Module 7

Reporting and Analyzing

Intercorporate Investments
Learning Objectives – coverage by question
True/ Multiple Essay
Exercises Problems
False Choice Questions
LO1 Describe
and illustrate
accounting for 1-6 1-12 1-10 1-4 1-2
passive
investments.
LO2 Explain
and illustrate
accounting for 7-12 10-19 8-13 5-7 1-5
equity method
investments.
LO3 Describe
and illustrate 12, 1-3,
12-15 14-19 8-10
accounting for 20-25 6-8
consolidations.

© Cambridge Business Publishers, 2010

Test Bank, Module 7 7-1
Module 7: Reporting and Analyzing Intercorporate Investments

True/False
Topic: Available-for-sale
LO: 1
1. When investments are classified as available-for-sale, fair-value changes are recognized in
the balance sheet as unrealized gains or losses that affect owners’ equity.

Answer: True
Rationale: Unrealized gains and losses on available-for-sale investments bypass the income
statement. Fair-value changes are recorded in the other comprehensive income (OCI) component
of stockholders’ equity.

Topic: Trading securities

LO: 1
2. Realized gains and losses on investments classified as trading securities are reported in a
company’s net income in the period that they are realized.

Answer: True
Rationale: The “trading” classification implies that those investments are viewed as part of the
company’s operations; therefore, any gains/losses are presented as investment gain/loss on the
income statement, whether realized or unrealized.

Topic: Passive investments

LO: 1
3. When a passive investment is sold, the gain (loss) is typically reported in “other” income

Answer: True
Rationale: The gain (loss) on sale is then reported as a component of “other” income, which is
commonly commingled with interest and dividend income.

Topic: Fair-value accounting

LO: 1
4. Available-for-sale is the only classification that requires fair-value accounting.

Answer: False
Rationale: Two classifications require mark-to-market accounting: available-for-sale securities
that management intends to hold for capital gains and dividend income, and trading securities
that management intends to actively trade for profits as fair values fluctuate.

Topic: Available for sale

LO: 1
5. Fair-value changes in available-for-sale investments are recognized in the income statement
as unrealized gains or losses.

Answer: False
Rationale: Fair value changes are only reported in the accumulated OCI section of equity until
realized.

Cambridge Business Publishers, ©2010

7-2 Financial Accounting for MBAs, 4th Edition
Topic: Available for sale
LO: 1
6. If marketable securities are classified in the current asset section, as “available for sale”
securities, then the assumption is that the shares will be sold during the current year.
Answer: False
Rationale: The available-for-sale classification means that the securities might be sold, not that
they will be.

Topic: Equity method

LO: 2
7. If company A accounts for its investment in company B using the equity method, then a
portion of company B’s earnings are reported on company A’s income statement.

Answer: True
Rationale: The proportion of Company B’s stock that is owned by company A dictates the
proportion that A recognizes of B’s earnings as equity earnings.

Topic: Equity method

LO: 2
8. Under the equity method, fair-value changes in the investee company’s stock are not reflected
in the investor’s accounting records.

Answer: True
Rationale: Unrealized gains on equity-method investments are not recognized until the
investment is sold.

Topic: Significant influence

LO: 2
9. Regardless of the legal agreements, technology licensing, and the like between two
companies, significant influence is determined by ownership of a sufficient percentage of
outstanding common stock. This is called the significance influence test.

Answer: False
Rationale: Usually, the investor company can exert significant influence over the activities of the
investee company when it owns 20% - 50% of the voting stock of the investee company. An
investor company might also exert significant influence if it is the sole customer or supplier of the
investee customer, or has contractual rights, even if the investor owns less than 20%.

Topic: Equity method

LO: 2
10. Under the equity method, the investment account is recorded at fair value but only if fair
value exceeds original cost.

Answer: False
Rationale: Fair-value accounting is not used for equity method investments.

© Cambridge Business Publishers, 2010

Test Bank, Module 7 7-3
Topic: Equity method
LO: 2
11. Dividends received from an investee company are reported as investment income by the
investor company when the investor does not control the investee.

Answer: False
Rationale: Under equity method accounting, the investor has no control. Yet, dividends are
treated as a return of investment, thereby reducing the investment account, not as income.

Topic: Equity method vs. consolidation

LO: 2 & 3
12. Shareholder equity of the investee company will be same using either equity method
accounting or the consolidation accounting method for an investment.

Answer: True
Rationale: Shareholder equity will be same using either equity method accounting or
consolidation accounting for an investment.

Topic: Control
LO: 3
13. The investor company cannot be considered to have control over the investee company if it
owns less than 50% of the outstanding voting stock of the investee company.

Answer: False
Rationale: Circumstances may point to control even if stock ownership is less than 50%.
Examples include contracts and licenses that confer control in the absence of majority stock
ownership.

Topic: Consolidation
LO: 3
14. Financial statements of investee and investor companies can only be consolidated if both
companies use the same accounting principles.

Answer: False
Rationale: Consolidation does not require consistent accounting policies among the consolidated
group.

Topic: Goodwill
LO: 3
15. Goodwill is recorded when the fair value of the assets acquired in a merger exceeds the net
book value of those same assets.

Answer: False
Rationale: Good will is recorded with the purchase price of the assets acquired exceeds the fair
value of the individual assets and liabilities acquired.

Cambridge Business Publishers, ©2010

7-4 Financial Accounting for MBAs, 4th Edition
Multiple Choice
Topic: Unrealized gains
LO: 1
1. For which of the following types of intercorporate investments are unrealized gains reflected in
the shareholders’ equity section of the investor’s balance sheet?
a. Equity method
b. Trading securities
c. Available-for-sale securities
d. b and c only
e. a, b and c

Answer: d
Rationale: Unrealized gains for trading securities are reflected in the income statement of the
investor company which flows to retained earnings on the balance sheet. Unrealized gains on
available-for-sale securities are recorded in shareholders’ equity in the Accumulated Other
Comprehensive Income account.

Topic: Understanding fair-value method of accounting

LO: 1
2. Which of the following statements does not accurately describe the fair-value method of
accounting?
a. Investments for which current, reliable fair values exist are accounted for using this method.
b. Held-to-maturity investments are not accounted for using this method.
c. Dividends and interest received are recognized in current income.
d. The investment is recorded on the balance sheet at its fair value.
e. None of the above

Answer: a
Rationale: Fair values exist for any marketable security but this does not mean that the fair-value
method is appropriate. If the investor controls an entity with traded equity securities, the
investment is consolidated and thus, the fair-value method is not used.

Topic: Available-for-sale
LO: 1
3. When the fair value of a company’s portfolio of available-for-sale equity securities exceeds its
book value, the difference should be:
a. Written off as an impairment
b. Added to stockholders’ equity of the investee
c. Recorded on the company’s income statement
d. Added to the investment account
e. None of the above.

Answer: d
Rationale: Available-for-sale securities are accounted for on a fair-value basis; therefore, an
increase in fair value would result in an increase in both of the investment account and the
stockholders’ equity (through accumulated other comprehensive income/loss). Note that answer b
is incorrect because the unrealized gain is added to the investor’s equity and not the investee’s
equity.

© Cambridge Business Publishers, 2010

Test Bank, Module 7 7-5
Topic: Effect of fair value changes – Numerical calculations required
LO: 1
4. On its 2008 balance sheet, Bank of America Corporation reports marketable debt securities of
$276,904 million. The footnotes disclose that these securities have an amortized cost of $286,245
million. Which of the following is true?
a. These are available-for-sale securities.
b. These are trading securities.
c. There are net unrealized losses of $11,341 on these securities.
d. Both a and c
e. Both b and c

Answer: c
Rationale: The fair value of the securities is less than cost, this is an unrealized loss. We do not
know if these are trading or available for sale from the information provided.

Topic: Sale of marketable securities

LO: 1
5. On its most recent balance sheet, CVS CareMark Inc. reports short-term investments in
marketable debt securities of $27.5 million at December 29, 2007 and $0 at December 31, 2008.
Which of the following is true?
a. During fiscal 2008, CVS CareMark sold all of its short-term investments.
b. If CVS CareMark classified these securities as available-for-sale the only income arising from
these securities in fiscal 2007 would be interest income earned.
c. If CVS CareMark classified these securities as trading the only income arising from these
securities in fiscal 2007 would be interest income earned.
d. CVS CareMark realized a loss or gain on these marketable securirties calculated as the sales
proceeds less $27.5 million.
e. None of the above

Answer: b
Rationale: Available for sale securities affect the income statement via interest earned and
realized gains or losses. If the securities are on the balance sheet at year end 2007, any
unrealized gains of losses arising from these securities had no effect on income. Answer a is
incorrect because CVS could still own the securities but their fair value had decreased to $0
million. This also explains why answer d is incorrect.

Topic: Fair-value method of accounting

LO: 1
6. Which of the following statements is not true of the fair-value method of accounting for
marketable securities?
a. The investment account is recorded at current fair value on the balance sheet.
b. Interim changes in the investments’ fair value may or may not affect income depending on the
securities’ classification.
c. This method is used when the reporting company generally owns less than 20% of the investee
company.
d. Dividends are treated as a return of the capital invested.
e. None of the above.

Answer: d
Rationale: Dividends are reported as income, rather than a return of the capital invested, which is
the case for equity method investments.

Cambridge Business Publishers, ©2010

7-6 Financial Accounting for MBAs, 4th Edition
Topic: Fair-value method of accounting – Numerical calculations required
LO: 1
7. Following is a portion of the investments footnote from Allstate’s 2008 10-K.

(in millions) 2008

Amortized cost of available-for-sale securities $77,104
Gross unrealized gains 2,545
Gross unrealized losses $11,041

What amount does Allstate report for available-for-sale securities on its 2008 balance sheet?
a. $8,496 million
b $68,608 million
c. $77,104 million
d. $85,600 million
e. None of the above

Answer: b.
Rationale: Available-for-sale investments are reported at fair value on the balance sheet. Thus,
Allstate’s bond investments are reported as $77,104 + $2,545 - $11,041 =$68,608 million as of
2008.

Topic: Held-to-maturity securities and fair value – Numerical calculations required

LO: 1
8. In footnotes to its 2008 annual report, Bancfirst Corp. reported that held-to-maturity securities
with an amortized cost of $34,468 thousand had an estimated fair value of $34,975 thousand.
The balance sheet reported:
a. Held-to-maturity assets of $34,468 thousand
b. Held-to-maturity assets of $34,975 thousand
c. Accumulated other comprehensive income of $507 thousand related to held-to-maturity assets
d. Both a and c
e. Both b and c

Answer: a.
Rationale: Held-to-maturity securities are recorded at amortized cost, which is $34,468. The
unrealized gains of $507 thousand are not reported on the balance sheet, but disclosed in the
footnotes only.

© Cambridge Business Publishers, 2010

Test Bank, Module 7 7-7
Topic: Fair-value method of accounting – Numerical calculations required
LO: 1
9. Starbuck’s Inc. reported that short-term investments consisted of the following (in millions):

Amortized cost Fair value

September 28, 2008
Short-term investments — available-for-sale securities $ 3.0 $ 3.0
Short-term investments — trading securities 58.2 49.5
Total short-term investments $61.2 $52.5

Which of the following is not true:

a. Starbuck’s 2008 balance sheet includes short-term investments of $52.5 million
b. Unrealized gains of $8.7 million on trading securities are included in 2008 income.
c. There are no net unrealized gains on available-for-sale securities.
d. Accumulated other comprehensive income included no unrealized gains or losses.
e. None of the above

Answer: b.
Rationale: Trading securities have unrealized losses, not gains.

Topic: Dividends
LO: 1 & 2
10. Principe holds a 10% equity investment in Del Fuego Inc. Clearwater Investments holds 40%
of Del Fuego’s stock. On April 1, 2010, Del Fuego declares and pays dividends to its
stockholders. How will the dividend affect each company’s balance sheet account: Del Fuego
investment?
Clearwater
Principe Investments
a. No effect Decrease
b. No effect No effect
c. Decrease No effect
d. Decrease Decrease
e. None of the above

Answer: a
Rationale: Principe should use the fair-value method to account for its investment in Del Fuego;
therefore, a dividend would not affect its investment account. Clearwater Investments should use
the equity method to account for its investment in Del Fuego. Therefore, a dividend will be
deducted from its investment account and added to cash.

Cambridge Business Publishers, ©2010

7-8 Financial Accounting for MBAs, 4th Edition
Topic: Dividends
LO: 1 & 2
11. Blue Dog Corp. holds a 10% equity investment in Del Fuego Inc. Masterfield Investments
holds 40% of Del Fuego’s stock. On April 1, 2010, Del Fuego declares and pays dividends to its
stockholders. How will the dividend affect each company’s net income for the year?

Blue Dog Masterfield

Corp. Investments
a. No effect Increase
b. No effect No effect
c. Increase No effect
d. Increase Increase
e. There is not enough information to determine the effect.

Answer: e
Rationale: Blue Dog Corp. should use the fair-value method to account for its investment in Del
Fuego; therefore, a dividend would increase net income but only if the investment was classified
as trading securities. Therefore, there is not sufficient information to determine the effect.

Topic: Levels of influence

LO: 1, 2 & 3
12. GAAP indentifies several levels of influence / control. If Company A owns 15% of the
outstanding voting stock of Company B, which level of influence / control is in evidence?
a. Passive
b. Significant Influence
c. Control
d. Fair-value method
e. None of the above

Answer: a
Rationale: An investment would be deemed passive if Company A owns 0% to 20% of the
investee company. Significant Influence would be used for investments of between 20% and
50%. Consolidation is required if more than 50% is owned.

Topic: Equity method investment- Numerical calculations required

LO: 2
13. Berlin Corporation purchases an investment in Best Pictures, Inc. at a purchase price of $3
million cash, representing 45% of the book value of Best Pictures. During the year, Best Pictures
reports net income of $350,000 and pays $90,000 of cash dividends. At the end of the year, the
market value of Berlin’s investment is $3.7 million. What is the year-end balance of the equity
investment in Best Pictures?

a. $3,000,000
b. $3,117,000
c. $3,157,500
d. $3,260,000
e $3,700,000

Answer: b
Rationale: The year-end balance of the investment account is computed as follows:
Beginning balance $3,000,000
+ Share of investee’s net income 157,500 ($350,000 × 45%)
- Dividends received from Best Pictures (40,500) ($90,000 × 45%)
Ending balance $3,117,000
© Cambridge Business Publishers, 2010
Test Bank, Module 7 7-9
Topic: Equity method investment
LO: 2
14. Berlin Corporation purchases an investment in Best Pictures, Inc. at a purchase price of $3
million cash, representing 45% (at book value) of Best Pictures. During the year, Best Pictures
reports net income of $350,000 and pays $90,000 of cash dividends. At the end of the year, the
market value of Berlin’s investment is $3.7 million. What amount of equity earnings would be
reported by Berlin Corporation?
a. $40,500
b. $117,000
c. $157,500
d. $817,000
e. None of the above

Answer: c
Rationale: The equity-method income that Berlin reports is $157,500. The equity earnings
represent Berlin’s share of the investee’s net earnings ($350,000 × 45%).

Topic: Equity method investment- Numerical calculations required

LO: 2
15. Austin Corporation purchases 40% of the common stock of Town & Country, Inc. at a
purchase price of $6 million cash. During the year, Town & Country reports net income of
$700,000 and pays $130,000 of cash dividends. At the end of the year, the market value of
Austin’s investment is $6.8 million. What is the year-end balance of the equity investment in Town
& Country?
a. $6,000,000
b. $6,280,000
c. $6,332,000
d. $6,228,000
e None of the above

Answer: d
Rationale: The year-end balance of the investment account is computed as follows:
Beginning balance $6,000,000
+ Share of investee’s net income 280,000 ($700,000 × 40%)
- Dividends received from Town & Country (52,000) ($130,000 × 40%)
Ending balance $6,228,000

Cambridge Business Publishers, ©2010

7-10 Financial Accounting for MBAs, 4th Edition
Topic: Equity method investment
LO: 2
16. Boston-Upp Corporation makes an equity-method investment in Wrap, Inc. at a purchase
price of $4.1 million cash, representing 35% (at book value) of Wrap. During the year, Wrap
reports net income of $1 million and Boston-Upp receives $900,000 of cash dividends from Wrap
Inc.. At the end of the year, the market value of Boston-Upp’s investment is $3.9 million. At year
end, what does Boston-Upp report on its balance sheet for its investment in Wrap Inc.?
a. $3,550,000
b. $3,900,000
c. $4,450,000
d. $4,135,000
e. None of the above

Answer: a
Rationale: The year-end balance of the investment account is computed as follows:
Beginning balance $4,100,000
+ Share of investee’s net income 350,000 ($1,000,000 × 35%)
- Dividends received from Wrap (900,000) Given
Ending balance $3,550,000

Topic: Significant influence

LO: 2
17. Significant influence is often presumed when the investor owns:
a. Greater than 20% of the voting stock of the investee
b. Greater than 50% of the voting stock of the investee
c. Between 20% and 50% of the voting stock of the investee
d. Greater than 20% of the voting stock or of the fair value of the investee
e. None of the above

Answer: c
Rationale: Ownership between 20% and 50% is often sufficient. However, significant influence
can also exist when ownership is less then 20% if the investor company gains a seat on the
board of directors due to its investment, or if the investor controls some sort of technical know-
how or patents that the investee uses.

Topic: ROE and equity method

LO: 2
18. When equity method accounting is used for investment, which component of ROE would
always be understated:
a. Net Profit Margin
b. Total Asset Turnover
c. Financial leverage
d. Return on Equity

Answer: c
Rationale: Financial leverage is understated due to nonrecognition of assets and liabilities and
the correct reporting of equity.

© Cambridge Business Publishers, 2010

Test Bank, Module 7 7-11
Topic: Equity method income- Numerical calculations required
LO: 2
19. Biblio Tech owns 40% of E-text Inc. and accounts for the investment using the equity
method. During the year E-text reports a net loss of $1,320,000 and pays total dividends of
$37,000. Which of the following describes the change in Biblio Tech’s investment in E-text during
the year.
a. The investment increases by $513,200
b. The investment decreases by $14,800
c. The investment decreases by $528,000
d. The investment decreases by $542,800.
e. None of the above

Answer: d
Rationale: Equity method investments increase with net income of the investee and decrease
with net loss and with dividends. 40% of ($1,320,000 + $37,000) = $542,800 decrease.

Topic: Intangible assets

LO: 3
20. Which of the following would not be considered an intangible asset?
a. Trademarks and internet domain names
b. Plant, Property, and Equipment
c. Patents, computer software, databases and trade secrets
d. Customer lists, production backlog, and customer contracts
e. None of the above

Answer: b
Rationale: Intangible assets is a term applied to a group of long-term assets, including patents,
copyrights, franchises, trademarks, and goodwill, that benefit an entity but do not have a physical
substance. Plant, property, and equipment are physical assets that depreciate over time.

Topic: In-process R&D

LO: 3
21. Which of the following refers to the value of projects that have not reached technological
feasibility at the acquisition date and have no alternative use?
a. Impairment
b. Initial public offering
c. Purchased in-process R&D
d. Redundant research assets
e. Both c and d

Answer: c
Rationale: An investor values IPR&D assets of an investee company before writing them off.
Although projects might be useful to the investor, benefits are not guaranteed at this point in their
development. Value is often computed at the present value of their estimated prospective cash
flows.

Cambridge Business Publishers, ©2010

7-12 Financial Accounting for MBAs, 4th Edition
Topic: Consolidation – calculating goodwill – Numerical calculations required
LO: 3
22. At the beginning of fiscal 2010, Williamsburg Trust Company acquired a small savings and
loan association for $40 million. The book value of the assets of the acquired company were $100
million, its liabilities $65 million. An appraiser determined that the acquiree’s land had a fair value
of $1 million in excess of its net book value. Williamsburg Trust also determined that the acquiree
had an unrecorded liability of $3 million relating to a lawsuit. The book value of all other assets
and liabilities approximated fair value. What did Williamsburg Trust record as goodwill for this
acquisition?
a. $0
b. $4 million
c. $5 million
d. $7 million
e. none of the above

Answer: d
Rationale: Goodwill = Cost to acquire - Fair value of net assets acquired
= $40 million – ($100 million + $1 million - $65 million - $3 million) = $7 million

Topic: Consolidation – calculating goodwill – Numerical calculations required

LO: 3
23. 1st Nebraska Bancorporation and Unity Trust Company merge on January 1, 2010. Before
the merger transaction, the balance sheets of the two companies are as follows:

(in millions) 1st Nebraska Unity Trust

Assets $1,700 $600
Liabilities 800 300
Common stock ($1 par value) 100 50
Additional paid-in capital 100 50
Retained earnings 700 200
Total liabilities and equities $1,700 $600

1st Nebraska issues 50,000 shares of its common stock with a market value of $470 million to the
owners of Unity Trust in return for all of their shares of Unity Trust common stock. The assets of
Unity Trust have a market value in excess of book value of $17 million. The consolidated balance
sheet of 1st Nebraska at January 1, 2010 would report goodwill of:
a. $0 (no goodwill)
b. $153 million
c. $170 million
d. $187 million
e. none of the above

Answer: b
Rationale: Goodwill = Cost to acquire - Fair value of net assets acquired
= $470 million – ($300 million + $17 million) = $153 million

© Cambridge Business Publishers, 2010

Test Bank, Module 7 7-13
Topic: Determining goodwill impairment – Numerical calculations required
LO: 3
24. On June 1, 2010, Precious Metals Corp. purchases 100% of Alberta Gold Company for $1.5
million. At the time of acquisition, the fair market value of Alberta Gold’s tangible net assets
(excluding goodwill) is $1.2 million. Precious Metals ascribes the excess of $300,000 to goodwill.
During the first half of the year, the fair value of Alberta Gold declines to $1.2 million and the fair
value of Alberta Gold’s tangible net assets is estimated at $1.1 million as of December 31, 2010.
This decline is deemed permanent. What impairment charge, if any, should Precious Metals
report at December 31, 2010.
a. $0
b. $100 million
c. $200 million
d. $300 million
e. none of the above

Answer: c
Rationale: The goodwill originally recorded is $300,000 ($1.5 million - $1.2 million). To determine
impairment, we calculate the imputed value of the goodwill as $1.2 million - $1.1 million =
$100,000. This is less than the carrying amount; therefore, the goodwill is impaired. Goodwill
must be written down by $300,000 - $100,000 = $200.000.

Topic: Consolidation versus equity method investment

LO: 3
25. In 2008, Oracle Corp purchased 100% of the common stock of BEA Systems for a total
purchase price of $8,573 million. On Oracle’s unconsolidated accounts, it uses the equity method
to account for BEA. For public disclosure, Oracle consolidates the accounts of BEA Systems.
Which of the following is true:
a. The consolidated shareholders’ equity exceeds the unconsolidated shareholders’ equity by
$8.573 million.
b. The consolidated total assets are greater than the unconsolidated total assets by $8.573
million.
c. Net income is the same on the consolidated and unconsolidated financial statements.
d. The consolidated net income is greater than the unconsolidated net income.
e. None of the above

Answer: c
Rationale: Equity is the same under both methods, thus a is false. While total assets on a
consolidated basis are greater, they are not greater by the amount given – this is the value of the
net assets at acquisition, thus b is false.

Cambridge Business Publishers, ©2010

7-14 Financial Accounting for MBAs, 4th Edition
Exercises
Topic: Accounting for available-for-sale securities
LO: 1
1. Pfizer Inc reports the following in its 2008 Form 10K:

2008 2007
Cost of available-for-sale equity securities $341 $202
Gross unrealized gains 17 127
Gross unrealized losses (39) (13)
Fair value of available-for-sale equity securities $319 $316

a. What amount appeared on Pfizer’s balance sheet in 2008 for available-for-sale securities?
b. Calculate the net unrealized gains and or losses available-for-sale securities for both years.

Answer:
a. The fair value of available-for-sale securities is reported on the balance sheet. For 2008, this is
$319 million.
b. Net unrealized gains at 2007 were $114 million ($127 million gains - $13 million losses). Net
unrealized losses at 2008 were $22 million ($39 million losses - $17 million gains).

Topic: Accounting for available-for-sale securities

LO: 1
2. Pfizer Inc reported net income of $8,144 million for fiscal 2008. The annual report included the
following details about its available-for-sale securities:

2008 2007
Cost of available-for-sale equity securities $341 $202
Gross unrealized gains 17 127
Gross unrealized losses (39) (13)

a. What amount appeared on Pfizer’s balance sheet in 2008 for available-for-sale securities?
b. If Pfizer had instead classified these securities as trading, what would net income have been?
Assume a marginal tax rate of 35% for your calculations.

Answer:
a. The fair value of available-for-sale securities is reported on the balance sheet. This is $319
million, calculated as: $341 million + $17 million - $39 million.
b. If the securities had been classified as trading, the company would have included in income the
change in unrealized gains or losses during the year. Unrealized gains at 2007 were $114 million.
Unrealized losses at 2008 were $22 million. The change during the year was $136 million loss
before tax and $88.4 million loss after tax, calculated as $136 million × (1 – 65%). Thus net
income would have been $8,056 million ($8,144 million - $88 million).

© Cambridge Business Publishers, 2010

Test Bank, Module 7 7-15
Topic: Accounting for trading securities
LO: 1
3. The 2008 annual report of Starbuck’s Inc reports the following (in millions):

Amortized
cost Fair value
September 28, 2008
Short-term investments — available-for-sale securities $ 3.0 $ 3.0
Short-term investments — trading securities 58.2 49.5
Total short-term investments $61.2 $52.5

September 30, 2007
Short-term investments — available-for-sale securities $ 83.9 $ 88.3
Short-term investments — trading securities 67.8 73.6
Total short-term investments $151.7 $157.4

a. What amount does Starbuck’s report as trading securities on its balance sheets for 2008?
b. How do the net unrealized gains (losses) on the company’s trading securities affect pre-tax
income for 2008?

Answer:
a. Trading securities are reported at fair value on the balance sheet. Thus, Starbuck’s trading
securities are reported at $49.5 million as of 2008.
b. Net unrealized losses on trading securities for 2008 are $8.7 million ($49.5 million fair value -
$58.2 million amortized cost). This amount is included on the 2008 income statement. Thus pre-
tax income is lower by $8.7 million.

Topic: Accounting for held-to-maturity securities

LO: 1
4. In footnotes to its 2008 annual report, Bancfirst Corp. reported that held-to-maturity securities
with an amortized cost of $34,468 thousand had an estimated fair value of $34,975 thousand.
a. What amount does Bancfirst report on its 2008 balance sheet for these held-to-maturity
securities?
b. If these securities had instead been classified as available-for-sale securities, how would
Bancfirst’s pre-tax income have been affected?

Answer:
a. Held-to-maturity securities are recorded on the balance sheet at amortized cost, which is
$34,468. The unrealized gains of $507 thousand are not reported on the balance sheet, but
disclosed in the footnotes only.
b. The unrealized gains of $507 thousand are not reported in income for either held-to-maturity or
available-for-sale securities. Thus there would be no impact on income of a change in
classification.

Cambridge Business Publishers, ©2010

7-16 Financial Accounting for MBAs, 4th Edition
 Topic: Trading securities - Financial Statements Effects Template
LO: 1
5. Record the following transactions of Sentient Inc, in the financial statements effects template
below.
1) Purchased 4,000 shares of Proxperity common stock for $15 per share. These securities are
publicly traded and Sentient classifies them as trading securities.
2) Received a cash dividend of $0.50 per share from Proxperity.
3) Year-end market price of Proxperity common stock is $12 per share.
4) Sold 1,000 shares for $10 per share, the closing price for the day.

Balance Sheet Income Statement

Cash Noncash Liabil- Contrib. Earned Rev- Expen- Net

Transaction
Asset
+
Assets = ities
+
Capital
+
Capital enues – ses = Income
1) = – =
2) = – =
3) = – =
4) = – =

Answer:
Balance Sheet Income Statement

Cash Noncash Liabil- Contrib. Earned Rev- Expen- Net

Transaction
Asset
+
Assets
= ities
+
Capital
+
Capital enues
– ses
= Income
+60,000
1) -60,000
(MS) = – =
+2,000
+2,000
2) +2,000 = (Retained
(DI) – = +2,000
earnings)
-12,000
-12,000 -12,000
3) (MS) = (Retained
(UG) – = -12,000
earnings)
-2,000
-12,000 -2,000
4) +10,000
(MS) = (Retained
(LS) – = -2,000
earnings)

© Cambridge Business Publishers, 2010

Test Bank, Module 7 7-17
 Topic: Available-for-sale securities - Financial Statements Effects Template
LO: 1
6. Wichita Corp. invests in the publicly traded stock of Precision Instruments, Inc. Record the
following transactions in the financial statements effects template below.
1) Purchased 1,000 shares of Precision Instruments’ common stock for $43 per share. Wichita
classifies these securities as available-for-sale.
2) Received a cash dividend of $1.10 per share from Precision
3) Year-end market price of Precision common stock is $48 per share
4) Sold all 1,000 shares for $55 per share, the closing price for the day

Balance Sheet Income Statement

Cash Noncash Liabil- Contrib. Earned Rev- Expen- Net

Transaction
Asset
+
Assets = ities
+
Capital
+
Capital enues – ses = Income
1) = – =
2) = – =
3) = – =
4) = – =

Answer:
Balance Sheet Income Statement

Cash Noncash Liabil- Contrib. Earned Rev- Expen- Net

Transaction
Asset
+
Assets
= ities
+
Capital
+
Capital enues
– ses
= Income
+43,000
1) -43,000
(MS) = – =
+1,100
+1,100
2) +1,100 = (Retained
(DI) – = +1,100
earnings)
+5,000 +5,000
3) (MS) = (OCI) – =
-5,000
(AOCI)
-48,000 +12,000
4) +55,000
(MS) = +12,000
(GN) – = +12,000
(Retained
earnings)

Cambridge Business Publishers, ©2010

7-18 Financial Accounting for MBAs, 4th Edition
Topic: Income for investments in marketable securities
LO: 1, 2
7. On January 1, 2009, Mexicali Company purchases an investment in Posada, Inc., a company
whose stock trades over the counter, for $700,000, representing 20% of the book value of
Posada. During the year, Posada reports a net income of $300,000 and pays cash dividends of
$100,000. The fair value of Posada’s stock on December 31, 2009 is $5,000,000. Mexicali has a
calendar year end.
a. What amount does Mexicali report on its 2009 balance sheet for its investment in Posada, if
20% ownership does not imply any significant influence over Posada?
b. What amount does Mexicali report on its 2009 balance sheet for its investment in Posada, if
20% ownership implies significant influence over Posada?

Answer:
a. If 20% does not imply significant influence, Mexicali should use the fair-value method of
accounting for its investment in Posada. Thus, the investment would be reported at fair value of
$5,000,000 × 20% = $1,000,000.
b. If 20% does imply significant influence, Mexicali should use the equity method to account for its
investment in Posada. Thus, the investment would be reported as, $700,000 + ($300,000 × 20%)
– (100,000 × 20%) = $750,000.

Topic: Marketable securities compared to equity method investments

LO: 1 & 2
8. On January 1, 2010, Mirage Entertainment acquired common stock of Risk Patrol Inc. At the
time of acquisition, the book value and the market value of Risk Patrol’s net assets were $210
million. During the current year, Risk Patrol earned $50 million and declared dividends of $10
million. The market value of Risk Patrol on December 31, 2010 was $240 million. For each
scenario below, determine the amount that Mirage would report on its balance sheet for its
investment in Risk Patrol at December 31, 2010; and the amount of income Mirage would report
for 2010 related to its investment.
a. Scenario 1: Mirage Entertainment paid $21 million for a 10% interest in Risk Patrol and
classifies the Risk Patrol stock as trading securities.
b. Scenario 2: Mirage Entertainment paid $70 million for a 30-percent interest in Risk Patrol and
uses the equity method to account for the investment.

Answer: in millions
Investment account (Asset) Pre-tax income
a. $24 $4 =
Fair value $240 × 10% dividends: $10 × 10% = $1
+ fair-value increase ($240 - $210) × 10% = $3

b. $82 $15
= $70 + ($50 - $10) × 30% =$50 × 30%

© Cambridge Business Publishers, 2010

Test Bank, Module 7 7-19
Topic: Assessing income statement effects of different classifications for marketable securities
LO: 1 & 2
9. Nichol Industries acquired common stock of Crest View Inc. as an investment. Consider the
following transactions.

2009:
Purchase 5,000 (15%) of the common shares of Crest View, Inc. for $10 cash per share plus a
$800 brokerage commission
Crest View Inc. reports net income of $54,600.
Nichol receives a cash dividend of $1.20 per share from Crest View, Inc.
Year-end market price of Crest View is $10.75 per share
2010:
Sell all 5,000 shares for $9.50 per share.

Complete the table below to show what Nichol Industries would report on its balance sheet in
2009 and on its income statement in 2009and 2010 if the investment is classified as Trading,
available-for-sale or as an equity method investment.

2009 Balance 2009 Income 2010 Income

Sheet Statement Statement
Trading securities

Available-for-sale
securities

Equity method
investment

Answer:
2009 Balance 2009 Income 2010 Income
Sheet Statement Statement
Trading securities (5,000 × $1.20) +
5,000 × $10.75 (5,000 × $9.50) -
($53,750- $50,800)
= $53,750 $53,750 = ($6,250)
= $8,950
Available-for-sale 5,000 × $10.75 (5,000 × $1.20) (5,000 × $9.50) –
securities
= $53,750 = $6,000 $50,800 = ($3,300)
Equity method $50,800 + ($54,600
investment ($54,600 × 15%) (5,000 × $9.50) -
× 15%) – (5,000 ×
= $8,190 $52,990 = ($5,490)
$1.20) = $52,990

Cambridge Business Publishers, ©2010

7-20 Financial Accounting for MBAs, 4th Edition
Topic: Analyzing and interpreting equity method
LO: 2
10. Berlin Corporation purchases an investment in Best Pictures, Inc. at a purchase price of $3
million cash, representing 45% of the book value of Best Pictures. During the year, Best Pictures
reports net income of $350,000 and pays $90,000 of cash dividends. At the end of the year, the
market value of Berlin’s investment is $3.7 million.
a. What is the year-end balance of the equity investment in Best Pictures?
b. What amount of equity earnings would be reported by Berlin Corporation?
c. What is the amount of the unrealized gain or loss at the end of the year? How does Berlin
account for this unrealized gain or loss?

Answer:
a. The year-end balance of the investment account is computed as follows:
Beginning balance $3,000,000
+ Share of investee’s net income 157,500 ($350,000 × 45%)
- Dividends received from Best Pictures (40,500) ($90,000 × 45%)
Ending balance $3,117,000

b. The equity-method income that Berlin reports is $157,500. The equity earnings represent
Berlin’s share of the investee’s net earnings ($350,000 × 45%).
c. The unrealized gain at year end is $583,000 ($3,700,000 - $3,117,000). Berlin does not record
this in the accounting records because the company uses the equity method for the investment.

Topic: Analyzing and interpreting equity method

LO: 2
11. In 2002, GTSI Corporation, a NYSE firm, made a $0.4 million investment in Eyak and
assumed a 37% ownership of Eyak. The investment in Eyak is accounted for under the equity
method. Eyak reported the following financial information for the year ended December 31 (in
thousands):

Year ended December 31, 2008

Revenues $273,475
Gross margin 31,292
Net income $ 13,044

December 31, 2008

Current assets $104,069
Noncurrent assets 1,003
Current liabilities 93,092
Noncurrent liabilities 77
Equity $ 11,901

a. Calculate the equity earnings that GTSI reported on its 2008 income statement.
b. Determine the investment balance for Eyak on GTSI’s balance sheet at December 31, 2008.

Answer:
a. Eyak’s total 2008 net income is $13,044 thousand. GTSI’s 37% share of the net income is
$4,826 thousand.
b. Eyak’s equity (assets less liabilities) at December 31, 2008 is $11,901 thousand. GTSI’s 37%
share is $4,403. This is the amount on GTSI’s balance sheet.

© Cambridge Business Publishers, 2010

Test Bank, Module 7 7-21
 Topic: Equity method investment- Financial Statements Effects Template
LO: 2
12. Portland Coffee Co invests in the stock of Classic Cup, Inc. Record the following transactions
in the financial statements effects template below.
1) Purchased 6,000 shares of Classic Cup Inc. common stock for $10 per; these shares
represent 25% ownership of Classic Cup, which conveys to Portland Coffee significant influence
over the operations of Classic Cup.
2) Received a cash dividend of $2.20 per share from Classic Cup, Inc.
3) Classic Cup reports net income of $100,000.
4) Sold all 6,000 shares of Classic Cup for $87,000.

Balance Sheet Income Statement

Cash Noncash Liabil- Contrib. Earned Rev- Expen- Net

Transaction
Asset
+
Assets = ities
+
Capital
+
Capital enues – ses = Income
1) = – =
2) = – =
3) = – =
4) = – =

Answer:
Balance Sheet Income Statement

Cash Noncash Liabil- Contrib. Earned Rev- Expen- Net

Transaction
Asset
+
Assets
= ities
+
Capital
+
Capital enues
– ses
= Income
+60,000
1) -60,000
EMI = – =
-13,200
2) +13,200
EMI = – =
+25,000
+25,000 +25,000
3) EMI = (Retained
EI – = +25,000
earnings)
+15,200
-71,800 +15,200
4) +87,000
EMI = (Retained
GN – = +15,200
earnings)

Cambridge Business Publishers, ©2010

7-22 Financial Accounting for MBAs, 4th Edition
Topic: Consolidation – no goodwill or asset revaluation
LO: 3
13. Consider companies with the pre-acquisition balance sheets presented below. Investor
Company purchases 100% of Investee Company’s stock at book value by issuing new common
stock. Complete the columns for Investor’s post-acquisition balance sheet and the Consolidated
Company post-acquisition balance sheet.

Pre-acquisition balance sheets Post-acquisition balance sheets

Investor
Investor Investee Company Consolidated
Company Company (Equity Method) Company
Current Assets $10,000 $15,000
Investment
Other Assets 80,000 19,000
Total Assets $90,000 $34,000

Liabilities $40,000 $10,000

Common
Stock 30,000 15,000
Retained
Earnings 20,000 9,000
Total Liabilities
and Equity $90,000 $34,000

Answer:
Post-acquisition balance sheets
Investor Company Consolidated
(Equity Method) Company
Current Assets $10,000 $25,000
Investment 24,000 0
Other Assets 80,000 99,000
Total Assets $114,000 $124,000

Liabilities $40,000 $50,000

Common Stock 54,000 54,000
Retained Earnings 20,000 20,000
Total Liabilities and Equity $114,000 $124,000

© Cambridge Business Publishers, 2010

Test Bank, Module 7 7-23
Topic: Effect of acquisition on balance sheet – with asset revaluation and goodwill
LO: 3
14. Lampoon Company and Bles Company merge on January 1, 2010. Before the merger
transaction, the balance sheets of the two companies are as follows:

Lampoon
(in thousands) Company Bles Company
Assets $3,100 $1,500
Liabilities 800 700
Common stock ($1 par value) 200 100
Additional paid-in capital 400 300
Retained earnings 1,700 400
Total liabilities and equities $3,100 $1,500

Lampoon issues 50,000 shares of its common stock with a market value of $1,400 thousand to
the owners of Bles in return for their 100,000 shares of Bles Company common stock. The assets
of Bles Company have a market value in excess of book value of $400 thousand. Prepare a
consolidated balance sheet for the Lampoon-Bles Company on January 1, 2010.

Answer:
Lampoon - Bles Company
Consolidated Balance Sheet
January 1, 2010
(in thousands)
Assets at historical cost $4,600
Asset revaluation 400
Goodwill 200
Total assets $5,100

Liabilities $1,500
Common stock 250
Additional paid-in capital 1,750
Retained earnings 1,700
Total liabilities and equity $5,200

Note: Common stock = $200,000 + (50,000 × $1) = $250,000

Additional Paid-in Capital = $400,000 + (50,000 × $27) = $1,750,000

Topic: In-process R&D

LO: 3
15. In 2008, Oracle Corporation purchased 100% of BEA Systems, assigning $17 million of the
purchase price to in-process research and development (IPR&D). What is IPR&D? How does this
allocation of the purchase price affect consolidated profit in the year of acquisition?

Answer: IPR&D is technology that is not sufficiently advanced to warrant treatment as an asset.
Oracle values the technology but the future economic benefits are too uncertain or too difficult to
reliably measure, that the company cannot record an asset. Under GAAP, IPR&D is expensed
upon acquisition. Oracle will write off the entire $17 million of IPR&D, reducing consolidated pre-
tax profit by that amount.

Cambridge Business Publishers, ©2010

7-24 Financial Accounting for MBAs, 4th Edition
Topic: Goodwill Impairment
LO: 3
16. On January 1, 2010, Quinn Corp. purchases 100% of Mercury Biometrics Inc. for $5.7
million. At the time of acquisition, the fair market value of Mercury Biometrics’ tangible net assets
(excluding goodwill) is $5.1 million. Quinn ascribes the excess of $600,000 to goodwill. During the
year the fair value of Mercury Biometrics declines to $5.4 million and the fair value of Mercury
Biometrics’ tangible net assets is estimated at $4.9 million as of December 31, 2010.
a. Determine if the goodwill has become impaired and, if so, the amount of the impairment.
b. What impact does the impairment of goodwill have on Quinn Corp’s financial statements?

Answer:
a. The investment is initially recorded on Quinn’s balance sheet at the purchase price of $5.7
million, including $600,000 of goodwill. At the end of the year, because the fair value of Mercury
Biometrics is less than the carrying amount of the investment on Quinn’s balance sheet, the
goodwill might be impaired. To determine impairment, the imputed value of the goodwill is
determined to be $5.4 million - $4.9 million = $500,000. This is less than the carrying amount;
therefore, the goodwill is impaired.
b. Goodwill must be written down by $100,000. The write-down will reduce the carrying amount of
goodwill by $100,000 and yield a loss in Quinn’s income statement, thus reducing retained
earnings by that amount.

Topic: Consolidation with goodwill

LO: 3
17. Parent Company bought 100% of Sub Company for $7,000. Use the following table to
consolidate the balance sheets of the two companies as of the acquisition date.

Consolidating Consolidated
Parent Sub
adjustments Balance Sheet
Investment in Sub $7,000
Other assets 13,580,000 $2,137
Goodwill
Total assets $13,587,000 $2,137
Liabilities $5,382,000 $1,137
Common stock 4,926,000 955
Retained earnings 3,279,000 45
Total liabilities &
stockholders’ equity $13,587,000 $2,137

Answer:
Consolidating Consolidated
Parent Sub
adjustments Balance Sheet
Investment in Sub $7,000 (7,000) $ 0
Other assets 13,580,000 $2,137 13,582,137
Goodwill 6,000 6,000
Total assets $13,587,000 $2,137 $13,588,137
Liabilities $5,382,000 $1,137 $5,383,137
Common stock 4,926,000 955 (955) 4,926,000
Retained earnings 3,279,000 45 (45) 3,279,000
Total liabilities &
stockholders’ equity $13,587,000 $2,137 $13,588,137

© Cambridge Business Publishers, 2010

Test Bank, Module 7 7-25
Topic: Consolidation with revalued assets and goodwill
LO: 3
18. Maricopa Company purchased all of MixMax Company's common stock for $950,000 cash
on January 1. When analyzing the purchase price, Maricopa determined that the other assets of
MixMax were undervalued by $82,000, with any excess purchase price considered to be goodwill.
Use the following table to consolidate the balance sheets of the two companies as of the
acquisition date.

Consolidating Consolidated
Maricopa MixMax adjustments Balance Sheet
Investment in MixMax $ 950,000
Other assets 1,880,000 1,485,000
Goodwill
Total assets $2,830,000 $1,485,000
 
Liabilities $1,659,000 $850,000
Common stock 921,000 130,000
Retained earnings 250,000 505,000
Total liabilities &
stockholders’ equity $2,830,000 $1,285,000

Answer:
Consolidating Consolidated
Maricopa MixMax adjustments Balance Sheet
Investment in MixMax $ 950,000 (950,000) $ 0
Other assets 1,880,000 1,485,000 82,000 3,447,000
Goodwill 233,000 233,000
Total assets $2,830,000 $1,485,000 $3,680,000
 
Liabilities $1,659,000 $850,000 $2,509,000
Common stock 921,000 130,000 (130,000) 921,000
Retained earnings 250,000 505,000 (505,000) 250,000
Total liabilities &
stockholders’ equity $2,830,000 $1,485,000 $3,680,000

Cambridge Business Publishers, ©2010

7-26 Financial Accounting for MBAs, 4th Edition
Topic: Consolidation with revalued assets, unrecorded liability, and goodwill
LO: 3
19. Brittan Corp. purchased all of Kay Company's common stock for $1,140,000 cash on January
1. When analyzing the purchase price, Brittan Corp. determined that the other assets of Kay were
undervalued by $191,000 and that the company had an unrecorded liability of $50,000 related to
ongoing litigation. Any excess purchase price was for goodwill. Use the following table to
consolidate the balance sheets of the two companies as of the acquisition date.

Consolidating Consolidated
Brittan Kay adjustments Balance Sheet
Investment in Kay $1,140,000
Other assets 2,370,000 $933,000
Goodwill
Total assets $3,510,000 $933,000
 
Liabilities $1,467,000 $443,000
Common stock 710,000 190,000
Retained earnings 1,333,000 300,000
Total liabilities &
$3,510,000 $933,000
stockholders’ equity

Answer:
Consolidating Consolidated
Brittan Kay adjustments Balance Sheet
Investment in Kay $1,140,000 $(1,140,000) $ 0
Other assets 2,270,000 $933,000 191,000 3,394,000
Goodwill 509,000 509,000
Total assets $3,410,000 $933,000 $3,903,000
 
Liabilities $1,367,000 $443,000 50,000 $1,860,000
Common stock 710,000 190,000 (190,000) 710,000
Retained earnings 1,333,000 300,000 $(300,000) 1,333,000
Total liabilities &
$3,410,000 $933,000 $3,903,000
stockholders’ equity

© Cambridge Business Publishers, 2010

Test Bank, Module 7 7-27
 Problems
Topic: Interpreting Disclosures of Available-For-Sale Securities
LO: 1
1. The 2008 annual report of Bank of American includes the following footnote related to its
available-for-sale securities:

Gross Gross
Amortized Unrealized Unrealized Fair
(in millions) Cost Gains Losses Value
U.S. Treasury securities and agency
debentures $ 4,540 $ 121 $ (14) $ 4,647
Mortgage-backed securities 235,137 3,924 (9,483) 229,578
Foreign securities 5,675 6 (678) 5,003
Corporate/Agency bonds 5,560 31 (1,022) 4,569
Other taxable securities 24,832 11 (1,300) 23,543
Total taxable securities 275,744 4,093 (12,497) 267,340
Tax-exempt securities 10,501 44 (981) 9,564
Total available-for-sale debt securities $286,245 $ 4,137 $(13,478) $276,904

Available-for-sale marketable equity securities $ 18,892 $ 7,717 $ (1,537) $ 25,072

a. What amount will Bank of America report for available-for-sale equity securities on the balance
sheet? Explain.
b. How do gross unrealized gains and losses arise on these available-for-sale equity securities?
c. Calculate the net unrealized gains or losses for 2008.
d. How do these unrealized gains and losses affect Bank of America’s 2008 income statement?
e. How do these unrealized gains and losses affect Bank of America’s 2008 balance sheet?

Answer:
a. The available-for-sale securities will be reported at the fair value of $301,976 in the balance
sheet. This is calculated as the sum of the total available-for-sale debt securities ($276,904) and
the available-for-sale marketable equity securities ($25,072).
b. Unrealized gains and losses arise from changes in the interest rate environment because Bank
of America holds fixed-income securities (that is, debt instruments such as US Treasury
securities and mortgage backed securities) and equity securities (that is, stock in other
companies). Unrealized gains (losses) reflect the difference between the fair value of the security
and its amortized cost.
c. 2008 (in millions): $(13,478) + $(1,537) + $4,137 + $7,717 = $(3,161). This is a net unrealized
loss at the end of 2008.
d. Because the investments are classified as available-for-sale, the net unrealized losses do not
affect reported income. Had these investments been accounted for as trading securities, the
change during the year in the unrealized gains or losses would have flowed to income.
e. Bank of America’s net unrealized losses affect the balance sheet in two ways. First, the asset
side of the balance sheet reports the securities at fair value. Second, the unrealized losses (net of
deferred taxes) will be reported in the equity section, in an account called Accumulated Other
Comprehensive Income.

Cambridge Business Publishers, ©2010

7-28 Financial Accounting for MBAs, 4th Edition
Topic: Marketable Securities
LO: 1
2. Following is a portion of the investments footnote from Allstate’s 2008 10-K. Investment
earnings are a crucial component of the financial performance of insurance companies such as
Allstate, and investments comprise a large part of Allstate’s assets. Allstate accounts for its fixed-
income (i.e. debt) securities as available-for-sale securities.

(in millions) 2008 2007

Amortized cost $77,104 $93,495
Gross unrealized gains 2,545 3,151
Gross unrealized losses 11,041 2,195
Estimated fair value $68,608 $94,451

Required:
a. What amount does Allstate report for fixed-income securities on its balance sheets for 2008
and 2007?
b. What are the net unrealized gains (losses) for 2008 and 2007? How did these unrealized gains
(losses) affect the company’s reported income in 2008 and 2007?
c. If the company had accounted for these securities as trading securities, how would income
before income tax have been affected in 2008? Your response should quantify the effect in
dollars.
d. What is the difference between realized and unrealized gains and losses? Are realized gains
and losses treated differently in the income statement than unrealized gains and losses?
e. At December 31, 2008, Allstate reports a balance for unrealized gains (losses) on available-for-
sale securities of $4,626 million in Accumulated Other Comprehensive Income (in the equity
section of the balance sheet). Explain the difference between this amount and the amount
computed in part b.

Answer:
a. Available-for-sale investments are reported at market value on the balance sheet. Thus,
Allstate’s bond investments are reported at:
$68,608 million as of 2008
$94,451 million as of 2007
b. Net unrealized losses for 2008 are $8,496 million ($11,041 million losses - $2,545 million
gains). Net unrealized gains for 2007 are $956 million ($3,151 million gains - $2,195 million
losses). Because the investments are accounted for as available-for-sale, the net unrealized
gains and losses did not affect reported income in either year.
c. Had these investments been accounted for as trading securities, the change in net unrealized
gains and losses would have flowed to the income statement. Income before income taxes would
have been reduced by $9,452 million ($956 million – $(8,496) million)
d. Realized gains (losses) occur when the company sells the securities. These are reported in the
income statement and affect reported income. Unrealized gains (losses) reflect the difference
between the fair value of the security and its carrying cost (net book value). All realized gains and
losses are reported in income. Unrealized gains (losses) are only reported in income for trading
securities.
e. Net unrealized gains (losses) for 2008 are $8,496 million. The amounts reported in the
investment footnote are pretax, and the amount reported in the Accumulated Other
Comprehensive Income (AOCI) section of stockholders’ equity on Allstate’s balance sheet is on
an after-tax basis. This means that Allstate reports approximately $3,870 million of deferred taxes
relating to these 2008 net unrealized losses.

© Cambridge Business Publishers, 2010

Test Bank, Module 7 7-29
Topic: Marketable Securities
LO: 1
3. The following is from the footnotes to Abercrombie & Fitch’s recent financial statements.

Cash and equivalents and investments were reported on the balance sheet as follows:
January 31, February 2,
(in thousands) 2009 2008
Cash and equivalents:
Cash $ 137,383 $ 74,753
Money market funds 384,739 43,291
Total cash and equivalents 522,122 118,044

Marketable Securities:
Available-for-sale securities:
Auction rate securities — student loan backed 139,239 258,355
Auction rate securities — municipal authority bonds 27,294 272,131
Total available-for-sale securities 166,533 530,486

Trading securities:
Auction rate securities — student loan backed 50,589 0
Auction rate securities — municipal authority bonds 11,959 0
Total trading securities 62,548 -
Total marketable securities $ 229,081 $ 530,486

Marketable securities with a par value of $194.7 million and $530.5 million as of January 31, 2009
and February 2, 2008, respectively, were classified as available-for-sale securities in accordance
with SFAS No. 115.

Required:
a. Explain the difference between “Cash and equivalents,” “Available-for-sale securities,” and
“Trading securities.”
b. What amount does Abercrombie & Fitch report for available-for-sale securities on its balance
sheets at January 31, 2009 and February 2, 2008? How are these values measured?
c. What are the net unrealized gains (losses) on available-for-sale securities for 2009 and 2008?
d. How did these unrealized gains (losses) on available-for-sale securities affect the company’s
reported income in 2009?
e. What is the difference between realized and unrealized gains and losses? Are realized gains
and losses treated differently in the income statement than unrealized gains and losses?

Cambridge Business Publishers, ©2010

7-30 Financial Accounting for MBAs, 4th Edition
Answer:
a. Cash and equivalents includes the physical currency the company has at its stores, the cash in
bank accounts available for cash disbursements, and highly liquid investments that mature in 90-
days or fewer that act as a liquidity back up. Available-for-sale and trading securities are
marketable securities for which there is a ready market. The difference between the two is as
follows: the company may or may not sell the AFS securities in the coming year, this will depend
on prices and need for cash; the company anticipates selling the trading securities during the
year.
b. Available-for-sale (AFS) investments are reported at fair value on the balance sheet. Thus,
Abercrombie & Fitch’s AFS securities are reported at $166,533 thousand and $530,486 thousand
in 2009 and 2008 respectively.
c. The footnote reports that the “par value” of the AFS securities was $194.7 million and
$530.5 million in 2009 and 2008. Thus, net unrealized gains and losses are as follows:
January 31, February 2,
(in thousands) 2009 2008
Par value — original cost $194,700 $530,500
Fair value on balance sheet 166,533 530,486
Unrealized gains (losses) $(28,167) $ 4

d. For available-for-sale securities, unrealized gains and losses flow through accumulated other
comprehensive income in the equity section of the balance sheet (i.e. no income statement
effects).
e. Realized gains (losses) occur when the company sells the securities. These are reported in the
income statement and affect reported income. Unrealized gains (losses) reflect the difference
between the fair value of the security and its carrying cost (net book value). All realized gains and
losses are reported in income. Unrealized gains (losses) are only reported in income for trading
securities.

© Cambridge Business Publishers, 2010

Test Bank, Module 7 7-31
Topic: Marketable Securities
LO: 1
4. Following is a portion of the investments footnote from Starbuck’s 2008 10-K report.

The Company’s short-term investments consisted of the following (in millions):

Amortized
cost Fair value
September 28, 2008
Short-term investments — available-for-sale securities $ 3.0 $ 3.0
Short-term investments — trading securities 58.2 49.5
Total short-term investments $61.2 $52.5

September 30, 2007
Short-term investments — available-for-sale securities $ 83.9 $ 88.3
Short-term investments — trading securities 67.8 73.6
Total short-term investments $151.7 $157.4

Required:
a. What amount does Starbuck’s report as trading securities on its balance sheets for 2008 and
2007?
b. What are the net unrealized gains (losses) on the company’s trading securities for 2008 and
2007?
c. What amount does Starbuck’s report as available-for-sale securities on its balance sheets for
2008 and 2007?
d. How did the unrealized gain on available-for-sale securities in 2007, affect the company’s
balance sheet that year?
e. If Starbuck’s had always accounted for its available-for-sale securities as trading securities,
how would net income before income taxes have been affected in 2008? Your response should
quantify the effect in dollars.

Answer:
a. Trading securities are reported at fair value on the balance sheet. Thus, Starbuck’s trading
securities are reported at: $49.5 million as of 2008 and $73.6 million as of 2007.
b. Net unrealized losses on trading securities for 2008 are $8.7 million ($49.5 million fair value -
$58.2 million amortized cost). Net unrealized gains on trading securities for 2007 are $5.8 million
($73.6 million fair value - $67.8 million amortized cost).
c. Available-for-sale securities are reported at fair value on the balance sheet. Thus, Starbuck’s
available-for-sale investments are reported at: $3.0 million as of 2008 and $88.3 million as of
2007.
d. Unrealized gain on available-for-sale securities is recorded on the balance sheet in two ways.
First, the asset is increased to reflect the unrealized gain – the fair value is reported in the asset
section of the balance sheet. Second, the unrealized gains are recorded in accumulated other
comprehensive income in the equity section of the balance sheet.
e. During 2008, the unrealized gain on the available-for-sale securities of $4.4 million from the
prior year fell to $0. Thus, if the securities had been classified as trading, the pre-tax income for
2008 would have been lower by the difference of $4.4 million.

Cambridge Business Publishers, ©2010

7-32 Financial Accounting for MBAs, 4th Edition
Topic: Held-to-maturity securities
LO: 1
5. Following is a portion of the investments footnote from the 2008 10-K report of Bancfirst
Corporation (in thousands), related to held-to-maturity securities.

December 31 2008 2007 2006

Held for investment (at amortized cost)
U.S. Treasury and other federal agencies $ 1,855 $ 2,393 $ 3,084
States and political subdivisions 32,613 22,877 22,968
Total $34,468 $25,270 $26,052
     
Estimated market value $34,975 $25,472 $26,087

Required:
a. What amount does Bancfirst report on its balance sheet at December 31, 2008 for these held-
to-maturity securities?
b. Calculate the unrealized gains or losses on these securities at December 31, 2008. How do
these unrealized gains or losses affect the 2008 balance sheet and the 2008 income statement?
c. If these held-to-maturity securities had instead been classified as available-for sale, how would
Bancfirst’s 2008 balance sheet and income statement been different?

Answer:
a. Bancfirst reports the held-to-maturity securities at their amortized cost of $34,468 thousand.
b. The securities had an unrealized gain of $507 thousand at December 31, 2008, calculated as
$34,975 thousand market value - $34,468 thousand amortized cost.
c. Available-for-sale securities are carried on the balance sheet at fair value (market value). Thus,
Bancfirst would have reported the securities at $34,975 on the asset side. The unrealized gain of
$507 thousand would also have been included in the equity section of the balance sheet, as
accumulated other comprehensive income. The income statement in 2008 would have been no
different.

© Cambridge Business Publishers, 2010

Test Bank, Module 7 7-33
Topic: Equity method investments
LO: 2
6. Waste Management Inc. reports the following in the 2008 Form 10-K (in millions):

2008 2007
From the Income Statement:
Equity in net losses of unconsolidated entities ($4) ($35)

From the Operating section of the Cash Flow

Statement:
Equity in net losses of unconsolidated entities,
net of distributions $1 $39

a) Why does Waste Management’s income statement deduct equity in net losses of the
unconsolidated entities?
b) Explain the reconciling item on Waste Management’s statement of cash flow that adds back
equity in net losses of unconsolidated entities.
c) Explain why the income statement and statement of cash flow line items related to the
unconsolidated subsidiaries differ in amount.

Answer:
a) Waste Management uses the equity method for its unconsolidated entities. The investor’s
share of net income or of net loss is included as income. Waste Management’s unconsolidated
entities reported losses (in aggregate). Therefore, this reduced Waste Management’s net income
– the losses amounts are deducted to arrive at net income.
b) The net losses of unconsolidated entities are a non-cash expense for the year. Therefore to
reconcile net income to cash from operations, the amount must be added back to net income
because it was originally subtracted in arriving at net income.
c) The income statement and statement of cash flow line items related to the unconsolidated
subsidiaries differ in amount because the unconsolidated entities paid cash dividends during the
year – the statement of cash flows says “net of distributions.” Because these dividends are paid in
cash, the reconciling item is less than the income statement item.

Cambridge Business Publishers, ©2010

7-34 Financial Accounting for MBAs, 4th Edition
Topic: Equity method investments
LO: 2
7. The 2008 income statement of GTSI Corp. follows:

GTSI CORP.
CONSOLIDATED STATEMENTS OF OPERATIONS
(In thousands)
For the Years Ended December 31, 2008 2007
Sales
Product $745,366 $641,560
Service 56,529 59,658
Financing 19,270 22,247
821,165 723,465
Cost of sales
Product 673,858 568,247
Service 31,551 40,609
Financing 8,403 9,889
713,812 618,745
Gross margin 107,353 104,720

Selling, general and administrative expenses 103,848 106,335

Income (loss) from operations 3,505 (1,615)

Interest and other income (expense)

Interest and other income 760 1,191
Equity income from affiliates 4,892 3,802
Interest expense (3,128) (4,577)
Interest and other income (expense), net 2,524 416
Income (loss) before income taxes 6,029 (1,199)
Income tax benefit (expense) 1,806 (568)
Net income (loss) $ 7,835 $ (1,767)

Required:
a. What accounting method does GTSI use to account for its investments in affiliates?
b. According to GAAP, when must GTSI account for its investments in affiliates by consolidating
their financial statements?
c. How does GTSI recognize income received from its affiliates? What amount did GTSI report in
2008?
d. What financial reporting benefits arise from GTSI keeping its investment in affiliates at less
than 50 percent ownership?
e. How do the dividends received from the equity investee affect the equity-method investment on
GTSI’s balance sheet? On the income statement?
f. Describe the effects on GTSI’s statement of cash flow from these equity method investments.

© Cambridge Business Publishers, 2010

Test Bank, Module 7 7-35
Answer:
a. GTSI uses the equity method to account for its investments in joint ventures and affiliates.
b. Because GTSI has significant influence, but not control, it employs the equity method. GAAP
requires the company to consolidate its investments when there is evidence of control.
c. Under the equity method of accounting for investments, which generally applies to investments
that represent a 20% to 50% ownership of the equity securities of the investees, GTSI recognizes
as income, its share of the net earnings or losses of the affiliated companies. GTSI includes this
as a separate line item on its income statement. In 2008, GTSI included $4,892 thousand of
equity income from affiliates.
d. Because GTSI does not consolidate the equity affiliates, it does not report the individual assets
and liabilities comprising the equity it owns. GTSI can report additional income with only a
moderate increase in net assets. This keeps debt off the books and improves certain
performance ratios such as return on assets.
e. Dividends received from the investee decrease GTSI’s investment account on the balance
sheet. The income statement is not affected by dividends from the investee.
f. GTSI’s statement of cash flows would add back the non-cash income from unconsolidated
entities net of any cash dividends received.

Cambridge Business Publishers, ©2010

7-36 Financial Accounting for MBAs, 4th Edition
Topic: Equity method investments
LO: 2
8. The following information comes from the 2008 annual report of GTSI Corp.

In 2002, GTSI made a $0.4 million investment in Eyak and assumed a 37% ownership of Eyak.
The investment in Eyak is accounted for under the equity method and adjusted for earnings or
losses as reported in the financial statements of Eyak and dividends received from Eyak.

The following table summarizes Eyak’s financial information as of and for the year ended
December 31 (in thousands):

Years Ended December 31, 2008 2007

Revenues $273,475 $228,585
Gross margin 31,292 20,368
Net income $ 13,044 $ 7,005

December 31, 2008 2007

Current assets $104,069 $89,351
Noncurrent assets 1,003 2,632
Current liabilities 93,092 81,846
Noncurrent liabilities 77 1,584
Equity $ 11,901 $ 8,553

Required:
a. GTSI uses the equity method to account for its investment in Eyak. Briefly explain how this
accounting method affects GTSI’s balance sheet and income statement.
b. Use the income statement information for Eyak presented above, to calculate the equity
earnings that GTSI reported on its 2008 income statement.
c. Use the balance sheet information for Eyak presented above, to determine the investment
balance for Eyak at December 31, 2008.
d. GTSI’s footnotes revealed that Eyak had no transactions with equity holders during 2008 other
than paying dividends. What amount of dividends did GTSI receive from Eyak during 2008?

Answer:
a. Under the equity method of accounting for investments, which generally applies to investments
that represent a 20% to 50% ownership of the equity securities of the investees, GTSI recognizes
as income, its share of the net earnings or losses of the affiliated companies. GTSI includes this
as a separate line item on its income statement. On the balance sheet, the company records the
original investment. Each period, the investment account is increased by GTSI’s share of the
investee’s net income and reduced by dividends received from the investee.
b. Eyak’s total 2008 net income is $13,044 thousand. GTSI’s 37% share of the net income is
$4,826 thousand.
c. Eyak’s equity (assets less liabilities) at December 31, 2008 is $11,901 thousand. GTSI’s 37%
share is $4,403. This is the amount on GTSI’s balance sheet.
d. 2007 Equity + 2008 Net income – 2008 Dividends = 2008 Equity
In thousands: 2008 Dividends = $8,553 + $13,044 - $11,901 = $9,696. GTSI’s share = $9,696 ×
37% = $3,588.

© Cambridge Business Publishers, 2010

Test Bank, Module 7 7-37
Topic: Acquisition and consolidation
LO: 3
9. Oracle Corp. acquired BEA Systems in 2008. Oracle included the following information in its
2008 annual report:

We acquired BEA Systems, Inc. on April 29, 2008 by means of a merger of one of our wholly
owned subsidiaries such that BEA became a wholly owned subsidiary of Oracle. The total
purchase price for BEA was $8,573 million. Our preliminary purchase price allocation for BEA is
as follows:

(in millions)
Cash and marketable securities $ 1,775
Trade receivables 167
Goodwill 4,355
Intangible assets 3,343
Other assets 248
Accounts payable and other liabilities (386)
Restructuring (see Note 7) (231)
Deferred tax liabilities, net (551)
Deferred revenues (164)
In-process research and development (IPR&D) 17
Total purchase price $ 8,573

a. What method did Oracle use to account for this acquisition?

b. What amount(s) will be recorded in the investment account of Oracle’ balance sheet for the
BEA Systems acquisition?
c. Oracle acquired other assets of $248 million. Explain what this amount represents.
d. How will the purchase of intangible assets affect the Oracle consolidated balance sheet? How
will this asset change in subsequent years?
e. How will the purchase of goodwill affect the Oracle consolidated balance sheet? How will this
asset change in subsequent years?
f. Explain the accounting treatment for the acquired in-process research and development costs.
What justification is there for this treatment?

Answer:
a. Oracle used consolidation accounting for the BEA Systems acquisition.
b. On Oracle’s balance sheet, the BEA Systems investment account will increase by $8,573
million.
c. This amount is the fair value of the assets acquired. Oracle used market values or appraisals to
determine the amount to allocate to these assets.
d. The consolidated balance sheet will report an increase in intangible assets of $3,343 million.
This will be amortized over time as the various intangible assets are used up. Thus, the balance
will decrease in subsequent years.
e. The consolidated balance sheet will report an increase in goodwill of $4,355 million. Goodwill is
not systematically amortized. Instead, Oracle will check the account for impairment each year.
f. The acquired in-process research and development costs (total $17 million) will be expensed in
2008 when the BEA acquisition happened. This is current GAAP for these costs because there is
a presumption that the R&D is not far enough along to be reliably measured as an asset.

Cambridge Business Publishers, ©2010

7-38 Financial Accounting for MBAs, 4th Edition
Topic: Allocating Purchase Price including In-Process R&D
LO: 3
10. Oracle Corp. acquired BEA Systems in 2008. Oracle included the following information in its
2008 annual report:

We acquired BEA Systems, Inc. on April 29, 2008 by means of a merger of one of our wholly
owned subsidiaries such that BEA became a wholly owned subsidiary of Oracle. The total
purchase price for BEA was $8,573 million.

In performing our preliminary purchase price allocation, we considered, among other factors, our
intention for future use of acquired assets, analyses of historical financial performance and
estimates of future performance of BEA’s products. The fair values of intangible assets were
calculated using an income approach and estimates and assumptions provided by both BEA and
Oracle management. The rates utilized to discount net cash flows to their present values were
based on our weighted average cost of capital and ranged from 7% to 17%. The following table
sets forth the preliminary components of intangible assets associated with the BEA acquisition:

(Dollars in millions) Fair Value Useful Life

Software support agreements and related relationships $1,115 8 years
Developed technology 1,118 6 years
Core technology 518 7 years
Customer relationships 530 8 years
Trademarks and other 62 5 years
Total intangible assets  $3,343

Required:
a. Are the intangible assets purchased in the BEA Systems acquisition, reported on the Oracle
consolidated balance sheet at the book value or at the fair value on the date of the acquisition?
Explain.
b. Explain in plain English, how Oracle valued the intangible assets at the time of the acquisition.
Your explanation should explicitly include the role played by the average cost of capital.
c. How are the tangible and intangible assets accounted for subsequent to the acquisition? What
will be the value of the acquired intangibles at the end of fiscal 2009? State any assumptions that
you make.
d. As part of the acquisition, Oracle also recorded $4,355 million of goodwill. Explain how Oracle
arrived at this amount for goodwill.
e. If the amount allocated to software support agreements was decreased to $315 million, what
effect would this have on the allocation of the purchase price to the remaining acquired assets?
What effect would this have on current and future earnings? You should quantify the effect in
dollar terms.

© Cambridge Business Publishers, 2010

Test Bank, Module 7 7-39
Answer:
a. All assets of the acquired company are reported on the consolidated balance sheet at their fair
market values on the date of the acquisition, not at their net book values. Fair values are the most
objective value at acquisition – they are the “historic cost” of the new assets.
b. Intangible assets are valued as an estimate of the value of future economic benefits. Oracle
used an income approach to value the intangible assets. This is very imprecise and involves
significant estimates, both of the timing and amount of expected cash flows and of the discount
rate. Oracle estimated all the future cash flows or other benefits that would accrue from the
various types of intangibles. These were discounted with the cost of capital ranging from 7 to 17
percent. The higher the discount rate, the lower the calculated fair-value for the asset.
c. Subsequent to the acquisition, the tangible assets are accounted for like any other acquired
asset: the receivables are removed when collected, inventories become future cost of goods sold,
and depreciable assets are depreciated over their estimated useful lives. Intangible assets with a
determinable life are amortized over their useful lives. Assuming that Oracle uses straight-line
depreciation and assuming no salvage value, the net book value of the intangible assets at the
end of fiscal 2009 would be $2,865 million calculated as, $3,343 million - $478 million. The
table below shows these calculations.
Fair Useful Amortization
(Dollars in millions) Value Life 2009
Software support agreements and
related relationships 1,115 8 years 139
Developed technology 1,118 6 years 186
Core technology 518 7 years 74
Customer relationships 530 8 years 66
Trademarks and other 62 5 years 12
Total intangible assets 3,343 478

d. Goodwill is calculated as the residual of total purchase price over the fair value of the separate
assets and liabilities acquired. Thus, goodwill is calculated indirectly, after the purchase price is
allocated to all the other assets.
e. If the software support agreements were estimated at a lower amount, more of the purchase
price would be allocated to goodwill. If software support agreements were estimated at $315
million instead of $1,115 million, goodwill would increase by $800 million. Current pre-tax
profitability would be higher by $100 million per year because there would be less amortization on
the intangible ($800 million / 8 year useful life). The same would be true for future earnings over
the subsequent seven years. The only exception would be if the goodwill is deemed to be
impaired and written down.

Cambridge Business Publishers, ©2010

7-40 Financial Accounting for MBAs, 4th Edition
Essay Questions
Topic: Motivations for investment
LO: 1, 2, & 3
1. Why do corporations undertake intercorporate investments? How might our understanding of
these reasons influence our analysis of such investments?

Answer: There are several reasons for intercorporate investments and the various accounting
methods reflect this.
Passive ownership, (either trading, available-for-sale, or held-to-maturity securities), is
generally used as a way to put excess cash to good use. However, in our analysis we should
watch for investor companies that place a disproportionate amount of their wealth in marketable
securities, rather than into their core operations. If these securities are held for trading, then we
should be even more attuned to the possibility that the investor company is attempting to “play
the market” in an unwise fashion, mimicking the practices of a financial services corporation.
Significant-influence equity ownership often stems from a strategic alliance with the
investee company, and such relations are often very sensible business arrangements.
Unfortunately, these relations cloud our ability to analyze the investor company because some of
the investee’s assets and all of its liabilities are not represented. Additionally, even though the
investor company is not legally liable for the debts of the investee, business realities may dictate
that the practical exposure of the investor company is more significant.
Investments with control investment allow the investor company access to new markets,
new technologies, or new products. Acquisitions often bring skilled personnel, such as
researchers or sales staff. Even though consolidation of the balance sheet makes many details
of the investment more transparent, complications can arise, especially with regards to income.
Many things about the structure and policy of the investee company may differ from the investor
company, and these differences are allowed to persist after consolidation. Some of these
differences can pertain to dividend policy or restrictions, varying international regulations, and the
power of minority shareholders.

© Cambridge Business Publishers, 2010

Test Bank, Module 7 7-41
Topic: Accounting for investments
LO: 1, 2, & 3
2. What are the various methods used to account for investments? When is each appropriate?
Explain how each method affects a company’s balance sheet and income statement and the
appropriate uses for each method.

Answer: The accounting methods are as follows:

 Fair-value method: Used with available-for-sale and trading securities, which do not represent
more than 20% ownership in the investee company’s business. Mark-to-market accounting
reports investments on a company’s balance sheet at fair values as determined by security
exchanges and the appropriate markets. Therefore, the reporting of such investments is both
relevant and objective. Dividends and capital gains on sale of such investments affect current
income. Interim changes in fair values may or may not affect current income, depending on
whether the securities are classified as trading or available-for-sale.
 Cost method: Used for passive investments in debt securities, where the intention of the
investor is to hold the debt instrument until it matures. Because of this long-term investment
intention, the investment is not adjusted to fair value each period. The balance sheet reports the
amortized cost of the investment. The income statement includes interest income earned each
period.
 Equity Method: Used with investments where the investor company has significant influence
over the investee company’s operations. Significant influence is often in evidence when the
investor owns 20-50% of a company’s common stock. Under the equity method, the investment
account equals the percent ownership in the investee’s stockholders’ equity, plus the percent of
income declared by the investee that belongs to investor, minus any dividends paid. Therefore
the investment is reported at “adjusted cost.” Assets and liabilities associated with the
investment are not appropriately represented on the investor’s balance sheet. The investor
records income equal to the percent owned of investee company income. Any capital gains
resulting from sale the sale of investment are reported as income by the investor as well.
 Consolidation: Consolidation accounting is used with investments in which the investor
company practically has control over the investee company’s operations. Control is determined
by greater than 50% ownership in the investee’ outstanding common stock. Under
consolidation, the balance sheets and income statements of the investor and investee
companies are combined and reported under a single entity. In the process of consolidation,
certain intercompany transactions are eliminated and adjustments in stockholders’ equity are
made to avoid double counting income and assets. Therefore, consolidation accurately
represents assets and liabilities of the investor associated with its investment in the other entity.

Cambridge Business Publishers, ©2010

7-42 Financial Accounting for MBAs, 4th Edition
Topic: Equity Method vs. Consolidation
LO: 2 & 3
3. Explain the standards that determine if an investor company will report its investment in an
investee company using the equity method or will consolidate the investee. Why might the
investor company prefer the equity method?

Answer: Consolidation must be used if the investor has “control,” usually indicated if the investor
owns more that 50% of the investee company voting stock. Other contractual agreements can
result in “control” even if the percentage held is less than 50%. The relevant test is whether or not
the investor company can dictate key strategic policies. The equity method is used when a lesser
standard of “significant influence” is met, typically assumed when the portion of the investee
company shares owned lies between 20-50%.
Consolidation (purchase) requires that the balance sheet of the investee company be
combined with that of the investor company. This increases both the assets and liabilities of the
investor company. As long as the investor holds just enough of the investee company to maintain
equity-method status, some of assets and (more importantly) all of the liabilities of the investee
company are missing from the investor company’s balance sheet. Without consolidation, ratios
that measure leverage and profitability are improved.

Topic: Ratio effects of equity method investments

LO: 2
4. How does the equity-method of accounting for investments, affect financial ratios of the
investor company?

Answer: Effects on the financial ratios of the investor company can be significant. Specifically,
the investment account reports only the percentage owned of the investee company’s stockholder
equity and not the underlying assets and liabilities. Similarly, the income statement reports the
proportionate share of investee income and not its sales and expenses. Equity method
accounting for investments results in the following effects on the components of return on equity
(ROE). The net operating profit margin (NOPM) is overstated due to nonrecognition of sales and
total operating profit. The net operating asset turnover (NOAT) is understated due to
nonrecognition of sales, but is overstated by nonrecognition of assets. Financial leverage (FLEV)
is understated due to nonrecognition of assets and the correct reporting of income. ROE,
however, is correct because net income is correct and equity is correct.

© Cambridge Business Publishers, 2010

Test Bank, Module 7 7-43
Topic: Definition of significant influence
LO: 2
5. What is meant by the term, “significant influence”? Describe situations in which you believe a
company has significant influence over the operations of another company. What is the
accounting method used when there is significant influence over an investee?

Answer: Significant influence is determined by such factors as representation on the board of

directors of the investee company, participation in decision making processes, sharing of
managerial personnel, legal agreements (such as license to use technology, a formula or a trade
secret) or substantial intercompany transactions (such as sole supplier, sole customer
relationships). Unless there is evidence to the contrary, significant influence is presumed if a
company owns more than 20% and no more than 50% of the outstanding voting stock of an
investee. Significant influence can be determined, however, in cases when the investor owns less
than 20% of the outstanding common stock of another entity, if one or more of the above
described situations exist. In general, if a company can exercise some control over the
operations of another entity, it should be scrutinized for significant influence over that entity.
Significant influence investments are accounted for using the equity method: the investor sets
up an investment account and records the percent of its ownership in the investee’s equity. The
percent of investee’s income/loss is added to the investment account and any dividends are
subtracted. Equity method does not present the actual assets and liabilities associated with the
investment.

Topic: Allocation of purchase price

LO: 3
6. What steps are taken to allocate the purchase price when it exceeds the book value of the
investee’s stockholders’ equity? Include an explanation of intangible assets and goodwill.

Answer: The purchase price of the investee company is first allocated to tangible assets and
liabilities, at their fair value at the time of acquisition. Then value is ascribed to intangible assets,
again at current fair values. Intangible assets include assets that provide quantifiable benefits to a
company but do not have physical substance. Examples of intangible assets include trademarks,
internet domain names, customer lists, customer contracts, books, video, licensing and royalty
agreements, franchise agreements, and patents. After the appropriate amount is ascribed to
identifiable intangible assets, the remainder of the purchase price is allocated to goodwill.
Intangible assets that have a definite life expectancy should be amortized over time. Goodwill,
however, is not amortized, but it can be impaired. Goodwill should be evaluated for impairment
on an annual basis.

Topic: Goodwill impairment

LO: 3
7. Why is goodwill not amortized? When is goodwill impaired and how is it treated?

Answer: Goodwill has an indefinite life and, for that reason, it is not amortized. Previously,
goodwill was amortized over a period of up to 40 years. Under current GAAP, goodwill is tested at
least annually for impairment.
The impairment of Goodwill is a two-step process. First, the fair value of the company is
compared with the book value of its associated investment account on the investor’s books. Fair
value is determined using a number of alternative methods (such as comparable market prices of
existing businesses or discounted free cash flow valuation method). If the result of that valuation
is less than the investment balance, goodwill is deemed to be impaired, and an impairment loss is
computed and recorded in the consolidated income statement. Disclosure of the facts and
circumstances are also required, and this information is typically reported in a footnote.

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7-44 Financial Accounting for MBAs, 4th Edition
Topic: Limitations of consolidated financial statements
LO: 3
8. Describe the limitations of consolidated financial statements.

Answer: While consolidated financial statements can be helpful in analyzing the state of a
company, the financial statements have certain limitations. First, there can be difficulty in
comparing the financial statements of individual subsidiaries. Differences in accounting
procedures, etc, means that the financial statements were arrived at differently, and therefore are
not directly comparable. Second, because the assets for all the subsidiaries are lumped together
on the consolidated balance sheet, there is no indication of the cash flows of individual
subsidiaries. Potential problems with liquidity may not be easily recognizable. Next, in some
cases a financially strong company will combine with a financially weak company. Because the
assets, liabilities, etc, are all rolled into one, the strength or weakness of individual companies is
hidden. This is inaccurate partly because the resources of one company will not necessarily be
used to settle the debts of another. Fourth, the consolidated financial statements generally do not
indicate intercompany transactions. Last, the consolidation of finance and insurance subsidiaries
can be particularly problematic for analysis. Because the companies are so dissimilar, the
consolidated numbers could be very distorted.

© Cambridge Business Publishers, 2010

Test Bank, Module 7 7-45