Aik CH 5
Aik CH 5
Long-term investments are usually investments in assets such as debt instruments, equity securities,
real estate, mineral deposits, or joint ventures acquired with longerterm goals. Such goals often
include the acquisition of control or affiliation with other companies, investment in suppliers,
securing sources of supply, etc. The valuation and presentation of noncurrent investments depends
on the degree of influence that the investor company has over the investee company. With no
influence, debt investments other than held-to-maturity bonds and equity investments are
accounted for at market value. Once influence is established, equity investments are accounted for
under the equity method or consolidated with the statements of the investor company.
a. In the absence of evidence to the contrary, an investment (direct or indirect) in 20% or more of
the voting stock of an investee carries the presumption of an ability to exercise significant influence
over the investee. Conversely, an investment of less than 20% in the voting stock of the investee
leads to the presumption of a lack of such influence unless the ability to influence can be
demonstrated. Accounting requirements are: Held-to-maturity securities are reported at amortized
cost. Noncurrent available-for-sale securities are reported at fair value. Influential securities are
accounted for under the equity method.
b. Standards indicate that a position of more than 20% of the voting stock might give the investor
the ability to exercise significant influence over the operating and financial policies of the investee.
When such an ability to exercise influence is evident, the investment should be accounted for under
the equity method. Basically this means at cost, plus the equity in the earnings or losses of the
investee since acquisition (with the addition of certain other adjustments). Evidence of an investor's
ability to exercise significant influence over operating and financial policies of the investee is
reflected in several ways such as management representation and participation. While eligibility to
use the equity method is based on the percent of voting stock outstanding, that can include, for
example, convertible preferred stock, the percent of earnings that can be picked up under the equity
method depends on ownership of common stock only.
5–3. Describe weaknesses and inconsistencies in accounting for noncurrent security investments
that are relevant for analysis purposes.
Some weaknesses and inconsistencies pertaining to the accounting for marketable securities carried
as noncurrent assets include:
• Equity securities of companies in which the enterprise has a 20 percent or larger interest, and in
some instances an even smaller interest than 20 percent, need not be adjusted to market. Instead, it
is reported using the equity method, which may at times yield values significantly below and at other
times above, market.
• With regard to such relatively substantial blocks of securities, the values at which they are carried
on the balance sheet may be substantially different that their realizable values.
5–5. Distinguish between hedging and speculative activities with regard to derivatives.
Hedging activities are designed to protect the company against fluctuations in market instruments.
Speculative activities seek to profit on fluctuations in market instruments.
5–7. Describe a swap contract. How are swaps typically used by companies?
A swap contract is an arrangement between two or more parties to exchange future cash flows.
Swaps are typically used to hedge risks such as interest rate and foreign currency risks.
5–11. Give an example of a cash flow hedge and an example of a fair value hedge.
A cash flow hedge is designed to hedge exposure to volatility in cash flows attributable to a specific
risk. An example of a cash flow hedge is a floating-for-fixed interest rate swap. This swap hedges the
cash flows related to an interest-bearing financial instrument. An example of a fair value hedge is a
fixed future commitment to sell a fixed quantity of a commodity at a specified price. This transaction
hedges the fair value of the commodity against loss before the time that it is sold.
5-1 An important element in accounting for investment securities concerns the distinction between
its noncurrent and current classification. Required: a. Why do most companies maintain an
investment portfolio consisting of both current and noncurrent securities? b. What factors should an
analyst consider when evaluating whether investments in marketable equity securities are properly
classified as current or noncurrent? How do these factors affect the accounting treatment for
unrealized losses?
a. Usual objectives underlying the holding of both current and noncurrent portfolios of securities
are: Current—for temporary investments of excess cash in highly liquid investments. Noncurrent—
for investment income, appreciation value, control purposes of another entity, or to secure sources
of supplies or avenues of sales.
b. Securities should be classified as follows: Trading securities are always classified as current. Held-
to-maturity securities are classified as noncurrent, except for the reporting period immediately prior
to maturity. Available-for-sale securities are classified as current or noncurrent based on
management’s intent regarding sale. Influential securities are noncurrent unless their sale is
imminent. Marketable securities that are temporary investments of cash specifically designated for
special purposes such as plant expansion or sinking fund requirements are classified as noncurrent.
Unrealized losses on trading securities (which are classified as current assets) are the only unrealized
losses to flow through the income statement. Unrealized losses on noncurrent investments (and
current investments in available-for sale securities) are included as a separate component of
shareholders' equity. Some analysts treat much if not all of these unrealized gains and losses as
another component of adjusted net income.
5-3 A company can have passive interest (noninfluencial) investments, significant influential
investments, or controlling interests. Passive interest investments can be trading, available-for-sale,
or held-to-maturity securities. Required: a. Describe the valuation basis at which each of these types
of investments is reported on the balance sheet. b. If the investment type is reported at fair value,
indicate where any value fluctuation is reported (net income or comprehensive income). c. What is
the rationale for reporting held-to-maturity securities at cost? Does this rationale make economic
sense?
c. Held-to-maturity securities are reported at historical cost because period to period value
fluctuations are arguably less relevant since the company intends to hold the security to maturity
and receive the maturity value of the investment. On one hand, not reporting the volatility in the
value of held-to-maturity securities seems appropriate since the company does not intend to sell the
security at its higher or lower current value. On the other hand, management intent can change, and
such changes in market value directly impact the value of the company.
5-5 The diagram below portrays Company X (the parent or investor company), its two subsidiaries C1
and C2, and its “50 percent or less owned” affiliate C3. Each of the companies has only one type of
stock outstanding, and there are no other significant shareholders in either C2 or C3. All four
companies engage in commercial and industrial activities.
Required:
a. Explain whether or not each of the separate companies maintains distinct accounting records.
b. Identify the type of financial statements each company prepares for financial reporting.
c. Assume you have the ability to enforce your requests of management, describe the type of
financial statement information about these companies (separate or consolidated) that you would
request.
d. Explain what Company X reports among its assets regarding subsidiary C1.
e. In the consolidated balance sheet, explain how the 20 percent of C2 that is not owned by
Company X is reported.
f. Identify the transaction that is necessary before C3 is included line by line in the consolidated
financial statements.
g. If combined statements are reported for C1 and C2, discuss the need for any elimination entries.
JAWAB :
a. Each of the four corporations will maintain separate accounting records based on its own
operations (for example, C1's accounting records are not affected by the fact it has only one
stockholder).
b. For SEC filing purposes, consolidated statements would be presented for Co. X and Co. C1 and Co.
C2 as if these three separate legal entities were one combined entity. C1 or C2 would probably not
be consolidated if controlled only temporarily. C3 would be shown as a one-line consolidation (both
balance sheet and income statement) under the equity method.
c. The analyst likely would request the following types of information (only consolidated statements
normally are available):
(1) Consolidated Co. X with subsidiaries C1 and C2 (C3 would be a one-line consolidation).
(2) Co. X statements only (all three investee companies, C1, C2, and C3 would be one-line
consolidations).
(3) Separate statements for one or more of the investee companies (C1, C2, and C3).
(4) Consolidating statements (which would provide everything in (1)-(3) except separate statements
for C3, and would also show the elimination entries).
(5) Sometimes partial consolidations (such as Co. X plus C2) or combining statements (such as only
C1 and C2) also are useful. For example, if C1 is a foreign subsidiary, the analyst may ask for a partial
consolidation excluding C1, with separate statements for C1. Also, loan covenants (or loan collateral)
frequently cover only selected companies, and a partial consolidation or combined statements are
necessary to assess safety margins.
d. Co. X will show an asset "investment in common stock of subsidiary" valued at either cost or
equity. (The equity method would be required only if no consolidated statements were presented.)
Note: Co. X owns shares of common stock of Co. C1—that is, Co. X does not own any of C1's assets
or liabilities.
e. 100 percent of C2's assets and liabilities are included in the consolidated balance sheet. However,
the stockholders' equity of C2 is split into two parts: 80 percent is added to the stockholders' equity
of Co. X and 20 percent is shown on a separate line (above Co. X's stockholders' equity) as "minority
ownership of C2" (frequently just simply called "minority interest"). The portion of the 80 percent
representing the past purchase by Co. X would be eliminated (in consolidation) against the
"investment in subsidiary."
f. Co. X must purchase enough additional common stock from the other stockholders in C3 or
purchase enough new shares issued by C3 to increase its ownership to more than 50 percent of C3's
common stock. (Alternatively, C1 or C2 could purchase the additional shares.) g. There would be no
intercompany investment or intercompany dividends. But any other intercompany transactions must
be eliminated (such as intercompany sales and intercompany receivables and payables).
5-1
Munger.Com began operations on January 1, 2006. The company reports the following information
about its investments at December 31, 2006:
a. Show how each of these investments are reported on the Munger.Com balance sheet.
b. For assets that are marked to market, indicate where the unrealized value fluctuation is reported
(in net income and/or in comprehensive income).
Total $4,220
• Unrealized price fluctuations on trading securities are reported in net income (Caltran bonds and
trading equity securities).
5-3
The following data are taken from the December 31 annual report of Bailey Company:
Bailey had 1,000,000 common shares outstanding during this entire period and there is no public
market for Bailey Company shares. Also during this period, Simpson Corp. bought Bailey shares for
cash, as follows:
January 1, 2005 290,000 shares at $11 per share, increasing ownership to 300,000 shares
January 1, 2006 700,000 shares at $15 per share, resulting in 100% ownership of Bailey Company
Simpson assumed significant influence over Bailey’s management in 2005. Ignore income tax effects
and the opportunity costs of making investments in Bailey for the requirements listed here.
Required:
a. Compute the effects of these investments on Simpson’s reported sales, net income, and
cash flows for each of the years 2004 and 2005
b. Compute the carrying (book) value of Simpson’s investment in Bailey as of December 31,
2004, and December 31, 2005.
c. Identify the U.S. GAAP-based accounting method Simpson would use to account for its
intercorporate investment in Bailey for 2006. Give two reasons this accounting method
must/should be used.
Net income: Simpson’s net income increases by the 2004 dividend income from Bailey Company (BC)
of $10,000 (computed as: [$1,000,000 dividend /1,000,000 shares = $1.00 per share] x 10,000 shares
= $10,000)
Cash flows:
Net income: Simpson’s net income increases by 30% share earnings of Bailey Company (BC)
(computed as: [300,000 shares /1,000,000 shares = 30%] x $2,200,000 income = $660,000)
Cash flows:
At December 31, 2004, Simpson’s carrying value of the investment in BC is the historical cost of
$100,000 (10,000 shares * $10 per share).
Net carrying value at December 31, 2005 ($12 per share) $3,600,000
c. Accounting method for 2006. For 2006, with ownership in excess of 50% (in this case, 100%) and
Simpson in control of BC, the consolidation method is used to combine BC’s financial statements
with those of Simpson. In a consolidation, only the purchase method is available to account for the
investment–pooling of interest is not allowed.
5-5
The following data are from the annual report of Francisco Company, a specialized packaging
manufacturer:
Note: Francisco had 1,000 common shares outstanding during the entire period. There is no public
market for Francisco shares.
Potter Company, a manufacturer of glassware, made the following acquisitions of Francisco common
shares:
January 1, Year 7 290 shares at $11 per share, increasing ownership to 300 shares
January 1, Year 8 700 shares at $15 per share, yielding 100% ownership of Francisco
Ignore income tax effects and the effect of lost income on funds used to make these investments.
Required:
a. Compute the effects of these investments on Potter Company’s reported sales, net income, and
cash flows for each of the Years 6 and 7
b. Calculate the carrying value of Potter Company’s investment in Francisco as of December 31, Year
6, and December 31, Year 7.
c. Discuss how Potter Company accounts for its investment in Francisco during Year 8. Describe any
additional information necessary to calculate the impact of this acquisition on Potter Company’s
financial statements for Year 8.
a. For Year 6:
• No effect on sales.
• Net income effect equals the dividend income of $10 (1% of $1,000, or $1 per share) since the
investment is accounted for under the market method. Also, assuming the shares are classified as
available-for-sale (a reasonable assumption given subsequent purchases), the price appreciation of
$1 per share will bypass the income statement.
• Cash flow effect equals the dividend income of $10. If the outflow due to the stock purchase is
included: Net cash flow = dividend income less purchase price = $10 - $100 = $(90).
• No effect on sales.
• Net income effect equals the percentage share of Francisco earnings for Year 7, or 30% of $2,200 =
$660.
• Cash flow effect equals the dividend income of $360 (computed as 30% of $1,200). If the outflow
due to the stock purchase is included: Net cash flow = dividend income less purchase price = $360 -
$3,190 = $(2,830).
At December 31, Year 6, the carrying value of the investment in Francisco is $110 (computed as 10
shares x $11 per share). The $11 per share figure is the fair value at Jan. 1, Year 7.
Step one—the equity method is applied retroactively to the prior years of ownership (that is, Year 6).
c. For Year 8, with ownership in excess of 50% (indeed, 100%), Francisco’s financial statements
would be consolidated with those of Potter. The purchase method is the only available choice under
current GAAP. Under this method, all assets and liabilities for Francisco are restated to fair market
value. To do this, one must know fair market values. Also, information about off-balance sheet items
(such as identifiable intangibles) that may need to be recognized must be obtained. Due to these
implications to asset and liability values in applying purchase accounting, knowing that the initial
purchase price is in excess of the book value of the acquired company’s net assets does not
necessarily indicate that goodwill is recorded.