Calculation of Controlling interest in Consolidated Net Income For Year Ended Dec. 31,

Pinta Company’s net income from operations Less unrealized profit on 2011 sales of equipment to Standard Company Plus profit on sales of equipment to Standard Company realized through depreciation in 2011 Pinta Company’s income from its independent operations that has been realized in transactions with third parties Income of Standard Company that has been realized in transactions with third parties Pinta Company’s share Controlling Interest in Consolidated Net Income – 2011 7 - 10

$700,000 (90,000) 10,000 620,000 $250,000 80%

200,000 $820,000

Exercise 7-12

Original Cost After Purchase (Sale) Adjustments

Book Value $ 600,000 780,000 $ 180,000

Remaining life 3 yr 3 yr

Excess Depreciation $ 200,000 260,000 $ 60,000

2011

2012

Gain on Sale of Equipment Equipment (net)

180,000

Accumulated Depreciation Depreciation Expense

60,000

Beginning Retained Earnings – Pomeroy (.9  $180,000) Noncontrolling Interest (.1  $180,000) Equipment

162,000 18,000

Accumulated Depreciation Depreciation Expense Beginning Retained Earnings – Pomeroy (.9  $60,000) Noncontrolling Interest (.1  $60,000)

120,000

180,000 60,000

7 - 11

180,000 60,000 54,000 6,000

ANSWERS TO ASC (Accounting Standards Codification) EXERCISES ASC7-1 Presentation A subsidiary sold an old, abandoned plant to its parent and incurred a loss of $10 million. Can this loss be reported on the subsidiary-only income statement as an extraordinary item? Step 1: Use the drop-down menus under the ‘presentation’ general topic on the homepage and choose ‘225 Income Statement.’ Use the second drop-down menu and choose ’20 Extraordinary and Unusual Items.’ Step 2: Click on the ‘Expand’ option and scroll through the topics. Note that in section 45 there is a section on criteria for presentation as extraordinary items and in section 55 there is a section on events or transactions that do and do not meet extraordinary items criteria. The answer is found in section 45. FASB ASC paragraph 225-20-45-4 Certain gains and losses shall not be reported as extraordinary items (except as indicated in the following paragraph) because they are usual in nature or may be expected to recur as a consequence of customary and continuing business activities. Examples include all of the following: item D is other gains or losses from sale or abandonment of property, plant, or equipment used in the business. ASC7-2 Disclosure Is a change in the method of accounting for depreciation considered a change in estimate or a change in accounting principle? What is the justification? Has it always been treated this way under U.S. GAAP? Explain. Alternative 1: Step one: In the master glossary, in the ‘glossary term quick find’ box slowly type ‘change in’. Alternatives are provided below the box and click on ‘Change in accounting estimates.’ You learn that it is covered in Topic 250, but you can also click on the incoming links to see specific links in the standards. There are three links. Step two; after clicking on incoming links, click on ‘250 Accounting Changes and Error Corrections > 10 Overall > 45 Other Presentation> General, paragraph 45-17,’ the answer is found in paragraph 18. Alternative 2: Step 1: Use the drop-down menus under the ‘presentation’ general topic on the homepage and choose ‘250 Accounting Changes and Error Corrections.’ Use the second drop-down menu and choose 10 overall.’ Step 2: Click on the ‘Expand’ option and scroll through the topics looking for changes in estimates. Clicking on change in accounting estimates in section 45 or section 50 will lead you to the correct answer. FASB ASC paragraph 250-10-45-18 Distinguishing between a change in an accounting principle and a change in an accounting estimate is sometimes difficult. In some cases, a change in accounting estimate is effected by a change in accounting principle. One example of this type of change is a change in method of depreciation, amortization, or depletion for long-lived, nonfinancial assets (hereinafter referred to as depreciation method). The new depreciation method is adopted in partial or complete recognition of a change in the estimated future benefits inherent in the asset, the pattern of consumption of those benefits, or the information available to the entity about those benefits. The effect of the change in accounting principle, or the method of applying it, may be inseparable from the effect of the change in accounting estimate. Changes of that type often are related to the continuing process of

7 - 12

obtaining additional information and revising estimates and, therefore, shall be considered changes in estimates for purposes of applying this Subtopic. ASC7-3 Glossary Define a related party and provide an example. In the master glossary, in the ‘glossary term quick find’ box slowly type ‘related part.’ And choose the alternative ‘Related Parties.’ You learn that it is covered in ten different Topics 310, 460, 715, 718, 730, 810, 820, 850, 946, and 958. Note that Topic 850 provides guidance for related party disclosures. Click on this topic and join all sections. Scroll through the paragraphs. FASB ASC paragraph 850-1005-3 provides examples of related party transactions. Related parties include: a. Affiliates of the entity b. Entities for which investments in their equity securities would be required, absent the election of the fair value option under the Fair Value Option Subsection of Section 825–10–15, to be accounted for by the equity method by the investing entity c.Trusts for the benefit of employees, such as pension and profit-sharing trusts that are managed by or under the trusteeship of management d. Principal owners of the entity and members of their immediate families e. Management of the entity and members of their immediate families f. Other parties with which the entity may deal if one party controls or can significantly influence the management or operating policies of the other to an extent that one of the transacting parties might be prevented from fully pursuing its own separate interests g. Other parties that can significantly influence the management or operating policies of the transacting parties or that have an ownership interest in one of the transacting parties and can significantly influence the other to an extent that one or more of the transacting parties might be prevented from fully pursuing its own separate interests. Examples of related party transactions include those between a parent entity and its subsidiaries, an entity and its principal owners, management, or members of their immediate families, etc. ASC7-4 Cross-Reference FASB’s Emerging Issues Task Force (EITF) issued EITF 00-21 to provide guidance on revenue arrangements with multiple deliverables. List the topic and subtopic where this information can be found in the Codification (i.e., ASC XXX-XX). Step 1: Choose the cross reference tab on the opening page of the Codification. Step 2: Use the ‘By Standard’ drop down menu. Choose EITF as the standard type and 00-21 as the standard number. Click on ‘Generate Report.’ The EITF is included in Subtopic 605-25 Revenue Recognition - Recognition.

7 - 13

ANSWERS TO PROBLEMS Problem 7-1 Intercompany sale of equipment Accumulated Cost Depreciation Original Cost $780,000 $400,000 Intercompany Selling Price 500,000 _______ Difference $280,000 $400,000

Part A (1)

(2)

(1)

(2)

Part B

Carrying Value $380,000 500,000 $120,000

2011 Equipment Gain on Sale of Equipment ($500,000 - $380,000) Accumulated Depreciation - Equipment Accumulated Depreciation - Equipment Depreciation Expense ($120,000/4)(1/2)

Remaining Life Depreciation 4 yr $ 95,000 4 yr 125,000 $ 30,000

280,000 120,000 400,000 15,000 15,000

2012 Equipment (to original cost) Beginning Retained Earnings - Powell Co. ($120,000  .8) Noncontrolling Interest ($120,000  .2) Accumulated Depreciation - Equipment Accumulated Depreciation - Equipment Depreciation Expense ($120,000/4) Beginning Retained Earnings - Powell Co. ($15,000  .8) Noncontrolling Interest ($15,000  .2)

280,000 96,000 24,000 400,000 45,000 30,000 12,000 3,000

Consolidated Income = $300,000 + $200,000 + $30,000 $ 530,000 Noncontrolling Interest in Consolidated Income = .20  ($200,000 + $30,000) (46,000) Controlling Interest in Consolidated Net Income = $300,000 + [.8  ($200,000 + $30,000)] $ 484,000

Problem 7-2 Intercompany Sale of Equipment Accumulated Cost Depreciation Original Cost $ 260,000 -0Intercompany Selling Price 350,000 _______ Difference $ 90,000

7 - 14

Carrying Value $ 260,000 350,000 $ 90,000

Remaining Life Depreciation 6 yr $ 43,333 6 yr 58,333 $ 15,000

Problem 7-2(continued) Part A 2011 (1) Sales Cost of Goods Sold Equipment

350,000 260,000 90,000

(2) Accumulated Depreciation Depreciation Expense ($90,000/6)

15,000 15,000

2012 (1) Beginning Retained Earnings - Pico Equipment

90,000 90,000

(2) Accumulated Depreciation Depreciation Expense Beginning Retained Earnings - Pico Part B

30,000 15,000 15,000

Pico Company's reported net income $ 600,000 Less unrealized intercompany profit on 1/1/11 sales of equipment to Seward Company (90,000) Plus Profit on 1/1/11 sale realized through depreciation 15,000 Pico Company's reported net income from independent operations that has been realized in transactions with third parties 525,000 180,000 Plus Pico Company's share of Seward's reported net income (.90  $200,000) Controlling Interest in Consolidated Net Income $ 705,000

Problem 7-3 Intercompany sale of equipment Accumulated Cost Depreciation Original Cost $450,000 -0Intercompany Selling Price 600,000 _______ Difference $150,000 Part A (1) (2)

P Company’s Books 2011 Equipment Cash

Carrying Value $450,000 600,000 $150,000

Remaining Life Depreciation 6 yr $ 75,000 6 yr 100,000 $ 25,000

600,000 600,000

Depreciation Expense - Equipment Accumulated Depreciation

100,000 100,000

2012 Cash Accumulated Depreciation ($600,000/6) Equipment Gain on Sale of Equipment 7 - 15

550,000 100,000 600,000 50,000

Problem 7-3 (continued) Part B

P Company $600,000 (100,000) 500,000 550,000 $50,000

Cost Accumulated Depreciation 1/1/2012 Book Value Proceeds Gain *$450,000 -

Consolidated

$ 375,000* 550,000 $ 175,000

1 ($450,000) = $375,000 6

Cost Method or Partial Equity Method Beginning Retained Earnings - P Company (.8  $125,000) Noncontrolling Interest (.2  $125,000) Gain on Sale of Equipment ($175,000 - $50,000)

100,000 25,000

Complete Equity Method Investment in S Company (.8  $125,000) Noncontrolling Interest (.2  $125,000) Gain on Sale of Equipment ($175,000 - $50,000)

100,000 25,000

7 - 16

125,000

Problem 7-4 Part A

PROUT COMPANY AND SUBSIDIARY Consolidated Statements Workpaper For the Year Ended December 31, 2012 Prout Sexton Company Company

INCOME STATEMENT Sales Dividend Income Total Revenue Cost of Goods Sold: Income Tax Expense Other Expenses Total Cost & Expenses Net /Consolidated Income Noncontrolling Interest Income Net Income to Retained Earnings

1,475,000 1,110,000 80,000 (4) 1,555,000 1,110,000 942,000 795,000 187,200 90,000 145,000 90,000 1,274,200 975,000 280,800 135,000 280,800

135,000

STATEMENT OF RETAINED EARNINGS 1/1 Retained Earnings Prout Company 1,300,000 Sexton Company Net Income from above Dividends Declared Prout Company Sexton Company 12/31 Retained Earnings to Balance Sheet

Eliminations Debit Credit

Noncontrolling Consolidated Interest Balances 2,585,000

80,000

(3)

80,000

8,000

(2)

120,000 (1) (3) 1,040,000 (5) 1,040,000 280,800 135,000 80,000

2,585,000 1,737,000 277,200 227,000 2,241,200 343,800 27,000 * (27,000) 27,000 316,800

192,000 8,000

1,380,000

8,000

27,000

80,000

(20,000 )

288,000

7,000

(120,000 )

316,800 (120,000)

(100,000 ) 1,460,800 1,075,000

(4) 1,240,000

* Noncontrolling interest in consolidated income = .20  $135,000 = $27,000 Explanations of workpaper entries are on next page

7 - 17

1,576,800

Problem 7-4 (continued) Prout Sexton Company Company BALANCE SHEET Current Assets Investment in Sexton Company Fixed Assets Accumulated Depreciation Other Assets Total Assets

568,000 271,000 1,600,000 (1) 1,972,000 830,000 (2) (375,000 ) (290,000 ) (3) 1,000,800 1,600,000 4,765,800 2,411,000

Eliminations Debit Credit

839,000 192,000 (5) 1,792,000 40,000 16,000 (2) 160,000

Other Liabilities 305,000 136,000 Capital Stock Prout Company 3,000,000 Sexton Company 1,200,000 (5) 1,200,000 Retained Earnings from above 1,460,800 1,075,000 1,240,000 Noncontrolling Interest in Net Assets (5) Total Liabilities & Equity

4,765,800 2,411,000

Noncontrolling Consolidated Interest Balances

2,688,000

7 - 18

2,842,000 (809,000) 2,600,800 5,472,800 441,000 3,000,000

288,000 448,000 2,688,000

7,000 448,000 455,000

1,576,800 455,000 5,472,800

Problem 7-4 (continued) Intercompany Sale of Equipment Accumulated Cost Depreciation Original Cost $400,000 $160,000 Intercompany Selling Price 360,000 _______ Difference $ 40,000 $160,000

Carrying Value $240,000 360,000 $120,000

Remaining Life Depreciation 15 yr $16,000 15 yr 24,000 $ 8,000

Explanation to workpaper entries (not required) (1) Investment in Sexton Company 192,000 Retained Earnings - Prout 192,000 To establish reciprocity/convert to equity (.80  ($1,040,000 - $800,000)) (2) Equipment 40,000 Beginning Retained Earnings - Prout 120,000 Accumulated Depreciation 160,000 To reduce beginning consolidated retained earnings by amount of unrealized profit at the beginning of the year, to restate property and equipment to its book value to Prout Company on the date of the intercompany sale. (3) Accumulated Depreciation 16,000 Depreciation Expense 8,000 Beginning Retained Earnings - Prout 8,000 To reverse amount of excess depreciation recorded during current year and recognize an equivalent amount of intercompany profit as realized (4) Dividend Income Dividends Declared To eliminate intercompany dividends

80,000 80,000

(5) Beginning Retained Earnings – Sexton 1,040,000 Common Stock – Sexton 1,200,000 Investment in Sexton Company ($1,600,000 + $192,000) 1,792,000 Noncontrolling Interest [$400,000 + ($1,040,000 - $800,000) x .20] 448,000 To eliminate investment account and create noncontrolling interest account Part B (1)Cash Accumulated Depreciation - Fixed Assets ($360,000/15)(2 ) Loss on Sale of Equipment Plant and Equipment

300,000 48,000 12,000

(2)Beginning Retained Earnings – Prout($120,000 - $16,000) Loss on Sale of Equipment Gain on Sale of Equipment

104,000

360,000 12,000 92,000

Cost to the Affiliated Companies $400,000 Accumulated Depreciation Based on Original Cost ((12/25)  $400,000) 192,000 Book Value to the Affiliated Companies on 1/1/13 208,000 Proceeds from Sale to Non-affiliate (300,000) Gain to Affiliated Companies on Sale $92,000 (3) No workpaper entries are necessary for 2014 and later years. As of Dec. 31, 2013, the amount of profit recorded by the affiliates on their books ($120,000 - $12,000 = $108,000) is equal to the amount of profit considered realized in the consolidated financial statements ($8,000 + $8,000 + $92,000) = $108,000. 7 - 19

Problem 7-5

Debits Currents Assets Investment in Sexton Company Fixed Assets Other Assets Dividends Declared Prout Company Sexton Company Cost of Goods Sold Other Expenses Income Tax Expense Totals Credits Liabilities Accumulated Depreciation Common Stock Prout Company Sexton Company Retained Earnings Prout Company Sexton Company Sales Dividend Income Totals

PROUT COMPANY AND SUBSIDIARY Consolidated Statements Workpaper – For the Year Ended 12/31/12 Prout Sexton Eliminations Consolidated Consolidated Noncontrol. Consolidated Company Company Debit Credit Income Stat. Ret. Earnings Interest balances 568,000 271,000 839,000 1,600,000 (1) 192,000 (5) 1,792,000 1,972,000 830,000 (2) 40,000 2,842,000 1,000,800 1,600,000 2,600,800 120,000

(120,000 )

100,000 942,000 795,000 145,000 90,000 187,200 90,000 6,535,000 3,776,000 305,000 375,000

(4) (3)

80,000 8,000

(20,000 ) 1,737,000 227,000 277,200 6,281,800

136,000 290,000 (3)

441,000 809,000

16,000 (2) 160,000

3,000,000

3,000,000 1,200,000 (5) 1,200,000

1,300,000

(2)

120,000 (1) (3) 1,040,000 (5) 1,040,000 1,475,000 1,110,000 80,000 (4) 80,000 6,535,000 3,776,000

192,000 8,000

1,380,000

(2,585,000 )

Net/ Consolidated Income Noncontrolling Interest in Income (.20 x $135,000 = $27,000) Controlling Interest in Consolidated Income

343,800 (27,000) 316,800

Consolidated Retained Earnings

27,000 316,800 1,576,800

Noncontrolling Interest in Net Assets

(5)

448,000

1,576,800 448,000 455,000

2,688,000 Totals

455,000

2,688,000 6,281,800

7 - 20

Problem 7-6 Part A

Income Statement Sales Dividend Income Total Revenue Cost of Goods Sold: Other Expenses Total Cost & Expenses Net/Consolidated Income Noncontrolling Interest Income Net Income to Retained Earnings Statement of Retained Earnings 1/1 Retained Earnings Pitts Company

PITTS COMPANY AND SUBSIDIARY Consolidated Statements Workpaper For the Year Ended December 31, 2012 Pitts Company

Shannon Company

1,950,000 60,000 2,010,000 1,350,000 225,000 1,575,000 435,000

1,350,000

435,000

300,000

Net Income from above Dividends Declared Pitts Company Shannon Company 12/31 Retained Earnings to Balance Sheet

435,000

3,300,000 (4)

60,000

1,350,000 900,000 150,000 1,050,000 300,000

1,215,000

Shannon Company

Eliminations Noncontrolling Consolidated Debit Credit Interest Balances

(3) 15,000

(2)

60,000

15,000

120,000

(1) 290,400 (3) 12,000

1,038,000

(5) 1,038,000

300,000

60,000

15,000

1,218,000

(4) 60,000 377,400

(150,000) 1,500,000

(75,000) 1,263,000

*Noncontrolling interest in income = .20  ($300,000 + $15,000) = $63,000. Explanations of workpaper entries are on separate page.

7 - 21

3,300,000 2,250,000 360,000 2,610,000 690,000 63,000* (63,000) 63,000 627,000

1,397,400

63,000

627,000

(150,000) (15,000) 48,000 1,874,400

Problem 7-6 (continued) Balance Sheet Assets Inventory Investment in Shannon Company Fixed Assets Accumulated Depreciation Total Assets Liabilities Capital Stock Pitts Company Shannon Company Retained Earnings from above Noncontrolling Interest Total Liabilities and Equity

Pitts Company

Shannon Company

498,000 960,000 2,168,100 (900,000) 2,726,100

225,000 2,625,000 (612,000) 2,238,000

465,600

450,000

Eliminations Noncontrolling Debit Credit Interest

723,000 (1) 290,400 (2) 390,000 (3) 30,000

(5) 1,250,400 (2)

5,183,100 (2,022,000) 3,884,100

540,000

915,600

760,500 1,500,000

2,726,100

Consolidated Balances

760,500 525,000 1,263,000

2,238,000

7 - 22

(5) 525,000 1,218,000 (2) 30,000 2,483,400

(5) (3)

377,400 312,600 3,000 2,483,400

48,000 285,600

1,874,400

333,600

333,600 3,884,100

Problem 7-6 (continued) Intercompany Sale of Equipment Accumulated Cost Depreciation Original Cost $1,350,000 $540,000 Intercompany Selling Price 960,000 _______ Difference $ 390,000 $540,000

Carrying Value $810,000 960,000 $150,000

Remaining Life Depreciation 10 yr $81,000 10 yr 96,000 $15,000

Explanation of workpaper entries (not required) (1) Investment in Shannon Company 290,400 Retained Earnings – Pitts To establish reciprocity/convert to equity (.80  ($1,038,000 - $675,000))

290,400

(2) Equipment 390,000 Retained Earnings – Pitts ($150,000)(.80) 120,000 Noncontrolling Interest ($150,000)(.20) 30,000 Accumulated Depreciation 540,000 To reduce controlling and noncontrolling interests for their respective shares of unrealized intercompany profit at beginning of year, to restore property and equipment to its book value to the selling affiliate on the date of the intercompany sale (3) Accumulated Depreciation 30,000 Other Expenses (Depreciation Expense) Retained Earnings – Pitts ($15,000  ) Noncontrolling Interest ($15,000  ) To reverse amount of excess depreciation recorded during year and to recognize an equivalent amount of intercompany profit as realized (4) Dividend Income Dividends Declared

15,000 12,000 3,000

60,000 60,000

(5) Beginning Retained Earnings - Shannon 1,038,000 Common Stock - Shannon 525,000 Investment in Shannon Company ($960,000 + $290,400) Noncontrolling Interest [$240,000 + ($1,038,000 – $675,000) x.20] To eliminate investment account and create noncontrolling interest account Part B Calculation of Consolidated Retained Earnings Pitts Company's retained earnings on 12/31/12 Amount of Pitts Company’s retained earnings that have not been realized in transactions with third parties Pitts Company's retained earnings that have been realized in transactions with third parties Increase in retained earnings of Shannon Company from date of acquisition to 12/31/12 ($1,263,000 - $675,000) $588,000 Less unrealized profit on sales of equipment to Pitts on 1/1/11 included therein ($150,000 - $15,000 - $15,000) (120,000) Increase in reported retained earnings of Shannon Company that has been realized in transactions with third parties 468,000 Pitts Company share ___80% Consolidated retained earnings on 12/31/12 7 - 23

1,250,400 312,600

$1,500,000 0 1,500,000

374,400 $1,874,400

Problem 7-6 (continued) Consolidated Retained Earnings

Pitts' Company’s share of unrealized gain on upstream sales of equipment from S Company ($150,000 - $15,000 - $15,000).8

Pitts Company's Retained Earnings on 12/31/12

$1,500,000

Pitts Company's share of the increase in Shannon Company's Retained Earnings 96,000 since acquisition ($1,263,000 - $675,000).8

470,400

Consolidated Retained Earnings

7 - 24

$1,874,400

Problem 7-7 Part A

PARSONS COMPANY AND SUBSIDIARY Consolidated Statements Workpaper For the Year Ended December 31, 2013 Parsons Shea Company Company

Income Statement Sales Dividend Income Total Revenue Cost of Goods Sold Expenses Total Cost & Expense Net/Consolidated Income Noncontrolling Interest in Income Net Income to Retained Earnings Statement of Retained Earnings 1/1 Retained Earnings Parsons Company

2,555,500 54,000 2,609,500 1,730,000 654,500 2,384,500 225,000

1,120,000 1,120,000 690,500

Eliminations Noncontrolling Consolidated Debit Credit Interest Balances (6) (12)

375,000 54,000

(8)

10,500 (5) 7,500 (6) 375,000 12,667 (3) 9,500

251,000 (11) 941,500 178,500

3,300,500

225,000

178,500

452,167

392,000

595,000

(2) (4) (5) (11) 139,500 (9)

47,500 (1) 13,500 (3) 6,750 17,100 139,500

71,550 9,500

178,500

452,167

392,000

Shea Company

Net income from above 225,000 Dividend Declared Parsons Company (100,000) Shea Company 12/31 Retained Earnings to Balance Sheet 720,000

3,300,500 2,048,500

16,283 * 16,283

908,667 2,957,167 343,333 (16,283)* 327,050

591,200

16,283

327,050 (100,000)

(60,000) 258,000

(12) 676,517

7 - 25

54,000 527,050

(6,000) 10,283

818,250

Problem 7-7 (continued) Balance Sheet Cash Accounts Receivable Inventory Other Current Assets Investment in Shea Company Difference between Implied and Book Value Land Plant and Equipment Accumulated Depreciation Manufacturing Formula Total Assets Accounts Payable Other Liabilities Capital Stock Parsons Company Shea Company Additional Paid-in Capital Shea Company Retained Earnings from above 1/1 Noncontrolling Interest in Net Assets

12/31Noncontrolling Interest in Net Assets Total Liabilities & Equity

Parsons Shea Company Company 119,500 342,000 362,000 40,500 426,000

Eliminations Debit Credit

132,500 125,000 201,000 13,000

150,000 825,000 (207,000)

241,000 (53,500)

2,058,000

659,000

295,000 43,000

32,000 19,000

Noncontrolling Consolidated Interest Balances 252,000 407,000 552,500 53,500

(7) 60,000 (8) 10,500 (1) 71,550

(9) 497,550

(9) 63,333

(10) 63,333 (4) 15,000

(2) 2,500 (3) 19,000 (10) 63,333

135,000 1,068,500 (291,500) 31,666 2,208,666

(2) 50,000 (11) 31,667

(7) 60,000

267,000 62,000

1,000,000

720,000

2,058,000

1,000,000 300,000

(9) 300,000

50,000 258,000

(9) 50,000 676,517 (4) 1,500 (9) (5) 750 (11) 1,900

659,000

1,310,383

527,050 55,283

1,310,383

* Noncontrolling interest income = .10  ($178,500 + $7,500 - $10,500 - $12,667) = $16,283 Explanations of the workpaper entries are on a separate page 7 - 26

10,283 51,133

818,250

61,416

61,416 2,208,666

Problem 7-7 (continued) Intercompany Sale of Equipment Accumulated Cost Depreciation Original Cost $100,000 $50,000 Intercompany Selling Price 97,500 _______ Difference $ 2,500 $50,000

Carrying Value $50,000 97,500 $47,500

Remaining Life Depreciation 5 yr $10,000 5 yr 19,500 $ 9,500

Explanations of workpaper entries (1) Investment in Shea Company 1/1 Retained Earnings - Parsons Co. To establish reciprocity/convert to equity (.9  ($139,500 - $60,000)) (2)

(3)

(4)

(5)

(6)

71,550 71,550

Plant and Equipment ($100,000 - $97,500) 2,500 Beginning Retained Earnings – Parsons ($50,000 - $2,500) 47,500 Accumulated Depreciation To eliminate unrealized profit on intercompany sale of equipment and to restore plant and equipment to its book value on the date of intercompany sale

50,000

Accumulated Depreciation Expenses (Depreciation Expense) Beginning Retained Earnings - Parsons To reverse excess depreciation recorded during 2013 (.20  $47,500)

9,500 9,500

19,000

Beginning Retained Earnings - Parsons Co. (.90  $15,000) 13,500 Noncontrolling Interest (.10  $15,000) 1,500 Land To eliminate unrealized profit on intercompany sale of land (upstream sale) Beginning Retained Earnings - Parsons Co. (.90  $7,500) Noncontrolling Interest (.10  $7,500) Cost of Goods Sold To eliminate intercompany profit in beginning inventory (upstream sale) Sales

6,750 750 7,500

375,000

Cost of Goods Sold (Purchases) To eliminate intercompany sale (7)

(8)

15,000

375,000

Accounts Payable Accounts Receivable To eliminate intercompany payables and receivables

60,000

Cost of Goods Sold (Ending Inventory – Income Statement) Inventory To eliminate unrealized profit in ending inventories

10,500

7 - 27

60,000

10,500

Problem 7-7 (continued) (9) Beginning Retained Earnings - Shea Co. 139,500 Capital Stock - Shea Co. 300,000 Additional Paid-in Capital - Shea Co. 50,000 Difference between Implied and Book Value 63,333 Investment in Shea ($426,000 + $71,550) Noncontrolling Interest [$47,333 + ($139,500 – $60,000) x .10] To eliminate the investment account and create noncontrolling interest account (10) Manufacturing Formula Difference between Implied and Book Value To allocate the difference between implied and book value

63,333

(11) Beginning Retained Earnings - Parsons Co. ($63,333/5 x 1.5) x .90 Noncontrolling Interest ($63,333/5 x 1.5) x .10 Expenses ($63,333/5) Manufacturing Formula To amortize the difference between implied and book value

17,100 1,900 12,667

Alternative to entries (10) and (11) (10a) Beginning Retained Earnings - Parsons Co. ($63,333/5 x 1.5) x .90 Noncontrolling Interest ($63,333/5 x 1.5) x .10 Manufacturing Formula Expenses ($63,333/5) Difference between Implied and Book Value To allocate and amortize the difference between implied and book value ($63,333/5) = $12,667; $63,333 - ($12,667  2.5) = $31,666 (12) Dividend Income Dividends Declared To eliminate intercompany dividend ($60,000  .90 = $54,000)

7 - 28

497,550 55,283

63,333

31,667

17,100 1,900 31,666 12,667 63,333

54,000 54,000

Problem 7-7 (continued) Part B Parsons Company's retained earnings on 12/31/2013 Less intercompany unrealized profit on sales of equipment to Shea on 12/31/2011 included therein ($47,500 - $9,500 - $9,500) Parsons Company's retained earnings that have been realized in transactions with third parties Increase in retained earnings of Shea Company from date of acquisition to 12/31/2013 ($258,000 - $60,000) Less cumulative effect of adjustment to date relating to amortization of manufacturing formula ($19,000 + $12,667) Less unrealized profit on sales to Parsons in 2012 and 2013 that has not been realized by sales to third parties ($15,000 + $10,500) Increase in reported retained earnings of Shea since acquisition that has been realized in transactions with third parties Parsons Company share thereof (.90  $140,833) Consolidated retained earnings on 12/31/2013

$ 720,000 (28,500) 691,500 198,000 (31,667) (25,500) 140,833 ___90%

126,750 $ 818,250

Alternatively Consolidated Retained Earnings Unrealized profit on upstream sales in Parson’s ending inventory ($15,000 + $10,500)(.90)

Parsons Company's Retained Earnings on 12/31/13

$720,000

22,950 Increase in Shea Company's Retained Earnings since acquisition ($258,000 - $60,000) = $198,000 Unrealized gain on downstream sales of Less: amortization of the difference equipment to Shea Company between implied and book value 31,667 ($47,500 - $9,500 - $9,500) 28,500 Adjusted increase $166,333 Parson Company’s share _ 90%

149,700

Consolidated Retained Earnings

7 - 29

$818,250

Problem 7-8

PHELPS COMPANY AND SUBSIDIARY Consolidated Statements Workpaper For the Year Ended December 31, 2011 Phelps Sloane Company Company

Income Statement Sales Other Income Dividend Income Total Revenue Cost of Goods Sold Depreciation Expense Interest Expense Other Expenses Total Cost and Expense Net/Consolidated Income Noncontrolling Interest in Income Net Income to Retained Earnings Statement of Retained Earnings 1/1 Retained Earnings Phelps Company

Sloane Company Net Income from above Dividends Declared Phelps Company Sloane Company 12/31 Retained Earnings to Balance Sheet

Eliminations Noncontrolling Consolidated Debit Credit Interest Balances

1,291,500 560,000 (2) 260,000 140,000 (5) 140,000 42,500 (11) 42,500 1,334,000 700,000 660,000 300,000 (4) 15,000 (2) 260,000 (8) 24,000 (3) 10,000 138,000 20,000 (6) 18,667 8,000 10,000 (9) 6,000 174,000 140,000 980,000 470,000 354,000 230,000 354,000 230,000

350,500

487,500

288,667

1,591,500

1,591,500 729,000

13,300 * 13,300

(3) 8,500 (1) 85,000 (8) 20,400 (9) 5,100 250,000 (7) 250,000

139,333 24,000 314,000 1,206,333 385,167 (13,300) 371,867

401,500

354,000 230,000

487,500

288,667

13,300

(50,000 ) 604,500 430,000

(11) 42,500 771,500 416,167

(7,500 ) 5,800

371,867 (100,000)

7 - 30

673,367

Problem 7-8 (continued) Phelps Company Balance Sheet Cash Accounts Receivable Inventory Investment in Sloane Company Difference between Implied and Book Value Land Plant and Equipment Accumulated Depreciation Goodwill Total Assets Accounts Payable Bonds Payable Discount on Bonds Payable Capital Stock Phelps Company Sloane Company Retained Earnings from above 1/1 Noncontrolling Interest in Net Assets 12/31 Noncontrolling Interest in NA Total Liabilities & Equity

127,000 300,000 270,000 955,000

Sloane Company

Debit

70,000 210,000 175,000

167,500 80,000

(10) (4) 85,000 (7)

40,000 15,000 1,040,000

223,529 (8) 36,000 26,667 18,667 (5) 91,529

223,529

(1)

(7) 100,000 290,000 (8) 800,000 800,000 (5) (200,000) (200,000) (6) (8) 2,352,000 1,345,000

Eliminations Credit

65,000 (10) 100,000 (8)

Noncontrolling Consolidated Interest Balances 197,000 470,000 430,000

426,000 1,626,667 (548,000) 91,529 2,693,196

166,667

40,000 48,000 (9)

192,500 180,000 (36,000)

12,000

1,500,000

604,500

1,500,000 750,000 (7)

750,000

430,000

771,500 1,500 (7) 3,600 900

(3) (8) (9) 2,352,000 1,345,000

2,096,892

416,167 183,529

5,800 177,529

673,367

183,329

183,329 2,693,196

2,096,892

* Noncontrolling interest income = .15  ($230,000 + $10,000 - $140,000 + $18,667 – $24,000 – $6,000) = $13,300 Explanations of the workpaper entries are on a separate page

7 - 31

Problem 7-8 (continued) Intercompany Sale of Equipment Cost Depreciation Original Cost $666,667 $166,667 Intercompany Selling Price 640,000 _______ Difference $ 26,667 $166,667 Original cost Depreciation Ac. depreciation Book value

Carrying Value $500,000 640,000 $140,000

Remaining Life Depreciation 7.5 yr $66,667 7.5 yr 85,333 $18,666

[$500,000/(7.5/10 years)] = $500,000/.75 = $666,667 $666,667/10 years = $66,667 $66,667  2.5 years = $166,667 $666,667 - $166,667 = $500,000

Explanations of workpaper entries (not required) (1) Investment in Sloane Company Beginning Retained Earnings - Phelps Co. To establish reciprocity/convert to equity [($250,000 - $150,000)  .85]

85,000

(2) Sales Cost of Goods Sold (Purchases) ($200,000  1.3) To eliminate intercompany sales

260,000

85,000

260,000

(3) 1/1 Retained Earnings - Phelps 1/1 Noncontrolling Interest Cost of Goods Sold To recognize intercompany profit realized during the year

8,500 1,500

(4) Cost of Goods Sold (Ending Inventory – Income Statement) Inventory (Balance Sheet) To eliminate unrealized intercompnay profit in ending inventory [$65,000 - ($65,000/1.30)]

15,000

(5) Plant and Equipment Gain on Sale (other income) Accumulated Depreciation To eliminate unrealized profit recorded on intercompany sale of equipment and restate equipment to its book value on date of intercompany sale

26,667 140,000

(6) Accumulated Depreciation Depreciation Expense To reverse amount of excess depreciation recorded during current year and to recognize an equivalent amount of intercompany profit as realized ($140,000/7.5 years)

18,667

7 - 32

10,000

15,000

166,667

18,667

Problem 7-8 (continued) (7) 1/1 Retained Earnings – Sloane 250,000 Capital Stock – Sloane 750,000 Difference between Implied and Book Value 223,529 Investment in Sloane Company ($955,000 + $85,000) Noncontrolling interest [$168,529 + ($250,000 – $150,000) x .15] To eliminate investment account and create noncontrolling interest account (8) Beginning Retained Earnings – Phelps (1/2 of inventory sold in 2010) Noncontrolling Interest (1/2 of inventory sold in 2010) Cost of Goods Sold (1/2 of inventory sold in 2011) Goodwill Land Discount on Bonds Payable Difference between Implied and Book Value

20,400 3,600 24,000 91,529 36,000 48,000

(9) Beginning Retained Earnings – Phelps Noncontrolling Interest Interest Expense ($48,000/8) Discount on Bonds Payable

5,100 900 6,000

1,040,000 183,529

223,529

12,000

Alternative to entries (8) and (9) (8a) Beginning Retained Earnings - Phelps ($20,400 + $5,100) Noncontrolling interest ($3,600 + $900) Cost of Goods Sold Interest Expense ($48,000/8) Land Discount on Bonds Payable ($48,000 - $6,000 - $6,000) Goodwill Difference between Implied and Book Value To allocate, amortize and depreciate the difference between implied and book value

25,500 4,500 24,000 6,000 36,000 36,000 91,529 223,529

(10) Accounts Payable Accounts Receivable To eliminate intercompany payable and receivable

40,000

(11) Dividend Income Dividends Declared To eliminate intercompany dividends ($50,000  .85)

42,500

40,000

42,500

7 - 33

Problem 7-9 Computation and Allocation of Difference Schedule Parent Share Purchase price and implied value $1,480,000 Less: Book value of equity acquired 1,350,000 Difference between implied and book value 130,000 Inventory (45,000) Equipment (135,000) Land (90,000) Balance (excess of FV over implied value) (140,000) Gain 140,000 Increase noncontrolling interest to fair value of assets Total allocated bargain Balance -0-

NonEntire Controlling Value Share 164,444 1,644,444 * 150,000 1,500,000 14,444 144,444 (5,000) (50,000) (15,000) (150,000) (10,000) (100,000) (15,556) (155,556) 15,556 -0-

155,556 -0-

*$1,480,000/.90 Amortization Schedule Inventory ($50,000  .80); ($50,000  .20) Plant and Equipment ($150,000/10) Land Total

2011 $40,000 $15,000 $0 $55,000

7 - 34

2012 $10,000 $15,000 $0 $25,000

Problem 7-9

PIERCE COMPANY AND SUBSIDIARY Consolidated Statements Workpaper For the Year Ended December 31, 2012 Pierce Sanders Company Company

Income Statement Sales Gain on sale of land Dividend income Total revenue Cost of goods sold Depreciation expense Other expenses Total cost and expense Net/consolidated income Noncontrolling interest in income Net income to retained earnings Statement of Retained Earnings 1/1 Retained earnings Pierce Company

1,700,000 63,000 1,763,000 600,000 60,000 400,000 1,060,000 703,000

900,000 (2) 430,000 50,000 (5) 50,000 (10) 63,000 950,000 400,000 (3) 11,000 (2) 430,000 (7) 10,000 (4) 20,000 40,000 (8) 15,000 260,000 700,000 250,000

703,000

250,000

706,000

(4) 19,000 (1) 72,000 (7) 36,000 (7) 140,000 (8) 13,500 580,000 (6) 580,000

703,000

250,000

Sanders Company Net income from above Dividends declared Pierce Company Sanders Company 12/31 Retained earnings to balance sheet

Eliminations Noncontrolling Consolidated Debit Credit Interest Balances

579,000

450,000

2,170,000

2,170,000 571,000

18,000 * 18,000

849,500

450,000

18,000

(10) 63,000

(7,000)

725,000

11,000

(120,000 )

806,000 (120,000)

(70,000) 1,289,000

115,000 660,000 1,346,000 824,000 (18,000) 806,000

760,000

1,227,500

7 - 35

1,535,500

Problem 7-9 (continued) Balance Sheet Cash Accounts receivable Inventory Marketable securities Investment in Sanders Company Difference between implied and book value Land Plant and equipment Total Assets Accounts payable Notes payable Capital stock Pierce Company Sanders Company Retained earnings from above 1/1 Noncontrolling interest in net assets

12/31 Noncontrolling interest in net assets Total liabilities & equity

Pierce Company

Sanders Company

Eliminations Debit Credit

200,000 300,000 300,000 100,000 1,480,000

150,000 250,000 250,000 200,000

(1) (6) 400,000 350,000 (7) 1,000,000 800,000 (7) 3,780,000 2,000,000 241,000 350,000

140,000 (9) 100,000

(9) (3)

Noncontrolling Interest

Consolidated Balances 350,000 490,000 539,000 300,000

60,000 11,000

72,000 (6) 1,552,000 144,444 (7) 144,444 100,000 (5) 50,000 150,000 (8) 30,000

800,000 1,920,000 4,399,000

60,000

321,000 450,000

1,900,000

1,000,000 (6) 1,000,000 1,289,000 760,000 1,227,500 (4) 1,000 (6) (7) 4,000 (7) (8) 1,500 3,780,000 2,000,000

2,760,444

725,000 172,444 15,556

11,000 181,500

1,535,500

192,500

192,500 4,399,000

2,760,444

* Noncontrolling interest income = .10  ($250,000 + $10,000 - $5,000 - $50,000 - $10,000 - $15,000) = $18,000. Explanations of the workpaper entries are on a separate page.

7 - 36

Problem 7-9 (continued) Explanations of workpaper entries (1) Investment in Sanders Company Beginning Retained Earnings - Pierce Co. To establish reciprocity/convert to equity [($580,000 - $500,000)  .90]

72,000

(2) Sales Cost of Goods Sold (Purchases)($350,000 + $80,000) To eliminate intercompany sales

430,000

(3) Cost of Goods Sold (Ending Inventory – Income Statement) Inventory (Balance Sheet) To eliminate unrealized intercompany profit in ending inventory [$30,000 - ($30,000/1.25) = $6,000] + [$20,000 - ($20,000/1.3333*) = $5,000] * (1/(1-.25) = 1.3333

11,000

72,000

430,000

11,000

(4) 1/1 Retained Earnings - Pierce 19,000 1/1 Noncontrolling Interest (.1  $10,000) 1,000 Cost of Goods Sold To recognize intercompany profit realized during the year and to reduce noncontrolling interest at beginning of year for its share of unrealized intercompany profit at beginning of year [$50,000 - ($50,000/1.25) = $10,000] + [$40,000 - ($40,000/1.3333) = $20,000] (5) Gain on Sale of Land Land To eliminate unrealized profit recorded on intercompany sale of land and reduce carrying value of land to its book value on date of sale

50,000

(6) 1/1 Retained Earnings – Sanders Common Stock – Sanders Difference between Implied and Book Value Investment in Sanders Company ($1,480,000 + $72,000) Noncontrolling interest [$164,444 + ($580,000 - $500,000) x.10]

580,000 1,000,000 144,444

(7) 1/1 Retained Earnings - Pierce ($45,000  .8) Noncontrolling Interest ($5,000 x .8) Cost of Goods Sold (.2  $50,000) Land Plant and Equipment Difference between Implied and Book Value Gain – Retained Earnings - Pierce Noncontrolling Interest

7 - 37

20,000

50,000

1,552,000 172,444 36,000 4,000 10,000 100,000 150,000 144,444 140,000 15,556

Problem 7-9 (continued) (8)1/1 Retained Earnings - Pierce Noncontrolling Interest Depreciation Expense ($150,000/10) Plant and Equipment (net)

13,500 1,500 15,000 30,000

Alternative to entries (7) and (8) (7a)1/1 Retained Earnings - Pierce ($36,000 + $13,500) Noncontrolling Interest ($4,000 + $1,500) Cost of Goods Sold (.2  $50,000) Depreciation Expense ($150,000/10) Land Plant and Equipment ($150,000 - $30,000) Difference between Implied and Book Value Gain Noncontrolling Interest To allocate, amortize and depreciate the difference between implied and book value

49,500 5,500 10,000 15,000 100,000 120,000 144,444 140,000 15,556

(9) Accounts Payable Accounts Receivable To eliminate intercompany payable and receivable

60,000

(10)Dividend Income Dividends Declared To eliminate intercompany dividends ($70,000  .90).

63,000

60,000

63,000

7 - 38

Problem 7-10 Part A

Income Statement Sales Equity in Subsidiary Income Total Revenue Cost of Goods Sold: Income Tax Expense Other Expenses Total Cost & Expenses Net /Consolidated Income Noncontrolling Interest Income* Net Income to Retained Earnings

PROUT COMPANY AND SUBSIDIARY Consolidated Statements Workpaper For the Year Ended December 31, 2012 Prout Company

Sexton Company

1,475,000 108,000 1,583,000 942,000 187,200 145,000 1,274,200 308,800

1,110,000

308,800

135,000

Eliminations Noncontrolling Consolidated Debit Credit Interest Balances 2,585,000 (1)

108,000

1,110,000 795,000 90,000 90,000 975,000 135,000

(3)

108,000

Statement of Retained Earnings 1/1 Retained Earnings Prout Company 1,492,000 (2) 120,000 (3) Sexton Company 1,040,000 (4) 1,040,000 Net Income from above 308,800 135,000 108,000 Dividends Declared Prout Company (120,000 ) Sexton Company (100,000 ) (1) 12/31 Retained Earnings to Balance Sheet 1,680,800 1,075,000 1,268,000 * Noncontrolling interest in consolidated income = .20  $135,000 = $27,000

7 - 39

8,000

2,585,000 1,737,000 277,200 227,000 2,241,200 343,800 27,000 * (27,000) 27,000 316,800

8,000

1,380,000

8,000

27,000

316,800 (120,000)

80,000

(20,000)

96,000

7,000

1,576,800

Problem 7-10 (continued) Prout Company

Sexton Company

Balance Sheet Current Assets Investment in Sexton Company

568,000 1,820,000

271,000

Plant and Equipment Accumulated depreciation Other Assets Total Assets

1,972,000 (375,000) 1,000,800 4,985,800

830,000 (2) (290,000) (3) 1,600,000 2,411,000

305,000

136,000

Other Liabilities Capital Stock Prout Company Sexton Company Retained Earnings from above 1/1 Noncontrolling Interest 12/31 Noncontrolling Interest Total Liabilities & Equity

Eliminations Debit

Credit

Noncontrolling Consolidated Interest Balances 839,000

(1) 28,000 (4) 1,792,000 40,000 16,000 (2)

2,842,000 (809,000) 2,600,800 5,472,800

160,000

441,000

3,000,000 1,680,800

3,000,000 1,200,000 (4) 1,075,000

1,200,000 1,268,000 (4)

4,985,800

2,411,000

2,524,000

Explanations of workpaper entries are on separate page.

7 - 40

96,000 448,000 2524,000

7,000 448,000 455,000

1,576,800 455,000 5,472,800

Problem 7-10 (continued) Schedule to calculate intercompany profit Intercompany Sale of Equipment Accumulated Cost Depreciation Original Cost $400,000 $160,000 Intercompany Selling Price 360,000 _______ Difference $ 40,000 $160,000

Remaining Carrying Value Life Depreciation $240,000 15 yr $16,000 360,000 15 yr 24,000 $120,000 $ 8,000

Explanation of workpaper entries (not required) (1) Equity in Subsidiary Income Dividends Declared (.80)($100,000) Investment in Sexton Company To reverse the effect of parent company entries during the year for subsidiary dividends and income

108,000

(2) Property and Equipment ($400,000 - $360,000) Beginning Retained Earnings - Prout Company Accumulated Depreciation To reduce beginning consolidated retained earnings by amount of unrealized profit at the beginning of the year, and to restore the value of the equipment to its book value on the date of intercompany sale

40,000 120,000

(3) Accumulated Depreciation Depreciation Expense Beginning Retained Earnings - Prout Company To reverse amount of excess depreciation recorded during current year and recognize an equivalent amount of intercompany profit as realized

16,000

80,000 28,000

160,000

(4) Beginning Retained Earnings – Sexton 1,040,000 Common Stock – Sexton 1,200,000 Investment in Sexton Company ($1,820,000 - $28,000) Noncontrolling Interest [$400,000 + ($1,040,000 - $800,000) x .20] To eliminate investment account and create noncontrolling interest account

7 - 41

8,000 8,000

1,792,000 448,000

Problem 7-10 (continued) Part B (1) Cash Accumulated Depreciation - Fixed Assets ($360,000/15 yrs.  2 yrs.) Loss on Sale of Equipment Plant and Equipment

300,000

(2) Beginning Retained Earnings - Prout Loss on Sale of Equipment Gain on Sale of Equipment

104,000

48,000 12,000 360,000

12,000 92,000

Cost to the affiliated companies Accumulated depreciation based on original cost [(12/25  $400,000)] Book value to the affiliated companies on 1/1/13 Proceeds from sale to non-affiliate Gain to affiliated companies on sale

$ 400,000 192,000 208,000 (300,000) $ 92,000

(3) No workpaper entries are necessary for 2014 and later years. As of December 31, 2013, the amount of profit recorded by the affiliates on their books [$120,000 - $12,000 = $108,000] is equal to the amount of profit considered realized in the consolidated financial statements [$8,000 + $8,000 + $92,000 = $108,000].

7 - 42

Problem 7-11

Prout Company and Subsidiary, Consolidated Statements Workpaper - FYE December 31, 2012 Prout Sexton Eliminations Consolidated Consolidated Noncontrolling Consolidated Debits Company Company Debit Credit Income Stat. Ret. Earnings Interest Bal. Sheet Currents Assets 568,000 271,000 839,000 Investment in Sexton Company 1,820,000 (1) 28,000 (4) 1,792,000 Fixed Assets 1,972,000 830,000 (2) 40,000 2,842,000 Other Assets 1,000,800 1,600,000 2,600,800 Dividends Declared Prout Company 120,000 (120,000) Sexton Company 100,000 (1) 80,000 (20,000) Cost of Goods Sold 942,000 795,000 1,737,000 Other Expenses 145,000 90,000 (3) 8,000 227,000 Income Tax Expense 187,200 90,000 277,200 Totals 6,755,000 3,776,000 6,281,800 Credits Liabilities Accumulated Depreciation Common Stock Prout Company Sexton Company Retained Earnings Prout Company Sexton Company Sales Equity In Subsidiary Income Totals

305,000 375,000

136,000 290,000 (3)

16,000 (2)

441,000 809,000

160,000

3,000,000

3,000,000 1,200,000 (4) 1,200,000

1,492,000

(2) 120,000 (3) 1,040,000 (4) 1,040,000 1,475,000 1,110,000 108,000 (1) 108,000 6,755,000 3,776,000

8,000

1,380,000 (2,585,000)

Net/Consolidated Income

343,800

Noncontrolling Interest in Income (.20  $135,000 = $27,000)

(27,000) 316,800

Controlling Interest in Consolidated Net Income Consolidated Retained Earnings

27,000 * 316,800 1,576,800

1/1 Noncontrolling Interest in Net Assets 12/31 Noncontrolling Interest

(4) 2,524,000

448,000

1,576,800 448,000 455,000

455,000

2,524,000

Totals

6,281,800

7 - 43

Problem 7-12 Part A

PRATHER COMPANY AND SUBSIDIARY Consolidated Statements Workpaper For the Year Ended December 31, 2012 Prather Company

Income Statement Sales Equity in Subsidiary Income Total Revenue Cost of Goods Sold Other Expenses Total Cost & Expenses Net /Consolidated Income Noncontrolling Interest Income Net Income to Retained Earnings

Eliminations Debit Credit

Noncontrolling Consolidated Interest Balances

1,950,000 240,000 2,190,000 1,350,000 225,000 1,575,000 615,000

1,350,000

615,000

300,000

240,000

15,000

(2) 1,038,000 (4)

120,000 (3) 1,038,000

12,000

300,000

240,000

15,000

63,000

60,000

(15,000)

87,000

48,000

Statement of Retained Earnings 1/1 Retained Earnings Prather Company 1,505,400 Stone Company Net Income from above Dividends Declared Prather Company Stone Company 12/31 Retained Earnings to Balance Sheet

Stone Company

615,000

3,300,000 (1)

240,000

1,350,000 900,000 150,000 1,050,000 300,000

(3)

15,000

63,000* 63,000

1,397,400

(150,000)

627,000 (150,000)

(75,000) 1,970,400

3,300,000 2,250,000 360,000 2,610,000 690,000 (63,000) 627,000

1,263,000

(1) 1,398,000

7 - 44

1,874,400

Problem 7-12 (continued)

Balance Sheet Assets Inventory Investment in Stone Company Plant and Equipment Accumulated Depreciation Total Assets Liabilities Capital Stock Prather Company Stone Company Retained Earnings from above 1/1 Noncontrolling Interest 12/3630001 Noncontrolling Interest Total Liabilities and Equity

Prather Company

Stone Company

Eliminations Debit Credit

498,000 1,430,400

225,000

2,168,100 (900,000) 3,196,500

2,625,000 (2) (612,000) (3) 2,238,000

465,600

450,000

Noncontrolling Consolidated Interest Balances 723,000

(1) 180,000 (4) 1,250,400 390,000 30,000 (2)

5,183,100 (2,022,000) 3,884,100

540,000

915,600

760,500 1,970,400

3,196,500

760,500 525,000 (4) 1,263,000 (2)

2,238,000

525,000 1,398,000 30,000 (4) (3) 2,373,000

87,000 312,600 3,000 2,373,000

* Noncontrolling interest in consolidated income = .20  ($300,000 + $15,000) = $63,000 Explanations of workpaper entries on separate page

7 - 45

48,000 285,600

1,874,400

333,600

333,600 3,884,100

Problem 7-12 (continued) Intercompany Sale of Equipment Accumulated Cost Depreciation Original Cost $1,350,000 $540,000 Intercompany Selling Price 960,000 _______ Difference $ 390,000 $540,000

Carrying Value $ 810,000 960,000 $ 150,000

Remaining Life Depreciation 10 yr $81,000 10 yr 96,000 $15,000

Explanations of workpaper entries (not required) (1)

(2)

(3)

(4)

Equity In Subsidiary Income Dividends Declared (.80)($75,000) Investment in Stone Company To reverse the effect of parent company entries during the year for subsidiary dividends and income

240,000

Plant and Equipment 390,000 Retained Earnings - Prather Company ($150,000)(.80) 120,000 Noncontrolling Interest ($150,000)(.20) 30,000 Accumulated Depreciation To reduce controlling and noncontrolling interests for their respective shares of unrealized intercompany profit at beginning of year, to restore the carrying value of equipment to its book value on the date of the intercompany sale Accumulated Depreciation 30,000 Other Expenses (Depreciation Expense) Retained Earnings - Prather Company ($15,000)(.80) Noncontrolling Interest ($15,000)(.20) To reverse amount of excess depreciation recorded during year and to recognize an equivalent amount of intercompany profit as realized Beginning Retained Earnings –Stone 1,038,000 Common Stock – Stone 525,000 Investment in Stone Company ($960,000 + $290,400*) Noncontrolling Interest [$240,000 + ($1,038,000 - $675,000) x .2] To eliminate investment account and create noncontrolling interest account.

60,000 180,000

540,000

15,000 12,000 3,000

1,250,400 312,600

* (( $1,263,000 - $675,000)  .8) - $180,000 = $290,400 or ($1,038,000 - $675,000)  .8 = $290,400

7 - 46

Problem 7-12 (continued) Part B. Calculation of Consolidated Retained Earnings Prather Company's retained earnings on 12/31/12 $1,970,400 Unrealized profit on downstream sales included therein 0 Unrealized profit on upstream sales included therein .8  ($150,000 - $15,000 - $15,000) (96,000) Consolidated retained earnings on 12/31/12 $1,874,400 Consolidated Retained Earnings

Prather’s share of unrealized gain on upstream sales of equipment from Stone Company ($150,000 - $15,000 - $15,000).8

Prather Company's Retained Earnings on 12/31/12

$1,970,400

Consolidated Retained Earnings

$1,874,400

96,000

7 - 47

Problem 7-13 Part A

Income Statement Sales Equity in subsidiary income Total revenue Cost of goods sold Expenses Total cost & expenses Net/consolidated income Noncontrolling interest in income Net income to retained earnings Statement of Retained Earnings 1/1 Retained earnings Padilla Company

PADILLA COMPANY AND SUBSIDIARY Consolidated Statements Workpaper For the Year Ended December 31, 2013 Padilla Sanchez Eliminations Company Company Debit Credit 2,555,500 160,650 2,716,150 1,730,000

1,120,000 690,500

(6) (1)

375,000 160,650

(8)

10,500

251,000 (11) 941,500 178,500

12,667

331,650

178,500

558,817

666,550

(2) (4) (5) (11) 139,500 (9)

47,500 13,500 6,750 17,100 139,500

331,650

178,500

558,817

654,500 2,384,500 331,650

Sanchez Company

Net income from above Dividends declared Padilla Company Sanchez Company 12/31 Retained earnings to balance sheet

1,120,000

Noncontrolling Consolidated Interest Balances 3,300,500

(5) (6) (3)

(3)

7,500 375,000 9,500

3,300,500 2,048,500

392,000

908,667 2,957,167 343,333 16,283 * (16,283) 16,283 327,050

9,500

591,200

392,000

16,283

54,000

(6,000)

455,500

10,283

(100,000)

(100,000) (60,000)

898,200

327,050

258,000

(1) 783,167

7 - 48

818,250

Problem 7-13 (continued) Balance Sheet Cash Accounts receivable Inventory Other current assets Investment in Sanchez Company Difference between implied and book value Land Plant and equipment Accumulated depreciation Manufacturing formula Total Assets Accounts payable Other liabilities Capital stock Padilla Company Sanchez Company Additional paid-in capital Sanchez Company Retained earnings from above 1/1 Noncontrolling interest in net assets

Padilla Company 119,500 342,000 362,000 40,500 604,200

Sanchez Company

Eliminations Debit

132,500 125,000 201,000 13,000

(9) 150,000 825,000 (207,000) 2,236,200

241,000 (2) (53,500) (3) (10) 659,000

295,000 43,000

32,000 (7) 19,000

Credit

(7) (8)

60,000 10,500

(9) (1)

497,550 106,650

63,333 (10) (4) 2,500 19,000 (2) 63,333 (11)

63,333 15,000

Noncontrolling Interest

252,000 407,000 552,500 53,500

135,000 1,068,500 (291,500) 31,666 2,208,666

50,000 31,667

60,000

267,000 62,000

1,000,000

898,200

Consolidated Balances

1,000,000 300,000 (9)

300,000

50,000 (9) 258,000 (4) (5) (11)

50,000 783,167 1,500 (9) 750 1,900

455,500 55,283

10,283 51,133

818,250

12/31/ Noncontrolling interest in NA Total liabilities & equity 2,236,200 659,000 1,345,483 1,345,483 * Noncontrolling interest in income = .10  ($178,500 + $7,500 - $10,500 - $12,667) = $16,283 Explanations of the workpaper entries are on a separate page.

61,416

61,416 2,208,666

7 - 49

Problem 7-13 (continued) Intercompany Sale of Equipment Accumulated Cost Depreciation Original Cost $100,000 $50,000 Intercompany Selling Price 97,500 _______ Difference $ 2,500 $50,000

Remaining Carrying Value Life Depreciation $50,000 5 yr $10,000 97,500 5 yr 19,500 $47,500 $ 9,500

Explanations of workpaper entries (1) Equity in Subsidiary Income Investment in Sanchez Company Dividends Declared (.90)($60,000) To reverse the effect of parent company entries during the year for subsidiary dividends and income (2)

(3)

(4)

(5)

(6)

160,650 106,650 54,000

Plant and Equipment ($100,000 - $97,500) Beginning Retained Earnings - Padilla Accumulated Depreciation To eliminate unrealized profit on intercompany sale of equipment and to restore equipment to its book value on the date of the intercompany sale

2,500 47,500

Accumulated Depreciation Expenses (Depreciation expense) Beginning Retained Earnings - Padilla To reverse excess depreciation recorded during 2013 (.20  $47,500)

19,000

50,000

9,500 9,500

Beginning Retained Earnings - Padilla Co. (.90  $15,000) 13,500 Noncontrolling Interest (.10  $15,000) 1,500 Land To eliminate unrealized profit on intercompany sale of land (upstream sale) Beginning Retained Earnings - Padilla Co. (.90  $7,500) Noncontrolling Interest (.10  $7,500) Cost of Goods Sold To eliminate intercompany profit in beginning inventory (upstream sale) Sales

6,750 750 7,500

375,000

Cost of Goods Sold (Purchases) To eliminate intercompany sale (7)

(8)

15,000

375,000

Accounts Payable Accounts Receivable To eliminate intercompany payables and receivables

60,000

Cost of Goods Sold (Ending Inventory – Income Statement) Inventory To eliminate unrealized profit in ending inventories

10,500

7 - 50

60,000

10,500

Problem 7-13 (continued) (9) Beginning Retained Earnings - Sanchez Co. 139,500 Capital Stock - Sanchez Co. 300,000 Additional Paid-in Capital - Sanchez Co. 50,000 Difference between Implied and Book Value 63,333 Investment in Sanchez ($426,000 + (($139,500 - $60,000)  .90) Noncontrolling Interest [$47,333 + ($139,500 – $60,000) x .10] To eliminate the investment account and create noncontrolling interest account (10) Manufacturing Formula Difference between Implied and Book Value To allocate the difference between implied and book value

63,333

(11) Beginning Retained Earnings - Padilla Co. ($63,333/5 x 1.5) x .90 Noncontrolling interest ($63,333/5 x 1.5) x .10 Expenses (or COGS) ($63,333/5) Manufacturing Formula To amortize the difference between implied and book value

17,100 1,900 12,667

Alternative to entries (10) and (11) (10a) Beginning Retained Earnings - Padilla Co. ($63,333/5 x 1.5) x .90 Noncontrolling Interest ($63,333/5 x 1.5) x .10 Manufacturing Formula Expenses ($63,333/5) Difference between Implied and Book Value To allocate and amortize the difference between implied and book value ($63,333/5) = $12,667; $63,333 - ($12,667  2.5) = $31,666

497,550 55,283

63,333

31,667

17,100 1,900 31,666 12,667

Part B.Padilla Company's retained earnings on 12/31/2013 Less intercompany unrealized profit on sale of equipment to Sanchez on 12/31/2011 included therein ($47,500 - $9,500 - $9,500) Unrealized profit on upstream sales of land and merchandise [.9  ($15,000 + $10,500)] Less cumulative effect of adjustment to date relating to amortization of manufacturing formula ($17,100 + $11,400) Consolidated retained earnings on 12/31/2013

63,333

$ 898,200

(28,500) (22,950) (28,500) $ 818,250

Alternatively

Unrealized profit on upstream sale in Padilla’s ending inventory & land

Consolidated Retained Earnings Padilla Company's Retained Earnings on 12/31/13

($15,000 + $10,500)(.90)

22,950

Unrealized gain on downstream sale of equipment to Sanchez Company ($47,500 - $9,500 - $9,500)

28,500

Amortization of the difference between implied and book value ($17,100 + $11,400), where $11,400 = $12,667  .9

28,500 Consolidated Retained Earnings 7 - 51

$898,200

$818,250

Problem 7-14 Part A. (1) Gain on Sale of Equipment Equipment (net) To eliminate unrealized profit recorded on intercompany sale of equipment and reduce the carrying value on date of sale. (2)

(3)

180,000 180,000

Beginning Retained Earnings - Platt Company (.80  $250,000) 200,000 Noncontrolling Interest (.20  $250,000) 50,000 Equipment To reduce the controlling and noncontrolling interest for their share of unrealized intercompany profit on upstream sale at beginning of year, to restore equipment to its book value on date of intercompany sale. Accumulated Depreciation ($50,000 + $50,000 + $30,000) 130,000 Depreciation Expense ($50,000 + $30,000) Beginning Retained Earnings - Platt Company (.8)($50,000) Noncontrolling Interest (.2)($50,000) To reverse amount of excess depreciation recorded during current year and to recognize an equivalent amount of intercompany profit as realized [($250,000/5) + ($180,000/6)]

250,000

80,000 40,000 10,000

Part B. Calculations of Controlling interest in Consolidated Net Income For Year Ended December 31, 2012 Platt Company's net income from independent operations Less unrealized intercompany profit on 2012 sale of equipment to Sloane Company Plus profit on 1/1/12 sale of equipment considered realized in current year through depreciation Platt Company's net income from independent operations that has been realized in transactions with third parties Reported net income of Sloane Company Plus profit on 1/1/11 sales of equipment considered realized in current year through depreciation Sloane Company's net income that has been realized in transactions with third parties Platt Company's share thereof Controlling interest in consolidated net income

7 - 52

$ 400,000 (180,000) 30,000

250,000 $ 180,000 50,000 230,000 ___80%

184,000 $ 434,000

Problem 7-14 (continued) Part C. Calculation of 12/31/12 Consolidated Retained Earnings Platt Company's retained earnings on 12/31/12 Less the amount of Platt Company's retained earnings that have not been realized in transactions with third parties or through depreciation ($180,000 - $30,000)

$ 1,800,000

(150,000)

Platt Company's retained earnings that have been realized 1,650,000 in transactions with third parties or through depreciation Increase in retained earnings of Sloane Company from date of acquisition to 12/31/12 ($640,000 - $300,000) $ 340,000 Less unrealized profit included in Sloane's Company's retained earnings on 12/31/12 ($250,000 - $50,000 - $50,000) (150,000) Increase in reported retained earnings of Sloane Company since acquisition that has been realized in transactions with third parties 190,000 Platt Company's share thereof ___80% 152,000 Consolidated Retained Earnings 12/31/12 $ 1,802,000

Part D. Calculation of Noncontrolling Interest in the Consolidated Income For the Year Ended December 31, 2012 Sloane Company reported net income Plus amount of intercompany profit realized through depreciation during current year Amount included in consolidated income Noncontrolling interest in consolidated income (.20  $230,000)

7 - 53

$ 180,000 50,000 $ 230,000

$ 46,000

Problem 7-15 Part A

Income Statement Sales Equity in Subsidiary Income Total Revenue Cost of Goods Sold Income Tax Expense Other Expenses Total Cost & Expenses Net /Consolidated Income Noncontrolling Interest in Income Net Income to Retained Earnings Statement of Retained Earnings 1/1 Retained Earnings Prout Company Sexton Company Net Income from above Dividends Declared Prout Company Sexton Company 12/31 Retained Earnings to Balance Sheet

PROUT COMPANY AND SUBSIDIARY Consolidated Statements Workpaper For the Year Ended December 31, 2012 Prout Company

Sexton Company

Eliminations Noncontrolling Consolidated Debit Credit Interest Balances

1,475,000 116,000 1,591,000 942,000 187,200 145,000 1,274,200 316,800

1,110,000

316,800

135,000

116,000

1,040,000 (4) 135,000

1,040,000 116,000

2,585,000 (1)

116,000

1,110,000 795,000 90,000 90,000 975,000 135,000

(3)

8,000

2,585,000 1,737,000 277,200 227,000 2,241,200 343,800 27,000 * (27,000) 27,000 316,800

1,380,000 316,800

1,380,000 8,000

27,000

(120,000 )

(120,000) (100,000 )

1,576,800

316,800

1,075,000

(1) 1,156,000

7 - 54

80,000

(20,000)

88,000

7,000

1,576,800

Problem 7-15 (continued) Prout Company

Sexton Company

Eliminations Debit Credit

Balance Sheet Current Assets Investment in Sexton Company

568,000 1,716,000

271,000

Plant and Equipment Accumulated Depreciation Other Assets Total Assets

1,972,000 (375,000) 1,000,800 4,881,800

830,000 (2) (290,000)) (3) 1,600,000 2,411,000

305,000

136,000

Other Liabilities Capital stock Prout Company Sexton Company Retained Earnings from above 1/1 Noncontrolling Interest in Net Assets 12/31 Noncontrolling Interest Total Liabilities & Equity

Noncontrolling Consolidated Interest Balances 839,000

(2)

120,000 (1) 36,000 (3) 8,000 (4) 1,792,000 40,000 16,000 (2) 160,000

2,842,000 (809,000)) 2,600,800 5,472,800 441,000

3,000,000 1,576,800

3,000,000 1,200,000 (4) 1,075,000

1,200,000 1,156,000 (4)

4,881,800

2,411,000

2,532,000

* Noncontrolling interest in consolidated income = .20  $135,000 = $27,000 Explanations of workpaper entries are on separate page.

7 - 55

88,000 448,000 2,532,000

7,000 448,000 455,000

1,576,800 455,000 5,472,800

Problem 7-15 (continued) Schedule to calculate intercompany profit Selling Price of Fixed Assets Book Value of Assets [$400,000  (15/25)] Gain recognized on intercompany sale

$360,000 240,000 $120,000

Excess Annual Depreciation ($120,000/15)

$8,000

Intercompany Sale of Equipment Accumulated Cost Depreciation Original Cost $ 400,000 $ 160,000 Intercompany Selling Price 360,000 _______ Difference $ 40,000 $ 160,000

Remaining Carrying Value Life Depreciation $ 240,000 15 yr $ 16,000 360,000 15 yr 24,000 $ 120,000 $ 8,000

116,000 80,000 36,000

(2) Property and Equipment ($400,000 - $360,000) 40,000 Investment in Sexton Company 120,000 Accumulated Depreciation To reduce beginning consolidated retained earnings by amount of unrealized profit at the beginning of the year, and to restore the equipment to its book value on the date of intercompany sale (3) Accumulated Depreciation Depreciation Expense Investment in Sexton Company To reverse amount of excess depreciation recorded during current year and recognize an equivalent amount of intercompany profit as realized

16,000

(4) Beginning Retained Earnings – Sexton 1,040,000 Common Stocks – Sexton 1,200,000 Investment in Sexton Company ($1,716,000 - $36,000 + $120,000 - $8,000) Noncontrolling Interest [$400,000 + ($1,040,000 - $800,000) x .2] To eliminate investment account and create noncontrolling interest account

7 - 56

160,000

8,000 8,000

1,792,000 448,000

Problem 7-15 (continued) Part B (1) Cash Accumulated Depreciation - Fixed Assets ($360,000/15 yrs.  2 yrs.) Loss on Sale of Equipment Plant and Equipment

300,000

(2) Investment in Sexton Company Loss on Sale of Equipment Gain on Sale of Equipment

104,000

48,000 12,000 360,000

12,000 92,000

Cost to the affiliated companies Accumulated depreciation based on original cost (12/25  $400,000) Book value to the affiliated companies on 1/1/13 Proceeds from sale to non-affiliate Gain to affiliated companies on sale

$ 400,000 192,000 208,000 (300,000) $ 92,000

7 - 57

Problem 7-16 Part A

PRATHER COMPANY AND SUBSIDIARY Consolidated Statements Workpaper For the Year Ended December 31, 2012 Prather Company

Income Statement Sales Equity in Subsidiary Income Total Revenue Cost of Goods Sold Other Expenses Total Cost & Expenses Net /Consolidated Income Noncontrolling Interest in Income Net Income to Retained Earnings Statement of Retained Earnings 1/1 Retained Earnings Prather Company Stone Company Net Income from above Dividends Declared Prather Company Stone Company 12/31 Retained Earnings to Balance Sheet

Stone Company

Eliminations Debit Credit

1,950,000 252,000 2,202,000 1,350,000 225,000 1,575,000 627,000

1,350,000

627,000

300,000

252,000

1,038,000 (5)

1,038,000

300,000

252,000

Noncontrolling Consolidated Interest Balances 3,300,000

(1)

252,000

1,350,000 900,000 150,000 1,050,000 300,000

(3)

15,000

3,300,000 2,250,000 360,000 2,610,000 690,000 63,000 * (63,000) 63,000 627,000

1,397,400

627,000

1,397,400

15,000

63,000

(150,000)

(150,000) (75,000)

1,874,400

627,000

1,263,000

(1) 1,290,000

7 - 58

60,000

(15,000)

75,000

48,000

1,874,400

Problem 7-16 (continued)

Balance Sheet Assets Inventory Investment in Stone Company

Plant and Equipment Accumulated Depreciation Total Assets Liabilities Capital Stock Prather Company Stone Company Retained Earnings from above 1/1 Noncontrolling Interest in Net Assets 12/31 Noncontrolling Interest in Net Assets Total Liabilities and Equity

Prather Company

Stone Company

Eliminations Debit Credit

498,000 1,334,400

225,000

2,168,100 (900,000) 3,100,500

2,625,000 (2) (612,000) (3) 2,238,000

465,600

450,000

Noncontrolling Consolidated Interest Balances 723,000

(2)

120,000 (1) 192,000 (3) 12,000 (4) 1,250,400 390,000 30,000 (2) 540,000

5,183,100 (2,022,000) 3,884,100 915,600

760,500 1,874,400

3,100,500

760,500 525,000 (4) 1,263,000 (2)

2,238,000

525,000 1,290,000 30,000 (5) (3)

2,385,000

75,000 312,600 3,000

2,385,000

* Noncontrolling interest in consolidated income = .20  ($300,000 + $15,000) = $63,000 Explanations of workpaper entries on separate page.

7 - 59

48,000 285,600

1,874,400

333,600

333,600 3,884,100

Problem 7-16 (continued) Intercompany Sale of Equipment Accumulated Cost Depreciation Original Cost $1,350,000 $540,000 Intercompany Selling Price 960,000 _______ Difference $ 390,000 $540,000

Carrying Value $810,000 960,000 $150,000

Remaining Life Depreciation 10 yr $81,000 10 yr 96,000 $15,000

Explanations of workpaper entries (not required) (1)

(2)

(3)

(4)

Equity in Subsidiary Income Dividends Declared (.80)($75,000) Investment in Stone Company To reverse the effect of parent company entries during the year for subsidiary dividends and income

252,000 60,000 192,000

Plant and Equipment 390,000 Investment in Stone Company ($150,000)(.80) 120,000 Noncontrolling Interest ($150,000)(.20) 30,000 Accumulated Depreciation To reduce controlling and noncontrolling interests for their respective shares of unrealized intercompany profit at beginning of year, to restore the carrying value of equipment to its book value on the date of the intercompany sale Accumulated Depreciation 30,000 Other Expenses (Depreciation Expense) Investment in Stone Company ($15,000)(.8) Noncontrolling Interest ($15,000)(.2) To reverse amount of excess depreciation recorded during year and to recognize an equivalent amount of intercompany profit as realized

540,000

15,000 12,000 3,000

Beginning Retained Earnings –Stone 1,038,000 Common Stock – Stone 525,000 Investment in Stone Company 1,250,400 ($960,000 + $290,400*) Noncontrolling Interest [$240,000 + ($1,038,000 - $675,000)  .2] 312,600 To eliminate investment account and create noncontrolling interest account * (($1,263,000 - $675,000)  .8) - $180,000 = $290,400, or ($1,038,000 – 675,000) x .8.

Part B. Calculation of Consolidated Retained Earnings Prather Company's retained earnings on 12/31/12

$1,874,400

Consolidated retained earnings on 12/31/12

$1,874,400

7 - 60

Problem 7-17 Part A PADILLA COMPANY AND SUBSIDIARY Consolidated Statements Workpaper For the Year Ended December 31, 2013 Padilla Sanchez Company Company Income Statement Sales Equity in Subsidiary income Total Revenue Cost of Goods Sold Expenses Total Cost & Expenses Net/Consolidated Income Noncontrolling Interest in Income * Net Income to Retained Earnings Statement of Retained Earnings 1/1 Retained Earnings Padilla Company Sanchez Company Net Income from above Dividends Declared Padilla Company Sanchez Company 12/31 Retained earnings to Balance Sheet

Eliminations Noncontrolling Consolidated Debit Credit Interest Balances

2,555,500 1,120,000 (6) 375,000 156,050 (1) 156,050 2,711,550 1,120,000 1,730,000 690,500 (8) 10,500 (5) 7,500 (6) 375,000 654,500 251,000 (11) 12,667 (3) 9,500 2,384,500 941,500 327,050 178,500

327,050

178,500

554,217

392,000

3,300,500 3,300,500 2,048,500

16,283

908,667 2,957,167 343,333 (16,283)

16,283

327,050

591,200

591,200 139,500 (9) 139,500

327,050

178,500

554,217

392,000

16,283

54,000

(6,000)

446,000

10,283

(100,000)

(100,000) (60,000)

818,250

327,050

258,000

(1) 693,717

7 - 61

818,250

Problem 7-17 (continued) Padilla Sanchez Company Company Balance Sheet Cash Accounts Receivable Inventory Other Current Assets Investment in Sanchez Company

119,500 342,000 362,000 40,500 524,250

Eliminations Noncontrolling Consolidated Debit Credit Interest Balances

132,500 125,000 201,000 13,000

(7) (8) (2) (4) (5) (11) (9)

Difference between Implied and Book Value Land 150,000 Plant and Equipment 825,000 241,000 (2) Accumulated Depreciation (207,000) (53,500) (3) Manufacturing Formula (10) Total Assets 2,156,250 659,000 Accounts Payable Other Liabilities Capital stock Padilla Company Sanchez Company Additional paid-in capital Sanchez Company Retained Earnings from above Noncontrolling Interest in Net Assets

295,000 43,000

32,000 (7) 19,000

252,000 407,000 552,500 53,500 0

60,000 10,500

47,500 (1) 102,050 13,500 (3) 9,500 6,750 (9) 497,550 17,100 63,333 (10) 63,333 (4) 15,000 2,500 19,000 (2) 50,000 63,333 (11) 31,668

0 135,000 1,068,500 (291,500) 31,665 2,208,665

60,000

267,000 62,000

1,000,000

1,000,000 300,000 (9) 300,000

50,000 (9) 50,000 818,250 258,000 693,717 446,000 (4) 1,500 (9) 55,283 (5) 750 (11) 1,901 Total Liabilities & Equity 2,156,250 659,000 1,340,884 1,340,884 * Noncontrolling interest in income = .10  ($178,500 + $7,500 - $10,500 - $12,667) = $16,283

7 - 62

10,283 51,132

818,250

61,415

61,415 2,208,665

Problem 7-17 (contiued) Intercompany Sale of Equipment Accumulated Cost Depreciation Original Cost $100,000 $50,000 Intercompany Selling Price 97,500 _______ Difference $ 2,500 $50,000

Carrying Value $50,000 97,500 $47,500

Remaining Life Depreciation 5 yr $10,000 5 yr 19,500 $ 9,500

Explanations of workpaper entries (1)

(2)

(3)

(4)

(5)

(6)

Equity in Subsidiary Income Investment in Sanchez Company Dividends Declared (.90)($60,000) To reverse the effect of parent company entries during the year for subsidiary dividends and income

156,050 102,050 54,000

Plant and Equipment ($100,000 - $97,500) 2,500 Investment in Sanchez Company ($50,000 - $2,500) 47,500 Accumulated Depreciation To eliminate unrealized profit on intercompany sale of equipment and to restore plant and equipment to its book value on the date of intercompany sale

50,000

Accumulated Depreciation Expenses (Depreciation expense) Investment in Sanchez Company To reverse excess depreciation recorded during 2013 (.20  $47,500)

9,500 9,500

19,000

Investment in Sanchez Company (.90  $15,000) 13,500 Noncontrolling Interest (.10  $15,000) 1,500 Land To eliminate unrealized profit on intercompany sale of land (upstream sale) Investment in Sanchez Company (.90  $7,500) Noncontrolling Interest (.10  $7,500) Cost of Goods Sold To eliminate intercompany profit in beginning inventory (upstream sale) Sales

6,750 750 7,500

375,000

Cost of Goods Sold (Purchases) To eliminate intercompany sale (7)

15,000

375,000

Accounts Payable Accounts Receivable To eliminate intercompany payables and receivables

7 - 63

60,000 60,000

Problem 7-17 (continued) (8)

(9)

Cost of Goods Sold (Ending Inventory – Income Statement) Inventory To eliminate unrealized profit in ending inventories

10,500 10,500

Beginning Retained Earnings - Sanchez Co. 139,500 Capital Stock - Sanchez Co. 300,000 Additional Paid-in Capital - Sanchez Co. 50,000 Difference between Implied and Book Value 63,333 Investment in Sanchez ($426,000 + (($139,500 - $60,000)  .9) Noncontrolling Interest [$47,333 + ($139,500 – $60,000) x .10] To eliminate the investment account and create noncontrolling interest account

(10) Manufacturing Formula Difference between Implied and Book Value To allocate the difference between implied and book value

63,333

(11) Investment in Sanchez Company ($11,400  1.5) Noncontrolling Interest ($1,267 x 1.5) Expenses ($63,333/5) Manufacturing Formula To amortize the difference between implied and book value

17,100 1,901 12,667

Alternative to entries (10) and (11) (10a) Investment in Sanchez Company ($11,400  1.5) Noncontrolling Interest Manufacturing Formula Expenses ($63,333/5) Difference between Implied and Book Value To allocate and amortize the difference between implied and book value ($63,333/5) = $12,667; $63,333 - ($12,667  2.5) = $31,665

497,550 55,283

63,333

31,668

17,100 1,901 31,665 12,667 63,333

Part B. Padilla Company's retained earnings on 12/31/2013

$ 818,250

Consolidated retained earnings on 12/31/2013

$ 818,250

7 - 64

Problem 7 - 18A Part A ( 1 ) Gain on Sale of Equipment Equipment (net) To eliminate unrealized profit recorded on intercompany sale of equipment and reduce carrying value of equipment to its book value on date of intercompany sale

100,000 100,000

( 2 ) Accumulated Depreciation Depreciation Expense To reverse amount of excess depreciation recorded during year and to recognize an equivalent amount of intercompany profit as realized ( $100,000 / 4 )

25,000

( 3 ) Deferred Tax Asset Income Tax Expense To defer income tax paid or accrued by the selling affiliate on unrealized intercompany profit in equipment at the end of the year .4  ( $100,000 - $25,000 )

30,000

( 4 ) Sales Cost of Goods Sold (purchases) To eliminate intercompany sales

200,000

( 5 ) Cost of Goods Sold Inventory ( Balance Sheet ) To eliminate intercompany profit in ending inventory

10,000

( 6 ) Deferred Tax Asset Income Tax Expense To defer income tax paid or accrued by the selling affiliate on unrealized intercompany profit in ending inventory ( .4  $10,000 ) = $4,000.

4,000

( 7 ) Income Tax Expense Deferred Income Tax Liability To recognize income tax consequence of Sells undistributed income. $300,000 - [ .6  ( $100,000 - $25,000 ) ] = $255,000 $255,000  .80  .20  .40 = $16,320

16,320

25,000

30,000

200,000

10,000

7 - 65

4,000

16,320

Problem 7 - 18A (continued) ( 8 ) Common Stock - Sells Co. Retained Earnings - Sells Co. Investment in Sells Co. To eliminate investment account Part B.

1,200,000 400,000 1,600,000

Calculation of Controlling Interest in Consolidated Net Income For Year Ended December 31, 2011

Peer Company's net income from independent operations Less after-tax unrealized intercompany profit on 2011 sales included in ending inventory ( .60  $10,000 ) Peer Company's net income from independent operations that has been realized in transactions with third parties Reported net income of Sells Company Less after-tax unrealized profit on 1/2/11 sale of equipment to Peer Company ( .60  $100,000 ) Plus after-tax profit on 1/2/11 sale of equipment considered realized in current year through depreciation ( .60  $25,000 ) Sells Company’s net income that has been realized in transactions with third parties Peer Company's share Less income tax consequence of undistributed income of Sells Company for 2011 that has been realized in transactions with third parties ( $255,000  .80  .20  .40 ) Controlling interest in consolidated net income

$ 800,000

(6,000)

794,000 $300,000

(60,000)

15,000 $ 255,000 ___80%

204,000

(16,320) $ 981,680

Part C. Calculation of Noncontrolling Interest in Consolidated Income for 2011 Sells reported net income Less after-tax unrealized profit on 1/2/11 sale of equipment to Peer ( .60  $100,000 ) Plus after-tax profit on 1/2/11 sale realized through depreciation ( .60  $25,000 ) Sells Company's income that is included in 2011 consolidated income

$ 300,000

Noncontrolling interest in consolidated income ( .2  $255,000 )

$ 51,000

7 - 66

(60,000) 15,000 $ 255,000

Chapter 7 CHAPTER SEVEN – ELIMINATION OF UNREALIZED GAINS OR LOSSES ON INTERCOMPANY SALES OF PROPERTY AND EQUIPMENT I.

INTERCOMPANY SALES OF LAND (NONDEPRECIABLE PROPERTY) A. When there have been intercompany sales of nondepreciable property, workpaper entries are necessary to accomplish the following financial reporting objectives in the consolidated financial statements. 1. To include gains or losses on the sale of nondepreciable property in consolidated net income only at the time such property is sold to parties outside the affiliated group and in an amount equal to the difference between the cost of the property to the affiliated group and the proceeds received from outsiders. 2. To present nondepreciable property in the consolidated balance sheet at its cost to the affiliated group. B.

II.

For firms using the cost or partial equity methods to account for the investments in subsidiaries, the workpaper entries serve to equate beginning consolidated retained earnings with the amount of consolidated retained earnings reported at the end of the prior reporting period. 1. Workpaper Entry in Year of Intercompany Sale 2. Workpaper Entry in Subsequent Years 3. Cost or Partial Equity Method 4. Complete Equity Method These entries are shown on textbook, pages 382 and 383.

INTERCOMPANY SALES OF DEPRECIABLE PROPERTY (Machinery, Equipment, and Buildings): A. Realize through usage 1. A firm may sell property or equipment to an affiliate for a price that differs from its book value. In the year of the sale, the amount of intercompany gain (loss) recorded by the selling affiliate must be eliminated in consolidation. After the sale, the purchasing affiliate will calculate depreciation on the basis of its cost, which is the intercompany selling price. The depreciation recorded by the purchasing affiliate will, therefore, be excessive (deficient) from a consolidated point of view and will also require adjustment. 2. From the view of the consolidated entity, the intercompany gain (loss) is considered to be realized from the use of the property or equipment in the generation of revenue. Because such use is measured by depreciation, the recognition of the realization of intercompany profit (loss) is accomplished through depreciation adjustments. 3. When there have been intercompany sales of depreciable property, workpaper entries are necessary to accomplish the following financial reporting objectives in the consolidated financial statements.

Chapter 7 a.

b. c.

To report as gains or losses in the consolidated income statement only those that result from the sale of depreciable property to parties outside the affiliated group. To present property in the consolidated balance sheet at its cost to the affiliated group. To present accumulated depreciation in the consolidated balance sheet based on the cost to the affiliated group of the related assets. To present depreciation expense in the consolidated income statement based on the cost to the affiliated group of the related assets. For firms using the cost or partial equity method, an additional objective is to equate beginning consolidated retained earnings with the amount of consolidated retained earnings reported at the end of the prior reporting. For firms using the complete equity method, this final objective is not necessary because the parent’s retained earnings already reflects all adjustments accurately. For upstream sales, the entries also serve to equate current period beginning NCI and prior period ending NCI.

B. Illustration of Basic Workpaper Elimination Entries – Downstream Sales - These entries are shown on textbook, pages 385 and 389.

Determination of Noncontrolling Interest - Subsidiary as Intercompany Seller (Upstream Sale) 1. If the selling affiliate is a less than wholly owned subsidiary (upstream sale), workpaper modifications in the determination of the noncontrolling interest would be necessary if the controlling and the noncontrolling interests were to be adjusted in proportion to their interest in the amount of unrealized intercompany profit eliminated. 2. Intercompany sales of property, plant and equipment, as in the case of intercompany inventory sales, necessitate adjustments to the calculation of the distribution of income to the controlling and noncontrolling interests. Whether the adjustments directly affect the noncontrolling interest (or only the controlling interest) depends on who is the intercompany seller. If the intercompany seller is the subsidiary, it is the subsidiary’s income that needs adjustment, hence directly affecting the noncontrolling interest, as shown in Illustration 7-3 (see textbook, page 390). 3. Procedurally, the steps needed differ slightly between the year of the intercompany sale and subsequent years. To calculate the noncontrolling interest in consolidated net income, begin as always with the subsidiary’s reported income. As always, subtract any excess depreciation, amortization, or impairment charges related to

Chapter 7

differences between implied and book values. In the year of the intercompany upstream sale (subsidiary is the intercompany seller), adjust the subsidiary’s reported income by subtracting the unrealized gain on the intercompany sale (or adding an unrealized loss, as appropriate). Next, subtract (add) the portion of the intercompany gain (loss) that is considered realized through usage (i.e. the depreciation adjustment for the year of the sale). This is shown in Illustration 7-3 for the year 2012 in t-account form (see textbook, page 390). The calculations are the same in subsequent years except that the intercompany gain (or loss) does not need to be subtracted (or added) since it is not included in the subsidiary’s reported income in those years. Realization through usage, however, occurs as long as the property is being used by the intercompany buyer (the parent, in the case of an upstream sale). Note, however, that the adjustment for realization through usage appears on the t-account to compute the noncontrolling interest in the case of upstream sales.

Consolidated statements workpaper – cost and partial equity methods subsidiary is Intercompany Seller (Upstream Sale) 1. Consolidated Statements Workpaper Entries - Year of Intercompany Sale 2. Consolidated Statements Workpaper Entries - Year Subsequent to Intercompany Sale These entries are shown on textbook pages 392 to 400. Disposal of Property and Equipment by Purchasing Affiliate (see textbook, pages 400 and 401).

III.

CALCULATION OF CONSOLIDATED NET INCOME AND CONSOLIDATED RETAINED EARNINGS: Complete Equity Method For firms using the complete equity method, the controlling interest in consolidated net income will always equal the net income reported by the parent. Thus it is not necessary to reconcile the two. Similarly, consolidated retained earnings will equal the retained earnings reported by the parent at any point, assuming the parent has correctly adjusted for any and all unrealized (and subsequently realized) intercompany profit.

IV.

SUMMARY OF WORKPAPER ENTRIES RELATING TO INTERCOMPANY SALES OF EQUIPMENT A. Consolidated statements workpaper eliminating are the same whether the parent company uses the cost method or the partial equity method to record its investment. However, the form of the workpaper entry to adjust for unrealized intercompany profit at the beginning of the year differs as

Chapter 7 between upstream and downstream sales and between the complete equity method and the other two.

INTERCOMPANY INTEREST, RENTS, AND SERVICE FEES Income and expenses relating to interest, fees, and rents should be reported in the consolidated income statement only when they arise from transactions with parties outside the affiliated group. Also, only receivables and payables that are receivable from or payable to parties outside the affiliated group should be reported in the consolidated balance sheet. A.

Intercompany Interest When interest is charged on intercompany loans, the intercompany interest income on the lending affiliate's books is equal to the intercompany interest expense on the borrowing affiliate's books. Both are eliminated.

Intercompany Rents Rental income recorded by one affiliate is eliminated against rental expense recorded by the other.

Intercompany Service Fees When one affiliate charges fees to another, the form of the eliminating entry is determined by how the transaction is recorded by the affiliates. If the affiliate that provides the service treats the fee as revenue and the affiliate that receives the service treats the fee as an expense, the necessary workpaper entry is simply a debit to service fee revenue and a credit to service fee expense. On the other hand, the affiliate that receives the service may treat the amount it is charged for the service as a capital addition. For example, fees for architectural services to an affiliate may be treated by the purchasing affiliate as part of the cost of a building. In this case, architectural fees should be debited for the amount recorded as revenue on the intercompany transaction, appropriate expense accounts (as recorded on the selling affiliates books) should be credited for the cost to the selling affiliate of providing the services, and the building should be credited for the difference between the revenue recorded and the cost of providing the service. Additional workpaper entries will also be necessary in subsequent years to report balances for the building, accumulated depreciation, and depreciation expense at amounts based on the cost of the building to the affiliated group. a. In the Year the Services Are Rendered b. In the Year the Building Is Opened c. In the Fifth Year After the Building Is Opened These entries are shown on textbook, page 414.

Chapter 7 Note: Eliminating entries relating to intercompany transactions depend on how these transactions are recorded on the books of the affiliates. In all cases, however, the financial reporting objectives identified in this chapter and in Chapter 6 apply.

Appendix: Deferred Tax Consequences Related to Intercompany Sales of Equipment I.

Introduction A. The balances reported by the parent company in income, retained earnings, and the investment account differ depending on the method used by the parent company to record its investment. However, the method used by the parent company to record its investment has no affect on the consolidated balances. B. When the parent company records its investment using the equity method, a workpaper entry to reverse the effect of parent company entries during the year for subsidiary dividends and income replaces the cost method entries to establish reciprocity and to eliminate dividend income. C. Workpaper entries to allocate and amortize the difference between implied and book value, to eliminate intercompany sales, and to eliminate unrealized intercompany profit are the same regardless of whether the investment is recorded using the cost method or the partial equity method. D. Workpaper entries to record deferred tax consequences of unrealized intercompany profit and undistributed subsidiary income are also the same when the parent company records its investment using the partial equity method or the cost method. E. The principal difference between the workpaper entries for these methods and for the complete equity method is that entries to Retained Earnings-P Company are generally replaced by entries to the Investment in S Company. F. The calculation of the tax consequences of undistributed income is based on the undistributed income of the subsidiary that has been included in consolidated net income. Thus, before calculating the deferred tax consequences relating to undistributed subsidiary income, the amount of undistributed income must be adjusted for the after-tax amount of unrealized intercompany profit recorded by the subsidiary that has been recognized in the determination of consolidated net income.

II. Calculations (and Allocation) of Consolidated Net Income and Consolidated Retained Earnings A. When the affiliated companies file separate income tax returns, the calculations of consolidated net income and consolidated retained earnings must be modified to incorporate income tax consequences. B. When calculating the amounts of net income or retained earnings that have been realized in transactions with third parties, adjustments must now be made for the after-tax amounts of unrealized intercompany profit. In addition, consolidated net income is reduced by the income tax consequence

Chapter 7 of undistributed income for the current year and consolidated retained earnings is reduced by the income tax consequence of undistributed income from the date of acquisition to the date of the calculation.

CHAPTER 8 ANSWERS TO QUESTIONS 1. The three types of transactions that result in a change in a parent company’s ownership interest are: a. The parent company may buy additional shares of subsidiary stock or sell a portion of its holdings; b. The subsidiary may issue additional shares of stock to outsiders; c. The subsidiary may acquire or reissue treasury shares from or to the noncontrolling shareholders or the parent company 2. The date of acquisition of subsidiary stock is important under the purchase method because subsidiary retained earnings accumulated prior to the date of acquisition constitute a portion of the equity acquired by the parent company, whereas the parent’s share of subsidiary retained earnings accumulated after acquisition is a part of consolidated retained earnings. 3. On the date that control is achieved, all previous purchases are revalued to reflect the market value on the “acquisition date,” which is the date that control is achieved. Thus, they all have the same basis. 4. The correct accounting depends on whether the parent retains control, or maintains some ownership but surrenders control. If the parent retains control, no gain or loss is reflected in the Income Statement. Instead, an adjustment is made to contributed capital. If the parent surrenders control, the entire interest is adjusted to fair value, and a gain or loss reflected in the Income Statement on all shares owned prior to the sale. 5. A loss would be reported because the total of the $5 per share gain related to (1) the undistributed profits of EZ Company from the date of acquisition to the beginning of the year of sale and (2) the undistributed profit of EZ Company from the beginning of the year of sale to the date of sale exceeds the $5 per share overall gain. Thus, the total assigned to the first two components of gain exceed the total gain. The other market factors effect (the third component) produced a loss. 6. If a parent company owns less than 100% of a subsidiary and purchases an entire new issue of common stock directly from the subsidiary, either (1) the preemptive right has been waived previously, or (2) the noncontrolling stockholders elected not to exercise their rights. 7. Regardless of whether the issuance results in an increase or a decrease in the book value of the parent’s share of the subsidiary’s equity, the correct accounting is to adjust the contributed capital of the controlling interest 8. Noncontrolling Interest Situation Total Book Value Percent of Ownership (a) No Change Decrease (b) Decrease Decrease (c) Increase Decrease (d) Increase Increase

8-1

BUSINESS ETHICS 1. This is an awkward situation. One strategy would be to wait a reasonable period of time, and check to see if anything has changed (have the entries been documented, adjusted, reversed, etc.?) If nothing has been done, mention it to the supervisor again. If he (she) is unresponsive this time, tactfully bring up your concern with a higher-level supervisor.

ANSWERS TO FINANCIAL STATEMENT ANALYSIS EXERCISES AFS8-1 Cadbury Acquisition A. The appropriate accounting for a step-acquisition includes: a. Measuring and recognizing the acquiree’s identifiable assets and liabilities at 100% of their fair values on the date the acquirer obtains control, and b. Recognize all the acquiree’s goodwill (not just the parent’s share), measured as the difference between the fair value of the acquiree on the acquisition date and the fair value of the identifiable net assets. c. Any previously held noncontrolling equity interests should be remeasured to fair value, with the resulting adjustment recognized in income. d. After control is achieved, subsequent adjustments due to increased ownership are shown as Additional Contributed Capital, not as income. B. The journal entry on Kraft’s books to acquire the remaining 28.27% of Cadbury would have been (dollars in millions): Investment in Cadbury Cash (and stock)

$5,400 $5,400

On the consolidating worksheet to eliminate the additional $5.4 billion: Noncontrolling interest (plus 38 million) Investment in Cadbury Additional paid in capital

5,438 5,400 38

8-2

ANSWERS TO EXERCISES Exercise 8-1 Part A Investment in Sanno Company Cash Loss on Revaluation* Investment in Sanno Company To adjust the first purchase to fair value *[$262,350/9,900 – (($46,000+$6,500)/1,800)] x 1,800 = - $4,800 where $6,500 = ($85,000 - $20,000)×0.10, (1,800/18,000=10%)

262,350 262,350 4,800 4,800

Loss on Revaluation* Investment in Sanno Company To adjust the second purchase to fair value *[($262,350/9,900) – (($95,000+$28,750)/4,500)] x 4,500 = -$4,500 where $28,750 = ($85,000 + $30,000)×0.25, (4,500/18,000=25%)

4,500

Cash

45,000

Dividend Income ($50,000  (1,800 + 4,500 + 9,900)/(18,000))

Part B Dividend Income Dividends Declared - Sanno

4,500

45,000 45,000 45,000

Investment in Sanno Company Retained Earnings - Peck To establish reciprocity/convert to equity [(.10  ($ −$20,000)+ (.25  ($ +$30,000)) ]

35,250 35,250

Common Stock - Sanno Company(18,000  $) 360,000 Retained Earnings - Sanno Company (1/1) 85,000 Difference between Implied and Book Value 32,000 Investment in Sanno Company* Noncontrolling interest To eliminate investment account and create noncontrolling interest account * $429,300 = 46,000+95,000+262,350-4,800-4,500 + 35,250 Goodwill Difference between Implied and Book Value

8-3

429,300 47,700

32,000 32,000

Exercise 8-1 (continued) Computation and Allocation of Difference between Implied and Book Value Acquired Parent Share Purchase price and implied value* Less: Book value of equity acquired:

$429,300 400,500

NonControlling Share 47,700 44,500

477,000 445,000

28,800 (28,800) -0-

3,200 (3,200) -0-

32,000 (32,000) -0-

Difference between implied and book value Goodwill Balance 16,200 shares × $262,350/9,900 = $429,300 or

$46,000+$95,000 + $262,350 + $35,250 - $4,800 - $4,500 = $429,300

8-4

Entire Value

Exercise 8-2 January 1, 2011 Investment in Serbin Company Cash Note: The $9,333 transfer to paid in capital is handled in consolidation. April 1, 2011 Cash

220,000 220,000

260,000

Investment in Serbin Company ((21,600/72,000)  $490,000) Additional Contributed Capital

147,000 113,000

September 30, 2011 Cash

16,750 Dividend Income (.67*  $25,000) * .67 = (72,000 + 30,000 -21,600)120,000

16,750

Exercise 8-3 Part A Investment in Serbin Company Retained Earnings 1/1 - Papke Company To establish reciprocity to 1/1/2011 (.6  .7  ($201,000 - $175,000) Cost of Shares (21,600/72,000 × $490,000) Plus: Undistributed Income: (A) Change in Retained Earnings from the date of acquisition (1/1/10) to the beginning of the year (1/1/11) ($201,000 - $175,000) Ownership percentage sold (B) Earnings from beginning of current year to the the date of sale (1/1/11 to 4/1/11) Ownership percentage sold Adjusted cost of shares sold

10,920 10,920

$147,000

$26,000 18% 15,000 18%

Selling price of shares Adjusted cost of shares sold Additional paid in capital – Papke Company Paid in capital already recorded on Papke Company books Decrease needed to Paid in Capital – Papke Company

4,680

2,700 $154,380 $260,000 154,380 $105,620 113,000 7,380

Additional Contributed Capital 4,680 Retained Earnings 1/1 - Papke Company 4,680 To adjust additional contributed capital for the portion for earnings accruing to the shares sold included in consolidated income in prior years (($201,000 - $175,000)  .18) Additional Contributed Capital ($15,000  .18) 2,700 Subsidiary Income Sold 2,700 To adjust for current year’s income soldto the noncontrolling stockholders ($15,000  .18) 8-5

Exercise 8-3 (continued) Dividend Income Dividends Declared - Serbin Company To eliminate intercompany dividends on the remaining shares owned (80,400/120,000  $25,000) = (.67  $25,000) = 16,750

16,750 16,750

Common Stock - Serbin Company 600,000 Retained Earnings - Serbin 201,000 Difference between Implied and Book Value 41,667 Additional Contributed Capital- Papkea 9,333 Investment in Serbin Company 573,920 Noncontrolling interestb 278,080 To eliminate investment account and create noncontrolling interest account Goodwill Difference between Implied and Book Value

41,667 41,667

Computation and Allocation of Difference between Implied and Book Value Acquired Parent Share Purchase price and implied value Less: Book value of equity acquired: Common Stock Retained Earnings

$490,000

NonControlling Share 326,667

816,667

(360,000) (105,000)

(240,000) (70,000)

(600,000) (175,000)

25,000 (25,000) -0-

16,667 (16,667) -0-

41,667 (41,667) -0-

Difference between implied and book value Goodwill Balance a

Price paid for 25% interest Less interest acquired: Common Stock (25% x 600,000) 150,000 Retained Earnings (25% x $201,000) 50,250 Goodwill (25% x $41,667) 10,417 Adjustment to Additional Contributed Capital – Papke b

Entire Value

220,000

(210,667) 9,333

33% x 816,667 + 33% x ($201,000-$175,000) = $278,080 or

$326,667 – $210,667 + 40% x ($201,000-$175,000) + $154,380 - $2,700 = $278,080 Part B $278,080 + 33% x ($60,000 - $25,000) = $289,630

8-6

Exercise 8-4 Part A 2010 Investment in Sanno Company Cash

95,000 95,000

Retained Earnings Investment in Sanno Company (.10 of $50,000 decrease in Sanno Company retained earnings during 2009)

5,000

Investment in Sanno Company Equity in Investee Income (.35  $115,000)

40,250

5,000

40,250

2011 Investment in Sanno Company Cash

262,350 262,350

Loss on Revaluation* Investment in Sanno Company To adjust the first purchase to fair value *[$262,350/9,900 – (($46,000+$6,500)/1,800) ] x 1,800 = - $4,800 where $6,500 = ($85,000 - $20,000)×0.10, (1,800/18,000=10%)

4,800

Loss on Revaluation * Investment in Sanno Company To adjust the second purchase to fair value *[($262,350/9,900) – (($95,000+$28,750)/4,500) ] x 4,500 = -$4,659 where $28,750 = ($85,000 + $30,000)×0.25, (4,500/18,000=25%)

4,500

Cash

Investment in Sanno Company (.90  $50,000 subsidiary dividend)

Investment in Sanno Company Equity in Subsidiary Income (.90  $135,000)

Part B Equity in Subsidiary Income Dividends Declared - Sanno Investment in Sanno Company

4,800

4,500

45,000 45,000 121,500 121,500

121,500 45,000 76,500

Common Stock - Sanno 360,000 1/1 Retained Earnings - Sanno 85,000 Difference between Implied and Book Value 32,000 Investment in Sanno Company* 429,300 Noncontrolling interest 47,700 * $403,350- $5,000 + $40,250 - $45,000 + $121,500 - $76,500 - $4,800 - $4,500 Goodwill Difference between Implied and Book Value 8-7

32,000 32,000

Exercise 8-5 Part A 2010 Investment in Serbin Company Cash

490,000

Cash

12,000

490,000

Investment in Serbin Company (.60  $20,000 subsidiary dividend)

Investment in Serbin Company Equity in Subsidiary Income (.60  $46,000 subsidiary income)

12,000 27,600 27,600

2011 Investment in Serbin Company Additional Paid in Capital – Papke Company a Cash a

210,667 9,333 220,000 220,000

(210,667)* 9,333

* or 25% of the total carrying value of Serbin Company, or ($490,000/.60) plus the change in retained earnings for 2010 of $26,000), or (25%)($842,667) = $210,667. Investment in Serbin Company 12,750 Equity in Subsidiary Income (.85  $15,000 income for 1st three months) 12,750 Cash

260,000 Investment in Serbin Company* Additional Contributed Capital

154,380 105,620

Cost of first purchase (60%) 2010 subsidiary income (.60  $46,000) 2010 subsidiary dividends (.60  $20,000) 2011 subsidiary income to April 1 (.60  $15,000) Total Portion sold (21,600/72,000) Carrying value of investment sold Cash

Investment in Serbin Company (.67**  $25,000 subsidiary dividend) ** .67 =(72,000 + 30,000 -21,600)120,000

Investment in Serbin Company Equity in Subsidiary Income [.67  ($60,000 - $15,000)] Part B Equity in Subsidiary Income ($12,750 + $30,150) Subsidiary Income Sold ($15,000  .60  .30) Dividends Declared – Serbin ($25,000  .67) Investment in Serbin Company 8-8

$490,000 27,600 (12,000) 9,000 514,600  .30 $154,380 16,750 16,750 30,150 30,150 42,900 2,700 16,750 23,450

Exercise 8-5 (continued) Common Stock - Serbin 1/1 Retained Earnings – Serbin Difference between Implied and Book Value Investment in Serbin Company Noncontrolling interest b

600,000 201,000 41,667

Goodwill Difference between Implied and Book Value

41,667

564,587 278,080 41,667

Computation and Allocation of Difference between Implied and Book Value Acquired Parent Share Purchase price and implied value Less: Book value of equity acquired: Common Stock Retained Earnings

$490,000

NonControlling Share 326,667

816,667

(360,000) (105,000)

(240,000) (70,000)

(600,000) (175,000)

25,000 (25,000) -0-

16,667 (16,667) -0-

41,667 (41,667) -0-

Difference between implied and book value Goodwill Balance a

Price paid for 25% interest Less interest acquired: Common Stock (25% × 600,000) 150,000 Retained Earnings (25% × $201,000) 50,250 Goodwill (25% × $41,667) 10,417 Adjustment to Additional Contributed Capital – Papke b

Entire Value

220,000

(210,667) 9,333

33% × 816,667 + 33% × ($201,000-$175,000) = $278,080 or

$326,667 – $210,667 + 40% × ($201,000-$175,000) + $154,380 - $2,700 = $278,080 Exercise 8-6 Part A Investment in Sime Company ($1.50×250,000 shares) Cash New percentage of ownership is 712,500/750,000 = 95%

375,000

Part B Dividend Income (.95  $30,000) Dividends Declared - Sime

28,500

375,000

28,500

Investment in Sime Company Retained Earnings 1/1 - Pace To establish reciprocity (.925  ($150,000 - $60,000))

8-9

83,250 83,250

Exercise 8-6 (continued) Common Stock - Sime 750,000 Other Contributed Capital – Sime ($40,000 + 0.50  $250,000) 165,000 Retained Earnings 1/1 - Sime 150,000 Difference between Implied and Book Value ($578,125/.925 –$600,000) 25,000 Additional Contributed Capital - Pace 875 Investment in Sime ($578,125 + $375,000 + $83,250) 1,036,375 Noncontrolling Interest [$46,875*+ ($150,000- $60,000) × .075 +$875] 54,500 Land

25,000 Difference between Implied and Book Value

25,000

*$578,125/.925 –$578,125 = $46,875 **Pace Company’s share of Sime Company’s equity: Before new purchase (.925  $690,000) After new purchase (.95  ($690,000 + $375,000)) Stockholders equity purchased Plus: Land purchased ($25,000× 2.5%) Total carrying value acquired Cost Change in paid in capital (decrease to Pace)

$ 638,250 1,011,750 373,500 625 374,125 375,000 $ 875

Exercise 8-7 Part A Investment in Sime Company Cash ($1.30  250,000)

325,000

Part B Dividend Income (.95  $30,000) Dividends Declared - Sime

28,500

325,000

28,500

Investment in Sime Company Retained Earnings 1/1 - Pace To establish reciprocity (.925  $150,000 - $60,000)

83,250 83,250

Common Stock - Sime 750,000 Other Contributed Capital – Sime ($40,000 + 0.30  $250,000)) 115,000 Retained Earnings 1/1 - Sime 150,000 Difference between Implied and Book Value ($578,125/.925 –$600,000) 25,000 Investment in Sime 986,375 Noncontrolling Interest [$46,875 + ($150,000- $60,000) × .075 - $1,625] 52,000 Additional Contributed Capital - Pace 1,625 Land

25,000 Difference between Implied and Book Value

*$578,125/.925 –$578,125 = $46,875

8 - 10

25,000

Exercise 8-7 (continued) ** Pace Company’s share of Sime Company’s equity: Before new purchase (.925  $690,000) After new purchase (.95  ($690,000 + $325,000)) Stockholders equity purchased Plus: Land purchased ($25,000 × 2.5%) Carrying value acquired Cost Change in paid in capital (increase to Pace)

$638,250 964,250 326,000 625 326,625 325,000 ($1,625)

Exercise 8-8 Part A Cost, Partial Equity, and Complete Equity Methods Additional Contributed Capital* Investment in Skon Company

880 880

* Padilla Company’s share of Skon Company’s equity: Before sale to noncontrolling shareholders (.8  $170,500) After sale to noncontrolling shareholders (.64**  ($170,500 + $45,000) Increase in Padilla Company’s share Less land sold ($15,000 x 16%) ** (.80  60,000)/(60,000 + 15,000) = .64

$136,400 137,920 $1,520 (2,400) (880)

Alternative solution

Implied value 1/1/09 Book value – Skon Excess To Land

Padilla 132,000 120,000 12,000 -12,000

NCI 33,000 30,000 3,000 -3,000

Total 165,000 150,000 15,000 -15,000

Beginning carrying value Change in RE in 2009 & 2010 Carrying value 1/1/11

132,000 16,400 148,400

33,000 4,100 37,100

165,000 20,500 185,500

New issue by Skon Carry value before adjustment

______ 148,400

45,000 82,100

45,000 230,500

No participation by Padilla

Carry value based on % owned 147,520 Adjustment to paid in capital -880

82,980 +880

230,500 0

(64% to Padilla, 36% NCI)

8 - 11

Notes: (132,000/.80) (common stock and RE)

($50,500 - $30,000)

Exercise 8-8 (continued) Part B Cost Method Investment in Skon Company Retained Earnings 1/1 - Padilla Company To establish reciprocity/convert to equity .8  ($50,500 - $30,000) Common Stock - Skon Company Other Contributed Capital - Skon Company Retained Earnings - Skon Difference between Implied and Book Value Investment in Skon Company ($132,000 - $880 + $16,400) Noncontrolling interest**

16,400 16,400

150,000 15,000 50,500 15,000 147,520 82,980

** ($132,000/.8 - $132,000) + ($50,500 – $30,000) x .2 + $45,000 + $880 Land

15,000 Difference between Implied and Book Value

15,000

Partial Equity and Complete Equity Methods Equity Income ($10,000)(.64) Investment in Skon Company

6,400 6,400

Common Stock - Skon Company Other Contributed Capital - Skon Company Retained Earnings - Skon Difference between Implied and Book Value Investment in Skon Company Noncontrolling interest

150,000 15,000 50,500 15,000

Land

15,000 Difference between Implied and Book Value

8 - 12

147,520 82,980

15,000

ANSWERS TO ASC (Accounting Standards Codification) EXERCISES ASC8-1 Recognition FASB assumes that if the number of shares issued in a stock dividend is large enough to materially reduce the per-share market value, it is inappropriate to record the impact using the firm’s market value. What is the preferred treatment in such cases? Does FASB provide a guideline as to the percentage of previously outstanding shares that would qualify for the treatment? Step 1: Use the drop-down menus under the ‘Presentation’ general topic on the homepage and choose ‘505-Equity’; then under the second drop-down menu, choose ’20-Stock Dividend and Stock Split’. Step 2: Click Expand (beneath the table of contents). Click on Section 25 recognition. The answers can be found in FASB ASC paragraphs 505-20-25-2 and 3. The point at which the relative size of the additional shares issued becomes large enough to materially influence the unit market price of the stock will vary with individual entities and under differing market conditions and, therefore, no single percentage can be established as a standard for determining when capitalization of retained earnings in excess of legal requirements is called for and when it is not. Except for a few instances, the issuance of additional shares of less than 20 or 25 percent of the number of previously outstanding shares would call for treatment as a stock dividend. The number of additional shares issued as a stock dividend may be so great that it may reasonably be expected to materially reduce the share market value. In such a situation, the substance of the transaction is clearly that of a stock split. ASC8-2 Overview Does ASC 505 (stock dividends and stock splits) apply to both issuers and recipients? If not, which party is addressed? Step 1: Use the drop-down menus under the ‘Presentation’ general topic on the homepage and choose ‘505-Equity’; then under the second drop-down menu, choose ’20-Stock Dividend and Stock Split’. Step 2: Click Expand (beneath the table of contents). Click on Section 05- Overview and Background. FASB ASC paragraph 505-20-05-1 states that the guidance for stock dividends and stock splits includes guidance for both the recipient as well as for the issuer. ASC8-3 Glossary There are three definitions of control in the glossary. Which definition is used for business combinations? Provide the definition. On the Codification homepage, click on ‘Master Glossary’ in the left-hand column. In the ‘glossary term quick find’ menu type ‘control’ and hit return.’ (note if you type control in slowly, possible matches are displayed below the menu.) Since business combinations are covered in Topic 805, the third definition of control is the appropriate definition. In the glossary, the definition for control related to Topic 805 is ‘The same as the meaning of controlling financial interest in paragraph 810-10-15-8.’ Clicking on paragraph 810-10-15-8 provides the condition for a controlling financial interest. The usual condition for a controlling financial interest is ownership of a majority voting interest, and, therefore, as a general rule ownership by one reporting entity, directly or indirectly, of more than 50 percent of the outstanding voting shares of another entity is a condition pointing toward consolidation.

8 - 13

The power to control may also exist with a lesser percentage of ownership, for example, by contract, lease, agreement with other stockholders, or by court decree. ASC8-4 Glossary Define kick-out rights. How can you determine if the kick-out rights are substantive? On the Codification homepage, click on ‘Master Glossary’ in the left-hand column. In the ‘glossary term quick find’ menu type ‘kick-out’ and hit return.’ (note if you type control in slowly, possible matches are displayed below the menu.) Two definitions of kick-out rights are provided. Kick-out rights (related to consolidations and not partnership related) are the ability to remove the reporting entity with the power to direct the activities of the Variable Interest Entity (VIE) that most significantly impact the VIE’s economic performance. Click on ‘income links’ for the first definition. None of the links provide guidance on how to determine whether the kick-out rights are substantial. Click on Advanced Search at the top of the Codification. In the search terms, type ‘kick-out substantial’ and click on ‘all words.’ The first result returns the answer (after scrolling through the paragraphs). FASB ASC paragraph 810-10-55-35 states that substantive kick-out rights must have both of the following characteristics: a. The decision maker can be removed by the vote of a simple majority of the voting interests held by parties other than the decision maker and the decision maker’s related parties. b. The parties holding the kick-out rights have the ability to exercise those rights if they choose to do so; that is, there are no significant barriers to the exercise of the rights.

8 - 14

ANSWERS TO PROBLEMS Problem 8-1 Part A Computation and Allocation of Difference between Implied and Book Value Acquired Fair value price = $1,890,000/135,000 shares = $14/share Fair value of 1/1/10 shares (30,000 shares at $14/share) Cost of 30,000 shares (10% ownership) 365,000 Change in retained earnings (630,000-260,000)(10%) 37,000 Adjusted carrying value of shares Increase to fair value

$420,000

Fair value of 1/1/11 shares (75,000 shares at $14/share) Cost of 75,000 shares (25% ownership) 960,000 Change in retained earnings (630,000-540,000)(25%) 22,500 Adjusted carrying value of shares Increase to fair value

$1,050,000

Parent Share

402,000 $18,000

982,500 $67,500

NonControlling Share

Entire Value

4,200,000

Fair value of 1/1/10 purchase ($14/share) Fair value of 1/1/11 purchase ($14/share) Purchase price 1/1/12 purchase ($14/share) Purchase price and implied value* Less: Book value of equity acquired: Common Stock Retained Earnings

420,000 1,050,000 1,890,000 $3,360,000

840,000

(2,400,000) (504,000)

(600,000) (3,000,000) (126,000) (630,000)

Difference between implied and book value Goodwill Balance * $1,890,000/45% = 4,200,000 where 45% = 135,000/300,000

456,000 (456,000) -0-

8 - 15

114,000 (114,000) -0-

570,000 (570,000) -0-

Problem 8-1 (continued) Part B Investment in Sarko Company ($37,000 + $22,500) Retained Earnings 1/1 - Pelzer Company To establish reciprocity/convert to equity 0.10  ($630,000 - $260,000) + .25  ($630,000 - $540,000)

59,500 59,500

Common Stock - Sarko Company 3,000,000 Retained Earnings 1/1 - Sarko 630,000 Difference between Implied and Book Value 570,000 Investment in Sarko Company 3,360,000 Noncontrolling interest 840,000 To eliminate investment account and create noncontrolling interest account Goodwill Difference between Implied and Book Value To allocate the difference between implied and book value to goodwill

570,000 570,000

Problem 8-2 Pyle Company’s Books (1/2/09 Purchase of 51,000 shares of Stern Company) Investment 510,000 Cash 510,000 Implied value by the purchase is ($510,000/.85) = $600,000, with NCI = $90,000. The carrying value of Stern Company, on January 1, 2011, is computed as follows: Carrying value of Stern Company Carrying value of Stern Company (on 1/1/2011) Pyle Company’s carrying value of Company Stern Initial cost (51,000 shares) $510,000 Increase in retained earnings ($292,000-120,000 x 0.85) 146,200 Carrying value of Investment in Stern Company 1/1/2011

656,200

Noncontrolling carrying value in Company Stern Initial value (9,000 shares) $90,000 Increase in retained earnings ($292,000-120,000 x 0.15) 25,800 Carrying value of Investment in Stern Company 1/1/2011 Total carrying value of Stern Company (1/1/2011)

115,800 772,000

8 - 16

Problem 8-2 (continued) To retroactively record Pyle’s share of Stern Company earnings in the investment account on 1/1/2011. Investment in Stern Company 146,200 1/1 Retained Earnings – Pyle Company 146,200 The gain or loss in net income attributable to Pyle Company is computed as follows: Gain or loss is the difference in: 1) Total carrying value of Stern Company 2) Sum of: Fair value of consideration received (40,000 shares) $480,000 Fair value of retained NCI (11,000 x $12) 132,000 Carrying value of the NCI (9,000 shares) 115,800 Total Loss attributable to Pyle Company

772,000

727,800 $ 44,200

The loss will be split between the 40,000 shares that are sold and the 11,000 shares that are still held as an investment. To record the sale of the shares, Pyle Company makes the following entry in its books on January 1, 2011. Pyle Company’s Books (1) Cash (40,000 x $12/share) Realized loss on sale (on 40,000 shares sold) Investment in S Company (40/51 × $656,200) (2)

480,000 34,667

Unrealized loss (on 11,000 shares retained) 9,533 Investment in Stern Company (remaining 11,000 shares) To reduce the remaining shares to market value.

514,667

9,533

After the last entry, the balance in the investment account is equal to the fair value of the remaining interest ($132,000 or 11,000 shares at $12/share)

8 - 17

Problem 8-3

PYLE COMPANY AND SUBSIDIARY Consolidated Statements Workpaper For the Year Ended December 31, 2011 Pyle Stern Company Company

Income Statement Income before Dividend Income* Dividend Income Net/Consolidated Income Subsidiary Income Sold Noncontrolling Interest in Income (.2  $186,000) Net Income to Retained Earnings Retained Earnings Statement Retained Earnings, 1/1: Pyle Company Stern Company Net Income from above Dividends Declared: Pyle Company Stern Company 12/31 Retained Earnings to Balance Sheet *Reported Net Income Less: Dividend Income (.8  $60,000)

Eliminations Dr. Cr.

Noncontrolling Consolidated Interest Balances

$172,000 $186,000 48,000 (1) 48,000 220,000

$358,000

186,000

358,000 2,325

(3) 2,325

$220,000 $186,000

48,000

$1,200,000

220,000

2,325

37,200 37,200

(2) 8,600 (4)137,600 292,000 (5) 292,000 186,000 48,000

2,325

(80,000) (60,000) $1,340,000 $418,000 $220,000 (48,000) $172,000

8 - 18

(37,200) $323,125

1,346,200 37,200

323,125 (80,000)

(1) 48,000 $340,000 $196,525

(12,000) $25,200 $1,589,325

Problem 8-3 (continued) Balance Sheet Current Assets Investment in Stern Company Other Assets Total Liabilities Common Stock: Pyle Company Stern Company Other Contributed Capital Pyle Company Stern Company Retained Earnings from above 1/1 Noncontrolling Interest in Net Assets 12/31 Noncontrolling Interest

Pyle Company

Stern Company

Eliminations Dr. Cr.

Noncontrolling Interest

Consolidated Balances

$600,000 480,000 1,180,000 $2,260,000

$320,000 668,000 $988,000

1,848,000 $2,768,000

$190,000

$90,000

$280,000

$920,000 (4) 137,600

(5) 617,600

500,000

500,000 300,000

(5) 300,000

180,000 418,000

(2) 8,600 (3) 2,325 (5) 180,000 340,000

230,000

1,340,000

219,075

196,525 (5) 154,400

25,200 154,400 $179,600

1,589,325 179,600

Total $2,260,000 $988,000 $968,525 $968,525 $2,768,000 (1) To eliminate intercompany dividends. (80% of $60,000) (2) To adjust additional contributed capital for portion included in income in prior years 3/51  [.85  ($292,000 - $120,000)] (3) To adjust additional contributed capital for current year's income sold to noncontrolling stockholders 3/51  (3/12  $186,000  .85) (4) To establish reciprocity/convert to equity on shares retained (.8  ($292,000 - $120,000)) (5) To eliminate investment account and create noncontrolling interest account. $510,000/.85 x.2 + ($292,000 - $120,000) x .2 Verification of Controlling interest in Consolidated Net Income: Stern company's reported income Allocated to noncontrolling interest: First three months ($46,500  .15) Last nine months ($139,500  .2) Allocated to controlling interest (Pyle Company) Pyle Company's Income Controlling interest in Consolidated Net Income

$186,000 $6,975 27,900

8 - 19

34,875 151,125 172,000 $323,125

On Pyle’s books 4/1/11 Cash 100,000 Investment in S Company (3,000/51,000 × $510,000) 30,000 Additional Contributed Capital—Pyle Company 70,000 Cost of Shares (3,000/51,000 × $510,000) Plus: Undistributed Income: (A) Change in Retained Earnings from the date of acquisition (1/2/09) to the beginning of the year (1/1/11) ($292,000 - $120,000) Ownership percentage sold (B) Earnings from beginning of current year to the the date of sale (1/1/11 to 4/1/11) ($186,000/4) Ownership percentage sold Adjusted cost of shares sold

$30,000

$172,000 5%

46,500 5%

8,600

Selling price of shares Adjusted cost of shares sold Additional paid in capital – Pyle Company Paid in capital recorded on Pyle’s books Reduction in paid in capital needed

2,325 $40,925 $100,000 40,925 $59,075 70,000 10,925

(1) Dividend Income Dividend Declared—Stern Company

48,000

(2) Additional Contributed Capital—Pyle Company 1/1 Retained Earnings— Pyle Company (Consolidated Retained Earnings) (3) Additional Contributed Capital— Pyle Company Subsidiary Income Sold

8,600

48,000

8,600 2,325 2,325

(4) Investment in Stern Company (.8  ($292,000 - $120,000)) 137,600 1/1 Retained Earnings— Pyle Company 137,600 To establish reciprocity on shares still owned at year-end (5) Common Stock— Stern Company Other Contributed Capital – Stern Company 1/1 Retained Earnings— Stern Company Investment in S Company (72%) ($510,000 - $30,000 + $137,600) Noncontrolling Interest $510,000/.85 x.2 + ($292,000 - $120,000) x .2

8 - 20

300,000 180,000 292,000 617,600 154,400

Problem 8-4

PORTER COMPANY AND SUBSIDIARY Consolidated Statements Workpaper For the Year Ended December 31, 2011 Porter Spitz Company Company

Income Statement Income before Dividend Income* Dividend Income Net/Consolidated Income Subsidiary Income Sold Noncontrolling Interest in Income (.19  $60,000) Net Income to Retained Earnings Retained Earnings Statement Retained Earnings, 1/1: Porter Company Spitz Company Net Income from above Dividends Declared: Porter Company Spitz Company 12/31 Retained Earnings to Balance Sheet

$63,200 24,300

$60,000

87,500

60,000

Eliminations Dr. Cr.

Noncontrolling Consolidated Interest Balances $123,200

(1) 24,300

(3) 1,800 $87,500

$60,000

24,300

$206,500

87,500

1,800

11,400 11,400

(2) 9,540 (4) 85,860 126,000 60,000

(5) 126,000 24,300

1,800

301,900 11,400

(50,000) $244,000

123,200 1,800 (11,400) $113,600

113,600 (50,000)

(30,000) $156,000

* Reported Net Income Less: Dividend Income (45,000 – 4,500)/50,000)  $30,000)

150,300 $87,500 (24,300) $63,200

8 - 21

(1) 24,300 121,500

(5,700) 5,700

$365,500

Problem 8-4 (continued) Balance Sheet Cash Accounts Receivable Inventory Investment in Spitz Company Difference b/w Implied and Book Value*** Plant Assets Land Total Liabilities Common Stock: Porter Company Spitz Company Other Contributed Capital Porter Company Spitz Company Retained Earnings from above 1/1 Noncontrolling Interest in Net Assets** 12/31 Noncontrolling Interest in Net Assets Total

Porter Spitz Company Company $90,000 62,000 106,000 121,500

$40,000 38,000 64,000

320,000 69,000 $768,500

149,000 46,000 $337,000

$102,000

$61,000

Eliminations Dr. Cr.

Noncontrolling Interest

Consolidated Balances $130,000 100,000 170,000

(4) 85,860 (5) 10,000

(5) 207,360 (6) 10,000 469,000 125,000 $994,000

(6) 10,000

$163,000

250,000

250,000 100,000 (5) 100,000

172,500

244,000

20,000 156,000

(2) 9,540 (3) 1,800 (5) 20,000 150,300

$768,500

$337,000

387,500

161,160

121,500 (5) 48,640

5,700 48,640 $54,340

387,500

(1) To eliminate intercompany dividends. ($30,000  (45,000 - 4,500)/50,000) (2) To adjust additional contributed capital for portion included in income in prior years. .1  [.9  ($246,000 - $140,000)] (3) To adjust additional contributed capital for current year's income sold to noncontrolling stockholders .1  (4/12  $60,000  .9) (4) To establish reciprocity/convert to equity on shares retained. .81  ($126,000 - $20,000) (5) To eliminate investment account and create noncontrolling interest account. **$135,000/.9 x .19 + ($126,000 - $20,000) x .19 (6) To allocate the difference between implied and book value *** $135,000/.9 - $140,000 Verification of Controlling interest in Consolidated Net Income: Spitz company's reported income Allocated to noncontrolling interest: First four months (4/12  $60,000  .10) $2,000 Last eight months (8/12  $60,000  .19) 7,600 Allocated to controlling interest Porter Company's Income Controlling interest in Consolidated Net Income

8 - 22

365,500 54,340 $994,000

$60,000

(9,600) 50,400 63,200 $113,600

Problem 8-4 (continued) Cost of Shares (4,500/45,000 × $135,000) Plus: Undistributed Income: (A) Change in Retained Earnings from the date of acquisition (1/1/07) to the beginning of the year (5/1/11) ($126,000 - $20,000) Ownership percentage sold (B) Earnings from beginning of current year to the the date of sale (1/1/11 to 5/1/11) ($60,000/3) Ownership percentage sold Adjusted cost of shares sold

$13,500

$106,000 9%

9,540

20,000 9%

1,800 $24,840

Selling price of shares Adjusted cost of shares sold Additional paid in capital – Porter Company Paid in capital recorded on P’s books ($28,000-13,500) Reduction in paid in capital needed On Porter’s books Cash Investment in Spitz Other Contributed Capital – Porter Company

$28,000 24,840 $3,160 14,500 -11,340 28,000 13,500 14,500

(1) Dividend Income Dividends declared—Spitz Company (2) Additional Contributed Capital—Porter Company 1/1 Retained Earnings—Porter Company

24,300

(3) Additional Contributed Capital—Porter Company Subsidiary Income Sold

1,800

24,300 9,540 9,540

1,800

(4) Investment in Spitz Company (.81  ($126,000 - $20,000)) 1/1 Retained Earnings—Porter Company To establish reciprocity on shares still owned at year-end

85,860

(5) Common Stock— Spitz Company Other Contributed Capital – Spitz Company 1/1 Retained Earnings— Spitz Company Difference between Implied Value and Book Value Investment in Spitz Company ($135,000-24,840+106,000  .9 +1,800) Noncontrolling Interest [($135,000/.90)]  .1 + 24,840 +106,000  .1 -1,800

100,000 20,000 126,000 10,000

(6) Land Difference between Implied Value and Book Value ($135,000/.9) - $140,000

10,000

8 - 23

85,860

207,360 48,640

10,000

Problem 8-5

PYLE COMPANY AND SUBSIDIARY Consolidated Statements Workpaper For the Year Ended December 31, 2011 Pyle Company

Stern Company

$172,000 151,125 323,125

$186,000

Eliminations Dr. Cr.

Noncontrolling Consolidated Interest Balances

Income Statement Income before Equity in Subsidiary Equity in Subsidiary Income Net/Consolidated Income Subsidiary Income Sold Noncontrolling Interest in Income (.2  $186,000) Net Income to Retained Earnings Retained Earnings Statement Retained Earnings, 1/1: Pyle Company Stern Company Net Income from above Dividends Declared: Pyle Company Stern Company 12/31 Retained Earnings to Balance Sheet

$358,000 (1) 151,125

186,000 (1) 2,325

$323,125

$186,000

$151,125

$2,325

37,200 $37,200

$1,346,200 323,125

$1,346,200 292,000 186,000

(2) 292,000 151,125

2,325

37,200

$443,125

(1) 48,000 $50,325

(12,000) $25,200

(80,000) $1,589,325

8 - 24

323,125 (80,000)

(60,000) $418,000

* Reported Net Income Less: Equity in Subsidiary Income ($46,500  .85*) + ($139,500  .80**) * 51,000/60,000 = .85; ** (51,000 – 3,000)/60,000 = .80

358,000 2,325 (37,200) $323,125

$323,125 (151,125) $172,000

$1,589,325

Problem 8-5 (continued) Balance Sheet Current Assets Investment in Stern Company Other Assets Total Liabilities Common Stock: Pyle Company Stern Company Other Contributed Capital: Pyle Company Stern Company Retained Earnings from above 1/1 Noncontrolling Interest 12/31 Noncontrolling Interest Total

Pyle Company

Stern Company

Eliminations Dr. Cr.

Noncontrolling Interest

Consolidated Balances

$600,000 718,400

$320,000

$920,000

1,180,000 $2,498,400

668,000 $988,000

1,848,000 $2,768,000

$190,000

$90,000

$280,000

(1) 100,800 (2) 617,600

500,000

500,000 300,000

(2) 300,000

180,000 418,000

(2) 180,000 443,125

219,075 1,589,325

$2,498,400

219,075

$988,000

$923,125

50,325 (2) 154,400

25,200 154,400 $179,600

$923,125

(1) To reverse the effect of parent company entries during the year for subsidiary dividends and income (2) To eliminate investment account and create noncontrolling interest account $510,000/.85 x.2 + ($292,000 - $120,000) x .2 Verification of Consolidated Net Income: Stern Company's reported income Allocated to noncontrolling interest: First three months $46,500  .15 $6,975 Last nine months $139,500  .2 27,900 Allocated to controlling interest (Pyle Company) Pyle Company's Income Consolidated Net Income

8 - 25

1,589,325 179,600 $2,768,000

$186,000

34,875 151,125 172,000 $323,125

Problem 8-5 (continued) On Pyle’s books Cash 100,000 Investment in S Company (3,000/51,000 × $510,000) 40,925 Additional Contributed Capital—Pyle Company 59,075 Cost of Shares (3,000/51,000 × $510,000) Plus: Undistributed Income: (A) Change in Retained Earnings from the date of acquisition (1/2/09) to the beginning of the year (1/1/11) ($292,000 - $120,000) Ownership percentage sold (B) Earnings from beginning of current year to the the date of sale (1/1/11 to 4/1/11) ($186,000/4) Ownership percentage sold Adjusted cost of shares sold

$30,000

$172,000 5%

46,500 5%

Selling price of shares Adjusted cost of shares sold Additional paid in capital – Pyle Company

8,600

2,325 $40,925 $100,000 40,925 $59,075

(1) Equity Income ($46,500×.85)+($139,500×.80) Investment in Skon Company Dividends Declared – Skon Company ($60,000×.80) Subsidiary income sold ($46,500×.05)

151,125

(2) Common Stock— Skon Company Other Contributed Capital – Skon Company 1/1 Retained Earnings— Skon Company Investment in Skon Company ($510,000-40,925 + 2,325 + $146,200) Noncontrolling Interest [90,000 + 15% (292,000 - 120,000) + 40,925 - 2,325]

300,000 180,000 292,000

Cost of Shares Plus: Undistributed Income: (A) Change in Retained Earnings from the date of acquisition (1/2/09) to the beginning of the year (1/1/11) ($292,000 - $120,000) Ownership percentage (B) Earnings from beginning of current year to the the date of sale (1/1/11 to 4/1/11) ($186,000/4) Ownership percentage Adjusted cost of shares sold Less carrying value sold 8 - 26

100,800 48,000 2,325

617,600 154,400

$510,000

$172,000 85%

46,500 85%

146,200

39,525 $695,725 40,925

Carrying value of retained ownership Earnings since 4/1/11 ($186,000-46,500)× .80 Dividends since 4/1/11 ($60,000 × .80) Investment balance 12/31/2011

8 - 27

654,800 111,600 -48,000

63,600 718,400

Problem 8-6

PORTER COMPANY AND SUBSIDIARY Consolidated Statements Workpaper For the Year Ended December 31, 2011 Porter Company

Spitz Company

$63,200 50,400 113,600

$60,000

Eliminations Dr. Cr.

Noncontrolling Consolidated Interest Balances

Income Statement Income before Equity in Subsidiary * Equity in Subsidiary Income Net/Consolidated Income Subsidiary Income Sold Noncontrolling Interest in Income (.19  $60,000) Net Income to Retained Earnings Retained Earnings Statement Retained Earnings, 1/1: Porter Company Spitz Company Net Income from above Dividends Declared: Porter Company Spitz Company 12/31 Retained Earnings to Balance Sheet

$123,200 (1) 50,400

60,000 (1) 1,800

$113,600

$60,000

50,400

1,800

11,400 11,400

$301,900

$301,900 126,000 60,000

113,600

(2) 126,000 50,400

1,800

11,400

(50,000) $365,500

123,200 1,800 (11,400) $113,600

113,600 (50,000)

(30,000) $156,000

* Reported Net Income Less: Equity in Subsidiary Income [(.90  $20,000) + (.81  $40,000)]

(1) 24,300 176,400 26,100

(5,700) 5,700

$113,600 (50,400) $63,200 The problem uses the account title ‘Net Income before Equity in Subsidiary Income and Gain on Sale of Investment’

8 - 28

$365,500

Problem 8-6 (continued) Balance Sheet Cash Accounts Receivable Inventory Investment in Spitz Company Difference b/w Implied and Book Value*** Plant Assets Land Total

Porter Company

Spitz Company

$90,000 62,000 106,000 231,660

$40,000 38,000 64,000

Eliminations Dr. Cr.

149,000 46,000 $337,000

Consolidated Balances $130,000 100,000 170,000

(2) 10,000 320,000 69,000 $878,660

Noncontrolling Interest

(3) 10,000

(1) 24,300 (2) 207,360 (3) 10,000 469,000 125,000 $994,000

Liabilities $102,000 $61,000 $163,000 Common Stock: Porter Company 250,000 250,000 Spitz Company 100,000 (2) 100,000 Other Contributed Capital Porter Company 161,160 161,160 Spitz Company 20,000 (2) 20,000 Retained Earnings from above 365,500 156,000 176,400 26,100 5,700 365,500 1/1 Noncontrolling Interest in Net Assets** (5) 48,640 48,640 12/31 Noncontrolling Interest in Net Assets $54,340 54,340 Total $878,660 $337,000 $316,400 $316,400 $994,000 (1) To reverse effect of subsidiary income and dividends on investment account for the year (2) To eliminate investment account and create noncontrolling interest account. **$135,000/.9 x .19 + ($126,000 - $20,000) x .19 (3) To allocate the difference between implied and book value *** $135,000/.9 - $140,000 Verification of Controlling interest in Consolidated Net Income: Spitz company's reported income Allocated to noncontrolling interest: First four months (4/12  $60,000  .10) Last eight months (8/12  $60,000  .19) Allocated to controlling interest Porter Company's Income Controlling interest in Consolidated Net Income

$60,000 $2,000 7,600

8 - 29

(9,600) 50,400 63,200 $113,600

Problem 8-6 (continued) Cost of Shares (4,500/45,000 × $135,000) Plus: Undistributed Income: (A) Change in Retained Earnings from the date of acquisition (1/1/07) to the beginning of the year (5/1/11) ($126,000 - $20,000) Ownership percentage sold (B) Earnings from beginning of current year to the the date of sale (1/1/11 to 5/1/11) ($60,000/3) Ownership percentage sold Adjusted cost of shares sold

$13,500

$106,000 9%

9,540

20,000 9%

1,800 $24,840

Selling price of shares Adjusted cost of shares sold Additional paid in capital – Porter Company On Porter’s books Cash Investment in Spitz Other Contributed Capital – Porter Company

$28,000 24,840 $3,160

28,000

Workpaper elimination entries (1) Equity Income [(.90  $20,000) + (.81  $40,000)] Dividends declared—Spitz Company (.81  $30,000) Investment in Spitz Company Equity Income Sold

24,840 3,160

50,400 24,300 24,300 1,800

(2) Common Stock— Spitz Company Other Contributed Capital – Spitz Company 1/1 Retained Earnings— Spitz Company Difference between Implied Value and Book Value Investment in Spitz Company ($135,000-24,840+106,000  .9 +1,800) Noncontrolling Interest [($135,000/.90)]  .1 + 24,840 +106,000  .1 -1,800

100,000 20,000 126,000 10,000

(3) Land Difference between Implied Value and Book Value ($135,000/.9) - $140,000

10,000

8 - 30

207,360 48,640

10,000

Problem 8-7

1/1/2011 purchase 7/1/2011 purchase 11/1/2011 sale

Shares Traded 30,000 210,000 (3,000)

Shares Owned 30,000 240,000 237,000

% Owned 10% 80% 79%

Cost Method (Part A and B) Part A 1/1/2011 Investment in Spivey Company Cash

122,000 122,000

7/1/2011 Investment in Spivey Company ($3.76 per share x 210,000 shs) Cash

789,600 789,600

Shares to fair value (30,000)($3.76/share) $112,800 Carrying value (adjusted) Cost 122,000 Income first six months ($60,000)(10%) 6,000 128,000 Total Loss on revaluation 15,200 Loss on revaluation* Investment in Spivey Company *[$789,600/210,000 – ($122,000+$6,000)/30,000] x 30,000 = - $15,200 (10%)($60,000)= 6,000 income first six months Selling price 3,000 shares ($7/share) Carry value 6/30/2011 (240,000)($3.76/share) Income since 6/30 ($36,000)(80%) Carrying value 11/1/2011 Percent sold (3,000/240,000) Carrying value sold Additional paid in capital – Plum Company

15,200 15,200

$21,000 $902,400 28,800 931,200 1.25% 11,640 $ 9,360

11/1/2011 Cash

21,000 Investment in Spivey Company ($3.56**)(3,000 shares) Additional Contributed Capital (On worksheet need to reduce additional contributed capital by ($10,320-9,360 = $960) ** ($122,000 -15,200)/30,000 shares = $3.56 per share

8 - 31

10,680 10,320

Problem 8-7 (continued) Part B Additional Contributed Capital (1) Subsidiary Income Sold Subsidiary Income Purchased ($60,000 x 70%) Investment in Spivey Company Investment in Spivey Company Subsidiary Income Sold ($60,000 x 10%)

960 960 42,000 42,000 6,000 6,000

(1) 3,000/300,000  $96,000 = $9,600  3,000/30,000 = $960 Common Stock - Spivey Company Retained Earnings 1/1 - Spivey Company Difference between Implied and Book Value Investment in Spivey Company ($902,400- $10,680 -42,000) Noncontrolling interest ($225,600+$10,680+42,000)

600,000 240,000 288,000

Goodwill Difference between Implied and Book Value

288,000

849,720 278,280 288,000

Computation and Allocation of Difference between Implied and Book Value Acquired Parent Share Purchase price and implied value* Less: Book value of equity acquired

$902,400 672,000

NonEntire Controlling Value Share 225,600 1,128,000 168,000 840,000

Difference between implied and book value 230,400 57,600 288,000 Goodwill (230,400) (57,600) (288,000) Balance -0-0-0*$789,600/210,000*240,000 = $902,400 or $122,000+$789,600– $15,200+$6,000 = $902,400 Partial Equity and Complete Equity Methods (Part A and B) Part A 1/1/2011 Investment in Spivey Company Cash

122,000

7/1/2011 Investment in Spivey Company Cash

789,600

122,000

789,600

Investment in Spivey Company Equity income (1st six months, $60,000× 10%)

6,000

Loss on revaluation* Investment in Spivey Company *[(30,000 × $3.76)- ($122,000 + $6,000) = - $15,200

15,200

8 - 32

6,000 15,200

Problem 8-7 (continued) 11/1/2011 Cash Investment in Spivey Company ($3.88)(3,000)* Additional Contributed Capital – Plum Company * Book value of shares sold Cost on 1/1/2011 Income to 11/1/2011 ($96,000)(.10) or (.80) Carrying value of shares Fair value adjustment Adjusted cost Shares Cost per share

21,000 11,640 9,360

30,000 Shares Total 240,000 Shares $122,000 911,600 9,600 34,800 $131,600 946,400 (15,200) 15,200 116,400 931,200 30,000 240,000 $3.88 $3.88

For 7/1 to 11/1 (80%)($36,000)= 28,800 Investment in Spivey Company Equity in Subsidiary Income

28,800 28,800

For 11/1 to 12/31 (79%)($34,000)= 26,860 Investment in Spivey Company Equity in Subsidiary Income

26,860

Part B Equity income (6,000 + 28,800 + 26,800) Equity in Subsidiary Income Purchased (1) Investment in Spivey Company

61,660 36,040

26,860

96,700

(1) $60,000  3,000/30,000 = ($6,000) 210,000/300,000  $60,000 = $42,000 30,000/300,000  $96,000 = $9,600  3,000/30,000 = (960) Total 36,040 Common Stock - Spivey Company Retained Earnings 1/1 - Spivey Company Difference between Implied and Book Value Investment in Spivey Company* Noncontrolling interest ($225,600+$11,640+96,700-55,660) * 902,400-11,640+55,660 – 96,700

600,000 240,000 288,000

Goodwill Difference between Implied and Book Value

288,000

Part C Plum’s reported net income Plum’s share of Spivey’s income: 1/1/2011 to 6/30/2011 = (.1  $60,000) 7/1/2011 to 10/31/2011 = (.8  $36,000) 11/1/2011 to 12/31/2011= (.79  $34,000) Controlling interest in Consolidated Net Income 8 - 33

849,720 278,280

288,000 $225,000 $6,000 28,800 26,860

61,660 $286,660

Parent Share Carrying value on 6/30/2011 Change in RE 6/30 to 11/1 ($36,000) Adjusted cost Sell 3,000 shares $3.88 New carrying value (79%,21%) Correct Carrying value Adjustment needed

$902,400 28,800 931,200 -21,000 910,200 919,560 +360 +9,360

NonEntire Controlling Value Share 225,600 1,128,000 7,200 36,000 232,800 1,164,000 +21,000 253,800 1,164,000 244,440 -360 -9,360

Carrying value Change in RE

919,560 61,660 981,220

244,440 27,300 271,740

8 - 34

1,164,000

Problem 8-8 Part A Investment in Spero Company Cash (7,500  $8.50)

63,750

Part B Dividend Income Dividends Declared - Spero Company (.86666*  $40,000) * (51,000 + 7,500)/(60,000 + 7,500) = .86666.

34,667

63,750

Investment in Spero Company 1/1 Retained Earnings - Pryor Company To establish reciprocity/convert to equity (.85  ($360,000 - $200,000))

34,667 136,000 136,000

Common Stock - Spero ($300,000 + (7,500 $5) 337,500 Other Contributed Capital – Spero (7,500 $3.5) 26,250 1/1 Retained Earnings – Spero 360,000 Investment in Spero Company* 599,750 Difference between Implied and Book Value ($400,000/.85 - $500,000) 29,412 Additional Contributed Capital** 2,012 Noncontrolling Interest [$70,588 + .15 x ($360,000 - $200,000) - $2,012] 92,576 Difference between Implied and Book Value Land

29,412 29,412

* $400,000 + $63,750 + $136,000 ** Pryor Company’s share of the new assets of Spero Company: Before the issue of new shares (.85  $660,000) After the issue [(58,500/67,500)  ($660,000 + $63,750)] Stockholders equity purchased Less: Land purchased (-$29,412 x 0.0166) Total interest acquired Cost of the shares (7,500  $8.50) Excess of book value over cost

$ 561,000 627,250 66,250 (488) 65,762 63,750 $ 2,012

Problem 8-9 Part A (1) Investment in Sally Company Additional Contributed Capital* * Purdy Company’s share of Sally Company’s equity: Before new issue (.84  $1,200,000**) After new issue (.7  ($1,200,000 + (6,000  $55))) Increase in Purdy Company’s share Less Land sold Net increase Cost Adjustment to Additional Contributed Capital

57,400 57,400 $1,008,000 1,071,000 63,000 (5,600) 57,400 0 $57,400

** $600,000 + $200,000 + $400,000 = $1,200,000 (2) Investment in Sally Company

201,600 8 - 35

1/1 Retained Earnings -Pryor Company To establish reciprocity/convert to equity (.84  ($400,000 - $160,000))

201,600

(3) Common Stock - Sally ($600,000 + $120,000) 720,000 Other Contributed Capital - Sally ($200,000 + $210,000) 410,000 Retained Earnings – Sally 1/1 400,000 Difference between Implied and Book Value ($840,000/.84 - $960,000) 40,000 Investment in Sally Company ($840,000 + $201,600 + $57,400) 1,099,000 Noncontrolling interest* 471,000 Land

40,000 Difference between Implied and Book Value

40,000

* ($720,000+$410,000+$400,000+$40,000) x .30 = $471,000 or $160,000 +($400,000 – $160,000 x .16) +$120,000 +$210,000 -$57,400

8 - 36

Problem 8-9 (continued) Part B (1) Additional Contributed Capital* Investment in Sally Company

30,800 30,800

* Purdy Company’s share of Sally Company’s equity: Before new issue (.84  $1,200,000) After new issue (.7  ($1,200,000 + (6,000  $34)) Decrease in Purdy Company’s share Less goodwill sold Total decrease Cost Loss from subsidiary issuance of shares

$1,008,000 982,800 25,200 5,600 30,800 0 $ 30,800

(2) Investment in Sally Company 1/1 Retained Earnings -Pryor Company To establish reciprocity (.84  ($400,000 - $160,000))

201,600 201,600

(3) Common Stock - Sally 720,000 Other Contributed Capital - Sally ($200,000 + $84,000) 284,000 Retained Earnings – Sally 1/1 400,000 Difference between Implied and Book Value ($840,000/.84 - $960,000) 40,000 Investment in Sally Company ($840,000 + $201,600 - $30,800) 1,010,800 Noncontrolling interest** 433,200 ** $160,000 +($400,000 – $160,000 × 0.16) +$120,000 +$84,000 + $30,800 (4) Land

40,000 Difference between Implied and Book Value

Problem 8-10 Cost of Shares (13,500/135,000) × $665,000 Plus: Undistributed Income: (A) Change in Retained Earnings from the date of acquisition (1/1/10) to the beginning of the year (1/1/11) ($500,000 - $400,000) $100,000 Ownership percentage sold (13,500/150,000) 9% (B) Earnings from beginning of current year to the the date of sale (1/1/11 to 5/1/11) ($270,000/3) 90,000 Ownership percentage sold (13,500/150,000) 9% Adjusted cost of shares sold Selling price of shares (13,500 shares) Adjusted cost of shares sold Additional paid in capital – Pullen Company

8 - 37

40,000 $66,500

9,000

8,100 $83,600 $91,000 83,600 $7,400

Problem 8-10 (continued) Part A May 1 Cash (13,500 shares) 91,000 Investment in Souza Company ((13,500/135,000)  $665,000) 66,500 Additional Contributed Capital 24,500 (note: you need to reduce additional contributed capital on the worksheet by $17,100 to get from $24,500 to $7,400) Dec.16 Cash

Dividend Income (.81*  $70,000) * (135,000 – 13,500)/150,000 = .81

Part B Investment in Souza Company Retained Earnings 1/1 – Pullen (.81  ($500,000 - $400,000))

56,700 56,700 81,000 81,000

Dividend Income (0.81 x $70,000) Dividends Declared - Souza Company

56,700

Additional Contributed Capital * Retained Earnings - Pullen Subsidiary Income Sold

17,100

56,700 9,000 8,100

*[($500,000 – $400,000) + ($270,000 x 4/12)] x 13,500/150,000 Common Stock - Souza Retained Earnings 1/1 - Souza Difference between Implied and Book Value Investment in Souza ($665,000 - $66,500 + $81,000) Noncontrolling interest*

300,000 500,000 38,889 679,500 159,389

*($300,000+$500,000+$38,889) x .19 or $73,889 + ($500,000 - $400,000) x .19 +$66,500 Land

38,889 Difference between Implied and Book Value

Part C Pullen Company’s reported income Less: Dividend income from Souza Company Pullen Company’s independent income Add: Pullen Company’s share of Souza Company Income: 1/1/2011 to 4/30/2011 = .9  ($270,000  4/12) 5/1/2011 to 12/31/2011 = .81  ($270,000  8/12) Controlling interest in consolidated net income Part D Investment in Souza Company Retained Earnings 1/1 – Pullen (.81  ($700,000 - $400,000))

8 - 38

38,889 $ 352,500 (56,700) 295,800 81,000 145,800 $ 522,600 243,000 243,000

Problem 8-11 Pyle Company’s Books Investment in Stern Cash

600,000 600,000

Implied value by the purchase is ($510,000/.85) = $600,000, with NCI = $90,000. The carrying value of Stern Company, on January 1, 2010, is computed as follows: Carrying value of Stern Company Carrying value of Stern Company Pyle Company’s carrying value of Company Stern Initial cost (51,000 shares) (on 1/1/2009) $510,000 Increase in retained earnings ($292,000-120,000 x 0.85) 146,200 Carrying value of Investment in Stern Company 1/1/2011 656,200 Noncontrolling carrying value in Company Stern Initial value (9,000 shares) Increase in retained earnings ($292,000-120,000 x 0.15) Carrying value of Investment in S Company 1/1/2011 Total carrying value of Stern Company (1/1/2011)

$90,000 25,800 115,800 772,000

The gain or loss in net income attributable to Pyle Company is computed as follows: Gain or loss is the difference in: 1) Total carrying value of Stern Company 2) Sum of: Fair value of consideration received (40,000 shares) $480,000 Fair value of retained NCI (11,000 x $12) 132,000 Carrying value of the NCI (9,000 shares) 115,800 Total Loss attributable to Pyle Company

772,000

727,800 $ 44,200

The loss will be split between the 40,000 shares that are sold and the 11,000 shares that are still held as an investment. To record the sale of the shares, Pyle Company makes the following entry in its books on January 1, 2011. Pyle Company’s Books (1) Cash (40,000 x $12/share) 480,000 Realized loss on sale (on 40,000 shares sold) 34,667 (40/51 x $44,200) Investment in Stern Company (40/51 × $656,200) 514,667 (2)

Unrealized loss (on 11,000 shares retained) 9,533 Investment in Stern Company (remaining 11,000 shares) 9,533 (11/51 x $44,200) To reduce the remaining shares to market value.

8 - 39

Problem 8-12 Worksheet, multiple purchases, cost method Required: Control achieved on 1/1/2010, with the purchase of 12,500 shares (total shares owned equals 21,500 (53.75%) which include 9,000 shares acquired on 1/1/2009 and the 12,500 shares acquired on 1/1/2010). Computation and Allocation of Difference between Implied and Book Value Acquired Fair value price = $210,000/12,500 shares = $16.8/share Fair value of 1/1/09 shares (9,000 shares at $16.8/share) Cost of 9,000 shares (22.5% ownership) 110,500 Change in retained earnings (165,000-46,000)(22.5%) 26,775 Adjusted carrying value of shares Increase to fair value

Parent Share

$151,200

137,275 $13,925

NonControlling Share

Entire Value

Fair value of 1/1/09 purchase ($16.8/share) Fair value of 1/1/10 purchase ($16.8/share) Purchase price and implied value* Less: Book value of equity acquired: Capital Stock Retained Earnings

151,200 210,000 $361,200

310,800

672,000

(215,000) (88,688)

(185,000) (76,312)

(400,000) (165,000)

Difference between implied and book value Land (other assets) Balance * $210,000/31.25% = 672,000 where 31.25% = 12,500/40,000

57,512 (57,512) -0-

49,488 (49,488) -0-

107,000 (107,000) -0-

8 - 40

Problem 8-12 (continued) Worksheet journal entries (1)

(2)

Dividend Income (.5375 × $70,000) Dividends declared – Sato Company To eliminate dividends.

37,625

Investment in Sato Company Retained Earnings 1/1 - Phan Company To establish reciprocity/convert to equity (165,000-46,000)(22.5%) = 26,775

26,775

37,625

26,775

(3)

Capital Stock - Sato Company 400,000 Retained Earnings 1/1 – Sato Company 165,000 Difference between Implied and Book Value 107,000 Investment in Sato Company 361,200 Noncontrolling interest 310,800 To eliminate investment account and create noncontrolling interest account

(4)

Other assets (Land) Difference between Implied and Book Value To allocate the difference between implied and book value to goodwill

8 - 41

107,000 107,000

Problem 8-12 (continued) Phan Company and Subsidiary Consolidated Statements Workpaper For the Year Ended December 31, 2010 Phan Company Income Statement Sales Gain on revaluation Dividend Income Total Revenue Cost of Goods Sold Other Expense Total Cost and Expense Net/Consolidated Income Noncontrolling Interest in Income Net Income to Retained Earnings Retained Earnings Statement 1/1 Retained Earnings: Phan Company Sato Company Net Income from Above Dividends Declared: Phan Company Sato Company 12/31 Retained Earnings to Balance Sheet

Sato Company

1,800,000 13,925 37,625 1,851,550 1,100,000 350,000 1,450,000 401,550

605,000

401,550

155,000

Eliminations Dr.

Noncontrolling Interest

(1)

37,625

605,000 320,000 130,000 450,000 155,000 71,688 71,688

37,625

(2) 165,000 155,000

(3)

26,775

165,000 37,625

2,418,925 1,420,000 480,000 1,900,000 518,925 (71,688) 447,237

353,100 71,688

(150,000)

447,237 (150,000)

(70,000) 577,875

Consolidated Balances 2,405,000 13,925

326,325 401,550

Cr.

(1)

250,000

202,625

8 - 42

37,625

(32,375)

64,400

39,313

650,337

Problem 8-12 (continued) Phan Company Balance Sheet Current Assets

165,500

Investment in Sato Company

334,425

Difference b/w implied and book value Other Assets Total Assets Liabilities Paid in Capital - Phan Company Capital Stock: Phan Company Sato Company Retained Earnings from Above 1/1 Noncontrolling Interest 12/31 Noncontrolling Interest Total Liabilities and Equity

Sato Company

Eliminations Dr.

Cr.

Noncontrolling Interest

138,000

920,000 1,419,925

672,000 810,000

142,050 100,000

160,000

303,500 (2)

26,775

(3)

361,200

(3) (4)

107,000 107,000

(4)

107,000 1,699,000 2,002,500 302,050 100,000

600,000 577,875

600,000 400,000 250,000

(3)

400,000 202,625 (3)

1,419,925

Consolidated Balances

810,000

843,400

8 - 43

64,400 310,800 843,400

39,313 310,800 350,113

650,337 350,113 2,002,500

Problem 8-13 On Phan Company’s books Investment in Sato Company (36.25%) 280,000 Cash 280,000 No revaluation is required for additional shares purchased after control is already achieved. The new ownership percentage is 90% or 36,000 shares divided by 40,000 shares outstanding. The balance in the investment account is $614,425 ($110,500 + $210,000 + $280,000 + 13,925). P Company’s Carrying Value of the Investment in S Company Before New After New Book Value of Purchase Purchase Interest (53.75%) (90%) Acquired Common Stock (1) $215,000 (3) $360,000 $145,000 Retained Earnings (2) 134,375 (4) 225,000 90,625 Total Stockholders’ Equity $349,375 $585,000 $235,625 Land to fair value (5) 57,513 (6) 96,300 38,787 Carrying Value in S Company 406,888 681,300 $274,412 Cost of New Shares 280,000 Decrease in Paid in Capital – Phan Company $ 5,588 (1) .5375 × $400,000. (2) .5375 × $250,000. (3) .90 × $400,000. (4) .90 × $250,000. (5) .5375 × $107,000. (6) .90 × $107,000. Worksheet journal entries (1)

(2)

Dividend Income (.90 × $70,000) Dividends declared – Sato Company To remove dividends.

63,000

Investment in Sato Company ($26,775 + $45,688) Retained Earnings 1/1 - Phan Company To establish reciprocity/convert to equity (165,000-46,000)(22.5%) = 26,775 (250,000-165,000)(53.75%) = 45,688

72,463

63,000

72,463

(3)

Capital Stock - Sato Company 400,000 Retained Earnings 1/1 – Sato Company 250,000 Difference between Implied and Book Value 107,000 Paid in capital – Phan Company 5,588 Investment in Sato Company ($614,425+72,463) 686,888 Noncontrolling interest 75,700 To eliminate investment account and create noncontrolling interest account

(4)

Other assets (Land) Difference between Implied and Book Value To allocate the difference between implied and book value to goodwill

8 - 44

107,000 107,000

Problem 8-13 (continued) Phan Company and Subsidiary Consolidated Statements Workpaper For the Year Ended December 31, 2011 Phan Company Income Statement Sales Dividend Income Total Revenue Cost of Goods Sold Other Expense Total Cost and Expense Net/Consolidated Income Noncontrolling Interest in Income Net Income to Retained Earnings Retained Earnings Statement 1/1 Retained Earnings: Phan Company Sato Company Net Income from Above Dividends Declared: Phan Company Sato Company 12/31 Retained Earnings to Balance Sheet

1,800,000

Sato Company

Eliminations Dr.

Noncontrolling Interest

600,000

63,000 1,863,000 1,100,000 350,000 1,450,000 413,000

600,000 325,000 125,000 450,000 150,000

413,000

150,000

(1)

63,000

15,000 15,000

63,000

(2) 250,000 150,000

(3)

72,463

250,000 63,000

2,400,000 1,425,000 475,000 1,900,000 500,000 (15,000) 485,000

650,338 15,000

(150,000)

485,000 (150,000)

(70,000) 840,875

Consolidated Balances 2,400,000

577,875 413,000

Cr.

(1)

330,000

313,000

8 - 45

63,000

(7,000)

135,463

8,000

985,338

Problem 8-13 (continued) Phan Company

Sato Company

Current Assets

165,500

218,000

Investment in Sato Company

614,425

Eliminations Dr.

Cr.

Noncontrolling Interest

Consolidated Balances

Balance Sheet

Difference b/w implied and book value Other Assets Total Liabilities Paid in Capital - Phan Company Capital Stock: Phan Company Sato Company Retained Earnings from Above 1/1 Noncontrolling Interest 12/31 Noncontrolling Interest Total

383,500 (2)

920,000 1,699,925

672,000 890,000

159,050 100,000

160,000

72,463

(3) (4)

107,000 107,000

(3)

5,588

(3)

400,000 313,000

(3)

686,888

(4)

107,000 1,699,000 2,082,500 319,050 94,412

600,000 840,875

600,000 400,000 330,000

(3) 1,699,925

890,000

1,005,051

8 - 46

135,463 75,700 1,005,051

8,000 75,700 83,700

985,338 83,700 2,082,500

Problem 8-14 Worksheet, multiple purchases, equity method Control achieved on 1/1/2010, with the purchase of 12,500 shares (total shares owned equals 21,500 (53.75%) which includes 9,000 shares acquired on 1/1/2009 and the 12,500 shares acquired on 1/1/2010). Computation and Allocation of Difference between Implied and Book Value Acquired Fair value price = $210,000/12,500 shares = $16.8/share Fair value of 1/1/09 shares (9,000 shares at $16.8/share) Cost of 9,000 shares (22.5% ownership) 110,500 Change in retained earnings (165,000-46,000)(22.5%) 26,775 Adjusted carrying value of shares Increase to fair value Parent Share

$151,200

137,275 $13,925

NonControlling Share

Entire Value

Fair value of 1/1/09 purchase ($16.8/share) Fair value of 1/1/10 purchase ($16.8/share) Purchase price and implied value* Less: Book value of equity acquired: Capital Stock Retained Earnings

151,200 210,000 $361,200

310,800

672,000

(215,000) (88,688)

(185,000) (76,312)

(400,000) (165,000)

Difference between implied and book value Land (other assets) Balance * $210,000/31.25% = 672,000 where 31.25% = 12,500/40,000

57,512 (57,512) -0-

49,488 (49,488) -0-

107,000 (107,000) -0-

On Phan Company’s books (2010) Investment in S Company Cash

210,000 210,000

Investment in S Company 26,775 1/1 Retained Earnings—P Company 26,775 [.225 × ($165,000 - $46,000) or the change in retained earnings from 1/1/09 to 1/1/10]. Investment in S Company $13,925 Gain on revaluation $13,925 To record the adjusted carrying value of the original purchase of $137,500 to fair value of $151,200. Investment in Sato Company Equity in Subsidiary Income [53.75% × ($605,000 - $320,000-130,000)] 8 - 47

83,313 83,313

Problem 8-14 (continued) Cash

37,625 Investment in Sato Company Dividend $70,000 x .5375

37,625

Worksheet journal entries (1)

Equity Income (.5375 × $155,000) Dividends declared – Sato Company (.5375 × $70,000) Investment in Sato Company To remove equity income.

83,313 37,625 45,688

(2)

(3)

Other Assets (Land) Difference between Implied and Book Value To allocate the difference between implied and book value to goodwill

8 - 48

107,000 107,000

Problem 8-14 (continued) Phan Company and Subsidiary Consolidated Statements Workpaper For the Year Ended December 31, 2010 Phan Company

Sato Company

Eliminations Dr.

Cr.

Noncontrolling Interest

Consolidated Balances

Income Statement Sales Gain on revaluation Equity Income Total Revenue Cost of Goods Sold Other Expense Total Cost and Expense Net/Consolidated Income Noncontrolling Interest in Income Net Income to Retained Earnings Retained Earnings Statement 1/1 Retained Earnings: Phan Company Sato Company Net Income from Above Dividends Declared: Phan Company Sato Company 12/31 Retained Earnings to Balance Sheet

1,800,000 13,925 83,313 1,897,238 1,100,000 350,000 1,450,000 447,238

605,000

605,000 320,000 130,000 450,000 155,000

447,238

155,000

2,405,000 13,925 (1)

83,313

71,688 71,688

83,313

353,100 447,238

353,100 165,000 155,000

(2)

165,000 83,313

71,688

(150,000)

447,237

(150,000) (70,000)

650,338

2,418,925 1,420,000 480,000 1,900,000 518,925 (71,688) 447,237

(1)

250,000

248,313

8 - 49

37,625

(32,375)

37,625

39,313

650,337

Problem 8-14 (continued) Phan Company Balance Sheet Current Assets Investment in Sato Company Difference b/w implied and book value Other Assets Total Liabilities Paid in Capital - Phan Company Capital Stock: Phan Company Sato Company Retained Earnings from Above 1/1 Noncontrolling Interest 12/31 Noncontrolling Interest Total

165,500 406,888

Sato Company

Eliminations Dr.

Cr.

Noncontrolling Interest

138,000

Consolidated Balances 303,500

(2) (3)

107,000 107,000

(1) (2) (3)

45,688 361,200 107,000

920,000

672,000

1,699,000

1,492,388

810,000

2,002,500

142,050 100,000

160,000

302,050 100,000

600,000 650,338

600,000 400,000 250,000

(2)

400,000 248,313 (2)

1,492,388

810,000

862,313

8 - 50

37,625 310,800 862,313

39,313 310,800 350,113

650,337 350,113 2,002,500

Problem 8-15 Worksheet, Multiple Stock Purchases, Equity Method On Phan Company’s books Investment in Sato Company (36.25%) Cash Investment in Sato Cash Equity Income

280,000 280,000 72,000 63,000 135,000

No revaluation is required for additional shares purchased after control is already achieved. The new ownership percentage is 90% or 36,000 shares divided by 40,000 shares outstanding. The balance in the investment account is $758,888 ($110,500 + $26,775 + $210,000 + 45,688 + $280,000 + 13,925 +72,000). P Company’s Carrying Value of the Investment in S Company Before New After New Book Value of Purchase Purchase Interest (53.75%) (90%) Acquired Common Stock (1) $215,000 (3) $360,000 $145,000 Retained Earnings (2) 134,375 (4) 225,000 90,625 Total Stockholders’ Equity $349,375 $585,000 $235,625 Land to fair value (5) 57,513 (6) 96,300 38,787 Carrying Value in S Company 406,888 681,300 $274,412 Cost of New Shares 280,000 Decrease in Paid in Capital – Phan Company $ 5,588 (1) .5375 × $400,000. (2) .5375 × $250,000. (3) .90 × $400,000. (4) .90 × $250,000. (5) .5375 × $107,000. (6) .90 × $107,000. Worksheet journal entries (1)

Equity Income (.90 × $150,000) Dividends declared – Sato Company (.90 × $70,000) Investment in Sato Company To remove dividends.

135,000 63,000 72,000

(2)

Capital Stock - Sato Company 400,000 Retained Earnings 1/1 – Sato Company 250,000 Difference between Implied and Book Value 107,000 Paid in capital – Phan Company 5,588 Investment in Sato Company ($758,888-72,000) 686,888 Noncontrolling interest 75,700 To eliminate investment account and create noncontrolling interest account

(3)

Other assets (Land) Difference between Implied and Book Value To allocate the difference between implied and book value to goodwill

8 - 51

107,000 107,000

Problem 8-15 (continued) Phan Company and Subsidiary Consolidated Statements Workpaper For the Year Ended December 31, 2012 Phan Company Income Statement Sales

Sato Company

1,800,000

600,000

Equity Income Total Revenue Cost of Goods Sold Other Expense Total Cost and Expense Net/Consolidated Income Noncontrolling Interest in Income

135,000 1,935,000 1,100,000 350,000 1,450,000 485,000

600,000 325,000 125,000 450,000 150,000

Net Income to Retained Earnings

485,000

Retained Earnings Statement 1/1 Retained Earnings: Phan Company Sato Company Net Income from Above Dividends Declared: Phan Company Sato Company 12/31 Retained Earnings to Balance Sheet

Eliminations Dr.

Cr.

Noncontrolling Interest

2,400,000 (1)

135,000

150,000

135,000

15,000

2,400,000 1,425,000 475,000 1,900,000 500,000 (15,000)

15,000

485,000

650,338 485,000

650,338 250,000 150,000

(2)

250,000 135,000

15,000

(150,000)

485,000 (150,000)

(70,000) 985,338

Consolidated Balances

(1)

330,000

385,000

8 - 52

63,000

(7,000)

63,000

8,000

985,338

Problem 8-15 (continued) Phan Company

Sato Company

Balance Sheet Current Assets

165,500

218,000

Investment in Sato Company

758,888

Difference b/w implied and book value Other Assets Total

920,000 1,844,388

672,000 890,000

Liabilities Paid in Capital - Phan Company Capital Stock: Phan Company Sato Company

159,050 100,000

160,000

Retained Earnings from Above 1/1 Noncontrolling Interest in Net Assets 12/31 Noncontrolling Interest in Net Assets

985,338

Total

Eliminations Dr.

Cr.

Noncontrolling Interest

383,500

(2) (3)

107,000 107,000

(2)

5,588

(2)

400,000

(1) (2)

72,000 686,888

(3)

107,000 1,699,000 2,082,500 319,050 94,412

600,000

600,000 400,000 330,000

385,000 (2)

1,844,388

Consolidated Balances

890,000

1,004,588

8 - 53

63,000 75,700

1,004,588

8,000 75,700

985,338

83,700

83,700 2,082,500

Chapter Eight CHAPTER 8 CHANGES IN OWNERSHIP INTEREST I. INTRODUCTION This chapter eliminates a simplifying assumption that we’ve made previously. Many times P doesn’t buy a controlling interest in S all at once – it’s done over time. Until P has actually achieved control, its investment in S is treated as a simple investment. No consolidated statements are prepared. Now we’re going to look at how P changes its books into a parent-subsidiary relationship when it achieves control of S, and at how other S equity transactions affect the consolidated entity and its workpaper. Transactions with Third Parties A. Preliminary assumptions – we’ve used two simplifying assumptions: 1. P’s interest in S was obtained through a single open-market transaction. 2. P’s interest in S hasn’t changed. B. More realistic events might include: 1. P might buy its interest over a period of time before it achieves control (over 50 percent ownership, for example). 2. After P achieves control, the percentage of ownership might change. a. P buys S stock from outsiders b. P sells S stock to outsiders c. S buys or sells its stock to outsiders 3. Accounting treatment of each of the following events is listed in your book. All of the issues relate to the substance over form argument discussed in Chapter 2. C. Under GAAP: a. Measure and recognize the acquiree’s identifiable assets and liabilities at 100% of their fair values on the date the acquirer obtains control. b. Recognize all the acquiree’s goodwill (not just the parent’s share). c. Any previously held noncontrolling equity interests should be remeasured to fair value, with the resulting adjustment recognized in income. d. After control is achieved, subsequent adjustments due to increased ownership are shown as Additional Contributed Capital, not as income. e. If a parent loses control, the retained investment should be remeasured to fair value and the adjustments recognized in net income. II.

PARENT ACQUIRES SUBSIDIARY STOCK THROUGH SEVERAL OPEN MARKET PURCHASES – COST METHOD A. When P’s control of S is achieved in a single open market purchase, the date of acquisition is the date that purchase was made. B. When more than one purchase is made before control is achieved, the acquisition date is the date when control is achieved.

Chapter 8 1. Determination of the date of acquisition is important because previously purchased shares must be revalued and the gain or loss included in income. 2. Under GAAP [FASB ASC paragraph 805-10-25-9]: a. The previously held noncontrolling equity interest should be remeasured to fair value when control is achieved, and the resulting adjustment should be recognized in net income. b. If a parent loses control but retains a noncontrolling interest, the portion retained should be remeasured to fair value on the date control is surrendered and the adjustment reflected in the income statement. 3 The fair values of the acquirer’s interest in the acquiree and the noncontrolling interest on a per-share basis might differ. In this textbook, for practical considerations, we assume that the per-share fair value for pricing the controlling and noncontrolling shares are the same. A CAD is based on the value implied by the purchase that resulted in a controlling interest. C. In the first year of control, there must be a workpaper entry to convert to equity (establish reciprocity) for all of S’s increase in retained earnings that have been earned between P’s initial purchase of S’s stock and the date on which control was achieved. This entry must be repeated in every future worksheet. 1. On the workpaper, the investment is eliminated per the CAD Schedule (the noncontrolling interest in equity is recorded). The workpaper is then completed as illustrated in previous chapters. D. E. The noncontrolling interest –in consolidated net income is based on end- ofyear percentages. III.

PARENT SELLS SUBSIDIARY STOCK INVESTMENT ON THE OPEN MARKET – COST METHOD A. The treatment of the sale of a portion of investment depends on whether the sale results in the loss of control of the subsidiary. 1. If control is maintained, no gain or loss is recognized in the income statement. Instead, all shares are adjusted to fair value, and an adjustment is made to additional contributed capital of the controlling interest. 2. If control is lost, the entire interest should be adjusted to fair value, and a gain or loss recorded in income on all shares owned prior to sale. B. Under past GAAP, the treatment of the sale of a portion of an investment by the parent company was the same, regardless of whether or not control was surrendered.

Commented [S1]: This needs to be aligned under ‘the fair values’ in the first line.

Chapter 8 C.

When P sells part of its investment in S and retains control: 1. Selling price is readily determined by the market transaction. 2. Cost is more complex. The original cost of the shares must be adjusted for the change in S’s retained earnings. Cost of S’s shares sold (+ P’s share of the change in S’s retained earnings from the date of acquisition to the beginning of the year + P’s share of S’s current earnings to date of sale) X Ownership percentage sold P’s adjusted cost of shares sold 3. In its books, Precords the sale of the shares To record sale of shares Cash Investment in S Company (% of shares sold x adjusted cost – revalued on the date of acquisition) Additional Contributed Capital – P Company (difference between the adjusted cost and the selling price)

The workpaper entries 1. The workpaper entries must eliminate some of the additional contributed capital as income purchased. To adjust contributed capital for undistributed income on shares sold. (This amount reduces the additional contributed capital and increases retained earnings for the prior year’s unrecorded earnings in P’s retained earnings.) Additional contributed capital-P Beginning retained earnings – P 2. The consolidated statement elimination entries should also include an entry to recognize P’s share of S’s current year earnings which was sold. To adjust for current year’s income sold to noncontrolling stockholders. Additional contributed capital-P Subsidiary income sold 3. The third workpaper entry must include the traditional entry to establish reciprocity for the shares of S stock still owned by P. To establish reciprocity based on remaining percentage. Investment in S Beginning retained earnings – P Entry (3) contains two components. The first component is the adjustment for the shares purchased before control was obtained and retroactively adjusting the books for retained earnings. The second component establishes 3

Chapter 8 reciprocity by recognizing P Company’s share of the increase in S Company’s retained earnings from the date of control to the beginning of the year on the shares still held at end the end of the year (year in which control was achieved). E.

The noncontrolling interest in consolidated income will include two amounts: 1. The percentage for the income earned before P sold some of S’s stock. 2. The larger percentage for income earned after that sale.

Chapter 8 IV.

EQUITY METHOD – PURCHASES AND SALES OF SUBSIDIARY STOCK BY THE PARENT A. This chapter simplifies the workpaper to the extent that there is assumed to be no difference between the complete and partial equity methods. That is, we ignore the complications of excess depreciation, amortization, and impairment due to differences between implied and book values, as well as intercompany sales, in order to focus on the new issues introduced here. B. When P achieves control of S Company, it revalues its initial investment to fair value. To revalue initial investment Investment in S Gain on revaluation C. As with the cost method, when P finally achieves control of S Company, it must account for its share of S’s income earned after P’s initial purchase of S’s stock. 1. Under the equity method, when it finally achieves a controlling interest, P must record its share of S’s interim earnings as an adjustment to the investment account and as equity in S income. To record P’s share of S’s income since initial acquisition of S’s stock Investment in S Equity in S income 2. After control is achieved, P will record its new share of S’s income as in previous chapters. D. P sells some of its investment in S. 1. P must first record its share of S’s income since the beginning of the current year. 2. The investment in S account will include all adjustments for S’s income in prior years. 3. P’s cost for the S stock sold can then be easily calculated Cost of first purchase, adjusted Cost of second purchase (identified by purchase date) + P’s share of S’s retained income since acquisition Cost of acquisition of stock sold x percent of total purchase sold Carrying value of investment sold 4. The adjustment to the Additional Contributed Capital on P’s sale of part of its investment is recorded on P’s books. To record gain on the sale of S stock Cash Investment in S [from above] Additional Contributed Capital 5. As usual, in the equity method, consolidated Additional Contributed Capital is the same as P’s Additional Contributed Capital.

Chapter 8 V. SUBSIDIARY ISSUES STOCK A. P’s equity interest can decrease if S issues more stock B. Issuance of additional shares by a subsidiary 1. If S issues new shares, P can purchase all, some, or none of the new stock issued 2. If some or all of the shares are purchased by outsiders, P loses part of its equity interest just like it does when it sells some of its investment a. If the stock is sold at more than S’s book value, P gets an increase in the additional contributed capital. b. If the stock is sold at less than S’s book value, P suffers a decrease in the additional contributed capital. 3. 100 percent of new shares purchased by P a. Unless P originally owned 100 percent of S’s outstanding shares, its ownership interest will increase, while the noncontrolling interest will decline. b. P’s share of S’s equity must be recalculated, since S’s equity accounts will change. c. New shares issued above existing book value per share. i. P must calculate the book value per share of S’s equity S’s Equity – Book Value per Share Before New Issue After Common stock Other contributed capital Retained earnings ______________ ______________ ______________ Total divided by Common shares equals Book value per share

Chapter 8 ii.

Then it must calculate its new book value

Carrying Value of P’s Share of S’s Equity Old New Book Value of Percentage Percentage Interest Acquired Common stock Other contributed capital Retained earnings ______________ ______________ _____________ Total equity acquired Plus or Minus: Adjustment per ______________ ______________ _____________ the CAD Total interest acquired iii.When S’s new shares are sold at greater than book value that excess increases the noncontrolling interest in book value per share, even though the total percent of the noncontrolling interest decreased. iv. The book value increase in noncontrolling interest equals the amount debited to the parent’s additional contributed capital. v. The controlling interest stockholders paid more than existing book value per share, which increased the noncontrolling interest shareholders’ book value. c. New shares issued at or below existing book value per share i. If new shares are issued at their book value, the parent’s additional contributed capital will change only by the amount of the net asset transferred. The noncontrolling interest percentage decreases and its share of net assets decreases only by the value of the net asset transferred. ii. If the new shares are issued below book value, total noncontrolling book value interest decreases, and the controlling book value interest increases by more than the amount of the net asset transferred. d. New shares purchased ratably by parent and noncontrolling stockholders i. If the noncontrolling stockholders exercise their preemptive right and buy their share of the new stock issue, both P and the noncontrolling interest will maintain their percent interest in S’s equity.

Chapter 8 ii. There will be no need to adjust the parent’s additional contributed capital. e. New shares purchased entirely by noncontrolling stockholders i. Sometimes S issues new shares which are all purchased by outsiders. ii. To meet requirements of employee stock options or stock purchase plans, the subsidiary may issue new shares entirely to noncontrolling interest stockholders. iii. Stock sold to outsiders generates capital for the consolidated entity. iv. This reduces P’s percentage of ownership, equivalent to P selling part of its interest. v. P’s book value can increase, decrease, or remain the same, depending upon the issue price to book value per share of stock. vi. If issue price is greater than book value, P’s share of S’s net assets increases. vii. If issue price is less, P’s share of S’s net assets decreases. viii.If issue price equals book value, P’s share of S’s net assets stays the same. VI. IFRS and STEP ACQUISITIONS A. Under IFRS a choice is available to measure noncontrolling interest either at their proportionate interest in the net identifiable assets of the acquired firm or at fair value (required under U.S. GAAP). B. Under IFRS, a change in control is a significant economic event. Consequently, goodwill is identified and net assets remeasured to fair value only in respect of the transaction that achieved control, and not in respect of any earlier or subsequent acquisitions of equity interests. In measuring goodwill, any previously held interests in the acquiree are first remeasured to fair value, with any gain recognized in income (including the reclassification of gains or losses included in other comprehensive income). Similarly, on disposal of a controlling interest, any residual interest is remeasured to fair value and reflected in income on disposal. C. After control is attained, any subsequent transactions between the parent and noncontrolling interests (that do not result in a loss of control) are accounted for as equity transactions.

CHAPTER 9 ANSWERS TO QUESTIONS 1.

Constructive retirement refers to the purchase of an affiliate's outstanding bonds from outsiders. From a consolidated entity viewpoint, the consolidated entity has retired its outstanding debt, and is thus treated as an early extinguishment of debt. The difference between the carrying value of the bonds and the purchase price to the purchasing affiliate is the constructive gain or loss on bond retirement.

The gain or loss is composed of two elements: (1) the discount or premium on the books of the issuer, and (2) the discount or premium paid by the purchaser. Discounts and/or premiums on the books of the two affiliates will be subsequently amortized to income. The cumulative effect on income of the amortization of the discount or premium by the two affiliates is equal to the constructive gain or loss.

The allocation of a gain or loss would be made to each affiliate based on whether the affiliate paid or issued the bonds for more or less than book value or par value. A discount (premium) to the issuer would be allocated to the issuing company as a loss (gain), whereas a discount (premium) to the purchasing affiliate would be a gain (loss). The sum of the two is the total constructive gain or loss.

Support for allocating the total gain or loss to the issuing company is based on the contention that the purchasing affiliate is acting as an agent for the issuing company. Since both companies are under the control of the management of the parent company, the bonds could be transferred to the issuing company. Thus, the purchase is in substance a retirement by the issuing company.

The noncontrolling interest is affected by the portion of the constructive gain or loss allocated to the subsidiary. Because the loss is recognized in the consolidated income statement in the year the bonds are purchased, a discount or premium amortization related to bonds that is made subsequent to the purchase is added back or is subtracted from the subsidiary's reported income. Such adjustments will increase or decrease the noncontrolling interest in the income of the subsidiary.

a. Investor Company Purchase price Par value Constructive gain

$338,000 350,000 $ 12,000

b. Investee Company Carrying value Par value Constructive gain

$360,000 350,000 $ 10,000

The outside party (the maker of the note) is primarily liable; and Affiliate Y, who discounted the note with an outside party, is contingently liable for it.

Stock dividends are viewed as a distribution of the earliest earnings accumulated in the retained earnings account.

The retained earnings balance at the date of acquisition is reduced since the issuance of a stock dividend is viewed as a distribution of the earliest earnings accumulated. 10. A memorandum entry is required to recognize the number of shares received since a dividend in stock is not considered income to the recipient. 9-1

11. In the year of declaration, one additional elimination entry is required to eliminate the effects of the dividend. In subsequent periods the amounts of this entry are combined with the investment elimination entry. 12. Preferred stock of a controlled corporation held by others not in the controlled group represents noncontrolling interest in the controlled corporation. The rights of these shareholders depend on the stock's preference; possibilities are an interest in net assets, earnings, and retained earnings of the controlled corporation. 13. Excess of cost over book value is debited to Other Contributed Capital or to Retained Earnings; excess of book value acquired over cost is credited to Other Contributed Capital. 14. The preferred stock's cumulative preference would increase the net loss allocable to the common stockholders. SOLUTIONS TO BUSINESS ETHICS CASE The responsibility of the management of the company is to present accurately the financial statements to the shareholders and investors. Accordingly if an error is detected in the books, it should be rectified as soon as it is discovered so that shareholders and investors are not misled. Intercompany sales are eliminated in the consolidating process. Failure to do so is a material omission, particularly when the inventories in question have not been sold to outsiders but remain in the inventories of the consolidated entity. You should not succumb to the pressure exerted by the manager of the subsidiary.

9-2

ANSWERS TO FINANCIAL STATEMENT ANALYSIS EXERCISES AFS9-1 Off-Balance Sheet Debt Related to Equity Investments The information in the footnotes for investments in joint ventures and the investments in affiliates is provided both using the actual percentage of the company that is owned and as 100% of the company. For instance, assume that the total assets of the company (of which we own 60 percent) are $100. In the asset row stating ‘100% of the company;, the amount for assets is $100; while in the row labeled ‘% of company owned’ the amount for assets is $60. This implies that $40 of the assets are owned by someone else. A. Using the balance sheet, compute the ratio of total liabilities to total assets.

Ratio of total Liabilities to assets (computations)

2010 36.1% (2,760.5/7,650.5)

2009 54.8% (4,732.7/8,628.7)

B. Assume that instead of reporting only the net investment, the standards required the consolidated entity to reflect separately Goodman’s percentage of both assets and liabilities for its investment in joint ventures. Compute the ratio of total liabilities to total assets and comment. Adjustment to total assets (assets minus equity) +199.2 (computation) (1,023.8-296.8 =727) Adjustment to total liabilities

+75.4 (667.6-158.5 =509.1)

+199.2

+75.4

2010 Ratio of total Liabilities to assets 37.7% (computations) ((2,760.5+199.2)/(7,650.5+199.2))

2009 55.2% ((4,732.7+75.4)/(8,628.7+75.4))

C. Repeat part B, except assume that the standards required the consolidated entity to reflect separately Goodman’s percentage of both assets and liabilities for all equity investments. Compute the ratio of total liabilities to total assets and comment. Adjustment to total assets (assets minus equity) +2,267.6 (computation) (4,339-2,071.4 =2,267.6) Adjustment to total liabilities

+2,267.6

2010 Ratio of total Liabilities to assets 50.7% (computations) ((2,760.5+2,267.6)/(7,650.5+2,267.6))

+2,398.8 (or 2,417) (4,726.2-2,327.4 =2,398.8) +2,398.8 (or 2,417) 2009 64.7% ((4,732.7+2,398.8)/(8,628.7+2,398.8))

D. Assume that the equity investments in joint ventures are fully consolidated instead (typically, the ownership percentage is close to 50%). Compute the ratio of total liabilities to total assets. Compare your answer to part A, and comment. Adjustment to total assets (assets minus equity) +727 (computation) (1,023.8-296.8 =727) Adjustment to total liabilities

+727 9-3

+509.1 (667.6-158.5 =509.1) +509.1

2010 Ratio of total Liabilities to assets 41.6% (computations) ((2,760.5+727)/(7,650.5+727))

2009 57.4% ((4,732.7+509.1)/(8,628.7+509.1))

E. Assume that all equity investments are fully consolidated. Compute the ratio of total liabilities to total assets. Compare your answer to parts A and B and C and comment. Adjustment to total assets (assets minus equity) +727 (computation) (1,023.8-296.8 =727) Adjustment to total liabilities

+727

+509.1 (667.6-158.5 =509.1) +509.1

2010 2009 Ratio of total Liabilities to assets 41.6% 57.4% (computations) ((2,760.5+727+6,118.3)/(7,650.5+727+6,118.3)) ((4,732.7+509.1+6,900.7)/(8,628.7+509.16,900.7)) Comparison Ratio of total liabilities to assets Joint Ventures Ratio of total liabilities to assets (using 100% owned) Ratio of total liabilities to assets (assuming % owned) All Equity Investments Ratio of total liabilities to assets (using 100% owned) Ratio of total liabilities to assets (assuming % owned)

2010 36.1%

2009 54.8%

41.6%

57.4%

37.7%

55.2%

66.3%

75.7%

50.7%

64.7%

9-4

SOLUTIONS TO EXERCISES Exercise 9-1 Part A

Part B

Cost of bond investment Par value Unamortized discount ($60,000  (16/20)) Carrying value of bonds Percent of bonds purchased Carrying value of bonds purchased Total constructive loss

$820,000 $1,000,000 48,000 952,000 .80 761,600 $58,400

Pacelli Company

Salez Company

Carrying value of bonds purchased $761,600 Par value 800,000 Constructive loss $ 38,400

Cost of bond investment Par value of bonds purchased Constructive loss

$820,000 800,000 $ 20,000

Part C June 30 and December 31, 2012 Pacelli Company Interest Expense (10%)(1/2)($1,000,000) Cash Interest Expense Discount on Bonds Payable $60,000 / 20 interest periods = $3,000

50,000 50,000 3,000 3,000

Salez Company Cash Interest Income ($800,000)(1/2)(10%) Interest Income Investment in Pacelli Company Bonds $20,000 premium /16 periods = $1,250

40,000 40,000 1,250 1,250

Part D Note: We have provided solutions assuming the use of any of the three methods. Since the schedules start with the same reported income of Pacelli under all three methods, this results in three different consolidated net income numbers. 2011

Partial Complete Cost Method Equity Method Equity Method $260,000 $260,000 $260,000 48,000 112,000

Reported net income - Pacelli Less: Dividend income ($60,000)(.80) Less: Equity Income ($140,000)(.80) Less: Adjusted Equity Income 9-5

($112,000-38,400-(80% of 20,000)) Net income from independent operations - Pacelli 212,000 Less: Constructive loss on bond retirement 38,400 Pacelli's contribution to consolidated income 173,600 Reported net income of Salez $140,000 Less: Constructive loss on bond retirement 20,000 Salez's contribution to consolidated income 120,000  .80 96,000 Controlling interest in consolidated net income $269,600 Noncontrolling interest in consolidated income ($120,000  .20) $24,000

9-6

148,000 38,400 109,600

57,600 202,400 38,400 164,000

96,000 $205,600

96,000 $260,000

$24,000

Exercise 9-1 (continued) Partial Complete 2012 Cost Method Equity Method Equity Method Reported net income - Pacelli $280,000 $280,000 $280,000 Less: Dividend income ($60,000)(.80) 48,000 Less: Equity income ($190,000)(.80) 152,000 Less: Adjusted Equity income ($152,000 + $4,800 + (.80  $)) 158,800 Net income from independent operations - Pacelli 232,000 128,000 121,200 Add: Constructive loss recorded* 4,800 4,800 4,800 Pacelli's contribution to consolidated income 236,800 132,800 126,000 Reported net income of Salez $190,000 Add: Constructive loss recorded** 2,500 Salez's contribution to consolidated income 192,500  0.80 154,000 154,000 154,000 Controlling interest in consolidated net income $390,800 $286,800 $280,000 Noncontrolling interest in consolidated income ($192,500  .20)

$38,500

*($3,000    .80) = $4,800 or constructive loss divided by 8 years = $38,400/8 years = $4,800 ** Constructive loss divided by 8 years = $20,000/8 = $2,500 Exercise 9-2 December 31, 2011 Loss on Constructive Retirement of Bonds Discount on Bonds Payable

Cost and Partial Equity 38,400 38,400

Loss on Constructive Retirement of Bonds Investment in Pacelli Company Bonds

20,000

Bonds Payable Investment in Pacelli Company Bonds

800,000

Complete Equity 38,400 38,400 20,000

20,000

20,000 800,000

800,000

December 31, 2012 Beginning Retained Earnings - Pacelli Company Discount on Bonds Payable

38,400 38,400

Investment in Salez Discount on Bonds Payable

38,400 38,400

Discount on Bonds Payable Interest Expense (($3,000 + $3,000)  .80)

4,800

4,800 4,800

Exercise 9-2 (continued) 9-7

4,800

Cost and Partial Equity 16,000 4,000 20,000

Beginning Retained Earnings - Pacelli Noncontrolling Interest Investment in Pacelli Company Bonds Investment in Salez Noncontrolling Interest Investment in Pacelli Company Bonds

Complete Equity

16,000 4,000 20,000

Investment in Pacelli Company Bonds Interest Income ($1,250 + $1,250)

2,500

Interest Income Interest Expense Nominal interest of $100,000  .80 = $80,000

80,000

Bonds Payable Investment in Pacelli Company

800,000

2,500 2,500

2,500 80,000

80,000

80,000 800,000

800,000

Cost and Partial Equity 38,400 38,400

Complete Equity

December 31, 2013 Beginning Retained Earnings - Pacelli Discount on Bonds Payable Discount on Bonds Payable Beginning Retained Earnings - Pacelli Interest Expense (($3,000 + $3,000)  .80)

9,600 4,800 4,800

Investment in Salez Discount on Bonds Payable

38,400

Discount on Bonds Payable Investment in Salez Interest Expense (($3,000 + $3,000)  .80)

9,600

38,400 4,800 4,800

Beginning Retained Earnings - Pacelli –Noncontrolling Interest Investment in Pacelli Company Bonds

16,000 4,000

Investment in Pacelli Company Bonds Beginning Retained Earnings - Pacelli Noncontrolling Interest Interest Income ($1,250 + $1,250)

5,000

20,000 2,000 500 2,500

9-8

Exercise 9-2 (continued) Cost and Partial Equity

Complete Equity

Investment in Salez Noncontrolling Interest Investment in Pacelli Company Bonds

16,000 4,000

Investment in Pacelli Company Bonds Investment in Salez Noncontrolling Interest Interest Income ($1,250 + $1,250)

5,000

20,000 2,000 500 2,500

Interest Income Interest Expense Nominal interest of $100,000  .80 = $80,000

80,000

Bonds Payable Investment in Pacelli Company

800,000

80,000 80,000

80,000 800,000

800,000

Exercise 9-3 Part A Cost of bond investment ($510,000  .90) Par value Unamortized premium ($42,500  ()) Carrying value of bonds Percent of bonds purchased (510/850) Carrying value of bonds purchased Total constructive gain Part B Fairfield Company Cost of bond investment Par value Constructive gain

$459,000 $850,000 34,000 884,000 .60 530,400 $71,400

$459,000 510,000 $ 51,000

Weber Company Carrying value of bonds purchased $530,400 Par value 510,000 Constructive gain $ 20,400

Part C June 30 and December 31, 2012 Fairfield Company Cash ($510,000  .10 

6 ) 12

25,500

Interest Income

25,500

Investment in Weber Company Bonds Interest Income $51,000 / 8 periods = $6,375

6,375 6,375

9-9

Exercise 9-3 (continued) Weber Company Interest Expense

42,500

6 Cash ($850,000  .10  ) 12

42,500

Premium on Bonds Interest Expense $34,000 / 8 periods = $4,250

4,250 4,250

Part D Note: We have provided solutions assuming the use of any of the three methods. Since the schedules start with the same reported income of Fairfield under all three methods, this results in three different consolidated net income numbers. 2011 Reported net income - Fairfield Less: Dividend income ($60,000  .90) Less: Equity income ($190,000)(.90) Less: Adjusted Equity income (171,000+51,000 + .9(20,400)) Net income from independent operations – Fairfield Add: Constructive gain on bond retirement Fairfield's contribution to consolidated income Reported net income - Weber $190,000 Add: Constructive gain on bond retirement 20,400 Weber's contribution to consolidated income 210,400  .90 Controlling interest in consolidated net income Noncontrolling interest in consolidated income ($210,400  .10)

9 - 10

Partial Complete Cost Method Equity Method Equity Method $275,000 $275,000 $275,000 54,000 171,000 221,000 51,000 272,000

104,000 51,000 155,000

240,360 34,640 51,000 85,640

189,360 $461,360

189,360 $344,360

189,360 $275,000

$21,040

Exercise 9-3 (continued) 2012 Reported net income - Fairfield Less: Dividend income ($80,000  .90) Less Equity income ($225,000)(.90) Less: Adjusted Equity income ($202,500 - $12,750 - (.9)5,100) Net income from independent operations - Fairfield Less: Constructive gain recorded* Fairfield's contribution to consolidated income Reported net income - Weber $225,000 Less: Constructive gain recorded** 5,100 Weber's contribution to consolidated income 219,900  .90 Controlling interest in consolidated net income

Partial Complete Cost Method Equity Method Equity Method $350,000 $350,000 $350,000 72,000 202,500 278,000 12,750 265,250

147,500 12,750 134,750

185,160 164,840 12,750 152,090

197,910 $463,160

197,910 $332,660

197,910 $350,000

$21,990

Noncontrolling interest in consolidated income ($219,900  .10)

* $6,375  2 = $12,750 or $51,000/4 periods = $12,750 **$4,250  .60 = $2,550; $2,550  2 = $5,100 Exercise 9-4 December 31, 2011 Premium on Bonds Payable ($34,000  .60) Constructive Gain on Bond Retirement

Cost and Partial Equity 20,400 20,400

Investment in Weber Company Bonds Constructive Gain on Bond Retirement

51,000

Bonds Payable Investment in Weber Company Bonds

510,000

Complete Equity 20,400 20,400 51,000

51,000 510,000 510,000

9 - 11

51,000 510,000

Exercise 9-4 (continued) December 31, 2012 Investment in Weber Co. Bonds Beginning Retained Earnings - Fairfield

Cost and Partial Equity 51,000 51,000

Investment in Weber Co. Bonds Investment in Weber Co. Stock

Complete Equity

51,000 51,000

Interest Income ($6,375  ) Investment in Weber Company Bonds

12,750

Premium on Bonds Payable Beginning Retained Earnings - Fairfield Noncontrolling Interest

20,400

12,750 12,750

12,750

18,360 2,040

Premium on Bonds Payable Investment in Weber Co. Stock Noncontrolling Interest

20,400 18,360 2,040

Interest Expense (($4,250  2)  .60) Premium on Bonds Payable

5,100

Interest Income Interest Expense

51,000

Bonds Payable Investment in Weber Company Bonds

510,000

5,100 5,100

5,100 51,000

51,000 510,000 510,000

9 - 12

51,000 510,000

Exercise 9-4 (continued) December 31, 2013 Investment in Weber Co. Bonds Beginning Retained Earnings - Fairfield

Cost and Partial Equity 51,000 51,000

Investment in Weber Co. Bonds Investment in Weber Co. Stock

Complete Equity

51,000 51,000

Beginning Retained Earnings – Fairfield Interest Income ($6,375  ) Investment in Weber Company Bonds

12,750 12,750

12,750 25,500

Investment in Weber Co. Stock Interest Income ($6,375  ) Investment in Weber Company Bonds

12,750 12,750 12,750 25,500

Premium on Bonds Payable Beginning Retained Earnings - Fairfield Noncontrolling Interest

20,400 18,360 2,040

Premium on Bonds Payable Investment in Weber Co. Stock Noncontrolling Interest

20,400 18,360 2,040

Beginning Retained Earnings – Fairfield Noncontrolling Interest Interest Expense (($4,250  2)  .60) Premium on Bonds Payable

4,590 510 5,100 10,200

Investment in Weber Co. Stock Noncontrolling Interest Interest Expense (($4,250  2)  .60) Premium on Bonds Payable

4,590 510 5,100 10,200

Interest Income Interest Expense

51,000

Bonds Payable Investment in Weber Company Bonds

510,000

51,000 51,000 510,000 510,000

9 - 13

51,000 510,000

Exercise 9-5 1.

Carrying value of debt - 1/2/2011 Less: Premium amortization - (($5,000/20)  2 periods) Carrying value of debt - 12/31/2011

$505,000 500 $504,500

Stated interest (30% of $500,000  .11) Add: Discount amortization (($10,000/20)  2 periods) Interest revenue

$16,500 1,000 $17,500

Stated interest ($500,000  .11) Less: Premium amortization ($5,000/20)(2) Interest expense

$55,000 500 $54,500

Cost of bond investment (1/2/2011) Add: Discount amortization * Investment account balance - 12/31/2011

$140,000 1,000 $141,000

* $500,000 par  30% less $140,000 paid divided by 10 years = $1,000

9 - 14

Exercise 9-5 (continued) 5.

Reported net income - Peoples Less: Dividend income ($90,000  .80) Independent net income Add: Constructive gain on bond retirement Less: Constructive gain recorded during year Contribution of Peoples to consolidated income Reported net income - Schmidt Less: amortization of difference between implied and book value - COGS Add: Constructive gain on bond retirement ($505,000 - $500,000)  .30 = Less: Constructive gain recorded during year Income after adjustment for constructive gain

$300,000 72,000 228,000 10,000 (1,000) 237,000 $320,000 (60,000) 1,500 (150) 261,350  .80

Parent's share of adjusted income Controlling interest in consolidated net income

209,080 $446,080

Computation and Allocation of Difference between Implied and Book Value Acquired Parent Share

NonEntire Controlling Value Share 225,000 1,125,000 200,000 1,000,000

Purchase price and implied value Less: Book value of equity acquired:

$900,000 800,000

Difference between implied and book value Allocated to inventory Balance Goodwill Balance

100,000 (48,000) 52,000 (52,000) -0-

$261,350  .20 = $52,270

Noncontrolling interest in consolidated income

25,000 (12,000) 13,000 (13,000) -0-

125,000 (60,000) 65,000 (65,000) -0–

Exercise 9-6 Part A Face (Par) value of note Interest ($60,000  .12  ()) Maturity value Less: Discount ($61,800  .13  ()) Proceeds

9 - 15

$60,000 1,800 61,800 1,339 $60,461

Exercise 9-6 (continued) Part B

Notes Receivable Notes Receivable Discounted

Parent Company Dr (Cr) 60,000 (60,000)

Wyatt Corporation Dr (Cr) 60,000 (60,000)

*Elimination entry Notes Receivable Discounted Notes Receivable

Elimination Entries Debit Credit 60,000* 60,000*

Consolidated Balances Dr (Cr) 60,000 (60,000)

60,000 60,000

The results of the elimination entry is to show that the consolidated entity has a contingent liability for $60,000. Exercise 9-7 Part A Memorandum entry - Received a stock dividend of 1,050 shares of Salata Company common stock (7,000 shares  .15) Part B Investment in Salata Company Beginning Retained Earnings - Perez ($500,000 - $400,000)  .70 = $70,000 Common Stock ((1,500 shares  $100)  .70) Other Contributed Capital ((1,500  $60)  .70) Stock Dividend Declared ((10,000 shares  .15  $160)  .70 = $168,000)

70,000 70,000

105,000 63,000 168,000

Beginning Retained Earnings – Salata 500,000 Other Contributed Capital 100,000 Common Stock 1,000,000 Land (Difference between Implied and Book Value) 285,714 Investment in Salata Company ($1,250,000 + $70,000) 1,320,000 Noncontrolling interest [$535,714* + ($500,000 – 400,000) x .30] 565,714 * $1,250,000/.7 = $1,785,714 x .3 = $535,714 Part C Investment in Salata Company ($180,000  .70) Beginning Retained Earnings - Perez Retained earnings balance 1/1/2012 ($500,000 + $80,000 - $240,000*) Retained earnings balance - date of acquisition Less: Stock dividend Increase in retained earnings * (($1,000,000/$100)  .15  $160)

9 - 16

126,000 126,000

$340,000 $400,000 240,000

160,000 $180,000

Exercise 9-8 Part A 2011 Cash ($90,000  .90) Investment in Swartz Corporation

81,000

2012 Cash ($40,000  .9) Investment in Swartz Corporation

36,000

81,000

36,000

Part B Equity in Subsidiary Income ($65,000)(.90) Investment in Swartz Corporation Dividends Declared ($90,000  .90)

58,500 22,500 81,000

Common Stock - Swartz Corporation Beginning Retained Earnings - Swartz Corporation Difference between Implied and Book Value Investment in Swartz Corporation Noncontrolling interest

500,000 200,000 100,000

Land

100,000

720,000 80,000

Difference between Implied and Book Value Part C Equity in Subsidiary Income ($80,000)(.90) Investment in Swartz Corporation Dividends Declared ($40,000  .90)

100,000 72,000 36,000 36,000

Retained earnings - 1/1/2012 ($200,000 + $65,000 - $90,000)

$175,000

Common Stock - Swartz Corporation 500,000 Beginning Retained Earnings - Swartz Corporation 175,000 Difference between Implied and Book Value 100,000 Investment in Swartz Corporation 697,500 Noncontrolling interest [$80,000 + ($175,000 – 200,000) x .10] 77,520 Land

100,000 Difference between Implied and Book Value

Cost of investment Equity income (2011), .90  $65,000 Dividends (2011), .90  $90,000 Equity income (2012), .90  $80,000 Dividends (2012), .90  $90,000 Investment account

100,000

$720,000 58,500 (81,000) 72,000 (81,000) $733,500

Part D 2011 Cash ($90,000  .90) Dividend Income ($65,000  .90) Investment in Swartz Corporation

81,000 58,500 22,500

9 - 17

Exercise 9-8 (continued) 2012 Cash ($40,000  .9) Dividend Income

36,000 36,000

Exercise 9-9 Part A Cost Method Investment in Sung Company Preferred Stock Investment in Sung Company Common Stock Cash

70,000 400,000 470,000

Cash (preferred stock) Dividend Income ($200,000  12%  30%) Investment in Sung Company Preferred Stock ($200,000  12%  30%)

14,400

Cash ($50,000 - $48,000)  80%) Dividend Income (common stock)

1,600

7,200 7,200

1,600

Equity Method (complete and partial) Investment in Sung Company Preferred Stock Investment in Sung Company Common Stock Cash

70,000 400,000 470,000

Cash (preferred stock) Equity in Subsidiary Income –Preferred Stock Investment in Sung Company Common Stock

14,400

Cash

1,600

7,200 7,200

Investment in Sung Company Common Stock

1,600

Investment in Sung Company Common Stock 52,800 Equity in Subsidiary Income ($90,000 – ($200,000  .12))(.80) 52,800

Arrears Current year Total Percentage interest

Preferred Stock $24,000 24,000 48,000 .30 $14,400

9 - 18

Common Stock $2,000 2,000 .80 $1,600

Exercise 9-9 (continued) Part B Reported net income - 2011 $90,000 Allocation to preferred stock interest ($200,000  .12) 24,000  .70 = Residual to common stock interest $66,000  .20 = Noncontrolling interest in 2011 net income

$16,800 13,200 $30,000

Part C Cost Method Investment in Sung Company Preferred Stock Dividends Declared

7,200 7,200

Dividend Income Dividends Declared

8,800 8,800

Beginning Retained Earnings - Sung Company Preferred Stock Other Contributed Capital (or Retained Earnings) Investment in Sung Company Preferred Stock Noncontrolling interest

24,000 200,000 9,333 70,000 163,333

Computation and Allocation of Difference between Implied and Book Value Acquired (Preferred) Parent Share Purchase price and implied value $70,000 Less: Book value of equity acquired Preferred Stock (60,000) Retained Earnings (dividends in arears) (7,200) Difference between implied and book value 2,800 Beginning Retained Earnings - Sung Company ($100,000 - $24,000) Common Stock Land (Difference between Implied and Book Value)* Investment in Sung Company Common Stock Noncontrolling interest [$500,000 - $400,000 – ($100,000-$24,000)] = $24,000 Equity Method (complete and partial) Investment in Sung Company Preferred Stock Investment in Sung Company Common Stock Dividends Declared – Preferred Stock Equity in Subsidiary Income Dividends declared – Common Stock Investment in Sung Company Common Stock

9 - 19

NonControlling Share 163,333

Entire Value 233,333

(140,000) (16,800) 6,533

(200,000) (24,000) 9,333 76,000 400,000 24,000 400,000 100,000

7,200 7,200 14,400 52,800 1,600 51,200

Exercise 9-9 (continued) Beginning Retained Earnings - Sung Company Preferred Stock Other Contributed Capital (or Retained Earnings) Investment in Sung Company Preferred Stock Noncontrolling interest

24,000 200,000 9,333 70,000 163,333

Beginning Retained Earnings - Sung Company ($100,000 - $24,000) Common Stock Land (Difference between Implied and Book Value) Investment in Sung Company Common Stock Noncontrolling interest

76,000 400,000 24,000 400,000 100,000

Exercise 9-10 Beginning Retained Earnings - Sam'sa Preferred Stock Other Contributed Capital* Investment in Preferred Stock

Case 1 2,000 40,000 13,000 55,000

Case 2 11,600 40,000 3,400 55,000

Case 3 9,000 40,000 6,000 55,000

* The difference between the implied value of the preferred stock investment and the book value acquired is not allocated to specific assets or liabilities, but rather is accounted for as an equity transaction and debited to Other Contributed Capital. Beginning Retained Earnings - Sam'sa Common Stock Other Contributed Capital Land (difference between implied & book value) Investment in Common Stock Noncontrolling interest

105,000 500,000 160,000

81,000 500,000 160,000

87,500 500,000 160,000

151,667

175,667

169,167

550,000 366,667

aAllocation of Retained Earnings of $110,000: Case 1 To Preferred Stock $5,000 To Common Stock 105,000 $110,000 Par value $100,000 Call premium 5,000 Dividends in arrears Fully participating (1/6)(110-5) ______ Total 105,000 Par value 100,000 Retained earnings to preferred 5,000 Peterson’s percentate 40% Beginning Retained Earnings – Sam’s 2,000 Exercise 9-10 (continued)

9 - 20

550,000 366,667

Case 2 $29,000 81,000 $110,000

Case 3 $22,500 87,500 $110,000

$100,000 5,000 24,000 ______ 129,000 100,000 29,000 40% 11,600

$100,000 5,000 17,500 122,500 100,000 22,500 40% 9,000

550,000 366,667

Alternatively: $5,000 + ($100/$100+$500)  $105,000 = $5,000 + $17,500 = $22,500; $500  $105,000 = $87,500 $600 Exercise 9-11 Cost Method Case Reported net income - Perez Co. Less: Dividend incomea Independent income Perez Company's interest in net income of Serranob Controlling interest in consolidated net income

1 $200,000 32,800 167,200 60,800 $228,000

2 3 4 $200,000 $200,000 $200,000 20,000 31,500 25,900 180,000 168,500 174,100 60,800 56,000 56,000 $240,800 $224,500 $230,100

a Computation of dividend income Preferred Stock Arrears* Current $8,000  .4 $3,200

Case 1 – Noncumulative, nonparticipating Current Case 2 – Cumulative and nonparticipating Arrears ($100,000  .08  2) Current

$16,000 ______ $16,000

Preferred Stock Arrears* Current $8,000

Case 3 – Noncumulative and fully participating Current Participating: ($100/$400)  $13,000 ($300/$400)  $13,000

(1)

$8,000 8,000  .4 $3,200

3,250 ______ $11,250  .4 $4,500

$300,000  .08

9 - 21

Common Stock $37,000  .8 $29,600

$21,000 21,000  .8 $16,800

Total $45,000 $32,800 $16,000 29,000 $45,000 $20,000

Common Stock Total $24,000 (1) $32,000

9,750 $33,750  .8 $27,000

13,000 $45,000 $31,500

Exercise 9-11 (continued) Case 4 – Cumulative and fully participating Arrears ($100,000  .08) Current Participating: ($100/$400)  $5,000 ($300/$400)  $5,000

$8,000

_____ $8,000

$8,000

$24,000

1,250 _____ 9,250  .4 $3,700

3,750 27,750  .8 $22,200

*Dividends in arrears at date of acquisition are accounted for as a liquidating dividend. b Allocation of reported net income of Serrano, $80,000 Cases 1 and 2

Preferred Stock $8,000  .4 = Common Stock ($80,000 - $8,000) $72,000  .8 = Total

Cases 3 and 4 Current year Participating ($100/$400)  $48,000 ($300/$400)  $48,000

Preferred Stock $8,000

Common Stock $24,000

12,000 _____ 20,000  .4 $8,000

36,000 60,000  .8 $48,000

9 - 22

Total $32,000

48,000 $80,000 $56,000

$3,200 57,600 $60,800

$8,000 32,000

5,000 $45,000 $25,900

Exercise 9-12 Part A

Part B

Cost of bond investment Par value Unamortized discount Carrying value of bonds Percent of bonds purchased Carrying value of bonds purchased (rounded up) Total constructive loss Pacman Company Carrying value of bonds purchased Par value Constructive loss

$77,362 $100,000 6,462 93,537 .80 74,830 $2,532 Space Invaders Company

$74,830 80,000 $ 5,170

Cost of bond investment Par value of bonds purchased Constructive gain

Part C July 1 and January, 2012 Pacman Company’s amortization schedule (a) (b) Date Interest Cash Expense Payment (10%) 12/31/2009 6/30/2010 4,614 4,000 12/31/2010 4,645 4,000 6/30/2011 4,677 4,000 12/31/2011 4,711 4,000 6/30/2012 4,746 4,000 12/31/2012 4,783 4,000 6/30/2013 4,823 4,000 12/31/2013 4,864 4,000 6/30/2014 4,907 4,000 12/31/2014 4,952 4,000

9 - 23

(d) Carrying value (on Balance Sheet) $ 92,278 92,892 93,537 94,214 94,925 95,671 96,454 97,277 98,141 99,048 100,000

$77,362 80,000 $ 2,638

Exercise 9-12 (continued) Space Invaders Company’s amortization schedule (a) (b) (c) Date Interest Cash Premium Income Receipt Amortization 9% a+ b 12/31/2010 6/30/2011 3,481 3,200 281 12/31/2011 3,494 3,200 294 6/30/2012 3,507 3,200 307 12/31/2012 3,521 3,200 321 6/30/2013 3,535 3,200 335 12/31/2013 3,551 3,200 351 6/30/2014 3,566 3,200 366 12/31/2014 3,583 3,200 383 June 30, 2011 Pacman Company Interest Expense Cash

(d) Carrying value (on Balance Sheet) 77,362 77,643 77,937 78,244 78,565 78,900 79,251 79,617 80,000

4,000 4,000

Interest Expense Discount on Bonds Payable

677 677

Space Invaders Company Cash Interest Income ($80,000)(1/2)(8%) or (0.80)(4,000) Investment in Pacman Company Bonds Interest Income

3,200 3,200 281 281

December 31, 2011 Pacman Company Interest Expense Cash

4,000 4,000

Interest Expense Discount on Bonds Payable

711 711

Space Invaders Company Cash Interest Income ($80,000)(1/2)(8%) or (0.80)(4,000) Interest Income Investment in Pacman Company Bonds

9 - 24

3,200 3,200 294 294

Exercise 9-12 (continued) Part D Note: We have provided solutions assuming the use of any of the three methods. 2010

Partial Complete Cost Method Equity Method Equity Method $260,000 $316,000 $312,677 -42,000 -98,000

Reported net income - Pacman Less: Dividend income ($60,000)(.70) Less: Equity Income ($140,000)(.70) Less: Adjusted Equity Income ($98,000 - 5,170 + (70% of 2,638)) Net income from independent operations - Pacman 218,000 Less: Constructive loss on bond retirement -5,170 Pacman contribution to consolidated income 212,830 Reported net income of Space Invaders $140,000 Add: Constructive gain on bond retirement 2,638 Space Invaders contribution to consolidated income 142,638 .70 99,847 Controlling interest in consolidated net income $312,677 Noncontrolling interest in consolidated income ($142,638 .30) $42,791

9 - 25

218,000 -5,170 212,830

-94,677 218,000 -5,970 212,830

99,847 $312,677

$42,791

Partial Complete 2011 Cost Method Equity Method Equity Method Reported net income - Pacman $280,000 $371,000 $371,708 Less: Dividend income ($60,000)(.70) -42,000 Less: Equity income ($190,000)(.70) -133,000 Less: Adjusted Equity income ($133,000 + ($677 +711)   - (.70  (281+294))) -133,708 Net income from independent operations - Pacman 238,000 238,000 238,000 Add: Constructive loss recorded* (677+711)   1,110 1, 110 1, 110 Pacman contribution to consolidated income 239,388 239,388 239,388 Reported net income of Space Invaders $190,000 Less: Constructive gain recorded** 575 Space Invaders contribution to consolidated income 189,425  0.70 132,598 132,598 132,598 Controlling interest in consolidated net income $371,708 $371,708 $371,708 Noncontrolling interest in consolidated income ($189,425  .30) * discount amortized ($677+711) ** discount amortized (281+294)

9 - 26

$56,828

Exercise 9-13 December 31, 2010 Cost and Partial Equity 5,170 5,170

Loss on Constructive Retirement of Bonds Discount on Bonds Payable Investment in Pacman Company Bonds Gain on Constructive Retirement of Bonds

2,638

Bonds Payable Investment in Pacman Company Bonds

80,000

Complete Equity 5,170 5,170 2,638

2,638

2,638 80,000

80,000

Cost and Partial Equity 5,170 5,170

Complete Equity

December 31, 2011 Beginning Retained Earnings - Pacman Company Discount on Bonds Payable Investment in Space Invaders Discount on Bonds Payable

5,170 5,170

Discount on Bonds Payable Interest Expense (($677 + $711)  .80)

1,110

Beginning Retained Earnings – Pacman (70%) Noncontrolling Interest (30%) Investment in Pacman Company Bonds

1,847 791

1,110 1,110

1,110

2,638

Investment in Space Invaders (70%) Noncontrolling Interest (30%) Investment in Pacman Company Bonds

1,847 791 2,638

Investment in Pacman Company Bonds Interest Income ($281 + $294)

575

575 575

Interest Income (intercompany interest) Interest Expense Nominal interest of $8,000  .80 = $6,400

6,400

Bonds Payable Investment in Pacman Company

80,000

6,400 6,400

6,400 80,000

80,000

9 - 27

575

80,000

December 31, 2012 Cost and Partial Equity 5,170 5,170

Beginning Retained Earnings - Pacman Discount on Bonds Payable Discount on Bonds Payable Beginning Retained Earnings - Pacman Interest Expense ((746 + 783)  .80)

Complete Equity

2,333 1,110 1,223

Investment in Space Invaders Discount on Bonds Payable

5,170

Discount on Bonds Payable Investment in Space Invaders Interest Expense ((746 + 783)  .80)

2,333

5,170 1,110 1,223

Investment in Pacman Company Bonds Beginning Retained Earnings – Pacman (70%) Noncontrolling Interest (30%)

2,638

Beginning Retained Earnings - Pacman Noncontrolling Interest Interest Income ($307 + $321) Investment in Pacman Company Bonds

402.5 172.5 628.0

1,847 791

1,203

Investment in Pacman Company Bonds Beginning Retained Earnings – Pacman (70%) Noncontrolling Interest (30%)

2,638

Beginning Retained Earnings - Pacman Noncontrolling Interest Interest Income ($307 + $321) Investment in Pacman Company Bonds

402.5 172.5 628.0

1,847 791

1,203

Interest Income Interest Expense Nominal interest of $8,000  .80 = $6,400

6,400

Bonds Payable Investment in Pacman Company

80,000

6,400 6,400 80,000 80,000

9 - 28

6,400

80,000

ANSWERS TO ASC (Accounting Standards Codification) EXERCISES ASC9-1 Disclosure A company purchased a loan from another company and classified the loan as a receivable. When the cash is collected, how should the company classify the cash received on the statement of cash flows? Step 1: Use the drop-down menus under the ‘Presentation’ general topic on the homepage and choose ‘230-Statement of Cash Flows’; then under the second drop-down menu, choose ’10-overall’. Step 2: Click on Expand beneath the table of contents In Section 45 Other Presentation Matters there is a section discussing ‘classification’. Click on classification and read through the paragraphs. FASB ASC sub-paragraph 230-10-45-12(a) states that receipts from collections of loans of other entities’ debt instruments that were purchased by the entity are cash inflows from investing activities. ASC9-2 Disclosure A company incurred debt issue costs. Where is the cash paid for debt issue costs classified on the statement of cash flows? Step 1: Use the drop-down menus under the ‘Presentation’ general topic on the homepage and choose ‘230-Statement of Cash Flows’; then under the second drop-down menu, choose ’10-overall’. Step 2: Click on Expand beneath the table of contents In Section 45 Other Presentation Matters there is a section discussing ‘classification’. Click on classification and read through the paragraphs. FASB ASC sub-paragraph 230-10-45-15(e) states that payments for debt issue costs are classified as a cash outflow for financing activities. ASC9-3 Disclosure Cash paid for interest expense amounted $10,000. Where is the cash outflow reported on the statement of cash flows? Step 1: Use the drop-down menus under the ‘Presentation’ general topic on the homepage and choose ‘230-Statement of Cash Flows’; then under the second drop-down menu, choose ’10-overall’. Step 2: Click on Expand beneath the table of contents In Section 45 Other Presentation Matters there is a section discussing ‘classification’. Click on classification and read through the paragraphs. FASB ASC sub-paragraph 230-10-45-17(d) states that cash payments to lenders and other credictors for interest are classified as a cash outflow for operating activities.

9 - 29

SOLUTIONS TO PROBLEMS Problem 9-1

Case 1 $512,000 3,600 508,400 514,000 $ (5,600)

2 $488,000 3,600 491,600 486,000 $ 5,600

Pace Corporation Carrying value - 1/1/2009 Par value Constructive gain (loss)

$508,400 500,000 $ 8,400

$491,600 500,000 $ (8,400)

Supra Corporation Purchase price Par value Constructive gain (loss)

$514,000 500,000 $ (14,000)

$486,000 500,000 $ 14,000

Part A Issue price Amortization – 2006 to 2009 ($12,000/10)  3 Carrying value - 1/1/2009 Purchase price Total constructive gain (loss)

Part B Pace Corporation Case 1 Interest Expense ($500,000  .15  ()) Cash Premium on Bonds Payable ($12,000/20) Interest Expense Case 2 Interest Expense Cash

37,500 37,500 600 600 37,500 37,500

Interest Expense Discount on Bonds Payable ($12,000/20) Supra Corporation Case 1 Cash Interest Income ($500,000  .15  6/12) Interest Income Investment in Pace Corp. Bonds ($14,000/14) Case 2 Cash

600 600 37,500 37,500 1,000 1,000 37,500

Interest Income

37,500

Investment in Pace Corp. Bonds ($14,000/14) Interest Income

9 - 30

1,000 1,000

Problem 9-1 (continued) Part C Issue Price Pace Corporation $512,000 $488,000 Bonds Payable $500,000 $500,000 Unamortized Premium (discount) – after 4 years ($12,000 – ($1,200 x 4) 7,200 (7,200) Carrying Value of Bonds $507,200 $492,800 Cash Payment for Interest - 2009 (Premium) Discount Amortization (per year) Bond Interest Expense - 2009

$75,000 (1,200) $73,800

$75,000 1,200 $76,200

Increase (decrease) in Net Income from Amortization

$1,200

$(1,200)

Supra Corporation Investment in Pace Corp. Bonds

Purchase Price $514,000 $486,000 $512,000 $488,000

Cash Receipts for Interest - 2009 (Premium) Discount Amortization ($14,000/7) Bond Interest Income - 2009

$75,000 (2,000) $73,000

$75,000 2,000 $77,000

Increase (decrease) in Net Income from Amortization

$(2,000)

$2,000

Case 3

Amount of constructive gain (loss) recognized by Pace Corporation $1,200 $(1,200) $1,200 $(1,200) Amount of constructive gain (loss) recognized by Supra Corporation (2,000) 2,000

2,000 (2,000)

Part D Case 1 Premium on Bonds Payable Gain on Constructive Retirement of Debt

8,400

Interest Expense Premium on Bonds Payable

1,200

Loss on Constructive Retirement of Debt Investment in Pace Corporation Bonds

14,000

1,200

Investment in Pace Corporation Bonds Interest Income

14,000 2,000 2,000

Interest Income Interest Expense

75,000

Bonds Payable Investment in Pace Corporation Bonds

500,000

75,000

Problem 9-1 (continued)

9 - 31

500,000

Case 2 Loss on Constructive Retirement of Debt Discount on Bonds Payable

8,400 8,400

Discount on Bonds Payable Interest Expense

1,200 1,200

Investment in Pace Corp. Bonds Gain on Constructive Retirement of Debt

14,000

Interest Income Investment in Pace Corp. Bonds

2,000

Interest Income Interest Expense

75,000

Bonds Payable Investment in Pace Corporation Bonds

500,000

14,000 2,000 75,000 500,000

Problem 9-2 Part A

Prezo Company Purchase price of bonds Par value of bonds ($400,000  .60) Constructive gain

$225,000 240,000 $ 15,000

Satz Company Premium amortization per period: Premium balance 12/31/2009 Number of interest periods to maturity Amortization per period Bonds Payable Unamortized premium ($9,000 + $1,500) Carrying value - 7/1/2009 Carrying value of bonds retired Par value Constructive gain

9 - 32

$9,000 6 $1,500 $400,000 10,500 410,500  .60 246,300 240,000 $ 6,300

Problem 9-2 (continued) Part B

Income Statement Sales Dividend Income Other Income Gain on Constructive Retirement of Bonds Total Revenue Expenses Net/Consolidated Income Noncontrolling Interest in Consolidated Income ($400,000 + $6,300 - $900)  .20 Net Income to Retained Earnings Retained Earnings Statement 1/1 Retained Earnings: Prezo Company Satz Company Net Income from above Dividends Declared: Prezo Company Satz Company 12/31 Retained Earnings to Balance Sheet

PREZO COMPANY AND SUBSIDIARY Consolidated Statements Workpaper For the Year Ended December 31, 2009 Prezo Company

Salz Company

2,680,000 120,000 266,000

1,860,000 120,000

Eliminations Dr. Cr.

Noncontrolling Consolidated Interest Balances 4,540,000

(7) 120,000 (2) 2,143 (5) 12,000

371,857 (1) 15,000 (3) 6,300

3,066,000 2,678,000 388,000

388,000

1,980,000 1,580,000 400,000

(4)

900

400,000

135,043

300,000 400,000

(8) 300,000 135,043

21,300 4,933,157 4,246,900 686,257

(5) 12,000

33,300

81,080 81,080

480,000 388,000

480,000 33,300

81,080

(250,000) 618,000

(81,080) 605,177

605,177 (250,000)

(150,000) 550,000

9 - 33

435,043

(7) 120,000 153,300

(30,000) 51,080

835,177

Problem 9-2 (continued)

Prezo Company

Salz Company

920,000 880,000 227,143

580,000

Other Assets Total Assets

2,345,457 4,372,600

1,320,000 1,900,000

Bonds Payable Premium on Bonds Payable Other Liabilities Common Stock Prezo Company Satz Company Retained Earnings from above Noncontrolling Interest in Net Assets

700,000 20,000 1,434,600

400,000 9,000 141,000

(6) 240,000 (3) 6,300

800,000 550,000

(8) 800,000 435,043

Balance Sheet Current Assets Investment in Satz Company Common Stock Investment in Satz Co. Bonds

Total Liabilities and Equity

Eliminations Dr. Cr.

Noncontrolling Consolidated Interest Balances 1,500,000

(8) 880,000 (1) 15,000 (2) 2,143 (6) 240,000 3,665,457 5,165,457 (4)

860,000 23,600 1,575,600

900

1,600,000 618,000 4,372,600

1,600,000

1,900,000

9 - 34

1,496,343

153,300 (8) 220,000 1,496,343

51,080 220,000 271,080

835,177 271,080 5,165,457

Problem 9-2 (continued) Explanations of workpaper entries (1) Investment in Satz Company Bonds 15,000 Constructive Gain on Bond Retirement To recognize constructive gain and adjust the bond investment to par value (2) Interest Income ($15,000 gain/7 periods) Investment in Satz Company Bonds To adjust interest income for the gain recorded this period

2,143 2,143

(3) Premium on Bonds Payable 6,300 Constructive Gain on Bond Retirement To recognize constructive gain and adjust the intercompany bonds to par value (4) Interest Expense ($6,300 gain/7 periods = $900) Premium on Bonds Payable To adjust interest expense for the gain recorded this period (5) Interest Income ($240,000  .10  ()) Interest Expense To eliminate intercompany interest.

15,000

6,300

900 900 12,000 12,000

(6) Bonds Payable Investment in Satz Company Bonds To eliminate intercompany bond investment and liability

240,000

(7) Dividend Income Dividends Declared To eliminate intercompany dividends

120,000

240,000

120,000

(8) Beginning Retained Earnings – Satz 300,000 Common Stock – Satz 800,000 Investment in Satz Company Common Stock 880,000 Noncontrolling interest 220,000 To eliminate investment account and create noncontrolling interest account Part C

Income of Prezo from independent operations ($388,000 - $120,000) Add: Constructive gain on bond retirement Less: Portion of constructive gain recorded this period ($15,000/7) Prezo's contribution to combined income Reported net income of Satz $400,000 Add: Constructive gain on bond retirement 6,300 Less: Portion of constructive gain recorded this period (900) Satz's contribution to consolidated income 405,400 Prezo’s percentage  .80 Controlling interest in consolidated net income

9 - 35

$268,000 15,000 (2,143) 280,857

324,320 $605,177

Problem 9-3 Part A

PASTA COMPANY AND SUBSIDIARY Consolidated Statement Workpaper For the Year Ended December 31, 2011

Income Statement Sales Other Revenues Total Revenue Cost of Goods Sold Other Expenses Gain or Loss on Constructive Retirement of Bonds Total Cost & Expense Net/Consolidated Income Noncontrolling Interest in Consolidated Income* Net Income to Retained Earnings *($62,000 - $1,500)  .20 = $12,100 Retained Earnings Statement 1/1 Retained Earnings: Pasta Company Salsa Company Net Income from above Dividends Declared: Pasta Company Salsa Company - Stock 12/31 Retained Earnings to Balance Sheet

Pasta Company

Salsa Company

370,000 15,000 385,000 180,000 80,000

200,000 2,000 202,000 110,000 30,000

260,000 125,000

140,000 62,000

Eliminations Dr. Cr.

(3) 1,500

125,000

62,000

1,500

Noncontrolling Consolidated Interest Balances

(2) 6,000

6,000

12,100 12,100

96,000 125,000

96,000 85,000 62,000

(5) 85,000 1,500

6,000

12,100

86,500

(1) 24,000 30,000

(6,000) 6,100

(30,000) 191,000

570,000 17,000 587,000 290,000 110,000 (4,500) 395,500 191,500 (12,100) 179,400

179,400 (30,000)

(30,000) 117,000

9 - 36

245,400

Problem 9-3 (continued)

Pasta Company

Salsa Company

171,000 148,000 94,000 300,000 713,000

169,000

Accounts Payable Long-Term Bonds Payable Discount on Bonds Payable Common Stock: Pasta Company Salsa Company

72,000 250,000

40,000 200,000 (3,000)

Retained Earnings from above 1/1 Noncontrolling Interest in Net Assets*

191,000

Balance Sheet Current Assets Investment in Salsa Company Stock Investment in Salsa Company Bonds Other Assets Total Assets

12/31 Noncontrolling Interest in Net Assets Total Liabilities and Equity

Eliminations Dr. Cr.

Noncontrolling Consolidated Interest Balances

340,000 (5) 148,000 (2) 6,000 (4) 100,000

315,000 484,000

615,000 955,000 112,000 350,000 (1,500)

(4) 100,000 (3) 1,500

200,000

200,000 130,000

713,000

117,000

484,000

(1) 30,000 (5) 100,000 86,500

322,500

30,000 (5) 37,000 (1) 6,000

6,100 43,000

245,400

49,100

49,100 955,000

322,500

No entry is necessary to establish reciprocity since there was a liquidating dividend last year (1) (2) (3) (4) (5)

To reverse the effects of the stock dividend. To recognize the constructive loss not recorded by Pasta Company and adjust the bond investment to par value. To recognize the constructive gain not recorded by Salsa Company and adjust the intercompany bonds payable to par value. To eliminate the intercompany bond investment and liability. To eliminate the investment account and create noncontrolling interest account.

* $38,000 + ($85,000 – $90,000) x .20 = $37,000

9 - 37

Problem 9-3 (continued) Pasta Company Cost of bond investment Par value of bonds purchased Constructive gain

$ 94,000 100,000 $ 6,000

Salsa Company Carrying value of bonds Percent purchased ($100,000/$200,000) Carrying value of bonds purchased Par value of bonds purchased Constructive loss

$197,000 .50 98,500 100,000 $ 1,500

Part B Investment in Salsa Company Stock Beginning Retained Earnings - Pasta Company $62,000  .80 = $49,600 Retained earnings - 1/1/2012 Retained earnings - date of acquisition Less: Liquidating dividend - 2010 Stock dividend - 2011 Undistributed net income

49,600 49,600

$117,000 $90,000 (5,000) (30,000)

55,000 $62,000

Problem 9-4 Part A Investment in South Company Stock Equity in Subsidiary Income

160,000 160,000

Cash ($100,000  .80) Investment in South Company Stock

80,000

Investment in South Company Bonds Cash

315,000

Cash ($300,000  .10  ()) Interest Income

15,000

Interest Income ($15,000/5 periods) Investment in South Company Bonds

3,000

80,000

315,000

15,000

9 - 38

3,000

Problem 9-4 (continued) Supporting Computation Prince Company Cost of bond investment Par value of bonds purchased Constructive loss

$315,000 300,000 $ 15,000

South Company Premium on bonds payable Amortization periods remaining as of December 31, 2011 Amortization per period

$ 40,000 4 $ 10,000

Carrying value July 1, 2011: Bonds payable Premium on bonds payable ($40,000 + $10,000) Carrying value - July 1, 2011 Percentage of bonds purchased Carrying value of bonds purchased Par value of bonds purchased Constructive gain

$500,000 50,000 550,000 .60 330,000 300,000 $ 30,000

9 - 39

Problem 9-4 (continued) Part B

PRINCE COMPANY AND SUBSIDIARY Consolidated Statements Workpaper For the Year Ended December 31, 2011

Income Statement Sales Equity in Subsidiary Income Other Income Total Revenue Expenses Gain or Loss on Constructive Retirement of Bonds Net/Consolidated Income Noncontrolling Interest (($200,000 + $30,000 - $6,000)  .20) Net Income to Retained Earnings Retained Earnings Statement 1/1 Retained Earnings: Prince Company South Company Net Income from above Dividends Declared: Prince Company South Company 12/31 Retained Earnings to Balance Sheet

Prince Company

South Company

3,000,000 160,000 100,000 3,260,000 2,800,000

2,000,000

460,000

200,000

460,000

200,000 2,200,000 2,000,000

Eliminations Dr. Cr.

Noncontrolling Consolidated Interest Balances 5,000,000

(1) 160,000 (6) 15,000

(3) 3,000

(5) 6,000 (2) 15,000

(6) 15,000 (4) 30,000

200,000

196,000

300,000 200,000

(8) 300,000 196,000

48,000

288,000 5,288,000 (4,791,000) 15,000 512,000 44,800 44,800

600,000 460,000

600,000 48,000

44,800

(250,000)

467,200 (250,000)

(100,000) 810,000

(44,800) 467,200

400,000

9 - 40

496,000

(1) 80,000

(20,000)

128,000

24,800

817,200

Problem 9-4 (continued) Balance Sheet Current Assets Investment in South Company Common Stock Investment in South Company Bonds Other Assets Total Assets Bonds Payable Premium on Bonds Payable Other Liabilities Capital Stock Prince Company South Company Retained Earnings from above 1/1 Noncontrolling Interest in Net Assets 12/31 Noncontrolling Interest in Net Assets Total Liabilities and Equity

Prince Company

South Company

826,000 1,120,000

700,000

312,000

Eliminations Dr. Cr.

1,526,000

(3)

1,252,000 3,510,000

1,400,000 2,100,000

300,000 20,000 380,000

500,000 40,000 160,000

Noncontrolling Consolidated Interest Balances

(1) 80,000 (8) 1,040,000 3,000 (2) 15,000 (7) 300,000 2,652,000 4,178,000

(7) 300,000 (4) 30,000

500,000 36,000 540,000

(5) 6,000

2,000,000

810,000

1,000,000 400,000

(8) 1,000,000 496,000

3,510,000

2,100,000

1,829,000

Explanations for workpaper eliminating entries are on the following page.

9 - 41

128,000 (8) 260,000 1,829,000

24,800 260,000 284,800

817,200 284,800 4,178,000

Problem 9-4 (continued) Explanations of workpaper entries (1) Equity in Subsidiary Income 160,000 Dividends Declared ($100,000  .80) Investment in South Company To reverse the effect of parent company entries during the year for subsidairy dividend and income.

80,000 80,000

(2) Gain (Loss) on Constructive Retirement of Bond 15,000 Investment in South Company -Bonds To recognize constructive loss and adjust bond investment to par value.

15,000

(3) Investment in South Company -Bonds Other Income (Interest) To adjust interest income for loss recorded.

3,000

(4) Premium on Bond Payable 30,000 Gain (Loss) on Constructive Retirement of Bonds To recognize constructive gain and adjust intercompany bonds to par value.

30,000

(5) Expenses (Interest) Premium on Bond Payable To adjust interest expense for gain recorded.

6,000 6,000

(6) Other Income (Interest) Expenses (Interest) To eliminate the intercompany interest.

15,000

(7) Bonds Payable Investment in South Company -Bonds To eliminate the intercompany bond investment and liability.

300,000

15,000

300,000

(8) 1/1 Retained Earnings – South Company 300,000 Common Stock – South Company 1,000,000 Investment in South Company – Common Stock 1,040,000 Noncontrolling interest [$250,000 + ($300,000 – $250,000) x 0.2 260,000 To eliminate the investment account and create noncontrolling interest account.

9 - 42

Problem 9-5

Income Statement Sales Expenses Net Income Preferred Stock ($40,000(1)  .7) Common Stock ($60,000(2)  .2) Net Income to Retained Earnings (1) $400,000  .10; (2) $100,000 - $40,000 Retained Earnings Statement 1/1 Retained Earnings: Pabst Company Secor Company Preferred Stock Common Stock Net Income from above Dividends Declared 12/31 Retained Earnings to Balance Sheet

PABST COMPANY AND SUBSIDIARY Consolidated Statements Workpaper For the Year Ended December 31, 2011 Pabst Company

Secor Company

700,000 (580,000) 120,000

450,000 (350,000) 100,000

120,000

Eliminations Dr. Cr.

1,150,000 (930,000) 220,000 28,000 12,000 40,000

100,000

507,000

120,000 (100,000) 527,000

Noncontrolling Consolidated Interest Balances

(1) 140,000 56,000* 374,000 100,000

(2) 56,000 (3) 374,000

530,000

430,000

647,000

40,000 140,000

40,000

*Dividends in arrears + call premium = ($400,000  .10  1 year) + ($4  4,000 shares) = $40,000 + $16,000 = $56,000

9 - 43

(40,000) 180,000

180,000 (100,000) 727,000

Problem 9-5 (continued) Balance Sheet Current Assets Investment - Common Stock Preferred Stock Other Assets

Liabilities Preferred Stock Pabst Company Secor Company Common Stock Pabst Company Secor Company Other Contributed Capital Pabst Company Secor Company Retained Earnings from above 1/1 Noncontrolling Interest in Net Assets

Pabst Company

Secor Company

1,618,000 680,000 135,000 1,025,000 3,458,000

890,000

1,000,000 1,890,000

931,000

360,000

Eliminations Dr. Cr.

Noncontrolling Consolidated Interest Balances 2,508,000

(1) 128,000 (3) 808,000 (1) 12,000 (2) 147,000 (3) 36,000

1,291,000

400,000

400,000 400,000

(2) 400,000

500,000

(3) 500,000

100,000 530,000

(2) 34,000 (3) 100,000 430,000

1,000,000

600,000 527,000

566,000 140,000 (2) 343,000 (3) 202,000

12/31 Noncontrolling Interest in Net Assets 3,458,000 (1) (2) (3)

2,061,000 4,569,000

1,890,000

1,640,000

To establish reciprocity. $40,000  .3 = $12,000; ($374,000 – ($230,000 – $16,000))  .80 = $128,000 To eliminate the investment preferred stock account and create noncontrolling interest account. To eliminate the investment common stock account and create noncontrolling interest account. Computation to verify difference between implied and book value. Total stockholders' equity - date of purchase $1,230,000 Preferred stock $400,000 Retained earnings ($4 per share  4,000 shares) 16,000 Book value interest of preferred stock 416,000 = $416,000 − $450,000 Book value interest of common stock $814,000 = $814,000 − $850,000

9 - 44

40,000 343,000 202,000 585,000

= =

727,000

585,000 4,569,000

$34,000 $36,000

Problem 9-6 Part A Computation and Allocation of Difference between Implied and Book Value Acquired (Common Stock) Parent Share Purchase price and implied value Less: Book value of equity acquired Common Stock Retained Earnings* Difference between implied and book value Allocated to land (other assets) Balance

$600,000

NonControlling Share 66,667

Entire Value 666,667

(360,000) (144,000) 96,000 (96,000) -0-

(40,000) (16,000) 10,667 (10,667) -0-

(400,000) (160,000) 106,667 (106,667) -0–

Computation and Allocation of Difference between Implied and Book Value Acquired (Preferred Stock) Parent Share Purchase price and implied value Less: Book value of equity acquired Preferred Stock Retained Earnings* Difference between implied and book value

$60,000

NonControlling Share 90,000

Entire Value 150,000

(40,000) (16,000) 4,000

(60,000) (24,000) 6,000

(100,000) (40,000) 10,000

*Based on ratio of capital balances since there are no preferred dividends in arrears.

$100,000  $200,000 = $40,000 $500,000 $400,000 Common stock  $200,000 = $160,000 $500,000 Preferred stock

9 - 45

Problem 9-6 (continued) Part B

Income Statement Sales Other Revenues Total Revenue Cost of Goods Sold Other Expenses Net/Consolidated Income Noncontrolling Interest in Consolidated Income Preferred Stock ($24,000*  .60) Common Stock ($96,000  .10) Net Income to Retained Earnings * ($100/$500  $120,000) Retained Earnings Statement 1/1 Retained Earnings: PAL Corporation Saltz, Inc. Preferred Stock Common Stock Net Income from above Dividends Declared Preferred Stock Common Stock 12/31 Retained Earnings to Balance Sheet

PAL CORPORATION AND SUBSIDIARY Consolidated Statements Workpaper For the Year Ended December 31, 2011 PAL Corporation

Saltz Inc.

890,000 91,000 981,000 500,000 330,000 151,000

750,000 50,000 800,000 400,000 280,000 120,000

Eliminations Dr. Cr.

1,640,000 73,000 1,713,000 900,000 610,000 203,000

(2) 68,000

______ 151,000

120,000

560,000

68,000

(3)

151,000

74,000 256,000 120,000

711,000

(26,000) (64,000) 360,000

9 - 46

Noncontrolling Consolidated Interest Balances

14,400 9,600 24,000

10,000 (1) 100,000

(3) 74,000 (4) 256,000 68,000 (2) 10,400 (2) 57,600 408,000 168,000

(24,000) 179,000

650,000

24,000

179,000

(15,600) (6,400) 2,000

829,000

Problem 9-6 (continued) Balance Sheet Current Assets Investment in Saltz, Inc. Common Stock Preferred Stock Other Assets

Liabilities Preferred Stock Common Stock - PAL Corporation Saltz, Inc. Retained Earnings from above 1/1 Noncontrolling Inerest in Net Assets

PAL Corporation

Saltz Inc.

810,000

380,000

600,000 60,000 1,276,000 2,746,000 1,335,000

600,000 980,000

Eliminations Dr. Cr.

Noncontrolling Consolidated Interest Balances 1,190,000

(1) 86,400 (4) 686,400 (1) 13,600 (3) 73,600 (4) 106,667

120,000 100,000

(3) 100,000

400,000 360,000

(4) 400,000 408,000

1,982,667 3,172,667 1,455,000

700,000 711,000

700,000 168,000 (3) 110,400 (4) 76,267

12/31 Noncontrolling Interest in Net Assets 2,746,000

980,000

1,114,667

(1) To establish reciprocity $34,000  .40 = $13,600; $96,000  .90 = $86,400 (2) To eliminate intercompany dividends $26,000*  .40 = $10,400; $64,000**  .90 = $57,600 (3) To eliminate the preferred stock investment account and create noncontrolling interest account. (4) To eliminate the common stock investment account and create noncontrolling interest account. * ($100,000  .10  2) + [($90,000 - $60,000)  ($100/$500) = $26,000; ** ($90,000 - $26,000) = $64,000.

9 - 47

2,000 110,400 76,267 188,667

829,000

188,667 3,172,667

Problem 9-6 (continued) 1.

Supporting computations for workpaper. Allocation of beginning retained earnings Preferred Stock $ 10,000 64,000 $ 74,000

Common Stock $0 (4/5) 256,000 $ 256,000

Total $ 10,000 320,000 $ 330,000

Computation of dividend allocation – 2011 Dividends in arrears $ 10,000 Current year's dividend 10,000 Participating dividend (1/5) 6,000 $ 26,000

$0 40,000 24,000 $ 64,000

$ 10,000 50,000 30,000 $ 90,000

(4/5)

$0 96,000 $ 96,000

$ 10,000 120,000 $ 130,000

(4/5)

$ 40,000 56,000 $ 96,000

$ 50,000 70,000 $ 120,000

Dividends in arrears - 1/1/2011 Participating (1/5)

Computation of net income allocation – 2010 Current year's dividend $ 10,000 Participating (1/5) 24,000 $ 34,000 Computation of net income allocation – 2011 Current year's dividend $ 10,000 Participating (1/5) 14,000 $ 24,000

Problem 9-7 Part A Preferred stock Common stock Retained earnings Total Percentage interest held Book value interest acquired * (8,000  $27) - $200,000

Account Balance $200,000 500,000 160,000 $860,000

9 - 48

(4/5)

Book Value Interest Preferred Common Stock Stock $200,000 $0 500,000 16,000* 144,000 216,000 644,000 20% 80% $ 43,200 $ 515,200

Problem 9-7 (continued) Part B Computation and Allocation of Difference between Implied and Book Value Acquired (Common Stock) Parent Share Purchase price and implied value Less: Book value of equity acquired Difference between implied and book value Allocated to Inventory ($150,000 - $120,000) Allocated to Equipment ($640,000 - $560,000) Balance Goodwill Balance Part C 1. Dividends in arrears ($200,000  .09) Current year Percentage interest held Total dividends received 2.

$650,000 515,200 134,800 (24,000) (64,000) 46,800 (46,800) -0-

NonControlling Share 162,500 128,800 33,700 (6,000) (16,000) 11,700 (11,700) -0-

Preferred Stock $ 18,000 18,000 36,000 20% $7,200

Common Stock $ 0 14,000 14,000 80% $11,200

Reported net income - S Company Less: Depreciation for the period $80,000/5 Add: Realized profit in beginning inventory ($77,500/1.25)= $62,000; $77,500 - $62,000 = Less: Unrealized profit in ending inventory ($54,000/1.25) = $43,200; $54,000 - $43,200 = Realized net income of S Company Allocation to preferred stockholders Residual to common stockholders Noncontrolling interest in consolidated income Preferred stock $18,000  .80 = Common stock $70,700  .20 = Total P Company's net income Dividend income P Company's share of realized income of S Company Preferred stock $18,000  .20 = Common stock $70,700  .80 = Controlling interest in consolidated net income

9 - 49

Entire Value 812,500 644,000 168,500 (30,000) (80,000) 58,500 (58,500) -0– Total $ 18,000 32,000 $50,000 $ 18,400

$ 100,000 (16,000) 15,500 (10,800) 88,700 18,000 $ 70,700 $ 14,400 14,140 $ 28,540 $ 234,500 (18,400) $ 3,600 56,560 60,160 $ 276,260

Problem 9-7 (continued) 4. Retained earnings - P Company P Company's share of increase in S Company's retained earnings from date of acquisition: Preferred stock ($34,000* - $16,000)  .20 = Common stock ($276,000 - $144,000)  .80 = Unrealized profit on sales to P Company at 1/1/2011 ($15,500  .80) Cumulative effect to 1/1/2011 of amortization of difference between implied and book value: Inventory ($30,000 x .80) Equipment ($16,000  2 years) x .80 Consolidated retained earnings - 1/1/2011 * $16,000 + $18,000 = $34,000

9 - 50

$ 430,000 3,600 105,600 (12,400) (24,000) (25,600) $ 477,200

Problem 9-8 Part A Computation and Allocation of Difference between Implied and Book Value Acquired Parent Share Purchase price and implied value Less: Book value of equity acquired: Common Stock Other Contributed Capital Retained Earnings Difference between implied and book value Equipment Inventories Land Balance Goodwill Balance

$300,000

NonControlling Share 75,000

375,000

160,000 40,000 34,400 65,600 (10,000) (5,000) (5,000) 45,600 (45,600) -0-

40,000 10,000 5,600 16,400 (2,500) (1,250) (1,250) 11,400 (11,400) -0-

200,000 50,000 43,000a 82,000 (12,500) (6,250) (6,250) 57,000 (57,000) -0–

a Allocation of retained earnings: Retained earnings balance, date of purchase Allocation of preferred stock Call premium Dividends in arrears Allocation to common stock

9 - 51

Entire Value

$62,000 $4,000 15,000

19,000 $43,000

Problem 9-8 (continued) Part B

PARSON INDUSTRIES AND SUBSIDIARY Consolidated Statements Workpaper For the Year Ended December 31, 2011

Income Statement Sales Dividend Income Total Revenue Cost of Goods Sold

Parson Industries 404,000 4,000 408,000 200,000

Succo Company 300,000

Operating Expenses

36,400

50,000

Income Taxes

40,200 276,600 131,400

27,000 237,000 63,000

Net/Consolidated Income Noncontrolling Interest in Consolidated Income Preferred Stock ($15,000  1.00) Common Stock ($41,375*  .20) Net Income to Retained Earnings Retained Earnings Statement 1/1 Retained Earnings - Parson Industries

131,400

63,000

157,400

Succo Company Preferred Stock Common Stock Net Income from above Dividends Declared Parson Industries Succo Company Preferred Stock Common Stock 12/31 Retained Earnings to Balance Sheet

300,000 160,000

131,400

Eliminations Dr. Cr. (5) 100,000 (8) 4,000 (6)

4,167

(4) (11)

6,000 625

Noncontrolling Interest

(5) 100,000 (7) 2,500

261,667 93,025 67,200 421,892 182,108

114,792 (4) (7) (10) (11)

2,400 2,500 5,000 3,500

34,000 73,000

(9) 73,000

63,000

114,792

102,500

15,000 8,275 23,275

(1) 24,000 (3) 24,000

(23,275) 158,833

192,000

34,000 102,500

23,275

(65,000)

223,800

Consolidated Balances 604,000 0 604,000

158,833 (65,000)

(45,000) (5,000) 120,000

* ($63,000 - $6,000 loss - $625 depreciation) - $15,000

9 - 52

201,192

(8) 4,000 154,500

(45,000) (1,000) 11,275

285,833

Problem 9-8 (continued) Balance Sheet Cash and Receivables Inventories Land Buildings and Equipment

Parson Industries

Succo Company

396,800 200,000 300,000 697,000

205,000 170,000 120,000 245,000

Accumulated Depreciation

(100,000)

Investment in Succo Company Goodwill Difference between Implied and Book Value Total Assets

300,000

Current Liabilities Bonds Payable Preferred Stock - Succo Company Common Stock Parson Industries, $10 par Succo Company, $10 par Other Contributed Capital Parson Industries Succo Company Retained Earnings from above 1/1 Noncontrolling interest in Net Assets

12/31 Noncontrolling interest in Net Assets Total Liabilities and Equity

(70,000)

1,793,800

670,000

370,000 400,000

100,000 100,000 100,000

Eliminations Dr. Cr.

Noncontrolling Consolidated Interest Balances

(2) 10,000 (6) 4,167

591,800 365,833 426,250

(10) 6,250 (3) 50,000 (10) 12,500

1,004,500

(3) 20,000 (4) 9,000 (11) 5,000 (1) 24,000 (9) 324,000 (10) 57,000 (9) 82,000 (10) 82,000

(204,000) 0 57,000 0 2,241,383

(2) 10,000

460,000 500,000 100,000

600,000

600,000 200,000

(9) 200,000

200,000 223,800

1,793,800

200,000 50,000 120,000

670,000

9 - 53

(9) 50,000 201,192 (4) 600 (10) 1,250 (11) 875 695,667

154,500 (3) 6,000 (9) 81,000

695,667

11,275 84,275

285,833

195,550

195,550 2,241,383

Problem 9-8 (continued) Explanations of workpaper entries (1) Investment in Succo Company 1/1 Retained Earnings - Parson Industries To establish reciprocity (convert to equity), (($73,000 - $43,000)  .80 = $24,000). (2) Current Liabilities (Accounts Payable) Cash and Receivables (Accounts Receivables) To eliminate intercompany receivable and payable.

24,000 24,000

10,000 10,000

(3) Buildings and Equipment 50,000 1/1 Retained Earnings - Parson Industries ($30,000  .80) 1/1 Noncontrolling Interest Accumulated Depreciation To eliminate unrealized loss on intercompany sale of equipment and to restate property and equipment at original cost to Succo Company (4) 1/1 Retained Earnings - Parson Industries ($3,000  .80) 1/1 Noncontrolling interest Operating expenses (depreciation expense) ($80,000 − $50,000)/5 Accumulated Depreciation To adjust depreciation recorded during the current and prior years. (5) Sales

24,000 6,000 20,000

2,400 600 6,000 9,000

100,000

Cost of Goods Sold (purchases) To eliminate intercompany sales.

100,000

(6) Cost of Goods Sold (Ending Inventory – Income Statement) Inventory (Balance Sheet) ($25,000 − $25,000/1.20) To eliminate unrealized intercompany profit in ending inventory.

4,167

(7) 1/1 Retained Earnings Parson Industries Cost of Goods Sold ($15,000 − $15,000/1.20) To recognize profit realized during the year.

2,500

(8) Dividend Income Dividends declared To eliminate intercompany dividends.

4,000

4,167

2,500

4,000

(9) 1/1 Retained Earnings – Succo- Common Stock 73,000 Common Stock – Succo 200,000 Other Contributed Capital – Succo 50,000 Difference between Implied and Book Value 82,000 Investment in Succo Company 324,000 Noncontrolling interest account [$75,000 + ($73,000 - $43,000) x .2] 81,000 To eliminate the investment account and create noncontrolling interest account.

9 - 54

Problem 9-8 (continued) (10)Buildings and Equipment Land Goodwill 1/1 Retained Earnings Parson Industries Noncontrolling interest Difference between Implied and Book Value To allocate the difference between implied and book value.

12,500 6,250 57,000 5,000 1,250

(11) 1/1 Retained Earnings - Parson Industries* Noncontrolling interest* Operating Expense (Depreciation) Accumulated Depreciation To depreciate the difference between implied and book value.

3,500 875 625

82,000

5,000

* $625 x 7 x .8 = $3,500; $625 x 7 x .2 = $875 Supporting Computations: (3)(4)

Loss on sale of equipment - $80,000 - $50,000 = $30,000; Loss recognized per year $6,000. 1  $6,000 = $3,000 recognized last year 2 $25,000 (6) = $20,833; gross profit $4,167 1.20 $15,000 (7) = $12,500; gross profit $2,500 1.20 (10), (11) Allocation of difference 2010 2011-16 Equipment $12,500/20 $625 $3,750 Inventories 6,250 6,250 Land 6,250 --Goodwill 57,000 Total $82,000 $6,875 $3,750

9 - 55

2017 $625

$625

Unamortized $7,500 --6,250 57,000 $70,750

Problem 9-8 (continued) Part C Reported net income - Parson Industries Less: Dividend income

$131,400 4,000 127,400 2,500 (4,167) 125,733

Add: Realized gross profit in beginning inventory Less: Unrealized gross profit in ending inventory Parson's contribution to consolidated income Reported net income - Succo Company Less: Amortization of difference Less: Recorded loss on upstream sale of fixed asset Succo Company's realized reported income Less: Net income allocated to preferred stockholders Net income allocated to common stockholders Parson Industries' interest Controlling interest in consolidated net income

9 - 56

$63,000 (625) (6,000) 56,375 15,000 41,375  .80

33,100 $158,833

Problem 9-9 Part A Computation and Allocation of Difference between Implied and Book Value Acquired Parent Share Purchase price and implied value Less: Book value of equity acquired: Common Stock Other Contributed Capital Retained Earnings Difference between implied and book value Equipment Inventories Land Balance Goodwill Balance

$300,000

NonControlling Share 75,000

375,000

160,000 40,000 34,400 65,600 (10,000) (5,000) (5,000) 45,600 (45,600) -0-

40,000 10,000 5,600 16,400 (2,500) (1,250) (1,250) 11,400 (11,400) -0-

200,000 50,000 43,000a 82,000 (12,500) (6,250) (6,250) 57,000 (57,000) -0–

a Allocation of Retained Earnings: Retained Earnings balance, date of purchase Allocation of Preferred Stock Call premium Dividends in arrears Allocation to common stock

9 - 57

Entire Value

$62,000 $4,000 15,000

19,000 $43,000

Problem 9-9 (continued) Part B Income Statement Sales Equity in Subsidiary Income Cost of Goods Sold

Parson Succo Industries Company 404,000 300,000 31,433 435,433 300,000 200,000 160,000

Operating Expenses

36,400

50,000

Income Taxes Total Expenses Net/Consolidated Income Noncontrolling Interest in Cons. Income Preferred Stock ($15,000 X 1.00) Common Stock ($41,372 X .20) Net Income to Retained Earnings Retained Earnings Statement 1/1 Retained Earnings Parson Industries Succo Company Preferred Stock Common Stock

40,200 276,600 158,833

27,000 237,000 63,000

Net Income from above Dividends Declared Parson Industries Succo Company Preferred Stock Common Stock 12/31 Retained Earnings to Balance Sheet

158,833

NonconEliminations trolling Consolidated Dr. Cr Interest Balances (4) 100,000 604,000 (7) 31,433 604,000 (5) 4,167 (4) 100,000 261,667 (6) 2,500 (3) 6,000 93,025 (10) 625 67,200 421,892 182,108

63,000

142,225

102,500

15,000 8,275 23,275

192,000

192,000 34,000 73,000 63,000

34,000 (8)

73,000 142,225

102,500

23,275

(65,000)

285,833

(23,275) 158,833

158,833 (65,000)

(45,000) (5,000) 120,000

9 - 58

(7) 215,225

4,000 106,500

(45,000) (1,000) 11,275

________ 285,833

Problem 9-9 (continued) Balance Sheet Cash and Receivables Inventories Land Buildings and Equipment

Parson Succo Industries Company 396,800 205,000 200,000 170,000 300,000 120,000 697,000 245,000

Accumulated Depreciation

(100,000)

Investment in Succo Company

362,033

Goodwill Difference between Implied & Book Value Total Assets Current Liabilities Bonds Payable Preferred Stock - Succo Company Common Stock Parson Industries, $10 par Succo Company, $10 par Other Contributed Capital Parson Industries Succo Company Retained Earnings from above 1/1 Noncontrolling Interest in Net Assets

12/31 Noncontrolling Interest in Net Assets Total Liabilities and Equity

_________ 1,855,833 370,000 400,000

Eliminations Dr.

(9) (2) (9)

Cr. (1) 10,000 (5) 4,167 6,250 50,000 12,500

(70,000)

_________ 670,000 100,000 100,000 100,000

Noncontrol. Interest

(3) (6) (9) (10) (9) (8)

2,400 2,500 5,000 3,500 57,000 82,000

(1)

10,000

(2) 20,000 (3) 9,000 (10) 5,000 (7) 27,433 (8) 324,000 (2)

(9)

(204,000)

24,000 57,000 __________ 2,241,383 460,000 500,000

82,000

100,000

600,000

600,000 200,000

(8) 200,000

200,000 285,833

1,855,833

Consolidated Balances 591,800 365,833 426,250 1,004,500

200,000 50,000 120,000

670,000

9 - 59

(8)

50,000 215,225 (3) 600 (9) 1,250 (10) 875 699,100

106,500 (2) 6,000 (8) 81,000

699,100

11,275 84,275

285,833

195,550

195,550 2,241,383

Problem 9-9 (continued) Explanations of workpaper entries (1) Current Liabilities (accounts payable) Cash and Receivables (Accounts Receivables) To eliminate intercompany receivable and payable.

10,000 10,000

(2) Buildings and Equipment 50,000 Investment in Succo Company ($30,000  .80) 1/1 Noncontrolling Interest Accumulated Depreciation To eliminate unrealized loss on intercompany sale of equipment and to restate property and equipment at original cost to Succo Company (3) Investment in Succo Company ($3,000  .80) 2,400 1/1 Noncontrolling Interest 600 Operating Expenses (Depreciation Expense) 6,000 Accumulated Depreciation To adjust depreciation recorded during the current and prior years. (4) Sales

24,000 6,000 20,000

9,000

100,000

Cost of Goods Sold (Purchases) To eliminate intercompany sales.

100,000

(5) Cost of Goods Sold (Ending Inventory – Income Statement) 4,167 Inventory (Balance Sheet) ($25,000 – ($25,000/1.20)) To eliminate unrealized intercompany profit in ending inventory.

4,167

(6) Investment in Succo Company Cost of Goods Sold ($15,000 – ($15,000/1.20)) To recognize profit realized during the year.

2,500

(7) Equity in Subsidiary Income 31,433 Dividends Declared Investment in Succo Company To reverse the effect of parent company entries during the year for subsidiary dividend and income.

4,000 27,433

(8) 1/1 Retained Earnings – Succo- Common Stock 73,000 Common Stock – Succos 200,000 Other Contributed Capital – Succo 50,000 Difference between Implied and Book Value 82,000 Investment in Succo Company 324,000 Noncontrolling interest account [$75,000 + ($73,000 - $43,000) x .2] 81,000 To eliminate the investment account and create noncontrolling interest account.

9 - 60

Problem 9-9 (continued) (9) Buildings and Equipment 12,500 Land 6,250 Goodwill 57,000 Investment in Succo Company 5,000 Noncontrolling interest 1,250 Difference between Implied and Book Value To allocate the difference between implied and book value. (10) Investment in Succo Company ($625 x 7 x .8 ) 3,500 Noncontrolling interest ($625 x 7 x .2 ) 875 Operating Expense (depreciation) 625 Accumulated Depreciation To depreciate the difference between implied and book value.

82,000

5,000

Supporting Computations: (2)(3)

Loss on sale of equipment - $80,000 - $50,000 = $30,000; Loss recognized per year $6,000. 1  $6,000 = $3,000 recognized last year 2 $25,000 (5) = $20,833; gross profit $4,167 1.20 $15,000 (6) = $12,500; gross profit $2,500 1.20 (9), (10) Allocation of difference 2010 2011-16 Equipment $12,500/20 $625 $3,750 Inventories 6,250 6,250 Land 6,250 --Goodwill 57,000 Total $82,000 $6,875 $3,750

9 - 61

2017 $625

$625

Unamortized $7,500 --6,250 57,000 $70,750

Problem 9-9 (continued) Part C Reported net income - Parson Industries Less: Dividend income

$131,400 4,000 127,400 2,500 (4,167) 125,733

9 - 62

$63,000 (625) (6,000) 56,375 15,000 41,375  .80

33,100 $158,833

Problem 9-10 Part A

Prezo Company Purchase price of bonds Par value of bonds ($400,000 × 0.60) Constructive loss

$247,071 240,000 $ 7,071

Satz Company Bonds Payable Unamortized premium ($9,000 + $1,500) Carrying value - 7/1/2011 Carrying value of bonds retired Par value Constructive gain

9 - 63

$400,000 24,008 424,008 ×.60 254,405 240,000 $ 14,405

Problem 9-10 (continued) Part B

Income Statement Sales Dividend Income Other Income

PREZO COMPANY AND SUBSIDIARY Consolidated Statements Workpaper For the Year Ended December 31, 2011 Prezo Company

Salz Company

2,680,000 120,000 266,000

1,860,000

Eliminations Dr. Cr.

Noncontrolling Consolidated Interest Balances 4,540,000

(7) 120,000 120,000

(2)

882

(5) 7,200 Gain on Constructive Retirement of Bonds Loss on Constructive Retirement of Bonds Total Revenue Expenses Net/Consolidated Income Noncontrolling Interest in Consolidated Income ($400,000 + $14,405- $1,824) × 0.20 Net Income to Retained Earnings Retained Earnings Statement 1/1 Retained Earnings: Prezo Company Satz Company Net Income from above Dividends Declared: Prezo Company Satz Company 12/31 Retained Earnings to Balance Sheet

374,882 14,405 (7,071) 4,927,016 4,252,624 674,392

(3) 14,405 3,066,000 2,678,000 388,000

388,000

1,980,000 1,580,000 400,000

400,000

(1)

7,071

(4)

1,824

(5) 7,200

_______ 136,095

______ 22,487

82,516 82,516

480,000 388,000

480,000 300,000 400,000

(8) 300,000 136,095

22,487

82,516

(250,000) 618,000

(82,516) 591,876

591,876 (250,000)

(150,000) 550,000

9 - 64

436,095

(7) 120,000 142,487

(30,000) 52,516

821,876

Problem 9-10 (continued) Balance Sheet Current Assets Investment in Satz Company Common Stock Investment in Satz Co. Bonds Other Assets Total Assets Bonds Payable Premium on Bonds Payable Other Liabilities Common Stock Prezo Company Satz Company Retained Earnings from above Noncontrolling Interest in Net Assets Total Liabilities and Equity

Prezo Company

Salz Company

920,000 880,000 246,189

580,000

2,326,411 4,372,600

1,320,000 1,900,000

700,000

400,000 20,968 129,032

(6) 240,000 (3) 14,405 (4)

800,000 550,000

(8) 800,000 440,895

1,454,600

Eliminations Dr. Cr.

Noncontrolling Consolidated Interest Balances 1,500,000

(8) 880,000 (2) 882 (1) 7,071 (6) 240,000 3,646,411 5,146,411 860,000 8,387 1,583,632

1,824

1,600,000 618,000 4,372,600

1,600,000

1,900,000

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1,491,382

142,487 (8) 220,000 1,491,382

52,516 220,000 272,516

821,876 272,516 5,146,411

Problem 9-10 (continued) Explanations of workpaper entries (1) Constructive Loss on Bond Retirement 7,071 Investment in Satz Company Bonds To recognize constructive loss and adjust the bond investment to par value (2) Investment in Satz Company Bonds Interest Income To adjust interest income for the loss recorded this period

7,071

882 882

(3) Premium on Bonds Payable 14,405 Constructive Gain on Bond Retirement To recognize constructive gain and adjust the intercompany bonds to par value

14,405

(4) Interest Expense ($3,040 × 0.60) Premium on Bonds Payable To adjust interest expense for the gain recorded this period

1,824 1,824

(5) Interest Income ($240,000 × 0.10 × (6/12)) × 0.60 Interest Expense To eliminate intercompany interest.

7,200 7,200

(6) Bonds Payable Investment in Satz Company Bonds To eliminate intercompany bond investment and liability

240,000

(7) Dividend Income Dividends Declared To eliminate intercompany dividends

120,000

240,000

120,000

Income of Prezo from independent operations ($388,000 - $120,000) Less: Constructive loss on bond retirement Add: Portion of constructive loss recorded this period Prezo's contribution to combined income Reported net income of Satz $400,000 Add: Constructive gain on bond retirement 14,405 Less: Portion of constructive gain recorded this period (1,824) Satz's contribution to consolidated income 412,581 Prezo’s percentage × 0.80 Controlling interest in consolidated net income

9 - 66

$268,000 (7,071) 882 261,811

330,065 $591,876

Chapter 9 CHAPTER NINE – INTERCOMPANY BOND HOLDINGS AND MISCELLANEOUS TOPICS -- CONSOLIDATED FINANCIAL STATEMENTS

In this chapter, we discuss several areas related to the preparation of consolidated financial statements, including: 1. Intercompany bond holdings. 2. Intercompany notes receivable discounted. 3. Stock dividends issued by a subsidiary company. 4. Cash dividends from preacquisition earnings. 5. Preferred stock of a subsidiary. All new aspects of consolidations introduced in this chapter are the same whether the parent uses the cost of partial equity method. As in prior chapters, the complete equity method differs from the other two in that the beginning retained earnings of the parent always equals the beginning consolidated retained earnings under the complete equity method. Reciprocity entries, shown in the illustrations in this outline, are not needed under the equity method (partial or complete). I.

INTERCOMPANY BOND HOLDINGS An affiliate company may purchase bonds issued by another affiliate directly from the issuing company or from outsiders after the original issue. In either case, because the bonds are held within the affiliated group, the intercompany bond investment (a receivable) and the bonds payable (a liability), along with any related intercompany interest expense and interest revenue, must be eliminated. A.

ACCOUNTING FOR BONDS - A REVIEW 1.

Bonds are issued at a discount when proceeds are less than face value. The amortization of bond discount over the life of the bonds increases periodic interest expense.

Bonds are issued at a premium when proceeds are more than face value. The amortization of bond premium over the life of the bonds reduces periodic interest expense.

ACCOUNTING FOR BONDS ON BOOKS OF AFFILIATES 1.

The purchase of an affiliate’s bonds does not alter the accounting on the books of the individual companies. The purchase is recorded as if it were made from an independent party.

. C.

CONSTRUCTIVE GAIN OR LOSS ON INTERCOMPANY BOND HOLDINGS 1.

Computing the Constructive Gain or Loss a.

In the preparation of consolidated statement, the acquisition of an affiliate’s outstanding bonds from outsiders is considered a constructive retirement of the bond obligation by the consolidated entity.

The generally accepted practice of accounting for the early extinguishment of debt is to report an ordinary gain (loss) if the carrying value of the bonds is greater than (less than) the purchase price. Thus, as with the intercompany sale of inventory or other assets, the constructive gain or loss is eventually recognized both on the books of the individual companies and the consolidated financial statements but in different periods.

The gain or loss on the bond retirement is computed as the difference between the carrying value (book value) of the liability and the purchase price of the bonds. There is general agreement on the amount of the gain or loss to be reported, but not on how the gain or loss should be allocated between the affiliated companies involved in the bond transaction for purposes of calculating the controlling and noncontolling interests in consolidated net income.

Allocation of Constructive Gain or Loss Four methods for allocating the constructive gain or loss between the parent and subsidiary are supported in practice and in the accounting literature. a.

The constructive gain or loss is allocated entirely to the issuing company.

The constructive gain or loss is allocated entirely to the purchasing company.

The constructive gain or loss is allocated entirely to the parent company.

The constructive gain or loss is allocated between the purchasing and issuing companies. i. Probably the soundest method conceptually ii. Consistent with the allocation of gains or losses between parent and subsidiary on other types of intercompany transactions.

II. ILLUSTRATION OF ACCOUNTING FOR INTERCOMPANY BOND HOLDINGS On the date the bonds are purchased, a constructive gain or loss is computed and allocated between the purchasing and issuing companies. The portion allocated to the purchasing company is the difference between the cost of the bonds and their par value. The constructive gain or loss to the issuing company is the difference between the carrying value of the bonds purchased and their par value. A.

OVERVIEW OF CONSTRUCTIVE LOSS CALCULATIONS

Assume that P Co. purchases one $1,000 S Co. bond for $1,200. The carrying value of the bonds on S Co.’s books is $970. There is a $200 constructive loss to P Co., a $30 constructive loss to S Co., and a net constructive loss of $230 to the consolidated entity because the purchase price exceeded the carrying value of the debt ($1,200 - $970). If P Co., had purchased the bond for only $950, there would be a $50 constructive gain to P Co., the same $30 constructive loss to S Co., and a net consolidated gain of $20 since the purchase price ($950) was less than the carrying value ($970). B.

MECHANICS OF INTERCOMPANY BOND HOLDINGS

Assume that P Co. owns 80% of the common stock of S Co. The subsidiary issued $10,000 of 6%, ten-year bonds at 90 on January 1, 2008. Interest is payable January 1 and July 1. P Co. bought one-half these bonds at 120 on December 31, 2009.

S Co. booked the following entry when the bonds were issued:

Cash Discount on bonds payable Bonds payable 2.

9,000 1,000 10,000

At the end of 2008 and 2009, S Co. recorded the following entries for bond interest and discount amortization:

Bond interest expense .03(10,000) Bond interest payable

300

Bond interest expense (1,000  10) Discount on bonds payable

100

300

100

On December 31, 2009, P Co. would record the investment with the following entry: Investment in S Co. bonds 6,000 (1,200 x 5) Cash 6,000 4.

The net constructive gain or loss to be reported in the 2009 consolidated income statement, and the allocation to P Co. and S Co. is determined as follows:

S Co.: Book Value* Par Value

$4,600 $5,000

P Co.: Purchase Price $6,000 Par Value 5,000 Net Constructive Loss

Constructive Loss

$(400)

Constructive Loss

($1,000) $(1,400)

*($10,000 - $800) .50

(1)

(2)

(3)

The following December 31, 2009 workpaper entries are necessary:

Loss on constructive retirement of bonds Investment in S Co. bonds Loss on constructive retirement of bonds Discount of bonds payable Bonds payable Investment in S Co. bonds 6.

1,000 1,000 400 400 5,000 5,000

The 2010 interest expense, interest income, and amortization entries booked by the two companies would be as follows: S Co.

Bond interest expense Bond interest payable/cash Bond interest expense Discount on bonds payable P Co. Interest receivable/cash Interest income Interest income (1,000  8) Investment in S Co. bonds 7.

(1)

(2)

(3) (4)

600 100 100

300 300 125 125

Book balances of the related accounts at the end of 2010 would then be:

S Co. Bonds payable Discount on bonds payable Bond interest expense P Co. Investment in S Co. bonds Interest income 8.

600

10,000 700 700 5,875 175

The December 31, 2010 consolidated statements workpaper entries would be:

Retained earnings, 1/1—P Co. 1,000 Interest income Investment in S. Co. bonds Retained earnings, 1/1—P Co. .8(400) Retained earnings, 1/1—S Co. .2(400) Interest expense ½ (100) Discount on bonds Payable ½ (700)

125 875

320 80 50 350

Interest income 300 Interest expense Bonds payable 5,000 Investment in S Co. bonds

300 5,000

SUMMARY OF INTERCOMPANY BOND HOLDINGS IN ABOVE ILLUSTRATION

Each year $175 of the loss is effectively recognized on the books of the two companies. S Co. debits interest expense for $50 for the related discount amortization on one-half of the bonds and P Co. debits interest income for $125 for the amortization of the bond investment. After eight years all the loss will have been recognized in the books of the affiliated companies (8 x 175 = 1,400). The bonds payable and the investment account will both be at par and will be eliminated on the books when the bonds are actually retired by S Co.

EFFECT ON CONSOLIDATED NET INCOME OF GAIN OR LOSS ON CONSTRUCTIVE BOND RETIREMENT 1.

Referring to the bond purchase illustrated in part B and assuming that P Co. reported net income of $100,00 and S Co. reported net income of $20,000 and distributed $5,000 of dividends, consolidated net income for 2010 would be calculated as follows:

Reported net income of P Co. Less: Dividend income .8(5,000) Net income from independent Operations Less: Constructive loss not Recorded by P Co. P Co.’s contribution to Consolidated net income

$100,000 4,000 $ 96,000 1,000 $ 95,000

Reported net income of S Co. $20,000 Less: Constructive loss not recorded by S Co. 400 S Co.’s contribution to consolidated net income $19,600 P Co.’s share of subsidiary income x .8 Controlling interest in consolidated net income

15,680 $110,680

Noncontrolling interest in consolidated net income ($19,600 x .2) Total consolidated net income

$ 3,920 $ 114,600

The effect of the constructive loss would have to be considered in the following years, too. For example, assume that in 2010 both P Co. and S Co. reported the same net income and dividends. Consolidated net income for 2010 would be calculated as follows:

Reported net income of P Co. Less: Dividend income Net income from independent operations Add: Constructive loss realized by P Co. by premium amortization (1,000/8) P Co.’s contribution to consolidated net income

III.

$100,000 4,000 $ 96,000

125 $ 96,125

Reported net income of S Co. $20,000 Add: Constructive loss realized by discount amortization (400/8) 50 S Co.’s contribution to consolidated net income $20,050 P Co.’s share x .8 Controlling interest in consolidated net income

16,040 $112,165

Noncontrolling interest in consolidated net income ($20,050 x .2) Consolidated net income

4,010 $116,175

NOTE RECEIVABLE DISCOUNTED

Occasionally a company may issue a note to an affiliated company that may then discount the note with an outside party, or a company holding a note receivable from an outside party may discount the note again with an outside party. From a consolidation point of view, a receivable held by one of the affiliated companies should be reported in the consolidated balance sheet only if the note is due from an outside party. A contingent liability should be disclosed if a note has been discounted with an outside party and the endorsement was with recourse. . .

IV.

STOCK DIVIDENDS ISSUED BY SUBSIDIARY COMPANY A subsidiary may issue stock dividends in the same class of stock that is held by the parent company. A.

ACCOUNTING BY SUBSIDIARY

A subsidiary issuing stock dividends will charge retained earnings in the amount of par value of new shares issued if the dividend is larger than 20-25% of the outstanding shares. If the dividend is smaller than 20-25% of the outstanding shares, retained earnings will be charged in the amount of the current market value of the new shares issued. B.

ACCOUNTING BY PARENT

The parent company receiving the new shares will make a memo entry only. No income is recognized and the percentage of control remains the same. In consolidation, the entry the subsidiary made will be partially reversed on the workpaper. C.

DIVIDENDS FROM PREACQUISITION EARNINGS If the stock dividend exceeds subsidiary retained earnings at the date of acquisition, some of the postacquisition earnings of the subsidiary would have been capitalized. The capitalization of current earnings does not affect consolidated retained earnings, but it does result in the inclusion of earnings in consolidated retained earnings balance that have been capitalized and are not available for the payment of dividends. The amount of the subsidiary’s postacquistion earnings should be disclosed in the consolidated financial statements.

SUBSIDIARY WITH BOTH COMMON AND PREFERRED STOCK OUTSTANDING A.

DETERMINATION OF CONTROLLING INTEREST

A subsidiary may have both common and preferred stock outstanding. A parent must hold a controlling interest in the subsidiary’s common stock in order to justify consolidation. A parent may own some or all of the subsidiary preferred stock. Whatever preferred stock is not owned by the parent is part of

the noncontrolling interest. For example, if P Co. owns 60% of S Co.’s common stock only, 100% of any S Co. preferred stock is noncontrolling interest. B. DETERMINING EQUITY INTEREST OF EACH CLASS OF STOCKHOLDERS If a subsidiary has both common and preferred stock outstanding, equities must be allocated to the two interests depending on the rights of the preferred stock. 1. If the preferred stock is cumulative and nonparticipating, retained earnings equal to any passed preferred dividends must be allocated to the preferred stock and the rest of retained earnings must be allocated to the common stock,. Income equal to the current preferred dividend must be allocated to the preferred stock and the rest of the income must be allocated to the common stock. 2. If the preferred stock is noncumulative, any passed dividends are lost to the preferred stock interest. 3. If the preferred stock is participating, both the preferred stock interest and the common stock interest may share in retained earnings and income in excess of stated preferred dividend rates.

WORKPAPER MECHANICS 1.

If the parent company has an investment in both preferred stock and common stock of a subsidiary, workpaper mechanics are similar to those illustrated earlier. The only difference is that an additional entry must now be made to eliminate the preferred stock investment account.

Illustration: Year 2008

Assume that on January 1, 2008, S Co. had the following capitalization: Preferred stock, 6%, $100 par. Cumulative and non-participating (no dividends in arrears) $100,000 Common stock, $100 par 200,000 Retained earnings 50,000 On that date, P Co. bought 200 shares (20%) of the preferred stock for $21,000 and 1,800 shares (90%) of the common stock for $225,000. During 2008, S Co. earned $3,000 of net income and distributed no dividends. a.

(1)

(2)

Investment in S Co. Preferred stock Cash Investment in S Co. Common stock Cash b.

(1)

In 2008, P Co. would record only the purchase of the two holdings:

21,000 21,000 225,000 225,000

At December 31, 2008, the following consolidated statements workpaper entries would be made:

Preferred stock S Co. Other contributed Capital – P Co. Nocontrolling interest Investment in S Co. Preferred stock Noncontrolling interest

100,000 1,000 4,000 21,000 84,000

There is an excess of implied over book value of $5,000 as calculated below:

Paid Book value .2(100,000) Excess of cost over Book value

$21,000 20,000 $ 1,000/.20 = $5,000

If the excess of implied over book value pertained to an investment in common stock, it would be allocated to specific tangible and intangible assets and amortized on the consolidated statements workpaper, as illustrated in previous chapters (or reviewed for impairment periodically, in the case of goodwill or intangible assets with indefinite lives). In the case of preferred stock purchases, however, the excess of cost over book value is generally accounted for as an equity item and is debited to other contributed capital. (2)

Common stock – S Co. Retained earnings, 1/1—S Co. Investment in S Co. Common stock Noncontrolling interest c.

Preferred Common

200,000 50,000 225,000 25,000

Noncontrolling interest in 2008 consolidated net income would be as calculated below: Income Allocation $6,000 (3,000) $3,000

Noncontrolling Interest % 80% 10%

Noncontrolling Interest In Income $4,800 (300) $4,500

d. Assuming that P Co. earned $50,000 of net income in its independent operations, controlling interest in consolidated net income would be calculated as follows: P Co.’s income from Independent operations P Co.’s share of S Co. income Preferred interest .2(6,000) $1,200 Common interest .9(-3,000) -2,700 Controlling interest in consolidated 2008 net Income

$50,000

-1,500 $48,500

3. Illustration: year 2009 a.

(1) (2)

Cash .2(12,000) Dividend income Cash .9(4,000) Dividend income b.

(1)

In 2009, S Co. made $20,000 of net income and distributed $16,000 of dividends. Under the cost methods, P Co. would book the following entries: 2,400 2,400 3,600 3,600

The December 31, 2009 consolidated statements workpaper entries would be:

Investment in S Co.’s Preferred stock 1,200 Retained earnings, 1/1-P Co.

1,200

This entry establishes reciprocity at the beginning of the year for the passed dividend in 2008. (2)

(3)

Dividend income Dividends declared –S Co.

2,400

Preferred stock – S Co. Retained earnings, 1/1 – S Co. Other contributed Capital – P Co. Noncontrolling interest Investment is in S Co. Preferred stock Noncontrolling interest

100,000

2,400

6,000 1,000 4,000 22,200 88,800

Note that $6,000 of beginning subsidiary retained earnings was allocated to the preferred stock because of the passed dividend in 2008. Note also that the $1,000 adjustment for excess cost over book value will be made each year on the workpaper. (4)

Retained earnings, 1/1-P Co. .9(6,000 – 3,000) Investment in S Co. Common stock

2,700 2,700

This entry establishes reciprocity at the beginning of the year. Again, as far as the common stockholders are concerned, their interest decreased in 2008 because subsidiary income was less than the cumulative dividend that accrues to the preferred stock. (5)

(6)

Dividend income 3,600 Dividends declared—S Co. Common stock – S Co. Retained earnings, 1/1— S Co. (53,000 – 6,000) Investment in S Co. Common stock Noncontrolling interest

3,600

200,000 47,000 222,300 24,700

Note that the beginning retained earnings is reduced by the passed cumulative dividend which was allocated on the workpaper to the preferred interest.

Noncontrolling interest in 2009 income would be .8(6,000) + .1(20,000 – 6,000) or $6,200. Again assuming that P Co. made $50,000 of net income from independent operations, controlling interest in consolidated 2009 net income would be 50,000 + .2(6,000) + .9(20,000 – 6,000) or $63,800.

CHAPTER 10 ANSWERS TO QUESTIONS 1. Extension of payment periods. The debtor continues to manage the business, and the creditors merely extend the payment due date(s) for existing debts. Composition agreements. A composition agreement is an agreement between the debtor company and its creditors under which the creditors agree to accept less than the full amount of their claims. Formation of a creditor’s committee. The debtor company and its creditors agree to form a committee of creditors responsible for managing the debtor’s business affairs for the period during which plans are developed to rehabilitate, reorganize, or liquidate the business. Voluntary assignment of assets. An insolvent debtor elects to voluntarily place his property under the control of a trustee for the benefit of his creditors. 2. In a voluntary petition, the debtor files a petition with a bankruptcy court for liquidation under Chapter 7 or for reorganization under Chapter 11. The bankruptcy judge may refuse a voluntary petition if refusal is considered to be in the best interest of the creditors. In an involuntary petition, creditors initiate the action by filing a petition for liquidation or reorganization with the bankruptcy court. If there are twelve or more creditors, the petition must be signed by three or more of such creditors whose claims aggregate at least $5,000 more than the value of any liens on the property of the debtor. If there are fewer than twelve creditors, the petition may be filed by one or more of such creditors whose claims aggregate at least $5,000 more than the value of any liens on the debtor’s property. 3. Fully secured claims. Those claims with liens against specific assets whose realizable value is equal to or in excess of the claim. Partially secured claims. Those claims with liens against specific assets whose realizable value is less than the amount of the claim. Unsecured claims. Those claims that are not secured by liens against specific assets and are, therefore, paid from whatever total money remains after secured creditors are satisfied. Some unsecured claims take priority over others under federal bankruptcy law.

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4. The five categories of unsecured claims with priority are: a. Administrative expenses, fees, and charges incurred in administering the bankrupt’s estate. b. Unsecured claims for wages, salaries, or commissions earned by an employee within 90 days before the date of filing a petition in bankruptcy, limited to the extent of $4,650 per employee. c. Claims for contributions to employee benefit plans from services rendered within 180 days before the date of filing a petition in bankruptcy, but subject to certain limitations. d. Unsecured claims of individuals, to the extent of $2,100 for each such individual, arising from the deposit of money in connection with the purchase, lease, or rental of property or services that were not delivered or performed. e. Claims of governmental units for unpaid taxes. 5. Dividends represent the final distribution made to general unsecured creditors. 6. a. Transfer of Assets: The transfer of assets by a debtor to a creditor generally produces two types of gain or loss. A gain on restructuring of debt is recognized for the excess of the carrying value of the payable over the fair value of the assets transferred. This gain is reported as a component of operating income. In addition, a gain or loss on transfer of assets is recognized for the difference between the fair value and book value of the assets transferred. This gain (loss) is reported as a component of operating income also. b. Grant of an Equity Interest: A debtor who grants an equity interest to a creditor will report a gain for the difference between the fair value of the equity interest issued and the carrying amount of the payable settled. c. Modification of Terms: In a modification of terms, the debtor will report a gain on restructuring only if the total future cash payments specified by the new terms are less than the carrying value of the payable. The amount of gain is measure as the difference between the total future cash payments specified by the new terms and the carrying value of the payable. 7. The statement of affairs is an accounting report that is designed to permit interested parties to determine the total expected amounts that could be realized from the disposition of a company’s assets, the priorities in the use of the realization proceeds in satisfying claims, and the potential net deficiency that would result if the assets were realized and claims liquidated. 8. The officer is incorrect. Some claims, such as for taxes, fines, and penalties are not discharged.

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9. The primary duties of a trustee are: a. To be accountable of all property received. b. To examine proofs of claims and object to the allowance of any claim that is improper. c. To furnish such information concerning the estate and the estate’s administration as is requested by a party in interest. d. If the business of the debtor is authorized to be operated, file with the court and with any governmental unit charged with responsibility for collection of any tax arising out of such operation, periodic reports and summaries of the operation of the business. e. If the debtor has not done so, file with the court a list of creditors, a schedule of assets and liabilities, and a statement of the debtor’s financial affairs. f. If applicable, file a plan of reorganization, and, if the plan is accepted, file such reports as are required by the court. 10. The purpose of a combining workpaper is to serve as a means by which the trustee’s accounts are united with the debtor company’s accounts in order to prepare appropriate financial statements. 11. The purpose of a realization and liquidation account is to report summary realization and distribution activities of a trustee or receiver to the court. It reports the changes that have occurred during a period in the monetary items because that is what the court officials are primarily interested in. BUSINESS ETHICS SOLUTIONS 1. In chapter 7 bankruptcy liquidation, firms are assumed to be past the stage of reorganization and must sell off any un-exempt assets to pay creditors. In contrast, Chapter 11 bankruptcy allows the firm the opportunity to reorganize its debt and to try to re-emerge as a healthy organization. In both cases, the creditors and other claim-holders suffer losses as they will be most likely getting less return on investment than expected at the time of the initial decision to invest in the company. From an ethical perspective, a chapter 11 bankruptcy provides the creditors and other claim-holders a better chance of recovering higher value for their investments than under chapter 7 as the firm strives to recover and reorganize under chapter 11 but not under chapter 7. 2. The new law makes sweeping changes to American bankruptcy laws and makes it more difficult for individuals to file bankruptcy under chapter 7. The new law requires a means test to determine whether the borrowers have enough resources to pay for their debts. For additional information, see the following link: http://en.wikipedia.org/wiki/Bankruptcy_Abuse_Prevention_and_Consumer_Protection_Act]

In addition the new law laid down the following requirements • Mandatory credit counseling and debtor education • Additional filing requirements and fees • Increased attorney liability and costs • Fewer automatic protections for filers • Increased compliance requirements for small businesses • Increased amount of debt repayment under Chapter 13 • Increased length of time between discharges

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These changes provide more safety for the creditors, who should consequently be better protected. Individuals who fail the means test may opt instead for Chapter 13, which involves a repayment of their debt over time. 3. Applying this test to businesses would benefit the creditors and other claim-holders, as they would feel a slight buffer to their risk, which might stimulate new business as a result of easier fund raising. It may also prevent businesses from venturing into unduly risky areas as they would not be able to bail out as easily by filing under chapter 7 if things went wrong (hence becoming somewhat more risk averse). It would seem to shift the risk balance somewhat to the shoulders of the entrepreneur from those of the investor. 4. Filing for bankruptcy is never a desirable or ethical option, but sometimes circumstances may arise that seem to force a business or an individual into this tough situation. Whether the individual finds another way at such a time or not is a personal issue and an ethical dilemma, and there is not necessarily a correct answer to this question. The purpose of this discussion is to get the student to thinking about his or her personal position, and where his ethical stance would be before the situation arises. Ideally, of course, the student will never find himself or herself in such a position, but, as the old saying goes, until you’ve walked a mile in another’s shoes…

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ANSWERS TO FINANCIAL STATEMENT ANALYSIS EXERCISES AFS10-1 Circuit City versus Best Buy The z-score is defined as: Z = 1.2x1 +1.4x2 + 3.3x3+ 0.6x4 + 0.999x5, where x1 = (current assets less current liabilities)/total assets x2 = retained earnings/total assets x3= earnings before interest and taxes/total assets x4 = market value of equity/total liabilities x5 = sales/total assets For Circuit City and Best Buy, the z-scores are plotted as follows from 2000 to 2007.

The bankruptcy prediction model show both companies well above the cut-off for bankruptcy. However, the trend over the last three years reveals both companies’ numbers to be declining, with the numbers for Circuit City declining at a faster rate. The ratio analysis (shown on the next two pages) provides important differences between the two companies. Most of Best Buy’s profitability ratios (ROE and ROA) have been increasing (ROA went from 9.6% to 11%), while Circuit City’s ratios have been declining (ROA went from 3.4% to a negative 8.5%). Best Buy’s profit margin remained fairly stable, hovering between 3 and 4%. Best Buy’s profit margin decreased from 1.2% to a negative 2.7%. Both companies generated more sales per dollar of assets (asset turnover increased). Best Buy generated positive cash from operation (CFO) in every year (which also averaged around 5% of sales) while Circuit City’s CFO was negative in 2007. Coupled with a negative net income and with CFO becoming negative, Circuit City’s future is in question as of the end of 2007.

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ROE Best Buy

2007 2006 2005

31.1% 22.1% 21.7%

ROA 2007 2006 2005

Leverage 2007 2.820 2006 2.176 2005 2.257

11.0% 10.1% 9.6%

Profit Margin 2007 3.5% 2006 3.8% 2005 3.7%

Asset Turnover 2007 3.137 2006 2.648 2005 2.600

Asset/MV 2007 0.722 2006 0.607 2005 0.454

Profit Margin 2007 3.5% 2006 3.8% 2005 3.7%

NI/CFO 2007 0.695 2006 0.781 2005 0.673

MV/BV 2007 3.903 2006 3.583 2005 4.970

Asset turnover 2007 3.137 2006 2.648 2005 2.600

CFO/Sales 2007 5.1% 2006 4.9% 2005 5.5%

Sales/WC 2007 69.848 2006 12.926 2005 15.992

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WC/Assets 2007 4.5% 2006 20.5% 2005 16.3%

ROE Circuit City

2007 2006 2005

-21.3% -0.5% 7.1%

ROA 2007 2006 2005

Leverage 2007 2.492 2006 2.237 2005 2.082

-8.5% -0.2% 3.4%

Profit Margin 2007 -2.7% 2006 -0.1% 2005 1.2%

Asset Turnover 2007 3.135 2006 3.102 2005 2.850

Asset/MV 2007 5.019 2006 1.236 2005 0.969

Profit Margin 2007 -2.7% 2006 -0.1% 2005 1.2%

NI/CFO 2007 7.011 2006 (0.026) 2005 0.383

MV/BV 2007 0.497 2006 1.811 2005 2.149

Asset turnover 2007 3.135 2006 3.102 2005 2.850

CFO/Sales 2007 -0.4% 2006 2.5% 2005 3.1%

Sales/WC 2007 14.081 2006 10.628 2005 9.577

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WC/Assets 2007 22.3% 2006 29.2% 2005 29.8%

AFS10-2 Blockbuster versus Netflix The z-score is defined as: Z = 1.2x1 +1.4x2 + 3.3x3+ 0.6x4 + 0.999x5, where x1 = (current assets less current liabilities)/total assets x2 = retained earnings/total assets x3= earnings before interest and taxes/total assets x4 = market value of equity/total liabilities x5 = sales/total assets For Netflix and Blockbuster, the z-scores are plotted as follows from 2001 to 2009.

Netflix’s z-score, after a rather rocky start, has remained fairly constant since 2005. On the other hand, Blockbuster’s z-score, which had been fairly constant from 2001 to 2008, took a dramatic drop in 2009. The dramatic drop was caused primarily because retained earnings decreased by $500 million and total assets decreased by $600 million. This case also illustrates the dangers from using ratio analysis when a company’s financial performance is decreasing. Notice that Blockbusters ROE went from a negative 174.6% to a positive 177.6%. This change would indicate a significant improvement, but it is an artifact of the computations. Both earnings and equity turned negative in 2009, resulting in the ROE computation becoming positive. ROE should not be used as a performance measure in cases similar to this one. For Blockbuster, both ROA and the profit margin percentage are becoming increasingly negative. CFO is still positive but only at approximately 1% of sales. Despite the fact that the asset turnover has been increasing for Blockbuster, they have not been able to generate significant amounts of income or cash flows. The future of Blockbuster is not clear. The ratios for Netflix, on the other hand, indicate either improving or constant performance over time. ROE, ROA, and the profit margin percentage have increased over the last three years. The profit margin percentage in 2009 was almost 7%. Netflix is generating CFO equal to approximately 20% of sales (with sales increasing over time). 10 - 8

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ROE Blockbuster

2009 2008 2007

177.6% -174.6% -11.3%

ROA 2009 2008 2007

Leverage 2009 -4.894 2008 10.054 2007 4.169

-36.3% -17.4% -2.7%

Profit Margin 2009 -13.7% 2008 -7.1% 2007 -1.3%

Asset Turnover 2009 2.641 2008 2.454 2007 2.018

Asset/MV 2009 12.357 2008 10.833 2007 3.795

Profit Margin 2009 -13.7% 2008 -7.1% 2007 -1.3%

NI/CFO 2009 (19.051) 2008 (7.335) 2007 1.313

MV/BV 2009 -0.396 2008 0.928 2007 1.099

Asset turnover 2009 2.641 2008 2.454 2007 2.018

CFO/Sales 2009 0.7% 2008 1.0% 2007 -1.0%

Sales/WC 2009 32.447 2008 1,016.904 2007 179.720

10 - 10

WC/Assets 2009 8.1% 2008 0.2% 2007 1.1%

ROE Netflix

2009 2008 2007

58.2% 23.9% 15.5%

ROA 2009 2008 2007

Leverage 2009 3.413 2008 1.780 2007 1.502

17.0% 13.4% 10.3%

Profit Margin 2009 6.9% 2008 6.1% 2007 5.6%

Asset Turnover 2009 2.457 2008 2.219 2007 1.863

Asset/MV 2009 0.231 2008 0.351 2007 0.374

Profit Margin 2009 6.9% 2008 6.1% 2007 5.6%

NI/CFO 2009 0.356 2008 0.292 2007 0.241

MV/BV 2009 14.783 2008 5.068 2007 4.012

Asset turnover 2009 2.457 2008 2.219 2007 1.863

CFO/Sales 2009 19.5% 2008 20.7% 2007 23.0%

Sales/WC 2009 9.046 2008 9.428 2007 5.910

10 - 11

WC/Assets 2009 27.2% 2008 23.5% 2007 31.5%

ANSWERS TO EXERCISES Exercise 10-1 1. a 2. b 3. a

4. c 5. b

10 - 12

Exercise 10-2 1. False

Insolvency is the inability to pay debts as they become due. Classification as to current and long-term is irrelevant.

2. True 3. True 4. False

Secured creditors are paid first from the proceeds of sale of specific assets. If there are proceeds remaining, unsecured creditors with priority will be paid before other unsecured creditors.

5. True 6. False

A gain on restructuring is measured by the excess of the carrying value of the payable settled over the fair value of the assets transferred.

7. False

Restructuring gains from troubled debt restructurings are reported by the debtor as a separate component of operating income.

8. False

The statement of affairs is a report that shows the estimated amount to be paid to each class of claim in the event of liquidation.

Exercise 10-3 Part A Copyright 50,000 Gain on Transfer of Assets 50,000 To revalue the copyright to its current fair value. [$95,000 – ($100,000 - $55,000)] Notes Payable Accrued Interest Payable Accumulated Amortization – Copyright Copyright ($100,000 + $50,000) Gain on Debt Restructuring

150,000 15,000 55,000 150,000 70,000

Part B The gain on transfer of assets ($50,000) should be reported as a separate component (assuming material in amount) of operating income; the gain on restructuring ($70,000) should also be reported as a separate component of operating income. Part C Loss on Transfer of Assets 15,000 Copyright 15,000 To revalue the copyright to its current fair value. [$30,000 – ($100,000 - $55,000)] Notes Payable Accrued Interest Payable Accumulated Amortization – Copyright Copyright ($100,000 - $15,000) Gain on Debt Restructuring ($165,000 - $30,000) 10 - 13

150,000 15,000 55,000 85,000 135,000

Exercise 10-4 Part A No gain should be recognized because the total future cash payments specified by the new terms of $1,144,250 ($995,000 carrying value plus 3 years’ interest at $49,750 per year) exceed the current carrying value of the debt, $995,000. Part B Note Payable Accrued Interest Payable Restructured Debt

900,000 95,000 995,000

Exercise 10-5 Part A A gain on restructuring should be recognized because the carrying value of the debt, $995,000, exceeds the total future cash payments specified by the new terms, $744,000 ($600,000 face value plus $144,000 interest). The gain of $251,000 should be reported as a separate component of operating income. Part B Notes Payable Accrued Interest Payable Restructured Debt Gain on Debt Restructuring

900,000 95,000

Part C Restructured Debt Cash

48,000

744,000 251,000

48,000

Exercise 10-6 Realizable Value of all Assets ($190,000 + $90,000 + $102,000) Allocated to: Fully secured creditors Partially secured creditors Unsecured creditors with priority Remainder available to general unsecured creditors Payment rate to general unsecured creditors (Including balance due to partially secured creditors) $171,000 / ($350,000 + ($120,000 - $90,000))

$382,000

(91,000) (90,000) (30,000) $171,000

45%

Realizable Value of Assets: Assets pledged to fully secured creditors Assets pledged to partially secured creditors Free assets Total realizable value

$190,000 90,000 102,000 $382,000

Amounts to be paid to: Fully secured creditors Partially secured creditors [$90,000 + .45($30,000)] Unsecured creditors with priority General unsecured creditors .45($350,000) Total

$ 91,000 103,500 30,000 157,500 $382,000

10 - 14

Exercise 10-7 BALL COMPANY Statement of Affairs June 30, 2012 Book Value

Realizable Value

Assets

Assets Pledged with Fully Secured Creditors: $180,000 Inventory $110,000 Note Payable 100,000

170,000

20,400 430,000

Assets Pledged with Partially Secured Creditors: Accounts Receivable 95,000 Note Payable 100,000 Free Assets Cash Property and Equipment Total Net Realizable Value Liabilities having Priority – Wages Net Free Assets

20,400 320,000 350,400 120,000 230,400

Estimated Deficiency to Unsecured Creditors $800,400

$120,000

Fully Secured Creditors: 100,000 Note Payable

$100,000

350,000

400,000 (269,600) $800,400

Partially Secured Creditors: Note Payable Accounts Receivable Unsecured Creditors: Accounts Payable

124,600 $355,000 Unsecured

Equities Liabilities Having Priority: $120,000 Accrued Wages

100,000

$ 10,000

$100,000 95,000

5,000

350,000

Stockholders’ Equity Common Stock Retained Earnings (deficit) $355,000

10 - 15

Exercise 10-7 (continued) BALL COMPANY Deficiency Account June 30, 2012 Estimated Losses: Accounts Receivable Inventory Property and Equipment

Estimated Gains: $ 75,000 Common Stock $ 400,000 70,000 Retained Earnings (269,600) 110,000 Estimated Deficiency to Unsecured Creditors 124,600 $255,000 $255,000

Exercise 10-8 Part A Retained Earnings Allowance for Uncollectibles ($48,700 - $40,000) Property and Equipment ($142,000 - $118,000) Goodwill To record the revaluation of assets

52,700 8,700 24,000 20,000

Common Stock - $20 par 200,000 Common Stock - $4 par ($4  10,000) 40,000 Reorganization Capital 160,000 To record the exchange of $20 par common stock for $4 par common stock. 10% Bonds Payable 130,000 Reorganization Capital 24,000 Common Stock (6,000 shares at $4 per share) 24,000 8% Bonds Payable 130,000 To record the exchange of 8% bonds and common stock for the 10% bonds. Reorganization Capital Retained Earnings ($81,300 + $52,700) To eliminate the deficit in retained earnings.

10 - 16

134,000 134,000

Exercise 10-8 (continued) Part B

CRANE COMPANY Balance Sheet December 31, 2012 Cash Accounts Receivable Less Allowance for Uncollectibles Inventory Property and Equipment ($142,000 - $24,000) Total Assets

$ 33,000 $ 52,500 12,500

40,000 71,000 118,000 $262,000

Accounts Payable 8% Bonds Payable, due 6/30/2016 Common Stock, $4 par, 16,000 shares Reorganization Capital ($160,000 – $24,000 - $134,000) Total Equities

$ 66,000 130,000 64,000 2,000 $262,000

Exercise 10-9 Cash Accounts Receivable (old) Inventory Property and Equipment Allowance for Uncollectibles (old) Accumulated Depreciation TRX Company – in Receivership ($939,400 – $16,000 - $211,500) To record the receipt of TRX Company assets.

26,700 130,400 191,900 590,400

Cash Accounts Receivable (new) Sales To record cash sales and sales on account.

31,500 264,500

Cash

319,000

16,000 211,500 711,900

296,000

Accounts Receivable (old) Accounts Receivable (new)

76,800 242,200

Purchases Accounts Payable (new) To record purchases on account.

127,500

TRX Company – in Receivership Accounts Payable (new) Operating Expenses Trustee Expenses Cash To record cash payments.

206,500 61,600 46,000 13,000

127,500

327,100

10 - 17

Exercise 10-9 (continued) Bad Debt Expense Depreciation Expense Allowance for Uncollectibles (old) Allowance for Uncollectibles (new) Accumulated Depreciation To record estimated bad debts and depreciation expense.

21,600 32,400

Allowance for Uncollectibles (old) Account Receivable (old) To write off uncollectible accounts.

21,000

Sales

296,000

13,000 8,600 32,400

21,000

Inventory ($191,900 - $149,700) Purchases Operating Expenses Trustee Expenses Bad Debt Expense Depreciation Expense Income Summary To close nominal accounts and to adjust inventory. Income Summary TRX Company – in Receivership To Close income summary account.

42,200 127,500 46,000 13,000 21,600 32,400 13,300

13,300 13,300

Reconciliation of Cost of Goods Sold: Beginning Inventory $191,900 Purchases 127,500 Subtotal 319,400 Ending Inventory (149,700) Cost of Goods Sold $169,700

10 - 18

10 - 19

Exercise 10-10 TRX COMPANY – IN RECEVERSHIP Combining Workpaper December 31, 2012 Trial Balance TRX Trustee Company

Adjustments and Eliminations Dr. Cr.

Combined Income Statement

Balance Sheet

Debits Cash ($26,700 + $31,500 + $319,000 - $327,100) Accounts Receivable (old) ($130,400 -$76,800$21,000) Accounts Receivable (new) Inventory Property and Equipment Purchases Operating Expenses Trustee Expenses Bad Debt Expense Depreciation Expense Cost of Goods Sold ($191,900 + $127,500 - $149,700) Your Name, Trustee Total

50,100 32,600

22,300 191,900 590,400 127,500 46,000 13,000 21,600 32,400

22,300 149,700 590,400

(1) 1,127,800

(1)

42,200

(1)

127,500 46,000 13,000 21,600 32,400 169,700

169,700

505,400 505,400

(2)

505,400 282,700

845,100

Credits Allowance for Uncollectibles: (Old) ($16,000+$13,000=$21,000) (New) Accumulated Depreciation Accounts Payable: (Old) (New) Capital Stock Retained Earnings (Deficit) Sales TRX Company-in Receivership Total

8,000 8,000 8,600 243,900

8,600 243,900 101,900 65,900 800,000 (396,500)

101,900 65,900 800,000 (396,500) 296,000 505,400 1,127,800

296,000 (2) 505,400

505,400 675,100

675,100

296,000 (13,300) 282,700

Net Income (1) To adjust inventory and set up cost of goods sold.

10 - 20

13,300 845,100

(2) To eliminate reciprocal accounts.

10 - 21

ANSWERS TO ASC (Accounting Standards Codification) EXERCISES ASC10-1 Presentation A sometimes-confusing aspect of the definition of current assets is the inclusion of prepaid items. Prepaid expenses are not usually converted into cash in the current period. How do GAAP rationalize this classification issue? Alternative 1: in the search menu, type ‘current assets.’ Narrow the search by clicking on presentation. Narrow the search again by clicking on balance sheet. Scroll through the results to find the answer. The third returned result provides the correct answer. Alternative 2: Step 1: Use the drop-down menus under the ‘Presentation’ general topic on the homepage and choose ‘210-Balance Sheet’; then under the second drop-down menu, choose ’10-overall’. Expand the table of contents. Step 2: Click on section 45 Other Presentation Matters. FASB ASC paragraph 210-10-45-2 states that prepaid expenses are not current assets in the sense that they will be converted into cash but in the sense that, if not paid in advance, they would require the use of current assets during the operating cycle. ASC10-2 Disclosure Must a firm separately disclose the cash flow pertaining to extraordinary items or discontinued items in operating activities? Step 1: Use the drop-down menus under the ‘Presentation’ general topic on the homepage and choose ‘230 Statement of Cash Flows’; then under the second drop-down menu, choose ’10-Overall.’ Step 2: There is no information to answer the question in the section 50 disclosure, so return to section 10 and expand the table of contents. Click on ‘Other Presentation Matters’ and scroll through the paragraphs FASB ASC paragraph 230-10-45-24 states that separate disclosure of cash flows pertaining to extraordinary items or discontinued operations reflected in those categories is not required. An entity that nevertheless chooses to report separately operating cash flows of discontinued operations shall do so consistently for all periods affected, which may include periods long after sale or liquidation of the operation. ASC10-3 Scope Must a defined pension plan that presents financial information in accordance with the provisions of topic 960 provide a statement of cash flows? Step 1: Use the drop-down menus under the ‘Industry’ general topic on the homepage and choose ‘96X-Plan Accounting’; then under the second drop-down menu, choose 960-Plan Accounting – Defined Benefit Pension Plan.’ In the third drop down menu choose ‘205 Presentation of Financial Statements.’ Step 2: The answer to the question cannot be found in section 15 Scope, so scroll through the ‘Other Presentation Matters’ paragraphs (960-205-45). FASB ASC paragraph 960-205-45-6 states that defined benefit pension plans that presents financial information in accordance with Topic 960 are not required to provide a statement of cash flows, but are encouraged to include a statement of cash flows if that statement would provide relevant information about the ability of the plan to meet future obligations. 10 - 22

ASC10-4 General List all the topics found in topic 400—Liabilities. (Hint: There are nine topics.) ASC 405-10 provides the overall guidance for liabilities. What is the overall objective of this section? Click on the general topic ‘Liabilities’. The nine topics are Topics 405 Liabilities, 410 Asset Retirement and Environmental Obligations, 420 Exit or Disposal Cost Obligations, 430 Deferred Revenue, 440 Commitments, 450 Contingencies, 460 Guarantees, 470 Debt, and 480 Distinguishing Liabilities from Equity. FASB ASC paragraph 405-10-05-2 states that this section does not contain any accounting guidance, but its purpose is to identify the locations in the Codification that provide guidance for liabilities. ASC10-5 Glossary What is a troubled debt restructuring? On the Codification homepage, click on ‘Master Glossary’ in the left-hand column. In the ‘glossary term quick find’ menu type ‘troubled debt restructuring’ and hit return.’ A troubled debt restructuring is a restructuring of a debt constitutes a troubled debt restructuring if the creditor for economic or legal reasons related to the debtor's financial difficulties grants a concession to the debtor that it would not otherwise consider.

ASC10-6 Presentation Describe fresh start accounting and the conditions under which it is acceptable under current GAAP. In the search box enter ‘fresh start accounting.’ The first returned result identifies the appropriate section in the Codification discussing fresh start accounting. Topic 852 discusses reorganization and the financial reporting requirements when entities emerge from Chapter 11 reorganization. FASB ASC 852-10-45-19 states that if the reorganization value of the assets of the emerging entity immediately before the date of confirmation is less than the total of all post-petition liabilities and allowed claims, and if holders of existing voting shares immediately before confirmation receive less than 50 percent of the voting shares of the emerging entity, the entity shall adopt fresh-start reporting upon its emergence from Chapter 11. If the above conditions are met, a new reporting entity is created and assets and liabilities should be recorded at their fair value.

10 - 23

ANSWERS TO PROBLEMS Problem 10-1 1.

Accounts Payable Cash ($71,600  .42) Gain on Restructuring of Debt

71,600

Allowance for Uncollectible Accounts Loss on Transfer of Assets Accounts Receivable ($92,000 - $69,000)

19,450 3,550

Accounts Payable Accounts Receivable Gain on Restructuring of Debt ($132,400 - $69,000)

132,400

30,072 41,528

23,000

69,000 63,400

Accrued Expenses Cash

14,620

Notes Payable Accrued Interest Payable Cash Restructured Debt Gain on Restructuring of Debt ($327,000 - $309,000)

300,000 27,000

14,620

9,000 300,000 18,000

Problem 10-2 Part A 1. Allowance for Uncollectibles Loss on Transfer of Assets Accounts Receivable ($71,450 - $51,000)

16,750 3,700 20,450

Accounts Payable Accounts Receivable Gain on Restructuring of Debt

69,000

Patents Gain on Transfer of Asset ($50,000 - $42,000)

8,000

Accounts Payable Patents Gain on Restructuring of Debt

54,000

Accrued Wages Cash

11,900

Accounts Payable ($142,700 - $69,000 - $54,000) Cash ( .6  $19,700) Gain on Restructuring of Debt

19,700

51,000 18,000 8,000 50,000 4,000 11,900

10 - 24

11,820 7,880

Problem 10-2 (continued) 4.

Notes Payable Accrued Interest Payable Restructured Debt – due 1/3/14

57,000 6,000 63,000

Total future cash payments: Principal Interest (6%  $63,000)  2 Total Carrying value No gain recognized 5.

$63,000 7,560 70,560 $63,000

Notes Payable Accrued Interest Payable Restructured Debt – due 1/3/15 Gain on Restructuring of Debt

54,400 11,900 52,000 14,300

Total future cash payments: Principal ($54,400 - $14,400) Interest (10%  $40,000)  3 Total Carrying value ($54,400 + $11,900) Gain on Restructuring 6.

Mortgage Note Payable Accrued Interest Payable Common Stock (100,000  $0.50) Paid-in Capital in Excess of Par Gain on Restructuring of Debt ($100,500 – (100,000  $.59)

80,000 20,500

Common Stock ($290,000 – (580,000  $.10) Retained Earnings Paid-in Capital in Excess of Par

232,000

Balance 1/2/12 Loss on transfer (1)

Balance

$40,000 12,000 52,000 66,300 $14,300

Retained Earnings 156,800 Gain on restructuring (1) 3,700 Gain on transfer (2) Gain on restructuring (2) Gain on restructuring (3) Gain on restructuring (5) Gain on restructuring (6) 66,820

10 - 25

50,000 9,000 41,500 66,820 165,180

18,000 8,000 4,000 7,880 14,300 41,500

Problem 10-2 (continued) Part B

SRP COMPANY Balance Sheet January 2, 2012 Cash ($32,200 - $11,900 - $11,820) Inventories Plant and Equipment Less Accumulated Depreciation Land Patents ($92,000 + $8,000 - $50,000) Total

$ 8,480 126,600 $322,000 180,700

Restructured Debt – Due 2012 Due 2012 Common Stock, $ .10 par value, 580,000 shares outstanding Paid-in Capital in Excess of Par Retained Earnings since Reorganization on 1/2/12 Total Part C 12/31/12 Interest Expense Interest Payable ($63,000  .06)

141,300 20,800 50,000 $347,180 $ 63,000 52,000 58,000 174,180 - 0 $347,180

3,780 3,780

No interest is accrued on the debt due in 2015 because all cash payments are reductions of the carrying value of the debt. 1/2/13 Interest Payable Cash

3,780 3,780

Restructured Debt Cash ($52,000  .10)

5,200 5,200

10 - 26

Problem 10-3 Part A PROST COMPANY Statement of Affairs December 31, 2012 Book Value

Assets Assets Pledged with Fully Secured Creditors: $140,000 Land $200,000 400,000 Plant and Equipment 205,000 $405,000 Mortgage Payable Accrued Interest

350,000 3,000

353,000

Realizable Value

$ 52,000

Assets Pledged with Partially Secured Creditors: 60,000 Notes Receivable * 57,500 76,000 Accounts Receivable 55,000 112,500 Notes Payable

2,500 4,000 43,000 60,000 51,000 12,000 10,000

225,000

Free Assets Cash Prepaid Expenses Inventories: Finished Goods (1) Work in Process (2) Raw Materials Investment in Stock Goodwill Total Net Realizable Value Liabilities having Priority – Accrued Wages Net Free Assets Estimated Deficiency to Unsecured Creditors

$858,500 * $60,000 - $2,500 = $57,500. **$220,000 + $112,500 - $182,165

10 - 27

2,500 4,000 47,515 84,150 18,000 19,000 - 0 227,165 45,000 182,165 150,335** $332,500

Problem 10-3 (continued) Book Value $ 45,000

350,000

225,000

220,000

380,000 (361,500) $858,500

Equities Liabilities Having Priority: Accrued Wages

Unsecured $ 45,000

Fully Secured Creditors: Mortgage Payable Accrued Interest Partially Secured Creditors: Bank Notes Payable Notes Receivable Accounts Receivable

350,000 3,000 $353,000 225,000 $57,500 55,000

112,500

Unsecured Creditors: Accounts Payable

$112,500

220,000

Stockholders’ Equity Capital Stock Retained Earnings $332,500

(1) $43,000  1.3 = $55,900  .85 = $47,515 (2) ($60,000 + $30,000)  1.10 = $99,000  .85 = $84,150 Deficiency Account December 31, 2012 Estimated Losses: Notes Receivable Accounts Receivable Inventory * Property and Equipment Goodwill Unrecorded Accrued Interest

Estimated Gains: $ 2,500 Land 21,000 Investment in Stock 4,335 Common Stock 195,000 Retained Earnings 10,000 Estimated Deficiency 3,000 to Unsecured Creditors $235,835

* ($47,515 + $84,150 + $18,000) – ($43,000 + $60,000 + $51,000) Part B Estimated dividend to be paid general unsecured creditors: Net free assets minus cash payment to complete work in process inventory Total amount owed unsecured creditors ($182,165 - $11,000)/$332,500 = 51.6%

10 - 28

$ 60,000 7,000 380,000 (361,500) 150,335 $235,835

Problem 10-4 BRAN COMPANY Jim Brown, Trustee Reconciliation and Liquidation Account June 30, 2012 to December 31, 2012 Assets to be Realized Receivables (old) Less: Allowance for Uncollectibles Inventory Plant and Equipment Less: Accumulated Depreciation

$ 45,000 6,000 215,000 70,000

Assets Acquired Receivables (new) Supplementary Charges Purchases Operating Expenses Trustee Expenses Loss on Sale of Equipment Liabilities Liquidated Accounts Payable (old) Accounts Payable (new) Liabilities Not Liquidated Accounts Payable (old) Accounts Payable (new) Net Gain (1)

Assets Realized Receivables (old) $ 39,000 Receivables (new) 104,000 Plant and Equipment 145,000 Assets Not Realized Receivables (new) Less: Allowance for Uncollectibles Inventory 100,000 Plant and Equipment * Less: Accumulated Depreciation 35,000 Supplementary Credits 47,000 Sales 2,000 Gain on Sale of Land 12,000 Liabilities to be Liquidated Accounts Payable (old) 110,000 30,000 Liabilities Incurred Accounts Payable (new) 35,000 5,000 3,000 $667,000

* ($215,000 - $14,000 - $50,000) = $151,000

10 - 29

$ 38,000 85,000 39,000

$ 15,000 2,000 151,000 55,000

13,000 75,000 96,000

130,000 11,000

145,000

35,000

$667,000

Problem 10-4 (continued)

Balance June 30 Sales Accounts Receivable (old) Accounts Receivable (new) Sale of Land and Equipment Balance 12/31 (1)

Cash 15,000 Accounts Payable (old) 30,000 Accounts Payable (new) 38,000 Operating Expenses 85,000 Trustee Expenses 38,000 17,000

Proof of Gain: Sales Cost of Sales ($104,000 + $35,000 - $75,000) Operating Expenses Trustee Expenses Bad Debts Expense Depreciation Expense Gain on Sale of Land Loss on Sale of Equipment Net Gain

10 - 30

$ 130,000 (64,000) (47,000) (2,000) (3,000) (10,000) 11,000 (12,000) $ 3,000

110,000 30,000 47,000 2,000

Problem 10-5 Part A

Trustee’s Books Cash Accounts Receivable (old) Inventory Property and Equipment Allowance for Uncollectibles (old) Accumulated Depreciation Plum Company – in Receivership ($252,750 - $3,750 - $36,825) To record the receipt of Plum Company’s assets.

4,500 15,000 142,650 90,600 3,750 36,825 212,175

Cash Accounts Receivable (new) Sales To record merchandise sales.

78,000 75,000

Cash

75,750

153,000

Accounts Receivable (old) Accounts Receivable (new) To record collection of accounts receivable.

11,250 64,500

Operating Expenses Trustee Expenses Cash To record cash expenses.

11,850 3,000

Bad Debt Expense Depreciation Expense Allowance for Uncollectibles (new) Accumulated Depreciation To record adjustment for bad debts and depreciation.

2,250 5,250

Allowance for Uncollectibles (old) Accounts Receivable (old) ($15,000 – $11,250) To write off uncollectible accounts.

3,750

14,850

2,250 5,250

3,750

Plum Company – in Receivership Cash To record payment of old accounts payable.

143,175

Cash Accumulated Depreciation ($36,825 + $5,250) Loss on Sale of Equipment Property and Equipment To record the sale of property and equipment.

43,500 42,075 5,025

10 - 31

143,175

90,600

Problem 10-5 (continued) Sales Plum Company – in Receivership Inventory Operating Expenses Trustee Expenses Bad Debt Expense Depreciation Expense Loss on Sale of Equipment To close income statement accounts.

153,000 17,025 142,650 11,850 3,000 2,250 5,250 5,025

Plum Company Books Allowance for Uncollectibles Accumulated Depreciation P. Smith, Trustee Cash Accounts Receivable Inventory Property and Equipment To record the transfer of assets to P. Smith.

3,750 36,825 212,175 4,500 15,000 142,650 90,600

Accounts Payable P. Smith, Trustee To record the payment of accounts payable by P. Smith.

143,175

Retained Earnings P. Smith, Trustee To record operating effects reported by P. Smith.

17,025

10 - 32

143,175

17,025

Problem 10-5 (continued) Part B

PLUM COMPANY – IN RECEVERSHIP Combining Workpaper For Five Months Ending October 31, 2012 Trial Balance PLUM Trustee Company

Adjustments and Eliminations Dr. Cr.

Combined Income Balance Statement Sheet

Debits Cash * Accounts Receivable (new) Inventory Operating Expenses Trustee Expense Bad Debt Expense Depreciation Expense Cost of Goods Sold Loss on Sale of Equipment P Smith, Trustee Total Debits

43,725 10,500 142,650 11,850 3,000 2,250 5,250

43,725 10,500 (1)

(1)

142,650 11,850 3,000 2,250 5,250 142,650 5,025

142,650

5,025 69,000 $ 224,250 $ 69,000

(2)

69,000 $ 170,025

$ 54,225

Credits Allowance for Uncollectibles: (New) Capital Stock Retained Earnings (Deficit) Sales Plum Company-in Receivership Total Credits Net Loss

2,250

2,250 135,000 (66,000)

135,000 (66,000) 153,000 (2) 69,000 69,000 $ 224,250 $ 69,000 $211,650

* $4,500 + $78,000 + $75,750 - $14,850 - $143,175 + $43,500 (1) To adjust inventory and set up cost of goods sold. (2) To eliminate reciprocal accounts.

10 - 34

153,000 $211,650

153,000 17,025 $ 170,025

(17,025) $ 54,225

Problem 10-6 PLUM COMPANY P. Smith, Trustee Realization and Liquidation Account June 1, 2012 to October 31, 2012 Assets to be Realized Accounts Receivable (old) Less: Allowance for Uncollectibles Inventory Plant and Equipment Less: Accumulated Depreciation

$15,000 3,750 90,600 36,825

Assets Acquired Accounts Receivable (new) Supplementary Charges Operating Expenses Trustee Expense Loss on Sale of Equipment *

Assets Realized Accounts Receivable (old) $ 11,250 Accounts Receivable (new) 142,650 Property and Equipment Less: Accumulated Depreciation 53,775 Assets Not Realized Accounts Receivable (new) Less: Allowance for Uncollectibles 75,000 Supplementary Credits 11,850 Sales 3,000 5,025 Liabilities to be Liquidated Accounts Payable

Liabilities Liquidated Accounts Payable

143,175 Net Loss $ 445,725

Opening Amount Sales Accounts Receivable Sale of Land and Equipment Balance 10/31

10 - 35

$90,600 42,075

48,525

10,500 2,250

8,250

153,000

143,175 17,025 $ 445,725

* ($90,600 - $42,075) - $43,500 = $5,025 Cash 4,500 Operating Expenses 78,000 Trustee Expense 75,750 Accounts Payable 43,500 43,725

$ 11,250 64,500

11,850 3,000 143,175

Problem 10-7 MINER COMPANY Statement of Affairs May 31, 2012 Book Value

Assets Assets Pledged with Fully Secured Creditors: $ 50,000 Notes Receivable $39,800 1,200 Accrued Interest Rec. 1,000 $ 40,800

119,000

13,200

6,000 61,000 60,000 1,100 8,500

Notes Payable Accrued Interest Pay.

40,000 800

Building Note Payable Accrued Interest Pay.

20,000 800

Realizable Value

40,800 75,000 20,800

$ 54,200

Assets Pledged with Partially Secured Creditors: Equipment 4,200 Note Payable 10,000 Free Assets Cash Accounts Receivable Inventory Prepaid Insurance Goodwill Total Net Realizable Value Liabilities having Priority – Wages Taxes Net Free Assets

6,000 50,000 30,000 400 - 0 140,600 6,000 2,400

Estimated Deficiency to Unsecured Creditors $ 320,000

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8,400 132,200 53,600 $ 185,800

Problem 10-7 (continued)

Book Value

Equities Liabilities Having Priority: $ 6,000 Accrued Wages 2,400 Taxes Payable

60,000 1,600

Fully Secured Creditors: Notes Payable Accrued Interest Payable

Partially Secured Creditors: 10,000 Note Payable Equipment

Unsecured $ 6,000 2,400

$ 8,400

60,000 1,600

61,600

10,000 4,200

Unsecured Creditors: 170,000 Accounts Payable 10,000 Notes Payable

110,000 ( 50,000) $ 320,000

Estimated Losses: Accounts Receivable Notes Receivable Inventory Buildings Equipment Prepaid Insurance Goodwill

5,800

170,000 10,000

Stockholders’ Equity Common Stock Retained Earnings (Deficit) $ 185,800

Deficiency Account May 31, 2012 Estimated Gains: $ 11,000 Common Stock 10,400 Retained Earnings 30,000 Estimated Deficiency to 44,000 Unsecured Creditors 9,000 700 8,500 $113,600

$ 110,000 (50,000) 53,600

$ 113,600

Estimated final dividend rate to unsecured creditors is: $132,200/$185,800 = 71.15%

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Problem 10-8 Part A DAVIS MANUFACTURING COMPANY Statement of Affairs March 31, 2012 Book Value

Assets Assets Pledged with Fully Secured Creditors: $ 115,500 Accounts Receivable * $ 88,500 Notes Payable 10,000 66,250 Investment in Stock 100,000 Note Payable $41,000 Accrued Interest Pay. 1,750 42,750

Realizable Value

$ 78,500

57,250

Assets Pledged with Partially Secured Creditors: 50,000 Note Receivable 35,000 Note Payable 45,000 Accrued Interest Payable 1,000 46,000 105,000 495,000

22,500 10,000 1,375 140,000 97,500 60,000 7,750 3,000 232,500

Land Buildings Mortgage Note Payable Accrued Interest Pay.

165,000 260,000 440,000 21,250

425,000 461,250

Free Assets Cash Note Receivable Accrued Interest on Notes Receivable Finished Goods Inventory (1) Work-in-Process Inventory (2) Raw Materials Inventory (3) Supplies Inventory Prepaid Expenses Equipment Total Net Realizable Value Liabilities having Priority – Wages $ 33,750 Taxes 5,250 Net Free Assets Estimated Deficiency to Unsecured Creditors

$ 1,406,375 * ($75,000 + ($40,500/3)) = $88,500.

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22,000 10,000 1,375 151,200 130,000 10,000 1,300 - 0 100,000 561,625 39,000 522,625 212,125 $ 734,750

Problem 10-8 (continued)

Book Value $

33,750 5,250

Equities Liabilities Having Priority: Wages Payable Payroll Taxes Payable

Unsecured $ 33,750 5,250

51,000 1,750

Fully Secured Creditors: Notes Payable Accrued Interest Payable

51,000 1,750

45,000 1,000

Partially Secured Creditors: Note Payable Accrued Interest Payable

45,000 1,000 46,000 35,000

11,000

440,000 21,250 461,250 425,000

36,250

Notes Receivable 440,000 21,250

Mortgage Note Payable Accrued Interest Payable Land and Buildings

587,500 100,000

469,000 (349,125) $1,406,375

Unsecured Creditors: Accounts Payable Notes Payable

587,500 100,000

Stockholders’ Equity Common stock Retained Earnings (Deficit) $ 734,750

(1) $140,000  1.20 = $168,000 - $16,800 = $151,200 (2) Estimated Selling Price Less: Estimated Completion Costs Other than Raw Materials Realizable Value

$145,000 15,000 $130,000

(3) $60,000 - $40,000 = $20,000  .50 = $10,000

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Problem 10-8 (continued) Part B

Estimated Losses: Cash Accounts Receivable Notes Receivable Inventory * Buildings Prepaid Expenses Equipment

Deficiency Account May 31, 2012 Estimated Gains: $ 500 Land 27,000 Investment in Stock 15,000 Common Stock 12,750 Retained Earnings 235,000 Estimated Deficiency to 3,000 Unsecured Creditors 132,500 $425,750

60,000 33,750 469,000 (349,125) 212,125 $ 425,750

* ($140,000 + $97,500 + $60,000 + $7,750) – ($151,200 + $130,000 + $10,000 + $1,300) Part C Estimated dividend rate per dollar of general unsecured liabilities: $522,625/$734,750 = 71.1%

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Chapter 10 CHAPTER TEN – INSOLVENCY – LIQUIDATION AND REORGANIZATION I. INSOLVENCY

II.

Definition Insolvency occurs when a debtor is unable to pay its obligations as they become due.

Possible courses of action for an insolvent business 1. The debtor and its creditors may enter into a contractual agreement, outside of formal bankruptcy proceedings; 2.

The debtor or its creditors may file a bankruptcy petition, after which the debtor is liquidated under Chapter 7 of the Bankruptcy Reform Act; or

The debtor or its creditors may file a petition for reorganization under Chapter 11 of the Bankruptcy Reform Act.

CONTRACTUAL AGREEMENTS A.

A business that is unable to pay its obligations as they mature may attempt to reach an accommodation with its creditors without recourse to legal action.

The debtor and its creditors meet and develop a voluntary agreement or plan for settlement of obligations. The possibilities generally include: 1.

An extension of payment periods: May be advantageous in the long run for the creditors.

Composition agreement: An agreement between the debtor and its creditors under which the creditors agree to accept less than the full amount to their claims. In addition, accrued interest is sometimes canceled or the interest rate lowered.

Formation of a creditors' committee: The debtor and its creditors may agree to the formation of a creditors' committee that is responsible for managing the debtor's business affairs for the period during which plans are developed to rehabilitate, reorganize, or liquidate the business.

A voluntary assignment of assets: A debtor may elect to place its property under the control of a trustee for the benefit of its creditors. The purpose of the assignment is to permit the trustee to sell the property and distribute the proceeds among the creditors. 1

Chapter 10

III.

BANKRUPTCY A.

Voluntary Petitions A debtor may file a voluntary petition with a bankruptcy court for liquidation under Chapter 7 or for reorganization under Chapter 11. Filing of a voluntary or involuntary petition constitutes an order for relief, which prohibits the start or continuation of legal action against the debtor by its creditors.

Involuntary Petitions Creditors initiate the action by filing a petition for liquidation or reorganization with the bankruptcy court. If there are 12 or more creditors, the petition must be signed by three or more of such creditors whose claims aggregate at least $13,475 more than the value of any liens on the property of the debtor. If there are fewer than 12 creditors, the petition may be filed by one or more of such creditors whose claims aggregate at least $10,000 more than the value of any liens on the debtor's property.

Secured and Unsecured Creditors Creditors are classified by law as secured or unsecured. Secured creditors are those whose claims are secured by liens or pledges of specific assets. Unsecured creditors are subject to the following order of priority: 1. 2.

5. 6.

Administration expenses, fees, and charges incurred in administering the bankrupt's estate. Unsecured claims for wages, salaries, or commissions earned by an employee within 90 days before the date of filing of the petition, but limited to the extent of $4,650 per employee. Unsecured claims for contributions to employee benefit plans from services rendered within 180 days before the date of the filing of the petition, but subject to certain limitations. Unsecured claims of individuals, to the extent of $2,100 for each such individual, arising from the deposit of money in connection with the purchase, lease, or rental of property or services that were not delivered or performed. Unsecured claims of governmental units for unpaid taxes. After all these priorities have been satisfied, any remaining unsecured creditors participate pro rata in any remaining realization proceeds.

IV. LIQUIDATION (CHAPTER 7) A.

In addition to a voluntary assignment of assets, which constitutes a liquidation without bankruptcy proceedings, a voluntary or involuntary petition for liquidation may be filed under Chapter 7 of the Reform Act. The duties of the trustee in liquidation are specified in the Reform Act. The trustee shall 2

Chapter 10

1. 2. 3. 4. 5. 6.

7. 8.

Collect and reduce to money the property of the estate. Account for all money and property received. Investigate the financial affairs of the debtor. Examine claims and disallow any that are improper. Furnish reasonable requests for information about the estate and its administration to parties of interest. Operate the business of the debtor during the liquidation period if authorized by the court, and file periodic reports and summaries of operations. Pay creditors as promptly as possible, giving due regard to secured claims and priorities. File a final report on the administration of the estate including a statement of receipts and disbursements.

REORGANIZATION UNDER THE REFORM ACT (CHAPTER 11) A.

Creditors of an insolvent debtor may believe that their long-range interests would be better served by rehabilitating or reorganizing the debtor than by having it liquidated. In such a case, the creditors and debtor may agree to a plan for reorganization without recourse to the judicial process by employing one or more of the contractual agreements discussed earlier in this chapter. Alternatively, the debtor or creditors may prefer to file with the bankruptcy court a petition for reorganization under Chapter 11 of the Reform Act.

The committee appointed by the court has the following powers and duties: 1.

2. 3.

5. 6.

Select and authorize the appointment of one or more attorneys, accountants, or other agents, to represent or perform services for the committee. Consult with the trustee or debtor concerning the administration of the case. Investigate the acts, conduct, assets, liabilities, and financial condition of the debtor, the operation of the debtor's business and the desirability of the continuance of such business, and any other matter relevant to the case or to the formulation of a plan. Participate in the formulation of a plan, advise those represented by the committee of the committee's recommendations as to any plan formulated, and collect and file with the court acceptances of a plan. Request the appointment of a trustee if a trustee has not previously been appointed in the case. Perform such other services as are in the interest of those represented. 3

Chapter 10 C.

The court may permit the debtor to maintain possession of its assets and conduct the affairs of the business, or it may appoint a trustee. If a trustee is appointed, his or her primary duties in reorganization are: 1. 2. 3. 4.

6. 7.

Accounting for Reorganizations – Troubled Debt Restructurings Standards followed in debt restructurings are contained in FASB ASC subtopic 310-40 (debt restructuring by creditors) and FASB ASC subtopic 470-60 (debt restructuring by debtors). The standards deal primarily with valuation problems, the recognition of gain or loss on restructuring, and general disclosure requirements. In general, these subtopics do not apply to bankruptcy cases where there is a general restatement of liabilities; they apply only when dealing with the individual creditors and debtors. Debt may be restructured in any one (or a combination) of the following methods: 1. 2. 3.

VI.

Be accountable for all property received. Examine claims and object to the allowance of any claim that is improper. Furnish such information concerning the estate and the estate's administration as is requested by a party in interest. If the business of the debtor is authorized to be operated, file with the court and with any governmental unit charged with responsibility for collection of any tax arising out of such operation, periodic reports and summaries of the operation of the business. If the debtor has not done so, file with the court a list of creditors, a schedule of assets and liabilities, and a statement of the debtor's financial affairs. File a plan of reorganization. After confirmation of a plan, file such reports as are required by the court.

The debtor may transfer assets in full settlement of the payable. The debtor may give an equity interest in its firm in full settlement of the payable. The creditor may modify terms of the payable.

TRUSTEE ACCOUNTING AND REPORTING A. A trustee is often appointed to temporarily manage debtor’s business. The trustee takes title to the debtor’s asses and is accountable to the court, the creditors, and to others. The trustee can use two techniques to account for time of management: 1. Use debtor’s accounting records – easiest, but often not best. 2. Open a new set of books – frequently used when the assets are to be realized and liabilities liquidated. This is the better approach because it will make it easier to distinguish between the assets and liabilities of

Chapter 10 the debtor that existed before the appointment of the trustee and those arising after his or her appointment. B. If the trustee chooses to use new books, then: 1. The assets are recorded at book values and the net credit to an account titled “In Receivership”. 2. No existing liabilities are recorded. 3. New liabilities are incurred, recorded, and paid. C. At year end, the books of the company must be combined with the books of the trustee, using a worksheet to arrive at the ending income(loss) for the year.

Chapter 10 VII.

REALIZATION AND LIQUIDATION ACCOUNT A. When a trustee is appointed to handle the affairs of a company in financial difficulty, the court expects to receive periodic reports summarizing the realization and distribution activities of the fiduciary. B. The legal form is called a Realization and Liquidation Account. The end result is similar to, but not the same, as a balance sheet. C. Bankruptcy prediction models can be used to assess the likelihood that a company may not continue as a going concern. The Altman’s Z-score bankruptcy model is a widely used model used to assess the likelihood of bankruptcy.

D. FASB issued an exposure draft in October, 2008, in an attempt to align with the guidance under IFRS in determining going concern issues. The Board decided to carry forward the going concern guidance from AU Section 341, subject to several modifications to align the guidance with IFRS. These modifications include: 1. AU Section 341 states that there is “a responsibility to evaluate whether there is a substantial doubt about the entity’s ability to continue as a going concern for a reasonable period of time, not to exceed one year beyond the date of the financial statements being audited.” IAS 1 requires that an entity considers “all available information about the future, which is at least, but is not limited to, twelve months from the end of the reporting period” when assessing whether the going concern assumption is appropriate. 2. Other modifications include using the wording in IAS 1 with respect to the type of information that should be considered in making the going concern assessment and requiring an entity to disclose when it does not present financial statements on a going concern basis.

Chapter 11 ANSWERS TO QUESTIONS 1.

There might be considerable training costs in switching to IFRS because U.S. investors and accountants will need to learn how to apply and interpret IFRS. The use of IFRS might also reduce the quality of financial reports and impede comparability as the IFRS GAAP allows more judgment by management. Managers may choose to use methods that make them look better. Finally, it is not clear who will handle the enforcement of the international rules and how violators might be punished.

Two major projects are revenue recognition and financial statement presentation. Currently, U.S. GAAP provides significant guidance for revenue recognition, specifically with regards to some industries. It is hoped that the joint effort can lead to a joint revenue recognition standard that might eliminate guidance required for different industries. A second joint project is the financial statement presentation project. This project would provide consistent presentation of the financial statement and eliminate alternative reporting options.

The interest in harmonizing international accounting standards is due to many factors. Currently, most countries have their own accounting standard setting bodies resulting in a divergence of accounting practices in the world. In addition, the application of principles varies. As international trade and cross-border financing increase, it is difficult to evaluate the financial status of firms. The divergent accounting standards reduce the efficiency of the capital markets.

The SEC has been reluctant to accept IAS because they are more general and often provide little guidance on applying the methods. The SEC believes that the efficiency of the US markets is partly due to the high level of reporting required in the US and that any reduction in this quality would result in less efficient markets. However, over the last several years, the international rules and the U.S. rules have been converging and many of the significant differences that existed in the past have been eliminate.

ADRs are classified as either sponsored or unsponsored. Unsponsored ADRs are becoming less popular. These occur when a bank offers a DR program without an agreement with the issuing non-US company. Sponsored programs require an exclusive agreement between a bank and the non-US company. There are four types of sponsored ADR programs: for firms not issuing capital there are Level I and Level II ADR programs, and for firms issuing capital, there are Level III and Rule 144 A programs.

In a 1998 report of the FASB regarding the future of international accounting, the FASB described its vision of a successful international accounting system. The FASB stated its belief that the worldwide use of a single set of accounting standards is desirable and eventually attainable, but that the ideal outcome will result from “pursuing the overall objective of increasing international compatibility while maintaining the highest quality accounting standards in the United States.” Over the last five years, the FASB has worked jointly with the IASB on issuing new standards and converging accounting standards.

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7. The FASB outlined the following four points: a. The FASB has a leadership role to play in the evolution of the international accounting system. b. The FASB is willing to commit the required resources needed to ensure high quality standards while increasing the convergence and quality of standards used in different nations until the ideal outcome is achieved. c. The FASB will participate in establishing a quality international accounting standard-setting structure and process. d. The FASB recognizes that structural and procedural changes to the FASB may result, as well as potential changes in its national role. 8. Some of the major differences between U.S. GAAP and IFRS are: a. LIFO is acceptable in the U.S. but not allowed under IFRS. b. IFRS requires that the parent and subsidiaries use the same accounting methods, while in the U.S. they can use alternative methods. c. R&D is expensed in the U.S. while only research is expensed under IFRS and development costs are capitalized and amortized over future years.

Business Ethics Business ethics solutions are merely suggestions of points to address. The objective is to raise the students' awareness of the topics, and to invite discussion. In most cases, there is clear room for disagreement or conflicting viewpoints. 1. The separation of duties is an important feature of maintaining adequate internal controls. In this case, the individual submitting invoices should not be the same individual that approves the invoices. It is appropriate for high level management to approve departures from normal procedures, but it is still necessary to have controls to address this case. 2. Unfortunately there are instances where ethics and compliance programs are designed for mid- and lower-level employees. This should not lead anyone to believe that upper-level managers are always ethical. 3. This is a very difficult issue for companies to balance. On one hand, the managers of these companies do not want stockholders and other users of the financial statements to have a mistaken belief concerning the issues at hand. If the information is not reliably disclosed, there might be an adverse impact on the firm’s stock price. But at the same time, they don’t want to appear to be hiding information. In this case, the users might believe that more significant issues are being withheld, and a negative stock price reaction might occur regardless.

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ANALYZING FINANCIAL STATEMENTS AFS11-1 Challenger Limited (Unconsolidated Subsidiary of Bronco Drilling Company Inc.) A. Sometimes foreign companies prepare their financial statements in U.S. dollars as a convenience to financial statement users. The best approach to determine the GAAP followed in preparing the financial statements is to read the footnote on significant accounting policies and determine the basis for the preparation of the financial statements. In footnote 2 (provided in the problem), the company discloses that that financial statements have been prepared in accordance with IFRS. B. One major difference on the balance sheet (between U.S. GAAP and IFRS) is the under IFRS, assets are listed in increasing order of liquidity (the most liquid asset is listed last). Because of this, the items included in current assets are listed in the reverse order from U.S. GAAP (they are listed as inventory is first, receivables are listed second, cash is listed last). A second difference is that the equity section is listed above liabilities. A third difference affects both non-current assets and equity. Under IFRS, firms may elect to revalue property, plant, and equipment (PPE) on a recurring basis. Thus PPE may no longer be reported using historical cost numbers. The offsetting adjustment on the balance sheet is an equity account called ‘revaluation reserve.’ The equity section on the Balance Sheet for Challenger Limited includes a revaluation reserve account so that the user knows that PPE valuations have changed (in this case net PPE has been increased by $15,414,422 over time). C. Evaluate the performance of Challenger using the Income Statement. First prepare a common size income statement and compute the growth in selected income statement items from 2007 to 2008.

Income Statement Drilling revenue Drilling costs Gross profit General & administrative expenses Other income Other expense Profit from operations Finance income Finance cost Profit before income tax Income tax Profit for the year

2008 73,071,917 (52,933,369) 20,138,548 (9,775,827) 2,446,433 (1,870,000) 10,939,154 46,015 (673,397) 10,311,772 (3,389,127) 6,922,645

2007 46,043,831 (34,309,267) 11,734,564 (8,021,383) 19,005 3,732,186 751,224 (559,662) 3,923,748 (2,307,594) 1,616,154

Common Size % 2008 2007 100.0% 100.0% -72.4% -74.5% 27.6% 25.5% -13.4% -17.4% 3.3% 0.0% -2.6% 15.0% 8.1% 0.1% 1.6% -0.9% -1.2% 14.1% 8.5% -4.6% -5.0% 9.5% 3.5%

Growth Rates 2007 to 2008 58.7% 54.3% 71.6% 21.9%

Sales grew by over 58%. In addition, the gross profit margin increased by over 2% indicating that sales grew faster than the costs of drilling. Despite the fact that general and administration expenses increased, the expense as a percentage of sales actually 11 - 3

193.1% -93.9% 20.3% 162.8% 46.9% 328.3%

decreased by3% from 2007 to 2008. Other income increased by 2.4 million, but other expenses also increased by 1.9 million (but this still resulted in a net increase of 0.5 million in pretax income). The profit margin percentage increased from 3.5% to 9.5%. AFS11-2 Challenger Limited (Unconsolidated Subsidiary of Bronco Drilling Company Inc.) A. Under the revaluation model, revaluations should be carried out regularly, so that the carrying amount of an asset does not differ materially from its fair value at the balance sheet date. [IAS 16.31] It is generally assumed that assets will need to be revalued at least every other year. B. The gross increase in PPE was $20,481,823, but the net increase in PPE (after adjusting accumulated depreciation) was an increase of $15,378,561. The journal entry to record the revaluation would be: Property, Plant, and Equipment (Gross) 20,481,823 Accumulated depreciation 5,103,262 Revaluation Reserve (stockholders’ equity) 15,378,561 Note that the correct balance sheet amount for the revaluation reserve for 2008 should be $16,782,544. Thus the change in the balance sheet amount for the valuation reserve should equal 15,378,561. Also note that an increase in the valuation reserve does not affect income, but only increases a stockholders’ equity account. C. Decreases in fair value in amounts greater than previously recorded increases must be included in operating income. The balance in the revaluation reserve account is $16,782,544 which represents the previously recorded increases. Because the net decrease in value is $17,500,000 (or 25,000,000 less 30% of 25,000,000), and expense must be recorded for the difference. The entry to record the decrease in value ignoring the previously recorded increases would be: Revaluation Reserve Accumulated depreciation (30% of 25,000,000) Loss from revaluation (Income Statement) Property, Plant, and Equipment

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16,782,544 7,500,000 717,456 25,000,000

EXERCISE 11-1 Component Depreciation LO2

The following entries would be recorded assuming either U.S. GAAP or IFRS is used. U.S. GAAP Asset

100,000 Cash

100,000

IFRS Building – Electrical systems Building – Roof Building – Other Bank/Liability

12,000 15,000 73,000 100,000

The entry to record depreciation expense would be: Part A: Depreciation expense U.S. GAAP Depreciation ($100,000/40) Accumulated Depreciation

2,500 2,500

Part B: Depreciation expense IFRS Depreciation Building – Electrical Systems (12,000/20) Depreciation Building – Roof (15,000/15) Depreciation Building – Other (73,000/40) Accumulated Depreciation – Building

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600 1,000 1,825 3,425

EXERCISE 11-2 Some examples from the webpage are: October 19, 2011 The IASB issued today an Interpretation clarifying the requirements for accounting for stripping costs in the production phase of a surface mine. The Interpretation was developed by the IFRS Interpretations Committee, the interpretative body of the IASB. The Interpretations Committee was asked to clarify when and how to account for stripping costs (the process of removing waste from a surface mine in order to gain access to mineral ore deposits) to address diversity in practice. The Interpretation clarifies when production stripping should lead to the recognition of an asset and how that asset should be measured, both initially and in subsequent periods. The Interpretation is effective for annual periods beginning on or after 1 January 2013 with earlier application permitted. August 25, 2011 The International Accounting Standards Board (IASB) published today proposals to define investment entities as a separate type of entity that would be exempt from the accounting requirements in IFRS 10 Consolidated Financial Statements. Investment entities are commonly understood to be entities that pool investments from a wide range of investors for investment purposes only. Currently, IFRS 10 Consolidated Financial Statementswould require consolidation if an investment entity controls an entity it is investing in. However, when developing IFRS 10, investors commented that this would not provide them with the information they need to assess the value of their investments. To address this issue, the exposure draft published today proposes criteria that would have to be met by an entity in order to qualify as an investment entity. These entities would be exempt from the consolidation requirements and instead would be required to account for all their investments at fair value through profit or loss. The exposure draft also includes disclosure requirements about the nature and type of these investments. September 22, 2009 The Trustees of the IASC Foundation, the oversight body of the International Accounting Standards Board (IASB), welcomed today’s statement by the Monitoring Board, a group of public capital market authorities to whom the IASC Foundation established a public accountability link. In its statement of principles, the Monitoring Board emphasised the relevance of providing high-quality financial information to ensure the confidence of capital providers in making investment decisions. The Monitoring Board also highlighted the importance of ‘independence and transparency in the standard setter’s due process.’ October 8, 2009 The International Accounting Standards Board (IASB) issued today an amendment to IAS 32 Financial Instruments: Presentation. The amendment addresses the accounting for rights issues (rights, options or warrants) that are denominated in a currency other than the functional currency of the issuer. Previously such rights issues were accounted for as derivative liabilities. However, the amendment issued today requires that, provided

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certain conditions are met, such rights issues are classified as equity regardless of the currency in which the exercise price is denominated. EXERCISE 11-3 IFAC is the global organization for the accountancy profession. It works with its 157 members and associates in 123 countries and jurisdictions to protect the public interest by encouraging high quality practices by the world's accountants. IFAC members and associates, which are primarily national professional accountancy bodies, represent 2.5 million accountants employed in public practice, industry and commerce, government, and academia. Through its independent standard-setting boards, IFAC develops international standards on ethics, auditing and assurance, education, and public sector accounting standards. It also issues guidance to support professional accountants in business, small and medium practices, and developing nations.

The webpage has changed since the textbook was written. In place of the ‘media center’ the webpage contains a section labeled ‘News and Events.’ One example from the webpage is: October 24, 2011 IESBA Proposes Changes to the Code of Ethics for Professional Accountants to Address a Breach of a Requirement in the Code The International Ethics Standards Board for Accountants (IESBA) today released for exposure Proposed Changes to the Code of Ethics for Professional Accountants Related to Provisions Addressing a Breach of a Requirement of the Code. The IESBA believes that any breach of a provision of the Code of Ethics for Professional Accountants (IESBA Code) should be treated as a matter of utmost importance. Therefore, the IESBA has proposed changes to the IESBA Code that will provide guidance to a professional accountant on the action to be taken in such situations. This includes a robust framework for addressing a breach of an independence requirement that will result in greater transparency. This Exposure Draft is the result of a project that commenced in 2010. The proposed changes to the IESBA Code include a requirement that a professional accountant take whatever actions that might be available as soon as possible to satisfactorily address the consequences of a breach of a provision of the Code. For a breach of an independence requirement in the IESBA Code, a detailed framework is provided setting out the action to be taken. Specifically, the proposed changes would require a firm to: • terminate, suspend, or eliminate the interest or relationship that caused the breach; • evaluate the significance of the breach and determine whether action can be taken to satisfactorily address the consequences of the breach; • communicate all breaches with those charged with governance and obtain their agreement with the proposed course of action; and • document the actions taken and all the matters discussed with those charged with governance and, if applicable, any relevant regulators.

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EXERCISE 11-5A IFRS Balance Sheet LO2 A. What order are assets listed on the balance sheet? The assets are listed in order of increasing liquidity. The most liquid asset is listed last (cash). B. Comment on other differences (IFRS relative to U.S. GAAP) that you might notice on the balance sheet. Liabilities and equity are also reversed using IFRS. Equity accounts are listed above the liability accounts. In addition, issued capital is commonly called common stock in the U.S. Treasury stock is usually the last item listed in stockholders’ equity, but that is not the case under IFRS. C. What is the current ratio for the year’s ending March 31, 2006 and 2007? 2006 Current ratio =

8,493 = 1.0497 8,091

2007 Current ratio =

8,434 = 1.0336 8,160

The current ratio has decreased slightly. D. What is the ratio of long-term debt to equity for the year’s ending March 31, 2006 and 2007? 2006 long-term debt to equity ratio =

7,826 = 0.9966 7,853

2007 long-term debt to equity ratio =

7,419 = 0.8820 8,412

2006 Non-current liabilities to equity ratio =

10,535 = 1.3415 7,853

2007 Non-current liabilities to equity ratio =

10,098 = 1.2004 8,412

Both ratios indicate a decreasing leverage ratio. E. Are there any typical balance sheet ratios that can’t be computed using the IFRS-based financial statement? No, all the same balance sheet ratios can be computed.

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ANSWERS TO ASC (Accounting Standards Codification) EXERCISES ASC11-1 Overview Are International Financial Reporting Standards (IFRS) issued by the International Accounting Standards Board (IASB) considered authoritative by the Codification? Alternative 1 Step 1: Use the drop-down menus under the ‘General Principles’ general topic on the homepage and choose ‘105-Generally Accepted Accounting Principles’; then using the second pull-down menu choose ’10 Overall’. Step 2: Click on the red ‘join all sections’ button. Scroll through the paragraphs for guidance on what is authoritative GAAP. Alternative 2 Step 1: in the search box, enter ‘IFRS.’ Step 2: One result is returned which does not address the issue. Re-enter in the search box ‘International Financial Reporting Standards’. The first returned result provides the correct location for the answer. FASB ASC sub-paragraph 105-10-05-3(d) states that International Financial Reporting Standards are nonauthoritative. ASC11-2 Presentation How does the Codification define a highly inflationary country? Step 1: Go to the master glossary and enter ‘highly inflationary.’ No definition is included in the glossary. Step 2: In the search box, enter ‘highly inflationary’. Eleven results are obtained. Click on the first returned result and scroll through the paragraphs. FASB ASC paragraph 830-10-45-11 states that a highly inflationary economy is one that has a cumulative inflation of approximately 100 percent or more over a 3-year period.

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PROBLEM 11-1 LO2 A. Are expenditures reported on BP’s income statement reported by function or by nature of the expense? Be specific. Do you think that this format is more or less useful for users of the financial statements? BP’s income statement lists expenses by nature. This can be determined by examining the expenses. Instead of listing cost of goods sold, the expenses are listed as purchases, production and manufacturing expenses, and depreciation expenses. B. On the BP income statement, what is the earnings from affiliates usually referred to in the U.S.? In the U.S., investments in affiliates are typically equity method investments where the investor owns between 20 and 50% of the outstanding stock. C. On ExxonMobil’s income statement, are the expenses listed by function or by nature? ExxonMobil’s income statement discloses expenses using a combination of function and nature. This can be determined by examining the expenses. Some expenses are listed by the function, such as selling, general and administration expense while other expenses such as manufacturing costs are expensed by nature (such as crude oil purchases, production and manufacturing expenses, and depreciation). D. Compare the performance of BP relative to ExxonMobil. Is it easy to compare the numbers from companies using IFRS to companies using U.S. GAAP? BP Total Revenues Profit for the year Profit/Revenues

2008 367,053 21,666 5.9%

2007 Growth 291,438 25.9% 21,169 2.3% 7.3%

ExxonMobil 2008 2007 477,359 404,552 45,220 40,610 9.5% 10.0%

18.0% 11.4%

Looking at the growth in revenues and the bottom line profit margin percentage (profit divided by revenues), ExxonMobil’s revenues grew at 18% resulting in an 11.4% growth in profits. BP’s revenues grew at almost 26%, which resulted in a modest 2.3% growth in net income. Because the two companies prepare the income statement prepared using either the nature or the function of the expenses, direct comparisons of certain items, such as gross margin, are more difficult without extensive reading of the footnotes. E. Does it matter that BP is using FIFO and ExxonMobil is using LIFO for inventory? The LIFO reserve decreased by $15.4 billion dollars in 2008. Because the LIFO reserve dropped, reported income using LIFO will exceed the amount of income reported using FIFO. The user would need to determine if the change in the LIFO reserve was caused by falling prices or merely a reduction in inventory levels. This can have a significant impact on how you might interpret the results of operations for ExxonMobil.

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PROBLEM 11-2 IFRS Income Statement and Terminology Differences LO2 A. On the income statement, the first two lines in Unilever’s income statement are Turnover and then Operating profit. What does the term ‘Turnover’ mean? Which costs are typically reported between ‘Turnover’ and operating profit? The term ‘turnover’ is a term that is used internationally to indicate revenues or sales. In the financial statement for Unilever, the income statement simply listed ‘turnover’ and then operating profit on the next line. If you examine the footnotes, you would see that expenses not listed as a line item on the income statement (items between sales and operating margin) include cost of sales, distribution and selling costs, and administration expenses. B. How useful is Unilever’s income statement presentation considering that this information about expenses is disclosed in footnote 3 rather than being reported on the face of the income statement? The answer to this question depends on whether you believe that important line items should be disclosed on the face of the income statement versus disclosing the detail in a footnote to the financial statements. If companies only delivered summary financial statements to the users, this detail (the amount of off-balance sheet payments) often might not be disclosed. Information concerning the change in gross margin provides useful information to users about the growth in inventory costs relative to the change in revenues.

PROBLEM 11-3 Illustrated Financial Statements No solution is provided for this problem.

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Problem 11-4

Financial Statement Presentation

BUSINESS Operating assets and liabilities Short-term Accounts Receivable Allowance for doubtful accounts Inventory Prepaid insurance Short-term assets Accounts Payable - trade Accrued interest payable Short-term liabilities

2011

2012

81,000 (12,000) 432,000 20,500 521,500 (163,000) (9,500)

75,500 (10,500) 469,000 18,000 552,000 (139,000) (14,000)

(172,500)

Long-term Plant & equipment Accumulated depreciation Net long-term assets Net operating assets Investing assets Long-term Investment (equity method) Investments (Trading securities) Net long-term assets Net business assets FINANCING Financing assets Short-term Cash Financing liabilities Short-term Dividend payable Short-term loan payable Short-term liabilities Long-term Bond payable (net) Net financing liabilities

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(153,000)

613,000 (100,000) 513,000

650,000 (105,000) 545,000

862,000

944,000

28,000 6,000 34,000 896,000

32,000 8,000 40,000 984,000

35,000

26,000

(20,000) (55,000) (75,000)

(16,000) (65,000) (81,000)

(85,000)

(133,000)

(125,000)

(188,000)

Problem 11-4 (continued) INCOME TAXES Short-term Income taxes payable Long-term Deferred tax liability Net income tax liability NET ASSETS EQUITY Common Stock & paid in capital Retained Earnings Less: Treasury Stock EQUITY

Accounts Payable - trade Dividend payable Accrued interest payable Income taxes payable Short-term loan payable Bond payable (net) Deferred taxes Common Stock ($2 par, 45,000 & 55,000 shares) Capital-in-excess-of-par Retained Earnings Less: Treasury stock Total Liabilities & Equity

(16,000)

(11,000)

(55,000) (71,000)

(38,000) (49,000)

700,000

747,000

220,000 500,000 (20,000) 700,000

258,000 524,000 (35,000) 747,000

$163,000 20,000 9,500 16,000 55,000 85,000 55,000

$139,000 16,000 14,000 11,000 65,000 133,000 38,000

90,000

110,000

130,000 500,000 (20,000) $1,103,500

148,000 524,000 (35,000) $1,163,000

The solution listed above is in agreement with the discussion paper issued by the FASB in October 2008. However, in a subsequent meeting (November 2009), the FASB changed some of the aspects of the draft. The following are the changes that the FASB proposed to the original discussion paper on October 2008. 1. Equity will no longer be a separate category, but will be included within the Financing Section. 2. Cash and short-term financial assets (or financial liabilities) used as a substitute for cash will be included in the business section (rather than reported in the financing section). See note at the end of the solutions manual regarding other changes made by the FASB.

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PROBLEM 11-5 Financial Statement Presentation –Statement of Comprehensive Income Statement of Comprehensive Income For the year ended 2011

BUSINESS Operating: Sales Cost of Goods Sold Total cost of goods sold Gross margin Selling Expenses: Bad debt expense Total selling expense General and administration Expenses: Wage expense Depreciation expense Other expense Total general and administration expense

$800,000 $350,000

350,000 450,000 18,000 18,000 90,000 40,000 12,000 142,000

Other operating expense (income) 10,000 (14,000)

Loss on sale of equipment Gain on bond retirement

Total other operating expense (income) Operating income Investing: Equity income Investment income Business Income FINANCING: Interest expense Financing expenses

(4,000) 294,000 7,000 7,000 301,000

36,000 36,000

INCOME TAXES: Income Tax Expense Net Income

106,000 159,000

OTHER COMPREHENSIVE INCOME: Unrealized loss on available for sale securities Total Comprehensive Income

(11,000) $148,000

Continued

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An acceptable alternative is to present the statement of comprehensive income as a separate statement immediately following the income statement, as follows: Statement of Comprehensive Income For the year ended 2011

Net Income

159,000

OTHER COMPREHENSIVE INCOME: Unrealized loss on available for sale securities Total Comprehensive Income

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(11,000) $148,000

PROBLEM 11-6 Operating and Capital Leases LO4 1. Under existing U.S. GAAP, what is the amount of lease liability recorded on the balance sheet at January 1, 2011? In the U.S., only the present value of capital leases is recorded as a liability. Therefore, $18,954 is the amount of the lease liability reported on the balance sheet. In addition, the capitalized amount of the leased asset would also be recorded in property, plant, and equipment. (This amount cannot be determined in this problem.) 2. If the proposed changes in accounting for leases become authoritative, what would be the amount of lease liability recorded on the balance sheet at January 1, 2011? The present value of both the capital lease payments and the operating lease payments would be recorded as liabilities on the balance sheet under the proposed new rules. Assuming that the operating lease has a lease term equal to its useful life, the present value of the operating lease (with a zero salvage value) would be equal to its fair value. Thus the total liability reported on the balance sheet would be $33,875 rather than $18,954 (or $18,954 + $14,921). 3. Which approach (part 1 or part 2) do you think provides more relevant information to the users of the financial statements? Most users believe that if the lease payments are non-cancelable that they represent fixed payments that the firm is obligated to pay. Thus they should be recorded on the balance sheet at the present value of the payments. On the other hand, users might not care if the information is adequately disclosed in the footnotes.

Professor Notes FASB Financial Statement Presentation The solution listed above is in agreement with the discussion paper issued by the FASB in October 2008. However, in a subsequent meeting (November 2009), the FASB changed some of the aspects of the draft. The following are the changes that the FASB proposed to the original discussion paper on October 2008. 1. Equity will no longer be a separate category, but will be included within the Financing Section. 2. Cash and short-term financial assets (or financial liabilities) used as a substitute for cash will be included in the business section (rather than reported in the financing section). 3. Replace the reconciliation schedule with an analysis of the changes in balances of all significant asset and liability line items. Each line item analysis should distinguish the following components: a. Changes due to cash inflows and cash outflows

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b. Changes resulting from noncash (accrual) transactions that are repetitive and routine in nature (for example, credit sales, wages, material purchases) c. Changes resulting from noncash transactions or events that are nonroutine or nonrepetitive in nature (for example, acquisition or disposition of a business) d. Changes resulting from accounting allocations (for example, depreciation) e. Changes resulting from accounting provisions/reserves (for example, bad debts, obsolete inventory) f. Changes resulting from remeasurements 4. Present information about remeasurements in the financial statements. FASB would require disaggregation of remeasurements on the face of the statement of comprehensive income. Remeasurements would be defined as an amount recognized in comprehensive income that reflects the effects of a change in the carrying amount of an asset or liability to a current price or value (or to an estimate of a current price or value).

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Chapter 11

CHAPTER 11 – INTERNATIONAL FINANCIAL REPORTING STANDARDS I.

THE INCREASING IMPORTANCE OF INTERNATIONAL ACCOUNTING STANDARDS The capital markets are becoming increasingly global; U.S. investors have increased opportunities for international investment. In this environment, U.S. investors should benefit from an enhanced ability to compare financial information of U.S. companies with that of non-U.S. companies. With a single set of accounting standards, investors can more easily compare information and should be in a better position to make informed investment decisions. In mid 2007, the Securities and Exchange Commission (SEC) opened the door to the increased likelihood of one global accounting standard for all countries by: 1. Deciding to eliminate the need for foreign private investors to reconcile their financial statements to U.S. GAAP if the issuer uses International Financial Reporting Standards (IFRS) as issued by the International Accounting Standards Board (IASB). 2. Publishing the concept release for comment on allowing U.S. issuers to prepare their financial statements using IFRS as issued by the IASB. The IASB has made significant progress recently toward the harmonization of accounting standards. As of April 2010, over 90 countries require IFRS and another 30 countries permit some IFRS reporting. The decision by the SEC as to whether the U.S. will adopt IFRS is also expected in 2011. This textbook was finalized as of May 2001. Some of our discussion is likely to be affected by the finalized rules and the decision of the SEC.

II.

THE ROAD TO CONVERGENCE – U.S. GAAP AND IFRS The FASB and the IASB, through the Norwalk agreement, pledged their efforts to make their existing financial reporting standards fully compatible and to coordinate their future work to ensure that once achieved, compatibility would be maintained. Whether or not IFRS have the potential to provide the best common platform for global reporting is still being debated. On November 14, 2008, the SEC released a roadmap for the adoption of IFRS by U.S. issuers. Then, on February 24, 2010, the SEC issued a release, Commission Statement in Support of Convergence and Global Accounting Standards. In this release, the SEC stated its continued belief that a single set of high-quality globally acceptable accounting standards would benefit U.S. investors and its continued encouragement for the convergence of U.S. GAAP and IFRS. On May 26, 2011, the SEC released a staff paper discussing possible work plans for incorporating IFRS into the financial reporting system. The basis for considering the use of IFRS by U.S. issuers includes the following milestones which relate to issues that need to be addressed before adoption of IFRS by U.S. entities can occur: 1. Improvements in accounting standards.

Commented [S1]: This date, 2010, is from page 589 of the text.

Chapter 11

2. The accountability and funding of the IASC foundation 3. The improvement in the ability to use interactive data for IFRS reporting Education and training relating to IFRS The work plan for incorporating IFRS into the financial reporting system include: 1. Full adoption of IFRS on a specified date, without any endorsement mechanism. 2. Full adoption of IFRS following staged transition over several years, similar to theapproach described in the roadmap. 3. An option for U.S. issuers to apply IFRS. 4. Retaining U.S. generally accepted accounting principles (“GAAP”) with continuedconvergence efforts, with or without a specific mechanism in place to promotealignment with IFRS. 5. Retaining a U.S. standard-setter. This alternative has been labeled condorsement. U.S. GAAP would be retained, but the Financial Accounting Standards Board would incorporate IFRS into U.S. GAAP over a defined period, with the focus on minimizing transition costs. The FASB would incorporate newly issued IFRS into U.S. GAAP pursuant to some established endorsement protocol. The endorsement protocol would provide the Commission and the FASB with the ability to modify or supplement IFRS when in the public interest and necessary for the protection of investors. Thus a “U.S. version” of IFRS could result. III.

SIGNIFICANT SIMILARITIES AND DIFFERENCES BETWEEN U.S. GAAP AND IFRS In general, US GAAP are considered to be more rules-based, while IFRS are considered to be more principles-based. US GAAP includes more details at present than IFRS.

IV.

GAAP HIERARCHY – U.S. VERSUS IFRS GAAP Hierarchy refers to how an entity indentifies the sources of accounting principles and the framework for selecting the principles used in preparing financial statements. The objective of the GAAP hierarchy is to provide a consistent framework for selecting accounting principles to be used in preparing financial statements that are presented in conformity with U.S. GAAP. U.S. GAAP Hierarchy – Effective September 2009 1. Authoritative: Included in the FASB Accounting Standards Codification (ASC). 2. Non-Authoritative: Not included in the FASB Accounting Standards Codification (ASC). 3. Exceptions: SEC registrants must also follow SEC rules and regulations issued under the authority of federal securities laws. IFRS Hierarchy (Issued by the IASB) 1. IFRS/IAS statements (8 IFRS and 41 IAS standards) and IFRIC/SIC Interpretations (14 IFRIC and 32 SIC). SIC stands for the Standards Interpretations Committee. 2. Apply a method that is relevant, reliable, and represents faithfully the financial position, the performance, and cash flows of the firm; reflect the economic substance of the firm. 2

Chapter 11 3. Look to recent pronouncements of other standard-setters that use a similar conceptual framework (i.e. U.S GAAP) 4. The conceptual framework. Similarities and Differences between FASB and IASB Exhibits 11-1, 11-2, and 11-3 list similarities and differences between IFRS and U.S. GAAP. Principles and rules are constantly changing under both IFRS and U.S. GAAP, making it important to check continually for recent updates or modifications. Exhibit 11-1 addresses issues with financial statement presentations. Illustration 11-2 provides similarities and differences for certain balance sheet items and some disclosures. Exhibit 11-3 provides information on the similarities and differences on various topics and disclosure under U.S. GAAP and IFRS. IFRS Financial Statements Illustrated Illustrations 11-1, 11-2 and 11-3 provide examples of IFRS based financial statements. V.

LONG-TERM CONVERGENCE ISSUES FASB AND IASB The three long-term convergence issues between FASB and the IASB are: 1. Accounting for leases by the lessee 2. Revenue recognition 3. Financial statement presentation

VI.

LEASE ACCOUNTING CONVERGENCE The guidance for leases in the U.S. is FASB ASC topic 840 – Leases, while under IFRS it is IAS 17. For lessees in the U.S., there are two types of leases: operating and capital. Under IAS 17, capital leases are referred to as financing leases. The chapter uses the terms capital lease and financing leases as equivalent. Lessee Convergence Project Plan: The IASB’s and the FASB’s lease project to develop a new model for the recognition of assets and liabilities arising under lease contracts should be final by the end of 2011. Preliminary indications suggest that all leases would result in asset and liability recognition for lessees. A lessee would recognize: a. An asset representing its right to use the leased asset for the lease term (measured initially at the present value of the lease payments) plus b. A liability to make lease payments (measured initially at the present value of the lease payments)

VII.

REVENUE RECOGNITION CONVERGENCE The IASB and the FASB are working on a project to develop a single statement on revenue recognition for both U.S. GAAP and IFRS. In particular, the project is intended to improve financial reporting. It is hoped that the final document will be issued by 2011. 3

Chapter 11 The Boards have reached some preliminary views in developing a revenue recognition model. The proposed model would apply to contracts with customers where a contract is an agreement between two or more parties that creates an obligation (does not need to be in writing). A customer is a party that has contracted with an entity to obtain an asset (such as a good or a service) that represents an output of the entity’s ordinary activities. There are five steps in the proposed revenue recognition model: Step 1: Identify the contract(s) with the customer. Step 2: Identify the separate performance obligation. Step 3: Determine the transaction price. Step 4: Allocate the transaction price to the separate performance obligation. Step 5: Recognize revenue. Customer Consideration (Allocation) Model: Three new terms are introduced in the customer consideration model: contract rights, performance obligations, and net contract asset/liability. Under the customer considerations model, revenue is recognized from “increases” in the net contract position. Specifically, revenue is recognized when there is an increase in the contract asset or a decrease in the contract liability from satisfying performance obligations. Revenue is only recognized when a performance obligation is satisfied by transferring goods or services. VIII. FINANCIAL STATEMENT PRESENTATION In 2004, the FASB and the IASB initiated a joint project on financial statement presentation. The purpose of this joint project between the FASB and the IASB is to establish a standard that will guide preparers of the financial statements in presenting financial information. This project is to be released in three phases. Phase A is to address which statements constitute a complete set of financial statements and the periods that the statements are required to be presented. Phase B would address fundamental issues relating to presentation and display of information in the financial statements, including aggregating and disaggregating information in each primary financial statement. Phase C is expected to address the presentation and display of interim financial information in U.S. GAAP. At the October 2010 joint meeting between the FASB and IASB, the Boards acknowledged that they do not have the capacity currently to devote the time necessary to consider the information learned during outreach activities and modify their tentative decision. Consequently, the Boards decided not to issue an Exposure Draft in the first quarter of 2011 as originally planned. The Boards will return to this project when they have the requisite capacity.

IX.

HOW THE FINANCIAL STATEMENTS MIGHT CHANGE Statement of Comprehensive Income: It is proposed that items will be classified into operating, investing and financing categories rather than simply income and expense. It is expected that the new presentation model would include more subtotals than are currently presented in an income statement or a statement of comprehensive income. 4

Chapter 11

Statement of Financial Position: the statement of financial position would be grouped by major activities (operating, investing, and financing), not by assets, liabilities and equity. Statement of Cash Flow: There would be fewer changes to the statement of cash flows since the major categories already include operating, investing and financing. Reconciliation Schedule: The proposed presentation model includes a new schedule (to be included in the notes to financial statements) that reconciles cash flows to comprehensive income. Ratios: The new format would allow a clearer distinction of amounts between operating and non-operating making it easier for users to calculate some key financial ratios for an entity’s business activities or its financing activities. X.

INTERNATIONAL CONVERGENCE ISSUES There are many obstacles that will need to be overcome before IFRS becomes the standard for accounting in the United States. Few of these are noted below: LIFO Inventories: Fewer choices are allowed in valuing inventory for companies under IFRS than in United States. LIFO is not acceptable under IFRS. The specific cost method is recommended as per IAS 2. If specific cost is not determinable, the benchmark is FIFO or weighted average. In the United States, taxpayers using LIFO for tax purposes must also use it for financial reporting purposes. Hence, one important issue the SEC must face is the potential cost incurred by firms to switch from LIFO to another method. Private Companies: It is unclear at this point which accounting policies will be required for private companies. The IASB is currently developing IFRS for private entities, while in the United States, it remains likely that U.S. GAAP, or some variant of U.S. GAAP, will continue to be applied for some time to smaller private companies. SEC Registration and U.S. Listing for Non-U.S. Companies Non-US companies are mandated to register with the SEC under the 1934 Securities Act if they intend to be listed on a U.S. stock market. Under the Securities Act of 1934, a non-US company that registered with the SEC and listed its shares on a U.S. exchange would have to file annual reports on forms 20-F and interim reports on forms 6K in order to keep the registration “current”. 1.

20-F Statement a.

The 20-F filing is similar to the 10-K filing required of any publicly held domestic US company, but the 20-F allows the non-US company to retain its local GAAP reporting, so long as it meets one of two alternative conditions for explaining any differences between the reported numbers and numbers derived under US GAAP. The firm may either (1) reconcile net income and the shareholders equity, thus showing earnings based on US GAAP; or 5

Chapter 11 (2) fully disclosure all financial information required of US firms, including such detailed information as segmental disclosures. b.

XI.

The 20-F is comprised of various sub-sections, each of which provides detailed information on the company and its securities issues within the United States.

F-1 Statement a.

A first-time offer of securities by any non-US company that comes under the definition of a “foreign private issuer” requires filing an F-1 statement as the principal registration statement. To qualify as a “foreign private issuer,” a non-US company must meet certain conditions of ownership, location of assets and location of executive officers.

The most important component of a registration statement is the offer prospectus. The prospectus contains all information deemed necessary by the SEC for investors to make an informed investing decision. The financial statements must either be presented in accordance with US GAAP, IFRS as promulgated by the IASB, or include an audited reconciliation of the home country GAAP numbers to US GAAP.

AMERICAN DEPOSITORY RECEIPTS (ADRS): AN OVERVIEW 1.

The complexities in the mechanics of the resulting cross-border investing and capital raising may serve to explain, at least in part, the popularity of the Depositary Receipt (DR). A DR is a derivative instrument usually representing a certain fixed number of publicly traded shares of a non-U.S. Corporation. A DR that is traded in the United States is called an American Depository Receipt (ADR), while one that is traded globally (outside the United States) is called a Global Depository Receipt (GDR).

An intermediary known as the Depository Bank (DR bank) creates ADRs, usually with the consent of the issuing company. The DR bank is central to the creation and maintenance of the ADR market. The DR bank provides the interface between the non-U.S. Company and the U.S. investors who purchase ADRs. The creation of an ADR involves the purchase of shares of a non-U.S. Company from its home markets by the brokers of the DR bank and placement with its custodian. Afterwards, the bank issues ADRs (denominated in U.S. dollars) in the United States equivalent to the shares that were deposited with the home market custodians.

Types of ADR Programs

Chapter 11

XII.

Unsponsored ADRs. It is possible for a DR bank to create a DR program without a formal agreement with the issuing non-U.S. Company. Such ADR programs, called unsponsored ADRs, usually arise due to existence of a great demand for the company’s securities in the U.S. market.

Sponsored ADRs. Sponsored programs account for over 98% of existing ADR programs in the U.S. Sponsored ADRs may be of four types, depending on whether the company registers the ADRs with the SEC and/or whether there is a capital campaign concomitant with the creation of the ADR program. a.

Level I: This method is the simplest way for non-U.S. companies to access the U.S. markets. Under this method, depository banks create an ADR program based on the underlying shares that already trade on the home markets. There is no capital raised, and the ADRs are not listed on the U.S. markets.

Level II: These types of ADRs are similar to Level I since they do not involve raising new capital, but in contrast to Level I are registered with the U.S. SEC and listed on a major U.S. stock exchange. Level II ADRs have greater visibility because of their public listing.

Level III: Firms that want to raise capital from the public equity markets in the U.S. and also to list on a major U.S. stock exchange use the Level III ADRs. These programs comply with various rules and regulations of the SEC and with the requirements of the stock exchange on which they are traded.

Rule 144A: Rule 144A ADRs are those ADRs that are placed privately among large institutional buyers with over $100 million under management (known as QIB firms) with restrictions on the subsequent trading of these securities. Rule 144A ADRs are neither traded publicly nor listed on any U.S. stock exchanges and can be exchanged only among QIBs.

APPENDIX A: List of Current International Financial Reporting Standards Issued by IASC and IASB

CHAPTER 12 ANSWERS TO QUESTIONS 1.

An exchange rate is the ratio between a unit of one currency and the amount of another currency for which that unit can be exchanged at a particular time. A direct quotation is one in which the exchange rate is quoted in terms of how many units of the domestic currency can be converted into one unit of foreign currency. An indirect quotation is stated in terms of converting one unit of domestic currency into units of foreign currency.

When a transaction is to be settled in a foreign currency, a change in the exchange rate increases or decreases the expected cash flow to be received or paid when the account is settled.

(1) Transaction Date -- at this date, the transaction is recorded. If the transaction is stated in foreign currency units, the exchange rate prevailing at this date is used to convert the foreign currency units to domestic units. (2) Balance Sheet Date -- at this date, recorded dollar balances (or other domestic currency, if applicable) representing receivables or payables that are to be settled in foreign currency units are revalued at the exchange rate on this date. The adjustment is recorded as a transaction gain or loss. (3) Settlement Date -- the foreign currency received or paid is converted into domestic currency at the spot rate. A difference between the conversion and the carrying value of the receivable or payable is a transaction gain or loss.

A transaction gain (loss) related to an unsettled receivable should be included in the determination of net income for the current period.

Receivable recorded at the transaction date Receivable recorded at the balance sheet date Transaction loss Receivable is reported at $600 in the balance sheet.

A purchase (sale) is viewed as a transaction separate from the method of settlement. Once the purchase (sale) is made, a firm has the choice of settling at the transaction date, thus incurring no gain or loss from subsequent changes in the exchange rate; or purchasing a forward contract, and also avoiding a gain or loss from holding foreign currency commitments. The choice of settlement rests with management, and their decision should have no effect on the valuation of a purchase or sales transaction.

A forward exchange contract is an agreement to buy or sell foreign currency units at a particular time for an agreed upon exchange rate. This rate will usually be the forward rate at the time the contract is entered into and any difference between the forward rate and the spot rate is amortized to income over the life of the contract.

100,000  $.009 $900 100,000  $.006 600 $300

8. A forward contract to buy (sell) foreign currency has an opposite effect on income compared to the gain or loss associated with translation of a payable (receivable) to be settled in the foreign currency units. 12 - 1

In other words, as the exchange rate fluctuates, the forward contract will gain or lose the same amount as the payable or receivable will lose or gain. Therefore, no net transaction gain or loss will be incurred. 9. The transaction must be designated as, and is effective as, a hedge of a foreign currency commitment, and the foreign currency commitment is firm. 10. Forward contracts are valued using changes in forward rates and generally any gains or losses are recognized in the same period as changes in value of hedged item (Fair Value hedges). Gains or losses in Cash Flow hedges are deferred until the hedged item is included in income. A forward contract held for speculation is recorded at the transaction date using the forward rate. There is no separate accounting for a discount or premium. Subsequent valuations (at balance sheet dates) are based on the forward rate available for the remaining life of the forward contract. 11. Foreign currency exchange gains (losses) from hedging a forecasted transaction are deferred and included in the determination of the foreign currency transaction at transaction date. 12. A put option is a contract that gives the holder the right to sell an asset (such as a unit of foreign currency) at a specified price within a specified time period. Firms use these options to protect against expected unfavorable changes in exchange rates. If a company has a contract to sell inventory and is expected to receive a foreign currency, the company can use the option to sell the foreign currency received from the sale to deliver on the option, thus locking into a foreign exchange rate. 13. A derivative instrument may be defined as a financial instrument that by its terms at inception or upon occurrence of a specified event, provides the holder (or writer) with the right (or obligation) to participate in some or all of the price changes of another underlying value of measure, but does not require the holder to own or deliver the underlying value of measure. Thus its value is derived from the underlying value of measure. In FASB ASC 815-10-10, the FASB identified the following as keystones for the accounting for derivative instruments: * Derivative instruments represent rights or obligations that meet the definitions of assets or liabilities and should be reported in financial statements. * Fair value is the most relevant measure for financial instruments and the only relevant measure for derivative instruments. * Only items that are assets or liabilities should be reported as such in the balance sheet. * Special accounting for items designated as being hedged should be provided only for qualifying items, as demonstrated by an assessment of the expectation of effective offsetting changes in fair values or cash flows during the term of the hedge for the risk being hedged. 14. Deivative instruments can be divided into two broad categories: a) Forward-based derivatives, such as forwards, futures, and swaps, in which either party can potentially have a favorable or unfavorable outcome, but not both simultaneously (e.g., both will not simultaneously have favorable outcomes). b) Option-based derivatives, such as interest rate caps, option contracts, and interest rate floors, in which only one party can potentially have a favorable outcome and it agrees to a premium at inception for this potentiality; the other party is paid the premium, and can potentially have only an unfavorable outcome. 12 - 2

15. The FASB allows deferral of the income statement recognition of the gains and losses on forecasted transactions if certain criteria are met. Like other gains and losses that are excluded from the income statement, they must be included as components of “other comprehensive income” and reported in the stockholders’ equity section of the balance sheet. The criteria for this treatment include: • The forecasted transaction is specifically identifiable at the time of the designation as a single transaction or a group of individual transactions. • The forecasted transaction is probable and it presents exposure to price changes that are expected to affect earnings and cause variability in cash flows. • The forecasted transaction involves an exchange with an outside (unrelated) party (intercompany foreign currency transactions are excluded) • The forecasted transaction does not involve a business combination. They are reclassified into earnings when the forecasted transaction occurs and the item is recorded in earning. Business Ethics Business ethics solutions are merely suggestions of points to address. The objective is to raise the students' awareness of the topics, and to invite discussion. In most cases, there is clear room for disagreement or conflicting viewpoints. 1. Stock options, in theory, are used to create incentives for the firm’s executives to increase operating performance. The practice of backdating options defeats this purpose. The point of backdating options is to avoid issuing ‘in the money’ stock options which would have had both accounting and tax consequences not favorable to the firm. Backdating avoids accounting recognition. 2. Executives always have the right not to exercise options if they feel that there is an ethical issue. However, if the proper disclosures are followed (which is rarely the case), then back-dating options is not illegal under current laws.

12 - 3

ANSWERS TO FINANCIAL STATEMENT ANALYSIS EXERCISES AFS12-1 Mattel’s Exchange Rate Exposure Mattel seeks to mitigate its exposure to foreign currency transaction risk by monitoring its foreign currency transaction exposure for the year and partially hedging such exposure using foreign currency forward exchange contracts. Mattel uses foreign currency forward exchange contracts as cash flow hedges primarily to hedge its purchases and sales of inventory denominated in foreign currencies. These contracts generally have maturity dates up to 18 months. These derivative instruments have been designated as effective cash flow hedges, whereby the unsettled hedges are reported in Mattel’s consolidated balance sheets at fair value, with changes in the fair value of the hedges reflected in other comprehensive income (“OCI”). Realized gains and losses for these contracts are recorded in the consolidated statements of operations in the period in which the inventory is sold to customers. Additionally, Mattel uses foreign currency forward exchange contracts to hedge intercompany loans and advances denominated in foreign currencies. Due to the short-term nature of the contracts involved, Mattel does not use hedge accounting for these contracts, and as such, changes in fair value are recorded in the period of change in the consolidated statements of operations. A. Cash flow hedges: Unsettled cash flow hedges FC Receivables Foreign exchange loss - Other comprehensive income

8,725 8,725

Notice that unlike the fair value hedge, there is no offsetting firm commitment entry since this is a forecasted transaction. The exchange gain or loss is reported in comprehensive income and will affect the income statement when the inventory is eventually sold.

Settled cash flow hedges: Cost of goods sold (income statement) 3,024 Foreign exchange loss - Other comprehensive income 3,024 To reclassify amounts recorded in other comprehensive income into earnings (cost of goods sold is not the only possible income statement account that might be debited). B. Intercompany loans and advances: Unsettled foreign contracts Realized loss (income statement) FC Receivables

3,797 3,797

Settled foreign contracts: FC Receivables Realized gain (income statement)

3,052 3,052

C. The three levels of the fair value hierarchy are as follows: Level 1 – Valuations based on unadjusted quoted prices in active markets for identical assets or liabilities that the entity has the ability to access. Level 2 – Valuations based on quoted prices for similar assets or liabilities, quoted prices in markets that are not active, or other inputs that are observable or can be corroborated by observable data for substantially the full term of the assets or liabilities. Level 3 – Valuations based on inputs that are unobservable, supported by little or no market activity and that are significant to the fair value of the assets or liabilities.

12 - 4

ANSWERS TO EXERCISES Exercise 12-1 Apr. 3

Purchases Accounts Payable (1,600,000  $.0072)

11,520

Accounts Receivable Sales

2,800

9 Accounts Receivable Sales

16,800

11 Purchases Accounts Payable (801,282  $.0312)

25,000

16 Accounts Payable (1,000,000  $.0072) Transaction Gain Cash (1,000,000  $.0067)

7,200

18 Accounts Payable Transaction Loss Cash (801,282  $.0368)

25,000 4,487

22 Cash

16,800

11,520

2,800

16,800

25,000

500 6,700

29,487

Accounts Receivable

16,800

30 Accounts Payable (600,000  $.0072) Transaction Loss Cash (600,000  $.0078)

4,320 360

Exercise 12-2 Part A Dec 10 Accounts Receivable (8,541,000/365) Sales

23,400

4,680

12 Purchases Accounts Payable (500,000  $.0391) Part B Dec 31 Transaction Loss Accounts Receivable [(8,541,000  $.00268 = $22,890) – $23,400]

23,400 19,550 19,550 510

31 Accounts Payable 2,000 Transaction Gain [(500,000  $.0351 = $17,550) - $19,550]

12 - 5

510

2,000

Exercise 12-2 (continued) Part C Jan

10 Cash (8,541,000  $.00320) Accounts Receivable ($23,400 - $510) Transaction Gain

27,331

10 Transaction Loss Accounts Payable ($19,550 - $2,000) Cash (500,000  $.0398)

2,350 17,550

22,890 4,441

19,900

Part D Dec 10 Accounts Receivable Sales

23,400 23,400

31 No entry required. Jan

10 Cash

23,400 Accounts Receivable

Exercise 12-3 1.d 2.d 3.d 4.a

5.b

23,400

Exercise 12-4

Exercise 12-5

1.d

1.b

2.b 3.c 4.a

2.b

3.d

4.c

Exercise 12-6 Part A Accounts Receivable SLS, Inc. (denominated in $) TNT, Ltd. (130,000  $1.482) Accounts Payable AGT (600,000  $.460) SDS, Ltd. (denominated in $) Part B Transaction date Balance sheet date Transaction gain (loss)

SLS, Inc. $200,000 200,000 $ 0

Amount $200,000 192,660 276,000 $160,000 Receivable TNT, Ltd. $195,780* 192,660 $ ( 3,120)

* 130,000  $1.506 = $195,780 ** 600,000  $0.490 = $294,000

12 - 6

Payable AGT SDS, Ltd. $294,000** $160,000 276,000 160,000 $ 18,000 $ 0

Exercise 12-7 Part A Oct. 2 Accounts Receivable (300,000  $.4737) Service Revenue

142,110

2 Dollars Receivable from Exchange Dealer FC Payable to Exchange Dealer (300,000  $.473= $141,900)

141,900

142,110 141,900

Dec 31 Accounts Receivable 4,740 Transaction Gain [(300,000  $.4895 = 146,850) - 142,110] 31 Transaction Loss [(300,000  $.4810 = $144,300) - $141,900] FC Payable to Exchange Dealer

4,740

2,400 2,400

Feb 1 Accounts Receivable 1,650 Transaction Gain [(300,000  $.4950 = $148,500) - $146,850] 1 Transaction Loss [(300,000  $.4950 = $148,500) - $144,300] FC Payable to Exchange Dealer

4,200 4,200

Feb. 1 Investment in FC Accounts Receivable (300,000  $.4950)

148,500

Feb. 1 Cash FC Payable to Exchange Dealer Investment in FC Dollars Receivable from Exchange Dealer

141,900 148,500

148,500

2008 Part B 1. Revenue $142,110 Transaction gain (loss) related to the exposed receivable balance 4,740 Transaction gain (loss) related to the forward contract (2,400) Effect on net income $144,450 2. Cumulative effect on net income: $144,450 - $2,550 = $141,900 3. Cash received = $141,900

12 - 7

1,650

148,500 141,900 2009 0 1,650 (4,200) $(2,550) $

Exercise 12-8 Nov. 1

FC Receivable from Exchange Dealer Dollars Payable to Exchange Dealer (5,000,000  $.02634 = $131,700)

131,700

Dec 31 FC Receivable from Exchange Dealer Exchange Gain [(5,000,000  $.02735 = $136,750) - $131,700]

5,050

31 Exchange loss Firm Commitment May 1

1 1

131,700

5,050 5,050 5,050

Exchange loss FC Receivable from Exchange Dealer [(5,000,000  $.02591 = $129,550)- $136,750]

7,200

Firm Commitment Exchange Gain

7,200

Dollars Payable to Exchange Dealer Investment in FC FC Receivable from Exchange Dealer Cash

131,700 129,550

Merchandise Inventory Investment in FC Firm commitment

131,700

129,550 131,700 129,550 2,150

Alternative entries Nov. 1 No Entry is made Dec 31 FC contract Exchange Gain [(5,000,000  $.02735 = $136,750) - $131,700] 31 Exchange loss Firm Commitment May 1

1 1

5,050 5,050 5,050 5,050

Exchange loss FC Contract [(5,000,000  $.02591 = $129,550)- $136,750]

7,200

Firm Commitment Exchange Gain

7,200

FC Contract Cash

2,150

7,200

7,200 2,150

Investment in FC Cash

129,550

Merchandise Inventory

131,700

129,550

12 - 8

Investment in FC Firm Commitment

129,550 2,150

Exercise 12-9 Nov. 1

Dollars Receivable from Exchange Dealer FC Payable to Exchange Dealer (900,000  $.5085)

457,650

Dec. 31 FC Payable to Exchange Dealer Transaction Gain [(900,000  $.4996 = $449,640) - $457,650]

8,010

Jan. 30 FC Payable to Exchange Dealer Transaction Gain [(900,000  $.4826 = $434,340) - $449,640]

15,300

457,650

8,010

15,300

30 Investment in FC Cash

434,340

30 Cash FC Payable to Exchange Dealer Dollars Receivable from Exchange Dealer Investment in FC

457,650 434,340

434,340

457,650 434,340

Exercise 12-10 Nov. 1

FC Receivable from Exchange Dealer Dollars Payable to Exchange Dealer (900,000  $.5085)

457,650 457,650

Dec. 31 Transaction Loss FC Receivable from Exchange Dealer [(900,000  $.4996 = $449,640) - $457,650]

8,010

Jan. 30 Transaction Loss FC Receivable from Exchange Dealer [(900,000  $.4826 = $434,340) - $449,640]

15,300

30 Investment in FC Dollars Payable to Exchange Dealer Cash FC Receivable from Exchange Dealer

434,340 457,650

30 Cash

434,340 Investment in FC

8,010

15,300

457,650 434,340

434,340

12 - 9

Exercise 12-11 April 1

Equipment Notes Payable (120,000  $1.574)

188,880 188,880

June 30 Interest Expense Cash (3,600  $1.560)

5,616

Sept. 30 Interest Expense Cash (3,600  $1.526)

5,494

Dec. 31 Interest Expense Cash (3,600  $1.498)

5,393

5,616

5,494

5,393

31 Notes Payable Transaction Gain [(120,000  $1.498 = $179,760) - $188,880] Mar. 31 Transaction Loss Notes Payable [(120,000  $1.538 = $184,560) - $179,760] 31 Interest Expense (3,600  $1.538) Notes Payable Cash (123,600  $1.538)

9,120 9,120 4,800 4,800 5,537 184,560 190,097

12 - 10

Exercise 12-12 1. 50,000,000  $.0269 = $1,345,000 2. 50,000,000  $.0291 = $1,455,000 3. 50,000,000  ($.0269 - $.0239) = 150,000 premium (forward rate is greater than spot rate) 4. Valuation - 11/15/2008 50,000,000  $.0239 = $1,195,000 12/31/2008 50,000,000  $.0224 = 1,120,000 Transaction gain - 2008 $ 75,000 Valuation - 12/31/2008 1/15/2009 Transaction loss - 2009

50,000,000  $.0291 =

$1,120,000 1,455,000 $ 335,000

5. 2008 - Transaction loss $75,000 50,000,000 ($.0269) 50,000,000 ($.0254) Transaction loss

= =

$1,345,000 1,270,000 $ 75,000

2009 - Transaction gain $185,000 50,000,000 ($.0254) 50,000,000 ($.0291) Transaction gain

= =

$1,270,000 1,455,000 $185,000

Exercise 12-13 Part A Dec. 1 FC Receivable from Exchange Dealer Dollars Payable to Exchange Dealer (100,000  $1.01)

101,000 101,000

Dec. 31 FC Receivable from Exchange Dealer Foreign Exchange Gain – Other Comprehensive Income [100,000  ($1.01- $1.02)]

1,000

Jan. 31 FC Receivable from Exchange Dealer Foreign Exchange Gain – Other Comprehensive Income [100,000  ($1.02- $1.04)]

2,000

1,000

2,000

Investment in FC Dollars Payable to Exchange Dealer Cash FC Receivable from Exchange Dealer

104,000 101,000

Equipment Investment in FC

104,000

101,000 104,000

104,000

Part B Reclassification occurs when the asset is depreciated.

12 - 11

Exercise 12-14 Alternative entries are presented assuming the forward contract is not formally recorded on the books. Dec. 1 Dollars Receivable from Exchange Dealer (1,000,000  $.0948) 94,800 FC Payable to Exchange Dealer 94,800 Dec. 31 FC Payable to Exchange Dealer Foreign Exchange Gain [1,000,000  ($.0948 - $.0944)]

400

Foreign Exchange Loss Firm Commitment [1,000,000  ($.0948 - $.0944)]

400

March 1 Foreign Exchange Loss FC Payable to Exchange Dealer [1,000,000  ($.0944 - $.0947)]

300

Firm Commitment Foreign Exchange Gain [1,000,000  ($.0944 - $.0947)]

300

400

300

Investment in FC Firm Commitment Sales (1,000,000  .0948)

94,700 100

Cash FC Payable to Exchange Dealer Investment in FC Dollars Receivable from Exchange Dealer

94,800 94,700

Cost of Goods Sold (Cost of Equipment Sold) Inventory

40,000

94,800

94,700 94,800

40,000

Alternative entries assuming the forward contract is not formally recorded. Dec. 1 No Entry

Dec. 31 Foreign exchange contract Foreign Exchange Gain [1,000,000  ($.0948 - $.0944)]

400

Foreign Exchange Loss Firm Commitment [1,000,000  ($.0948 - $.0944)]

400

12 - 12

Exercise 12-14 continued

March 1 Foreign Exchange Loss Foreign exchange contract [1,000,000  ($.0944 - $.0947)]

300

Firm Commitment Foreign Exchange Gain [1,000,000  ($.0944 - $.0947)]

300

Cash

100

300

Foreign exchange contract

100

Cash Firm Commitment Sales (1,000,000  $.0948)

94,700 100

Cost of Goods Sold (Cost of Equipment Sold) Inventory

40,000

94,800

12 - 13

40,000

Exercise 12-15 Part A. If the Krona weakens relative to the dollar, it means that the firm would receive fewer dollars for each Krona received and an exchange loss would be recognized. Part B. A put option is used when foreign currency to be received in the future needs to be sold and converted into dollars. Part C. June 1

August 1

Option to sell Kronas Cash

15,000 15,000

Foreign Exchange Loss 12,000 Option to sell Kronas 12,000 To adjust the option to its intrinsic value of $3,000 [$15,000 – (2,000,000  ($.1035 - $.1020))] or $15,000 – $3,000 = $12,000. Firm Commitment Foreign Exchange Gain

12,000

Investment in FC (2,000,000  $.1020) Firm Commitment Revenues

204,000

Cost of Goods Sold (cost of equipment sold) Inventory

100,000

Cash (2,000,000  $.1035) Option to sell Kronas (intrinsic value) Investment in FC (2,000,000  $.1020)

207,000

12,000

12,000 192,000

100,000

Note that Revenues are equal to (2,000,000  $.1035) less the cost of the option of $15,000, or $207,000 less $15,000 or $192,000.

12 - 14

3,000 204,000

ANSWERS TO ASC (Accounting Standards Codification) EXERCISES ASC12-1 Scope and Disclosure Is a company that prepares financial statements in U.S. dollars required to disclose supplementary information on the effects of changing prices? Step 1: in the search box, enter ‘changing prices.’ Step 2: 244 results are returned. The first option identifies the topic related to changing prices, Topic 255 Changing Prices. Step 3: Use the drop-down menus under the ‘Presentation’ general topic on the homepage and choose ‘255-Changing Prices’; then using the second pull-down menu choose ’10-Overall’. Click on the red button ‘Join All Sections’ and read through the paragraphs. FASB ASC paragraphs 255-10-15-2 and 3 state that the guidance on changing prices apply to all entities that prepare their financial statements in U.S. dollars (and in accordance with U.S. GAAP). The guidance is encouraged, but not required. ASC12-2 Disclosure A company estimates an allowance for inventory obsolescence. However, this estimate is sensitive to changes in the short term. What are the disclosures required by current GAAP? Inventory obsolescence would not be considered a contingent liability so Topic 450 [Contingencies] would not be relevant. In the search menu, type ‘estimates are sensitive’. The results identify Topic 275 Risk and Uncertainty. FASB ASC paragraph 275-10-50-1 states that all disclosures required by this subtopic shall be included in the basic financial statements. Furthermore, it states that disclosures about the risk and uncertainties existing at the date of those financial statements include the use of estimates in the preparation of financial statements. FASB ASC paragraph 275-10-50-6 states that the estimate of the effect of a change in a condition, situation, or set of circumstances that existed at the date of the financial statements shall be disclosed and the evaluation shall be based on known information available before the financial statements are issued or are available to be issued ASC12-3 Presentation Is a firm required to reconcile net income and net cash flows from operating activities if the direct format is used to present the statement of cash flows? Step 1: Use the drop-down menus under the ‘Presentation’ general topic on the homepage and choose ‘230-Statement of Cash Flows’; then under the second drop-down menu, choose ’10-overall’. Step 2: Click on section 10 Objectives. Expand the table of contents. Notice a section on ‘reconciliation of net income and net cash flow from operating activities’. Click on this link. FASB ASC paragraph 230-10-45-29 states that the reconciliation of net income of a business entity or change in net assets of an NFP to net cash flow from operating activities shall be provided regardless of whether the direct or indirect method of reporting net cash flow from operating activities is used. In paragraph 30, FASB states that if the direct method of reporting net cash flow from operating activities is used, the reconciliation of net income of a business entity or change in net assets of an NFP to net cash flow from operating activities shall be provided in a separate schedule. ASC12-4 General Where in the Codification is the guidance for foreign currency transactions located? List the topic number (i.e., ASC XXX).

12 - 15

In the search box, type ‘foreign currency transactions.’ Twenty-seven results are obtained. The first result states that the Foreign Currency Matters Topic provides guidance on foreign currency transactions. This is Topic 830 Foreign Currency Matters. ASC12-5 Cross-Reference The rules providing guidance on using the current rate in foreign currency translation can be found in FASB Statement No. 52, paragraph 12. Where is this information located in the Codification? List the paragraph number (i.e., ASC XXX-XX-XX-X). Step 1: Choose the cross reference tab on the opening page of the Codification. Step 2: Use the ‘By Standard’ drop down menu. Choose FAS as the standard type and 52 as the standard number. Click on ‘Generate Report.’ Paragraph 12 of FASB Statement No. 52 can be found in FASB ASC paragraph 830-30-45-3 (other presentation matters) and FASB ASC paragraph 830-30-55-10 (implementation guidance and illustrations).

12 - 16

ANSWERS TO PROBLEMS

Problem 12-1 Part A Sept. 5

Accounts Receivable Sales (17,341  $1.1291)

19,580

Cost of Goods Sold Inventory (10  $950)

9,500

Raw Materials Inventory Accounts Payable (12,200  $1.6821)

20,522

19,580

9,500

20,522

14 Accounts Receivable Sales (160,274  $.1450)

23,240

14 Cost of Goods Sold Inventory (12  $970)

11,640

23,240

11,640

30 Transaction Loss (Peso) Accounts Receivable [(17,341  $1.1091 = $19,233) - $19,580]

12 - 17

347 347

Problem 12-1 (continued) 30 Transaction Loss (British Pound) 109 Accounts Payable [(12,200  $1.6911) = $20,631 - $20,522]

109

30 Accounts Receivable (Krone) 1,282 Transaction Gain [(160,274  $.1530) = $24,522 - $23,240]

1,282

Oct. 5

Cash (17,341  $1.1190) Transaction Gain (Peso) Accounts Receivable

19,405

Accounts Payable Transaction Gain (British Pound) Cash (12,200  $1.5948)

20,631

172 19,233

1,174 19,457

30 Cash (160,274  $.1440) Transaction Loss (Franc) Accounts Receivable

23,079 1,443 24,522 Transaction Sept. 5 Sept. 14

Part B September 30, 2008 year-end: Sales Transaction gain (loss) September 30, 2009 year-end: Sales Transaction gain (loss) Net effect on income for both years Cash received on settlement date

$19,580 (347)

$23,240 1,282

0 172 $19,405 $19,405

0 (1,443) $23,079 $23,079

Problem 12-2 Part A Dec 1

Purchases Accounts Payable (210,000  $.1265)

26,565

FC Receivable from Exchange Dealer Dollars Payable to Exchange Dealer (210,000  $.1314 = $27,594)

27,594

Dec. 29 Accounts Receivable (120,000  $.1240) Sales

14,880

12 - 18

26,565

27,594

14,880

Problem 12-2 (continued) 31 Accounts Payable Transaction Gain [(210,000  $.1259 = $26,439) - $26,565]

126

31 Transaction Loss FC Receivable from Exchange Dealer [(210,000  $.1308 = $27,468) - $27,594]

126

31 Accounts Receivable 228 Transaction Gain [(120,000  $.1259 = $15,108) - $14,880] Apr. 1

Cash (120,000  .1430) Accounts Receivable Transaction Gain

228

17,160 15,108 2,052

Transaction Loss 3,591 Accounts Payable [(210,000  $.1430 = $30,030) - $26,439]

3,591

FC Receivable from Exchange Dealer 2,562 Transaction Gain [(210,000  $.1430 = $30,030 - $27,468]

2,562

Investment in FC Dollars Payable to Exchange Dealer Cash FC Receivable from Exchange Dealer

30,030 27,594 27,594 30,030

Accounts Payable Investment in Foreign Currency

30,030 30,030

Part B The aggregate transaction gain of $228 ($126 - $126 + $228) is included in the firm's income statement as part of continuing operations.

12 - 19

Problem 12-3 Part A Dec. 1

Accounts Receivable Sales (1,000,000  $.4441)

444,100

Cost of Goods Sold Inventory

210,000

444,100 210,000

31 Transaction Loss Accounts Receivable [(1,000,000  $.3690 = $369,000) - $444,100] Jan. 31 Cash (1,000,000  $.4421) Transaction Gain Accounts Receivable ($444,100 - $75,100)

75,100 75,100

442,100 73,100 369,000

Part B Net income decreased by $75,100 in 2008 and increased by $73,100 in 2009. This results in a net decrease of $2,000 over both years. The decrease is equal to the difference between the cash received on the settlement date of $442,100 and the amount of sales recorded of $444,100. Part C Dec. 1

Jan.

Dollars Receivable from Exchange Dealer FC Payable to Exchange Dealer (1,000,000  $.4451 = $445,100)

445,100 445,100

31 FC Payable to Exchange Dealer Transaction Gain [(1,000,000  $.3810 = $381,000)- $445,100]

64,100

31 Transaction Loss [(1,000,000  $.4421 = $442,100)- $381,000] FC Payable to Exchange Dealer

61,100

31 Investment in FC (1,000,000  $.4421) Accounts Receivable

442,100

31 Cash FC Payable to Exchange Dealer Dollars Receivable from Exchange Dealer Investment in FC

445,100 442,100

12 - 20

64,100

61,100

442,100

445,100 442,100

Problem 12-3 (continued) Part D Exporting Transaction 2008 2009 Loss $75,100 Gain $73,100

Forward Contract 2008 2009 Gain $64,100 Loss $61,100

Problem 12-4 Sept. 1

Accounts Receivable Sales (16,500,000  $.1480)

2,442,000 2,442,000

Dollars Receivable from Exchange Dealer 2,379,300 FC Payable to Exchange Dealer (16,500,000  $.1442 = $2,379,300) 2,379,300

Accounts Receivable (In $) Sales

5,300,000 5,300,000

15 Purchases (20,000,000  $.006430) Accounts Payable

128,600

15 FC Receivable from Exchange Dealer Dollars Payable to Exchange Dealer (20,000,000  $.006490 = $129,800)

129,800

18 Accounts Receivable Sales (48,000  $.8245)

39,576

30 Transaction Loss Accounts Receivable Accounts Payable

41,320

128,600 129,800

39,576

41,260 60

Book Value Initial Sept. 30

Transaction Date Accounts Receivable Sept. 1 $2,442,000 5 Denominated in dollars 18 39,576 Accounts Payable 15 128,600 Transaction gain (loss) (a) 16,500,000  $.1455 = (b) 48,000  $.8243 = (c) 20,000,000  $.006433 =

$2,400,750 (a) 39,566 (b) 128,660 (c)

$2,400,750 39,566 128,660

12 - 21

Transaction Gain (Loss) (41,250) (10) Not hedged ( 60) (41,320)

Problem 12-4 (continued) 30 Transaction Loss FC Receivable from Exchange Dealer FC Payable to Exchange Dealer

15,000 1,800 13,200

Oct. 15 Transaction Loss Accounts Payable [(20,000,000  $.006435) = $128,700 - $128,660] 15 FC Receivable from Exchange Dealer Transaction Gain

40 40 700 700

15 Investment in FC (20,000,000  $.006435) Dollars Payable to Exchange Dealer Cash (20,000,000  $.006490) FC Receivable from Exchange Dealer

128,700 129,800

15 Accounts Payable Investment in FC

128,700

129,800 128,700 128,700

30 Accounts Receivable 3,300 Transaction Gain [(16,500,000  $.1457 )= $2,404,050)- $2,400,750]

3,300

30 Transaction Loss FC Payable to Exchange Dealer

11,550 11,550

30 Investment in FC (16,500,000  $.1457) Accounts Receivable

2,404,050

30 FC Payable to Exchange Dealer Cash (16,500,000  $.1442) Investment in FC Dollars Receivable from Exchange Dealer

2,404,050 2,379,300

Nov. 5

Cash

2,404,050

2,404,050 2,379,300 5,300,000

Accounts Receivable (In $)

5,300,000

12 - 22

Problem 12-4 (continued) Dec. 17 Cash (48,000  $.8250) Transaction Gain Accounts Receivable ($39,576 - $10)

39,600 34 39,566

Problem 12-5 Part A Nov. 2

Dec. 31

Mar. 1

Accounts Receivable Sales (50,000  $1.6021 = $80,105)

80,105

Dollars Receivable from Exchange Dealer (50,000  $1.5920 = 79,600) FC Payable to Exchange Dealer

79,600

Transaction Loss Accounts Receivable [(50,000  $1.5820 = 79,100) - $80,105]

1,005

80,105

79,600

1,005

FC Payable to Exchange Dealer Transaction Gain [(50,000  $1.58 = $79,000) – $79,600]

600

Accounts Receivable Transaction Gain [(50,000  $1.6543 = 82,715) - 79,100]

3,615

600

3,615

Transaction Loss 3,715 FC Payable to Exchange Dealer[(50,000  $1.6543 = $82,715) – $79,000]

3,715

Investment in FC (50,000 x 1.6543) Accounts Receivable

82,715 82,715

Cash FC Payable to Exchange Dealer Investment in FC Dollars Receivable from Exchange Dealer

79,600 82,715

12 - 23

82,715 79,600

Problem 12-5 (continued) Part B Nov. 2 Dollars Receivable from Exchange Dealer FC Payable to Exchange Dealer Dec. 31

Mar. 1

Part C Nov. 2 Dec. 31

Mar. 1

79,600 79,600

FC Payable to Exchange Dealer Exchange Gain

600

Exchange Loss Firm Commitment

600

600 600

Exchange Loss FC Payable to Exchange Dealer

3,715

Firm Commitment Exchange Gain

3,715

Investment in FC (50,000 x 1.6543) Sales Firm Commitment ($1.6543 - $1.592)  50,000

82,715

Cash FC Payable to Exchange Dealer Investment in FC Dollars Receivable from Exchange Dealer

79,600 82,715

Dollars Receivable from Exchange Dealer FC Payable to Exchange Dealer

79,600

3,715 3,715 79,600 3,115

82,715 79,600 79,600

FC Payable to Exchange Dealer ((50,000  $1.5800 = $79,000) - $79,600) Transaction Gain

600 600

Transaction Loss ((50,000  $1.6543 = $82,715) - $79,000) FC Payable to Exchange Dealer

3,715

Investment in FC Cash

82,715

Cash FC Payable to Exchange Dealer Dollars Receivable from Exchange Dealer Investment in FC

79,600 82,715

3,715 82,715

Part D 2008 Sales Transaction gain (loss)

79,600 82,715 A 80,105 600 (1,005) $ 79,700

Increase (decrease) in net income Problem 12-5 (continued) 12 - 24

B 0 600 (600) $ 0

C 0 600 0 $ 600

2009 Sales Transaction gain (loss) Increase (decrease) in net income

0 3,615 (3,715) $ (100)

79,600* 3,715 (3,715) $79,600

0 0 (3,715) $(3,715)

Net increase (decrease) in net income 2008 + 2009

$79,600

$(3,115)**

* $82,715 - $3,115 = $79,600 ** Verification of loss Cash paid to buy currency Cash paid to complete forward contract Net loss on forward contract On BS $ Receivable FC Payable

82,715 79,600 $ 3,115

2008 $79,600 79,000 $ 600

Problem 12-6 Part A

Oct 1 1

Sales contract - No entry required since it is a commitment to sell. Dollars Receivable from Exchange Dealer FC Payable to Exchange Dealer 50,100,000  $.007412 = $371,341

Dec 31 Exchange Loss FC Payable to Exchange Dealer [(50,100,000  $.007910 = $396,291) - $371,341] Firm Commitment Exchange Gain Jan

371,341 371,341 24,950 24,950 24,950 24,950

28 FC Payable to Exchange Dealer Exchange Gain [(50,100,000  $.007674 = $384,467) - $396,291]

11,824

28 Exchange Loss Firm Commitment

11,824

12 - 25

Problem 12-6 (continued) Jan

28 Accounts Receivable (50,100,000  $.007623) Sales Firm Commitment

381,912 368,786 13,126

Accounts Receivable is recorded at spot rate 28 Cost of Goods Sold (25,000  $7.50) Inventory

187,500 187,500

Mar 29 Accounts Receivable Transaction Gain [(50,100,000  $.007640 = $382,764) - $381,912]

852

29 FC Payable to Exchange Dealer Transaction gain [(50,100,000  $.007640 = $382,764) - $384,467]

1,703

852

1,703

29 Investment in FC Accounts Receivable

382,764

29 Cash (50,100,000  $.007412) FC Payable to Exchange Dealer Dollars Receivable from Exchange Dealer Investment in FC

371,341 382,764

382,764

Part B 2008 - 0 2009 Sales ($381,912 - $13,126) Cost of goods sold Gross profit Transaction Gain

371,341 382,764 $368,786 187,500 $181,286

$1,703 852

Net increase or Cash received Cost of goods sold

2,555 $183,841 $371,341 187,500 $183,841

Part C 2008 - 0 2009 Sales Cost of goods sold Gross profit Transaction gain Net increase or Cash received on March 29 Cost of goods sold Net increase

$381,912 187,500 $194,412 852 $195,264 $382,764 187,500 $195,264

12 - 26

Problem 12-7 Part A Rather than focusing on the solution, students should focus on the rational supporting their conclusions. Accordingly, the following questions should be given consideration: 1. What is the purpose of the company policy? Under what conditions might it be justified to deviate from company policy, if any? 2. In whose best interest was the controller acting? Is there some overall "best interest" which supersedes company policy? 3. Is it appropriate to have "situation specific" ethics?

Part B 1. HAL may hedge against future losses by entering into forward exchange contracts. 2. Advantages: (a) Determine the extent of loss related to each transaction which is important for planning purposes, and (b)Minimize potential losses. Disadvantage: Eliminates potential to take advantages of any favorable exchange rate changes. 3. FASB ASC 815-10-50-4H specifies the disclosure requirements concerning concentrations of credit risk for all financial instruments. SFAS No. 107 (codified into FASB ASC 825) is relied on to provide valuation guidance for measuring fair value. FASB ASC 815-10-30-1 requires that an entity recognize all derivatives as either assets or liabilities measured at fair value. Specific disclosures required under FASB ASC 815-10-501A are the objectives of the instruments, the context needed to understand them, the strategies for achieving them, the risk management policy, and a description of items or transactions that are hedged for each of the following: 1. Fair value hedges 2. Cash flow hedges 3. Foreign currency net investment hedges; and 4. All other derivatives. For derivative instruments not designated as hedges, the purpose of their activity must be disclosed. Qualitative disclosures concerning the use of derivative instruments are encouraged, particularly in a context of overall risk management, as well as for financial instruments or nonfinancial assets and liabilities related by activity to derivative instruments.

Part C 1. Options are to (a) enter into foreign currency hedges or (b) leave the contracts exposed to future currency fluctuations. 2. Rather than focusing on the specific decision, students should give consideration to the conflict between fiduciary responsibility to shareholders and desire for individual financial gain.

12 - 27

Problem 12-8 December 1, 2009 Option to sell Francs Cash

6,000 6,000

December 31, 2009 Option to sell Francs 3,000 Exchange Gain – Other Comprehensive Income (balance sheet equity) 3,000 To record a gain on the change in option value ($9,000 - $6,000) February 25, 2010 (3) Option to sell Francs 3,000 Exchange Gain – Other Comprehensive Income 3,000 To adjust the option value to its current realizable value of $12,000: the value of the option [($.60 exercise price less $.57 spot rate) x 400,000 francs] of $12,000 less the carrying value of the option ($9,000) (4) Cash (400,000  .60) Option to sell Francs Payable to Option Trader (400,000  $.57) To exercise the option and settle with the trader.

12 - 28

240,000 12,000 228,000

Problem 12-9 Dec. 1 Dollars Receivable from Exchange Dealer (200,000  $1.02) FC Payable to Exchange Dealer

204,000 204,000

Dec. 31 FC Payable to Exchange Dealer Foreign Exchange Gain – Other Comprehensive Income [200,000  ($1.02- $1.00)]

4,000

Jan. 31

2,000

Feb. 1

FC Payable to Exchange Dealer Foreign Exchange Gain – Other Comprehensive Income [200,000  ($1.00 - $0.99)]

4,000

2,000

Investment in FC Sales (200,000  $0.99)

198,000

Cost of Goods Sold (cost of equipment sold) Inventory

170,000

198,000

Foreign Exchange Gain – Other Comprehensive Income ($4,000 + $2,000) Cost of Goods Sold To reclassify other comprehensive income into earnings (alternatively, the credit may be recorded to Sales) Cash FC Payable to Exchange Dealer Investment in FC Dollars receivable from Exchange Dealer To settle with the trader

12 - 29

170,000 6,000 6,000

204,000 198,000 198,000 204,000

Problem 12-10 Part A Oct. 1 FC Receivable from Exchange Dealer (300,000  $1.23) Dollars Payable to Exchange Dealer

369,000 369,000

Nov. 15 FC Receivable from Exchange Dealer Foreign Exchange Gain [300,000  (1.23 - 1.30)]

21,000

Foreign Exchange Loss Firm Commitment [10,000  (1.23- 1.30)]

21,000

Investment in FC (300,000  $1.30) Dollars Payable to Exchange Dealer FC Receivable from Exchange Dealer Cash

390,000 369,000

Firm Commitment Equipment Investment in FC

21,000 369,000

Equipment Cash

390,000

21,000

390,000 369,000

390,000

Part B 390,000

12 - 30

Problem 12-11 Part A Oct. 1 FC Receivable from Exchange Dealer (300,000  $1.23) Dollars Payable to Exchange Dealer Nov. 15 FC Receivable from Exchange Dealer Foreign Exchange Gain [300,000  ($1.23 - $1.30)]

Dec.15

369,000 369,000 21,000 21,000

Foreign Exchange Loss Firm Commitment [300,000  ($1.23 - $1.30)]

21,000

Firm Commitment Equipment Accounts Payable (300,000  $1.30)

21,000 369,000

21,000

390,000

Foreign Exchange Loss FC Receivable from Exchange Dealer [300,000  ($1.30 - $1.28)] (using changes in forward rate)

6,000

Accounts Payable Transaction Gain [300,000  ($1.30 - $1.28)] using changes in spot rate)

6,000

Investment in FC (300,000  $1.28) Dollars Payable to Exchange Dealer FC Receivable from Exchange Dealer Cash

384,000 369,000

Accounts payable ($390,000 - $6,000) Investment in FC (300,000  1.28)

384,000

Equipment Accounts Payable

390,000

Accounts Payable Cash (300,000  $1.28) Transaction Gain

390,000

384,000 369,000

384,000

Part B 390,000

384,000 6,000

12 - 31

Problem 12-12 Part A Oct. 1 Option to buy FC Cash Nov 15

4,000 4,000

Option to buy FC 14,000 Foreign Exchange Gain 14,000 To adjust the option to its intrinsic value of $18,000 [300,000  ($1.24 - $1.30)] or $18,000 – $4,000 = $14,000. Foreign Exchange Loss Firm Commitment

14,000

Investment in FC (300,000  $1.30) Cash (300,000  $1.24) Option to buy FC (intrinsic value)

390,000

Equipment Firm Commitment Investment in FC (300,000  $1.30)

376,000 14,000

Equipment (300,000  $1.30) Cash

390,000

14,000

372,000 18,000

390,000

Part B

390,000

12 - 32

Chapter 12 CHAPTER 12 ACCOUNTING FOR FOREIGN CURRENCY TRANSACTIONS AND HEDGING FOREIGN EXCHANGE RISK I.

EXCHANGE RATES - MEANS OF TRANSLATION A.

Translation is the process of expressing monetary amounts that are stated in terms of a foreign currency in the currency of the reporting entity by using an appropriate exchange rate.

An exchange rate is the ratio between a unit of one currency and the amount of another currency for which that unit can be exchanged at a particular time. 1.

A direct exchange quotation (for U.S. dollars) is one in which the exchange rate is quoted in terms of how many U.S. dollars can be converted into one unit of foreign currency.

If the direct exchange rate increases, the foreign currency is strengthening relative to the dollar because more dollars are needed to purchase the equivalent amount of foreign currency. Similarly if the direct exchange rate decreases, the dollar is strengthening relative to the foreign currency.

Exchange rates are also stated in terms of converting one unit of the domestic currency into units of a foreign currency, which is called an indirect quotation.

Exchange rates may be quoted for the immediate delivery of currencies exchanged (spot rate), or for future delivery (forward or future rate) of currencies exchanged. The forward rate is an exchange rate established at the time a forward exchange contract is negotiated.

A forward exchange contract is a contract to exchange at a specified rate (the forward rate) currencies of different countries on a stipulated future date.

In both the spot and forward markets, a foreign exchange trader provides a quotation for buying (the bid rate) and a quotation for selling (the offer rate) foreign currency. The trader's buying rate will be lower than the quoted selling rate, and the spread between the two rates is profit for the trader

The relationship between major currencies is now determined largely by supply and demand factors, called floating rates. Floating rates increase the risk to companies doing business with a foreign company.

II.

III.

The selection of an exchange rate to be used in the translation process is complicated by the fact that some countries maintain multiple exchange rates. The government of a country may maintain official rates that differ from the market-determined rate, depending on the nature of the transaction.

MEASURED VERSUS DENOMINATED A.

Transactions are normally measured and recorded in terms of the currency in which the reporting entity prepares its financial statements. This currency is usually the domestic currency of the country in which the company is domiciled and is called the reporting currency.

Assets and liabilities are denominated in a currency if their amounts are fixed in terms of that currency. Thus, a transaction between two U.S. companies requiring payment of a fixed number of dollars is both measured and denominated in dollars. In a transaction between a U.S. firm and a foreign company, the two parties usually negotiate whether the settlement is to be made in dollars or in the domestic currency of the foreign company. If the transaction is to be settled by the payment of a fixed amount of foreign currency, the U.S. firm measures the receivable or payable in dollars, but the transaction is denominated in the specified foreign currency. To the foreign company, the transaction is both measured and denominated in its domestic currency.

FOREIGN CURRENCY TRANSACTIONS A transaction that requires settlement in a foreign currency is called a foreign currency transaction.

Importing or Exporting of Goods or Services 1.

In each unsettled foreign currency transaction, there are three stages of concern to the accountant. a.

At the date the transaction is first recognized in conformity with GAAP. Each asset, liability, revenue, expense, gain, or loss arising from the transaction is measured and recorded in dollars by multiplying the units of foreign currency by the current exchange rate (the spot rate in effect on a given date).

At each balance sheet date that occurs between the transaction date and the settlement date. Recorded balances that are denominated in a foreign currency are adjusted to reflect the current exchange (spot) rate in effect at the balance sheet date.

At the settlement date. In the case of a foreign currency payable, a U.S. firm must convert U.S. dollars into foreign currency units to settle the account, whereas foreign currency units received to settle a foreign currency receivable will be converted into dollars. Although translation is not required, a transaction gain or loss is recognized if the number of dollars paid or received upon conversion does not equal the carrying value of the related payable or receivable.

The increase or decrease in the expected cash flow is generally reported as a foreign currency transaction gain or loss, sometimes referred to as an exchange gain or loss, in determining net income for the current period. One exception to this treatment of transaction gains and losses is: *

Intercompany transactions that are of a long-term financing or capital nature between an investor and an investee that is consolidated, combined, or accounted for by the equity method. These are accounted for as a component of stockholders’ equity.

Hedging Foreign Exchange Rate Risk 1.

A derivative instrument may be defined as a financial instrument that, by its terms at inception or upon occurrence of a specified event, provides the holder (or writer) with the right (or obligation) to participate in some or all of the price changes of another underlying value of measure, but does not require the holder to own or deliver the underlying value of measure. 2. FASB ASC Paragraph 815-10-10-1 identifies the following as keystones for the accounting for derivative instruments: a.

Derivative instruments represent rights or obligations that meet the definitions of assets or liabilities and should be reported in financial statements.

Fair value is the most relevant measure for financial instruments and the only relevant measure for derivative instruments.

Only items that are assets or liabilities should be reported as such in the balance sheet.

Special accounting for items designated as being hedged should be provided only for qualifying items, as demonstrated by an assessment of the expectation of effective offsetting changes in fair values or cash flows during the term of the hedge for the risk being hedged.

Derivative instruments are sometimes separated into the following two broad categories: a.

Forward-based derivatives, such as forwards, futures, and swaps, in which either party can potentially have a favorable or unfavorable outcome, but not both simultaneously (e.g., both will not simultaneously have favorable outcomes).

Option-based derivatives, such as interest rate caps, option contracts, and interest rate floors, in which only one specified party can potentially have a favorable outcome and it agrees to a premium at inception for this potentiality. Tthe other party is paid the premium, and can potentially have only an unfavorable outcome.

Derivatives are recognized in the balance sheet at their fair value. Determination of that value is based on the changes in the underlying value of measure (commodity, financial instrument, index, etc.) and on assessment of the expected future cash flows. The result is a payable position for one of the involved parties and a receivable position for the other.

Forward Exchange Contracts 1.

A forward exchange contract (forward contract) is an agreement to exchange currencies of two different countries at a specified rate (the forward rate) on a stipulated future date. At the inception of the contract, the forward rate normally varies from the spot rate. The difference between the two rates is referred to as a discount (premium) if the forward rate is less than (greater than) the spot rate.

If the item being hedged is a foreign currency account payable, the firm should use a forward contract to purchase the foreign currency on the date the payable becomes due. One the other hand, if the item being hedged is a foreign currency accounts receivable, the firm should use a forward contract to sell the foreign currency on the date the receivable is expected to be collected.

The Uses of Forward Contracts as Hedges 1.

Forward contracts used as a hedge of a foreign currency transaction. These include importing and exporting transactions denominated in foreign currency. These hedges do not qualify for hedge accounting because the foreign exchange gains and losses are already reported in earnings under FASB ASC paragraph 83010-15-3, and the payables and receivables are reported at market value on the balance sheet. The accounting procedures are illustrated on textbook, pages 645 – 649.

Forward contracts used as a hedge of an unrecognized firm commitment (a fair-value hedge). An example of an unrecognized firm commitment is when a firm enters into a contract to purchase an asset in two months for a fixed amount of foreign currency. Since the exchange rate may change over the next two months, the firm might use a forward contract to hedge the potential change in value of the purchased asset. Hedge accounting rules apply. Both the change in value of the hedge and the value of the hedged item are reported in earnings (before the contract is reported on the books).

Forward contract used as a hedge of a foreign currency denominated ‘forecasted’ transaction (a cash flow hedge). A forecasted transaction is a situation where the firm has planned sales receipts (expected to occur in the near future), and uses the forward contract as a means to hedge the cash flow risk. Initially, foreign exchange gains and losses are reported in comprehensive income, while no offsetting amount is reported for the hedged item. Eventually, the exchange gains and losses will be reported in earnings in the period the hedged item affects earnings (i.e. if the item being hedged is a forecasted purchase of inventory, the gains and losses on the hedge will be reclassified into earnings when the inventory is sold).

Forward contracts can be used as a hedge of a net investment in foreign operations.

Forward contracts can also be used to speculate changes in foreign currency.

E. Fair Value Hedge -- Hedging an Unrecognized Foreign Currency Commitment 1.

If the U.S. firm at a date earlier than the transaction date made a commitment to a foreign company to sell goods or buy goods, and the price was established in foreign currency at the commitment date, changes in the exchange rate between the commitment date and the transaction date would be reflected in the cost or sales price of the asset. The company, however, may still acquire a forward contract to hedge against the unfavorable change in the fair value of the asset that may occur after the commitment date. This is considered a fair value hedge, a derivative designed to hedge exposure to either a recognized asset or liability, or, in this case, an unrecognized foreign currency commitment. A gain or loss on this type of forward contract as well as the offsetting gain or loss on the hedged item are recognized currently in earnings. The gain or loss (the change in the fair value of the forward contract) is an adjustment of the carrying value of the forward contract. Similarly, the change in value of the firm commitment is recorded as such on the balance sheet (even though the commitment has not yet been recorded).

Cash Flow Hedge - Hedge of a forecasted transaction 1.

Firms may also be concerned about future transactions that have not yet occurred or for which there are no firm commitments. Even though they might not have any firm contracts, the company may decide, because of the high probability of occurrence of these transactions, to use derivatives to hedge this foreign currency exchange risk by using a cash flow hedge. These types of hedges are known as hedges of forecasted transactions.

Unlike the treatment of fair value hedges, cash flow hedges may defer the income statement recognition of the gains and losses on forecasted transactions if certain criteria are met. Like other gains and losses that are excluded from the income statement, they must be included as components of “other comprehensive income” and reported in the stockholders’ equity section of the balance sheet.

Amounts in accumulated other comprehensive income are reclassified into earnings in the same period or periods during which the hedged forecasted transaction affects earnings. For example, if the forecasted hedged item is inventory, the reclassification from accumulated other comprehensive income into earnings occurs when the inventory is sold. If the forecasted hedged item is the purchase of a fixed asset, the reclassification occurs when the equipment is depreciated.

Economic Hedge of a Net Investment in a Foreign Entity A U.S. firm that maintains an equity investment in a foreign company may enter into a foreign currency transaction or a nonderivative financial instrument in an effort to minimize or offset the effects of currency fluctuations on the net investment. A foreign currency transaction is considered a hedge of a net investment in a foreign entity if the forward contract is designated as, and is effective as, a hedge of the net investment. The gain or loss on the hedging instrument is reported in the same manner as the translation adjustment, that is, reported in the cumulative translation adjustment section of other comprehensive income.

Forward Contracts Acquired to Speculate in the Movement of Foreign Currencies A forward contract may be acquired for speculative purposes in anticipation of realizing a gain.

Disclosure Requirements of the Various Hedges FASB ASC Section 815-20-50 specifies certain minimal disclosures for derivative instruments and nonderivative instruments designated as qualifying hedging instruments. The disclosures include: the objectives of the instruments, the strategies for achieving those objectives, the context needed for understanding them, and the risk management policy. In addition, a description of transactions or items that are hedged must be disclosed for each category. Also the following specific disclosures are required: 1.

Fair value hedges (such as hedges of the foreign currency exposure of unrecognized firm commitments) a. A description of where the amount of the gain or loss is reported on the income statement. b. The amount of the gain or loss recognized in earnings when the hedged item no longer qualifies as a fair value hedge.

Cash flow hedges (includes forecasted transactions) a. A description of where the amount of the gain or loss is reported on the income statement. b. A description of the transactions or other events that will result in the reclassification into earnings of gains and losses that are reported in accumulated other comprehensive income, and the estimation of the net amount of the existing gains or losses at the reporting date expected to be reclassified into earnings within the next 12 months. c. The maximum length of time over which the firm is hedging its exposure to the variability in future cash flows for forecasted transactions. d. The amount of the gain or loss reclassified into earnings as a result of the discontinuance of cash flow hedges because it is probably that the transaction will not occur.

Hedges of the net investment in a foreign operation The net amount of gains or losses included in the cumulative translation adjustment during the reporting period. All derivative instruments not designated as hedges must be identified as to their purpose, and qualitative disclosures about the use of derivatives are encouraged.

Disclosure Requirements Fair Value Measurements [FASB ASC Paragraphs Topics 820-10-50-1 and 2] Reporting entities should disclose information that helps users of the financial statements assess the fair value measurements used in the financial statements. Specifically, both of the following items should be disclosed: a. After initial recognition, the valuation techniques and inputs used to develop subsequent measurements of fair value for assets and liabilities measured on a recurring or nonrecurring basis in the statement of financial position b. For recurring fair value measurements using significant unobservable inputs (Level 3), the effect of the measurements on earnings (or changes in net assets) or other comprehensive income for the period In addition, each of the following items should be disclosed for each interim and annual period for each class of assets and liabilities. The information should be presented to permit reconciliation of the fair value measurement disclosures to the specific line items in the statement of financial position. a. The fair value measurement at the reporting date

Commented [S1]: ‘J’ needs to align with A – I.

b. The level within the fair value hierarchy in which the fair value measurement in its entirety falls, segregating the fair value measurement using any of the following: 1. Quoted prices in active markets for identical assets or liabilities (Level 1) 2. Significant other observable inputs (Level 2) 3. Significant unobservable inputs (Level 3) c. The amounts of significant transfers between Level 1 and Level 2 of the fair value hierarchy and the reasons for the transfers d. For fair value measurements using significant unobservable inputs (Level 3), a reconciliation of the beginning and ending balances e. The amount of the total gains or losses for the period included in earnings (or changes in net assets) that are attributable to the change in unrealized gains or losses relating to those assets and liabilities still held at the reporting date and a description of where those unrealized gains or losses are reported in the statement of income (or activities) f. For fair value measurements using significant other observable in-puts (Level 2) and significant unobservable inputs (Level 3), a description of the valuation technique (or multiple valuation techniques) used, such as the market approach, income approach, or the cost approach, and the inputs used in determining the fair values of each class of assets or liabilities

Chapter 13 CHAPTER THIRTEEN--THE TRANSLATION OF FINANCIAL STATEMENTS OF FOREIGN AFFILIATES I.

ACCOUNTING FOR OPERATIONS IN FOREIGN COUNTRIES A.

A U.S. firm may maintain branch offices or hold equity interests in companies that are domiciled in foreign countries. As a general rule, a foreign subsidiary is consolidated if the parent company owns, directly or indirectly, a controlling interest in the voting stock of the subsidiary or otherwise exercises the ability to control the activities of the subsidiary.

The exceptions to the general rule are as follows: 1. 2.

II.

The intent of the control is likely to be temporary. Control does not actually rest with the parent company. A foreign entity may operate under conditions of foreign exchange restrictions, controls, or other government-imposed regulations that are of a type that raise significant doubt on the parent’s ability to control the subsidiary.

TRANSLATING FINANCIAL STATEMENTS OF FOREIGN AFFILIATES A.

A U.S. company maintaining a branch office in a foreign country or holding an equity interest in a foreign company must convert the account data expressed in a foreign currency into dollars before the financial statements can be combined or consolidated. Furthermore, if the equity method of accounting is used to account for an investment in a foreign investee company, the financial statements of the affiliate must be converted into dollars before the investor's share of the investee's reported net income or loss is properly determinable. The conversion from another currency into the currency of the parent company is frequently called “translation”.

In the process of translation, all accounts of the foreign entity stated in units of foreign currency are converted into the reporting currency by multiplying the foreign currency amounts by an exchange rate. 1. 2.

The current exchange rate is the spot rate in effect at the end of the accounting period (i.e., the balance sheet date). The historical exchange rate is the spot rate in effect on the date a transaction takes place.

The translation of some accounts using the current exchange rate and others using the historical exchange rate will result in an inequality between the total of the debit account balances and the total of the credit

account balances. This difference may be referred to as a translation adjustment or translation gain or loss. The amount of the translation adjustment is affected by an entity’s accounting exposure to changes in the exchange rate. Current accounting standards require that the translation adjustment (gain or loss) be reported currently in income or deferred as a component of stockholders’ equity, depending on the method used to translate the account. The appropriate method is not a free choice, but rather is dictated by the circumstances as described in FASB ASC 830-3045-12. III.

OBJECTIVES OF TRANSLATION - SFAS NO. 52[ASC 830-30]

The objectives of translation are to:

IV.

Provide information that is generally compatible with the exposed economic effects of an exchange rate change on an enterprise's cash flows and equity.

Reflect in consolidated statements the financial results and relationships of the individual consolidated entities as measured in their functional currencies in conformity with U.S. generally accepted accounting principles

TRANSLATION METHODS A.

Current rate method. When using the current rate method, all assets and liabilities are translated using the current exchange rate. Revenue and expense transactions are translated at the exchange rate prevailing on the date each underlying transaction occurred. Since separate translation of each transaction is usually impractical, an appropriate average rate can be used to approximate the results that would be obtained from translation of each transaction.

Temporal method. Under this method, monetary assets and liabilities such as cash, receivables, and payables are translated at the current exchange rate. Assets and liabilities carried at historical cost are translated at historical exchange rates. Assets and liabilities carried at current values (such as inventory carried a market when applying the lower of cost or market rule) are translated at the current exchange rate. The, the temporal method places emphasis on whether an account is measured in terms of historical or current values.

IDENTIFYING THE FUNCTIONAL CURRENCY A.

Often, the functional currency is the local currency of the country in which the entity is located and in which the accounting records are maintained.

The U.S. dollar may be identified as the functional currency when a foreign subsidiary is a direct extension or an integral component of the reporting U.S. parent company.

The functional currency could be a currency other than the dollar, such as the local currency of the foreign entity or the currency of a third country.

Functional currency indicators are identified in FASB ASC 830-10-55-5. See textbook Exhibit 13-1.

VI.

TRANSLATION OF FOREIGN CURRENCY FINANCIAL STATEMENTS

Foreign Entity Operates in a Highly Inflationary Economy 1. The relative rate of inflation between two countries is an important contributing factor to changes in exchange rates. Using the current rate method to translate inventories and fixed assets of foreign operations in highly inflationary economies often results in a substantial reduction in the translated amounts. 2. FASB defines a highly inflationary economy as one with a cumulative inflation of approximately 100% over a three-year period (which is approximately a 26% annual rate). 3. As a practical solution, the Board prescribed that the financial statements of a foreign entity operating in a highly inflationary economy shall be remeasured as if the functional currency were the reporting currency (U.S. dollar). For such entities this means that the foreign financial statements should be translated using the temporal method.

Foreign Entity Operates in an Economy That Is Not Highly Inflationary

The local currency is the functional currency. The accounts are translated into dollars using the current rate method. Since the functional currency is the local currency, the accounts are already measured in the functional currency, and remeasurement is unnecessary. The resulting translation adjustment is recorded as a separate component of stockholders’ equity.

The U.S. dollar is the functional currency. When the foreign entity does not maintain its records in its functional currency, the accounts are remeasured into the functional currency, in this case dollars, using the temporal method. Since the U.S. dollar is the functional currency, remeasurement translates the accounts into

dollars and no further translation is necessary. The resulting translation adjustment is reported in the current period’s income statement. 3.

VII.

The functional currency is the currency of a third country. The local currency accounts are first (a) remeasured in the functional currency (the currency of the third country) using the temporal approach, and then (b) the remeasured functional currency amounts are translated into dollars using the current rate approach. The translation gain or loss from using the temporal method is reported in income, while the adjustment resulting from use of the current rate approach is reported in a separate component of owners’ equity.

TRANSLATION OF FOREIGN FINANCIAL STATEMENTS ILLUSTRATED A.

Functional Currency Is the Local Currency - Current Rate Method 1.

An Analysis of the Translation Adjustment: When some accounts in a trial balance are translated using one rate and other accounts are translated using a different rate, an inequality will result between the total of the debit account balances and the total of the credit account balances.

Interpretation of Results: Financial ratios, such as current ratio, debt to equity ratio, gross profit percentage, and net income to sales can be computed and analyzed. The effects of the changes in exchange rate, as well as the change in stockholders’ equity, can also be computed and analyzed.

Functional Currency Is the U.S. Dollar - Temporal Method 1.

The remeasurement process: a.

Monetary assets and liabilities that are expressed in the balance sheet at current values are translated using the current rate.

Nonmonetary assets and liabilities carried at past exchange prices are translated at historical exchange rates.

Nonmonetary assets and liabilities carried at current or future exchange prices are translated at the current exchange rate.

Paid-in capital accounts are translated using the historical exchange rate at the date of acquisition, or at the date the original capital transaction(s) occurred if subsequent to acquisition.

The components that make up the ending retained earnings balance are translated as follows:(a) The beginning balance is set equal to the ending balance of the last period. (b) Dividends are translated at the rate existing on the date of the declaration. (c) Net income or loss is carried forward from the translated income statement.

Revenues and expenses related to assets and liabilities translated at historical rates are translated at the respective historical rates used to translate the related asset or liability.

Other revenue and expense accounts are translated in a manner that produces approximately the same results as if the individual transactions were translated at the rate in effect when the transaction occurred.

The translation gain or loss is reported in the income statement.

An Analysis of the Translation Gain or Loss An increasing (decreasing) exchange rate will produce a translation loss (gain) on an exposed net monetary liability position.

C. Comparison of the Two Methods In translating the balance sheet, the differences and similarities between the temporal and current rate methods are highlighted in the following schedule:

Monetary asset Nonmonetary asset carried at historical cost Nonmonetary asset carried at market value Monetary liability Nonmonetary liability

Balance Sheet Translation Rates Current Rate Method Temporal Method Current Current Current Historical Current

Current

Current Current

Current Historical

The two methods differ primarily in terms of the appropriate rate to use for nonmonetary items carried at historical cost.

VIII. FINANCIAL STATEMENT DISCLOSURE Companies are required to disclose certain items, as follows: A.

The aggregate translation gain or loss included in the determination of net income for the period, including gains or losses related to forward contracts, should be disclosed in either the financial statements or notes thereto.

An analysis of the cumulative translation adjustment equity account should be provided in a separate statement or note or as part of a statement of changes in equity. The analysis should include: 1. 2.

The beginning and ending cumulative translation adjustment amounts. The aggregate adjustment for the period resulting from the translation of foreign currency statements and gains and losses from certain hedging activities and intercompany long-term investment transactions.

The amount of income taxes for the period allocated to the cumulative translation adjustment equity account.

The amounts transferred from the cumulative translation adjustment equity account and included in the determination of net income for the period as a result of the sale of part or all of an investment in a foreign entity.

Exchange rate changes that occur after the balance sheet date and their effect on unsettled foreign currency transactions, if significant.

CHAPTER 13 Note: The letter A or B indicated for a question, exercise, or problem means that the question, exercise, or problem relates to a chapter appendix. ANSWERS TO QUESTIONS 1.

(1) The parent company must control more than 50 percent of the voting stock of the subsidiary. (2) The intent of control should be permanent. (3) The control should rest with the majority owners.

The functional currency of an entity is the currency of the primary economic environment in which the entity operates. The FASB provided the following six economic indicators: a. The impact on the parent’s cash flow; b. The short-term responsiveness of the sales price to changes in the exchange rate; c. The sales market for the firm’s products; d. The currency in which labor, materials, and other factor inputs are primarily obtained; e. The currency in which debt is denominated and the ability of the foreign entity’s operations to generate amounts of that currency sufficient to service the debt; f. The volume of transactions between the foreign entity and its parent.

Local currency, current rate

U.S. dollar, temporal

The temporal method is used when a foreign subsidiary operates in a highly inflationary economy.

Remeasurement is the process of translating the accounts of a foreign entity into its functional currency when they are stated in another currency.

All assets and liabilities are translated using the current rate at the balance sheet date when the current rate method of translation is used.

8. Assets and liabilities are translated at the rate in effect at the balance sheet date. Common stock is translated at the historical rate when the stock was issued. Retained earnings consists of various period’s net income (translated at the yearly average rates) less dividends converted at the historical rates on the declaration dates. The cumulative translation adjustment is a balancing amount in equity, which results in total equity (including the cumulative adjustment) being driven back to the rate in effect at the balance sheet date. Thus, the ratios will not change from their calculations using the local currency.

Application of the temporal method produces translated amounts that reflect transactions as if they had been measured in dollars originally rather than in the local currency.

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10. Revenues and expenses are translated using the exchange rate in effect when they were recognized during the period except for expenses associated with nonmonetary items which are translated using historical rates. Because it is impractical to translate numerous transactions, the use of an appropriate average is permitted. 11. The translation adjustment is reported as a separate component of stockholders’ equity when the current rate method is used to translate the accounts. Business Ethics Solutions Business ethics solutions are merely suggestions of points to address. The objective is to raise the students' awareness of the topics, and to invite discussion. In most cases, there is clear room for disagreement or conflicting viewpoints. 1. Spring-loading is a contentious issue, and the following points are among those that may be considered in a discussion or debate of whether it should be allowed or not: • Though granting options is intended to motivate and incentivize the employees to generate more profits, granting an award that is already known (or strongly suspected) before-the-fact to be in the money very soon seems counter to this intent. • Companies engaged in spring-loading mislead investors by not disclosing that options are awarded with foreknowledge of the impending good news. • Spring-loading is legal as long as the compensation committee awarding the options knows the same information as the recipient, and the company informs shareholders that it does not withhold granting options when undisclosed, positive company information is pending. • Companies suspected of spring-loading cannot be said to have advantage of prior market reactions that have not actually taken place, and executives can argue, truthfully, that there is no way to know for certain how the market will react to impending news. Option manipulation is generally more likely to occur in circumstances in which the company executives like CEOs have greater influence on the company’s pay-setting and governance processes, which suggests a lack of board oversight. 2. Spring-loaded grants might violate insider-trading rules, particularly if managers with knowledge of the information gives options to themselves, or if executives conceal good news from directors while urging them to grant options. Also, see the following links: http://www.cfo.com/article.cfm/7880157/1/c_2984338 http://blog.issproxy.com/files/OptionsBackdating7806.pdf http://www.aflcio.org/corporatewatch/paywatch/stockoptions.cfm

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ANSWERS TO FINANCIAL STATEMENT ANALYSIS EXERCISES AFS13-1 Foreign Currency Translation A. Changes in values for available for sale securities are not reported on the income statement but are reported on the Statement of Comprehensive Income. For the year 2008, the value of these investments was less than original cost by $272,000. In 2009, the investments decreased in value by $716,000 ($988,000 less $272,000). In 2010, the investments decreased in value by $1,278,000. B. Because the translation adjustment is reported on the Statement of Comprehensive Income, the current rate method is used. C. The current rate method translates all assets and liabilities using the current rate, only the net assets are exposed to currency fluctuations. In 2008, the translation adjustment was a gain of $8,609,000. In 2009, the adjustment became negative, a loss, at $8,283,000 and then in 2010, the adjustment was a loss of $309,000. Because most firms have a net asset position (assets greater than liabilities), a gain indicates that the direct exchange rate increased while a loss indicates that the direct exchange rate decreased. Recall that an increase in the direct exchange rate implies that the foreign currency is strengthening relative to the dollar (thus if the firm is in a net asset position, more dollars would be received for a given level of assets). Similarly, a decrease in the direct exchange rate implies that the dollar is strengthening relative to the foreign currency (resulting in a exchange loss because fewer dollars would be received for a given level of assets). AFS13-2 Foreign Currency Translation A. In the first step of translation, each of the Company’s operating entities remeasures its recorded balances that are denominated in a currency other than its functional currency into that entity’s functional currency, with transaction gains and losses resulting from remeasurement reported in each entity’s income statement. In the second step, each such entity whose functional currency is a non-U.S. Dollar currency translates its financial statements to U.S. Dollars, with the translation adjustments reported in other comprehensive income as a cumulative translation adjustment in the Company’s consolidated balance sheets. B. The current rate method translates all assets and liabilities using the current rate, only the net assets are exposed to currency fluctuations. In 2010, the translation adjustment was a gain of $22,528,000. In 2011, the adjustment became negative, a loss, at $27,667,000. Because most firms have a net asset position (assets greater than liabilities), a gain indicates that the direct exchange rate increased while a loss indicates that the direct exchange rate decreased. Recall that an increase in the direct exchange rate implies that the foreign currency is strengthening relative to the dollar (thus if the firm is in a net asset position, more dollars would be received for a given level of assets). Similarly, a decrease in the direct exchange rate implies that the dollar is strengthening relative to the foreign currency (resulting in a exchange loss because fewer dollars would be received for a given level of assets).

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AFS5-13 Foreign Currency The exchange rate (EUR/HUF) between the euro and the Hungarian forint went from 268.57 to 272.48. However, the press release that this information came from to develop the problem reversed the ratio for the exchange rates. The correct exchange rate should be HUF/EUR rather than the inverse of the ratio. Therefore, we present the answers both ways. Direct Exchange Rates

March 31, 2010 March 31, 2011

EUR/HUF Euro Weakens HUF Strengthens 268.57 euro = 1 forint 272.48 euro = 1 forint

HUF/EUR HUF Weakens Euro Strengthens 268.57 forint = 1 Euro 272.48 forint = 1 Euro

If the Hungarian forint strengthens (weakens), revenues and expenses will be converted into higher (lower) amounts of euros. On the consolidated balance sheet, the net assets would result in a gain if the forint strengthens. AFS5-13 Foreign Currency A. The Company’s functional currency is the US dollar. All of Ivanhoe’s operations are considered integrated and are translated into US dollars using the temporal method. Under this method, monetary assets and liabilities are translated at the exchange rate in effect at the balance sheet date. Nonmonetary assets and liabilities, as well as operating transactions, are translated at the exchange rate prevailing at the time of the transaction. Translation exchange gains and losses are reflected in the results of operations. B. Because the Canadian dollar has been strengthening and the company borrowed a significant amount of Canadian Dollar debt, more U.S. dollars will be needed to repay the debt.

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ANSWERS TO EXERCISES

Exercise 13-1 Cash Accounts receivable Inventory carried at cost Inventory carried at market Prepaid rent Property, plant, and equipment Goodwill Accounts payable Bonds payable Unamortized premium on bonds payable Preferred stock carried at issuance price Common stock Sales Cost of goods sold Depreciation expense

Functional Currency U.S. Dollar Local Currency C C C C H C C C H C H C H C C C C C C C H H H H A A H A H A

Exercise 13-2 1. c 2. b 3. d 4. d 5. c

Exercise 13-3 1. a 2. c 3. c 4. b 5. b

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Exercise 13-4 Part A Consolidated Income and Retained Earnings Statement Revenues Operating Expenses Net Income Retained Earnings - 1/1 Dividends Retained Earnings - 12/31 Balance Sheet Cash and Receivables Net Property, Plant, and Equipment Total Accounts and Notes Payable Common Stock Retained Earnings Cumulative Translation Adjustment (debit) Total

Part B Exposed net asset position - 1/1 (given) Adjustment for changes in the net asset position during the year: Net income Dividends Net asset position translated using rate in effect at date of transactions Exposed net asset position - 12/31 Cumulative translation adjustment (debit)

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Swiss Francs

Translation Rate

75,000 (30,000) 45,000 10,000 55,000 (15,000) 40,000

$.5654 .5654

55,000 37,000 92,000

.5321 .5321

29,266 19,688 48,954

32,000 20,000 40,000 92,000 --92,000

.5321 .5987

17,027 11,974 22,715 51,716 (2,762) 48,954

.5987 .5810

Balancing amt.

Swiss Francs 30,000

Translation Rate $.5987

45,000 (15,000) --60,000

.5654 .5810 .5321

$ 42,405 (16,962) 25,443 5,987 31,430 (8,715) 22,715

$ 17,961 25,443 (8,715) 34,689 31,927 (2,762)

Exercise 13-5 Part A Balance Sheet Cash and Receivables Net Property, Plant, and Equipment Total Accounts and Notes Payable Common Stock Retained Earnings Total Consolidated Income Statement and Retained Earnings Statement Revenue Operating Expenses: depreciation other Translation Loss Net Income Retained Earnings - 1/1 Dividends Retained Earnings - 12/31

Part B

Net monetary liability position - 1/1 ($20,000 - $30,000) Adjustment for changes in net monetary position during the year: Add: Increase in cash and receivables from sales Less: Decrease in net asset position: Other operating expenses Dividends Net asset position translated using rate in effect at date of transaction Net monetary asset position-12/31 ($32,000 - $55,000) Translation gain (loss)

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Swiss Francs

Translation Rate

55,000 37,000 92,000

$.5321 .5987

29,266 22,152 51,418

32,000 .5321 20,000 .5987 40,000 Balancing amt. 92,000

17,027 11,974 22,417 51,418

75,000 (3,000) (27,000) --45,000 10,000 55,000 (15,000) 40,000

.5654 42,405 .5987 (1,796) .5654 (15,266) Balancing amt. (198) 25,145 .5987 5,987 31,132 .5810 (8,715) 22,417

Swiss Francs

Translation Rate

(10,000)

$.5987

(5,987)

75,000

.5654

42,405

(27,000) (15,000) --23,000

.5654 .5810

(15,266) (8,715) 12,437 12,238 (199)

.5321

Exercise 13-6

Brazilian Real

Part B Translation Rate

1.3445

100,838

$.4751

47,908

1.3940 1.3445 Balancing amount

(4,182) (36,302) (2,271) 58,083 13,940 72,023 (18,657) 53,366

.4751 .4751 .4751

Dividends Retained Earnings - 12/31

(3,000) (27,000) --45,000 10,000 55,000 (15,000) 40,000

(1,987) (17,247) (1,079) 27,595 6,818 34,413 (8,843) 25,570

Balance Sheet Cash and Receivables Net Property, Plant, and Equipment Total

55,000 37,000 92,000

1.2899 1.3940

70,945 51,578 122,523

.4630 .4630

32,847 23,880 56,727

32,000 20,000 40,000 92,000 -92,000

1.2899 1.3940 Balancing amount

41,277 27,880 53,366 122,523 --122,523

.4630 .4891

19,111 13,636 25,570 58,317 (1,590) 56,727

Consolidated Income and Retained Earnings Statement Revenues Operating Expenses Depreciation Other Translation Loss Net Income Retained Earnings - 1/1

Accounts and Notes Payable Common Stock Retained Earnings Translation Adjustment (loss) Total

Swiss Franc

Part A Translation Rate

75,000

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1.3940 1.2438

.4891 .4740

Exercise 13-7 Consolidated Income and Retained Earnings Statement Sales Cost of Goods Sold Depreciation Expense Other Expenses Net Income Beginning Retained Earnings Less: Dividends Ending Retained Earnings Balance Sheet Cash and Receivables Merchandise Inventory Property, Plant, and Equipment

Current Liabilities Long-term Notes Payable Capital Stock Retained Earnings Cumulative Translation Adjustment Total

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Adjusted Trial Balance (£)

Translation Rate

Adjusted Trial Balance ($)

2,900,000 1,400,000 300,000 400,000 800,000 900,000 1,700,000 325,000 1,375,000

$1.4788 1.4788 1.4788 1.4788

4,288,520 2,070,320 443,640 591,520 1,183,040 1,593,408 2,776,448 478,725 2,297,723

1,275,000 490,000 3,450,000 5,215,000

1.4730 1.4730 1.4730

1,878,075 721,770 5,081,850 7,681,695

640,000 1,200,000 2,000,000 1,375,000 --5,215,000

1.4730 1.4730 1.8365

942,720 1,767,600 3,673,000 2,297,723 (999,348) 7,681,695

Given 1.4730

Balancing amount

Exercise 13-8

Adjusted Trial Balance (£)

Translation Rate

Adjusted Trial Balance ($)

1,275,000 490,000 3,450,000 5,215,000

$1.4730 1.4950 1.8365

1,878,075 732,550 6,335,925 8,946,550

640,000 1,200,000 2,000,000 1,375,000 --5,215,000

1.4730 1.4730 1.8365 Balancing amount

942,720 1,767,600 3,673,000 2,563,230

2,900,000 (1,400,000) (300,000) (400,000) --800,000 900,000 1,700,000 325,000 1,375,000

$1.4788 Schedule A 1.8365 1.4788

420,000 1,470,000 1,890,000 490,000 1,400,000

1.5300 1.4788

Balance Sheet Cash and Receivables Merchandise Inventory Property, Plant, and Equipment

Current Liabilities Long-term Notes Payable Capital Stock Retained Earnings Cumulative Translation Adjustment

Consolidated Income and Retained Earnings Statement Sales Cost of Goods Sold Depreciation Expense Other Expenses Translation Gain Net Income Beginning Retained Earnings Less: Dividends Ending Retained Earnings Schedule A - Translation of cost of goods sold Beginning Inventory Purchases (1,400,000 + 490,000 + 420,000) Ending Inventory Cost of Goods Sold

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8,946,550

Given 1.4730

1.4950

4,288,520 (2,083,886) (550,950) (591,520) 188,467 1,250,631 1,791,324 3,041,955 478,725 2,563,230

642,600 2,173,836 2,816,436 732,550 2,083,886

Exercise 13-9 Part A Exposed net asset position - 1/1 Adjustment for changes in the net asset position during the year Add: Revenues Less: Operating expenses Dividends Net asset position translated using rate in effect at date of transactions Exposed net asset position - 12/31 Cumulative translation adjustment - gain Part B Exposed net monetary liability position - 1/1 (15,500 + 25,000 – 32,000) Adjustment for changes in net monetary position during the year Less: Increase in cash and receivables - revenues Add: Decrease in monetary assets or increase in monetary liabilities Operating expenses - less depreciation and office supplies used Dividends Net monetary asset position translated using rate in effect at date of transactions Exposed net monetary asset position-12/31 (35,000 - 6,900 – 15,000) Translation gain

(£) 63,000

Translation Rate $1.5403

40,000 (20,000) (4,000)

1.5532 1.5532 1.5961

79,000

1.5961

8,500

$1.5403

13,093

(40,000)

1.5532

(62,128)

14,400 4,000 --13,100

1.5532 1.5961

22,366 6,384 20,285 20,909 624

1.5961

($) 97,039 62,128 (31,064) (6,384) 121,719 126,092 4,373

Part C An entity’s accounting exposure to changes in the exchange rate is related to the set of accounts translated at the current rate. Under the current rate method, all assets and liabilities are translated at the current rate. Thus, under this method, only the net asset position will result in a translation adjustment. Under the current rate method, a gain results from a net asset position and an increase in the exchange rate. In contrast, monetary assets and liabilities are translated at the current rate when using the temporal method. In this exercise, the company went from a net monetary liability position to a net monetary asset position during the year. A translation gain results from an increase in the exchange rate.

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Exercise 13-10A  $30,000  Part A 1. Inventory   = 57,781  50% = 28,891  $.4994 = $14,428  $.5192   $30,000  Accounts Payable   = 60,072  $.4994 = $30,000  .4994 

2. Measurement of accounts payable  $30,000  Year-end    .4994   $30,000  Date of transaction    .5192  Transaction loss

60,072 57,781 2,291

3. The transaction loss is reported in determining net income for the current period since the transaction is not of a long-term investment nature. Part B Unrealized profit in ending inventory - $6,000  50% = $3,000

Part C 1. Measurement of accounts receivable Year-end 50,204  $.4994 = Transaction date 50,204  $.5192 = Transaction loss

$25,878 26,066 $188

2. The transaction loss is reported in determining net income for the current period. 3. A transaction loss (or gain) related to a loan of a long-term investment nature is deferred and reported in a separate component of stockholders’ equity.

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ANSWERS TO ASC (Accounting Standards Codification) EXERCISES ASC13-1 Presentation The Statement of Comprehensive Income was required by FASB in SFAS Statement No. 130; describe the formats that are acceptable to display the information in the statement. The correct answer to this question depends on whether FASB delays the implementation of ASU No. 2011-05. The answers are presented both assuming the update is delayed and assuming that the update is implemented. Step 1: Use the drop-down menus under the ‘Presentation’ general topic on the homepage and choose ‘220-Comprehensive Income;’ then using the second pull-down menu choose ’10-Overall’. Step 2: Click on section 45 Other Presentation Matters. Scroll through the paragraphs for guidance on investees reporting extraordinary items. Paragraph 45-8 provides the guidance (assuming the update is not implemented or is not official guidance). FASB ASC paragraph 220-10-45-8 does not require a specific format for the statement of comprehensive income but requires that an entity display net income as a component of comprehensive income in that financial statement. The components of other comprehensive income and total comprehensive income can be reported below the total for net income in a statement that reports results of operations, in a separate statement of comprehensive income that begins with net income, and in a statement of changes in equity. ASU No. 2011-05 eliminates the option for reporting comprehensive income in the statement of changes in equity. ASC13-2 Disclosure One of the items reported as part of comprehensive income relates to foreign currency translation gains or losses. Describe the circumstances under which such gains/losses appear only in comprehensive income and not in net income. List examples of other items that are appropriately reported as components of “other comprehensive income.” In the glossary, comprehensive income is defined as the change in equity (net assets) of a business entity during a period from transactions and other events and circumstances from nonowner sources. It includes all changes in equity during a period except those resulting from investments by owners and distribution to owners. FASB ASC paragraph 220-10-45-10A lists items include in other comprehensive income. Some of which include: a. Foreign currency translation adjustments. b. Gains and losses on foreign currency transactions that are designated as, and are effective as, economic hedges of a net investment in a foreign entity, commencing as of the designation date. c. Gains and losses on intra-entity foreign currency transactions that are of a long-term-investment nature (that is, settlement is not planned or anticipated in the foreseeable future), when the entities to the transaction are consolidated, combined, or accounted for by the equity method in the reporting entity's financial statements. d. Gains and losses (effective portion) on derivative instruments that are designated as, and qualify as, cash flow hedges. 13 - 13

e. Unrealized holding gains and losses on available-for-sale securities. ASC13-3 Presentation For purposes of topic 830, what is a highly inflationary economy and how is a highly inflationary economy determined? Step 1: Go to the master glossary and enter ‘highly inflationary.’ No definition is included in the glossary. Step 2: In the search box, enter ‘highly inflationary’. Eleven results are obtained. Click on the first returned result and scroll through the paragraphs. FASB ASC paragraph 830-10-45-11 states that a highly inflationary economy is one that has a cumulative inflation of approximately 100 percent or more over a 3-year period. ASC13-4 Cross-reference The rules providing guidance on foreign currency translation can be found in FASB Statement No. 52. Where is this information located in the Codification? List all the topics and subtopics in the codification (i.e., ASC XXX–XX). (Hint: There are three main topics.) Step 1: Choose the cross reference tab on the opening page of the Codification. Step 2: Use the ‘By Standard’ drop down menu. Choose FAS as the standard type and 52 as the standard number. Click on ‘Generate Report.’ FASB ASC Subtopic 830-10 [Foreign Currency Matters-Overall], Subtopic 830-20 [Foreign Currency Matters-Foreign Currency Transactions], and Subtopic 830-30 [Foreign Currency Matters-Translations of Financial Statements] ASC13-5 Presentation Can a gain or loss from a translation of foreign currencies due to a major devaluation in currency be treated as an extraordinary item? Alternative 1 Step 1: Use the drop-down menus under the ‘Broad Transactions’ general topic on the homepage and choose ‘830-Foreign Currency Matters;’ then using the second pull-down menu choose ’30-Translation of financial statements’. Step 2: Expand the table of contents. The paragraph under section 45 Other Presentation Matters contains the answer (paragraph 45-22). Alternative 2 Step 1: Use the drop-down menus under the ‘Presentation’ general topic on the homepage and choose ‘225-Income Statement;’ then using the second pull-down menu choose ’20-20 Extraordinary and Unusual Items’. Step 2: Expand the table of contents and click on ‘criteria for presentation as extraordinary items.’ Read through the paragraphs and the answer is found in paragraph 45-4(b). FASB ASC paragraph 830-10-45-19 states that gains or losses from translation of foreign currencies shall not be reported as extraordinary items because they are usual in nature or may be expected to recur as a consequence of customary and continuing business activities. FASB ASC paragraph 225-20-45-4(c) states that gains or losses from translation of foreign currencies are not extraordinary items.

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ANSWERS TO PROBLEMS Problem 13-1 Part A Consolidated Income and Retained Earnings Statement Revenues Cost of Goods Sold Depreciation Expense Other Expenses Net Income Retained Earnings - 1/1 Less: Dividends Declared - 7/1 12/31 Retained earnings - 12/31

New Zealand $

Translation Rate

U.S. $

3,225,000 2,200,000 140,000 540,000 345,000 720,000 1,065,000 (50,000) (50,000) 965,000

$.7480 .7480 .7480 .7480

2,412,300 1,645,600 104,720 403,920 258,060 570,528 828,588 (37,060) (36,490) 755,038

.7924 .7412 .7298

Balance Sheet Cash and Receivables Inventories Land Building (net) Equipment (net): Purchased before 1/1 Purchased 7/1 Totals

880,000 500,000 400,000 605,000

.7298 .7298 .7298 .7298

642,224 364,900 291,920 441,529

380,000 90,000 2,855,000

.7298 .7298

277,324 65,682 2,083,579

Short-Term Accounts and Notes Long-Term Notes Common Stock Additional Paid-in Capital Retained Earnings Totals Translation Adjustment Totals

210,000 680,000 800,000 200,000 965,000 2,855,000 --2,855,000

.7298 .7298 .7924 .7924

153,258 496,264 633,920 158,480 755,038 2,196,960 (113,381) 2,083,579

13 - 15

Balancing amt.

Problem 13-1 (continued)

New Zealand $

Translation Rate

U.S. $

Part B Exposed net asset position - 1/1 Adjustments for changes in net asset position during the year: Net income Dividends declared - 7/1 12/31 Net asset position translated using rate in effect at date of transaction Exposed net asset position - 12/31 Cumulative translation adjustment (debit)

1,720,000

$.7924

1,362,928

345,000 (50,000) (50,000)

.7480 .7412 .7298

1,965,000

.7298

258,060 (37,060) (36,490) 1,547,438 1,434,057 (113,381)

Problem 13-2

New Zealand $

Translation Rate

U.S. $

880,000 500,000 400,000 605,000

$.7298 .7476 .7924 .7924

642,224 373,800 316,960 479,402

380,000 90,000 2,855,000

.7924 .7412

301,112 66,708 2,180,206

210,000 680,000 800,000 200,000 965,000 2,855,000

.7298 .7298 .7924 .7924 Balancing amt.

153,258 496,264 633,920 158,480 738,284 2,180,206

Part A Balance Sheet Cash and Receivables Inventories Land Buildings (net) Equipment (net): Purchased before 1/1 Purchased 7/1 Totals Short-Term Payables Long-Term Notes Common Stock Additional Paid-in Capital Retained Earnings Totals

13 - 16

Problem 13-2 (continued) Consolidated Statement of Income and Retained Earnings Revenues Cost of Goods Sold Depreciation Expense Other Expenses Translation Loss (Gain) Net Income Retained Earnings - 1/1 Less: Dividends Declared - 7/1 12/31 Retained Earnings - 12/31 Schedule 1 - Translation of cost of goods sold Beginning Inventory Purchase

Less: Ending Inventory Cost of Goods Sold

3,225,000 2,200,000 140,000 540,000 --345,000 720,000 1,065,000 (50,000) (50,000) 965,000

.7480 Schedule 1 Schedule 2 .7480 Balancing amt.

New Zealand $ 600,000 2,100,000 2,700,000

Translation Rate .7924* .7480

U.S. $ 475,440 1,570,800 2,046,240

500,000 2,200,000

.7476

373,800 1,672,440

45,000 85,000 10,000 140,000

.7924 .7924 .7412

35,658 67,354 7,412 110,424

.7924 .7412 .7298

2,412,300 1,672,440 110,424 403,920 (15,790) 241,306 570,528 811,834 (37,060) (36,490) 738,284

Schedule 2 - Translation of Depreciation Expense Buildings Equipment on hand - 1/1 Equipment purchased - 7/1 Total

* Translation rate is the January 1, 2008 rate, the date the equity interest was acquired, rather than the $.7480 rate in effect when the inventory was purchased.

13 - 17

Problem 13-2 (continued)

New Zealand $ 395,000 (3,225,000)

Part B Exposed net monetary liability position - 1/1 (295,000 + 600,000 – 500,000) Less: Increase in cash and receivables from sales Add: Decrease in monetary assets or increase in monetary liabilities: Purchases 2,100,000 Other expenses 540,000 Dividends - 7/1 50,000 12/31 50,000 Purchase of equipment - 7/1 100,000 Net monetary liability position translation using rates in effect at date of each transaction Exposed net monetary liability position - 12/31 (210,000 + 680,000 – 880,000) 10,000 Translation gain (reported on the Income Statement)

Problem 13-3 Francs Part A Consolidated Statement of Income and Retained Earnings Sales Cost of Goods Sold Depreciation Expense Other Expense Income Tax Expense Net Income Retained Earnings - 1/1 Less: Dividends Declared Retained Earnings - 12/31

13 - 18

3,775,000 2,312,500 125,000 818,750 102,500 416,250 513,000 929,250 375,000 554,250

Translation Rate $.7924 .7480

U.S. $ 312,998 (2,412,300)

.7480 .7480 .7412 .7298 .7412

1,570,800 403,920 37,060 36,490 74,120 23,088 7,298 15,790

.7298

Translation Rate $.176 .176 .176 .176 .176 Given .18

U.S.$ 664,400 407,000 22,000 144,100 18,040 73,260 75,948 149,208 67,500 81,708

Problem 13-3 (continued) Balance Sheet Cash Accounts Receivable Inventories Land Buildings (net) Equipment (net) Accounts Payable Short-term Notes Payable Bonds Payable Common Stock Additional Paid-in Capital Retained Earnings Cumulative Translation Adjustment (Credit)

962,500 660,000 1,037,500 500,000 550,000 405,000 4,115,000

$.19 .19 .19 .19 .19 .19

182,875 125,400 197,125 95,000 104,500 76,950 781,850

800,000 650,750 850,000 960,000 300,000 554,250 --4,115,000

.19 .19 .19 .15 .15

152,000 123,643 161,500 144,000 45,000 81,708 73,999 781,850

Part B Verification of the Translation Adjustment Exposed net asset position - 1/1 Adjustments for changes in net asset position during the year: Net income for the year Dividends declared Net asset position translated using rate in effect at date of transaction Exposed net asset position - 12/31 Change in cumulative translation adjustment during the year - net increase Cumulative translation adjustment - 1/1 (Given) Cumulative translation adjustment - 12/31 (Credit balance) ** Difference of $1.00 ($74,000 compared to $73,999) due to rounding. * Common stock Additional paid-in capital Retained earnings

960,000 300,000 513,000 1,773,000 13 - 19

Francs 1,773,000* 416,250 (375,000) --1,814,250

Translation Rate $.17 .176 .18 .19

U.S.$ 301,410 73,260 (67,500) 307,170 344,708 37,538 36,462 74,000**

Problem 13-3 (continued) Part C Current ratio

Francs 2,660,000 = 1.83 1,450,750

505,400 = 1.83 275,643

Debt to equity

2,300,750 = 1.27 1,814,250

437,143 = 1.27 344,707

Gross profit percentage

1,462,500 = 38.7% 3,775,000

257,400 = 38.7% 664,400

Net income to sales

416,250 = 11.0% 3,775,000

73,260 = 11.0% 664,400

Problem 13-4 Francs Part A Balance Sheet Cash Accounts Receivable Inventories (FIFO Cost) Land Buildings (net) Equipment (net) Total Accounts Payable Short-term Notes Payable Bonds Payable Common Stock Additional Paid-in Capital Retained Earnings Total

Translation Rate

U.S.$

962,500 660,000 1,037,500 500,000 550,000 405,000 4,115,000

$.19 .19 Schedule 1 .15 .15 .15

182,875 125,400 191,938 75,000 82,500 60,750 718,463

800,000 650,750 850,000 960,000 300,000 554,250 4,115,000

.19 .19 .19 .15 .15

152,000 123,643 161,500 144,000 45,000 92,320 718,463

13 - 20

Problem 13-4 (continued) Francs Consolidated Income and Retained Earnings Statement Sales Cost of Goods Sold Depreciation Expense Other Expense Income Tax Expense Translation Loss Net Income Retained Earnings - 1/1

3,775,000 2,312,500 125,000 818,750 102,500 416,250

Translation Rate $.176 Schedule 1 .15 .176 .176 Balancing Amt.

Less: Dividends Declared Retained Earnings - 12/31

416,250 513,000 929,250 375,000 554,250

Schedule 1

Francs

Beginning inventory Purchases Goods available Ending inventory Cost of goods sold

830,000 2,520,000 3,350,000 1,037,500 2,312,500

13 - 21

Given .18

Translation Rate .165 .176 .185

U.S.$ 664,400 388,532 18,750 144,100 18,040 94,978 11,818 83,160 76,660 159,820 67,500 92,320

U.S.$ 136,950 443,520 580,470 191,938 388,532

Problem 13-4 (continued) Part B Verification of the Translation Loss Francs Exposed net monetary liability position - 1/1 637,000 Adjustments for changes in net monetary position during the year: Less: Increase in cash and receivables from sales (3,775,000) Add: Decrease in monetary assets or increase in monetary liabilities from operations: Purchases 2,520,000 Other expenses 818,750 Income taxes 102,500 Dividends declared 375,000 Net monetary liability position translated using rate in effect at date of transaction --Exposed net monetary liability position - 12/31 678,250* Translation Loss *End of Year: Monetary assets 962,500 + 660,000 = Monetary liabilities 800,000 + 650,750 + 850,000 = Net monetary liability position

1,622,500 2,300,750 678,250

13 - 22

Translation Rate

U.S.$

.17

108,290

.176

(664,400)

.176 .176 .176 .18

443,520 144,100 18,040 67,500

.19

117,050 128,868 (11,818)

Problem 13-5 Canadian $ Part A (1) Equipment: Drill press Stamping press Fork lift Total Accumulated depreciation: Drill press (30,000/5  4) Stamping press (80,000/4  3) Fork lift (42,000/6) Total

Translation Rate

30,000 80,000 42,000 152,000

$.8430 .7360 .6998

25,290 58,880 29,392 113,562

24,000 60,000 7,000 91,000

.8430 .7360 .6998

20,232 44,160 4,899 69,291

Equipment Less: Accumulated depreciation Net

Part B

U.S.$

113,562 69,291 44,271

(2) Ending inventory

60,000

.6845

41,070

(3) Marketable securities

30,000

.9320

27,960

Depreciation expense: Drill press Stamping press Fork lift Total depreciation

6,000 20,000 7,000

$.8430 .7360 .6998

5,058 14,720 4,899 24,677

Beginning inventory Purchases Goods available for sale Ending inventory Cost of goods sold

60,000 400,000 460,000 60,000 400,000

.7322 .7140

43,932 285,600 329,532 41,070 288,462

13 - 23

.6845

Problem 13-5 (continued) Canadian $

Translation Rate

U.S.$

30,000 80,000 42,000 152,000

$.6960

105,792

24,000 60,000 7,000 91,000

.6960

63,336 42,456

(2) Inventory

60,000

.6960

41,760

(3) Marketable securities

30,000

.6960

20,880

(4) Depreciation expense: Drill press Stamping press Fork lift Total depreciation

6,000 20,000 7,000 33,000

.7140

23,562

(5) Beginning inventory Purchases Goods available for sale Ending inventory Cost of goods sold

60,000 400,000 460,000 60,000 400,000

.7140

285,600

Current Rate Temporal Method Method $ 23,562 $ 24,677 285,600 288,462 $309,162 $313,139 309,162 $ 3,977

Difference: Effect on Income $ 1,115 2,862 $ 3,977

Part C (1) Equipment: Drill press Stamping press Fork lift Total Accumulated depreciation: Drill press Stamping press Fork lift Total Net

Part D

Depreciation expense Cost of goods sold Total Difference

Net income is increased under the current rate method because depreciation expense and cost of goods sold are translated using the average rate for 2008 which is lower than the historical rates used under the temporal method. Therefore, expenses in dollars are smaller under the current rate method.

13 - 24

Problem 13-6A Part A See Problem 13-3. Part B Cash ((375,000  $.18)  .80) Dividend Income

54,000

Part C Supporting Entries (the workpaper is on a following page) Elimination Entries: (1) Investment in SFr Company Beginning Retained Earnings - P Company ($75,948 - $72,000)  .80 = $3,158

3,158

54,000

3,158

(2) Dividend Income Dividends Declared

54,000

(3) Retained Earnings - 1/1 SFr Company Common Stock - SFr Company Additional Paid-in Capital - SFr Company Difference Between Implied and Book Value Investment in SFr Company ($300,000 + $3,158) Noncontrolling interest

75,948 144,000 45,000 114,000

54,000

303,158 75,790

(4) Cumulative Translation Adjustment - SFr Company ($73,999  .80) 59,199 Cumulative Translation Adjustment - P Company

59,199

(5) Beginning Retained Earnings - P Company (1st yr’s depreciation*) 4,680 Noncontrolling Interest (37,500  $.156) x .20 1,170 Depreciation Expense (current yr’s depreciation) ($37,500  $.176) 6,600 Land ($385,000  .19) 73,150 Buildings, net (unamortized balance) ($300,000  .19) 57,000 Cumulative Translation Adjustment ($13,200 + $15,400) Difference Between Implied and Book Value

28,600 114,000

* (37,500  $.156) x .80

13 - 25

Problem 13-6A (continued) Supporting computations for eliminating entries

Implied value of investment (2,000,000/.80) Book value of net assets Common stock Additional paid-in capital Retained earnings Net assets Difference between implied and book value Land Building Excess of cost over fair value

Francs 2,500,000 960,000 300,000 480,000 1,740,000

Translation Rate $.15

U.S.$ 375,000

1,740,000 760,000 (385,000) (375,000) 0

.15 .15 .15 .15

261,000 114,000 (57,750) (56,250) 0

Undervalued building Amortization - Prior year - 2009 Building translated using rate in effect at date of transaction Unamortized balance - 12/31/2009 Cumulative translation adjustment

375,000 (37,500) (37,500)

.15 .156 .176

300,000

.19

56,250 (5,850) (6,600) 43,800 57,000 13,200

Land - Date of acquisition - 12/31/2009 Cumulative translation adjustment

385,000 385,000

.15 .19

Total adjustment - $13,200 + $15,400 = $28,600

13 - 26

57,750 73,150 15,400

Problem 13-6A (continued)

Income Statement Sales Dividend Income Total Revenues Cost of Goods Sold Depreciation Expense Other Expense Income Tax Expense Total Expenses Net Income Noncontrolling Interest Net Income to Retained Earnings Retained Earnings Statement Retained Earnings - 1/1 P Company SFr Company Net Income from Above Dividends Declared P Company SFr Company Retained Earnings to Balance Sheet - 12/31 *($73,260 - $6,600) x

P COMPANY AND SUBSIDIARY Consolidated Statement Workpaper For the Year Ended December 31, 2009 P Company

SFr Company

4,200,000 54,000 4,254,000 2,720,000 210,000 914,000 100,000 3,944,000 310,000

664,400

310,000

73,260

60,600

75,948 73,260

(5) 4,680 (3) 75,948 60,600

Noncontrolling Consolidated Interest Balances

(2) 54,000 664,400 407,000 22,000 144,100 18,040 591,140 73,260

544,400 310,000

Eliminations Dr. Cr.

(5)

6,600

---

(1)

13,332* 13,332

3,158

542,878 13,332

309,328

(2) 54,000

(13,500)

(200,000) _______

57,158

(168)

652,206

(200,000) (67,500) 654,400

81,708

141,228

20%

13 - 27

4,864,400 ________ 4,864,400 3,127,000 238,600 1,058,100 118,040 4,541,740 322,660 (13,332) 309,328

Problem 13-6A (continued) Balance Sheet Cash Accounts Receivable Inventories (FIFO Cost) Investment in SFr Company Land Buildings (net) Equipment (net) Difference between Implied & Book Value Total Assets Accounts Payable Short-Term Notes Payable Bonds Payable Common Stock P Company SFr Company Additional Paid-in Capital P Company SFr Company Cumulative Translation Adjustment P Company SFr Company Retained Earnings 1/1 Noncontrolling interest 12/31 Noncontrolling interest Total Liabilities and Equity

P Company

SFr Company

500,200 516,400 627,800 300,000 450,000 610,000 290,000

182,875 125,400 197,125

--3,294,400

--781,850

540,000 300,000 700,000

152,000 123,643 161,500

95,000 104,500 76,950

Eliminations Dr. Cr.

(1) 3,158 (5) 73,150 (5) 57,000

(3) 303,158

(3) 114,000

(5) 114,000

Noncontrolling Consolidated Interest Balances 683,075 641,800 824,925 --618,150 771,500 366,950 ________ 3,906,400 692,000 423,643 861,500

800,000

800,000 144,000

(3) 144,000

45,000

(3) 45,000

300,000

---

654,400

3,294,400

(4) 59,199 (5) 28,600 73,999 81,708

(4) 59,199 141,228 (5) 1,170

781,850

637,905

13 - 28

57,158 (3) 75,790 637,905

87,799 14,800 (168) 74,620 89,252

652,206 89,252 3,906,400

Problem 13-7A Part A See Problem 13-4. Part B Cash ((375,000  $.18)  .80) Dividend Income

54,000 54,000

Part C Supporting Entries (the workpaper is on a following page) Elimination Entries (1) Investment in SFr Company Beginning Retained Earnings - P Company

3,728 3,728

Retained earnings - 1/1/2009 Retained earnings - Date of acquisition Undistributed net income

$76,660 72,000 $ 4,660  .8 = 3,728

(2) Dividend Income Dividends Declared

54,000

(3) Beginning Retained Earnings - SFr Company Common Stock - SFr Company Additional Paid-In Capital - SFr Company Difference Between Implied and Book Value Investment in SFr Company ($300,000 + $3,728) Noncontrolling interest

76,660 144,000 45,000 114,000

(4) Beginning Retained Earnings - P Company Noncontrolling interest (37,500 x $.15) x .20 Depreciation Expense Land Building Difference Between Implied and Book Value

4,500 1,125 5,625 57,750 45,000

54,000

303,728 75,932

Supporting computations: 375,000  $.15 = 37,500  $.15 = $5,625 10 Unamortized balance - 12/31/2009 Land 385,000  $.15 = $57,750 Building 375,000 - 37,500 - 37,500 = 300,000  $.15 = $45,000

Depreciation expense per year

13 - 29

114,000

Problem 13-7A (continued)

P COMPANY AND SUBSIDIARY Consolidated Statement Workpaper For the Year Ended December 31, 2009 P Company

SFr Company

4,200,000 54,000 4,254,000 2,720,000 210,000 914,000 100,000 3,944,000 ______ 310,000 ______ 310,000

664,400

Eliminations Dr. Cr.

Noncontrolling Consolidated Interest Balances

Income Statement Sales Dividend Income Total Revenues Cost of Goods Sold Depreciation Expense Other Expenses Income Tax Expense Total Expenses Translation Loss Net Income Noncontrolling Interest Net Income to Retained Earnings

(2) 54,000 664,400 388,532 18,750 144,100 18,040 569,422 11,818 83,160 _______ 83,160

(4) 5,625

______ 59,625

______ ---

(1) 3,728

15,507 15,507

4,864,400 --4,864,400 3,108,532 234,375 1,058,100 118,040 4,519,047 11,818 333,535 (15,507) 318,028

Retained Earnings Statement Retained Earnings - 1/1 P Company SFr Company Net Income from Above Dividends Declared P Company SFr Company Retained Earnings to Balance Sheet - 12/31

544,400 310,000

76,660 83,160

(4) 4,500 (3) 76,660 59,625

(200,000) ________

(67,500)

______

654,400

92,320

140,785

13 - 30

543,628 15,507

318,028

(2) 54,000

(13,500)

(200,000) ________

57,728

2,007

661,656

Problem 13-7A (continued)

P Company

SFr Company

500,200 516,400 627,800 300,000 450,000 610,000 290,000

182,875 125,400 191,938

_______ 3,294,400

______ 718,463

Accounts Payable 540,000 Short-Term Notes Payable 300,000 Bonds Payable 700,000 Common Stock P Company 800,000 SFr Company Additional Paid-in Capital P Company 300,000 SFr Company Retained Earnings from Above 654,400 1/1 Noncontrolling Interest 12/31 Noncontrolling Interest _______ Total Liabilities & Owner’s Equity 3,294,400

152,000 123,643 161,500

Eliminations Dr. Cr.

Noncontrolling Consolidated Interest Balances

Balance Sheet Cash Accounts Receivable Inventories Investment in SFr Company Land Building (net) Equipment (net) Difference between Implied and Book Value Total Assets

75,000 82,500 60,750

(1) 3,728 (4) 57,750 (4) 45,000

(3) 303,728

(3) 114,000

(4) 114,000

683,075 641,800 819,738 --582,750 737,500 350,750 ______ 3,815,613 692,000 423,643 861,500 800,000

144,000

(3) 144,000 300,000

45,000 92,320 _______ 718,463

(3) 45,000 140,785 (4) 1,125 _______ 551,388

13 - 31

57,728 (3) 75,932 _______ 551,388

2,007 74,807 76,814

661,656 76,814 3,815,613

Problem 13-8A

Adjusted Trial Balance, Aus.$

Translation Rate

Adjusted Trial Balance, U.S.$

$.7962 .7962 .7962

Dividends: 4/30 10/31 Retained Earnings - 12/31

250,000 121,500 51,750 76,750 165,000 241,750 15,625 15,625 210,500

199,050 96,738 41,203 61,109 130,928 192,037 12,342 12,359 167,336

Balance Sheet Cash Accounts Receivable Inventory - 12/31 Land Buildings and Equipment Accumulated Depreciation Totals

95,250 106,250 83,250 187,500 250,000 (93,750) 628,500

.7575 .7575 .7575 .7575 .7575 .7575

72,152 80,484 63,062 142,031 189,375 (71,016) 476,088

62,500 15,000 340,500 210,500 628,500

.7575 .7575 .7935

47,344 11,363 270,187 167,336 496,230 (20,142) 476,088

Part B Exposed net asset position - 1/1 505,500 Adjustment for changes in the net asset position during the year: Add: Net income 76,750 Less: Dividends 4/30 (15,625) 10/31 (15,625) Net asset position translated using rate in effect at date of transactions --Exposed net asset position - 12/31 551,000 Translation adjustment - debit

.7935

401,114

.7962 .7899 .7910

61,108 (12,342) (12,359) 437,521 417,383 20,138*

Part A Consolidated Income and Retained Earnings Statement Sales Cost of Goods Sold Other Expenses Net Income Retained Earnings - 1/1

Accounts Payable Notes Payable Capital Stock Retained Earnings Totals Translation Adjustment - debit Totals

*Difference of $4 due to rounding.

13 - 32

.7935 .7899 .7910

.7575

Problem 13-8A (continued) Part C Investment in Nakima Company Cash (648,500  $.7935) Cash

514,585 514,585 19,761

Dividend Income ($12,342 + $12,359)  .80 = $19,761

19,761

Part D Supporting schedules for workpaper entries Account Equipment Land Inventories Patent

Difference 73,875 54,063 27,187 150,000 305,125

Useful Life 5 --1 10

Amortization (Aus.$) 14,775 --27,187 15,000 56,962

Translation Rate $.7962 --.7962 .7962

Amortization (U.S.$) 11,764 --21,646 11,943 45,353

Other Expenses - $11,764 + $11,943 = $23,707 Undervalued net assets at the beginning of the year Amortization this period Net asset position translated using the rate in effect at date of transaction Unamortized balance at end of year Translation adjustment Beginning of Year 27,187 73,875 54,063 150,000 305,125

Inventories Equipment Land Patent

13 - 33

Aus.$ 305,125 (56,962) --248,163

End of Year 0 59,100 54,063 135,000 248,163

.7935 .7962 .7575

Translation Rate   

$.7575 .7575 .7575

U.S.$ 242,117 (45,353) 196,763 187,983 (8,780)

U.S. $ 44,768 40,953 102,263 187,984

Problem 13-8A (continued)

BABBIT, INC. AND FOREIGN SUBSIDIARY Consolidated Statement Workpaper For the Year Ended December 31, 2008 Babbit Inc.

Nakima Company

Eliminations Dr. Cr.

545,475 19,761 565,236 425,000 75,000 500,000 65,236

199,050

_______ 65,236

_______ 61,109

_______ 65,114

65,236

130,928 61,109

(1) 130,928 65,114

(50,000) _______ 340,236

(24,701) 167,336

_______ 196,042

Noncontrolling Consolidated Interest Balances

Income Statement Sales Dividend Income Cost of Goods Sold Other Expenses Net Income Noncontrolling Interest (61,109 – 21,646 – 23,707)  .20 Net Income to Retained Earnings

744,525 _______ 744,525 543,384 139,910 683,294 61,231

(3) 19,761 199,050 96,738 41,203 137,941 61,109

(4) 21,646 (4) 23,707

_______

3,151 3,151

(3,151) 58,080

Retained Earnings Statement Retained Earnings - 1/1 Babbit, Inc. Nakima Company Net Income from Above Dividends Declared Babbit, Inc. Nakima Company Retained Earnings to Balance Sheet - 12/31

325,000

13 - 34

(3)

19,761 19,761

3,151

58,080

(4,940) (1,789)

(50,000) _______ 333,080

Problem 13-8A (continued) Balance Sheet Cash Accounts Receivable Inventory Investment in Nakima Company Land Buildings and Equipment Accumulated Depreciation Difference between Implied and Book Value Patent Totals Accounts Payable Notes Payable Capital Stock Babbit, Inc. Nakima Company Translation Adjustment Babbit, Inc. Nakima Company Retained Earnings from Above 1/1 Noncontrolling Interest 12/31 Noncontrolling Interest Totals

Babbit Inc.

Nakima Company

65,885 150,116 115,000 514,585 59,400 200,000 (125,000) --_______ 979,986

72,152 80,484 63,062 --142,031 189,375 (71,016) --_______ 476,088

14,750 25,000

47,344 11,363

Eliminations Dr. Cr.

Noncontrolling Consolidated Interest Balances 138,037 230,600 178,062 242,384 434,143 (196,016)

(1) 514,585 (4) 40,953 (4) 44,768 (1) 242,117 (4) 242,117 (4) 102,263

102,263 1,129,473 62,094 36,363

600,000

600,000 270,187

(1) 270,187 (2) 16,114 (4) 8,780

340,236

(20,142) 167,336

196,042

_______ 979,986

_______ 476,088

_______ 921,224

(1) To eliminate investment account and create noncontrolling interest account (2) To recognize parent’s share of cumulative translation adjustment (3) To eliminate intercompany dividends (4) To allocate the difference between implied and book value.

13 - 35

(24,894) (2)

16,114 19,761 (1) 128,647 _______ 921,224

(4,028) (1,789) 128,647 122,830

333,080 122,830 1,129,473

Problem 13-9 (This is the same problem as Problem 13-3) Francs Part A Consolidated Income and Retained Earnings Statement Sales Cost of Goods Sold Depreciation Expense Other Expense Income Tax Expense Net Income Retained Earnings - 1/1

Translation Rate

U.S.$

$.176 .176 .176 .176 .176

Less: Dividends Declared Retained Earnings - 12/31

3,775,000 2,312,500 125,000 818,750 102,500 416,250 513,000 929,250 375,000 554,250

Balance Sheet Cash Accounts Receivable Inventories Land Buildings (net) Equipment (net) Totals

962,500 660,000 1,037,500 500,000 550,000 405,000 4,115,000

$.19 .19 .19 .19 .19 .19

182,875 125,400 197,125 95,000 104,500 76,950 781,850

Accounts Payable Short-Term Notes Payable Bonds Payable Common Stock Additional Paid-in Capital Retained Earnings Cumulative Translation Adjustment (Credit) Totals

800,000 650,750 850,000 960,000 300,000 554,250 --4,115,000

.19 .19 .19 .15 .15

152,000 123,643 161,500 144,000 45,000 81,708 73,999 781,850

13 - 36

Given .18

664,400 407,000 22,000 144,100 18,040 73,260 75,948 149,208 67,500 81,708

Problem 13-9 (continued) Part B Verification of the Translation Adjustment Exposed net asset position - 1/1 Adjustments for changes in net asset position during the year: Net income for the year Dividends declared Net asset position translated using rate in effect at date of transaction Exposed net asset position - 12/31 Change in cumulative translation adjustment during the year - net increase Cumulative translation adjustment - 1/1 (Given) Cumulative translation adjustment - 12/31 (Credit balance) * *Difference of $1.00 ($74,000 compared to $73,999) due to rounding. * Common stock Additional paid-in capital Retained earnings

960,000 300,000 513,000 1,773,000 Francs 2,660,000 = 1.83 1,450,750

$ 505,400 = 1.83 275,643

Debt to equity

2,300,750 = 1.27 1,814,250

437,142 = 1.27 344,707

Gross profit percentage

1,462,500 = 38.7% 3,775,000

257,400 = 38.7% 664,400

Net income to sales

416,250 = 11.0% 3,775,000

73,260 = 11.0% 664,400

Part C Current ratio

13 - 37

Francs 1,773,000* 416,250 (375,000) --1,814,250

Translation Rate $.17 .176 .18 .19

U.S.$ 301,410 73,260 (67,500) 307,170 344,708 37,538 36,462 74,000**

Problem 13-10 Francs Part A Balance Sheet Cash Accounts Receivable Inventories (FIFO Cost) Land Buildings (net) Equipment (net) Total Accounts Payable Short-Term Notes Payable Bonds Payable Common Stock Additional Paid-in Capital Retained Earnings Total

Translation Rate

U.S.$

962,500 660,000 1,037,500 500,000 550,000 405,000 4,115,000

.19 .19 Schedule 1 .15 .15 .15

182,875 125,400 191,938 75,000 82,500 60,750 718,463

800,000 650,750 850,000 960,000 300,000 554,250 4,115,000

.19 .19 .19 .15 .15

152,000 123,643 161,500 144,000 45,000 92,320 718,463

Translation Francs Rate U.S.$ Consolidated Statement of Income and Retained Earnings Sales 3,775,000 $.176 664,400 Cost of Goods Sold 2,312,500 Schedule 1 388,532 Depreciation Expense 125,000 .15 18,750 Other Expense 818,750 .176 144,100 Income Tax Expense 102,500 .176 18,040 416,250 94,978 Translation Loss ______ Balancing Amt. 11,818 Net Income 416,250 83,160 Retained Earnings - 1/1 513,000 76,660 929,250 159,820 Less: Dividends Declared 375,000 .18 67,500 Retained Earnings - 12/31 554,250 92,320

Schedule 1

Francs

Beginning inventory Purchases Goods available Ending inventory Cost of goods sold

830,000 2,520,000 3,350,000 1,037,500 2,312,500

13 - 38

Translation Rate .165 .176 .185

U.S.$ 136,950 443,520 580,470 191,938 388,532

Problem 13-10 (continued) Part B Verification of the Translation Loss Francs Exposed net monetary liability position - 1/1 637,000 Adjustments for changes in net monetary position during the year: Less: Increase in cash and receivables from sales (3,775,000) Add: Decrease in monetary assets or increase in monetary liabilities from operations: Purchases 2,520,000 Other expenses 818,750 Income taxes 102,500 Dividends declared 375,000 Net monetary liability position translated using rate in effect at date of transaction --Exposed net monetary liability position - 12/31 678,250* Translation Loss *End of Year: Monetary assets 962,500 + 660,000 = Monetary liabilities 800,000 + 650,750 + 850,000 = Net monetary liability position

1,622,500 2,300,750 678,250

13 - 39

Translation Rate

U.S.$

.17

108,290

.176

(664,400)

.176 .176 .176 .18

443,520 144,100 18,040 67,500

.19

117,050 128,868 (11,818)

Problem 13-11A Part A See Problem 13-9. Part B Cash ((375,000  $.18)  .80) Investment in SFr Company

54,000

Investment in SFr Company Equity in Subsidiary Income

53,328

54,000 53,328

Part C Elimination Entries (1) Equity Income Investment in SFr Company Dividends Declared

53,328 672 54,000

(2) Beginning Retained Earnings - SFr Company Common Stock - SFr Company Additional Paid-In Capital - SFr Company Difference Between Implied and Book Value Investment in SFr Company Noncontrolling Interest

75,948 144,000 45,000 114,000

(3) Cumulative Translation Adjustment –SFr Company ($73,999 x .80) Cumulative Translation Adjustment – P Company

59,199

(4) Investment in SFr Company (37,500  $.156) x .80 Noncontrolling interest (37,500  $.156) x .20 Depreciation Expense (37,500  $.176) Land (385,000  $.19) Building (300,000  $.19) Difference Between Implied and Book Value Cumulative Translation Adjustment ($13,200 + $15,400)

4,680 1,170 6,600 73,150 57,000

13 - 40

303,158 75,790

59,199

114,000 28,600

Problem 13-11A (continued) Supporting computations for eliminating entries

Francs 2,500,000 960,000 300,000 480,000 1,740,000

Translation Rate .15

U.S.$ 375,000

1,740,000 760,000 (385,000) (375,000) 0

.15 .15 .15 .15

261,000 114,000 (57,750) (56,250) 0

Undervalued building Amortization - Prior year - 2009 Building translated using rate in effect at date of transaction Unamortized balance - 12/31/2009 Cumulative translation adjustment

375,000 (37,500) (37,500)

.15 .156 .176

300,000

.19

56,250 (5,850) (6,600) 43,800 57,000 13,200

Land - Date of acquisition - 12/31/2009 Cumulative translation adjustment

385,000 385,000

.15 .19

Total adjustment - $13,200 + $15,400 = $28,600

13 - 41

57,750 73,150 15,400

Problem 13-11A (continued) Income Statement

P Company

SFr Company

Sales Equity in Subsidiary Income Total Revenues Cost of Goods Sold Depreciation Expense Other Expense Income Tax Expense

4,200,000 53,328 4,253,328 2,720,000 210,000 914,000 100,000

664,400

Total Expenses Net Income Noncontrolling Interest Net Income to Retained Earnings

3,944,000 309,328

591,140 73,260

Retained Earnings Statement Retained Earnings - 1/1 P Company SFr Company Net Income from Above Dividends Declared P Company SFr Company Retained Earnings to Balance Sheet - 12/31

309,328

664,400 407,000 22,000 144,100 18,040

Eliminations Dr. (1)

53,328

(4)

6,600

73,260

Noncontrolling Consolidated Interest Balances

Cr.

4,864,400 4,864,400 3,127,000 238,600 1,058,100 118,040

59,928

13,332 13,332

542,878 309,328

542,878 75,948 73,260

(2)

75,948 59,928

13,332

(200,000)

309,328 (200,000)

(67,500) 652,206

4,541,740 322,660 (13,332) 309,328

81,708

13 - 42

(1) 135,876

54,000

(13,500)

54,000

(168)

652,206

Problem 13-11A (continued) Balance Sheet Cash Accounts Receivable Inventories (FIFO Cost) Investment in SFr Company Land Buildings (net) Equipment (net) Difference between Implied & Book Value Total Accounts Payable Short-Term Notes Payable Bonds Payable Common Stock P Company SFr Company Additional Paid-In Capital P Company SFr Company Cumulative Translation Adjustment P Company SFr Company Retained Earnings 1/1 Noncontrolling Interest 12/31 Noncontrolling Interest Total

P Company

SFr Company

500,200 516,400 627,800 297,806

182,875 125,400 197,125

450,000 610,000 290,000

95,000 104,500 76,950

Eliminations Dr.

Cr.

(1) (4) (4) (4)

672 (2) 4,680 73,150 57,000

303,158

(2)

114,000

Noncontrolling Consolidated Interest Balances 683,075 641,800 824,925 -

3,292,206

781,850

618,150 771,500 366,950 3,906,400

540,000 300,000 700,000

152,000 123,643 161,500

692,000 423,643 861,500

(4)

800,000

800,000 144,000

(2)

144,000

300,000

300,000 45,000

(2)

45,000 (3) (4)

652,206

73,999 81,708

(3) (4)

3,292,206

781,850 13 - 43

59,199 135,876 1,170 (2) 634,747

59,199 28,600 54,000 75,790 634,747

87,799 14,800 (168) 74,620 89,252

652,206 89,252 3,906,400

Problem 13-12A Part A See Problem 13-10. Part B Cash ((375,000  $.18)  .80) Investment in SFr Company

54,000

Investment in SFr Company Equity in Subsidiary Income

53,328

54,000 53,328

Elimination Entries (1) Equity in Subsidiary Income Dividends Declared Investment in SFr Company

62,028

(2) Beginning Retained Earnings - SFr Company Common Stock - SFr Company Additional Paid-in Capital - SFr Company Difference Between Implied and Book Value Investment in SFr Company Noncontrolling interest

76,660 144,000 45,000 114,000

(3) Investment in SFr Company Noncontrolling interest (37,500 x $.15) x .20) Depreciation Expense Land Building Difference between Implied and Book Value

4,500 1,125 5,625 57,750 45,000

54,000 8,028

303,728 75,932

Supporting computations:

375,000  $.15 = 37,500  $.15 = $5,625 10 Unamortized balance - 12/31/2009 Land 385,000  $.15 = $57,750 Building 375,000 - 37,500 - 37,500 = 300,000  $.15 = $45,000 Depreciation expense per year

13 - 44

114,000

Problem 13-12A (continued) Part C Income Statement Sales Equity in Subsidiary Income Total Revenues Cost of Goods Sold Depreciation Expense Other Expense Income Tax Expense Total Expenses Translation Loss Net Income Noncontrolling Interest Net Income to Retained Earnings Retained Earnings Statement Retained Earnings - 1/1 P Company SFr Company Net Income from Above Dividends Declared P Company SFr Company Retained Earnings to Balance Sheet - 12/31

P Company

SFr Company

4,200,000 62,028 4,262,028 2,720,000 210,000 914,000 100,000 3,944,000

664,400

318,028 318,028

664,400 388,532 18,750 144,100 18,040 569,422 11,818 83,160

Eliminations Dr. (1)

62,028

(3)

5,625

83,160

Noncontrolling Consolidated Interest Balances

Cr.

67,653

15,507 15,507

543,628 318,028

543,628 76,660 83,160

(2)

76,660 67,653

15,507

(200,000)

318,028 (200,000)

(67,500) 661,656

4,864,400 4,864,400 3,108,532 234,375 1,058,100 118,040 4,519,047 11,818 333,535 (15,507) 318,028

92,320

13 - 45

(1) 144,313

54,000

(13,500)

54,000

2,007

661,656

Problem 13-12A (continued) Balance Sheet Cash Accounts Receivable Inventories (FIFO Cost) Investment in SFr Company Land Buildings (net) Equipment (net) Difference between Implied & Book Value Total Assets

P SFr Company Company 500,200 182,875 516,400 125,400 627,800 191,938 307,256 (3) 450,000 610,000 290,000 3,301,656

Accounts Payable Short-Term Notes Payable Bonds Payable Common Stock P Company SFr Company Additional Paid-In Capital P Company SFr Company Retained Earnings 1/1 Noncontrolling Interest 12/31 Noncontrolling Interest

540,000 300,000 700,000

Total Liabilities and Equity

3,301,656

75,000 (3) 82,500 (3) 60,750 (2) 718,463

Eliminations Dr.

4,500

(2) (1)

57,750 45,000 114,000 (3)

Noncontrolling Consolidated Cr. Interest Balances 683,075 641,800 819,738 303,728 8,028 582,750 737,500 350,750 114,000 3,815,613

152,000 123,643 161,500

692,000 423,643 861,500

800,000

800,000 144,000 (2)

144,000

300,000 661,656

300,000 45,000 (2) 92,320 (3) 718,463

13 - 46

45,000 144,313 1,125 555,688

(2)

54,000 75,932 555,688

2,007 74,807 76,814

661,656 76,814 3,815,613

Chapter 14 CHAPTER 14: REPORTING FOR SEGMENTS AND FOR INTERIM FINANCIAL PERIODS I. Need for disaggregated financial data: When a firm engages in activities in several industries and /or geographic areas, financial analysis and cash flow predictions are difficult. Major uncertainty results from: A. Factors unique to individual companies; B. Factors related to the industries and geographical areas in which those companies operate, and; C. Related national and international economic and political factors. Therefore, disaggregated information is needed to assist in analyzing the uncertainties surrounding the timing and amounts of expected cash flows. II Basic requirements of public companies in reporting segmental date: A. Information about major customers B. Countries in which they earn revenues and hold assets C. Revenues for each product and service D. A discussion of the firm’s relational or method for categorizing its operations into segments, as well as any difference in measurement techniques between periods being reported or between the segment and the entire entity. In general, FASB ASC Topic 280 Segment Reporting [SFAS No.131] implemented a management approach, focusing on the way in which management organizes segments internally to make operation decisions and to assess performance. III. Definition of the following terms that have been given specific connotations for purposes of segmental reporting: A. Operating segment: A component of an enterprise that may earn revenues and incur expenses, about which separate financial information is evaluated regularly by the chief operating decision maker in deciding how to allocate resources and in assessing performance. B. Reportable segment: A segment considered to be significant to an enterprise’s operations; specifically, one which has passed one of three 10% tests or has been identified as being reportable through other criteria (aggregation, for example). C. Chief operating decision maker: A person whose general function (not specific title) is to allocate resources to, and assess the performance of, the segments of an enterprise. D. Segment revenue: The revenue from sales to unaffiliated customers and from intersegment sales or transfers.

E. Segment operating profit or loss: All of a segment’s revenue minus all operating expenses, including any allocated revenues or expenses (e.g., common costs). . F. Segment assets: Those tangible and intangible assets directly associated with, or used by, a segment, including any allocated portion of assets used jointly by more than one segment. If portions of assets are allocated internally and used by the chief operating decision maker, then those amounts should be allocated on a reasonable basis and disclosed for external reporting purposes as well. G. Corporate assets: Assets maintained for general corporate purposes and not used in the operations of any segment. H. General corporate expense: An expense incurred for the benefit of the corporation as a whole, which cannot be reasonably allocated to any segment. I. Transfer pricing: The pricing of products or services between operating segments or geographic areas. IV. One of the most difficult tasks in applying the segment disclosure requirements is determining appropriate operating segments: A. Operating segments of the firm are determined using a modified management approach. An operating segment is a component that exhibits the following characteristics: 1. It engages in business activities that may earn revenues and incur expenses (including transactions with other component of the entity). 2. The entity’s chief operating decision maker regularly reviews the component’s operating results to assess its performance and make decisions about resources to be allocated to it. 3. Discrete financial information is available. B. Each operating segment that is significant to the enterprise as a whole must be identified as a reportable segments The flowchart on textbook, page 740 is helpful in determining which of the operating segments are reportable segments. The FASB standard implies that the number of reportable segments should probably not exceed 10 segments. If the number does exceed 10, then the entity should revisit the aggregation criteria. Disclosures are required for each operating segment, subject to the quantitative thresholds and aggregation criteria. V. Information to be presented for each of a firm’s reportable segments:

A. General information An explanation of how management identified its reportable segments, as well as whether any segments have been aggregated. A description is also required of the types of products or services from which each segment obtains its revenues. B. Information about segment operating profit or loss The standard designates that a management approach focusing on internal decision making be used to determine the measurement of segmental profit or loss. C. Information about segment assets Firms are required to disclose those assets that are evaluated by the chief operating decision maker for the segment. D. Information about the bases for measurement Differences in measurement between segments and the consolidated entity must be disclosed for: income before tax, discontinued operations, extraordinary items, and for segment profit or loss. E. Reconciliation of segment amounts and consolidated amounts for revenue, profit or loss, assets, and significant other items. A statement reconciling the differences must be presented in sufficient detail to explain the differences. It should include: 1. Revenue to revenue reported in the consolidated income statement. 2. Operating profit or loss to pretax income from continuing operations in the consolidated income statement. 3. Segment assets to consolidated total assets. F. Interim disclosures FASB ASC paragraph 280-10-50-32 requires that segmental disclosures be included in interim reports. 1. If the firm presents a complete set of statements, the interim disclosures are the same as presented above for reportable segments. 2. If condensed statements are presented for interim periods, they should include the following for each reportable segment: revenues, including intersegment sales; profit or loss; disclosures of any changes in measurement bases for segmentation or components of profit or loss since the most recent annual report; any material changes in assets since the most recent annual report; and a reconciliation of income from continuing operations for the consolidated entity and for the total of the reportable segments. G. Enterprisewide disclosures 1. Product or service disclosures Revenues from external customers for each product or service or group of products or services, on the same basis as the general-purpose financial statements. 2. Geographic area disclosures Revenues from external customers and long-lived assets for the firm’s country of domicile and for all other countries in total, also on the

same basis as the general purpose financial statements; and revenues from external customers and long-lived assets for each foreign country or group of foreign countries, if material, along with the basis for allocating revenues (location of customer, where shipped, etc.). ➢ These disclosures are generally not required if the company’s reportable segments have been organized around geographic area. 3. Major customer disclosures Information about major customers for each customer representing 10% or more of total enterprise revenues, including the amount of revenues and the segment(s) to which the revenue is traceable. VI. Methods of presentation Information about the reportable segments of a firm may be included in its financial statements in any of the following ways: A. Within the body of the financial statements, with appropriate explanatory disclosures in the footnotes to the financial statements. B. Entirely in the footnotes to the financial statements. C. In a separate schedule that is included as an integral part of the financial VII. Problems in interim reporting A. Revenue Revenue from products sold or services performed should be recognized as earned during an interim period on the same basis as that used for the full year. In addition, businesses with material seasonal variations should disclose the seasonal nature of their activities. B. Costs Associated with Revenue Costs and expenses that are associated directly with or allocated to the products sold or to the services rendered for annual reporting purposes should be similarly treated for interim reporting purposes. However, the following are acceptable alternatives for inventory costing. 1. Estimated gross profit rates may be used by some companies to determine the cost of goods sold during interim periods, or they may use methods other than those used for year-end inventories. 2. Companies using the LIFO method may encounter a liquidation of base period inventories at an interim date that is expected to be replaced by the end of the annual period. In these cases, cost of goods sold should be charged with the expected replacement cost of the liquidated LIFO base. 3. Inventory losses from market declines should be recognized in the interim period in which the decline occurs. Subsequent recoveries of these losses in interim periods should be recognized as gains to the extent of losses previously recognized in interim periods of the same fiscal period. However, market declines that are expected to be temporary within the fiscal year need not be recognized.

4. Companies that use standard cost for determining inventory and product cost should generally follow the procedures in reporting variances that are used for the fiscal year. C. All Other Costs and Expenses 1. Cost and expenses other than product costs should be charged to income in interim periods as incurred, or be allocated among interim periods based on an estimate of time expired, benefit received or activity associated with the periods. 2. Some costs and expenses incurred in an interim period cannot be readily identified with the activities or benefits of other interim periods and should be charged to the interim period in which incurred. 3. Arbitrary assignment of the amount of such costs to an interim period should not be made. 4. Gains and losses that arise in any interim period similar to those that would not be deferred at year-end should not be deferred to later interim periods within the same fiscal year. D. Provision for income taxes The basic technique for computing income tax provisions for interim financial statements is described in FASB ASC subtopic 740 -270 (Income Taxes — Interim Reporting). At the end of each interim period the company should make its best estimate of the effective tax rate expected to be applicable for the full fiscal year. E. Interim operating losses When an interim operating loss gives rise to an expected income tax benefit, an asset is created to recognize the benefit.

VIII. Accounting changes in interim periods and minimum disclosure in interim reports A. Changes in interim periods 1. Change in estimate A change in estimate should be accounted for in the interim period in which the change is made. No restatement of previously reported interim information should be made, but the effect on earnings of a change in estimate made in a current interim period should be reported in the current and subsequent interim periods. B. Current GAAP require retrospective application to financial statements of prior periods where practical. If not practical, the statement requires that the new statement be applied to the earliest period that is practical. If one of the prior year’s financial statements being presented cannot be adjusted, an adjustment should be make to the beginning balance of the retained earnings and not included in incomeMinimum disclosures in interim reports 1. Sales or gross revenues, provision for income taxes, extraordinary items (including related income tax effects), and net income.

2. Basic and diluted earnings per share data for each period presented determined in accordance with the provisions of FASB ASC Topic 260, Earnings per Share. 3. Seasonal revenues, costs or expenses. 4. Significant changes in estimates or provisions for income taxes. 5. Disposal of a segment of a business and extraordinary, unusual or infrequently occurring items. 6. Contingent items. 7. Changes in accounting principles or estimates. 8. Significant changes in financial position.

CHAPTER 14 ANSWERS TO QUESTIONS 1. Segmented financial reports would have the most significance for a highly diversified company because the industries in which the company operates may have widely different rates of profitability, degrees of risk, and opportunities for growth. Thus, investors need information about these operating segments in order to make informed decisions. 2. Financial statement users need information about segments of a firm to aid in evaluating prospective investments. Different industries may have different rates of profitability, opportunities for growth, and types of risk. Segmented financial data aid the investor in determining the uncertainties surrounding the timing and amount of expected future cash flows and, therefore, aid in assessing the related risk of an investment. 3. Operating segment. A component of an enterprise that may earn revenues and incur expenses, about which separate financial information is evaluated regularly by the chief operating decision maker in deciding how to allocate resources and in assessing performance. Reportable segment. A segment considered to be significant to an enterprise’s operations; specifically, one that has passed one of three 10% tests or has been identified as being reportable through other criteria (aggregation, for example). 4. A segment is an operating segment if it possesses the following characteristics. It engages in business activities that may earn revenues and incur expenses (including transactions with other components of the entity). The entity’s chief operating decision maker (may be one individual or a group of executives) regularly reviews the component’s operating results to assess its performance and make decisions about resources to be allocated to it. Discrete financial information is available. An operating segment is a significant segment if it meets one or more of the following tests: a) Its combined external and internal revenue is 10% or more of the combined external and internal revenue of all reportable segments. b)The absolute amount of its reported profit or loss is 10% or more of the greater absolute amount of: - the combined reported profit of all operating segments not reporting a loss. - the combined reported loss of all operating segments that reported a loss. c) Its assets are 10% or more of the combined assets of all operating segments. 5. (a) Product or service disclosures: revenues from external customers for each product or service or group of products or services, on the same basis as the general-purpose financial statements. This disclosure is not required if the reportable segments are structured around products or services. (b) Geographic area disclosures: revenues from external customers and long-lived assets for the firm’s country of domicile and for all other countries in total, also on the same basis as the general purpose financial statements; and revenues from external customers and long-lived assets for each foreign country or group of foreign countries, if material, along with the basis for allocating revenues (location of customer, where shipped, etc.). These disclosures are generally not required if the company’s reportable segments have been organized around geographic area. (c) Major customer disclosures: information about major customers for each customer representing 10% or more of total enterprise revenues, including the amount of revenues and the segment(s) to which the revenue is traceable. A group of customers under common control is treated as a single customer, as are the various agencies of a government. 14 - 1

6. SFAS No. 131 requires that segmental disclosures be included in interim reports. The extent of the disclosures depends upon whether the firm presents a complete set of financial statements for the interim period, or condensed financial statements. If the firm presents a complete set of statements, the interim disclosures are the same as presented above for reportable segments. If condensed statements are presented for interim periods, they should include the following for each reportable segment: revenues, including intersegment sales; profit or loss; disclosures of any changes in measurement bases for segmentation or components of profit or loss since the most recent annual report; any material changes in assets since the most recent annual report; and a reconciliation of income from continuing operations for the consolidated entity and for the total of the reportable segments. 7. Although the normal segment information disclosures need not be made, the financial statements should identify the industry in which the major portion of the firm’s operations takes place. 8. The following items are disclosed only if they are included in the measures reviewed by the chief operating decision maker: revenues from external customers, revenues from other segments, interest revenue and expense, depreciation, depletion, and amortization expense, income tax expense, equity income from investments, extraordinary items, other unusual items, and other significant noncash items. 9. Information about the reportable segments of a firm may be included in its financial statements in any of the following ways: a. Within the body of the financial statements, with appropriate explanatory disclosures in the footnotes to the financial statements. b. Entirely in the footnotes to the financial statements. c. In a separate schedule that is included as an integral part of the financial statements. 10. The types of information that must be disclosed for each foreign country or geographic area (and for domestic operations) are: a. Revenue, with separate disclosure of sales to nonaffliliates and intracompany sales or transfers, along with the basis of accounting for intracompany sales and transfers and the nature and effect of any change in method. b. Operating profit or loss, or some other measure of profitability. A common measure of profitability must be used for all countries and/or geographic areas presented. c. Identifiable assets, using the same procedures for presenting operating segment information. 11. Foreign operations are defined as those located outside the United States (or other “home country”) that produce revenue from sales to unaffiliated customers or from intra-enterprise sales or transfers between countries or geographic areas. Foreign operations do not, however, include unconsolidated subsidiaries and investees. If operations are conducted in two or more foreign countries or geographic areas, information must be presented separately for each significant foreign country or geographic area and in the aggregate for all other foreign operations. Where the operations of some foreign countries are grouped into geographic areas, the groupings should be made on the basis of a consideration of (1) proximity, (2) economic affinity, (3) similarities of business environments, and (4) the nature, scale, and degree of interrelationship of the operations in the various countries.

14 - 2

12. Factors to be considered in grouping foreign operations into geographic areas are (1) proximity, (2) economic affinity, (3) similarities of business environments, and (4) the nature, scale, and degree of interrelationship of the operations in the various countries. 13. To provide information about the potential effects of dependency on one or more major customers, if 10% or more of the revenue of a firm is derived from sales to any single customer, that fact and the amount of revenue from each such customer must be disclosed. Also, if 10% or more of the revenue is derived from sales to the federal government, a state government, a local government or a foreign government, that fact and the amount of revenue must be disclosed. Disclosure should include the amount of sales to each customer and the reportable segment making the sales. Customer's names, however, need not be disclosed. These disclosures are required even if the firm has only one reportable segment. 14. 14. The purpose of interim financial reporting is to present timely information for use by external users of financial statements. Publicly owned companies prepare quarterly reports that must be filed with the stock exchanges on which their stock is listed, and with the Securities and Exchange Commission. 15. Accountants who support the view that each interim period should stand alone as a basic accounting period believe that deferrals, accruals, and estimates at the end of each interim period should be determined by following essentially the same principles and judgments that apply to annual periods. Accountants who view interim periods as integral parts of annual periods believe that deferrals, accruals, and estimates at the end of each interim period should be affected by judgments made at the interim date as to results of operations for the balance of the annual period. 16. At the end of each interim period, the company should make its best estimate of the effective tax rate expected to be applicable for the full fiscal year. The rate determined should be used in providing for income taxes on a current year-to-date basis, giving effect to expected investment tax credit, foreign tax rates, percentage depletion, capital gain rates, and other available tax planning alternatives. 17. Change in estimates should be accounted for in the interim period in which the change is made.

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18. Minimum disclosure requirements for interim reports are: (a) Sales or gross revenues, provisions for income taxes, extraordinary items, cumulative effect of a change in accounting principle, and net income; (b) Basic and diluted earnings per share; (c) Seasonal revenue, cost and expenses; (d) Changes in estimates; (e) Effect of a disposal of a segment; (f) Contingencies; (g) Changes in accounting principles; (h) Significant changes in financial position. 19.The general rule is that costs and expenses that are associated directly with or allocated to the products sold or to the services rendered for annual reporting purposes should be treated in a similar manner for interim reports. BUSINESS ETHICS SOLUTIONS Business ethics solutions are merely suggestions of points to address. The objective is to raise the students' awareness of the topics, and to invite discussion. In most cases, there is clear room for disagreement or conflicting viewpoints. 1. Information to be presented for each of a firm’s reportable segments: • General information • Information about segment operating profit or loss • Information about segment assets • Information about the bases for measurement • Reconciliation (IAS 14 vs. FASB ASC 280) of segment amounts and consolidated amounts for revenue, profit or loss, assets, and significant other items. • Interim disclosures • Enterprise-wide disclosures 1. Product or service disclosures 2. Geographic area disclosures 3. Major customer disclosures 2. Since the management currently measures profit and losses and asset allocation by restaurant concept, an abrupt change to presenting the segment information by geographical location only could be viewed as unethical. However, this area is one where the standards clearly leave the door open for subjectivity in interpretation. If management has a motivation for preferring to keep the information about the poorly performing restaurant private that is not counter to the objectives of the shareholders and other claim-holders (for example, prefers not to expose that information to competitors while a restructuring plan is implemented), then there could be ethical reasons for a shift in disclosure choices. According to FASB ASC 280 , firms should segment their disclosures along the same lines that management uses in decision-making. This does not appear to be the case here. Thus, the CEO’s decision to present the segment information by geographical location seems to be counter to the intent of segmental reporting, i.e., the unveiling of information that has been merged or buried in the consolidated data. 14 - 4

ANALYZING FINANCIAL STATEMENTS SOLUTIONS AFS 14-1 1. GE organizes the segment data based on the nature of markets and customers. 2 and 3.

2010

2009

2008

2007

2006

Energy Infrastructure

$37,514

$40,648

$43,046

$34,880

$28,816

Growth Rate 20082010 -12.85%

Technology Infrastructure

37,860

38,517

41,605

38,338

33,735

-9.00%

NBC Universal

16,901

15,436

16,969

15,416

16,188

-0.40%

GE Capital

47,040

49,746

67,645

67,217

57,943

-30.46%

Home & Business Solutions

8,648

8,443

10,117

11,026

11,654

-14.52%

147,963

152,790

179,382

166,877

148,336

-17.52%

SEGMENT PROFIT

2010

2009

2008

2007

2006

Energy Infrastructure

$7,271

$7,105

$6,497

$5,238

$3,806

Technology Infrastructure

6,314

6,785

7,460

7,186

6,687

NBC Universal

2,261

2,264

3,131

3,107

2,919

GE Capital

3,265

1,462

8,063

12,306

10,324

457

370

365

983

928

19,568

17,986

25,516

28,820

24,664

Segment Profit Margin

2010

2009

2008

2007

2006

Energy Infrastructure

19.38%

17.48%

15.09%

15.02%

13.21%

Technology Infrastructure

16.68%

17.62%

17.93%

18.74%

19.82%

NBC Universal

13.38%

14.67%

18.45%

20.15%

18.03%

GE Capital

6.94%

2.94%

11.92%

18.31%

17.82%

Home & Business Solutions

5.28%

4.38%

3.61%

8.92%

7.96%

Total segment profit margin

13.22%

11.77%

14.22%

17.27%

16.63%

2010

2009

2008

Growth

38,606 51,474 33,792 575,908 4,280 704,060

36,663 50,245 32,282 607,707 4,955 731,852

36,973 51,863 33,781 627,501 4,908 755,026

REVENUES

Total segment revenues

Home & Business Solutions Total segment profit

Segment Assets

Energy infrastructure Technology infrastructure NBC Universal GE Capital Home & Business Solutions Total Assets

14 - 5

Segment Asset Turnover

2010

2009

2008

Energy Infrastructure

0.97

1.11

1.16

Technology Infrastructure

0.74

0.77

0.80

NBC Universal

0.50

0.48

0.50

GE Capital

0.08

0.11

Home & Business Solutions Total Segment Asset Turnover

2.02

1.70

2.06

0.21

0.24

4. Segment Revenues to Total Revenues 2010

2009

2008

2007

2006

Energy Infrastructure

25.35%

26.60%

24.00%

20.90%

19.43%

Technology Infrastructure

25.59%

25.21%

23.19%

22.97%

22.74%

NBC Universal

11.42%

10.10%

9.46%

9.24%

10.91%

GE Capital

31.79%

32.56%

37.71%

40.28%

39.06%

Home & Business Solutions

5.84%

5.53%

5.64%

6.61%

7.86%

100.00%

Total Revenues

Segment Profit to Total Profit 2010

2009

2008

2007

2006

Energy Infrastructure

37.16%

39.50%

25.46%

18.17%

15.43%

Technology Infrastructure

32.27%

37.72%

29.24%

24.93%

27.11%

NBC Universal

11.55%

12.59%

12.27%

10.78%

11.84%

GE Capital

16.69%

8.13%

31.60%

42.70%

41.86%

Home & Business Solutions

2.34%

2.06%

1.43%

3.41%

3.76%

100.00%

Total segment profits

All segments experienced negative sales growth with NBC Universal’s revenues staying relatively flat. In terms of grow in assets, the Energy Infrastructure grew at 4% while most of the remaining segment’s asset growth was negative. The energy and technology infrastructure segments generate more than 50% of GE’s revenue and approximately 79% of GE’s profits. Both segments have experienced recent declines in growth since 2006. However, the profit margin percentage for the energy segment has been growing and is almost 20% in 2010. NBC Universal has seen flat revenues since 2006 with declining profit margins. This segment contributes approximately 11% of both GE’s revenues and profits. GE Capital has seen the largest decline in revenues of all segments. The profit margin has a lot of variability ranging from a high of 18% of 2007 to a low of 3% in 2009.

14 - 6

AFS 14-1 (Concluded) NBC Universal’s revenues grew at 114% over the last three years, but it is the smallest segment measured by revenues. Even though, this segment generates over a 20% profit margin. Home & Business Solutions revenues also have been decreasing at around 14%. However, the segment still contributes around 5% of GE’s revenues and 2 to 3% of the profits. 5. In the appendix to the textbook, the revenues recognized within the US and outside the US are listed. Based on revenues, the amount of revenues recognized has been fairly constant over the last three years with 47% of the revenues recognized in the US and 53% outside the US. If you went to GE’s 10K and found the information on plant and equipment located within and outside the US, there is an increase in plant and equipment outside the US. In Millions of Dollars

Percentage

From the Appendix

2010

2009

2008

2010

2009

2008

Revenues within US Revenues Outside US

70,506 79,705

72,240 83,038

85,012 96,569

46.94% 53.06%

46.52% 53.48%

46.82% 53.18%

17,596 48,618

19,798 49,172

27,667 50,861

26.57% 73.43%

28.71% 71.29%

35.23% 64.77%

From the 10K Plant & Equip. within US Plant & Equip. outside US

AFS 14-2 Eli Lilly Interim Reports 1. Lilly’s gross margin increased by approximately 7 percent, and increased as a percentage of sales from 79.5% to 79.8%. March 31 Total revenue Cost of sales Gross margin

Three Months Ended 2011 2010 %Chg $5,839.20 $5,485.50 6% 1,180.10 1,122.50 5% $4,659.10 $4,363.00 7%

% of Sales 2011 2010 100.0% 100.0% 20.2% 20.5% 79.8% 79.5%

2. The following schedule shows the GAAP results and the Non-GAAP results.

14 - 7

March 31 Total revenue Cost of sales Gross margin Research and development Marketing, selling and administrative Acquired in-process research and development Asset impairments, restructuring and other special charges Operating income Net interest income (expense) Net other income (expense) Other income (expense) Income before income taxes Income taxes Net income

GAAP Results Three Months Ended 2011 2010 %Chg $5,839.20 $5,485.50 6% 1,180.10 1,122.50 5% $4,659.10 $4,363.00 7% 1,124.00 1,785.70

1,039.10 8% 1,614.40 11%

388 76.3 1,285.10 -30.3 19.1 -11.2

0.95 0.95

Analysts' projected EPS

1.16

1,124.00 1,785.70

1,039.10 1,614.40

8% 11%

1,749.40 -30.3 19.1 -11.2

1,709.50 -37 111.5 74.5

50 26.2 1,633.30 -21% -37 111.5 74.5

1,273.90 1,707.80 -25% 218 459.7 -53% $1,055.90 $1,248.10 -15%

EPS - Basic EPS - Diluted

NON GAAP Results Three Months Ended 2011 2010 %Chg $5,839.20 $5,485.50 6% 1,180.10 1,122.50 5% $4,659.10 $4,363.00

1.13 1.13

1,738.20 1,784.00 -3% 363.3 486.4 -25% $1,374.90 $1,297.60 6% 1.24 1.24

1.18 1.18

The items excluded in the non-GAAP are the acquired in-process R&D expenses and the asset impairment and restructuring charges. The one-time payment of 300 million euros is somewhat difficult to evaluate. If Lilly would have developed the compound on its own, the cost would have been expensed as R&D expense. Lilly is feeling the pressure from having several important products losing patent protection over the next several years and needed to find a way to develop some products. 3. The analysts must have excluded the same items because the 300 million euro payment was known as of January 2011. 4. The market is concerned about the loss in patent protection for two of its highest revenue producing drugs, Zyprexa this year and Cymbalta in 2013. Revenues increased by 6%; yet the operating margin dropped 21% (GAAP) or increased slightly by 2% (Non-GAAP).

14 - 8

AFS 14-3 IBM Segmental Reporting 1. First quarter 2011 revenues and gross margin percentage by segments. ($ millions) REVENUE Global Technology Services Gross profit margin Global Business Services Gross profit margin Software Gross profit margin Systems and Technology Gross profit margin Global Financing Gross profit margin Other Gross profit margin TOTAL REVENUE

2011

2010

% Chg.

$9,863 33.8% 4,710 27.4% 5,308 87.0% 4,019 37.8% 516 53.5% 190 -93.3% 24,607

$9,306 34.2% 4,410 27.2% 5,018 85.6% 3,385 33.1% 537 49.8% 200 -45.6% 22,857

6.00%

GROSS PROFIT Gross profit margin

10,858 44.1%

9,976 43.6%

6.80% 5.80% 18.70% -4.00% -4.60% 7.70%

8.80%

Overall revenues grew at 7.7% while the gross margin percentage increased to 441% a growth rate of 8.8%. 2. Geographical Areas Revenues ($ millions) Americas Europe Asia Pacific OEM Total Revenue

2011 10,300 7,800 5,900 600 24,600

Growth 9% 3% 12% 13% 8%

OEM is original equipment manufacturer (company that supplied equipment to other companies to resell or incorporate into another product using the reseller's brand name.) Growth markets resulted in higher revenue growth for IBM. 3. Reportable segment performance. The five reportable segments (technically six segments) are Global Technology Services, Global Business Services, Software, Systems and Technology, Global Financing, and Other.

14 - 9

AFS 14-3 IBM Segmental Reporting (continued) Segment Revenue Analysis ($ millions) REVENUE Global Technology Services Global Business Services Software Systems and Technology Global Financing Other TOTAL REVENUE

2011

2010

% Chg.

$9,863 4,710 5,308 4,019 516 190 24,607

$9,306 6.00% 4,410 6.80% 5,018 5.80% 3,385 18.70% 537 -4.00% 200 -4.60% 22,857 7.70%

% of Total Revenue 2011 2010 40.1% 19.1% 21.6% 16.3% 2.1% 0.8% 100.0%

40.7% 19.3% 22.0% 14.8% 2.3% 0.9% 100.0%

Revenues for the systems and technology segment grew at 19% and now comprise 16% of total revenues. The smallest two segments (global financing and other) were the only segments experiencing negative growth rates in revenues.

Gross Margin Analysis ($ millions) Gross Margin Global Technology Services Gross profit margin % Gross margin ($ millions) Global Business Services Gross profit margin % Gross margin ($ millions) Software Gross profit margin % Gross margin ($ millions) Systems and Technology Gross profit margin % Gross margin ($ millions) Global Financing Gross profit margin % Gross margin ($ millions) Other Gross profit margin % Gross margin ($ millions)

2011

2010

% Chg.

33.8% $3,334

34.2% $3,183

4.7%

27.4% $1,291

% of Total Gross Margin 2011 2010

30.7%

31.9%

27.2% $1,200 0.7%

11.9%

12.0%

87.0% $4,618

85.6% $4,295 1.6%

42.6%

43.1%

37.8% $1,519

33.1% $1,120 14.2%

14.0%

11.2%

53.5% $276

49.8% $267 7.4%

2.5%

2.7%

-93.3% ($177)

-45.6% ($91)

-1.6%

-0.9%

Total Gross profit margin % 44.1% 43.6% Gross margin ($ millions) $10,852 $9,966 8.9% 100.0% 100.0% The systems and technology segment’s gross margin increased by 14%, but the software segment generates a gross margin of around 87% (but the gross margin only grew by 1.6%).

14 - 10

ANSWERS TO EXERCISES Exercise 14-1 Segments A, C, and D are reportable segments because the amount of each of their operating profit or loss is more than 10% of the greater in absolute amount of the combined operating profit of all segments that did not incur a loss ($1,000) or the combined operating loss of all segments that did incur an operating loss($1,300). Thus, any segment with an operating profit or loss of $130 or more meets this test. Segment B is not a reportable segment because its operating profit is less than 10% of $1,300. Exercise 14-2 Segment V W X Y Z

Segment Sales to Total Sales 2 ,400 4 ,875 300 4 ,875 700 4 ,875 1,100 4 ,875 375 4 ,875

Reportable Segment

Yes

Exercise 14-3 Revenue Test Industry segments A and B are reportable segments under this test because their total revenue is 10% or more of combined total revenue of $366,000. The other segments do not meet this test. Operating Profit Test Industry segments A and B are reportable segments under this test because the absolute amounts of their operating profit or loss are each at least 10% of the greater of (1) the combined profit of all operating segments that did not incur a loss ($12,000 + $1,500 = $13,500), or (2) the combined loss of all operating segments that incurred a loss ($17,400 + $600 = $18,000). Segments A and B both have operating profit or loss of more than $1,800 (10%  $18,000). The other segments are not reportable segments under this test. Identifiable Assets Test Operating segments A and B are reportable segments because their identifiable assets are at least 10% of the combined assets of all segments. The other segments are not reportable segments under this test.

14 - 11

Exercise 14-3 (continued) Final Test Combined sales to nonaffiliated customers by segments A and B $100,000 Combined sales to nonaffiliated customers by all segments = = 73% $136,200 Because the 75% test is not met, one of the segments that did not qualify as a reportable segment under the previous tests must be included as a reportable segment. Exercise 14-4 Ratio of each segment's payroll dollars to total payroll dollars of all segments: 34,800 18,200 Segment A: Segment B: = 0.66 = 0.34 53,000 53,000 Ratio of each segment's operating revenue to the total operating revenue of all segments 99,000 60,000 = 0.38 Segment B: = 0.62 Segment A: 159,000 159,000 Ratio of each segment's assets to the total assets of all segments: 70,000 54,500 Segment A: = 0.56 Segment B: = 0.44 124,500 124,500 Formula Allocation of Joint Expenses The arithmetic average of the three percentages above for each segment times the joint expenses: 0.66 + 0.38 + 0.56 = 0.533 ; 0.533  $15,000 = $7,995 Segment A: 3 0.34 + 0.62 + 0.44 = 0.467 ; 0.467  $15,000 = $7,005 Segment B: 3 Operating Profit (Loss) of each Segment Segment A: $60,000 - $27,200 - $12,600 - $7,995 = $12,205 Segment B: $99,000 - $35,600 - $10,800 - $7,005 = $45,595 Exercise 14-5 Estimated income tax for the first three quarters: 0.38  ($70,000 + $50,000 + $40,600) Actual tax provision for the first two quarters: 0.32  ($70,000 + $50,000) Estimated provision for the first third quarter: Exercise 14-6 A. Property taxes B. Major repairs C. Inventory loss D. Gain on sale of equipment

March 31 $ 15,000 0 0 0

June 30 $ 15,000 22,000 0 0

14 - 12

Sept. 30 $ 15,000 22,000 150,000 10,500

Dec. 31 $ 15,000 22,000 0 0

$ 61,028 (38,400) $ 22,628

Exercise 14-7 Case A Cost of Goods Sold Quarter Cumulative $3,000,000 $3,000,000

Computation 1 Sold 100,000 units @ $30 2 Sold 30,000 units @ $30 Write down of ending inventory of 124,000 to market (124,000  ($30 - $22)

$900,000

3 Sold 42,500 units @ $22 Write down of ending inventory of 81,500 to market (81,500  ($22 - $18))

935,000

4 Sold 30,500 units @ $18 Less write down recovery on ending inventory of 51,000 (51,000  ($22 - $18))

549,000

992,000

326,000

204,000

1,892,000

4,892,000

1,261,000

6,153,000

345,000

6,498,000

Verification Units Sold During Year FIFO Cost per Unit Amount 203,000  $30 $6,090,000 Add: Write down of ending inventory to the lower of cost or market (51,000  ($30 - $22)) 408,000 Total cost of goods sold for the year $6,498,000 Case B Computation 1 Sold 100,000 units @ $30 Write down of ending inventory of 154,000 to market (154,000  ($30 - $25))

Cost of Goods Sold Quarter Cumulative $3,000,000 $3,770,000

$3,770,000

248,000

502,000

4,272,000

3 Sold 42,500 units @ $27 1,147,500 Write down of ending inventory of 81,500 units to market (81,500  ($27 - $19)) 652,000

1,799,500

6,071,500

171,500

6,243,000

2 Sold 30,000 units @ $25 Less write down recovery on ending inventory of 124,000 (124,000  ($27 - $25))

4 Sold 30,500 units @ $19 Less write down recovery on ending inventory of 51,000 (51,000  ($27 - $19))

770,000 750,000

579,500 408,000

Verification Units Sold During Year FIFO Cost per Unit 203,000  $30 Add: Write down of ending inventory to the lower of cost or market (51,000  ($30 - $27)) Total cost of goods sold for the year 14 - 13

Amount $6,090,000 153,000 $6,243,000

Exercise 14-8 First Quarter Estimated Annual Earnings Add: Environmental Violation Penalties

$1,350,000 25,000 1,375,000 180,000 $1,195,000

Deduct: Dividend Income Exclusion Estimated Taxable Income Estimated Annual Income Tax Payable ($1,195,000  0.42) $501,900 Estimated Effective Combined Annual Tax Rate ( ) $1,350,000 Income Tax Expense Income Tax Payable (0.372  $400,000) Second Quarter Estimated Annual Earnings Less: Net Permanent Differences ($180,000 - $25,000) Estimated Taxable Income

501,900 37.2% 148,800 148,800

$1,420,000 155,000 $1,265,000

Estimated Annual Income Tax Payable (1,265,000  0.42) $531,300 Estimated Effective Combined Annual Tax Rate ( ) $1,420,000 Cumulative Income to Date ($400,000 + $510,000) Estimated Income Tax Rate: Cumulative Tax Provision Needed Tax Provision in 1st Quarter Tax Provision in 2nd Quarter Income Tax Expense Income Tax Payable

531,300 37.4% $910,000 0.374 340,340 148,800 $191,540 191,540 191,540

Exercise 14-9 1. a 2. b 3. c 4. d 5. c 6. a 7. c 8. a

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ANSWERS TO ASC (Accounting Standards Codification) EXERCISES ASC14-1 Presentation Practices vary in determining costs of inventory. For example, cost of goods produced may be determined based on standard or actual cost, while cost of inventory may be determined on an average, first-in, first-out (FIFO), or last-in, first-out (LIFO) cost basis. While entities generally use the same inventory pricing methods, and make provisions for write-downs to market, at interim dates as at annual inventory dates, does the Codification allow for exceptions at interim reporting dates? What effect might differences in interim reporting have on evaluation methods employed by analysts and other users? Step 1: Use the drop-down menus under the ‘Assets’ general topic on the homepage and choose ‘330Inventory’; then using the second pull-down menu choose ‘10-Overall’. Step 2: Click on the red ‘join all sections’ button and expand the table of contents. Scroll through the paragraphs for guidance on interim reporting. Under section 35 for Subsequent Measurement, click on ‘Interim Financial Reporting.’ Interim reporting guidance is found in FASB ASC 270-10-45-6. In this paragraph, exceptions for companies to use alternative methods at an interim period are listed. These include: a. Some entities use estimated gross profit rates to determine the cost of goods sold during interim periods or use other methods different from those used at annual inventory dates. b. Entities that use the LIFO method may encounter a liquidation of base period inventories at an interim date that is expected to be replaced by the end of the annual period. In such cases the inventory at the interim reporting date shall not give effect to the LIFO liquidation, and cost of sales for the interim reporting period shall include the expected cost of replacement of the liquidated LIFO base. c. Inventory losses from market declines shall not be deferred beyond the interim period in which the decline occurs. Recoveries of such losses on the same inventory in later interim periods of the same fiscal year through market price recoveries shall be recognized as gains in the later interim period. Such gains shall not exceed previously recognized losses. Some market declines at interim dates, however, can reasonably be expected to be restored in the fiscal year. Such temporary market declines need not be recognized at the interim date since no loss is expected to be incurred in the fiscal year. d. Entities that use standard cost accounting systems for determining inventory and product costs should generally follow the same procedures in reporting purchase price, wage rate, usage, or efficiency variances from standard cost at the end of an interim period as followed at the end of a fiscal year. Purchase price variances or volume or capacity cost variances that are planned and expected to be absorbed by the end of the annual period, should ordinarily be deferred at interim reporting dates. The effect of unplanned or unanticipated purchase price or volume variances, however, shall be reported at the end of an interim period following the same procedures used at the end of a fiscal year. When a company uses an alternative method, such as gross profit rates, to estimate the cost of goods sold in an interim period, the analyst should exercise more caution in relying on the numbers, as small errors in gross profit rates can make large differences in reported earnings in many instances. One approach would be to look at actual gross profit rates for other firms in the same industry during the current year to see if any adjustments are likely to be needed. ASC14-2 Presentation Is a firm required to report a Statement of Comprehensive Income on an interim basis? 14 - 15

Step 1: Use the drop-down menus under the ‘Presentation’ general topic on the homepage and choose ‘270-Interim Reporting’; then using the second pull-down menu choose ‘10-Overall’. Step 2: Click on the red ‘join all sections’ button and expand the table of contents. Click on Section 45 Other Presentation Matters and scroll through the paragraphs. In paragraph 45-19, information on interim reporting is linked to paragraph 220-10-45-18. Click on this link. An entity shall report a total for comprehensive income in condensed financial statements of interim periods. In pending content (ASU 2011-05), an entity shall report the components of net income and other comprehensive income and total for comprehensive income in condensed financial statements of interim periods. ASC14-3 Disclosure A company incurred an extraordinary loss in the second quarter and has prorated this loss over the three remaining quarters in the current fiscal year. Is this appropriate? Why or why not? Step 1: Use the drop-down menus under the ‘Presentation’ general topic on the homepage and choose ‘270-Interim Reporting’; then using the second pull-down menu choose ‘10-Overall’. Step 2: Click on the red ‘join all sections’ button and expand the table of contents. Look for sections discussing extraordinary items. Both sections 45 Other Presentation Matters and section 50 on Disclosures provide guidance on interim reporting for extraordinary items. FASB ASC paragraph 270-10-45-11A states that extraordinary items shall not be prorated over the balance of the fiscal year. ASC14-4 Scope If a non-SEC reporting company decided to issue monthly interim financial statements, would the GAAP Codification apply? Step 1: Use the drop-down menus under the ‘Presentation’ general topic on the homepage and choose ‘270-Interim Reporting’; then using the second pull-down menu choose ‘10-Overall’. Step 2: Click on section 15 Scope and Scope Exceptions. Scroll through the paragraphs FASB ASC paragraph 270-10-15-3 states that the guidance in the Interim Reporting Topic applies whenever entities issue interim financial information. It provides guidance on the applicability of generally accepted accounting principles (GAAP) to interim financial information and indicates types of disclosures necessary to report on a meaningful basis for a period of less than a full year. There may be occasions when a private company provides an interim report to its local bank on an informal basis without an audit or review; in such cases, there may be certain aspects of the GAAP Codification that are not strictly adhered to. The question of whether there should be two sets of GAAP (sometimes referred to as big GAAP and little GAAP) for public and private companies has risen repeatedly over time, and has never been entirely put to rest. However, FASB has refrained from this path thus far, as it is most likely viewed as a rather slippery slope. ASC14-5 Presentation Are interim periods considered stand-alone financial statements or are they considered an integral part of the annual financial statements under current GAAP? Do you concur with this position? Why or why not? Alternative 1:

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ASC14-6 Disclosure If a company does not present a separate fourth-quarter interim report for its income statement, but presents only the annual income statement at that time, are there any additional disclosure requirements? If so, what are they? Alternative 1: Step 1: Use the drop-down menus under the ‘Presentation’ general topic on the homepage and choose ‘270-Interim Reporting’; then using the second pull-down menu choose ‘10-Overall’. Step 2: Click on the red ‘join all sections’ button and expand the table of contents. (If you are using a browser with search capabilities such as Firefox, you can use the ‘find’ feature and search for ‘fourth’. This eventually finds the correct paragraph. Alternative 2: Step 1: Use the drop-down menus under the ‘Presentation’ general topic on the homepage and choose ‘270-Interim Reporting’; then using the second pull-down menu choose ‘10-Overall’. Step 2: Click on section 50 Disclosure and scroll through the paragraphs FASB ASC paragraph 270-10-50-2 states that in the absence of a separate fourth quarter report or disclosure of the results for that quarter in the annual report, disposals of components of an entity and extraordinary, unusual, or infrequently occurring items recognized in the fourth quarter, as well as the aggregate effect of year-end adjustments that are material to the results of that quarter shall be disclosed in the annual report in a note to the annual financial statements. ASC14-7 General The guidance for segmental reporting is located in which general topic area (i.e., 100–general principles, 200–presentation, 300–assets, etc.)? List the specific topic number (i.e., ASC XXX). On the Codification homepage, use the drop-down menu for the general topics and look for a topic related to segmental reporting. FASB ASC Topic 280 [Segment Reporting]

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ANSWERS TO PROBLEMS Problem 14-1 Revenue Test Operating Segment 1 2 3 4 5 6 7

Revenue $ 4,200 6,000 51,000 48,000 13,000 64,500 12,000 $198,700

Operating Profit (Loss) Test Operating Operating Segment Profit 1 2 $2,000 3 2,100 4 8,800 5 3,200 6 4,000 7 ______ $20,100 Identifiable Assets Operating Identifiable Segment Assets 1 $ 7,000 2 8,800 3 35,400 4 37,600 5 14,000 6 52,000 7 16,400 $171,200

% of Total Revenue 2.1% 3.0% 25.7% 24.2% 6.5% 32.5% 6.0% 100.0%

Operating Loss $(600)

(3,000) $(3,600)

% of Total 4.1% 5.1% 20.7% 22.0% 8.2% 30.4% 9.6%

Reportable Segment No No Yes Yes No Yes No

% of Largest of Op. Profit or Op. Loss 3.0% 9.9% 10.4% 43.8% 15.9% 19.9% 14.9%

Reportable Segment No No Yes Yes Yes Yes Yes

Reportable Segment No No Yes Yes No Yes No

Thus, operating segments 3, 4, 5, 6, and 7 are reportable segments because they each meet one or more of the above tests.

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Problem 14-2 The joint expense allocation is determined as follows: Adjusted Operating Profit (Loss)

Profit Center A B C D

2,700  $2,400,000 = 12,000 5,700  $2,400,000 = 12,000 1,500  $2,400,000 = 12,000 2,100  $2,400,000 = 12,000

$540,000

$300,000

$1,140,000

$360,000

$300,000

$(60,000)

$420,000

$(480,000)

Part A The results of the tests for each combination are summarized below. Note that, although intersegment sales are included for purpose of segment reporting, intrasegment sales should be eliminated. Industry Segment AB CD

Revenue Test 70%* 30%

Operating Profit Test 100% 82%

AB C D

70% 9% 21%

100% 9% 73%

84% 8% 8%

Yes No Yes

A B CD

23% 50% 27%

56% 67% 100%

24% 60% 16%

Yes Yes Yes

A B C D

23% 50% 8% 19%

45% 55% 9% 73%

24% 60% 8% 8%

Yes Yes No Yes

A BD C

25% 66% 9%

100% 40% 20%

24% 68% 8%

Yes Yes Yes

Combination 1

Identifiable Reportable Assets Test Segment 84% Yes 16% Yes

*The percentages for combination one are determined as follows: AB segment: $3,600 + $8,700 + ($1,500 – $1,200) + ($2,400 - $1,200) = CD segment: $1,500 + $1,200 + ($300 – 0) + ($3,000 – $150) =

$13,800 5,850 $19,650

70% 30% 100%

Part B For combinations 1, 3, and 5, 100 percent for sales to unaffilated customers is explained by the reportable segments. For combinations 2 and 4, the figure is 90 percent ($13,500/$15,000). Thus, in each situation, the segments deemed reportable by applying the three tests are sufficient for purposes of satisfying the requirements of FASB ASC 280-10-50-12.

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Problem 14-3 Part A An operating segment that meets any one or more of the ten percent revenue, operating profit (or loss), or identifiable assets tests must be reported separately. Additionally, the combined revenue from sales to unaffiliated customers of all separately reported segments must constitute at least seventy-five percent of the combined revenue from sales to unaffiliated customers of all operating segments. These restrictions represent minimum levels that must be attained. Beyond these levels, management may report additional segments if it so desires. Part B

The fact that the FASB allows management considerable flexibility as to the method of presenting segment information can help to alleviate management's fears. The implication underlying management's concern is that too much information is being supplied in the statements. Too much information can result in an added burden to the statement users who may have to sift through excessively detailed information, some of which may not be relevant to their needs. Although this argument may or may not be valid, disclosure of segment information could be creatively presented. For instance, a separate section of the report could contain this information.

Part C

A primary objective of financial reporting is to provide information that is useful for making economic decisions. Investors, for example, need information to aid them in evaluating the risk and return of a prospective investment. Such an evaluation is not as easily made where consolidated financial statements reflect diversified operations, each of which experience different rates of profitability, growth, and risk. Thus, segment reporting represents an attempt to disaggregate the consolidated statements information so that each unique operation can be evaluated separately. Presumably, this approach will result in better economic decisions by users of financial statements.

Part D

The effect of intersegment transactions is included as a part of required segment information. This approach will enhance segment comparability with other unaffiliated entities or their segments. Comparability has been described as a qualitative characteristic which makes financial information useful. The required elimination of, say, a substantial portion of a segment's sales would seriously restrict the comparability between two otherwise similar entities. This is the major reason why the effect of such transfers is not eliminated. Arguments have been advanced, however, that favor the exclusion of intersegment sales when determining segment revenue. These arguments include: (1) The absence of a bargained market transaction normally precludes the recognition of revenue. (2) The transfer price is not objectively verifiable. (3) The level of intersegment transfers will often be affected by the internal production decisions of other segments.

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Problem 14-4 Part A Revenue Test Sales to Nonaffiliates Intersegment Sales Total Revenue

A $57,000 0 $57,000

B $120,000 0 $120,000

C $760,000 120,000 $880,000

D $50,000 0 $50,000

E $43,000 40,000 $83,000

Combined $1,030,000 160,000 $1,190,000

$16,000

$6,000

$165,000

Industries B and C have total revenue of 10% or more of combined total revenue. Operating Profit Test Operating Profit (Loss)

$12,000

$(25,000)

$156,000

Industries B and C are reportable segments because the absolute amounts of the operating profit or loss are at least 10% of the greater of (1) the combined profit of all operating segments that did not incur a loss ($190,000), or (2) the combined loss of all operating segments that incurred a loss ($25,000). Identifiable Assets Test Identifiable Assets $50,000 $95,000 $600,000 $98,000 $240,000 $1,083,000 Industries C and E are reportable segments because their identifiable assets are at least 10% of combined identifiable assets Overall 75% Test Sales to Nonaffiliates by Reportable Segments Total Sales to Nonaffiliates

Segments B, C, and E are reportable segments.

C $760,000 120,000 $880,000

E $43,000 40,000 $83,000

Other $107,000 $107,000

$(160,000) $(160,000)

Operating Profit (loss) $(25,000) General Corporate Expenses Income from Operations

$156,000

$6,000

$28,000

$165,000 76,000 $89,000

Identifiable Assets Corporate Assets Total Assets

$95,000

$600,000

$240,000

$148,000

$1,083,000 95,000 $1,178,000

Depreciation & Amortization $10,700 Capital Expenditures $8,000

$76,000 $39,000

$26,400 $25,000

$18,600 $25,600

Part B Sales to Nonaffiliates Intersegment Sales Total Revenue

B $120,000

$923,000 = 90% $1,030,000

$120,000

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Eliminations

Consolidated $1,030,000 $1,030,000

Problem 14-4 (continued) Enterprisewide Disclosures Revenue United States Canada Total Consolidated Revenues

$ 937,000 93,000 $1,030,000

Long-Lived Assets United States* Canada Total Consolidated Assets

$ 840,000 338,000 $1,178,000

* We have assumed that all corporate assets are located in the United States. Major Customers: We do not provide information on major customers because no single external customer represented 10% or more of total revenues.

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Problem 14-5 Part A Revenue Test Total Revenue

L $40,000

M $85,000

N $600,000

O $50,000

P $48,000

Combined $823,000

Industries M and N are the only ones whose total revenue is 10% or more of combined total revenue. Operating Profit Test Operating Profit (Loss) 8,000 (11,000) 81,000 9,000 3,000 90,000 Industries M and N are reportable segments because the absolute amounts of the operating profit or loss are at least 10% of the greater of (1) the combined profit of all operating segments that did not incur a loss ($101,000), or (2) the combined loss of all operating segments that incurred a loss ($11,000). Identifiable Assets Test Identifiable Assets 30,000 48,000 320,000 45,000 95,000 538,000 Industries N and P are reportable segments because their identifiable assets are at least 10% of combined identifiable assets. Overall 75% Test Sales to Nonaffiliates by Reportable segments Total Sales to Nonaffiliates

$733,000 = 89% $823,000

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Segments M, N, and P are reportable segments.

Problem 14-5 (continued) Part B – Reconciliation Revenue Total revenue for reportable segments Revenue for other segments aggregated Elimination of intersegment revenue Total Consolidated Revenue

$ 733,000 90,000 (15,000) $ 808,000

Profit and Loss Total profit and loss for reportable segments Other profit and loss Elimination of intersegment profits Unallocated amounts relating to corporate headquarters: Interest expense Depreciation expense Income before taxes

$ 73,000 17,000 0 90,000 1,000 2,000 $ 87,000

Assets Total assets for reportable segments Other assets General corporate assets Total Consolidated Assets

$ 463,000 75,000 90,000 $ 628,000

The following amounts would also be disclosed if known. Other Significant Items Segment depreciation Other depreciation Adjustment for depreciation on corporate assets Consolidated Totals Segment interest expense Other interest expense Adjustment for interest on corporate assets Consolidated Totals Segment capital expenditures Other capital expenditures Adjustment for acquisition on corporate assets Consolidated Totals

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Problem 14-6 First Quarter Estimated Annual Earnings Less: Net Permanent Differences Estimated Taxable Income

$400,000 26,000 $374,000

Estimated Annual Income Tax Payable $374,000  30% $112,200 Estimated Effective Tax Rate = 28.05% $400,000 Entry Income Tax Expense Income Tax Payable 0.2805  $95,000

$112,200

26,648 26,648

Second Quarter Estimated Annual Earnings Less: Net Permanent Differences Estimated Taxable Income

$370,000 26,000 $344,000

Estimated Annual Income Tax Payable $344,000  30% $103,200 Estimated Effective Tax Rate = 27.9% $370,000 Cumulative Income to Date ($95,000 + $85,000) Estimated Income Tax Rate Cumulative Tax Provision Needed Tax Provision in First Quarter Tax Provision in Second Quarter Entry Income Tax Expense Income Tax Payable

$103,200

$180,000 0.279 50,220 26,648 $23,572 23,572 23,572

Third Quarter Estimated Annual Earnings Less: Net Permanent differences Estimated Taxable Income

$370,000 36,000 $334,000

Estimated Annual Income Tax Payable $334,000  30% $100,200 Estimated Effective Tax Rate = 27.1% $370,000 Cumulative Income to Date ($95,000 + $85,000 + $92,000) Estimated Income Tax Rate Cumulative Tax Provision Needed Tax Provided in First Two Quarters Tax Provision for Third Quarter Entry Income Tax Expense Income Tax Payable

$100,200

$272,000 0.271 73,712 50,220 $23,492 23,492 23,492

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Problem 14-6 (continued) Fourth Quarter Actual Earnings For the Year Less: Net Permanent Differences Actual Taxable Income Income Tax Rate (Actual) Actual Income Tax Payable Tax Provided in First Three Quarters Tax Provide for Fourth Quarter

$368,000 41,000 327,000 0.30 98,100 73,712 $24,388

Entry Income Tax Expense Income Tax Payable

24,388 24,388

Problem 14-7 A. This is acceptable. A loss in inventory value should be reported in the period in which it occurs. Recoveries of losses on the same inventory in later periods should be recognized as gains in the later interim periods of the same fiscal year. These gains, however, should not exceed previously recognized losses. B. This is not acceptable. Gains on the sale of investments are not deferred if they occur at year end. Thus, these gains should not be deferred on interim statements, but should be reported in the interim period in which they are realized. C. This is acceptable. Annual audit fees are expenses that benefit the entire year. Companies should make quarterly estimates of these type expenses that generally result in year-end adjustments. Consequently, this expense should be prorated over the four quarters. D. This is not acceptable. Sales revenues should be recognized as earned during the interim period on the same basis as followed for the full year. Since Fur Company normally recognizes revenue when shipment occurs, they should recognize this revenue in the second quarter when the shipments were made. E. This is acceptable. Estimated gross profit rates should be used for interim reporting purposes as long as the method and rates used are reasonable. The company should disclose the method used and any significant adjustments that result from reconciliations with annual physical inventory. F. This is acceptable. Pension costs generally are identified with a time period rather than with the sale of a specific product or service. Companies should make quarterly estimates of these type items that generally result in year-end adjustments. Thus, these costs should be allocated to each of the four interim periods.

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CHAPTER 15 ANSWERS TO QUESTIONS 1. A partnership is not subject to an income tax, but the individual partners report their share of partnership income, whether distributed or not, on their respective individual tax returns. 2. A partner's capital balance represents his or her interest in the net assets of the partnership, whereas a partner's interest in income and loss represents how his or her interest in capital will be affected by the subsequent operations of the partnership. Generally, a partner's capital account is used to recognize asset investments and withdrawals which are not considered temporary. The partner's drawing account is generally used to record withdrawals of assets in anticipation of profitable operations of the partnership or any payments of a partner's personal expenses from partnership assets. 3. A partnership is viewed as a "separate economic entity" in accounting because it has a "separable and definable existence". The assets, liabilities, and residual capital interest, as well as the economic events which affect the various partnership accounts, require a "separable accounting" to provide necessary information to the partners and to others interested in the partnership's performance. 4. Some common methods used in allocating income and loss to partners are: fixed ratio, a ratio based on capital balances, interest on capital, and payment for time devoted to partnership operations, salary and/or bonus. 5. A withdrawal is a reduction in assets, not a distribution of income. A salary is a determinate in the allocation of income and is a reward to the partner for the amount of time devoted to the partnership's operations. 6. A bonus may be calculated in several ways. Some of these are: (1) net income before any income allocations are made; (2) net income after income allocations are made, but before subtracting the bonus; (3) net income after subtracting the bonus, but before any other income allocations are made; and (4) net income after all income allocations are made, including the bonus. 7. The UPA defines "dissolution" as a "change in the relation of the partners caused by any partner ceasing to be associated in the carrying on as distinguished from the winding up of the business." 8. The two methods used to record changes in partnership membership are (1) the bonus method and (2) the goodwill method. Under the bonus method, assets of the partnership are increased by the amount of the assets invested by the new partner or decreased by the amount of the assets paid to a withdrawing partner. The new (withdrawing) partner's capital account is debited (credited) for the capital interest acquired (the balance in the capital account). Any balancing amount is adjusted to the other partners' capital accounts. Under the goodwill method, an intangible asset is recorded based on the difference between the value implied by the amount of consideration exchanged in the admission or withdrawal of a partner and the capital interest of the new or withdrawing partner. 9. An interest in a partnership can be acquired either (1) by purchasing all or part of an interest directly from one or more partners (outside the partnership), called an assignment of partnership interest, or (2) by investing assets in the firm to acquire an interest in the partnership. 15 - 1

10. The bonus and goodwill methods will yield the same result when two conditions relating to the new profit and loss agreement are met. These are: (1) the new partner's profit sharing interest equals his or her initial interest in capital; and (2) the old partners' profit sharing ratio is in the same relative ratio as in the old partnership. 11. Neither the goodwill method nor the bonus method should be used to record the admission of a new partner when (1) the book value of the interest acquired is equal to the value of assets invested, or (2) the net assets of the firm are overvalued. 12. A partner withdrawing in violation of the partnership agreement and without the other partners' approval is entitled only to his or her interest in the firm, without consideration made for any goodwill. The withdrawing partner is also liable to the remaining partners for any damages created by his breach of the partnership agreement. A partner forced to withdraw, however, is entitled to his full interest in the partnership, including any goodwill.

BUSINESS ETHICS SOLUTIONS Business ethics solutions are merely suggestions of points to address. The objective is to raise the students' awareness of the topics, and to invite discussion. In most cases, there is clear room for disagreement or conflicting viewpoints. 1. The defined benefit plan creates a challenge for a firm in a fluctuating market. If the firm is simultaneously struggling with other financial issues, its manager may indeed consider reducing or eliminating the plan. However, such a decision should not be taken lightly, as it would remove an important and valuable benefit to its employees. Certainly, there would be no reason, particularly when the plan is fully funded as it is here, to eliminate any of the previously accrued benefits. However, the firm may wish to revisit the types of benefits offered in the future. One alternative is to switch to a defined contribution plan. This plan is somewhat less appealing to the employee, but it is certainly more desirable than no pension plan and it greatly reduces the volatility and risk to the employer. It is crucial that the employer take into account the manner in which a change in its pension plan will affect its ability to attract and keep top quality employees over the long run, as this is essential to the long-term viability of the company. Changing market dynamics have made firms realize that in order to maximize long-term profits, they have to be socially responsible. Firms, therefore, engage in social responsibility by responding to market demands, legal regulation, including consumer, employment and environmental laws, and by going beyond the letter of the law. Laws combined with markets are often adequate to make profit-maximizing and socially responsible behavior converge. The following points are among those to be considered in reconciling the tradeoffs between financial performance and responsibility to a firm’s employees: •

Employees can insist on socially responsible behavior, both by contract and by deciding where to work. Employees can contract not only about wages and working conditions, but also concerning social responsibility of firms. A corporation’s reputation for social responsibility can attract and retain employees.

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•

Employees derive satisfaction from being associated with, and expect better treatment from, responsible firms.

•

The more difficult the skill set and knowledge requirements for the employees’ position are to fill, the more likely that employee is to be influenced by such benefits as pension plans and such considerations as social responsibility of the firm.

•

Workers are also investors and, more importantly, consumers. The firms must not only hire and contract with its employees, but also motivate them to perform at their maximum level of effort. Disgruntled workers can erode a firm’s goodwill. As discussed above, unions and other groups prefer to deal with worker-friendly firms.

For additional information, see the following link: http://home.law.uiuc.edu/~ribstein/ribsteinpartnershipsocialresponsibility1229.pdf ANSWERS TO EXERCISES Exercise 15-1 Agreed Fair Values Cash Equipment Total assets Note payable assumed by partnership Net assets invested Part A

Bonus Method

Cash Equipment Note Payable John, Capital Jeff, Capital Jane, Capital

100,000 110,000

Invested by John $100,000 100,000 --$100,000

Invested by Jeff --110,000 110,000 30,000 $80,000

Part B

Goodwill Method

Cash Equipment Goodwill 30,000 Note Payable 60,000 John, Capital 60,000 Jeff, Capital 60,000 Jane, Capital

Invested by Jane ----0 --$0

100,000 110,000 90,000 30,000 90,000 90,000 90,000

Part C The bonus method is used when John and Jeff recognize that Jane is bringing something of value to the firm other than a tangible asset, but they do not want to recognize an intangible asset. To equalize the capital accounts, $40,000 is transferred from John's capital account and $20,000 is transferred from Jeff's capital account. The goodwill method is used when the partners recognize the intangible nature of the skills Jane is bringing to the partnership. However, the capital accounts are equalized by recognizing an intangible asset and a corresponding increase in the capital accounts of the partners. Unless the intangible asset can be specifically identified, such as a patent being invested, it should not be recognized, because of a lack of justification for goodwill in a new business.

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Exercise 15-2 Part A (1)

(2)

(3)

Part B

Cash Accounts Receivable Office Supplies Office Equipment Accounts Payable Tom, Capital

13,000 8,000 2,000 30,000

Cash Accounts Receivable Office Supplies Land Accounts Payable Mortgage Payable Julie, Capital

12,000 6,000 800 30,000

Tom, Drawing Cash

15,000

Julie, Drawing Cash

12,000

Income Summary Tom, Capital $50,000  ($51,000/$76,000) Julie, Capital $50,000  ($25,000/$76,000)

50,000

Tom, Capital Julie, Capital Tom, Drawing Julie, Drawing

15,000 12,000

2,000 51,000

5,000 18,800 25,000

15,000

12,000

33,553 16,447

15,000 12,000

TOM AND JULIE PARTNERSHIP Statement of Changes in Partners' Capital For the Year Ended December 31, 2008 Tom 0 51,000 33,553 84,553 15,000 $69,553

Capital balances, Jan. 1 Add: Additional investments Net income allocation Totals Less: Withdrawals Capital balances, Dec. 31

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Julie $ 0 25,000 16,447 41,447 12,000 $29,447

Total 0 76,000 50,000 126,000 27,000 $99,000 $

Exercise 15-3 1

Interest on capital Salary (12 months) Total Remainder divided equally Income allocation

Jones $4,000 24,000 28,000 16,000 $44,000

Silva Thompson $2,500 $3,000 0 18,000 2,500 21,000 16,000 16,000 $18,500 $37,000

Total $9,500 42,000 51,500 48,000 $99,500

Interest on capital and salary Excess allocation ($38,300 - $51,500) Income allocation

$28,000 (4,400) $23,600

$2,500 (4,400) $(1,900)

$21,000 (4,400) $16,600

$51,500 (13,200) $38,300

Interest on capital and salary Excess allocation (-$15,100 -$51,500) Net loss allocation

$28,000 (22,200) $5,800

$2,500 (22,200) $(19,700)

$21,000 (22,200) $(1,200)

$51,500 (66,600) $(15,100)

Nancy $25,000 8,000 33,000 (40,500) $(7,500)

Total $45,000 16,000 61,000 (81,000) $(20,000)

Exercise 15-4 Salary Interest Total Excess allocation (-$20,000 - $61,000) Net loss allocation

Mary $20,000 8,000 28,000 (40,500) $(12,500)

Mary, Capital Nancy, Capital Income Summary

12,500 7,500 20,000

Exercise 15-5 Salary Bonus (schedule 1) Interest on capital Total Remainder Income allocation

(40%)

Tony $42,000 0 38,400 80,400 2,851 $83,251

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(60%)

Jon $66,000 7,273 27,200 100,473 4,276 $104,749

Total $108,000 7,273 65,600 180,873 7,127 $188,000

Exercise 15-5 (continued) Schedule 1 - Bonus Calculation B = .10  (income after salaries - B) B = .10  [($188,000 - $108,000) - B] B = .10  ($80,000 - B) B = $8,000 - .10  B 1.10  B = $8,000 B = $7,273 Proof: Net Income Salaries Bonus Net income subject to bonus B = .10  $72,727 B = $7,273

$188,000 (108,000) (7,273) $72,727

Exercise 15-6 Balances before income allocation and cash distribution Income allocated (Schedule 1)

Hill $70,000

Jones $21,800

59,263

18,030

129,263 91,249 $38,014

Cash distributed (note 1) Ending balances - 12/31

(1)

Vose $(11,700)

Total $80,100 108,000

39,830 33,494 (2) $6,336

30,707 19,007

0.60

0.10

$19,007 0.30

Hill $12,000 4,875 16,875 42,388 (10%) $59,263

Jones $9,600 1,365 10,965 7,065 $18,030

Vose $8,800 713 9,513 (30%) 21,194 $30,707

188,100 124,743 $63,357

Schedule 1 - Income Allocation Salary Interest on capital (5%) Remainder

(60%)

(1) $129,263 – ($63,357 ×.60) (2) $39,830 – ($63,357 ×.10)

Note 1: Hill $129,263/0.60 = $215,438 Jones $39,830/0.10 = $398,300 Vose

Total $30,400 6,953 37,353 70,647 $108,000

$19,007/0.30 = $63,357

Vose is the limiting factor. His balance must be 30% of total capital without investing cash. Therefore the equation $19,007/0.30 = $63,357 is used to figure the maximum capital without additional investments.

15 - 6

Exercise 15-7 1. Phoenix, Capital Dallas, Capital

22,500

2. Phoenix, Capital Tucson, Capital Dallas, Capital

18,000 10,000

3. Cash

60,000

22,500

28,000

Phoenix, Capital ($60,000 - $40,000) × .50 Tucson, Capital Dallas, Capital

10,000 10,000 40,000

($90,000 + $50,000) + $60,000 = $200,000; Therefore, no goodwill is to be recognized. Dallas, capital = $200,000  0.20 = $40,000 4. Goodwill Phoenix, Capital Tucson, Capital

20,000 10,000 10,000

$40,000/0.20 = $200,000 Goodwill = $200,000 - ($90,000 + $50,000 + $40,000) = $20,000 Cash

40,000 Dallas, Capital

40,000

Exercise 15-8 1. Bad Debt Expense Allowance for Doubtful Accounts

180 180

2. Unrealized Loss on Revaluation of Inventory Merchandise Inventory

2,000 2,000

3. Operating Expenses Accrued Liabilities

600

4. Insurance Expense Prepaid Insurance

200

600

200

5. Income Summary Bad Debt Expense Unrealized Loss on Revaluation of Inventory Operating Expenses Insurance Expense

15 - 7

2,980 180 2,000 600 200

Exercise 15-8 (continued) 6. Bill, Capital ($2,980 × .70) Jane, Capital Income Summary

2,086 894 2,980

7. Total capital implied in contract ($14,000/ (1/3)) Minus capital balances + Mike’s investment [($12,000 + $8,000 - $2,980) + $14,000] Goodwill Entries to record Mike’s admission: Goodwill Bill, Capital Jane, Capital ($10,980 × .30)

10,980

Cash

14,000

7,686 3,294

Mike, Capital

14,000

Exercise 15-9 1. Cash

120,000 Mary, Capital

120,000

Calculation of investment: $600,000 = $720,000 - to compute total capital after investment 5/6 $720,000  (1 / 6) = $120,000 - to compute Mary's investment 2. Book value of interest acquired = ($600,000 + $160,000)  (1 / 5) = $152,000 Book value acquired ($152,000) is less than assets invested ($160,000) by $8,000 Bonus Method Cash

160,000

Beth, Capital (0.4  $8,000) Steph, Capital (0.4  $8,000) Linda, Capital (0.2  $8,000) Mary, Capital

3,200 3,200 1,600 152,000

Goodwill Method Total capital implied by contract ($160,000/0.20) Less: Current balances + Mary's investment * Goodwill * ($600,000 + $160,000)

15 - 8

$800,000 (760,000) $40,000

$42,000 31,020 $10,980

Exercise 15-9 (continued) Goodwill Beth, Capital Steph, Capital Linda, Capital (0.2  $40,000)

40,000

Cash

160,000

16,000 16,000 8,000

Mary, Capital

160,000

3. Book value of interest acquired = ($600,000 + $160,000)  ¼ = $190,000 Book value of interest acquired ($190,000) is greater than assets invested ($160,000) by $30,000 Bonus Method Cash Beth, Capital (0.4  $30,000) Steph, Capital (0.4  $30,000) Linda, Capital (0.2  $30,000) Mary, Capital

160,000 12,000 12,000 6,000 190,000

Goodwill Method Goodwill implicit in agreement: Current partners' capital balance total Percentage interest Implied total capital

$600,000 75% $800,000

Implied total capital Less: Current balances + Mary's investment Goodwill

$800,000 760,000 $40,000

Cash Goodwill Mary, Capital

160,000 40,000 200,000

4. Book value of interest acquired = ($600,000 + $160,000)  0.40 = $304,000 Book value of interest acquired ($304,000) is greater than assets invested ($160,000) by $144,000 Bonus Method Cash Beth, Capital (0.4 $144,000) Steph, Capital (0.4  $144,000) Linda, Capital (0.2  $144,000) Mary, Capital

160,000 57,600 57,600 28,800 304,000

15 - 9

Exercise 15-9 (continued) Goodwill Method Total capital implied by contract ($600,000/0.60) Less: Current balances + Mary's investment Goodwill Cash Goodwill Mary, Capital

$1,000,000 760,000 $240,000 160,000 240,000 400,000

Exercise 15-10 1. d

($125,000 + $250,000 - $25,000) = $350,000

2. c

$60,000 is the fair value of the land invested

3. c

$10,000 interest + $14,175 bonus + $6,775 underallocation

4. c

Tom Jim John

5. c

$39,000 + $8,000 (share of revalued assets) - $550 *(share of excess paid to Al)

$80,000 - (0.6  $10,000) $50,000 - (0.4  $10,000) $60,000

* [$61,200 – ($9,000 + $42,000 + $8,000)]  20/80 Exercise 15-11 1. 2. 3. 4. 5. 6.

c e d a b c

Supporting computations 3. Salary Bonus

High $45,000 7,500 52,500 (1,250) $51,250

Low $ -0_______ (1,250) $(1,250)

15 - 10

Total $45,000 7,500 52,500 (2,500) $50,000

Exercise 15-12 Part A Interest on beginning capital Salary Bonus Remainder divided equally Allocation Total

Sue $ 6,000 25,000 ______ 31,000 10,500 $41,500

Josh $ 8,000 21,000 9,000 38,000 10,500 $48,500

Total $14,000 46,000 9,000 69,000 21,000 $90,000

Sue $6,000 25,000

Josh $8,000 21,000 8,182 37,182 10,909 $48,091

Total $14,000 46,000 8,182 68,182 21,818 $90,000

Josh $8,000 21,000 2,727 31,727 13,637 $45,364

Total $14,000 46,000 2,727 62,727 27,273 $90,000

Calculation of bonus: 0.10  $90,000 = $9,000

Part B Interest on capital Salary Bonus

31,000 10,909 $41,909

Remainder divided equally Total Allocation Calculation of bonus:

B= B= 1.1  B = B=

0.10  ($90,000 - B) $9,000 - 0.1  B $9,000 $8,182 Sue $6,000 25,000

Part C Interest on capital Salary Bonus

31,000 13,636 $44,636

Remainder divided equally* Total Allocation Bonus Calculation:

B= B= B= B= 1.1  B = B=

0.1  (NI - I - S – B) 0.1  ($90,000 - $14,000 - $46,000 - B) 0.1  ($30,000 - B) $3,000 - 0.1  B $3,000 $2,727

 $27,273  *Rounded:   = $13,636.50 2  

15 - 11

Exercise 15-13 Part A

Inventory Land Kazma, Capital ($27,000  0.4) Folkert, Capital ($27,000  0.4) Tucker, Capital ($27,000  0.2)

8,000 19,000 10,800 10,800 5,400

Part B 1. Bonus Tucker, Capital ($45,000 + $5,400) Kazma, Capital ($4,600  0.5) Folkert, Capital ($4,600  0.5) Cash Note Payable

50,400 2,300 2,300 15,000 40,000

2. Partial goodwill recorded Goodwill ($15,000 + $40,000 – $50,400) Tucker, Capital

4,600

Tucker, Capital ($45,000 + $5,400 + $4,600) Cash Note Payable

55,000

4,600

15,000 40,000

3. Full goodwill recorded Goodwill ($4,600/0.20) Kazma, Capital ($23,000  0.4) Folkert, Capital Tucker, Capital

23,000

Tucker, Capital Cash Note Payable

55,000

9,200 9,200 4,600

15,000 40,000

15 - 12

ANSWERS TO ASC (Accounting Standards Codification) EXERCISES ASC15-1 General How does the presentation of personal balance sheets differ from balance sheets for entities (in general terms)? Where is this located in the Codification? On the Codification homepage, use the drop-down menu for the general topics and look for a topic related to personal financial statements. FASB ASC Topic 274 [Personal Financial Statements] addresses personal financial statements. Differences between personal balance sheets and entity balance sheets are provided in several sections in Subtopic 10 Overall. In Section 25 Recognition, FASB states that assets and liabilities should be recognized on an accrual basis. In Section 35 Subsequent Measurement, the guidance states that assets should be presented at their estimated current values and liabilities at their estimated current amounts at the date of the financial statements (paragraph 35-1). In Section 45 Other Presentation Matters, the statement of financial condition should include the net worth at a specified date (paragraph 45-4(a4)). Also, the assets and liabilities should be presented by order of liquidity and maturity without classification as current and noncurrent (paragraph 45-7). Estimated income taxes shall be presented between liabilities and net worth (paragraph 45-12). ASC15-3 Disclosure List the relevant paragraph in the Codification that describes the minimum disclosure requirements for personal financial statements. Section 50 Disclosure provides the disclosures that should be included in personal financial statements to make the statements adequately informative. FASB ASC paragraph 274-10-50-2 provides a list of disclosures. ASC15-3 Presentation Where are estimated income taxes reported on the statement of financial condition for personal financial statements? Using the advanced search box, enter the keyword ‘estimated taxes’ and in the codification reference box enter ‘274’ in the Topic box. Five results are obtained (the last one is the correct answer). FASB ASC paragraph 274-10-45-12 states that estimated income taxes shall be presented between liabilities and net worth in the statement of financial condition.

15 - 13

ANSWERS TO PROBLEMS Problem 15-1 1. If the agreement does not provide for a profit-sharing ratio, the UPA provides that profits are to be shared equally. Therefore Day and Night would each get $34,200 allocation. 2. Day Allocation 0.60  $68,400 = Night Allocation 0.40  $68,400 = Total

$41,040 27,360 $68,400

3. Capital Balance 1/1 + Investments - Withdrawals Balance 12/31

Day $75,000 56,250 (18,750) $112,500

Night $37,500 18,750 (9,375) $46,875

Day $75,000 56,250 93,750 112,500

Portion of Year Maintained  3/12  2/12  5/12  2/12 12/12

Total $112,500 75,000 (28,125) $159,375

Profit Allocation: $112,500 Day:  $68,400 = $48,282 $159,375 $46,875 Night: 20,118  $68,400 = $159,375 $68,400

4. 1/1 Balance Withdrawal 4/1 Investment 6/1 Investment 11/1 Average Balance

1/1 Balance Investment 7/1 Withdrawal 10/1 Average Balance

$18,750 37,500 18,750

$18,750 9,375

Profit Allocation: $85,938 Day:  $68,400 = $130,470 $44,532 Night:  $68,400 = $130,470 Total

Night $37,500  56,250  46,875 

$45,054 23,346 $68,400

15 - 14

6/12 3/12 3/12 12/12

Weighted Average $18,750 9,375 39,063 18,750 $85,938

$18,750 14,063 11,719 $44,532

Average Balance

$85,938*

44,532** $130,470

Problem 15-1 (continued) Day *$ 12,891 15,000 27,891 Remainder of $25,579 divided equally 12,790 $40,681

5. Interest on average balance Salaries

* **

Night **$ 6,680 8,250 14,930 12,789 $27,719

Total $ 19,571 23,250 42,821 25,579 $68,400

0.15  $85,938 = $12,891 (see part 4) 0.15  $44,532 = $6,680 (see part 4)

Problem 15-2 Part A

DAVE, BRIAN, AND PAUL PARTNERSHIP Statement of Changes in Partners' Capital Accounts For the Years Ended December 31, 2008, 2009, and 2010

December 31, 2008 Beginning Capital Balances - 1/1 Add: Investments Less: Withdrawals Net loss allocation Capital Balances - 12/31 December 31, 2009 Beginning Capital Balances - 1/1 Add: Investments Net income allocation (40:30:30) Less: Withdrawals Capital Balances - 12/31 December 31, 2010 Beginning Capital Balances - 1/1 Add: Investments Net income allocation: Salaries Bonus * Interest Residual – Equally divided

Dave $45,000 15,000 60,000 (17,000) (1,800) $41,200

Brian $45,000 15,000 60,000 (7,000) (1,800) $51,200

Paul $45,000 6,000 51,000 (3,200) (1,800) $46,000

Total $135,000 36,000 171,000 (27,200) (5,400) $138,400

$41,200 0 10,800 52,000 (17,000) $35,000

$51,200 0 8,100 59,300 (7,000) $52,300

$46,000 6,000 8,100 60,100 (3,200) $56,900

$138,400 6,000 27,000 171,400 (27,200) $144,200

$35,000 0

$52,300 0

$56,900 6,000

$144,200 6,000

42,000

30,000 8,889 5,230 2,231 46,350 98,650 (9,000) $89,650

18,000

90,000 8,889 14,420 6,691 120,000 270,200 (31,200) $239,000

3,500 2,230 47,730 82,730 (19,000) $63,730

Less: Withdrawals Capital Balances - 12/31 *Bonus = 0.08  (NI - B) B = 0.08  ($120,000 - B) = $9,600 - .08B 1.08B = $9,600 B = $8,889

15 - 15

5,690 2,230 25,920 88,820 (3,200) $85,620

Problem 15-2 (continued) Part B Closing Journal Entries: December 31, 2008 Dave, Capital Brian, Capital Paul, Capital Income Summary

1,800 1,800 1,800 5,400

December 31, 2009 Income Summary Dave, Capital Brian, Capital Paul, Capital

27,000 10,800 8,100 8,100

December 31, 2010 Income Summary Dave, Capital Brian, Capital Paul, Capital

120,000 47,730 46,350 25,920

Problem 15-3

2. Prepaid insurance expensed in 2007 Prepaid insurance expensed in 2008 Advances from customers in 2007 Advances from customers in 2008 Accrued interest expense 3. Add back provision for inventory decline 4. Add back purchase price of equipment expensed less depreciation expense of $880 5. Deduct (add) adjustment to allowance account 6. Deduct goodwill recognized Total adjustment to capital accounts

Adjustments to 2007 Income

Adjustments to 2008 Income

$800 --(1,500) --(450)

$(800)a 700 1,500b (900) 450c 8,000

(1,200)

3,520d 160e (5,000) $7,630

$(2,350)

aThis assumes that the prepaid insurance expires in the next year. bThis assumes that the advances are earned in the next year. cThis assumes that the interest expense was deducted in 2008. dDepreciation expense = $4,400  0.20 = $880 2007 e2% of current receivables (0.02  $50,000) $1,000 5% of past due receivables (0.05  $4,000) 200 Allowance account balance at 12/31 $1,200

15 - 16

(0.02  $32,000) (0.05  $8,000)

2008 $640 400 $1,040

Problem 15-3 (continued) Allowance for Bad Debts Write-off-2008 1,800 1/1 Adjustment 12/31 Bal.

1,200 1,640 1,040

During 2008, $1,800 was written off and debited to expense Adjustment to income is $160 or ($1,800 - $1,640) Analysis of Change in Capital Accounts

Cain Gallo Hamm

1/3 1/3 1/3

2007 Adjustment $(783) (783) (784) $(2,350)*

0.40 0.40 0.20

 $2,350  *Number is rounded:   = $783.33  3 

15 - 17

2008 Adjustment $3,052 3,052 1,526 $7,630

Total $2,269 2,269 742 $5,280

Problem 15-3 (continued)

Cain, Gallo, and Hamm Partnership Adjusted Trial Balance December 31, 2008

Unadjusted Balance Dr. Cr. Cash $15,000 Accounts Receivable 40,000 Inventory 30,000 Land 9,000 Buildings 50,000 Allowance for Depreciation of Buildings 6,000 Equipment 56,000 Allowance for Depreciation of Equipment 6,000 Goodwill 5,000 Accounts Payable 56,000 Allowance for Future Inventory Losses 8,000 Cain, Capital 37,000 Gallo, Capital 60,000 Hamm, Capital 32,000 Prepaid Insurance Advances from Customers Allowance for Doubtful Accounts _______ _______ $205,000 $205,000

Adjustment Dr Cr

4,400 880 5,000

Adjusted Balance 12/31/2008 Dr. Cr. $15,000 40,000 30,000 9,000 50,000 6,000 60,400 6,880 56,000

8,000 2,269 2,269 742 700 _______ $13,100

15 - 18

39,269 62,269 32,742

700 900 900 1,040 _______ 1,040 $13,100 $205,100 $205,100

Problem 15-4 1. Book value of interest acquired = ($180,000 + $90,000)  1/3 = $90,000 Bonus Method Cash Moore, Capital

90,000 90,000

2. Book value of interest acquired = ($180,000 + $120,000)  0.45 = $135,000 Book value of interest is greater than assets invested. Bonus Method Cash Brown, Capital (0.60  $15,000) Coss, Capital (0.40  $15,000) Moore, Capital

120,000 9,000 6,000 135,000

The goodwill method is not applicable because the partners agreed to total capital interest of $300,000. 1 = $100,000 3 Bonus method can not be used because Moore will not accept less than $120,000 capital interest.

3. Book value of interest acquired ($180,000 + $120,000) 

Goodwill Method Total capital implied from contract [$120,000/(1/3)] Minus current capital balance + Moore's investment ($180,000 + $120,000) Goodwill

$360,000 300,000 $60,000

Goodwill Brown, Capital (0.60  $60,000) Coss, Capital (0.40  $60,000)

60,000

Cash

120,000

36,000 24,000

Moore, Capital

120,000

4. Book value of interest acquired ($180,000 + $40,000)  ¼ = $55,000 Book value of interest acquired is greater than assets invested. Bonus Method Cash Brown, Capital (0.60  $15,000) Coss, Capital (0.40  $15,000) Moore, Capital

40,000 9,000 6,000 55,000

15 - 19

Problem 15-4 (continued) 5. Book value of interest acquired ($180,000 + $35,000)  0.20 = $43,000 Book value of interest acquired is greater than the asset invested. Goodwill Method Total capital $225,000 Minus recorded value of net assets + Moore's investment ($180,000 + $35,000) 215,000 Goodwill $10,000 Cash Goodwill Moore, Capital

35,000 10,000 45,000

6. Book value of interest acquired ($180,000 + $150,000)  (1/3) = $110,000 Book value of interest acquired is less than asset invested. Bonus Method Land

150,000 Brown, Capital (0.60  $40,000) Coss, Capital (0.40  $40,000) Moore, Capital

24,000 16,000 110,000

Goodwill Method Net value of firm implied by contract [$150,000/(1/3)] Minus current capital + Moore's investment ($180,000 + $150,000) Goodwill

$450,000 330,000 $120,000

Goodwill Brown, Capital (0.60  $120,000) Coss, Capital (0.40  $120,000)

120,000

Land

150,000

72,000 48,000

Moore, Capital

150,000

7. Bonus Method Brown, Capital (0.30  $92,000) Coss, Capital (0.30  $88,000) Moore, Capital

27,600 26,400 54,000

15 - 20

Problem 15-5 Part A 1. Bad Debt Expense Allowance for Doubtful Accounts (0.05  $33,600 = $1,680)

1,680 1,680

2. Inventory Unrealized Gain on Revaluation of Inventory ($41,250 - $35,750 = $5,500)

5,500

3. Land

38,000

5,500

Unrealized Gain on Revaluation of Land ($65,000 - $27,000 = $38,000)

38,000

4. Unrealized Loss on Revaluation of Building Building ($41,600 - $32,750 = $8,850)

8,850

5. Operating Expenses Accrued Liabilities

3,275

8,850

3,275

6. Total adjustment to capital accounts is $29,695 (credit) Unrealized Gain on Revaluation of Inventory Unrealized Gain on Revaluation of Land Bad Debt Expense Unrealized Loss on Revaluation of Building Operating Expenses Cox, Capital (0.40  $29,695) Andrews, Capital (0.30  $29,695) Bennet, Capital (0.30  $29,695)

5,500 38,000 1,680 8,850 3,275 11,878 8,909 8,908

Part B Book value of interest ($129,695 + $20,305*)  0.25 = $37,500 * $150,000 - $129,695 Bonus Method Cash Cox, Capital (0.40  $17,195) Andrews, Capital (0.30  $17,195) Bennet, Capital (0.30  $17,195) Meyers, Capital

20,305 6,878 5,159 5,158 37,500

15 - 21

Problem 15-5 (continued) Part C

CAB & M Partnership Balance Sheet December 31, 2008 Assets Cash ($8,000 + $20,305) Accounts Receivable Allowance for Doubtful Accounts Inventory Land Building (net of depreciation) Equipment (net of depreciation) Total Assets

$28,305 $33,600 1,680

Liabilities and Capital Accounts Payable Other Current Liabilities ($6,750 + $3,275) Long-Term Note (8% due 2012) Cox, Capital Andrews, Capital Bennet, Capital Meyers, Capital Total Liabilities and Capital

Cox Andrews Bennet Total

Before Adjustment $37,500 25,000 37,500 $100,000

Adjustment $11,878 8,909 8,908 $29,695

15 - 22

31,920 41,250 65,000 32,750 27,250 $226,475

$32,450 10,025 34,000 42,500 28,750 41,250 37,500 $226,475

Bonus to Meyers ($6,878) (5,159) (5,158) ($17,195)

Balance $42,500 28,750 41,250 112,500

Problem 15-6 Entry to be made before recording the withdrawal of Allen Inventory Interest Payable ($22,000  0.08  4/12) Dave, Capital ($5,413  0.50) Allen, Capital ($5,413  0.30) Matt, Capital ($5,413  0.20)

6,000 587 2,706 1,624 1,083

Allen now has a capital balance of $111,624 or ($110,000 + $1,624) 1. Allen, Capital Cash Note Payable

111,624

2. Allen, Capital Matt, Capital

111,624

3. Allen, Capital Dave, Capital (50/70  $13,376) Matt, Capital (20/70  $13,376) Cash Equipment

111,624 9,554 3,822

4. Allen, Capital Dave, Capital (50/70  $11,624) Matt, Capital (20/70  $11,624) Cash

111,624

5. Allen, Capital Dave, Capital (¼  $111,624) Matt, Capital (¾  $111,624)

111,624

36,624 75,000

111,624

35,000 90,000

8,303 3,321 100,000

27,906 83,718

15 - 23

Problem 15-7 Neal $250,000 50,000 300,000 (300,000)

1. Capital balances before withdrawal Allocate goodwill* Withdrawal of Neal Write-off Impaired Goodwill ($125,000  0.50)

Palmer $150,000 37,500 187,500 _______ 187,500 (62,500) $125,000

Ruppe $100,000 37,500 137,500 _______ 137,500 (62,500) $75,000

$125,000

$75,000

Neal $250,000 50,000 300,000 (300,000) -0-

Palmer $150,000 37,500 187,500 _______ 187,500

Ruppe $100,000 37,500 137,500 _______ 137,500

________ $ -0-

(75,000) _______ $112,500

(50,000) $87,500

$125,000

$75,000

_______ $ 0

Capital balances using the bonus method** 2. Capital balances before withdrawal Allocation of goodwill* Withdrawal of Neal Write-off Impaired Goodwill $125,000  0.60 $125,000  0.40 Capital balances using the bonus method** *Goodwill computation: Excess payment = $300,000 - $250,000 = $50,000 $50,000 Total goodwill = = $125,000 0.40

**The excess paid to Neal of $50,000 would have been divided equally between Palmer and Ruppe as follows: Palmer Ruppe Capital balance before withdraw $150,000 $100,000 Allocation of excess paid to Neal Capital balance using bonus method

(25,000) $125,000

(25,000) $75,000

Problem 15-8 1. Cash Inventory Equipment Snow, Capital

20,000 15,000 67,000 102,000

Cash Land

50,000 120,000 Mortgage Payable Waite, Capital

40,000 130,000 15 - 24

Problem 15-8 (continued) 2. Snow, Capital Waite, Capital Income Summary

7,680 16,320 24,000 Snow

Waite

Total

$23,200 35,000 58,200 (82,200) $(24,000)

Net loss to be allocated Interest on capital investment $102,000  10% $130,000  10% Salaries to partners

$10,200 15,000

$13,000 20,000

Allocation 40:60 Net loss allocated to partners

(32,880) $(7,680)

(49,320) $(16,320)

3. Cash Snow, Capital ($13,400  40%) Waite, Capital ($13,400  60%) Young, Capital

70,000 5,360 8,040 83,400

Capital interest of Snow ($102,000 - $7,680) Capital interest of Waite ($130,000 - $16,320) Investment of Young Total capital interest in new partnership Percentage acquired by Young Capital interest of Young Investment by Young Bonus to Young

$94,320 113,680 70,000 278,000 30% 83,400 (70,000) $13,400

4. Income Summary Snow, Capital ($150,000  20%) Waite, Capital ($150,000  50%) Young, Capital ($150,000  30%)

150,000

5. Snow, Capital* Waite, Capital ($18,960  50/80) Young, Capital ($18,960  30/80) Cash Note Payable

118,960

30,000 75,000 45,000

11,850 7,110 40,000 60,000

*$102,000 - $7,680 - $5,360 + $30,000 = $118,960

15 - 25

Problem 15-9 Part A

DISCOUNT PARTNERSHIP Worksheet to Adjust and Combine the Partnerships' Accounts June 30, 2008 Up & Down Trial Balance June 30, 2008

Cash Accounts Receivable Allowance for Doubtful Accounts Merchandise Inventory Land Buildings & Equipment Allowance For Depreciation Prepaid Expenses Accounts Payable Notes Payable Accrued Expenses Up, Capital

$25,000 90,000

Back & Forth Trial Balance June 30, 2008 $20,000 140,000

180,000 25,000 80,000

6,000 115,000 35,000 125,000

24,000 6,000

(2) 400 (3) 28,750

(1) 1,600

61,000

(4) 15,040

54,000 74,000 44,000

(5) 4,000

Back, Capital

65,000

Forth, Capital

139,000

$443,000

100,040 14,000

144,000

$406,000

9,200 323,750 60,000 205,000

8,000 42,000 65,000 34,000 95,000

$406,000

Discount Stores Beginning Balances $45,000 230,000

2,000

Down, Capital

Four Partners' Adjusting and Combining Entries

(1) (4) (1) (4) (5) (6) (7) (5) (6)

640 6,016 960 9,024 1,200 1,200 3,845 2,800 2,800

(6) 4,000 (7) 1,656

100,000 139,000 82,000 90,000

(7)

984

135,000

(2) 120 (3) 8,625

67,500

(2) 280 (3) 20,125 (7) 3,695

157,500

$443,000

Goodwill

(7) 2,490 $60,125

15 - 26

$60,125

2,490 $880,240

$880,240

Problem 15-9 (continued) (1,2)

To adjust allowance for doubtful accounts to 4% of receivables. Up and Down: $90,000  0.04 = $3,600 - $2,000 = $1,600 credit Back and Forth: $140,000  0.04 = $5,600 - $6,000 = $400 debit

(3)

To adjust inventory to FIFO valuation method

(4)

To adjust the allowance for depreciation account to an accumulation of depreciation for 3 years computed by the double-declining balance method

0.80  X = $115,000 X = $143,750 - $115,000 = $28,750

Desired accumulated depreciation balance: $16,000 + $12,800 + $10,240* Depreciation provided Adjustment needed * $80,000  0.20 = $16,000 $64,000  0.20 = $12,800 $51,200  0.20 = $10,240 (5) (6) (7)

$39,040 24,000 $15,040

To record unrecorded merchandise purchase To record vacation pay accrual ($200  10  2) To adjust capital account as agreed Unadjusted Capital Balances Net Adjustments Adjusted Capital Balance Opening Capital Balances* Distribution of Goodwill

Up $95,000 (6,656) 88,344 90,000 $1,656

Down $144,000 (9,984) 134,016 135,000 $984

( ) debit * Up $450,000  0.20 = $90,000 Down $450,000  0.30 = $135,000 Back $450,000  0.15 = $67,500 Forth $450,000  0.35 = $157,500 (0.20 + 0.30)X = $225,000 X = $450,000 15 - 27

Back $65,000 6,345 71,345 67,500 $(3,845)

Forth $139,000 14,805 153,805 157,500 $3,695

Total $443,000 4,510 447,510 450,000 $2,490

Problem 15-9 (continued) Part B

Computation of Cash Settlement Between Partners

Total Adjusted Capital Balances Excluding Goodwill Capital in Excess of Book Value Opening Capital Balances Settlement Between Parties

$222,360 2,640 225,000 225,000 $0

Between Up & Down Up Down $88,344 1,056 89,400 90,000 $600

$2,640  0.40 = $1,056 $2,640  0.60 = $1,584

15 - 28

$134,016 1,584 135,600 135,000 $(600)

Total $225,150 (150) 225,000 225,000 $0

Between Back & Forth Back $71,345 (45) 71,300 67,500 $(3,800)

($150)  0.30 = ($45) ($150)  0.70 = ($105)

Forth $153,805 (105) 153,700 157,500 $3,800

Chapter 15 CHAPTER 15—PARTNERSHIP: FORMATION, OPERATION AND OWNERSHIP CHANGES I.

PARTNERSHIP FORMATION A. Definition: Partnership is an association of two or more persons to carry on as co-owners a business for profit. B. Formation: 1. There must be an agreement, either expressed or implied, between two or more persons. 2. The business must be operated for the purpose of making a profit. 3. Members of the firm must be co-owners of the business. C. Reasons for forming a partnership: 1. Permit the pooling of capital and other resources without the complexities and formalities of a corporation. 2. Easier and less costly to establish than a corporation and is generally not subject to as much governmental regulation. 3. Operate with more flexibility because they are not subject to the control of a board of directors or outside shareholders. There may also be certain tax advantages to a partnership. D. Principal types of partnerships: 1. General partnership Mutual Agency: Every general partner is an agent of both the partnership and every other partner. Right to Dispose of a Partnership Interest: A capital interest in a general partnership is a personal asset of the individual partner that can be sold or disposed of in any legal way. Unlimited Liability: Each partner is jointly and severally liable for the debts and obligations of the partnership. Limited or Uncertain Life: A general partnership may be dissolved for a number of reasons, including the death of a partner, the bankruptcy of an individual partner, the withdrawal of a partner from the partnership or a judgment by a court that a partner is unsound of mind and incapable of performing his or her partnership duties. Tax Implications: A general partnership is not subject to income tax, but it must file an information return. 2. Limited partnership One or more of the partners are general partners and one or more are limited partners. Limited partners invest capital only and limit their liability for partnership obligations to the amount of investment they have agreed to make. Limited partners give up the right to participate in the management of the firm. 3. Joint ventures

Life of the joint venture is limited to that of the undertaking (a single or limited purpose), which may be of short- or long-term duration. The relationship between the parties in the arrangement is generally governed by a written agreement. A distinguishing characteristic of the agreement is that each joint venturer participates directly or indirectly in the overall management of the resources. Accordingly, major decisions require the consent of the ownership group. Joint ventures are commonly organized as corporations or partnerships. The authority of a joint venture is limited to a greater extent than that of a general partner. E. Partnership agreement A partnership is a voluntary association based on the contractual agreement between or among legally competent persons. The contract between the parties is called the partnership agreement, partnership contract, or articles of partnership. The agreement should include the following important points: 1. The name of the firm and identity of the partners. 2. The nature, purpose, and scope of the business. 3. The effective date of organization. 4. The length of time the partnership is to operate. 5. Location of the place of business. 6. Provision for the allocation of profit and loss. 7. Provision for salaries and withdrawals of assets by partners. 8. The rights, duties, and obligations of each partner such as the amount of time each partner will spend on business activities, and whether each partner is a general or limited partner. 9. Authority of each partner in contract situations. 10. Procedures for admitting a new partner. 11. Provisions that specify how operations are to be conducted and how the various partners' interests are to be satisfied on the withdrawal or the death of a partner. 12. Procedures for the arbitration of disputes. 13. Fiscal period of the partnership. 14. Identification and valuation of initial asset investments and the specification of capital interest that each partner is to receive. 15. Situations that may cause the dissolution of the partnership and provisions for terminating or continuing the business. 16. Accounting practices to be followed, such as depreciation policies, the sequence of closing procedures, and whether the cash or accrual basis is to be used in measuring net income. 17. Whether or not an audit is to be performed. II.

ACCOUNTING FOR A PARTNERSHIP A. Capital interest versus profit interest Capital interest: is a claim against the net assets of the partnership as shown by the balance in the partner's capital account.

Profit interest: determines how the partner's capital interest will increase or decrease as a result of subsequent operations. B. For accounting purposes, a partnership is considered a separate economic and accounting entity. The assets, liabilities, and residual capital interest, as well as the transactions and events that affect the accounts of the partnership, are areas of interest that require a separate accounting to provide information to the partners and other interested parties. Accounting for a partnership basically follows the same procedures and adheres to the same generally accepted accounting principles as accounting for a proprietorship or a corporation. The primary difference in accounting for the different forms of organization is in the recording and reporting of capital transactions. The entries follow: At the beginning of the partnership. Cash xxxx Partner A, Capital xxxx Partner B, Capital xxxx To form the partnership.

Each month to record the withdrawals. Partner A, Drawing Partner B, Drawing Cash To record monthly withdrawals. At the end of the period. Income Summary Partner A, Capital Partner B, Capital To close the income summary account. Partner A, Capital Partner B, Capital Partner A, Drawing Partner B, Drawing To close the partners' drawing accounts.

xxxx xxxx xxxx

xxxx xxxx xxxx xxxx

C. Differences to determine net income for proprietorships, partnerships and corporations: 1. A partnership is not subject to income tax. 2. Interest on capital investment and salaries to partners have traditionally been treated as allocations of net income, rather than as expenses of the business.

D. Recording the formation of a partnership Assets invested in the partnership, any debts assumed by the partnership, and the capital interest each partner is to receive should be specified in the partnership agreement. However, a problem results if the sum of the agreed net asset values does not equal the negotiated capital interest or if the agreement is unclear. For example, there are several possible interpretations of an agreement that each partner is to receive an equal capital interest. Two possible types of entries, the bonus method and the goodwill method, might be used to record the formation. E. Allocation of net income or net loss The profit and loss agreement determines how much each partner's interest in the firm increases or decreases as a result of operations. Often one of the major problems of accounting for a partnership is to determine the intent of the partners as indicated in the partnership agreement. Some of the more common agreements are based on some combination of the following: 1. Fixed ratio. One of the simplest agreements is for each partner to be allocated profit or loss on the basis of an equal percentage or some other specified ratio each period. The allocation determines the increase in each partner's interest in net assets resulting from operations. It has nothing to do with the withdrawals of assets by partners, which are recorded as debits to the capital or drawing accounts. 2. A ratio based on capital balances. The allocation of profits on the basis of the ratio of capital balances may result in an equitable allocation of profits where operation of the partnership requires little of the partners' time. Sometimes net income allocation is based on a ratio of the capital investment’s weighted-average, which is computed by multiplying the various capital balances that each partner maintained during the year by the fraction of the year that a particular capital balance was maintained. 3. Interest on capital investment. The partners may wish to allocate a portion of net income on the basis of invested capital and the rest on some other basis. One such method allows a certain percentage of interest on either the beginning, ending, or average capital balances and the rest of income is allocated in an agreed ratio. Such a provision may also provide an incentive for capital to be invested, if the firm has a use for added investment. The agreement should specify at a minimum: • The interest rate, • Which capital balance is to be used (beginning, ending, or average), • How remaining profits should be allocated, and • Whether or not interest should still be allocated in case of loss or in case profits are less than the agreed interest allocation.

4. An allocation for time or managerial talent devoted to the partnership operation, either in the form of a fixed allocation or a bonus as a percentage of income. Salary: The partners may provide, as part of the profit and loss formula, a salary allowance in recognition of personal services rendered by a partner. The amount by which net income exceeds the salary allowances may then be divided in any ratio agreed on by the partners. Bonus: Instead of basing the salary allocation on a fixed amount, the partners may provide for a bonus arrangement as a percentage of income or some other basis. Some possibilities based on net income are: • Net income before any allocation of income to partners (for example, before interest on capital, salaries to partners, and any bonus). • Net income after other income allocations, but before subtracting the bonus. • Net income after subtracting the bonus, but before subtracting the other allocations. • Net income after subtracting the bonus and other allocations from net income. F. Special problems in allocation of income and loss 1. Salaries and interest as an expense Salaries and interest may be accounted for as an allocation of net income, rather than as an expense in the determination of net income. However, the partners may find the income statement more useful for evaluating the operating performance of the partnership if either or both salary and interest allocations are treated as an expense in the determination of net income. Since the normal practice is to recognize salaries and interest as an allocation of profit, any such amounts treated, as an expense should be adequately disclosed so the statement reader can properly evaluate the operating performance of the firm. 2. Adjustment of income of prior years Errors may occur in accounting for partnership operations. The correction is allocated to the individual partners' capital accounts. The allocation should be based on the profit and loss agreement in effect during the period of the error. G. Financial statement presentation Difference in partnership reporting: 1. On the balance sheet or in a supplementary schedule, changes in partner's equity during the year should be disclosed. 2. Partners' salary allowances are generally recognized as an allocation of net income, not as an expense in the determination of net income. 3. There is no income tax expense. The partners report their share of the partnership income or loss for the period on their individual income tax returns. 4. Interest paid to a partner on a loan balance is recognized as an expense. Interest allowance on capital investment is considered an allocation of profit. III. CHANGES IN THE OWNERSHIP OF THE PARTNERSHIP A. Methods of recording changes in the membership of the partnership 1. The bonus method.

Under bonus method, the assets of the partnership are increased by the amount of the assets invested by the partner being admitted. Any difference between the assets invested and the credit to the new partner's capital account is adjusted to the capital accounts of the other partners involved in the negotiations. If a partner withdraws from a partnership, the partners may agree to settle his capital interest by permitting the withdrawal of partnership assets. 2. The goodwill method. Under the goodwill method, a new asset is recorded that is based on the difference between the value implied by the amount of consideration negotiated in the admission or withdrawal of a partner and the values reported in the partnership books. B. Admission of a new partner 1. Acquire an interest in a partnership • Purchasing all or part of an interest directly from one or more existing partners • Being admitted as an additional partner on the investment of assets in the firm. 2. Acquisition of interest by payment to one or more than one partner • This is a personal transaction between individuals. The only entry on the partnership books is to record the transfer of capital interest from the selling partner to the capital account established for the new partner. The entry is the same regardless of the amount transacted • Net assets and equities of the firm are not changed as a direct result of the transaction, since the sale was negotiated outside the partnership. However, the partners may choose to revalue assets and liabilities. • The amount of capital transferred to the new partner is equal to existing partners’ recorded capital multiplied by the percentage interest in his/theirs capital acquired by the new partner. • New partner’s profit interest does not have to equal percentage of his capital interest. 3. Acquisition of an interest by investing assets When assets are invested, the admission is recorded by debiting the assets invested and adjusting the net capital interest in the firm by a corresponding amount record the admission. It is important that the assets invested be fairly valued. Three situations can exist when an individual invests assets in a firm: • Book value of the capital interest acquired is equal to the fair value of the assets invested. • Book value of the capital interest acquired is less than the fair value of the assets invested. • Book value of the capital interest acquired is greater than the fair value of the assets invested. C. Withdrawal of a partner If a partner withdraws in violation of the partnership agreement and without approval of the remaining partners, he is entitled only to his interest in the firm

without consideration of goodwill. In such a case, the withdrawing partner is liable for damages sustained by the remaining parties for his breach of the partnership agreement. A partner who is forced to withdraw from a partnership is entitled to compensation for his full interest including goodwill. When partners mutually agree to the withdrawal: • The withdrawing partner may elect to sell his interest to an outside party; • The withdrawing partner may elect to sell his interest to one or more of the remaining partners; • The partners may mutually agree to transfer partnership assets to the withdrawing partner for his interest in the firm. 1. Payment to a retiring partner A. Payment in Excess of Book Value to a Withdrawing Partner 1. Bonus method: the remaining partners are charged with the amount of the payment that exceeds the book value of the retiring partner’s capital balance. 2. Goodwill method: This method is used if the remaining partners do not agree to a reduction in their capital balances, if the partnership agreement specifies how the withdrawal is to be recorded, or if the partners agree that an intangible asset should be recorded. B. Payment of Less Than Book Value to a Withdrawing Partner A partner who is anxious to dispose of his or her interest in the partnership may agree to accept less than his or her book value interest in the partnership. In such cases, the bonus method is justified, since the settlement may not be based on the economic value of the firm. 2. Death of a Partner If the surviving partners continue to operate the partnership, a new partnership should enter into a new agreement. A deceased partner's estate is entitled to receive the partner's current equity in the partnership. When a partner dies, assets are usually adjusted to current values and nominal accounts are closed to determine the net income or loss since the end of the last fiscal period.

CHAPTER 16 ANSWERS TO QUESTIONS 1. Realization gains or losses are allocated to partners in their profit and loss ratio because the changes in asset values are the result of risk assumed by the partnership. Also, because it may be difficult to separate gains and losses that result from liquidation from the under- or over-statement in book values that result from accounting policies followed in prior years. 2. The final cash distribution is based on capital balances, not on profit and loss ratios, since the capital balance represents the partners' "residual claims" to the assets remaining after settlement of partnership obligations. 3. Because the UPA order of payment ranks partnership obligations to a partner ahead of asset distributions to a partner for capital investments, a debit balance in a partner's capital account will create problems when that partner has an outstanding loan balance. Other partners will have a claim against this partner for the amount of his/her debit balance which is considered to be an asset of the partnership by the UPA. If the partner with a debit balance settles his/her obligation with the partnership, there is no problem. However, if he/she can't settle, the other partners must absorb the deficit as a loss, even though the partner with the debit balance had received cash for his/her outstanding loan balance. To avoid this inequity, the courts have recognized the right of the partnership to offset the loan balance against the debit capital balance. 4. Maintaining separate accounts for outstanding loan and capital accounts recognizes the legal distinction between the two. This would be important if the liquidation is carried on over an extended period, since the UPA provides that a partner is entitled to accrued interest on the loan balance. 5. When the equity interest of one partner is inadequate to absorb realization losses several alternative outcomes are possible. If the partner is personally solvent, he may pay the partnership for the amount he is liable. If he/she is personally insolvent then the other partners must absorb his/her debit balance in their respective profit and loss ratio. If the other partners are unsure of what the partner with the debit balance will do, but still wish to distribute cash, they can assume the worst (absorbing their share of the debit balance) to determine what amount of cash can be safely distributed. 6. Cash should not be distributed to any partner until all liquidation losses are recognized in the accounts or are provided for in determining a safe cash payment. 7. The classification of assets into personal and partnership categories in recognition of the rights of both partnership creditors and creditors of the individual partners is referred to as "marshalling of assets." 8. To the extent that personal creditors do not recover from personal assets they can seek recovery from those partnerships assets still available after partnership obligations have been met. This recovery, however, is limited to the extent that the partner involved has a credit interest in partnership assets.

16 - 1

9. Because in an installment liquidation the amount of cash to be received from the unsold assets and the resulting gain or loss is unknown, the partners should view each cash distribution as if it were the final distribution. 10. The three assumptions upon which a safe cash distribution is determined are (1) any loan balances to partners are offset against their capital accounts, (2) the remaining noncash assets will not generate any more cash, and (3) any partner with a deficit capital balance will not settle his/her obligation to the partnership. In other words, assume the worst. The safe cash balance is computed as the difference between the current capital balances and the balance required to maintain the above assumptions. 11. Unexpected costs are added to the book value of noncash assets. When the potential loss on the noncash assets is allocated in the determination of a safe payment, these costs are also included. 12. The objective of the procedure is to bring the balance of the partners' capital accounts into the agreed profit and loss ratio as soon as possible so that no one partner is placed in a better position than any other partner. 13. The "loss absorption potential" is determined by dividing the partners' net capital balances by their respective profit ratio. This determines the maximum amount of loss each partner can absorb. 14. The Uniform Partnership Act provides that the liabilities of the partnership shall rank in order of payment as follows: (1) Those owing to creditors other than partners, (2) Those owing to partners other than for capital and profits, (3) Those owing to partners in respect of capital, (4) Those owing to partners in respect of profits. Business Ethics Solution Business ethics solutions are merely suggestions of points to address. The objective is to raise the students' awareness of the topics, and to invite discussion. In most cases, there is clear room for disagreement or conflicting viewpoints. 1) Partnership laws grant each partner the right to information about the firm’s business. This allows each partner to monitor the firm’s activities. Given the circumstances of the case, it would be your duty to inspect any questionable transaction. Furthermore, you should ask the partner to explain the reason for increasing the cost by $10,000. This would give you the opportunity to raise the concern regarding the presence of the previously undetected rock. If the additional charge is not based on fact, the cost should be removed. 2) In the present scenario, it appears that the partner might be experiencing personal financial pressures. However, the firm’s reputation and future implications of the action must be considered for the benefit of the partnership. Your loyalty to your partner does not alter these responsibilities. You may wish to find other, more constructive ways to offer assistance to your partner in meeting his personal obligations, and surviving what may be a difficult time in his life. However, ignoring the situation is dishonest to the client and is likely to result in more serious long-term consequences. Reference: http://www.lrc.ky.gov/KRS/362-01/403.PDF 16 - 2

ANSWERS TO EXERCISES Exercise 16-1 Part A Capital balances Loan balances Net interest Potential loss - $50,000 Potential loss - $5,000 Cash distribution

Part B

(30%) Cook $(30,000) _______ (30,000) 15,000 (15,000) 3,000 $(12,000)

(50%) Parks $(10,000) (10,000) (20,000) 25,000 5,000 (5,000) $ -0-

Liabilities Cash

25,000

Cook, Capital Argo, Capital Cash

12,000 3,000

Cash Cook, Capital ($35,000  0.30) Parks, Capital ($35,000  050) Argo, Capital ($35,000  0.20) Other Assets

15,000 10,500 17,500 7,000

Parks, Loan Parks, Capital

10,000

Parks, Capital ($10,000 - $17,500 + $10,000) Cook, Capital Argo, Capital Cash

2,500 7,500 5,000

25,000

15,000

50,000

10,000

16 - 3

15,000

(20%) Argo $(15,000) ______ (15,000) 10,000 (5,000) 2,000 $(3,000)

Exercise 16-2 Part A Account balances Sale of assets Payment to creditors Cash distribution

Cash $70,000 270,000 340,000 (98,000) 242,000 (242,000) $ -0-

Noncash Assets $260,000 (260,000) 0 _______ 0 _______ $ -0-

Part B 1. Cash

Liabilities $(98,000) _______ (98,000) 98,000 _______ $ -0-

John $(90,000) (3,000) (93,000) _______ (93,000) 93,000 $ -0-

270,000 Other Assets John, Capital Jake, Capital Joe, Capital

260,000 3,000 4,000 3,000

2. Liabilities Cash

98,000

3. John, Capital Jake, Capital Joe, Capital Cash

93,000 82,000 67,000

Exercise 16-3 Capital balances Estimated loss on sale of assets ($45,000) Allocate debit balance Estimated cash payment

98,000

242,000

(1/3) Doug $(55,000) 15,000 (40,000) 11,500 $(28,500)

(1/3) Dave $(50,000) 15,000 (35,000) 11,500 $(23,500)

16 - 4

(1/3) Dan $8,000 15,000 23,000 (23,000) $ -0-

Capital Balances Jake $(78,000) (4,000) (82,000) _______ (82,000) 82,000 $ -0-

Joe $(64,000) (3,000) (67,000) _______ (67,000) 67,000 $ -0-

Exercise 16-4

(1/5) Amos $(49,000) 10,000

Capital balances Drawing account Loans Operating loss Liquidation loss

4,200 2,400 (32,400) 733 $(31,667)

Allocate debit balance Cash distribution

(2/5) Boone $(18,000) 15,000 (8,000) 8,400 4,800 2,200 (2,200) $0

(2/5) Childs $(10,000) 20,000 (25,000) 8,400 4,800 (1,800) 1,467 $(333)

The first $40,000 is paid to satisfy the claims of creditors. Exercise 16-5

Account balances Sale of inventory, collect accounts receivable - allocate loss Payment to creditors Payment to partners (Schedule 1)

Cash $10,000 38,000 48,000 (18,000) 30,000 (30,000) $ 0

Schedule 1 Capital balances Allocation of potential loss Allocation of deficit Safe Payment

Brink $(43,000) 34,800 (8,200) 6,533 $(1,667)

Davis $(25,000) 34,800 9,800 (9,800) $ -0-

Olsen $(49,000) 17,400 (31,600) 3,267 $(28,333)

16 - 5

Noncash Assets $130,000 (43,000) 87,000 87,000 _______ $87,000

Liabilities $(18,000) _______ (18,000) 18,000 0 _______ $ 0

Capital Balances Brink Davis Olsen 40% 40% 20% $(45,000) $(27,000) $(50,000) 2,000 2,000 1,000 (43,000) (25,000) (49,000) _______ _______ _______ (43,000) (25,000) (49,000) 1,667 28,333 $(41,333) $(25,000) $(20,667)

Exercise 16-6 Part A Cash $15,000 30,000 45,000

Balances Sale of other assets and allocation of loss

Noncash Assets $110,000 (110,000) 0

Liabilities $(42,000) 0 (42,000)

Allocate Zack's debit balance 45,000 14,286 59,286 (42,000) 17,286 (17,286) $0

Investment by Tom Payment to creditors Payment to Pete

(42,000)

(42,000) 42,000 0

Capital Balances Pete Tom Zack 40% 30% 30% $(55,000) $(14,000) $(14,000) 32,000 24,000 24,000 (23,000) 10,000 10,000 5,714 4,286 (10,000) (17,286) 14,286 0 (14,286) (17,286) 0 0 (17,286) 17,286 $0

$0 $0 Pete receives $17,286. Tom makes an additional investment of $14,286. Zack receives zero and cannot make an investment in the partnership because he is personally insolvent.

Part B

Personal Assets $55,000 30,000 30,000

Pete Tom Zack

Exercise 16-7 1. c 2. c 3. a 4. d 5. d

Personal Liabilities $80,000 10,000 50,000

Exercise 16-8 1. c; X = ¼  ($690,000 + X); X = $230,000 2. b 3. d 4. c 5. d

16 - 6

Excess (Deficiency) $(25,000) 20,000 (20,000)

Distribution from Partnership $17,286 -----

Total Payable to Creditors $72,286 10,000 30,000

Exercise 16-9 Part A The partnership creditors will receive payment before any distributions are made to the partners. The creditors can seek recovery from Q and S's personal assets after their personal creditors have been paid from their personal assets.

Part B The personal creditors have first claim to the personal assets. If they have not fully recovered the amount owed, they have a right to partnership assets after partnership creditors to the extent the partner has a credit interest in the partnership.

Part C Cash

Balances Investment by Q Payment of Liabilities Allocation of T's deficit Investment by S Payment to partners

Liabilities Q $ 0 $(2,000) $(500) 2,000 _______ (2,000) 2,000 (2,000) (2,500) (2,000) 2,000 ______ 0 0 (2,500) ______ ______ 2,000 0 0 (500) 7,000 (7,000) ______ 500 $ 0 $ 0 $ 0

Part D & E R T

Personal Assets $8,000 6,000

Partnership Distribution $6,500 ---

16 - 7

Total $14,500 6,000

Capital Balance R S $(7,500) $6,000 ______ ______ (7,500) 6,000 ______ ______ (7,500) 6,000 1,000 1,000 (6,500) 7,000 (7,000) 6,500 ______ $ 0 $ 0

T $4,000 ______ 4,000 ______ 4,000 (4,000) 0 ______ $ 0

Exercise 16-10 Part A Net capital interest Profit-loss ratio Loss absorption potential Order of cash distribution

Matt

Allen

Dave

$54,000 0.45 $120,000 1

$30,000 0.30 100,000 2

$18,000 0.25 $72,000 3 Loss Absorption Potential Matt Allen Dave 0.45 0.30 0.25 $120,000 $100,000 $72,000

Profit-loss ratio Loss absorption potential Net capital interest Distribution to Matt to reduce loss potential to Allen's Balance after distribution Distribution to Matt and Allen to reduce loss potential to Dave's

20,000 100,000 28,000 $72,000

______ 100,000 28,000 $72,000

Remainder of assets distributed Cash Distribution Plan Order of Cash Distribution 1. First $18,000 2. Next $9,000 3. Next $21,000 4. Remainder

Liabilities 100%

Part B First $9,000 available to partner Next $21,000 Total

Matt 45

Allen 30

Dave 25

100% 60% 45%

40% 30%

25%

Allen

Dave

$8,400 $8,400

_______ $ -0-

Matt $9,000 12,600 21,600

Matt, Loan Matt, Capital Allen, Capital Cash

10,000 11,600 8,400 30,000

16 - 8

______ 72,000 ______ $72,000

Assets Distribution Matt Allen Dave 0.45 0.30 0.25 $54,000 9,000 45,000 12,600 $32,400 0.45

$30,000 $18,000 ______ ______ 30,000 18,000 8,400 ______ $21,600 $18,000 0.30 0.25

ANSWERS TO ASC (Accounting Standards Codification) EXERCISES ASC16-1 Presentation Describe the conditions under which a firm can change one of its accounting principles. What is the preferred accounting treatment for a change in accounting principle? List the relevant paragraphs in the Codification. Step 1: Use the drop-down menus under the ‘Presentation’ general topic on the homepage and choose ‘250-Accounting Changes and Error Corrections; then under the second drop-down menu, choose ’10overall’. Step 2: Click on section 10 Objectives. Expand the table of contents. Look for guidance on changes in principles. There are two primary sections to investigate, section 45 Other Presentation Matters and section 50 on disclosures. FASB ASC paragraphs 250-10-45-1 through 5 provide the guidance for changes in an accounting principle. ASC16-2 Recognition Where in the Codification are the conditions listed that allow an entity that sells a product to recognize revenue on an accrual basis? Step 1: Use the drop-down menus under the ‘Revenue’ general topic on the homepage and choose ‘605-Revenue Recognition’; then under the second drop-down menu, choose ’15-Products’. Step 2: Expand the table of contents. Look for guidance on revenue from sales of product. Click on section 25 Recognition. FASB ASC paragraph 605-15-25-1 provides the conditions for recognizing the sale transaction at the time of the sale. Conditions include that the seller’s price to the buyer is substantially fixed or determinable at the date of sale, the amount of future returns can be reasonable estimated, etc. ASC16-3 Scope Is a debt restructuring always classified as a troubled debt restructuring if the entity is experiencing some financial difficulties? Explain. Step 1: Use the drop-down menus under the ‘Liabilities’ general topic on the homepage and choose ‘470-Debt’; then under the second drop-down menu, choose ’60-Troubled Debt Restructuring by Debtors’. Alternatively, you could use the search box to identify Subtopic 470-60. Step 2: Expand the table of contents. Click on section 15 – Scope and Scope Exceptions’. FASB ASC paragraph 470-60-15-12 states that a debt restructuring is not necessarily a troubled debt restructuring even if the debtor is experiencing some financial difficulties. The paragraph lists the conditions.

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ASC16-4 Recognition In a limited partnership with multiple general partners, the determination of which, if any, general partner within the group controls and consolidates the limited partnership is based on an analysis of the relevant facts and circumstances. List the rights of a limited partner that would indicate that the general partners do not control the limited partnership. In the advanced search box, enter ‘general partner control.’ Five results are returned. The first result identifies the correct subtopic (Subtopic 810-20 Consolidation – Control of Partnerships). FASB ASC paragraph 810-20-25-5 states that general partners do not control the limited partnership if the limited partners have either of the following: a. The substantive ability to dissolve (liquidate) the limited partnership or otherwise remove the general partners without cause (as distinguished from with cause) b. Substantive participating rights.

16 - 10

ANSWERS TO PROBLEMS Problem 16-1 Part A - 1

DISCOUNT PARTNERSHIP Schedule of Partnership Liquidation January 14, 2008

Explanation Balances before realization

Cash $25,000

Other Assets Liabilities $120,000 $(40,000)

Capital Balances Dawson Feeney Hardin $(31,000) $(65,000) $(9,000)

Sales of noncash assets Balances

60,000 85,000

(120,000) 0

18,000 (13,000)

Payment of liabilities Balances

(40,000) __________ 45,000 0

40,000 ________ ________ ________ 0 (13,000) (41,000) 9,000

Allocation of Hardin's debit balance Balances

______ __________ 45,000 0

______ 0

3,857 (9,143)

5,143 (35,857)

Distribution of cash to partners Balances

(45,000) __________ $ 0 $ 0

______ $ 0

9,143 $ 0

35,857 ________ $ 0 $ 0

16 - 11

______ (40,000)

24,000 (41,000)

18,000 9,000

(9,000) 0

Problem 16-1 (continued) DISCOUNT PARTNERSHIP Schedule of Partnership Liquidation January 14, 2008

Part A - 2

Explanation Balances before realization

Cash Other Assets $25,000 $120,000

Capital Balances Liabilities Dawson Feeney Hardin $(40,000) $(31,000) $(65,000) $(9,000)

Sales of noncash assets Balances

60,000 85,000

(120,000) 0

(40,000)

18,000 (13,000)

24,000 (41,000)

18,000 9,000

Payment of liabilities Balances

(40,000) 45,000

40,000 0

(13,000)

(41,000)

9,000

Cash investment by Hardin Balances

9,000 54,000

(13,000)

(41,000)

(9,000) 0

Distribution of cash to partners Balances

(54,000) $0

13,000 $0

41,000 $0

16 - 12

Problem 16-1 (continued) Part A – 3

Part B

DISCOUNT PARTNERSHIP Schedule of Partnership Liquidation January 14, 2008

Explanation Balances before realization

Capital Balances Cash Other Assets Liabilities Dawson Feeney Hardin $25,000 $120,000 $(40,000) $(31,000) $(65,000) $(9,000)

Sales of noncash assets Balances

50,000 75,000

(120,000) 0

(40,000)

21,000 (10,000)

28,000 (37,000)

21,000 12,000

Payment of liabilities Balances

(40,000) 35,000

40,000 0

(10,000)

(37,000)

12,000

Cash investment by Hardin Balances

8,000 43,000

(10,000)

(37,000)

(8,000) 4,000

1,714 (8,286)

2,286 (34,714)

(4,000) 0

8,286 $0

34,714 $0

Allocation of Hardin's deficit Balances

43,000

Distribution of cash to partners Balances

(43,000) $0

Cash Dawson, Capital Feeney, Capital Hardin, Capital Other Assets

60,000 18,000 24,000 18,000

Liabilities Cash

40,000

Cash

9,000

120,000 40,000

Hardin, Capital Dawson, Capital Feeney, Capital Cash

9,000 13,000 41,000 54,000 16 - 13

Problem 16-2 Balances Sale of asset and allocation of gain Payment to creditors Payment to partners (Schedule 1) Sale of assets and allocation of gain Payment to partners (Schedule 2) Sale of assets and allocation of loss Payment to partners Sale of asset and allocation of loss Payment to partners

Cash $5,000 16,000 21,000 (20,000) 1,000 (1,000) 0 12,000 12,000 (12,000) 0 10,000 10,000 (10,000) 0 2,000 2,000 (2,000) $0

Other Assets $60,000 (12,000) 48,000 --48,000 --48,000 (10,000) 38,000 --38,000 (20,000) 18,000 --18,000 (18,000) 0 --$0

Liabilities $(20,000) --(20,000) 20,000 0 --0 --0 --0 --0 --0 --0 --$0

Capital & Loan Balances Nelson Parker Rice 0.40 0.30  $(20,000) $(12,000) $(13,000) (1,600) (1,200) (1,200) (21,600) (13,200) (14,200) ------(21,600) (13,200) (14,200) 1,000 --(20,600) (13,200) (14,200) (800) (600) (600) (21,400) (13,800) (14,800) 6,200 2,400 3,400 (15,200) (11,400) (11,400) 4,000 3,000 3,000 (11,200) (8,400) (8,400) 4,000 3,000 3,000 (7,200) (5,400) (5,400) 6,400 4,800 4,800 (800) (600) (600) 800 600 600 $0 $0 $0

Schedules to Compute Safe Payments Schedule 1 Capital Balance Allocation of potential loss ($48,000) Allocation of deficit balance Safe payment

Nelson $(21,600) 19,200 (2,400) 1,400 $(1,000)

Parker $(13,200) 14,400 1,200 (1,200) $0

Rice $(14,200) 14,400 200 (200) $0

Nelson $(21,400) 15,200 $(6,200)

Parker $(13,800) 11,400 $(2,400)

Rice $(14,800) 11,400 $(3,400)

Schedule 2 Capital Balance Allocation of potential loss ($38,000) Safe payment

16 - 14

Problem 16-3

Beginning Balances 3/15 asset sale 3/16 A/R sale 3/16 pay creditors 3/18 cash distribution (Schedule 1) 3/19 adjustment to fair value 3/19 withdrawal by Murphey 3/21 sale – allocate loss 3/25 assign lease 3/25 cash distribution (Schedule 2) 4/1 adjustment to fair value 4/1 withdrawal by Hamm 4/5 sale and allocate loss 4/6 investment by Hamm 4/6 final distribution

Cash $10,000 80,000 90,000 26,000 116,000 (110,000) 6,000 (5,000) 1,000 --1,000 --1,000 30,000 31,000 12,000 43,000 (43,000) 0 --0 --0 4,000 4,000 2,000 6,000 (6,000) $0

Other Assets $218,000 (90,000) 128,000 (30,000) 98,000 --98,000 --98,000 3,000 101,000 (13,000) 88,000 (50,000) 38,000 --38,000 --38,000 (2,000) 36,000 (8,000) 28,000 (28,000) 0 --0 --$0

16 - 15

Liabilities $(110,000) --(110,000) --(110,000) 110,000 0 --0 --0 --0 --0 --0 --0 --0 --0 --0 --0 --$0

Capital & Loan Balances Hann Murphey Ryan 0.50 0.30 0.20 $(50,000) $(42,000) $(26,000) 5,000 3,000 2,000 (45,000) (39,000) (24,000) 2,000 1,200 800 (43,000) (37,800) (23,200) ------(43,000) (37,800) (23,200) --4,200 800 (43,000) (33,600) (22,400) (1,500) (900) (600) (44,500) (34,500) (23,000) --13,000 --(44,500) (21,500) (23,000) 10,000 6,000 4,000 (34,500) (15,500) (19,000) (6,000) (3,600) (2,400) (40,500) (19,100) (21,400) 21,500 7,700 13,800 (19,000) (11,400) (7,600) 1,000 600 400 (18,000) (10,800) (7,200) 8,000 ----(10,000) (10,800) (7,200) 12,000 7,200 4,800 2,000 (3,600) (2,400) (2,000) ----0 (3,600) (2,400) --3,600 2,400 $0 $0 $0

Problem 16-3 (continued) Schedules to Compute Safe Payments Schedule 1 Capital balances Allocation of potential loss ($99,000) Allocation of deficit balance Safe cash payment

Hann 0.50 $(43,000) 49,500 6,500 (6,500) $0

Murphey 0.30 $(37,800) 29,700 (8,100) 3,900 $(4,200)

Ryan 0.20 $(23,200) 19,800 (3,400) 2,600 $(800)

Hann $(40,500) 19,000 $(21,500)

Murphey $(19,100) 11,400 $(7,700)

Ryan $(21,400) 7,600 $(13,800)

Schedule 2 Capital balance Allocation of potential loss ($38,000) Safe cash distribution Problem 16-4

Part A Balances before realization Sale of assets

MARY, PAULA, AND RAY Schedule of Partnership Liquidation Cash $10,000 20,000 30,000

Other Assets $100,000 (100,000) 0 0

(40,000)

Mary 0.40 $(50,000) 32,000 (18,000) 8,000 (10,000)

(40,000) 40,000 $0

(10,000) 10,000 $0

Liabilities $(40,000) (40,000)

Allocate Ray's debit balance Investment by Paula Distribution of cash

30,000 20,000 50,000 (50,000) $0

Paula 0.30 $(10,000) 24,000 14,000 6,000 20,000 (20,000) 0

Ray 0.30 $(10,000) 24,000 14,000 (14,000) 0

Mary will receive $10,000. Paula must invest $20,000. Ray is personally insolvent and cannot make an investment in the partnership to eliminate the deficit balance. 16 - 16

Problem 16-4 (continued) Part B

Payments to Personal Creditors Personal $50,000 10,000 30,000

Mary Paula Ray

Partnership Distribution $10,000 0 0

Total $60,000 10,000 30,000

Problem 16-5 Part A Capital and loan balances Profit and loss ratio Loss absorption potential Order of cash distribution

Profit and loss rates Loss absorption potential Net capital interest Reduce loss absorption potential of Baker

Baker $55,000 .40 $137,500 1

Strong $45,000 .40 $112,500 3

Weak $24,000 .20 $120,000 2

Loss Absorption Potential Baker Strong Weak .40 .40 .20 $137,500 $112,500 $120,000 17,500 120,000

112,500

Reduce loss absorption potential of -Baker ($3,000/.40 = $7,500) -Weak

120,000

$112,500

Creditors 100%

7,500 $112,500

$45,000 0.40

Cash Distribution Baker Strong

Weak

100% 67% 40%

33% 20%

16 - 17

Cash Distribution Strong .40

Weak .20

$45,000

$24,000

45,000

24,000

3,000

Remainder

$17,000 7,000 4,500

$55,000 7,000 48,000

7,500 $112,500

First Next Next Remainder

Baker .40

40%

$45,000 0.40

1,500 $22,500 0.20

Problem 16-5 (continued) To Creditors To Baker To Baker and Weak Remainder -Profit and Loss Ratio

Total $17,000 7,000 4,500 77,500 $106,000

Part B July Account balances Collection of accounts receivable Sale of inventory Paid liquidation expenses Cash distribution (Schedule 1) Account balances (end of July) August Paid liquidation expenses Gain on equipment Withdrawal on equipment Cash distribution (Schedule 2) Account balances (end of August) September Sale of equipment Paid liquidation expense Balances Cash distribution

Creditors $17,000

$17,000

Cash Distribution Baker Strong

Weak

$7,000 3,000

$1,500

31,000 $41,000

$31,000 $31,000

15,500 $17,000

Accounts Plant and Accounts Baker Strong Weak Cash Receivable Inventory Equipment Payable 0.40 0.40 0.20 $6,000 $22,000 $14,000 $99,000 $(17,000) $(55,000) $(45,000) $(24,000) 16,500 (22,000) 2,200 2,200 1,100 10,000 (14,000) 1,600 1,600 800 (1,000) 400 400 200 (23,500) 17,000 6,500 8,000 0 0 99,000 0 (44,300) (40,800) (21,900)

(1,500)

600 (2,400)

3,750 (42,350)

250 (42,350)

(12,800)

0 0 $0

8,000 400 (33,950) 33,950 $0

4,000 200 (8,600) 8,600 $0

6,000 (10,000) (4,000) 2,500

75,000 (1,000) 76,500 (76,500) $0

95,000

(95,000) 0 0 $0

16 - 18

0 0 $0

300 (1,200) 10,000

Problem 16-5 (continued) Schedule 1 Total $17,000 6,500 $23,500

First $17,000 Up to $7,000

Creditors $17,000 _______ $17,000

0.4 Baker

0.4 Strong

0.2 Weak

$(42,600)

$(12,800)

$6,500 $6,500

Schedule 2 Capital balances Potential loss of $95,000 plus Cash retained 97,500  0.4 = 97,500  0.4 = 97,500  0.2 =

$(46,100) 39,000

Allocate Weak's potential deficit 1/2 1/2

Problem 16-6

3,350 _______ $(3,750)

3,350 $(250)

19,500 6,700 (6,700) _______ $0

MALONE, PATTON, AND SPENCER Statement of Changes in Partners' Capital For the Year Ended December 31, 2008

Part A

Capital balances, 1/1/2008 Add: Investments Net income allocation* Totals Less: Withdrawals Capital balances, 12/31/2008 * Malone Patton Spencer Total

______ (7,100)

39,000 _______ (3,600)

Malone $ 0 140,000 21,000 161,000 30,000 $131,000

$60,000  ($140,000/$400,000) $60,000  ($160,000/$400,000) $60,000  ($100,000/$400,000)

Patton $ 0 160,000 24,000 184,000 0 $184,000

Spencer $ 0 100,000 15,000 115,000 0 $115,000

$21,000 24,000 15,000 $60,000

Part B Malone, Capital Malone, Drawing

30,000

Income Summary Malone, Capital Patton, Capital Spencer, Capital

60,000

30,000 21,000 24,000 15,000

16 - 19

Total $

0 400,000 60,000 460,000 30,000 $430,000

Problem 16-6 (continued) Part C – On next page Part D Cash Malone, Capital Patton, Capital Spencer, Capital Accounts Receivable Inventory Furniture and Fixtures

243,000 36,400 41,600 26,000

Accounts Payable Cash

74,000

Patton, Capital Mortgage Payable Land Building

120,000 145,000

Malone, Capital Patton, Capital Spencer, Capital Cash

94,600 22,400 89,000

129,000 188,000 30,000 74,000

85,000 180,000

206,000

16 - 20

Problem 16-6 (continued) Part C

MALONE, PATTON, AND SPENCER Schedule of Partnership Liquidation January 2, 2009

Explanation

Capital Balances Malone Patton Spencer Other Assets Liabilities 35%_ 40%_ 25%_ $612,000 $(219,000) $(131,000) $(184,000) $(115,000)

Balances before realization

Cash $37,000

Sales of noncash assets Balances

243,000 280,000

(347,000) 265,000

________ (219,000)

36,400 (94,600)

41,600 (142,400)

26,000 (89,000)

Payment of accounts payable Balances

(74,000) 206,000

__________ 265,000

74,000 (145,000)

________ (94,600)

________ (142,400)

________ (89,000)

Distribution of land, bldg., and assumption of mortgage Balances

________ 206,000

(265,000) 0

145,000 0

________ (94,600)

120,000 (22,400)

________ (89,000)

Distribution to partners Balances

(206,000) $0

__________ $0

________ $0

94,600 $0

22,400 $0

89,000 $0

Accounts Receivable Inventory Furniture/Fixtures Total

Sales Price $ 92,000 141,000 10,000 $243,000

Book Value $129,000 188,000 30,000 $347,000

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Problem 16-7 Part A Valuation Adjustment Accumulated Depreciation Office Equipment Allowance for Uncollectibles Jan, Loan

2,700 12,600 14,200 900 200

Jan, Loan Jan, Capital

6,600

Jan, Capital Sue, Capital Valuation Adjustment

1,350 1,350

6,600

2,700

Part B Jan, Capital ($29,400 + $6,600 - $1,350) Sue, Capital ($28,000 – $1,350) Capital Stock (400  $100) Additional Paid-in Capital Proof Cash Accounts receivable Allowance for uncollectibles Prepaid insurance Office equipment Total stockholders' equity

34,650 26,650 40,000 21,300

$15,000 32,400 (2,900) 800 16,000 $61,300

16 - 22

Problem 16-8 Part A 1. Starnes, Capital Cash Partners 1-9, Capital ($50,000  90/95) Partner 10, Capital ($50,000  5/95) Cash

125,000 75,000 47,368 2,632 150,000

Norwood, Capital ($2,500,000  5%) Partners 1-9, Capital ($25,000  90/95) Partner 10, Capital ($25,000  5/95)

125,000 23,684 1,316

2. Because Alan is now a partner in the partnership, it is more difficult to determine the exact amount of his compensation because he will be taxed on his "share of partnership earnings" reported to him on his Schedule K-1 from BSM. While this share of earnings will most likely bear a relationship to the draws taken by Alan, it will undoubtedly be more or less than $216,000 ($18,000  12). Alan must also consider the following additional expenses which correspond to his increased compensation and status as a partner: (a)

Increased individual income tax to correspond to his increased earnings.

(b)

Self-employment tax. As an employee this was withheld from wages at a rate of 7.65% (2002 rate; with a ceilings of $84.900 for 6.2% of the tax). Now that Alan is a partner, he must pay these taxes himself at a rate of 15.3% with the same ceiling, and with an offsetting deduction for 50% of the self-employment tax. This additional tax must be remitted with Alan's individual income tax return.

(c)

Alan has invested $150,000 in the partnership. If he borrowed the funds to join, he must make interest and principal payments on the debt. The amount of required annual payments depends of course on the interest rate and term of the loan. If he used his own funds (say from a mutual fund earning 10%) for the investment, he has traded the earning power of the funds for earnings from the partnership. He has given up $15,000 in income from the former investment.

3. Alan should be concerned about the true value of a 5% interest in the partnership since Mr. Starns was paid $75,000 for his 5% interest while within the same time frame, Alan is expected to pay $150,000 for an equivalent interest. There may be mitigating circumstances (e.g. Mr. Starns contributes little to the firm, Alan lacks sufficient ability to bring in new clients), but Alan has a clear signal of a discrepancy which should prompt him to ask questions before investing in the partnership.

16 - 23

Problem 16-8 (continued) Part B 1. This matter is sometimes addressed in employment contracts. Some professional firms require employees to agree not to actively recruit clients upon their departure from the firm. Barring such a specific agreement or firm precedent (and profession-related guidelines), Alan and Mary must determine the basis on which they can rely to call a BSM client "their client". This may involve such issues as whether Alan or Mary were involved in bringing the client to BSM originally, or it may involve the extent to which the BSM clients were served by the firm as opposed to exclusively by Alan or Mary. Further, if the client's interests are better served by BSM as a larger firm or by Alan and Mary in a smaller firm, that should enter the decision made by the departing employees. 2. It may be difficult to block actions by Alan and Mary if a written agreement is not in existence. Clearly, the BSM partners can enlighten clients to any benefits of remaining a BSM client.

Part C 1. Current Net income Partners 1-9, Capital ($25,000  90%) Partners 10-11, Capital ($25,000  10%) Cash

25,000 22,500 2,500 8,000,000

Accounts Receivable

8,000,000

Liabilities - Outside Starns, Loan Cash

7,490,000 10,000 7,500,000

Partners 1-9, Capital ($3,750  90/95) Partner 10, Capital ($3,750  5/95) Starns, Capital ($125,000 - $130,000 + $1,250 = $3,750)

3,553 197 3,750

Partners 1-9, Capital ($2,395,000  90/95) 2,268,947 Partner 10, Capital ($2,395,000  5/95) 126,053 Cash 2,395,000 ($2,025,000 - $130,000 + $8,000,000 - $7,500,000 = $2,395,000) 2. Yes. The debit balance in the Starns capital account is considered a partnership asset. Judicial precedent exists to allow offset of the liability by the debit capital account balance. The net payment to the partner with the debit capital account leaves both the partnership and partner's obligations fully paid without "endangering" the capital of other partners.

16 - 24

Chapter 16 CHAPTER SIXTEEN – PARTNERSHIP LIQUIDATION I. STEPS IN THE LIQUIDATION PROCESS A. The first step in the liquidation process is to compute any net income or loss up to the date of dissolution. B. Assets that are not acceptable for distribution in their present form are converted into cash. If the sales price of an asset is greater than (less than) the recorded book value, there is a gain (loss) from the sale. C. Distribute the available assets to creditors and partners. The liabilities of the partnership shall rank in order of payment, as follows: 1. Liabilities to creditors other than partners, 2. Liabilities to partners other than for capital and profits (such as loans), 3. Liabilities to partners in respect of capital, 4. Liabilities to partners in respect of profits.

II. PRIORITIES OF PARTNERSHIP AND PERSONAL CREDITORS Recognition of the rights of these two groups of creditors and the classification of assets into personal and partnership categories is referred to as marshaling of assets. The order of priority concerning the availability of assets for each class of creditors in states that have adopted the UPA is as follows: A. Partnership assets 1. Partnership creditors. 2. Personal creditors that did not recover their claims in full from personal assets. Recovery from partnership assets is limited to the extent that the partner has a credit interest in the partnership assets. B. Personal assets 1. Personal creditors. 2. Partnership creditors who were not satisfied from partnership assets. Such claims may be made against an individual partner regardless of whether the partner has a debit or credit equity interest in the partnership. 3. Claims of the partnership against the partner by nature of a deficit equity interest. The partners share profits and losses equally. The personal assets of each partner must be applied to the settlement of his or her personal liabilities before personal assets can be used to satisfy any partnership claims. The cash distribution to partners is based on their capital balances, not their profit and loss ratio. The cash is distributed first to liquidate partnership liabilities and then to satisfy partners’ capital interests.

III. INSTALLMENT LIQUIDATION If the liquidation extends over a period of time, the partners will probably prefer that cash be distributed as it becomes available. If partners are to receive cash in installments before the total liquidation losses and the total cash available are known, safeguards must be taken to protect the interests of the creditors and the respective interest of each partner. A. Safe payment approach 1. One approach used to calculate a safe cash distribution is based on three assumptions: ➢ A loan to or from an individual partner will be combined with the respective partner’s capital account to determine his or her net interest in the partnership assets. ➢ The remaining noncash assets will not provide any additional cash. In other words, the maximum potential loss is equal to the book value of noncash assets. ➢ A partner with a debit balance in his or her capital account will be unable to pay amounts owed to the partnership 2. Computation of Safe Payment before Each Distribution A safe payment schedule is prepared each time cash is to be distributed; it is prepared to compute the amount of cash to be distributed and to determine which partner(s) will receive cash. The series of computations is not recorded in the accounts, since they are based upon certain assumed events that have not yet occurred. Only the actual transactions as they occur, such as the sale of assets and distribution of cash, are recorded in the accounts. 3. Additional Losses, Discovery of Liabilities, and Liquidation Expense The reasonable cost of carrying out the liquidation, additional losses and discovery of liabilities can be considered in the safe payment schedule by adding the estimated liquidation expenses, disposal cost, and unrecorded liabilities to the book value of noncash assets. The effect of the adjustment is to hold back cash equal to the estimated expenses. B. Advance plan for the distribution of cash It is more informative and efficient to prepare an advance schedule that specifies the order in which each partner will participate and the amount of cash each partner will receive as it becomes available for distribution. There are four steps to follow: 1. Determine the net capital interest of each partner by combining the balance in the partner’s capital account with obligations to or receivables from the partner. 2. Determine the order in which the partners are to participate in cash distributions. 3. Compute the amount of cash each partner is to receive as it becomes available for distribution.

4. A cash distribution plan is then prepared.

IV. INCORPORATION OF A PARTNERSHIP Upon incorporation, the assets and liabilities are transferred to the corporation and the partners receive capital stock in settlement of their interests. The partnership accounts should be restated to fair values to assure that the partners receive an equitable distribution of stock for their interests. A. Retention of partnership books by corporation The steps to record the incorporation are as follows: 1. Assets and liabilities are adjusted to fair value. Frequently, a valuation adjustment account is created to accumulate the gains and losses. 2. The valuation adjustment account is closed to the partners’ capital accounts in accordance with their profit and loss ratio. 3. The partners’ capital accounts are closed upon the transfer of capital stock. Since the books are retained, offsetting credits are made to Capital Stock at par value for the number of shares issued. If the debit to partners’ capital accounts exceeds the credit to Capital Stock, the difference is a credit to Additional Paid-in Capital B. New books established by corporation All accounts on the partnership books will end with a zero balance. The only difference as compared to the steps for retention of partnership books by the corporation is that on receipt of the stock, asset and liability accounts are closed on the partnership books and transferred to the corporation.