Chapter 11 Intercorporate Investments and Consolidations 567

CHAPTER 11 11-1 Marketable securities may be either short-term or long-term investments. Short-term refers to intention, not to salability. 11-2 Trading securities are debt or equity securities that a company buys only with the intent to resell them shortly. Held-to-maturity securities are debt securities that the company purchases with the intent to hold them until they mature. Available-for-sale securities include all short-term investments that are not trading or held-to-maturity securities. 11-3 The market method is now routinely applied to investments in short-term securities classified as available for sale or trading securities. The cost method applies only to held-tomaturity debt securities. 11-4 No. This statement is true for trading securities, but not for available-for-sale securities (where the gain or loss is taken directly to an account in stockholders equity) or for held-tomaturity securities (where changes in market price are not reported). 11-5 Amortization of bond discount increases an investor's interest income. The payment of $1,000 at maturity includes return of the $950 invested plus $50 of interest. Amortization spreads this extra interest income over the life of the bond. 11-6 Investments of 20 to 50 percent of the shares of unconsolidated subsidiaries over which significant influence, but not control, is exercised are carried in the balance sheet at original cost plus the consolidated group's share of accumulated income since acquisition reduced by dividends received. This is called the equity method. 566

11-7 The equity method is usually appropriate for long-term investments where the investor has an ownership interest of 20 to 50 percent, because the owner would usually have the ability to exert significant influence over the investee. This method is also often used by the parent to account for majority-owned subsidiaries between financial statement preparation dates. 11-8 Under the equity method the investor recognizes income as it is earned by the investee and accounts for dividends as a reduction of the investment. Under the market method the investor recognizes income when cash dividends are paid by the investee. In addition, the market method adjusts carrying values to market. 11-9 A parent-subsidiary relationship exists when one corporation owns more than 50% of the outstanding voting shares of another corporation. 11-10 The reasons for establishing subsidiaries include limiting the liabilities in a risky venture, saving income taxes, conforming with government regulations with respect to a part of the business, doing business in a foreign country, and expanding in an orderly way. It is also often easier to sell or spin-off a subsidiary than an integrated part of the firm. 11-11 The answer depends upon who sells Company A the shares. If Company A purchases the shares of B from the shareholders of B, not from the company itself, the company s books are unaffected. If Company A purchases the shares from Company B when Company B is created, Company B debits cash and credits common stock and additional-paid-in-capital. Chapter 11 Intercorporate Investments and Consolidations 567

11-12 Eliminating entries remove double-counting. Adding together the books of the parent and subsidiary includes both the net assets of the subsidiary and also the parent's ownership interest in those assets (the investment in subsidiary account). The consolidated statements should not show both amounts. The investment in subsidiary account is deleted by the eliminating entry along with the subsidiary s owners equity. Consolidation also requires adjustment for intercompany transactions: purchases and sales, receivables and payables between parent and subsidiary. 11-13 No. The consolidated statement and the parent-only statement will show the same amount of net income. The difference is in the format of reporting, not in the amount of income that is reported. The parent reports subsidiaries results using the equity method. 11-14 If the parent owns, say, 90% of the subsidiary stock, then outsiders to the consolidated group own the other 10%. The account Minority Interest in Subsidiaries is a measure of this outside interest. Note that this minority interest is in the subsidiary, not in the parent company. The financial statement of the consolidated company will show the minority interest. 11-15 According to the FASB, control cannot exist unless an ownership interest exceeds 50 percent. Significant influence is presumed if the ownership interest is between 20 and 50 percent. 11-16 Goodwill is measured by the excess of purchase price over the fair value, not the book value, of the net identifiable assets (identifiable assets less liabilities) acquired. Goodwill is an intangible asset related to the whole entity. 568

11-17 In the U.S. GAAP used to require that goodwill be amortized over no more than 40 years, assuming it does not have an infinite life. The rule was recently changed so that goodwill is written off only when its value is impaired. In some countries it is treated as having an infinite life and in other countries immediate write-off against equity is permitted. 11-18 Twenty percent is the common cut-off between the use of the market and equity method. Particularly when affiliates are incurring losses, parents might prefer the market method so they do not have to record their proportionate share of the losses on their income statement. Note that many start up companies may report losses while having steady or rising market values. 11-19 Historically, subsidiaries whose business is totally different from the parent and other subsidiaries were not consolidated. Examples were finance companies and insurance companies that are subsidiaries of parent companies with entirely different activities such as manufacturing, merchandising, mining, and transportation. Under current GAAP, all subsidiaries that are more than 50% owned are consolidated, unless the control is temporary. 11-20 Under the direct method the body of the statement of cash flows would show the $20,000 dividends as part of cash flows from operating activities. The reconciliation schedule would adjust net income as follows: Deduct: Pro-rata share of affiliated company net income $(32,000) Add: Dividends received 20,000 Alternatively, the reconciliation schedule might have the single line: Deduct: Undistributed earnings in affiliated company $ 12,000 Chapter 11 Intercorporate Investments and Consolidations 569

11-21 In consolidated statements, all the assets and liabilities of the parent and subsidiary are added together in the statements. But the shareholders of the parent do not own all of the combined assets and liabilities, so the interests of the minority owner s must be subtracted. In contrast, with an affiliated company, only the parent s proportional interest in the affiliated companies is added into the financial statements. Therefore, the owners of the parent own 100% of all the items in the financial statements. 11-22 Usually the parent uses the equity method to account for its ownership interest in subsidiaries and then consolidates all subsidiaries at the end of the year for reporting to the SEC and investors. Since the parent s separate income statement includes the parent s share of the subsidiaries earnings, net income is identical on the parent s separate income statement and on consolidated statements. 11-23 Next year the income statement will include the 100% gain on the portfolio because upon selling the securities the gains become realized. In the first year, the portfolio was treated as available-for-sale securities and therefore, gains were included in comprehensive income but not in net income. Savvy investors and analysts will already understand this, so the real issue from a performance standpoint will be about how the additional investment in the operating assets of the company translates into ongoing operating profit. 570

11-24 Most acquisitions fail. The current importing business demands expertise in style, consumer needs, and import and export practices. The nature of the business is selling to existing stores and the decision processes and staffing needs for such a wholesale business are very different than for a retail business. Thus, the approach faces many challenges along the lines discussed in the text. You are not an expert in this area and branching into retailing will raise many business practice and cultural issues. Ideas of this sort can work. This is called vertical integration, which means that a company supplies itself by, in this case, importing the goods that will be most useful for its retail establishments. However, most small businesses would be better advised to extend their business by adding product lines or adding countries to their importing activity. 11-25 The CFO is likely to point out that increasing your ownership position will alter the accounting from use of the market method to use of the equity method. Under the equity method you would need to report your share of the losses that the company is generating for financial reporting purposes. You may not want to do this. Chapter 11 Intercorporate Investments and Consolidations 571

11-26 There are a couple of critical issues. Sales would not rise by 25% because half of the sales from the target to us would be eliminated as intercompany transactions. For the consolidated entity, only sales to real outsiders would count. The increase in profit would depend on what proportion of the purchases we make from this supplier are resold to our customers during the year. Assuming instantaneous sales to our customers, our profit might rise by the full $5 million. However, that assumes that the purchase occurred at the current book values of the target. If the market values of existing assets exceeded their current book values and depreciation and other costs increased as a result, the increase in profit for the combined company could be much less than $5 million. Finally, much would depend on when the purchase occurred. The operating results for the target would only be included with the parent s results from the moment of acquisition forward. 11-27 (15-25 min.) Amounts are in millions. 1. Original cost on January 1, $160. End of Period 1 2 3 4 Market values 150 140 152 160 Balance Sheet Presentation: Trading securities (at market) 150 140 152 160 For Period 1 2 3 4 Income Statement Presentation: Unrealized gain (loss) on portfolio of trading securities (10) (10) 12 8 572

11-27 (continued) Current accounting rules require that changes in the market values of trading securities must affect income in the period when the market value changes. 2. Journal entries for Periods 1, 2, 3, and 4 follow: Unrealized loss in trading portfolio 10 Trading portfolio 10 To record unrealized loss in portfolio. Unrealized loss in trading portfolio 10 Trading portfolio 10 To record unrealized loss in portfolio. Trading portfolio 12 Unrealized gain on trading portfolio 12 To record unrealized gain. Trading portfolio 8 Unrealized gain on trading portfolio 8 To record unrealized gain. Chapter 11 Intercorporate Investments and Consolidations 573

11-28 (15-25 min.) Amounts are in millions. 1. Original cost on January 1, $160. End of Period 1 2 3 4 Market values 150 140 152 160 Balance sheet presentation: Available-for-sale securities (at market) 150 140 152 160 Stockholders' Equity: Unrealized loss on available-for-sale securities* (10) (20) (8) 0 * Part of Accumulated other comprehensive income. Income Statement Presentation: No effect Current accounting rules require that changes in the market values of available-for-sale securities do not affect income. Increases in market value are added to and decreases in market value are deducted from an account in stockholders equity. This might be called something like Unrealized gain (loss) on available-for-sale securities and is part of comprehensive income. 2. Journal entries for Periods 1, 2, 3, and 4 follow: Unrealized loss on available-for-sale securities 10 Available-for-sale securities 10 To record unrealized loss in portfolio. 574

11-28 (continued) Unrealized loss on available-for-sale securities 10 Available-for-sale securities 10 To record unrealized loss in portfolio. Available-for-sale securities 12 Unrealized gain on available-for-sale securities 12 To record unrealized gain. Available-for-sale securities 8 Unrealized gain on available-for-sale securities 8 To record unrealized gain. 11-29 (15-20 min.) 1. Cash interest payment:.10 x $1,000,000 x 1/2 $50,000 Semi-annual interest income, 6/30/X2,.12 x $926,400 x 1/2 55,584 Amortization of discount: $ 5,584 Analysis of Bond Transactions A = L + SE Investment Cash + in bonds = Retained Earnings a. Purchase 926,400 +926,400 = b. Semi-annual interest, 6/30/X2 + 50,000 + 5,584 = + 55,584 c. Maturity value +1,000,000 1,000,000 = Increase Interest Revenue Chapter 11 Intercorporate Investments and Consolidations 575

11-29 (continued) 2. a. Investment in bonds 926,400 Cash 926,400 To record the acquisition of $1 million face value 10% bonds maturing on December 31, 20X6, for $926,400 b. Cash 50,000 Investment in bonds 5,584 Interest revenue 55,584 To record receipt of interest and amortization of discount c. Cash 1,000,000 Investment in bonds 1,000,000 To record collection of bonds at maturity date 3. December 31, 20X1 June 30, 20X2 Investor' s Balance Sheets Investment in bonds, 10% due December 31, 20X6 926,400 931,984* * $926,400 + $5,584 = $ 931,984 While the issuer typically keeps a separate account for unamortized discounts and premiums, the investors do not (though they could if desired). 576

11-30 (15-20 min.) 1. Cash interest payment,.10 x $2,000,000 x 1/2 $100,000 Semi-annual interest income, 6/30/X2,.08 x $2,271,830 x 1/2 90,873 Amortization of premium $ 9,127 Analysis of Bond Transactions A = L + SE Investment Cash in bonds = Retained Earnings a. Purchase 2,271,830 +2,271,830 = Increase b. Semi-annual interest + 100,000 9,127 = +90,873 Interest Revenue c. Maturity value +2,000,000 2,000,000 = 2. a. Investment in bonds 2,271,830 Cash 2,271,830 To record the acquisition of $2 million face value 10% bonds maturing on December 31, 20Y1 for $2,271,830 b. Cash 100,000 Interest revenue 90,873 Investment in bonds 9,127 To record receipt of interest and amortization of premium c. Cash 2,000,000 Investment in bonds 2,000,000 To record collection of bonds at maturity date Chapter 11 Intercorporate Investments and Consolidations 577

11-30 (continued) 3. December 31, 20X1 June 30, 20X2 Investor' s Balance Sheets Investment in bonds, 10% due December 31, 20Y1 2,271,830 2,262,703* * $2,271,830 $9,127 = $2,262,703 While the issuer typically keeps a separate account for unamortized discounts and premiums, the investors do not (though they could if desired). 11-31 (15-20 min.) 1. Answers are in millions of dollars. Equity Method Market Method Liabilities & Liabilities & Assets = Stock Equity Assets = Stock Equity Cash Investments Liabil -ities Stock. Equity Cash Investments Liabilities Stock. Equity a. Acquisition 50 +50 = 50 +50 = b. Net income of = Bearpaw + 7 +7 c. Dividends from Bearpaw + 3 3 = + 3 = + 3 Effects for year 47 +54 = +7 47 +50 = + 3 The journal entries that would accompany this table are: 578

11-31 (continued) Equity Method Market Method a. Investment in Bearpaw 50 a. Investment in Bearpaw 50 Cash 50 Cash 50 b. Investment in Bearpaw 7 b. No entry Investment revenue* 7 c. Cash 3 c. Cash 3 Investment in Bearpaw 3 Dividend revenue** 3 * More frequently called "Equity in earnings of affiliates" ** Frequently called "dividend income" Under the equity method, income is recognized by Yukon as it is earned by Bearpaw rather than when dividends are received. Cash dividends do not affect net income; they increase Cash and decrease the Investment balance. In a sense, the dividend is a partial liquidation of the investor's "claim" against the investee. The receipt of a dividend is similar to the collection of an account receivable. The revenue from a sale of merchandise on account is recognized when the receivable is created; to include the collection also as revenue would be double-counting. Similarly, it would be double-counting to include the $3 million of dividends as income after the $7 million of income is already recognized as it is earned. 2. Yukon should account for the investment in Bearpaw Snowshoes using the equity method. The market method is generally not used for ownership interests in excess of 20%. Chapter 11 Intercorporate Investments and Consolidations 579

11-32 (15 min.) The year-end balance in Investment in Y is $102 million under the equity method: Assets = Liabilities and Stockholders' Equity Cash + Investment = Liabilities + Stockholders' Equity Equity Method 1. Acquisition 90 + 90 = 2. Net income of Y + 20 = + 20 3. Dividends from Y + 8 8 = Effects for year 82 + 102 = + 20 11-33 (10-15 min.) Amounts are in thousands. 1 and 2. Able Baker Consolidated Assets: Cash $ 300 $100 $ 400 Net plant 1,700 400 2,100 Investment in Baker 200 Total assets $2,200 $500 $2,500 Liabilities and stockholders equity: Accounts payable 175 $ 80 $ 255 Long-term debt 425 220 645 Stockholders equity 1,600 200 1,600 Total liabilities and stockholders equity $2,200 $500 $2,500 3. Consolidated net income = $250 + 50 = $300. 11-34 (5-10 min.) Minority interest on P s consolidated income statement is the unowned 5% times $200,000 = $10,000. From S Company s perspective there is no minority interest. Company P and the minority shareholders are all just shareholders in S. 580

11-35 (10-15 min.) 1. Goodwill = $470,000 $70,000 = $400,000. This would appear with the noncurrent assets on Megasoft s consolidated balance sheet. 2. Income before effect of Zenatel $150,000 Loss on Zenatel operations (10,000) Consolidated net income * $140,000 * This assumes no sales between the two companies. 3. Income before effect of Zenatel $150,000 Loss on Zenatel operations (10,000) Write-off of goodwill due to impairment (25,000) Consolidated net income $115,000 4. Goodwill = $400,000 $25,000 = $375,000 11-36 (10 min.) Company P would use the equity method and claim equity in earnings of Company S equal to 30% x $200,000 = $60,000. This would also increase the investment account by $60,000. When Company P receives 30% of $50,000 or $15,000, in dividends, the investment account is reduced by the $15,000. The net change in the investment account would be an increase of $60,000 $15,000 = $45,000. Chapter 11 Intercorporate Investments and Consolidations 581

11-37 (5-10 min.) The parent company could not achieve the window-dressing of income under the equity method. For example, if the subsidiary were wholly owned, each inflated profit to the parent would be offset by a loss at the subsidiary. The parent's share of subsidiary losses would be 100% and would be completely reflected in the parent's accounts. That is why the equity method is often called a "one-line consolidation." 11-38 (15-25 min.) Amounts are in thousands of dollars. 1. The balance sheet value of January 1 is the market value, 955,182. End of Period January February March Market values 980,160 940,000 960,000 Balance Sheet Presentation: Net trading portfolio 980,160 940,000 960,000 January February March Income Statement Presentation: Unrealized gain (loss) on trading portfolio 24,978* (40,160)** 20,000*** * 955,182 980,160 ** 980,160 940,000 *** 940,000 960,000 Current accounting rules require the recognition of changes in the market value of trading securities as gains or losses in the income statement. 582

11-38 (continued) 2. Journal entries for January, February, and March follow: Trading portfolio 24,978 Unrealized gain on trading portfolio 24,978 To record change in market value. Unrealized loss in trading portfolio 40,160 Trading portfolio 40,160 To record unrealized loss in trading portfolio. Trading portfolio 20,000 Unrealized gain on trading portfolio 20,000 To record unrealized gain. 3. If the securities were available-for-sale, the asset on the balance sheet would not be any different but the unrealized gains and losses would not appear in the income statement. Instead, they would be added to a separate Stockholders' equity account and included in other comprehensive income. 11-39 (15 min.) 1. Trading securities (at market): U.S. Government Bonds $ 660,000 Held-to-maturity securities (at cost): Bonds issued by Beta Corporation 540,000 Available-for-sale securities (at market): Common shares of Gamma Corporation 770,000 Total short-term investments $1,970,000 2. Unrealized loss on trading securities 25,000 Trading securities 25,000 Available-for-sale securities 60,000 Unrealized gain on available-for-sale securities 60,000 Chapter 11 Intercorporate Investments and Consolidations 583

11-40 (15-20 min.) 1. Carrying amount: Face or par value $10,000,000 Deduct: Initial discount on bonds ($10,000,000 - $8,852,950) (1,147,050) Add: Amortization, 6/30/X3 31,177* Amortization, 12/31/X3 33,048** $8,917,175 Cash received 9,100,000 Difference, gain on sale $ 182,825 * [.06 x 8,852,950] 500,000 = 31,177 ** [.06 x (8,852,950 + 31,177)] 500,000 = 33,048 2. Cash 9,100,000 Investment in bonds 8,917,175 Gain on disposal of bonds 182,825 To record the sale of bonds on the open market 11-41 (20 min.) CHOW COMPANY Consolidated Income Statement For the Year Ended December 31, 20X8 Sales $1,420,000* Operating expenses 1,312,000 Income before minority interests $ 108,000 Outside stockholders' interest in consolidated subsidiary's net income, 30% x $40,000 12,000 Net income, Chow Company (consolidated net income) $ 96,000 * This assumes that neither Chow nor its subsidiary had sales to the other. 584

11-41 (continued) A more detailed analysis follows: Parent Subsidiary Consolidated Sales $870,000 $550,000 $1,420,000 Operating expenses 802,000 510,000 1,312,000 Operating income $ 68,000 $ 40,000 $ 108,000 Parent's share (70%) of subsidiary net income of $40,000 28,000 Net income Parent $ 96,000 Minority's share (30%) of subsidiary net income 12,000 Net income to consolidated entity $ 96,000 CHOW COMPANY Consolidated Balance Sheet As of December 31, 20X8 Assets $916,000(a) Liabilities to creditors $380,000 Minority interests 36,000 (b) Total liabilities $416,000 Stockholders' equity 500,000 Total liab. & Stk. Eq. $916,000 (a) $800,000 + $200,000 $84,000 (b) $120,000 x.30 The balance sheet is based on the following analysis: A Liabilities + Stockholders' Equity Investment in S + Other Assets = Liabilities + Minority Interest + Stockholders' Equity Parent accounts 84,000 + 716,000 = 300,000 + 500,000 Subsidiary accounts 200,000 = 80,000 + 120,000 Eliminations 84,000 = +36,000 120,000 Consolidated 0 + 916,000 = 380,000 + 36,000 + 500,000 Chapter 11 Intercorporate Investments and Consolidations 585

11-42 (20-25 min.) Although this problem deals with two subsidiaries, it is not difficult. Amounts are in millions of dollars. Assets = Liabilities+ Stockholders' Equity Liabilities Investment in Other to Minority Stockholders' Subsidiaries + Assets = Creditors + Interests + Equity Parent's accounts 65 + 135 = 100 + 100 S1 accounts 90 = 20 + 70 S2 accounts 20 = 5 + 15 Intercompany eliminations Regarding S1 56 a = + 14 a 70 Regarding S2 9 b = + 6 b 15 Consolidated 0 + 245 = 125 + 20 + 100 a (.8 x 70) and (.2 x 70) b (.6 x 15) and (.4 x 15) Consolidated Balance Sheet December 31, 20X4 (in millions) Assets: Other assets $245,000 Total assets $245,000 Liabilities & Stockholders Equity Liabilities: Liabilities to creditors $125,000 Minority interests 20,000 Total liabilities 145,000 Stockholders equity 100,000 Total liabilities & stk. Eq. $245,000 586

11-42 (continued) Consolidated Income Statement For the Year Ending December 31, 20X4 (In Millions of Dollars) Consoli- Parent S1 S2 dated Sales 300 80 100 480 Expenses 280 90 90 460 Income before equity and minority interests 20 (10) 10 20 Earnings (losses) from subsidiaries (2) Net income 18** Minority interests (2)* Net income to consolidated entity 18 * 20% of (10) + 40% of 10 = (2) + 4 = 2 ** 20 +80% of (10) + 60% of 10 = 20 + (8) + 6 = 18 The parent would record equity interest in subsidiaries net income of (2) on its parent only financial statements. On the consolidated statements, the minority interest reduces consolidated net income. Chapter 11 Intercorporate Investments and Consolidations 587

11-43 (25-35 min.) 1. A common mistake is to think that the $120 is additional money flowing into the S Corporation rather than into the pockets of the S shareholders as individuals. Liabilities + Assets = Stockholders' Equity Invest- Cash and Accounts Stockment Other Payable, holders' in S + Assets = etc. + Equity P's accounts, January 1 Before acquisition 500 = 200 + 300 Acquisition of S +120 120 = S's accounts, January 1 160 = 40 + 120 Intercompany eliminations 120 = 120 Consolidated, January 1 0 + 540 = 240 + 300 2. P S Consolidated Sales $600 $180 $780 Expenses 450 170 620 Operating income $150 $ 10 $160 Pro-rata share (100%) of unconsolidated subsidiary net income 10 Net income $160 $ 10 588

11-43 (continued) 3. P's parent-company-only income statement would show its own sales and expenses plus its pro-rata share of S's net income, as the equity method requires. Reflect on the changes in P's balance sheet equation (in millions): Assets = Liabilities + Stockholders' Equity Invest- Cash and Accounts ment Other Payable, In S + Assets = etc. + Stockholders' Equity P's accounts: Beginning of year 120 + 380 = 200 + 300 Operating income + 150 = + 150 retained earnings Share of S income + 10 = + 10 retained earnings End of year 130 + 530 = 200 + 460 S's accounts: Beginning of year 160 = 40 + 120 Net income + 10 = + 10 retained earnings End of year 170 = 40 + 130 Intercompany eliminations 130 = 130 Consolidated, end of year 0 + 700 = 240 + 460 S's balance sheet accounts would have increased by $10 million, $170 million versus $160 million. At this point review to see that consolidated statements are the summation of the individual accounts of two or more separate legal entities. These statements are prepared periodically via worksheets. A consolidated entity does not have a separate continuous set of books like its legal entities. Moreover, a consolidated income statement is merely the summation of the revenues and expenses of the separate legal entities being consolidated after the elimination of double-counting. Chapter 11 Intercorporate Investments and Consolidations 589

11-43 (continued) 4. Consolidated accounts would be unaffected. S's cash and stockholders' equity would decline by $10 million. P's investment in S would decline by $10 million, but P's cash would rise by $10 million. Special note: Some instructors may wish to formulate eliminating entries to show how the accounts are consolidated: For For Requirement Requirement 1 3 Stockholders' equity (on S books) 120 130 Investment in S (on P books) 120 130 11-44 (30-45 min.) Amounts are in millions. A common error is to think that the $84 million is additional money flowing into the S Corporation rather than into the pockets of the S shareholders. 1. Assets = Liabilities + Stockholders' Equity Invest- Cash and Accounts ment Other Payable Minority Stockholders' in S + Assets = etc. + Interest + Equity P's accounts, January 1 Before acquisition 500 = 200 + 300 Acquisition of 80% of S 84 + 84 = S's accounts, January 1 160 = 40 + 120 Intercompany eliminations 84 = + 36 + 120 Consolidated, January 1 0 + 576 = 240 + 36 + 300 590

11-44 (continued) 2. The same basic procedures are followed by P and S regardless of whether S is 100 percent owned or 70 percent owned. However, the presence of a minority interest changes the consolidated statements slightly. The income statements would include: P S Consolidated Sales $600 $180 $780 Expenses 450 170 620 Operating income $150 $ 10 $160 Pro-rata share (70%) of Company S net income 7 Net income $157 $ 10 Minority interest (30%) in consolidated subsidiaries' net income 3 Net income to consolidated entity $157 3. Assets Liabilities + Stockholders' Equity Invest -ment Cash & Other Accounts Payable + Minority + Stockholder's (In Millions) in S + Assets = etc. Interest Equity P's accounts: Beginning of year 84 + 416a = 200 + 300 Operating income + 150 = + 150 Share of S income 7 = + 7 End of year 91 + 566 = 200 + 457 S's accounts: Beginning of year 160 = 40 + 120 Net income + 10 = + 10 End of year 170 = 40 + 130 Intercompany eliminations 91 = + 39b + 130 Consolidated, end of year 0 + 736 = 240 + 39 + 457 a 500 beginning of year 84 for acquisition = 416 b 36 beginning of year +.30 x 10 = 36 + 3 = 39 Chapter 11 Intercorporate Investments and Consolidations 591

11-44 (continued) Special Note: Some instructors may wish to formulate eliminating entries to show how the accounts are consolidated: For For Requirement Requirement 1 3 Stockholders' equity (on S books) 120 130 Investment in S (on P books) 84 91 Minority interest (in consolidated statements) 36 39 4. Consolidated accounts would be affected because the minority interest's claim would be partially liquidated in the amount of 30% of $10 million, or $3 million. S's cash would decline by $10 million, P's investment in S would decline by.70 x $10 million = $7 million, but P's cash would rise by $7 million. Assets = Liabilities + Stockholders' Equity Invest- Cash and Accounts ment Other Payable, Minority Stockholders' in S + Assets = etc. + Interest + Equity End of year balances: P's accounts (from 3) 91 + 566 = 200 + 457 Effect of S dividend 7 + 7 = Balance 84 + 573 = 200 + 457 S's accounts (from 3) 170 = 40 + 130 Effect of S dividend 10 = 10 Balance 160 = 40 + 120 Consolidated accounts (from 3) 736 = 240 + 39 + 457 Effect of S dividend 3 = 3 Balance 733 = 240 + 36 + 457 592

11-45 (25-35 min.) Assets = Liabilities + Stock. Equity Invest- Cash and Accounts ment Other Payable, Stockholders' (In Millions) in S + Assets = etc. + Equity P's accounts, January 1 Before acquisition 500 = 200 + 300 Acquisition of 100% of S +150 + 150 = S's accounts, January 1 160 = 40 + 120 Intercompany eliminations 120 = 120 Consolidated, January 1 30* + 510 = 240 + 300 * The $30 million "goodwill" would appear in the consolidated balance sheet as a separate intangible asset account. It often is the final item in a listing of assets. It is usually written off when it is determined that its value has decreased. 2. a. If the book values of the S individual assets are not equal to their fair market values, the usual procedures are: (1) S continues as a going concern and keeps its accounts on the same basis as before. (2) P records its investment at its acquisition cost (the agreed purchase price). (3) For consolidated reporting purposes, the excess of the acquisition cost over the book values of S is identified with the individual assets, item by item. (In effect, they are revalued at the current market prices prevailing when P acquired S.) Any remaining excess that cannot be identified is labeled as purchased goodwill. Chapter 11 Intercorporate Investments and Consolidations 593

11-45 (continued) The balance sheet accounts immediately after acquisition would be the same as in Requirement 1, except that Goodwill would be $20 million instead of $30 million, and Other Assets would be higher by $10 million. The $10 million would appear in the consolidated balance sheet as an integral part of the asset whose fair market value exceeded its book value. That is, the S equipment would be shown at $10 million higher in the consolidated balance sheet than the carrying amount on the S books. Similarly, the depreciation expense on the consolidated income statement would be higher. For instance, if the equipment had five years of useful life remaining, the straight-line depreciation would be $10 5 = $2 million higher per year. As in the preceding tabulation, the $20 million "goodwill" would appear in the consolidated balance sheet as a separate intangible asset account. b. Thus, consolidated income will be lower each year by the extra depreciation of $2 million. The assets are subject to depreciation, but goodwill is not. $10,000,000 5 years $2,000,000 The assigning of a "basket purchase price" to the various assets can have a dramatic effect on income taxes. For example, not only is income lower for corporate reporting purposes in part 2b, but also income tax cash outflows would be less during the next four years. Depreciation is deductible for Federal income tax purposes, but the write-off of goodwill frequently is not. 594

11-46 (20-25 min.) 1. Inventories Assets = Stockholders Equity Plant Investment Common Assets, Goodwill Stock Etc. Retained Net in B = + Earnings (in millions) Cash A s accounts: Before acquisition 150 +60 + 60 = 70 + 200 After acquiring B 100 100 = B s accounts 15 +25 + 30 = 30 + 40 Intercompany eliminations 20* +10 100 = 30 40 Consolidated 65 + 85 + 110* +10 0 = 70 + 200 * The $20 million would appear as an integral part of the plant assets because they would be carried at $20 million higher in the consolidated balance sheet than the carrying amount on the B books. Therefore, plant assets would appear on the consolidated balance sheet as ($60 + $30) + $20 = $110. 2. The B plant assets would be carried in the consolidated balance sheet at $60 million instead of $50 million, and no goodwill would appear as a separate intangible asset. 3. Consolidated cash would be $20 million less, and a goodwill account of $20 million would be created. Note in requirement 2 that all of the cost in excess of book value was linked to specific plant assets. The balance in the Investment in B account would be $120 million instead of $100 million on A s books before consolidation. Chapter 11 Intercorporate Investments and Consolidations 595

11-47 (15 min.) 1. Goodwill = $5.6 billion - $1.7 billion = $3.9 billion 2. Goodwill amortization was not tax deductible therefore the entire difference in amortization would affect net earnings. Amortization dropped by $1,097 so earnings would have been $11,102 - $1,097 = $10,005 if amortization had continued at prior levels and earnings would have increased by ($10,005 - $8,500) $8,500 or 18%. This is still a very strong increase, but only 60% as large as it first appeared. 3. The after tax effect of the Miller transaction would be $2,631 less $900 of taxes or $1,731 so we estimate net earnings to be $10,005 - $1,731 or $8,274 on a comparable basis to 2001. This changes the apparent 30% increase to a decline of ($8,274 - $8,500) $8,500 = (2.7%). Note that prior to the sale of Miller, Miller s net earnings were included in Altria s income via consolidation. Post-sale a similar net earnings contribution can be expected via the equity interest in SAB, so it is only the one-time recognition of gain on the sale that needs to be taken into account. 596

11-48 (30 min.) This problem is based on the acquisition of Paramount Pictures by Gulf & Western, although Gulf & Western accounted for the purchase as a pooling, which was then permissible. Note that this transaction differs from examples in the text in that Cinemon issued new shares of Cinemon stock in the transaction, and this increases Cinemon s stockholders equity. 1. Note that the purchase price ($180 million) is equal to the net assets of Bradley ($120 million $20 million = $100 million) plus the $80 million value of the film inventory. The combined company would have the following balance sheet accounts immediately after the acquisition (in million of dollars): Cash and receivables 30 + 22 = 52 Inventories 120 + 3 + 80 = 203 Plant assets, net 150 + 95 = 245 Total assets 500 Current liabilities 50 + 20 = 70 Common stock 100 + 180* = 280 Retained earnings 150 = 150 Total liabilities and stockholders' equity 500 * New equity issued by Cinemon in acquisition Chapter 11 Intercorporate Investments and Consolidations 597

11-48 (continued) An alternative format follows: Investment in Bradley Cash & Other Assets = Liabilities + Stockholders' Equity Cinemon Accounts: Before acquisition 300 = 50 + 250 Acquisition +180 = +180 Bradley accounts: 120 = 20 + 100 Intercompany eliminations 100 = 100 Consolidated 80* 420 70 430 * The 80 would appear in the consolidated balance sheet as an addition to inventory. An alternate format for the last two lines here would be equally acceptable: Intercompany eliminations 180 + 80** = 100 Consolidated 0* 500 = 70 430 ** As already stated, the 80 would appear in the consolidated balance sheet as an addition to inventory. The consolidating journal entry (on a working paper only) would be: Inventory 80 Stockholders' equity 100 Investment in Bradley 180 or Inventory 80 Common stock 10 Retained earnings 90 Investment in Bradley 180 598

11-48 (continued) 2. Net income for 20X7 $19 million Net income for 20X8: 20 + [21 (.25 x 80)] $21 million If the $80 million were assigned to goodwill and was not amortized, net income for 20X8 would be: 20 + 21 $41 million The chairman of Cinemon would prefer to assign as much as possible to goodwill because Cinemon could generate net income almost "on demand" by the timing of rentals or sales of its films. This avoids revelation of the cost of the library of films acquired. The immense size of this impact on income is vividly demonstrated by the fact that net income could jump to $41 million in just one year. This could take place because Cinemon would carry the film library at zero rather than the $80 million actual cost. The point of this example is to stress that assigning the purchase costs to goodwill, which need not be amortized, or other assets, which are depreciated or amortized, possibly over short periods, can significantly affect income. If management wants to show higher immediate net income, there will be a general pressure toward assigning as much of the total purchase price as possible to goodwill rather than to other assets. An alternate format that emphasizes how the accounts are affected is: Chapter 11 Intercorporate Investments and Consolidations 599

11-48 (continued) Cinemon Bradley Consolidated Sales Expenses Operating income 20 21 41 Equity in unconsolidated subsidiary net income (21 20 amort.) 1 Net income 21 Amortization of the $80 increase in inventory of films implicit in the purchase price of $180 paid for the investment (.25 x 80) 20 Net income to consolidated entity 21 Entries in parent's books to record the year s operations of Bradley: a. Investment in Bradley 21 Equity in earnings of Bradley 21 To record pro-rata share of earnings as recorded by Bradley (100% x 21). b. Equity in earnings of Bradley 20 Investment in Bradley 20 To amortize ($80 x 25% or $80 4) the $80 increase in inventory of films implicit in the purchase price of $180 paid for the investment. The T-account: Investment in Bradley Note that net effect on Acquire 180 b. Amortize Cinemon s earnings is a. Equity in 20X8 the 80 (80 4) 21-20 because, in a earnings 21 increase in sense, Cinemon had to pay 20 to obtain the 21 in equity earnings. inventory 20 600

11-49 (35-45 min.) This is a worthwhile problem because it provides an overall view of relationships. Students should reflect on the diagram in the chapter, and you might want to place a similar diagram on the board: Consolidated Parent S S S S 20-50% 20-50% 1 2 3 4 owned owned company company Minority Interests Investments in Affiliated Companies On balance sheets, the minority interest typically appears just above the stockholders' equity section; however, some accountants place it as a subpart of the stockholders' equity section. On income statements, the minority interest in net income is deducted as if it were an expense of the consolidated entity. Chapter 11 Intercorporate Investments and Consolidations 601

11-49 (continued) MIDLANDS DATA CORPORATION Consolidated Income Statement For the Year Ended December 31, 20X2 (In Millions) Net sales and other operating revenue $960 Cost of goods sold and operating expenses, exclusive of depreciation and amortization 710 Depreciation and amortization 20 Total operating expenses 730 Operating income before share of net income of affiliated companies 230 Equity in earnings of affiliated companies 20 Total income before interest expense and income taxes 250 Interest expense 25 Income before income taxes 225 Income taxes 90 Income before minority interest 135 Minority interest in subsidiaries' net income 20 Net consolidated income to Midlands Data Corporation 115* Preferred dividends 10 Net income to Midlands Data Corporation common stock $105 Earnings per share of common stock: On shares outstanding (10,000,000 shares) $ 10.50** Assuming full dilution, reflecting conversion of all convertible securities (12,000,000 shares) 9.58*** * This is the total figure in dollars that the accountant traditionally labels net income. It is reported accordingly in the financial press. ** This is the figure most widely quoted by the investment community. *** $115,000,000 12,000,000 = $9.58. This is significant potential dilution. Note that $115,000,000 is used rather than $105,000,000, because no preferred dividends would exist. Total common shares would be 10,000,000 + 2,000,000 = 12,000,000. See Exhibit 11-49 on the following page for the balance sheet. 602

EXHIBIT 11-49 MIDLANDS DATA CORPORATION Consolidated Balance Sheet As of December 31, 20X2 (In Millions of Dollars) Assets Liabilities and Stockholders Equity Current assets Current liabilities Cash $ 55 Account payable $200 Short-term investments at cost Accrued income taxes payable 30 (which approximates market value) 35 Total current liabilities $230 Accounts receivable 110 Long-term liabilities Inventories at average cost 390 First mortgage bonds, 10% interest, Total current assets 590 due Dec. 31, 20X8 80 Subordinated debentures, 11% interest, due Dec. 31, 20X9 100 Total long-term liabilities 180 Investments in affiliated companies 100 Minority interest in subsidiaries 90 Property, plant, and equipment, net 120 Total liabilities 500 Other assets: Stockholders' equity: Goodwill 100 Preferred stock, 2,000,000 shares, $50 par* 100 Common stock, 10,000,000 shares, $1 par 10 Paid-in capital in excess of par 82 Retained earnings 218 Total stockholders' equity 410 Total assets $910 Total liabilities and stockholders equity $910 * Dividend rate is $5 per share; each share is convertible into one share of common stock. Chapter 11 Intercorporate Investments and Consolidations 603

11-50 (15 min.) 1. (100% 80%) x Colorado Grande net income minority interest = $310,607 Colorado Grande s net income = $310,607.20 = $1,553,035 2. Colorado Grande s portion of Anchor Gaming s net income: (.80 x $1,553,035) $35,676,428 = $1,242,428 $35,676,428 = 3.5% 3. Minority Interest in Consolidated Subsidiary Dividends 0 Balance 672,955 Minority interest in earnings 310,607 Balance 983,562 4. Anchor Gaming has control over Colorado Grande. Therefore, we combine (or consolidate) the financial statements. However, the stockholders of Anchor Gaming do not have a claim on all the assets or net income of the consolidated entity. In a statement for Anchor Gaming shareholders, we deduct the claims of the minority shareholders. For example, shareholders of Anchor Gaming have claim on only 80% of the net income of Colorado Grande, but the consolidated statement includes 100% of the net income. After deducting the minority interest, the remaining net income represents the claim of the shareholders of Anchor Gaming. 604

11-51 (15-20 min.) 1. The idea behind discontinued operations is to segregate income that will not be ongoing so that predictions about the future do not incorporate elements that are known to not be part of the future. In this instance, IGT acquired Anchor Gaming in 2002 and only 2002 income statements for IGT included Anchor Gaming s results and, therefore, the results of Anchor Gaming s casino subsidiary. Thus no adjustment for discontinued operations is appropriate for IGT s previously reported earnings in 2001 or 2000. 2. There are two consequences. Assets and liabilities of the subsidiary to be discontinued should be segregated and they should be shown at expected liquidation value. Any expected gain or loss on sale of the activity should be shown in the income statement and the balance sheet values should be fair values, i.e. expected amounts to be realized at sale. In this instance, the subsidiary is just being acquired, so book values and liquidation values should be similar, hence, there was no gain or loss on discontinuance. IGT showed assets held for sale in the current assets section of the balance sheet of $147 million and current liabilities of discontinued companies of $11 million. 3. The distinction between identifiable intangibles and goodwill is important because the former are generally amortized and the latter is only subject to an impairment test. IGT indicates that identifiable intangibles are amortized over the following periods: i. Patents 14.6 years ii. Contracts 9.7 years iii. Technology 12.7 years iv. Trademarks 9.4 years Chapter 11 Intercorporate Investments and Consolidations 605

11-52 (5-10 min.) 1. Moscow Resources would recognize 40% x R 100 million = R 40 million as its pro-rata share of Siberia s net income, and Moscow Resources received 40% x R 60 million = R 24 million in cash dividends from Siberia. The R 40 million share of Siberia s income is included in the net income of Moscow Resources, but it is not a cash flow from operations. The R 24 million is a cash flow. Therefore, net income must be adjusted by deducting R 16 million (R 40million R 24 million). 2. The amount of cash dividends received, R 24 million, is shown as a cash inflow under operating activities. This question is about Moscow, the owner, not about the company that is paying the dividend. Some students may talk about transactions with owners not affecting the income statement, but that is true only from the issuer s side, not the investor s side. 606

11-53 (15 min.) 1. If there are no new investments or sales of existing investments then we would expect the asset account to change as follows: Beginning Balance + Equity in Earnings Dividends = Ending Balance To isolate any additional items we can rearrange this equation: Other items = Beg. Bal. + Equity in Earn. Divs. End. Bal. or $5,128 + $384 - $128 - $4,737 = $647. The T-account would show: Equity-Method Investments Beg. Bal. 5,128 Dividends received 128 Equity in income 384 Other decreases 647 End. Bal. 4,737 The ending balance is smaller than expected by $647 million. This suggests that Coca-Cola disposed of some equity investees that had a cost of $647 million. If true, there would be a gain or loss on the transaction included in the income statement and explained in the notes. Alternatively, Coca-Cola might have purchased additional amounts of an equity investee sufficient to change it to a consolidated company. The actual notes to Coca- Cola s 2002 report reveal a complex combination of such transactions. 2. Net earnings includes $384 million but only $128 million was received in dividends. Thus there should be an amount subtracted from net earnings labeled Equity in earnings in excess of dividends received equal to $256 million. Coca-Cola actually labels this number Equity income or loss, net of dividends and subtracts it from net income in its indirectmethod cash flow statement. Chapter 11 Intercorporate Investments and Consolidations 607

11-54 (20-30 min.) 1. Investment in SCC 2,000,000 Cash 2,000,000 To record the purchase of 40% of SCC for $2.0 million. Investment in SCC 160,000 Equity in earnings of SCC 160,000 To record a 40% share in the earnings of SCC. Cash 40,000 Investment in SCC 40,000 To record the receipt of dividends from SCC. 2. JORDAN SHOE COMPANY Income Statement For the Year Ended December 31, 20X6 Sales $12,500,000 Expenses 11,100,000 Operating income 1,400,000 Equity in earnings of SCC 160,000 Net income $ 1,560,000 Investment in SCC = $2,000,000 + $160,000 $40,000 = $2,120,000 608

11-54 (continued) 3. Numbers are in thousands of dollars. Assets = Liabilities + Stockholders' Equity Invest- Cash and Stockment Other Minority holders in SCC + Assets = Liabilities + Interests + Equity Jordan accounts, before acquisition 10,000 = 2,000 8,000 Acquisition of 80% of SCC +4,000 4,000 = SCC accounts 6,000 = 1,000 5,000 Intercompany eliminations 4,000 = +1,000 5,000 Consolidated 0 + 12,000 = 3,000 +1,000 + 8,000 Jordan Shoe journal entry: Investment in SCC 4,000,000 Cash 4,000,000 SCC has no journal entry 4. Jordan Shoe Company Consolidated Income Statement Fiscal year 20X6 Jordan SCC Consolidated Sales $12,500,000 $4,400,000 $16,900,000 Expenses 11,100,000 4,000,000 15,100,000 Operating income $ 1,400,000 $ 400,000 $ 1,800,000 Equity in SCC income (.80 x 400,000) 320,000 Net income $ 1,720,000 Less minority interest (.20 x 400,000) 80,000 Net income to consolidated entity $ 1,720,000 Note: Part four illustrates effectively that the equity method provides parent-only results equivalent to the consolidated results. The equity method is a "one-line consolidation." Chapter 11 Intercorporate Investments and Consolidations 609

11-55 (30-40 min.) One issue is to determine the sign of these items. Normally, if the equity investees are profitable, the equity in earnings will increase income or decrease a loss. Normally, if the consolidated but less-thanwholly-owned firms have a profit, the minority interests will represent a claim on part of that profit and will reduce the consolidated profit. Here the loss from continuing operations before minority interests and equity in earnings is reduced by both items. Thus the equity investees are reflecting a profit, but the consolidated subsidiaries are generating losses. Some of the losses are being allocated to the minority shareholders and therefore reducing the consolidated loss. 1. If $116 million is Corning s 40% interest in the profit of the equity investees, the total earnings of these companies is $116 million.40 = $290 million. 2. If $98 million is the minority investees 20% interest in the consolidated companies, the consolidated companies were generating $98 million.20 = $490 million in total. As indicated above, this is a loss of $490 million. 3. Net earnings increased by $116 million for equity in earnings. If dividends were exactly $116 million, no adjustment would have been required in the cash flow statement. An adjustment of $25 million suggests that $116 - $25 = $91 million was received from equity investees as dividends. 4. Net earnings fell by $98 million due to minority interests in the consolidated companies. Since the adjustment was exactly equal to the original minority interest, it appears that no dividends were paid by these companies. Since they were generating losses, this seems quite likely. 610