Advanced Accounting Chapter1

Advanced Accounting
Third Edition

Susan S. Hamlen

University at Buffalo, The State University of New York

Ronald J. Huefner

University at Buffalo, The State University of New York

James A. Largay III

Lehigh University

Cambridge
BUSINESS PUBLISHERS

Cambridge Business Publishers
ADVANCED ACCOUNTING, Third Edition, by Susan S. Hamlen, Ronald J. Huefner, and James A. Largay III.
COPYRIGHT © 2016 by Cambridge Business Publishers, LLC. Published by Cambridge Business
Publishers, LLC. Exclusive rights by Cambridge Business Publishers, LLC for manufacture and export.
ALL RIGHTS RESERVED. No part of this publication may be reproduced, distributed, or stored in a database or retrieval system in any form or by any means, without prior written consent of Cambridge
Business Publishers, LLC, including, but not limited to, in any network or other electronic storage or transmission, or broadcast for distance learning.

STUDENT EDITION ISBN: 978-1-61853-151-3
Bookstores & Faculty: to order this book, call 800-619-6473 or email customerservice@cambridgepub.com. Students: to order this book, please visit the book’s Website and order directly online.
Printed in Canada.
10 9 8 7 6 5 4 3 2 1

PREFACE

W

elcome to Advanced Accounting. We wrote this book with two major objectives in mind.
First, we seek to reflect the changing topical emphases and content in the advanced accounting course; coverage is completely updated for new developments concerning applicable reporting issues and requirements, including the newest FASB and GASB pronouncements and proposals. We extensively discuss International Financial Reporting Standards where appropriate throughout the book. Second, we write from the perspective of enhancing teachability; many of the topics in this course are complex and require careful explanation. We highlight the major issues in each topic and provide the student with the background and logical structure needed to analyze these issues, rather than merely explaining current practice. This view equips students to analyze and assess future reporting developments.
This book is the product of extensive market research including focus groups, market surveys, class tests, manuscript reviews, and interviews with faculty from across the country. We are grateful to the students and faculty who provided us with useful feedback during the preparation of this book.

TARGET AUDIENCE
Advanced Accounting is intended for use, at either the undergraduate or graduate level, in the course commonly known as advanced accounting. It is also designed to be used in courses focusing on mergers and acquisitions that are often part of the MBA curriculum or that are offered as a nondegree, professional development program.

How This Book Effectively Teaches Advanced

Accounting Topics
Conceptual Focus
Conceptual explanations focus on the logic underlying reporting standards rather than merely explaining procedures. We develop each topic by explaining the underlying business activity, the reporting goals, and how standards and procedures achieve these goals. Each topic is clearly developed in terms students can understand. We use illustrations from actual practice to enhance understanding and familiarize students with the information presented in real financial statements. Accounting standards are increasingly principles based, requiring substantial judgment in their application. And standards change every year. Conceptual understanding prepares students to evaluate and effectively apply future standards throughout their professional careers.

iii

iv

Preface

Logical Flow of Topical Coverage
The organization of chapters reflects the logical flow of topics:

• Mergers and acquisitions material is covered in Chapters 1–6.
• Foreign currency translation, foreign currency transactions and hedging, and other financial derivatives (futures, options, and swaps) are in Chapters 7–9.
• Reporting standards for state and local government and NFP organizations are in Chapters
10–13.
• Partnerships, bankruptcy and reorganization, and the SEC are covered in Chapters 14–16.

Relevant Real Company Illustrations
Each chapter begins with a description of a familiar focus company, and how its activities and reporting practices relate to that chapter’s topics. For example, in Chapter 2, IBM’s extensive acquisitions illustrate accounting for mergers and acquisitions. Noncontrolling interests are common in the resort indusChapter 3 • Consolidated Financial Statements: Date of Acquisition try, and in Chapter 5 Las Vegas Sands Corporation illustrates reporting for noncontrolling interests in subsidiaries. In Chapter 9, Kellogg’s hedging in Exhibit 3.7. Becausehedge accounting for futures, options
The consolidation working paper is shown practices illustrate we are consolidating balance sheet accounts, the $1,600,000 gain on acquisition enters IBM’s retained illustrate NFP reporting 5 and swaps. In Chapter 13, Beta Alpha Psi’s financial statements earnings directly; $17,600,000standards.
$16,000,000 1 $1,600,000.
Throughout each chapter, examples from actual practice highlight major topics, using either the focus company or other companies in the same industry. exHIBIT list Consolidation Working by chapter.
Following is a 3.7 of focus companies Paper, July 1, 2015, Bargain Purchase
Coca-Cola
Chapter 1
IBM
Chapter 2
General Motors
Chapter 3
Current assets Warner . . . . . . . . . . . . . . . .
Time . . . . . . .
Chapter 4
Plant and equipment, net . . . . . . . . . . . . . . .
Las Vegas Sands . . . . . . . . . . .
Chapter 5
Patents and copyrights . . . . . Corporation
Investment in DataFile . . . . . . . . . . . . . . . . .
Nike
Chapter 6
Wal-Mart
Chapter 7
Brand names . . . . . . . . . . . . . . . . . . . . . . . .
Favorable lease agreements . . . . . . . . . . . .
McDonald’s
Chapter 8
Contractual customer relationships . . . . . . .
Current liabilities. . . . . . . . . . . . . . . . . . . . . .
Long-term debt . . . . . . . . . . . . . . . . . . . . . .
Common stock, $0.50 par . . . . . . . . . . . . . .
Additional paid-in capital . . . . . . . . . . . . . . .
Retained earnings . . . . . . . . . . . . . . . . . . . .
Applications
Accumulated other comprehensive income.

accounts Taken from Books 9
Chapter
IBm dr (Cr)

datafile
Chapter 10 dr (Cr)
Chapter 11
$ 20,000,000
$ 2,300,000
Chapter 12
150,000,000
50,000,000
Chapter 13
3,000,000
1,000,000
21,600,000
Chapter 14—
Chapter 15—
—
—
Chapter 16—
—
—
(15,000,000)
(100,000,000)
(2,000,000)
(59,000,000)
(17,600,000)
(1,000,000)

(10,000,000)
(38,000,000)
(500,000)
(1,700,000)
(2,800,000)
(300,000)

Emphasis on Current Issues and Trends

eliminations
Kellogg’s

Mecklenburg County, NC dr Cr

Alameda County, CA
St. Louis, MO

$ 300,000 (R)

(R)$10,000,000
Beta Alpha Psi
(R) 4,000,000
5,300,000 (E)
Suburban Propane Partners

Quiznos
(R) 1,000,000

Consolidated
Balances
dr (Cr)
$ 22,000,000
210,000,000
8,000,000
—

16,300,000 (R)
1,000,000

(R)
600,000
Securities and Exchange Commission 600,000
(R)

3,000,000

(E)
(E)
(E)
(E)

500,000
1,700,000
2,800,000
300,000

2,000,000 (R)

3,000,000
(25,000,000)
(140,000,000)
(2,000,000)
(59,000,000)
(17,600,000)
(1,000,000)

Business
Taken from Total . . . . .news. and.actual. financial$statements, Business Application boxes illustrate reporting current . . . . . . . . . . . . . . . . . . . . . . .
0
$
0
$23,900,000 $23,900,000
$
practices, current issues, and controversies. The following is an example from Chapter 3.
BuSIneSS aPPlICaTIon

95

International subsidiaries, Taxes, and Disclosure

U.S. corporations often set up subsidiaries in other countries to take advantage of lower tax rates in these countries. For example, as of 2014, Ireland does not tax profits of subsidiaries incorporated in
Ireland but which have no tax residency anywhere in the world. In 2013, Apple Inc. owned three Irish subsidiaries with no tax residency, and the effective tax rate for its other two Irish subsidiaries was less than 2 percent. The U.S. does not require companies to pay U.S. taxes on profits of foreign subsidiaries, if these profits are not repatriated to the U.S. By routing much of its international business through its
Irish subsidiaries, Apple lowers its tax obligation.
It is difficult if not impossible for the average investor to determine the extent of a U.S. company’s operations reported through its international subsidiaries. The financial performance of a consolidated subsidiary is not separately observable in an annual report, because the subsidiary’s accounts are included with those of the parent. The SEC requires a listed company to disclose the names of its consolidated subsidiaries. However, names of subsidiaries may be omitted if, in the aggregate, they are not
“significant.” According to a May 2013 Wall Street Journal article, some companies have become less forthcoming about disclosing the names of their international subsidiaries. For example, in 2010 Oracle
Corporation named over 400 subsidiaries. In 2012, the list included only eight subsidiaries. Google Inc. named more than 100 subsidiaries in 2009, but only two in 2012. One might wonder if the reduction in disclosure of offshore subsidiaries operating in low-tax countries is related to the public’s increasing criticism of this practice. Source: Jessica Holzer, “From Google to FedEx: The Incredible Vanishing Subsidiary,”
Wall Street Journal, May 22, 2013.

Special Issues: depreciable assets and Previously Reported goodwill In the previous

0

Impairment loss on identifiable intangibles . . . . . . . . . . . . . . . . . . . . . . . . . . . .
40,000,000
Goodwill impairment loss. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 160,000,000 exHIBIT 5.5 Consolidation Working .Paper .for. admiral. and. gold. Road. at . .
Customer lists . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . december 31, 2016, Bargain Purchase
70,000,000
Brand names . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
60,000,000
accounts . . . . . . . . . . . . . . . . .
Goodwill. . . . . . . . . . . . . . . . . . . . . . . . Taken .from Books. . . . . . . .
160,000,000
Consolidated dr (Cr) eliminations To record amortization expense and impairment losses on previously
Balances
unreported intangibles and goodwill for 2017.

admiral

gold Road

dr

Cr

dr (Cr)

Reporting Perspectives
Current assets . . . . . . . . . . . . . . . . . . . . . . . $ 43,880,000
$ 8,900,000
$ 52,780,000
The Perspectives amortization expense such as the strengths customer lists and brand names54,000,000
Reporting$130,000,000. in comment. .on topicsand impairment losses onand weaknesses in reporting standards,
Equity investments . . . . . . . . . . . . . . . . .
50,000,000
4,000,000 can be for changes . . . . . . . . . items, such
Plant and equipment, net . . . other. operating ethical issues, implications for information if appropri64,000,000
299,000,000
motivations combined with .in. standards,235,000,000 as general and administrative expenses,quality, and proposals ate. When the amount . . . . . . . . . . .
Investment in Gold Road . . . is material,. the $160,000,000 goodwill impairment loss appears 3,392,000 (C) line
18,428,000
—
$ as a separate
—
for new the operatingThe following is an example from Chapter 4. standards. section of the consolidated income statement.
11,536,000 (E) in 3,500,000 (R)
Identifiable intangible assets . . . . . . . . . . . .
580,000,000
—
(R) $ 3,750,000
1,250,000 (O)
582,500,000
Current liabilities. . . . . . . . . . . . . . . . . . . . . .
(13,000,000)
(12,000,000)
(25,000,000)
Reporting .Perspective . . . . . . . (869,930,000)
Long-term debt . . . . . . . . . . . . . .
(44,990,000)
(914,920,000)
Capital stock . . . added .the. qualitative . assessment option (Step 0) to make impairment testing less onerous. (5,000,000)
(5,000,000)
(2,500,000)
(E)
2,500,000
The FASB . . . . . . . . . . . . . . . . . .
Retained earnings, January 1. . . . . . . . . . . .
(32,250,000)
Prior to 2012, all companies were required to compare(11,800,000) (E) each indefinite life intangible and (32,250,000) the fair value of 11,800,000
Accumulated other comprehensive reporting unit . . . . . . . . . . . . . . fair value income, January 1 to. its. book. value.. Companies complained that estimating the 120,000 of each intangible
(296,000)
(120,000)
(E)
(296,000) asset and reporting . . . . . . . . . . .
Noncontrolling interest . . . . unit .was. costly and time consuming, and unnecessary when fair value was obviously (3,982,000)
—
—
2,884,000 (E)
250,000 (R) higher than book value.
848,000 (N)
Critics claim that this option weakens the impairment test, by giving managers additional earnings
Dividends . . . . . . . . . . . . . . . . . . . . . . . . . . .
2,000,000
500,000
400,000 (C)
2,000,000
management opportunities. The subjective nature of the qualitative assessment increases the ability to de100,000 (N) also choose
Saleslay recognition of impairment. losses. Management can(160,000,000) to perform the quantitative test in good (780,000,000) and other revenue. . . . . . . . . . . . . . . (620,000,000) years, income of Gold Road . . . . . . likelihood of impairment recognition
Equity in net but take the qualitative .option in bad years, thus increasing the (C)
(3,800,000)
—
3,800,000
—
Equity in other comprehensive loss avoiding it when earnings are low. when earnings are high and of Gold Road . . . . . . . . . . . . . . . . . . . . . .
8,000
—
8,000 (C)
—
Cost of goods sold. . . . . . . . . . . . . . . . . . . .
410,000,000
120,000,000
530,000,000
continued
Operating expenses . . . . . . . . . . . . . . . . . . .
205,000,000
34,000,000
(O)
1,250,000
240,250,000
Other comprehensive (income)/loss. . . . . . .
(40,000)
10,000
(30,000)
Noncontrolling interest in net income . . . . .
—
—
(N)
950,000
950,000
IFRS
Noncontrolling interest in other comprehensive loss . . . . . . . . . . . . . . .
—
—
2,000 (N)
(2,000)
Extensive discussion .and .illustration of international financial reporting standards and proposals appear
Totals . . . . . . . . . . . . . . . . . . . . . . . . . . . $
0
$24,170,000 $24,170,000
$
0 in each of. the. business .combinations, foreign 0 $ currency translation and transactions, and futures, options and swaps chapters. The following is an excerpt from Chapter 5.

INTERNATIoNAl fINANCIAl REpoRTING sTANDARDs foR NoNCoNTRollING INTEREsTs
IFRS 3(R) presents IFRS for valuing and reporting noncontrolling interests in consolidated financial statements. Although IFRS agrees with U.S. GAAP that the noncontrolling interest should be reported at acquisition-date fair value, IFRS 3(R) actually allows the acquirer to choose between two different valuation methods:

lo4 Explain
IFRS for noncontrolling interests.

1. Value the noncontrolling interest at full fair value at the acquisition date, as in U.S. GAAP.
2. Value the noncontrolling interest at its share of the fair value of the subsidiary’s identifiable net assets at the acquisition date.
Using valuation method #2, the noncontrolling interest is not allocated any goodwill: only the controlling interest’s share of goodwill is recognized. Therefore the IFRS alternative reports goodwill and noncontrolling interests at lower amounts on the consolidated balance sheet than under U.S. GAAP.
When goodwill is impaired, IFRS noncontrolling interest in net income is higher than U.S. GAAP, since no goodwill impairment loss is charged against the noncontrolling interest.
Return to Admiral’s acquisition of 80 percent of Gold Road’s stock for $42,600,000. The alternative valuation method allowed by Development of Business Combinations
Clear and LogicalIFRS (#2) leads to this initial value of the noncontrolling interest:

Topics

Reporting issues related to business combinations cover a variety of topics. Consolidation procedures are difficult to comprehend and can be confusing to students. We emphasize the measurement aspects of combinations—reporting assets and liabilities acquired, determining acquisition cost, valuing noncontrolling interests, and eliminating intercompany accounts.
To make consolidation procedures more comprehensible, eliminations subsequent to acquisition
(covered in Chapters 4–6) presume that the parent uses the complete (full) equity method. Exclusive use of the complete (full) equity method allows students to focus on the goals of consolidation and the key issues in consolidation procedures. Once students develop a solid understanding of the consolidation process, changes in procedures required when the parent uses the cost method can be introduced.
The appendix to Chapter 4 explains the eliminating entries necessary to adjust the parent’s accounts to the complete equity method before proceeding with consolidation. The appendix also compares complete equity method eliminations to cost method eliminations.

Preface

v

Goodwill . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

vi

Preface

1,003

4,754

1,291

2,894

2,246

Total acquisition cost . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $1,471
Identifiable intangible assets as a percent of acquisition cost. . .
16%

$6,538
24%

$1,849
30%

$3,964
26%

$3,219
29%

73%

70%

73%

70%

Goodwill as a percent of acquisition cost . . . . . . . . . . . . . . . . . .

68%

The choice between recognition of identifiable intangibles versus goodwill has an impact on future in-

Additional Pedagogy intangibles have finite lives and must be amortized. In contrast, come, particularly if the identifiable goodwill is not amortized, although it is subject to impairment testing.

To reinforce concepts presented in each chapter and ensure student comprehension, we include two or more In-Chapter Review Problems that require students to recall and apply the accounting techniques and concepts described in the chapter. The solutions to the review problems are included after each chapter’s assignments. The following example is from Chapter 2.
RevIeW 1 • Reporting assets acquired and liabilities assumed
IBM acquires SoftCloud Technologies in an acquisition reported as a merger, for $1.2 billion in cash. At the acquisition date, the reported assets and liabilities of SoftCloud have fair values as follows:
(in millions)

fair value

Cash and receivables . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Inventories . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Property, plant and equipment. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Accounts payable. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

$ 400
800
3,500
300

Long-term debt . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

3,850

In addition, the following items are not currently reported on SoftCloud’s balance sheet:
(in millions)

fair value

Favorable lease agreements . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Skilled workforce . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

$150
15

Favorable press reviews on products . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

5

Required: Prepare the entry IBM makes to record its acquisition of SoftCloud.
Solutions are located after the chapter assignments.

Learning Objectives identify the primary learning outcomes for each chapter. An end-of-chapter
Review of Key Concepts summarizes the key topics of each chapter.

Extensive Class-Tested End-of-Chapter Material
Outstanding assignment material is an essential component of a successful textbook. End-of-chapter questions, exercises and problems cover all major topics and have a range of difficulty levels, allowing students ample opportunity to practice their understanding of the chapter. Some problems require students to use real company data in applying their knowledge. Assignment material is class-tested, with an emphasis on relevance and accuracy.
Certain business combination problems continue from chapter to chapter. For example, P3.2 covers consolidation at the date of acquisition, and P4.8 covers consolidation of the same two companies in subsequent years. P4.2 covers subsequent year consolidation of a wholly owned subsidiary, and
P5.7 addresses subsequent year consolidation of the same subsidiary, when the subsidiary has outside ownership. In P2.5, an acquisition is reported as a merger, and in P3.11 the same acquisition is reported as a stock investment and consolidation. P3.4, P4.4, P5.2, P5.4 and P5.5 use the same acquisition data to illustrate consolidation of a bargain purchase at the date of acquisition, subsequent years, and with a noncontrolling interest. Each of these problems can also be assigned separately. In working through these problems, students gain a clearer understanding of accounting for business combinations.

Features New To This Edition

• In the consolidation chapters, we use color pedagogically to identify eliminating entries, both in

journal form and in the consolidation working papers, making it easier for students to navigate the complexities of consolidation procedures.

Preface

• All consolidation chapters emphasize consolidation of the statement of income and comprehen-

sive income. Because in practice companies use a variety of formats to present consolidated operating results, the working paper consolidates the trial balances of the parent and subsidiary, which students then package into financial statements in whatever format desired. This approach increases students’ flexibility and understanding of basic concepts.
• Discussion of consolidation policy more clearly emphasizes the goal of consolidating controlled entities, and includes updates on development stage entities, kick-out rights, and partnerships as illustrations of this concept.
• A new section on valuation of acquired intangibles discusses and illustrates the cost, market and income approaches, with emphasis on appropriate judgments and related audit risks.
• We added new material on common reporting issues related to acquisitions, including valuation of acquired deferred taxes, classification of contingent consideration as acquisition cost versus future compensation, acquisition of entities previously reported as significant influence investments, and fair value measurement issues for impairment testing.
• In the governmental chapters, all illustrations are updated for current standards and practice in the areas of fund balance classifications, recognition of deferred inflows and outflows, and reporting for defined benefit pensions. We added new material on accounting for debt refundings, a common activity in state and local governments.
• We emphasize the commonality of reporting issues for different types of entities—businesses,
NFPs, governments, and even partnerships. Examples include consolidation policy, acquisition reporting, and hedge accounting.
• Chapter 16, covering SEC financial reporting and governance issues, is completely updated for current activities in the areas of regulation, enforcement, and monitoring.
• All illustrations, current practices, and reporting perspectives are completely updated.
• There are over 150 new exercises and problems, and a net increase of about 80 exercises and problems, and various levels of difficulty.
• In response to requests from adopters, more assignments have been added to myBusinessCourse for the 3rd edition, including the multiple choice questions at the end of each chapter.
The Website for this text provides updates for changes in standards occurring subsequent to the publication date.

ONLINE INSTRUCTION AND HOMEWORK

MANAGEMENT SYSTEM
: Is a web-based learning and assessment program intended to complement your textbook and faculty instruction. This easy-to-use program grades homework automatically (Instructor-Led course only) and provides students with access to narrated demonstrations and eLecture videos. Assignments with the in the margin are available in the Instructor-Led version of myBusinessCourse. Access is free with new copies of this textbook (look for a page containing the access code near the front of the book). If you buy a used copy of the book, you can purchase access at www.mybusinesscourse.com.

SUPPLEMENT PACKAGE
For Instructors
: Is a web-based learning and assessment program intended to complement your textbook

and classroom instruction. This easy-to-use program grades homework automatically (Instructor-Led course only) and provides students with access to narrated demonstrations and eLecture videos. Assignments with the in the margin are available in the Instructor-Led version of myBusinessCourse. Visit www.mybusinesscourse.com to sign up or to learn more about this program’s features and benefits. In addition, detailed diagnostic tools assess class and individual performance. myBusinessCourse is ideal for online courses, blended courses, and traditional face-to-face courses for which you want to offer students more resources to succeed.

vii

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Preface

Instructor CD-ROM: This convenient supplement provides the text’s ancillary materials on a portable CD-ROM. All the faculty supplements that accompany the textbook are available, including PowerPoint, Solutions Manual, Test Bank, Excel Templates, and Computerized Test Bank.
Solutions Manual:
Created by the textbook authors, the Solutions Manual contains complete solutions to all the assignments in the textbook.
Test Bank:
Written by the textbook authors, the test bank includes multiple-choice questions and problems. Excel Templates: Excel spreadsheets for select assignments are provided on the book’s
Website. These spreadsheets will save time in data entry and allow students to dedicate additional time to learning the material. The Excel spreadsheets are identified by the Excel icon.
PowerPoint:
Edited by the textbook authors, the PowerPoint slides outline key elements of each chapter. Computerized Test Bank:
This computerized version of the test bank enables an instructor to add and edit questions; create up to 99 versions of each test; attach graphic files to questions; import and export ASCII files; and select questions based on type or learning objective. It provides password protection for saved tests and question databases and is able to run on a network.
Website: All instructor materials are accessible via the book’s Website (password protected). www.cambridgepub.com For Students
: s a web-based learning and assessment program intended to complement your textI book and faculty instruction. This easy-to-use program grades homework automatically (Instructor-Led course only) and provides students with access to narrated demonstrations and eLecture videos. Access is free with new copies of this textbook (look for page containing the access code towards the front of the book). If you buy a used copy of the book, you can purchase access at www.mybusinesscourse.com.
Excel Templates: Excel spreadsheets for select assignments are provided on the book’s
Website. These spreadsheets will save time in data entry and allow students to dedicate additional time to learning the material. The Excel spreadsheets are identified by the Excel icon.
Website: Practice quizzes, Excel templates, and other useful links are available to students free of charge on the book’s Website.

ACKNOWLEDGEMENTS
Many individuals helped us develop this textbook. We gratefully acknowledge their assistance, and list their names and affiliations below.
Mark Anderson, University of Texas—Dallas
Mark Barfield, Baylor University
Mark Bauman, University Northern Iowa
Frank Beil, University of Minnesota—Twin Cities
John Bildersee, New York University
Andy Borchers, Lipscomb University
Gary Braun, University of Texas—El Paso
Kimberly Brickler-Ulrich, Lindenwood University
Richard Brown, Concordia University Wisconsin
Gene Bryson, University of Alabama—Huntsville
Kerry Calnan, Nichols College
Tina Carpenter, University of Georgia
Charles Carslaw, University of Nevada, Reno
Lynn Clements, Florida Southern College

Jacklyn Collins, University of Miami
Laurie Corradino, Colorado State University-Pueblo
Chris Cowles, Central Connecticut State University
Jean Crawford, Alabama State University
Donald Danner, Aurora University
Patricia Davis, Keystone College
Michael Davis, University of Alaska
Dennis Debrecht, Carroll University
Hemang Desai, Southern Methodist University
John Dexter, Northwood University
David Diehl, Aurora University
Cynthia Dittmer, St. Ambrose University
Reed Easton, Seton Hall University
Jack Elfrink, Western Illinois University

Preface

Michael Ettredge, University of Kansas
Mary Fischer, University of Texas at Tyler
Linda Flaming, Monmouth University
Sheila Foster, The Citadel
Carl Gabrini, College of Coastal Georgia
George Gardner, Bemidji State University
Earl Godfrey, Gardner-Webb University
Angela Gore, George Washington University
Ronald Guidry, Illinois State University
Michael Gurevitz, Montgomery College
Ling Harris, University of South Carolina
Judith Harris, NOVA Southeastern University
Anthony Herron, University of Oklahoma
Arlene Hibschweiler, University at Buffalo
Kenneth Hiltebeitel, Villanova University
Joan Hollister, SUNY at New Paltz
Yongtao Hong, North Dakota State University
Peter Hosker, Southern New Hampshire University
Huichi Huang, Oregon State University
Jodi Hunter, Lake Superior State University
Teresa Iannaconi, KPMG LLP
Marianne L. James, CSU—Los Angeles
Patricia Johnson, Canisius College
Bill Joyce, Bemidji State University
Roger Kerkenbush, Loras College
Ed Ketz, Penn State University
Myungsun Kim, University at Buffalo
Gordon Klein, University of California—Los Angeles
Lisa Koonce, University of Texas—Austin
Stanley Kratchman, Texas A&M University
Sudha Krishnan, CSU—Long Beach
Steve LaFever, Wichita State University
Robert Larson, University of Dayton
Mike Luehlfing, Louisiana Tech University
Cathy Margolin, Brandman University
Maureen Mascha, Purdue University Calumet
Dawn Massey, Fairfield University
Betsy Matz, University of Pittsburgh—Bradford
Katie Maxwell, University of Arizona
Reed McKnight, University of New Mexico
Allison McLeod, University of North Texas

Greg Merrill, St. Mary’s College
Scott Miller, Edinboro University
Ramin Mirsaidi, University of Washington—Tacoma
Maria Mitchell, Thomas More College
Adam Myers, Texas A&M University
Hugo Nurnberg, CUNY—Baruch
Bruce Oliver, Rochester Institute of Technology
Gary Olsen, Carroll University
Michael Owens, University of Tennessee—Chattanooga
Tina Quinn, Arkansas State University
Sara Reiter, Binghamton University
Susan Riffe, Southern Methodist University
Jane Romal, College at Brockport
John Rossi, Moravian College
Kenneth Shaw, University of Missouri
Margaret Shelton, University of St. Thomas
Andreas Simon, Pepperdine University
Richard Simpson, University of Massachusetts
Sheldon Smith, Utah Valley University
Ira Stolzenberg, Molloy College
William Stout, University of Louisville
Gina Sturgill, Bluefield State College
John Surdick, Xavier University
Margaret Tanner, University of Arkansas—Fort Smith
Diane Tanner, University of North Florida
Randy Thomas, Upper Iowa University
Carmelita Troy, Andrews University
Kenton B. Walker, University of Wyoming
David Wallin, Ohio State University
Larry Walther, Utah State University
Jamie Wang, University of Wisconsin—Parkside
Donna Whitten, Purdue University North Central
Latasha Williams, Keiser University
Debbie Williams, West Virginia State University
Jan Williams, University of Baltimore
Sung Wook Yoon, CSU—Northridge
Suzanne Wright, Penn State University
Jia Wu, University of Massachusetts—Dartmouth
Stephen Zeff, Rice University
Ling Zhou, Tulane University

We express our appreciation for the support of the School of Management, University at Buffalo, and the Department of Accounting, Lehigh University. A special acknowledgement goes to Angela Gore for her very valuable assistance in updating the state and local government chapters. Her help is much appreciated. We also thank Mark Bauman for his contributions to myBusinessCourse. In addition, we are extremely grateful to George Werthman, Lorraine Gleeson, Beth Nodus, Jill Sternard, Jocelyn Mousel, Debbie McQuade, Terry McQuade, and the entire team at Cambridge Business Publishers for their encouragement, enthusiasm, and guidance. Comments are invited and encouraged from all instructors, students, and readers.

Susan S. Hamlen (hamlen@buffalo.edu)
Ronald J. Huefner (rhuefner@buffalo.edu)
James A. Largay III (jal3@lehigh.edu)

ix

Brief Contents

Preface iii

Chapter 1

Intercorporate Investments: An Overview 2

Chapter 2

Mergers and Acquisitions 34

Chapter 3

Consolidated Financial Statements: Date of Acquisition 78

Chapter 4

Consolidated Financial Statements Subsequent to Acquisition 118

Chapter 5

Consolidated Financial Statements: Outside Interests 176

Chapter 6

Consolidated Financial Statements: Intercompany Transactions 228

Chapter 7

Consolidating Foreign Currency Financial Statements 272

Chapter 8

Foreign Currency Transactions and Hedging 328

Chapter 9

Futures, Options and Interest Rate Swaps 376

Chapter 10 State and Local Governments: Introduction and General Fund Transactions 414
Chapter 11 State and Local Governments: Other Transactions 468
Chapter 12 State and Local Governments: External Financial Reporting 518
Chapter 13 Private Not-For-Profit Organizations 564
Chapter 14 Partnership Accounting and Reporting 612
Chapter 15 Bankruptcy and Reorganization 662
Chapter 16 The SEC and Financial Reporting 704

x

Index 736

Contents
Preface

iii

Chapter

2

Mergers and Acquisitions 34
Chapter

1

Introduction 35
Motivations for Mergers and Acquisitions 35

Intercorporate Investments: An Overview 2

Overview of Reporting for Combinations 37

Introduction 3

Standards of Reporting for Business Combinations 39

Motivations for Intercorporate Investments 3

Valuation of Assets Acquired and
Liabilities Assumed 40

Types of Investments 4
Marketable Debt and Equity Investments 5

Acquisition Date 40

Trading Investments 5

Identifying the Acquiring Company 40

Available-for-Sale Investments 6

Measurement of Previously Reported Assets and Liabilities 41

Held-to-Maturity Investments 7
Proposed Reporting Changes for Financial Instruments 9
Review 1

• Trading, AFS, and HTM Investments

Types of Combinations 36

9

Identification and Measurement of Previously
Unreported Intangibles 42
Illustration of Reporting Assets Acquired and Liabilities
Assumed 45

Investments with Significant Influence 9

Review 1

Accounting Using the Equity Method 10

• Reporting Assets Acquired and Liabilities
Assumed 47

Equity in Net Income Calculation 10
Other Comprehensive Income and the Equity Method 12

Measurement of Acquisition Cost 48

Impairment Testing 13

Contingent Consideration 48

Joint Ventures 14

Employee Compensation 49

Review 2

• Reporting for Equity Method Investments

14

Controlling Investments 15
Mergers, Consolidations, and Asset Acquisitions 15
Stock Acquisitions 16
Variable Interest Entities 16
International Financial Reporting Standards For
Intercorporate Investments 17
Marketable Debt and Equity Investments 17
Investments with Significant Influence 18
Joint Ventures 18
Controlling Investments 18

Acquisition-Related Costs 50
Illustration of Reporting Consideration Given in an
Acquisition 50
Subsequent Changes in Asset, Liability, or
Contingent Consideration Values 51
Measurement Period 51
Reporting Subsequent Changes in Asset and Liability
Values 51
Reporting Subsequent Changes in Contingent Consideration
Value 52
Review 2

• Reporting Assets and Liabilities Acquired,

Consideration Paid, and Subsequent Events 53

Review of Key Concepts 19

Bargain Purchases 53

Multiple Choice Questions 20

Special Issues: Research and Development,
PREACQUISITION Contingencies, AND DEFERRED TAX
LIABILITIES 55

Exercises 22
Problems 26
Review Solutions 33

In-Process Research and Development 55
Preacquisition Contingencies 55

xi

xii

Contents
Acquired Deferred Tax Liabilities 56

International Financial Reporting Standards for
Business Combinations 57

Reporting Revaluations of Subsidiary Assets and
Liabilities in Subsequent Years 125
Previously Reported Assets and Liabilities 125

Review of Key Concepts 58

Previously Unreported Identifiable Intangibles 127

Multiple Choice Questions 59

Goodwill 128

Exercises 60

Amortization and Impairment of Identifiable Intangibles and
Goodwill: An Illustration 133

Problems 67

Review 1

Review Solutions 77

Chapter

3

Consolidation After One Year 137
Consolidation After Two Years 140
Review 2

• Consolidation in a Subsequent Year with
Identifiable Intangibles 144

IFRS for Acquired Intangibles 145
Identifiable Intangibles 145

Introduction 79

Goodwill 146

Criteria for Consolidation 80

Appendix to Chapter 4 148

Motivations for Off-Balance-Sheet Entities 80

Consolidation Eliminating Entries When the Parent Uses the
Cost Method 148

Standards for Consolidation 82
Control and Consolidation of Equity Investments 82

Review of Key Concepts 153

Control and Consolidation of Non-Equity Investments 83

• Identifying Consolidated Entities

135

Comprehensive Illustration: Consolidation in
Subsequent Years 136

Consolidated Financial Statements:
Date of Acquisition 78

Review 1

• Intangibles Impairment Testing

Multiple Choice Questions 154

87

Exercises 156

Consolidation at Date of Acquisition 88
Consolidation of Financial Statements: Preliminary Issues 88

Problems 162

Objectives of Consolidation 89

Review Solutions 173

Consolidation Working Paper 89
Review 2

• Consolidation with Identifiable Intangibles

97

International Financial Reporting Standards for
ConsolidationS 97
The Concept of Control 97
IFRS and U.S. GAAP Compared 98

Chapter

5

Consolidated Financial Statements:
Outside Interests 176

Review of Key Concepts 99

Introduction 177

Multiple Choice Questions 99

Noncontrolling Interests at Acquisition Date 178

Exercises 102
Problems 107

Valuation of Noncontrolling Interests and Goodwill at
Acquisition 178

Review Solutions 116

Measuring the Fair Value of Noncontrolling Interests 179
Consolidation Eliminating Entries at Acquisition Date 180

Chapter

4

Consolidated Financial Statements
Subsequent to Acquisition 118

Noncontrolling Interests in the Consolidated Balance
Sheet 181
Consolidating Variable Interest Entities 182
Noncontrolling Interests in Subsequent Years 182
Consolidation at End of the First Year 183

Introduction 119

Noncontrolling Interests in the Consolidated Statement of
Income and Comprehensive Income 185

Introduction to Consolidation Procedures 119

Consolidation at End of the Second Year 187

Consolidation Eliminating Entries 120
Illustration of Consolidation Process 121
Consolidated Financial Statements 123
Complete Equity Method as One-Line Consolidation 124

Review 1

• Consolidation with Noncontrolling Interest at
End of Third Year, U.S. GAAP 192

Noncontrolling Interests and Bargain
Purchases 192

Contents
Bargain Purchase Consolidation at Date of Acquisition 193

Multiple Choice Questions 251

Bargain Purchase Consolidation at End of the First Year 194

Exercises 253

Bargain Purchase Consolidation at End of the Second
Year 196

xiii

Problems 258
Review Solutions 268

International Financial Reporting Standards for
Noncontrolling Interests 197
Review 2

• Consolidation with Noncontrolling Interest at End of the Third Year, IFRS 201

Consolidated Statement of Cash Flows 201
Preparation of Consolidated Statement of Cash Flows 202
Consolidated Statement of Cash Flows: An Illustration 202

Chapter

7

Consolidating Foreign Currency
Financial Statements 272

Review of Key Concepts 204

Introduction 273

Multiple Choice Questions 205

C
onverting a Subsidiary’s Foreign Currency
Accounts to the Parent’s Currency 273

Exercises 207
Problems 213
Review Solutions 225

The Conversion Process 274
The Functional Currency 276
Translation and Remeasurement Procedures 277

Chapter

6

Consolidated Financial Statements:
Intercompany Transactions 228

Translation Procedures 277
Remeasurement Procedures 278
Comparing Translation and Remeasurement 278
Translation and Remeasurement Gains and Losses 278
Translation and Remeasurement Illustrated 284
Review 1

Intercompany Service and Financing
Transactions 230
Intercompany Profits 231
Equity in Net Income and Noncontrolling Interest in Net
Income 232
Intercompany Transfers of Land 233
Eliminations in the Year of Transfer 233
Eliminations in Subsequent Years 234
Eliminations in Year of Sale to Outside Party 236
Intercompany Transfers of Inventory 236
Unconfirmed Profit in Ending Inventory 238
Unconfirmed Profit in Beginning Inventory 238
Review 1

• Intercompany Eliminations: Land and
Merchandise Transfers 240

Intercompany Transfers of Depreciable Assets 240
Objectives of the Eliminations 241
Eliminations in Year of Transfer 241
Eliminations in Subsequent Years 242
Eliminations in Year of Sale to Outside Party 244
Review 2

• Intercompany Eliminations: Depreciable Asset
Transfers 244

I
nternational Financial Reporting Standards for
Intercompany Transactions 245
Comprehensive Illustration 246
Review of Key Concepts 250

• Calculation of Remeasurement and Translation
Gain or Loss 286

Introduction 229
Review 2

• Translation and Remeasurement of Foreign
Currency Financial Statements 287

Highly Inflationary Economies 288
Changing the Functional Currency 289
Translation and Remeasurement of an Existing Entity 289
Converting the Statement of Cash Flows to the Reporting
Currency 293
Disclosures 293
Financial Analysis Using Translated and
Remeasured Information 295
Effects on Profitability: The “DuPont Analysis” 295
Effects on Analysis of Short-Term Liquidity and Long-Term
Solvency 296
Consolidation of international Subsidiaries 297
Equity Method Reporting 297
The Consolidation Process 298
Review 3

• Consolidation of an International
Subsidiary 302

I
FRS for Translating and Consolidating Foreign
Currency Financial Statements 302
Translation and Remeasurement 302
Subsidiaries in Hyperinflationary Economies 302
Review of Key Concepts 304
Multiple Choice Questions 305
Exercises 307

xiv

Contents

Problems 313

Accounting Events in Futures Trading 381

Review Solutions 323

T-Account Analysis of Futures Contracts 381
Illustrations of Accounting for Futures Contracts 382

Chapter

8

Foreign Currency Transactions and Hedging 328
Foreign Currency Transactions and Risk 329
Foreign Currency Transactions 330
Import and Export Transactions 330
Review 1

• Foreign-Currency-Denominated Import and
Export Transactions 334

Foreign Borrowing and Lending Transactions 334
Hedging Foreign Exchange Exposures 335
Types of Foreign Exchange Risk 335
Derivative Instruments Used in Hedging 336
Reporting Investments in Foreign Currency Derivatives 338
Review 2

• Using Forward Contracts to Hedge

Review 1

• Accounting for Futures Contracts

Option Contracts 386
Definitions 386
Effects of Price Changes of Optioned Items 387
Accounting Events in Options Trading 387
Illustrations of Accounting for Options 388
Review 2

• Accounting for Option Contracts

Accounting for Interest Rate Swaps 394
Assessing Hedge Effectiveness 394
Accounting Events and Entries for Interest Rate Swaps 395
Review 3

• Accounting for Interest Rate Swaps

396

Disclosure Requirements 397
Derivatives and Hedging Disclosures 397
Derivatives and Hedging Under IFRS 399
IFRS 9 Hedge Accounting Requirements 399
Review of Key Concepts 400

Foreign-Currency-Denominated Firm
Commitments 349

Exercises 402

Currency-Denominated Forecasted
Transactions 351

Review 4

391

Interest Rate Swaps 392

Foreign-Currency-Denominated Import
Transactions 344

Review 3

386

Review Solutions 410

• Using Forward Contracts to Hedge

Multiple Choice Questions 401

• Using Forward Contracts to Hedge Foreign-

Problems 406

I
nternational Financial Reporting Standards for
Foreign Currency Transactions and Hedging 356

10

Qualifications for Hedge Accounting 357

Chapter

Differences Between IFRS and U.S. GAAP 357

State and Local Governments: Introduction and General Fund Transactions 414

Financial Instruments Disclosures 359
Review of Key Concepts 359
Multiple Choice Questions 360
Exercises 362
Problems 367
Review Solutions 373

Nature of Government Activities 415
External Users of Governmental Financial Statements 417
S
ources of GAAP for State and Local
Governments 417
GAAP Hierarchy in Government Accounting 418
Objectives of Financial Reporting 418

Chapter

9

Futures, Options and Interest
Rate Swaps 376
Derivatives and Hedge Accounting 377

Identifying the Reporting Entity 419
Fund Structure 420
Fund Types 422
Review 1

• Identifying Funds

423

Accounting and Reporting By Funds 424
Accounting for Governmental Funds 424

Accounting for Derivatives and Hedging Transactions 378

Accounting for Proprietary Funds 425

Hedge Accounting Qualifications 378

Accounting for Fiduciary Funds 425

Futures Contracts 380

Accounting for the General Fund 425

Introduction to Futures Contracts 380

Budgetary Accounts 427

Transacting in Futures Contracts 381

Recording Property Tax Revenue 429

Contents
Purchase of Goods and Services 430

Landfill Operations 493

Supplies Inventories 432

Accounting for Leased Assets 494

Interfund Transactions 433

Debt Refundings 495

Capital Assets and Long-Term Debt 434

Review of Key Concepts 496

Closing Entries 436

Multiple Choice Questions 497

Outstanding Encumbrances at Year-End 437

Exercises 499

C
omprehensive Illustration of General Fund
Accounting and Reporting 438
Transactions During the Year 439

Problems 503
Review Solutions 513

Closing Entries 442
Financial Statements 443
Review 2

• General Fund Budget and Closing Entries,
Financial Statements 446

Review of Key Concepts 446
Multiple Choice Questions 447
Exercises 449
Problems 454
Review Solutions 465

Chapter

12

State and Local Governments:
External Financial Reporting 518
External Reporting Model 519
Management’s Discussion and Analysis 520
Government-Wide Financial Statements 521
Statement of Net Position 521

Chapter

11

State and Local Governments:
Other Transactions 468
Accounting for Special Purpose Activities 469
Special Revenue Funds 470
Permanent Funds 470
Accounting for Capital Projects 472
Capital Projects 472
Accounting for the Capital Projects Fund 473
Accounting for General Obligation Debt 478
General Obligation Debt 478
Accounting for the Debt Service Fund 479
Review 1

•

Capital Projects and Debt Service Fund
Transactions and Financial Statements 482

Accounting for Proprietary Activities 482
Accounting for Enterprise and Internal Service Funds 483
Review 2

• Enterprise Fund Transactions and Financial
Statements 487

Accounting for Fiduciary Activities 487
Accounting for Trust and Agency Funds 488
Accounting for Investments 490
Derivatives Investments 491
Accounting for Other Liabilities and Debt
Refundings 493
Compensated Absences 493

Statement of Activities 522
Discussion of Government-Wide Statements 522
Review 1

• Prepare a Statement of Activities

525

Fund Financial Statements 525
Major Funds 526
Governmental Funds Financial Statements 526
Review 2

• Reconcile the Change in Fund Balances to
Change in Net Position 533

Proprietary Funds Financial Statements 533
Fiduciary Funds Financial Statements 538
C
omparison of Government-Wide and Funds
Information 539
Governmental Activities 539
Business-Type Activities 540
Notes and Required Supplementary
Information 541
Budgetary Comparison Schedules 541
Capital Assets, Infrastructure, Investments, AND
DEFINED BENEFIT PENSION PLANS 543
Capital Assets and Infrastructure 543
Investments 543
Defined Benefit Pension Plans 544
Review of Key Concepts 546
Multiple Choice Questions 547
Exercises 549
Problems 555
Review Solutions 562

xv

xvi

Contents

Chapter

13

Chapter

14

Private
Not-For-Profit Organizations 564

Partnership Accounting and Reporting 612

C
haracteristics of Private Not-For-Profit (NFP)
Organizations 565

Characteristics of a Partnership 613

NFP Reporting Environment 566
External Financial Reporting Requirements: General
Concepts 566
Financial Reporting Display Model 568
Statement of Financial Position 568

Introduction 613
Relations of Partners to Others 614
Relations Among Partners 614
Partners’ Property Rights 615
Contractual Provisions: The Partnership Agreement 615
Limited Partnerships 615

Statement of Activities 568

Comparison of Corporate and Partnership Forms of
Organization 616

Statement of Cash Flows 571

Partnership Reporting Issues 617

Accounting for Contributions Received 572
Unconditional and Unrestricted Cash Contributions 572
Unconditional and Unrestricted Contributions of Goods and
Services 573

Formation of the Partnership 619
Bonus and Goodwill Approaches 619
Review 1 Formation of a Partnership 620

•

Allocation of Partnership Income to PartnerS 620

Donor-Imposed Temporary Restrictions 574

Salaries to Partners 620

Donor-Imposed Conditions 576

Bonus to Partners 621

Donor-Imposed Permanent Restrictions 576

Interest on Partners’ Capital Accounts 622

Contributions of Long-Lived Assets 577

Percentage Allocation by Income-Sharing Ratio 622

Annuity and Life Income Contributions 578

Comprehensive Illustration of Partnership Net Income
Allocation 622

Contributions Received on Behalf of Others 579
REVIEW 1

•

Accounting for Contributions 580

ACCOUNTING FOR INVESTMENTS 580
REVIEW 2

•

Reporting for Investments 581

COMPREHENSIVE ILLUSTRATION OF NFP ACCOUNTING:
NORTHEASTERN HEART SOCIETY 582
REPORTING ISSUES FOR SPECIFIC NOT-FOR-PROFIT
ORGANIZATIONS 586
Voluntary Health and Welfare Organizations 586
Colleges and Universities 586
Health Care Organizations 587
EVALUATION OF EXTERNAL REPORTING FOR NFP
ORGANIZATIONS 589

Schedule of Changes in Capital Accounts 623
Review 2
Income Allocation 624

•

Admission of a New Partner 624
Admission by Purchase of an Existing Partnership
Interest 624
Admission by Investment of New Capital 626
Effects of Bonus and Goodwill Methods on Partners’
Capital 629
Evaluation of Bonus and Goodwill Methods 629
Retirement of a Partner 630
Purchase with Personal Assets 630

Strengths of External Reporting Requirements 589

Purchase with Partnership Assets 630
Review 3
Retirement of a Partner and Admission of a New
Partner 633

Criticisms of External Reporting Requirements 589

Partnership Liquidations 633

Current Developements in NFP Reporting 590

•

Priorities for Payments 633

REVIEW OF KEY CONCEPTS 591

Rights of Creditors 634

MULTIPLE CHOICE QUESTIONS 592

Simple Versus Installment Liquidations 635

EXERCISES 594
PROBLEMS 598
REVIEW SOLUTIONS 609

Simple Liquidations 635
Installment Liquidations 637
Review 4
Termination of the Partnership 643

•

Review of Key Concepts 644
Multiple Choice Questions 644
Exercises 646
Problems 650
Review Solutions 659

Contents

Chapter

15

xvii

16

Chapter

Bankruptcy and Reorganization 662

The SEC and Financial Reporting 704

Legal Aspects of Bankruptcy 664

Establishment of the SEC and Key Securities
Legislation 706

Legal Process of Chapter 7 Liquidation 665
Legal Process of Chapter 11 Reorganization 665
Financial Reporting for Chapter 7 Liquidation 665

• Chapter 7 Liquidation

670

Statement of Realization and Liquidation 670
Financial Reporting for Chapter 11
Reorganization 674
Reporting During the Reorganization Process 674
Reporting After Reorganization 677
Review 2

Securities Legislation and the SEC 706
Definition of a Security 707

Statement of Affairs 665
Review 1

Establishment of the SEC 706

•

Chapter 11 Reorganization 682

Other Forms of Restructuring 683

Organization and Structure of the SEC 708
SEC Pronouncements on Accounting and Auditing 709
Review 1

• Mission and Organization of the SEC

710

Registration of New Securities 710
Periodic Reporting Requirements 711
EDGAR 711
The Annual Report: Form 10-K 712
Regulation S-X 717

Quasi-Reorganization 683

The Quarterly Report: Form 10-Q 719

Troubled Debt Restructuring 683

Special Reports: Form 8-K 719

Review of Key Concepts 684
Multiple Choice Questions 685
Exercises 686
Problems 692
Review Solutions 701

Review 2

• Registration and Periodic Reporting
Requirements 720

Corporate Accountability and Governance 720
Audit Committees 721
Antifraud Provisions and Insider Trading 721
Proxy Statements 722
The Dodd-Frank Act 723
The SEC and Accounting Standards 723
Review 3

• Corporate Accountability and Governance, SEC
Intervention in Standard-Setting 724

Review of Key Concepts 724
Multiple Choice Questions 725
Exercises 727
Problems 731
Review Solutions 733

Index 736

Cha pter

1

Intercorporate
Investments: An
Overview

L e ar n i ng Objective s
LO1

Describe the reporting for trading, available-for-sale, and held-to-maturity intercorporate investments. (p. 5)

LO2

Explain the reporting for equity method intercorporate investments. (p. 9)

LO3

Describe the reporting for controlling interests in other companies. (p. 15)

LO4

Discuss International Financial Reporting Standards (IFRS) for intercorporate investments. (p. 17)

The Coca-Cola Company www.coca-cola.com The Coca-Cola Company is the world’s largest beverage company. In addition to Coca-Cola, its brands include Sprite, Dasani, and Minute Maid. Coca-Cola produces beverage syrup in concentrated form, and sells it to bottlers. The bottlers mix the syrup with water and other ingredients, and bottle or can the finished beverages for delivery to retailers, restaurants, and food distributors.
Coca-Cola’s investments in its bottlers and other companies take a variety of forms. At the end of 2013,
Coca-Cola owned several legally separate bottling companies, including Coca-Cola Refreshments Canada and BCI Coca-Cola Bottling Company of Los Angeles. These companies are subsidiaries of Coca-Cola
Company. Coca-Cola has a significant interest in some of its bottlers through equity ownership. It is involved in several joint ventures, where Coca-Cola shares decision-making authority with another company, and has certain financial relationships with other companies, called variable interests, which must be disclosed in its financial statements. Coca-Cola also holds marketable debt and equity investments in other companies, categorized as trading, available-for-sale, or held-to-maturity. These accounts appear as current and noncurrent assets on Coca-Cola’s balance sheet.
Coca-Cola’s financial statements illustrate the variety of intercorporate investments held by companies.
Each investment type involves a different set of reporting requirements. This chapter presents an overview of reporting for the major types of investments in other companies. Source: The Coca-Cola Company 2013 annual report. 2

C h a pt e r Or g a n i z a ti o n

Introduction

• Motivations for intercorporate investments

Marketable debt and equity investments • Trading investments • Available-for-sale

• Types of investments Investments with significant influence • Equity method investments • Joint ventures

investments

• Held-to-maturity investments Controlling investments • Mergers,

International
Financial Reporting
Standards

• Marketable

consolidations, and asset acquisitions debt and equity investments • Investments

• Stock acquisitions
• Variable interest

with significant influence • Joint ventures
• Controlling

entities

investments

Introduction
Companies invest in other companies for many reasons, using a variety of financing arrangements, operating relationships and legal structures. Intercorporate investments are pervasive business activities, affect financial performance in profound ways, and have detailed and complex reporting requirements.
How firms value investments and report gains and losses depends on the purpose of the investment and whether the investor has significant influence or control over the investee.

Motivations for Intercorporate Investments
Intercorporate investments achieve a variety of business purposes.

• A company purchases debt or equity securities of another company as a temporary investment of

excess cash or as part of a longer-term risk-adjusted portfolio, expecting to receive dividends and capital gains.
• A company makes strategic investments to develop relationships with suppliers or customers or to gain access to new product or geographic markets.
• A company obtains a controlling interest in another company to facilitate activity along its supply chain. The balance sheet and footnotes to The Coca-Cola Company’s December 31, 2013, annual report illustrate some of the most common types of intercorporate investments.
The Coca-Cola Company, Balance Sheet, Investments Lines Only
December 31 (in millions)

2013

Trading securities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 372
Available-for-sale securities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
4,842
Equity method investments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10,393

2012
$ 266
4,593
9,216

Coca-Cola holds trading and available-for-sale investments in the securities of other companies to generate investment income and capital gains. These investments are reported in various asset lines on
Coca-Cola’s balance sheet, including “marketable securities,” “other investments, principally bottling companies,” and “other assets.”

3

4

Chapter 1 • Intercorporate Investments: An Overview

Coca-Cola uses the equity method to account for investments in which it has significant influence. In 2013, Coca-Cola had a 29 percent ownership interest in Coca-Cola Amatil, one of the largest bottlers in the Asia-Pacific region, a 28 percent interest in the bottler Coca-Cola FEMSA, operating in Latin America, and a 23 percent interest in Coca-Cola Hellenic, operating in 28 European countries. Coca-Cola holds these investments for strategic reasons and exerts significant influence over the operations of these companies. Coca-Cola shares decision making authority in joint ventures with other companies. For example, Beverage Partners Worldwide is a 50/50 joint venture between CocaCola and Nestlé S.A., distributing Nestea products primarily in Europe and Canada. These investments are also reported using the equity method.
In recent years, beverage companies have changed strategy with respect to their bottlers, in some cases concluding that full ownership rather than significant influence results in more flexible, efficient and timely manufacture and delivery of products. For many years Coca-Cola held between 30 and 35 percent ownership in Coca-Cola Enterprises (CCE), a major bottler. In 2010 it acquired full ownership of CCE’s North American production, sales, and distribution operations. On the other hand, in
2013 Coca-Cola sold 51 percent of its investment in Coca-Cola Bottlers Philippines, Inc. to CocaCola FEMSA. Coca-Cola has controlling ownership of more than 50 companies.
Coca-Cola has financial relationships with other companies. In some cases these relationships give Coca-Cola the power to direct these companies’ activities and expose Coca-Cola to their benefits and losses, even though it does not have any ownership interests. The individual assets and liabilities of all these companies are included with Coca-Cola’s assets and liabilities on its balance sheet, through a process known as consolidation. There is no separate investment line for these companies.

Types of Investments
For reporting purposes, intercorporate investments are divided into the following categories:

• Trading debt or equity securities are held on a short-term basis to generate profits through realized

gains. Investors typically buy and sell these securities frequently.
• Held-to-maturity investments are debt securities intended to be held to maturity. Companies hold these investments for the interest and principal payments.
Available-for-sale investments are debt or equity securities held for income or gains in value that
•
are not classified as trading or held-to-maturity.
• Equity method investments are stock investments that provide the investor with a significant influence over the investee. This category includes joint ventures, where the investor shares joint control of an entity.
• Debt or equity securities can be held as hedges of the investor’s financial risk. For example, a U.S. company with payables denominated in euros may neutralize the risk of a weakening U.S. dollar by investing in euro-denominated debt securities, which gain in value to offset the loss on the payables if the U.S. dollar weakens.
• A company can acquire some or all of the assets and liabilities of another business to expand into new markets, develop new products or services, or for other strategic purposes. These transactions are mergers, consolidations, or asset acquisitions depending on the acquisition structure.
• A company can gain a controlling interest in another legally separate company, either through ownership of all or the majority of its voting stock—termed a stock acquisition—or through a legal agreement that gives the investor the right to the majority of the investee’s risks and rewards. These acquired companies are called subsidiaries. Entities controlled through a legal agreement rather than equity ownership are also known as variable interest entities.
FASB ASC Topic 825 allows companies to elect fair value reporting (the “fair value option”) for eligible noncontrolling intercorporate investments. These include trading, held-to-maturity, available-forsale, or equity method investments. Investments for which the fair value option is chosen are reported at fair value and value changes appear in income. The discussion that follows assumes the investor does not elect the fair value option. Controlling equity investments, in the form of mergers, consolidations, asset acquisitions and stock acquisitions, are not eligible for the fair value option.

Chapter 1 • Intercorporate Investments: An Overview

Marketable Debt and Equity Investments
Many businesses invest in the debt and equity securities of other companies to generate investment income and capital gains. Examples of debt securities include commercial paper, corporate bonds, and redeemable preferred stock. Equity investments typically take the form of shares of a company’s common or preferred stock, but often involve put or call options on the shares, allowing the investor to sell or buy shares at a fixed price. Such investors have no significant influence over the investee, either because the investments are debt securities, or the equity investment is a small fraction of total ownership. ASC Topic 320 describes reporting requirements for these securities.
The FASB is currently considering major changes in reporting requirements for investments covered by ASC Topic 320. As this edition goes to press, no Accounting Standards Update has been issued.
The discussion below reflects GAAP in effect in 2014.
ASC Topic 320 divides investments with readily determinable market values into three categories: trading, available-for-sale, and held-to-maturity investments. When market value is not determinable, investments are reported at cost. Because intermediate accounting courses detail the reporting for these investments, we provide only a brief discussion.

Trading Investments
Trading investments can be in the form of debt or equity securities. These investments appear on the balance sheet as current assets reported at fair value, with gains and losses reported on the income statement as market prices change. Investment income, in the form of interest or dividends, is reported in income as earned. An illustration is based on the information in Exhibit 1.1.
Exhibit 1.1 Securities Portfolio Security
A ��
B ��
C ��

Date Acquired
10/15/15
10/15/15
10/15/15

Cost
$100,000
500,000
200,000

Dec. 31, 2015 Fair Value

Date Sold

Selling Price

$125,000
485,000
N/A

1/15/16
1/15/16
12/5/15

$120,000
496,000
214,000

When these securities are classified as trading securities, the journal entries related to these securities are as follows:
2015

Oct. 15

Investment in trading securities �� Cash�� record investment in trading securities costing a total of
To
$800,000 in cash.

800,000

Cash �� Investment in trading securities�� Gain on trading securities (income) �� To record sale of trading security C.

214,000

Investment in trading securities �� Gain on trading securities (income) �� record unrealized value change in securities A and B;
To
unrealized gain of $25,000 on security A and unrealized loss of
$15,000 on security B.

10,000

Cash �� Investment in trading securities�� Gain on trading securities (income) �� record sale of trading securities A and B; cash received 5
To
$120,000 1 $496,000, credit to Investment 5 $125,000 1 $485,000.

616,000

800,000

2015

Dec. 5

200,000
14,000

2015

Dec. 31

10,000

2016

Jan. 15

610,000
6,000

All unrealized and realized gains and losses on trading securities are reported on the income statement.

LO1 Describe the reporting for trading, available-forsale, and heldto-maturity intercorporate investments.

5

6

Chapter 1 • Intercorporate Investments: An Overview

Available-for-Sale Investments
Investments in available-for-sale (AFS) securities are debt or equity securities reported at fair value as current or noncurrent assets on the balance sheet. As market prices change, unrealized gains and losses on AFS securities are reported in other comprehensive income (OCI), which is closed to accumulated other comprehensive income (AOCI) in the equity section of the balance sheet. When AFS securities are sold, the related unrealized gain or loss is recategorized from AOCI to the income statement. As a result, the entire gain or loss appears in income when the securities are sold. Interest or dividend income is reported in income as earned.
Assume that the securities in Exhibit 1.1 are classified as AFS securities. Journal entries are as follows:
2015

Oct. 15

Investment in AFS securities�� Cash�� To record investment in AFS securities A, B and C.

800,000

Cash �� Investment in AFS securities �� Gain on AFS securities (income)�� record the sale of AFS security C. When AFS securities are
To
purchased and sold in the same reporting period, gains and losses can be reported directly in income without going through OCI.

214,000

Investment in AFS securities�� Gain on AFS securities (OCI) �� record unrealized value changes for AFS securities A and B in
To
OCI; OCI is closed to AOCI on the balance sheet.

10,000

Cash ��
Reclassification of gain on AFS securities (OCI)�� Investment in AFS securities �� Gain on AFS securities (income)�� To record sale of AFS securities A and B.

616,000
10,000

800,000

2015

Dec. 5

200,000
14,000

2015

Dec. 31

10,000

2016

Jan. 15

610,000
16,000

Note that the effect of the January 15, 2016, entry is to reduce 2016 OCI by $10,000. To put this in perspective, look at Coca-Cola’s 2013 Statement of Comprehensive Income.
The Coca-Cola Company and Subsidiaries
Consolidated Statements of Comprehensive Income
Year Ended December 31, (In millions)
2013

2012

2011

Consolidated Net Income��
Other comprehensive income: Net foreign currency translation adjustment�� Net gain (loss) on derivatives�� Net unrealized gain (loss) on available-for-sale securities�� Net change in pension and other benefit liabilities��

$8,626

$9,086

$8,646

(1,187)
151
(80)
1,066

(182)
99
178
(668)

(692)
145
(7)
(763)

Total Comprehensive Income ��
Less: Comprehensive income (loss) attributable to noncontrolling interests��

8,576
39

8,513
105

7,329
10

Total Comprehensive Income Attributable to Shareowners of the Coca-Cola Company��

$8,537

$8,408

$7,319

Each type of other comprehensive income appears as one line. Coca-Cola’s 2013 net unrealized loss on available-for-sale securities of $80 million consists of two parts: (1) unrealized gains and losses on AFS securities held by Coca-Cola at December 31, 2013, and (2) reclassifications from other comprehensive income for AFS securities sold during 2013. In our example, the 2015 Statement of Comprehensive
Income reports an unrealized gain of $10,000 for AFS securities held at year-end. The 2016 Statement of Comprehensive Income reports the reclassification of the unrealized gain to income when the securities are sold, as a reduction in other comprehensive income.

Chapter 1 • Intercorporate Investments: An Overview

Beginning in 2013, U.S. companies are required to separately report reclassifications of AOCI, by type, either on the Statement of Comprehensive Income or in the footnotes. For example, if Coca-Cola’s
$80 million loss on AFS securities consists of $20 million in unrealized gains on securities held at yearend, and $100 million in reclassifications of previously recognized unrealized gains on securities sold in
2013, Coca-Cola is required to report each amount separately.
The principal difference in reporting for trading and available-for-sale investments is the timing of gain and loss recognition on the income statement. For trading securities, gains and losses affect net income as prices change. For AFS securities, gains and losses affect net income when they are sold.
Note that in the previous illustration, the gain reported in 2016 income is the difference between the selling price and the original cost of the investment ($16,000 5 $616,000 2 $600,000).
Impairment Testing for AFS Securities Although available-for-sale debt and equity securities are already carried at fair value on the balance sheet, ASC Section 320-10-35 requires impairment testing for these securities. Impairment losses differ from other declines in value because they are reported on the income statement, not in other comprehensive income. There are two steps to the impairment test.
1. Determine whether the investment is impaired. Impairment occurs if the security’s fair value is below its cost.
2. Decide whether the impairment is “other than temporary.” If the investor intends to sell the security soon after the balance sheet date, the impairment is clearly other than temporary. If not, the investor must assess whether, during the time it intends to hold the security, it will recover the security’s cost.
Suppose the $15,000 decline in value of AFS security B at December 31, 2015, is determined to be other than temporary. The entry to adjust securities A and B to fair value is:
2015

Dec. 31

Investment in AFS securities��
Impairment loss on security B (income) �� Gain on security A (OCI)��

10,000
15,000
25,000

record unrealized gain on security A and impairment loss on
To
security B.

For future impairment testing, security B’s “cost” is $485,000. Any subsequent increases in fair value are not reported. Note that the amount of the impairment loss reported on the income statement is the decline in value below cost, not carrying value. If unrealized gains or losses have previously been recorded, and the security incurs an other-than-temporary impairment loss, any amounts recorded in AOCI are reclassified to income. Suppose an AFS investment, carried at $200,000, was originally acquired for $160,000. Therefore unrealized gains of $40,000 have previously been reported in OCI. Its fair value is currently $90,000. The $70,000 loss (5 $160,000 2 $90,000) is determined to be otherthan-temporary. The entry to record the impairment loss is:
Reclassification of gain on AFS securities (OCI)��
Impairment loss on AFS securities (income)�� Investment in AFS securities �� record impairment loss on AFS securities.
To

40,000
70,000
110,000

Held-to-Maturity Investments
Investments in held-to-maturity (HTM) securities can only be debt securities, since equity securities have no maturity date. They appear on the balance sheet as noncurrent assets until the year of maturity, and are reported at amortized cost. No gains or losses are reported unless the securities are not held to maturity as intended, and this only occurs under limited circumstances, such as financial distress on the part of the issuer. When debt securities are purchased above or below face value, the premium or discount is amortized over time as interest income is reported.
Assume investment of $965,349 in a $1,000,000 face value corporate bond on January 1, 2015, a price producing a 6 percent yield to maturity. The bond pays 5 percent interest annually on December 31,

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Chapter 1 • Intercorporate Investments: An Overview

matures on December 31, 2018, and is classified as an HTM security. We use the effective interest method to amortize the discount. Journal entries to maturity are as follows:
2015

Jan. 1

Investment in HTM securities �� Cash�� To record investment in HTM securities.

965,349

Cash ��
Investment in HTM securities �� Interest income�� record interest income for 2015; $50,000 5 5% 3 $1,000,000;
To
$57,921 5 6% 3 $965,349.

50,000
7,921

Cash ��
Investment in HTM securities �� Interest income�� record interest income for 2016; $58,396 5 6% 3 $973,270
To
(5 $965,349 1 $7,921).

50,000
8,396

Cash ��
Investment in HTM securities �� Interest income�� record interest income for 2017; $58,900 5 6% 3 $981,666
To
(5 $973,270 1 $8,396).

50,000
8,900

Cash ��
Investment in HTM securities �� Interest income�� record interest income for 2018; $59,434 5 6% 3 $990,566
To
(5 $981,666 1 $8,900).
Cash �� Investment in HTM securities�� record receipt of the face value of the matured bond.
To

50,000
9,434

965,349

2015

Dec. 31

57,921

2016

Dec. 31

58,396

2017

Dec. 31

58,900

2018

Dec. 31

Dec. 31

59,434

1,000,000
1,000,000

Impairment Testing for HTM Investments Although companies normally report HTM securities at amortized cost, ASC Section 320-10-35 requires that they be evaluated for impairment. If the fair value of the security declines below amortized cost, and the decline is judged to be “other than temporary,” we write the security down to fair value and report the impairment loss on the income statement.
Any subsequent increases in fair value are not reported. The Codification offers the following guidance in measuring other-than-temporary impairment:
If the present value of cash flows expected to be collected is less than the amortized cost basis of the security, the entire amortized cost basis of the security will not be recovered (that is, a credit loss exists), and an other-than-temporary impairment shall be considered to have occurred. (ASC para.
320-10-35-33C)

The original yield on the investment is the discount rate used in determining present value. In the illustration above, assume that a significant decrease in the bond issuer’s profitability, and analysts’ severe downgrade of company prospects, reduced the December 31, 2016, fair value of the corporate bond to
$200,000 when the amortized cost of the bond is $981,666. If the decline in fair value is attributed to other-than-temporary impairment, the investor reports the impairment loss in income, as follows:
2016

Dec. 31

Impairment loss on HTM securities (income) �� Investment in HTM securities�� record other-than-temporary impairment of HTM securities;
To
$781,666 5 $200,000 2 $981,666.

781,666
781,666

Chapter 1 • Intercorporate Investments: An Overview

9

Proposed Reporting Changes for Financial Instruments
Since the 2008 credit crisis, the FASB has been working on a project to update reporting requirements for investments in debt and equity financial instruments that are currently classified as trading, AFS, and HTM. As of 2014, no new standards are effective. However, in 2013 the FASB issued a proposed
Accounting Standards Update focusing on classification and measurement of financial instruments.
For debt instruments involving contractual payments of principal and interest, the proposal retains the three current measurement classifications of fair value through income, fair value through OCI, and amortized cost. The fair values of debt instruments reported at amortized cost would be reported parenthetically on the face of the balance sheet. A company determines an investment’s classification based on investment objectives. Equity investments are reported at fair value through income, or at cost if fair value is not readily determinable.
A 2012 proposed ASU focuses on reporting for impairment of debt instruments. A company would recognize an allowance for expected credit losses, measured as management’s estimate of the investment’s lifetime uncollectible contractual cash flows. The 2013 proposed ASU addresses impairment testing of equity investments reported at cost. The investment is considered impaired if it is more likely than not that its fair value is less than its book value.
The proposals, if adopted, would significantly change the reporting for financial instruments.
Reporting classification would depend on investment strategy rather than legal form. A company would no longer be able to report equity investments at fair value through OCI. A more straightforward likelihood assessment replaces the “other-than-temporary” criterion for impairment recognition. Note that these changes are only proposals as of 2014. Consult the FASB web site for current updates.

Review 1 • Trading, AFS, and HTM Investments
Assume The Coca-Cola Company makes the following intercorporate investments on January 2, 2016:
Security
A ��
B ��
C ��

Type

Cost

Trading
AFS
HTM

$ 300,000
1,000,000
486,384

Security C is a 3-year $500,000 face value corporate bond paying 4% interest annually on December 31 and yielding 5% to maturity. Coca-Cola sells Security A for $265,000 on June 15, 2016, and acquires Security D on
October 15, 2016, for $250,000. Security D is classified as a trading security.
December 31, 2016, fair values are as follows:
Security
B ��
C ��
D ��

Type

Fair Value

AFS
HTM
Trading

$920,000
495,000
260,000

Cash dividends of $12,000 are received on the investments in Securities B and D on December 1, 2016. Interest of $20,000 is received on Security C on December 31, 2016.
Required: Prepare all entries related to the above investments for 2016.
Solutions are located after the chapter assignments.

Investments with Significant Influence
Unless a company elects the ASC Section 825-10-25 fair value option, ASC Topic 323 requires that the equity method be used to account for equity investments that allow the investor to exercise significant influence over the operating and financial decisions of the investee. Significant influence is assumed

LO2 Explain the reporting for equity method intercorporate investments.

10

Chapter 1 • Intercorporate Investments: An Overview

to be present if the investor owns between 20 and 50 percent of the investee’s voting stock. However, this is only a guideline to aid in assessing significant influence. The Codification offers indicators of the investor’s ability to exert significant influence, including:

• representation on the investee’s board of directors
• involvement in the development of investee operating and financial policies
• significant transactions between investor and investee

The key issue is whether the investor in fact exerts significant influence over the investee’s operations.
Significant influence may exist with less than 20 percent ownership of the investee’s voting shares, or there may be circumstances where a large minority ownership does not indicate significant influence. ASC para. 323-10-15-10 provides guidance on this point. For example, if the investor has given up significant shareholder rights, has tried but failed to gain representation on the investee’s board, or if other owners not influenced by the investor control the investee’s operations, the equity method is not appropriate even if the investor holds 20 to 50 percent of the voting stock.

Accounting Using the Equity Method
When the investor can influence the investee’s operating and financial decisions and the amount and timing of dividends the investee pays, performance of the investment is not accurately measured by dividend payout. Instead, investment performance should parallel the investee’s performance. The equity method achieves this goal with the following procedures:

• Increase (decrease) the investment account by the investor’s share of the investee’s income (loss).
• The investor reports its share of the investee’s income (loss) in income.
• Reduce the investment account for dividends from the investee.

The investor’s investment balance therefore changes in proportion to the changes in the investee’s retained earnings.
Suppose that on January 2, 2016, The Coca-Cola Company acquires 300,000, or 30 percent, of the voting shares of Rocky Mountain Bottlers for $40 per share, a total of $12 million in cash. Coca-Cola has a significant influence over Rocky Mountain, and therefore the equity method is appropriate. Rocky
Mountain reports net income of $2 million for the year ended December 31, 2016. It declares a cash dividend of $0.50 per share on November 1, 2016, and pays the dividend on December 2, 2016. CocaCola records the following entries for 2016 relative to its equity method investment in Rocky Mountain:
2016

Jan. 2

Investment in Rocky Mountain Bottlers �� Cash�� To record the investment.

12,000,000

Dividends receivable�� Investment in Rocky Mountain Bottlers�� To record the declared dividend; $150,000 5 $0.50 3 300,000.

150,000

Cash �� Dividends receivable �� To record receipt of the declared dividend.

150,000

Investment in Rocky Mountain Bottlers �� Equity in net income of Rocky Mountain Bottlers (income)�� To accrue the earnings of the investee; $600,000 5 30% 3 $2,000,000.

600,000

12,000,000

2016

Nov. 1

150,000

2016

Dec. 2

150,000

2016

Dec. 31

600,000

The December 31, 2016, investment balance, reported on Coca-Cola’s balance sheet in noncurrent assets, is $12,450,000 (5 $12,000,000 2 $150,000 1 $600,000). Equity in net income of Rocky Mountain Bottlers of $600,000 appears as a component of Coca-Cola’s income for 2016.

Equity in Net Income Calculation
The discussion above computed equity in net income as the investor’s share of the investee’s reported net income, based on the assumption that the investee’s reported net income accurately measures the

Chapter 1 • Intercorporate Investments: An Overview

performance of the investment. When investment cost differs from the investee’s book value, or the investor and investee transact business with each other, the investor must make adjustments to the investee’s reported income.
At the date of acquisition, investment cost usually exceeds the book value of the investee, calculated as its reported assets less liabilities. The investee reports its noncurrent assets such as plant and equipment at cost less accumulated depreciation, not current fair value. Internally developed intangible assets, such as favorable contractual agreements, customer base, technology and reputation do not appear as assets on the investee’s balance sheet. For these reasons an investee’s shares usually sell at a price in excess of book value.
Companies take large noncontrolling interests in other entities for strategic reasons that facilitate business activities between the companies. Common transactions involve intercompany sales of raw materials or finished goods inventories. For example, Coca-Cola sells syrup to its 29-percent-owned bottler, Coca-Cola Amatil. When related entities sell merchandise to each other, the profit on these transactions is not considered to be earned until the merchandise is sold to an unrelated outside party.
Amortization of Investment Cost in Excess of Book Value Acquired To accurately measure investment performance, we must consider any investment cost in excess of investee book value, also known as basis differences. The investee’s reported income reflects appropriate write-offs of its reported assets, in the form of depreciation, amortization, and impairment losses. If investment cost reflects additional assets not recorded on the investee’s books, equity in net income should in turn reflect writeoffs of these additional assets. In the previous discussion, we calculated Coca-Cola’s share of Rocky
Mountain Bottlers’ income as a proportion of Rocky Mountain’s reported net income. If Coca-Cola’s investment cost at the date of investment differs from Rocky Mountain’s underlying book value, we must make adjustments to accurately measure investment performance.
Suppose that on January 2, 2016, Rocky Mountain’s book value is $30 million. Coca-Cola therefore paid $3 million (5 $12 million 2 30% 3 $30 million) more for its 30 percent investment than its share of Rocky Mountain’s reported book value. Analysis of Rocky Mountain’s assets and liabilities reveals that its plant and equipment is reported at $1 million less than its fair value. It also has unreported technology valued at $5 million. We can explain the $3 million excess over acquired book value as follows:
Price paid ��
Share of Rocky Mountain’s net assets acquired: Book value (30% 3 $30,000,000)�� Revaluation of plant and equipment (30% 3 $1,000,000) �� Unreported technology (30% 3 $5,000,000) ��
Goodwill ��

$12,000,000
$9,000,000
300,000
1,500,000

10,800,000
$ 1,200,000

Of the total $3 million excess cost, $1,800,000 (5 $300,000 1 $1,500,000) is explained by specific asset undervaluations. The remaining unexplained cost is attributed to goodwill, representing the additional cost not explained by underreported or unreported identifiable assets.
Rocky Mountain does not report depreciation or amortization of the additional assets embedded in
Coca-Cola’s investment cost, because these assets do not appear on Rocky Mountain’s books. CocaCola therefore adjusts its equity in the net income of Rocky Mountain for basis difference write-offs.
Equity in net income is adjusted for write-offs of identifiable assets, but any adjustment for goodwill impairment is prohibited.
Continuing Coca-Cola’s investment in 30 percent of Rocky Mountain Bottlers’ voting stock, assume that the revalued plant and equipment has a remaining life of 10 years as of January 2, 2016, straightline, and the previously unreported technology is a limited life intangible asset with a five-year life.
Coca-Cola’s 2016 equity in the net income of Rocky Mountain Bottlers is reduced by $30,000 in depreciation on the plant and equipment revaluation (5 $300,000/10) and by amortization of previously unreported technology of $300,000 (5 $1,500,000/5). In practice, however, the investor often attributes the excess cost entirely to goodwill. This shortcut avoids any income adjustments for revaluation write-offs.
Unconfirmed Inventory Profits An investor may sell inventory to its investee, termed downstream sales, or an investee may sell merchandise to the investor, termed upstream sales. Both companies record the sales on their own books as if they are selling to outside customers. If both companies sell the merchandise at a markup over cost, they will report a gross margin on these intercompany sales

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12

Chapter 1 • Intercorporate Investments: An Overview

as part of their income. However, if the merchandise is not yet sold to an unrelated outside party at yearend, this gross margin is not yet earned and must be removed when calculating equity in the net income of the investee.
Suppose that during 2016 Rocky Mountain Bottlers sells merchandise to Coca-Cola (upstream) at an average markup of 20 percent on cost. Coca-Cola still holds $210,000 of this inventory at year-end.
During 2016 Coca-Cola sells merchandise to Rocky Mountain (downstream) at an average markup of
25 percent on cost. Rocky Mountain holds $100,000 of this inventory at year-end. The total unconfirmed profit on the ending inventories is as follows:
Unconfirmed gross profit on $210,000 upstream sales: $210,000 2 $210,000/1.20 5 $35,000
Unconfirmed gross profit on $100,000 downstream sales: $100,000 2 $100,000/1.25 5 $20,000

Coca-Cola’s 2016 equity in the net income of Rocky Mountain Bottlers is reduced by $10,500 (5 30%
3 $35,000) and $6,000 (5 30% 3 $20,000). When the beginning inventories are sold to outside customers, the profit is confirmed and equity in net income is increased by $10,500 and $6,000.
To summarize, Coca-Cola’s equity in the 2016 net income of Rocky Mountain is calculated as follows:
Coca-Cola’s share of Rocky Mountain’s reported net income (30% 3 $2,000,000)��
Revaluation write-offs: Plant and equipment�� Previously unreported technology��
Unconfirmed inventory profits: Upstream sales�� Downstream sales��

$600,000

Equity in net income of Rocky Mountain��

$253,500

(30,000)
(300,000)
(10,500)
(6,000)

Coca-Cola’s end-of-year entry to recognize its share of Rocky Mountain’s income is:
2016

Dec. 31

Investment in Rocky Mountain Bottlers �� Equity in net income of Rocky Mountain Bottlers �� To accrue Coca-Cola’s share of the earnings of the investee.

253,500
253,500

The investment balance at year-end is $12,103,500 (5 $12,000,000 2 $150,000 1 $253,500).

Other Comprehensive Income and the Equity Method
Using the equity method, the investor reports its share of the investee’s performance each year on its own books. A company’s performance is measured by its income, which accumulates in retained earnings, but other elements of performance are reflected in other comprehensive income, which appears in its statement of comprehensive income and accumulates in AOCI. To fully report the investee’s performance, the investor adjusts its investment and other comprehensive income for its share of the investee’s yearly OCI.
Assume that in 2016 Rocky Mountain reported $200,000 in unrealized gains on AFS securities, its only OCI item. In addition to the entries above, Coca-Cola makes the following entry to reflect these gains:
2016

Dec. 31

Investment in Rocky Mountain Bottlers �� Unrealized gains on AFS investments (OCI)�� report 30% share of Rocky Mountain’s unrealized gains on AFS
To
securities.

60,000
60,000

Chapter 1 • Intercorporate Investments: An Overview

Impairment Testing
ASC para. 323-10-35-32 requires impairment testing of equity method investments. If the fair value of the investment declines below its carrying value, and the decline is judged to be other than temporary, the investment is written down and the loss appears on the investor’s income statement. Any subsequent increases in fair value are not reported.
Reporting Perspective
Typically the cost of equity method investments exceeds the underlying book value of the investee, because the investee has assets valued by the market but not reported on its balance sheet. When using the equity method, the investor identifies the specific assets that are undervalued or not reported on the investee’s books. The investor then reports equity in the net income of the investee as its share of the investee’s reported net income, adjusted for write-offs of those undervalued or unreported assets with limited lives. However, equity in net income is not adjusted for goodwill impairment.
Why is goodwill impairment not included when computing equity in net income? One logical explanation is that the impairment test for the investment as a whole reflects impairment losses in the investee’s goodwill. If the investment is subject to other-than-temporary impairment, expectations concerning the investee’s future performance have significantly declined. A financially distressed investee’s goodwill is therefore impaired.
In practice, investors typically attribute to goodwill the entire difference between book value and investment cost. Therefore they rarely adjust equity in net income for write-offs of basis adjustments, since goodwill is not amortized and the FASB prohibits adjustments for goodwill impairment. For example, Coca-Cola’s 2013 annual report states that at December 31, 2013, its investment in equity method investees exceeded its proportionate share of investee book value by $2,202 million, but the difference is not amortized.

B u si n e ss App l ic a ti o n Impairment Testing
In 2011, The Coca-Cola Company recorded $17 million in losses on its AFS securities, and a $41 million loss on one of its equity method investments. In 2012 and 2013, Coca-Cola held AFS investments whose cost exceeded fair value. However, it recorded no impairment losses on these securities, since management determined that the decline in value was not other than temporary. Note 1 to the 2013 financial statements describes Coca-Cola’s impairment testing.
Each reporting period we review all of our investments in equity and debt securities, except for those classified as trading, to determine whether a significant event or change in circumstances has occurred that may have an adverse effect on the fair value of each investment. When such events or changes occur, we evaluate the fair value compared to our cost basis in the investment. . . . The fair values of most of our investments in publicly traded companies are often readily available based on quoted market prices. For investments in nonpublicly traded companies, management’s assessment of fair value is based on valuation methodologies including discounted cash flows, estimate of sales proceeds and appraisals, as appropriate.
In the event the fair value of an investment declines below our cost basis, management determines if the decline in fair value is other than temporary. . . . Management’s assessment as to the nature of a decline in fair value is based on, among other things, the length of time and the extent to which the market value has been less than our cost basis, the financial condition and near-term prospects of the issuer, and our intent and ability to retain the investment for a period of time sufficient to allow for any anticipated recovery in market value.

Coca-Cola uses a variety of methods to measure the fair value of its investments, and forecasts the future financial condition of the investee and the investment holding period to determine if declines in value are other than temporary. Source: The Coca-Cola Company 2013 annual report.

13

14

Chapter 1 • Intercorporate Investments: An Overview

Joint Ventures
A joint venture is an entity formed by a group of individuals or firms that contribute resources and jointly share in managing and controlling the venture. Joint ventures are traditionally established to carry out a single business transaction or activity, often over a limited period of time. Frequently, the owners of a joint venture are themselves large firms, either partnerships or corporations. Participants form joint ventures for activities when it is mutually desirable to combine expertise, special technology, capital, or access to certain markets. Examples include research projects or development of new products, in which two areas of technology must be joined, and large-scale construction projects, in which the capital and facilities of two or more contractors are needed. Although joint ventures are frequently short-lived, they can last several years and their initial projects may lead to ongoing business activities.
We discussed Coca-Cola’s joint venture with Nestlé earlier in this chapter. This joint venture expands Coca-Cola’s markets internationally. U.S. companies follow the guidelines of ASC Topic 323: joint ventures give the investor significant influence and require use of the equity method.
Reporting Perspective
If two companies form a joint venture with equal interests, U.S. GAAP allows both companies to report the venture using the equity method. As a result, the separate assets and liabilities of the joint venture do not appear on any balance sheet. Each investor reports its interest as a one-line equity investment in the asset section of its balance sheet. Similarly, the separate revenues and expenses of the joint venture do not appear on any income statement. Each investor reports its equity in the joint venture’s net income on one line in its income statement.

Coca-Cola and Nestlé each have 50 percent ownership in Beverage Partners Worldwide (BPW).
Suppose Coca-Cola instead had 60 percent ownership, and Nestlé 40 percent, and that Coca-Cola now controls BPW. Nestlé would continue to account for its investment using the equity method, assuming it retained significant influence over BPW. Coca-Cola, on the other hand, would consolidate BPW on its financial statements. Consolidation involves combining the separate assets, liabilities, revenues and expenses of BPW with Coca-Cola’s own accounts on its financial statements. The next section introduces reporting for controlling equity investments.

Review 2 • Reporting for Equity Method Investments
On January 5, 2017, Fizzy Cola Corporation, headquartered in Minneapolis, MN, acquires 25 percent of the voting stock of Armadillo Bottlers, located in Austin, TX, to support expansion in southwestern U.S. markets.
Fizzy Cola pays $15 million in cash for the stock. Armadillo’s book value is $20 million at the acquisition date, and its assets and liabilities are fairly stated except for unreported customer-related intangible assets valued at $10 million, with average expected lives of five years. In 2017, Armadillo reports net income of $3 million. Armadillo sells canned and bottled beverages to Fizzy Cola at a markup of 30 percent on cost. Fizzy
Cola sells syrup to Armadillo at a markup of 20 percent on cost. At December 31, 2017, Fizzy Cola’s inventory includes $325,000 in merchandise acquired from Armadillo. Armadillo’s inventory includes $480,000 in merchandise purchased from Fizzy Cola. Armadillo declares and pays total cash dividends of $500,000 on
December 1, 2017. Fizzy Cola accounts for its investment in Armadillo using the equity method.
Required: Prepare Fizzy Cola’s entries to record the above information for 2017.
Solutions are located after the chapter assignments.

Chapter 1 • Intercorporate Investments: An Overview

15

Controlling Investments
Investments in other companies may give the investor control over the operating and financial decisions of the investee. The investment structures may take different forms, as follows:

• Merger, consolidation, or asset acquisition, where the investor directly acquires the assets and

liabilities of the investee. Mergers occur when the investor acquires the investee and becomes the remaining legal entity. In a consolidation, a new entity is formed to acquire both the investor and investee. In asset acquisitions, the investor acquires a subset of the investee’s assets.
• Stock acquisition, where the investor acquires a controlling interest in the voting stock of the investee. • Variable interest entity, where the investor may not hold the investee’s stock, but legal agreements give it the power to direct the investee’s activities, the obligation to absorb its losses and the right to receive its benefits. The investee’s actual equity holders do not have the usual rights and responsibilities pertaining to equity ownership.
Investors should be able to evaluate a company’s complete financial performance by looking at its financial statements. If the company controls the resources of another company, investors should see the results of decisions affecting these resources in the controlling company’s financial statements. Therefore, regardless of the investment structure used to obtain control, reporting policies are generally the same—the assets, liabilities, revenues and expenses of the controlled investee are combined with those of the investor for presentation in its financial statements.

Mergers, Consolidations, and Asset Acquisitions
When the investor acquires the assets and liabilities of the investee, it records these assets and liabilities directly on its books at fair value. Consider again Coca-Cola’s acquisition of Rocky Mountain Bottlers, but assume Coca-Cola acquires all of Rocky Mountain’s assets and liabilities in a merger. Information on this acquisition is in Exhibit 1.2 below.
Exhibit 1.2 Coca-Cola’s Acquisition of Rocky Mountain Bottlers Coca-Cola pays $40,000,000 in cash to acquire the assets and liabilities of Rocky Mountain Bottlers on January 2,
2016. Fair values of Rocky Mountain’s reported assets and liabilities on that date are as follows:

Rocky Mountain Bottlers

Fair value

Current assets��
Plant and equipment��
Current liabilities��
Long-term liabilities��

$20,000,000
61,000,000
15,000,000
35,000,000

Coca-Cola identified and valued Rocky Mountain’s previously unreported intangible assets as follows:
Technology��

$ 5,000,000

The acquisition price is analyzed as follows:
Price paid ��
Fair value of identifiable net assets acquired: Current assets�� Plant and equipment�� Technology �� Current liabilities �� Long-term debt��
Goodwill ��

$40,000,000
$20,000,000
61,000,000
5,000,000
(15,000,000)
(35,000,000)

36,000,000
$ 4,000,000

LO3 Describe the reporting for controlling interests in other companies. 16

Chapter 1 • Intercorporate Investments: An Overview

Coca-Cola makes the following January 2 entry on its books:
Current assets��
Plant and equipment��
Technology��
Goodwill �� Current liabilities�� Long-term debt�� Cash�� To record the acquisition of Rocky Mountain Bottlers for $40,000,000 in cash.

20,000,000
61,000,000
5,000,000
4,000,000
15,000,000
35,000,000
40,000,000

Coca-Cola records Rocky Mountain’s assets and liabilities directly on its books, at date-ofacquisition market values. Rocky Mountain ceases to exist as a separate entity, and Coca-Cola reports
Rocky Mountain’s subsequent activities directly in its own financial records.

Stock Acquisitions
When an investor obtains control over another company by investing in its voting stock, the investor is known as the parent, the acquired company is the subsidiary, and the two companies remain as separate legal entities, recording transactions on their own books. At the end of each reporting period, the accountant consolidates the separate financial records of the parent and subsidiary for presentation in the annual report. Suppose Coca-Cola acquires and holds all of the voting stock of Rocky Mountain Bottlers, paying the former stockholders of Rocky Mountain $40,000,000 cash. Coca-Cola makes the following entry on its own books:
Investment in Rocky Mountain Bottlers �� Cash�� To record acquisition of all Rocky Mountain’s stock for $40,000,000 cash.

40,000,000
40,000,000

Rocky Mountain Bottlers continues to exist as a separate entity, and reports its financial activities on its own books. At the end of each reporting period, a consolidation working paper is used to combine the financial results of Coca-Cola and Rocky Mountain, as if Coca-Cola had reported Rocky Mountain’s acquired assets and liabilities, and subsequent activities, directly on its books. Chapters 3 through 6 discuss this process.

Variable Interest Entities
Variable interest entities (VIEs) are similar to stock acquisitions, in that the investee is a separate legal entity controlled by another company. However, control occurs through legal relationships rather than stock ownership. Two reporting questions arise: (1) Is the entity a variable interest entity, and
(2) must the investor consolidate the entity with its own financial statements? Chapter 3 provides detailed answers to these questions. The following discussion is a brief introduction.
According to ASC para. 810-10-15-14, if the entity must obtain guarantees from other parties in order to obtain financing, or if the equity holders do not have the usual rights and responsibilities pertaining to equity ownership, such as voting rights and the right to residual returns, the entity is a
VIE. A common example is a leasing arrangement where a company creates a separate legal entity to purchase long-term assets, funded by loans guaranteed by the company. That entity leases the assets to the company, and uses the lease payments to pay interest and principal on the debt. The entity has a small outside equity ownership, but rights to dividends or returns in liquidation may be contractually guaranteed or limited, leaving the equity owners with rights similar to debtholders. The question is whether the entity can finance its activities without additional support, such as guaranteed loans or future funding commitments, from affiliated entities. If not, the entity is a VIE.
ASC para. 810-10-25-38A requires the entity that has the power to direct the VIE’s activities, absorbs the majority of the VIE’s expected losses and/or receives a majority of the VIE’s residual gains, to consolidate the VIE. Consolidation procedures parallel those for stock investments.

Chapter 1 • Intercorporate Investments: An Overview

17

International Financial Reporting Standards
For Intercorporate Investments
International Financial Reporting Standards (IFRS) for intercorporate investments are found in the following pronouncements:

• IAS 28, Investments in Associates
• IAS 39, Financial Instruments: Recognition and Measurement
• IFRS 3(R), Business Combinations
• IFRS 9, Financial Instruments
• IFRS 10, Consolidated Financial Statements
• IFRS 11, Joint Arrangements

In light of the 2008 credit crisis, both the FASB and the IASB recently proposed significant changes in reporting for investments in debt and equity securities that do not involve significant or controlling interests. The IASB’s financial instruments project has three phases: classification and measurement, impairment, and hedge accounting. The classification and measurement phase was completed in 2009, with the issuance of IFRS 9. The guidance in the other two phases will be added to IFRS 9 as they are completed. Although IFRS 9 will eventually replace IAS 39, its effective date has been delayed since the impairment and hedge accounting phases are not yet complete. As of 2014, the standard becomes effective in 2018. The discussion below includes current IAS 39 guidance as well as IFRS 9 requirements.
The IASB also changed the requirements for joint ventures (IFRS 11) and for deciding when to consolidate an equity investment (IFRS 10). Both of these standards became effective in 2013, and the discussion below reflects their requirements.

Marketable Debt and Equity Investments
IFRS for marketable investments in debt and equity securities, found in IAS 39, generally parallel current U.S. GAAP. Investments are classified as trading, available-for-sale, and held-to-maturity. Trading and available-for-sale securities are reported at fair value, with unrealized gains and losses on trading securities reported in income, and unrealized gains and losses on available-for-sale securities reported in equity until the securities are sold. Held-to-maturity debt securities are carried at amortized cost.
Following both U.S. GAAP and IFRS, securities classified as available-for-sale are reported at fair value through OCI. Unrealized gains and losses are reported in OCI and reclassified to income when the securities are sold. U.S. companies must report OCI items by type, and disclose actual reclassifications separately by type. Unlike U.S. GAAP, IFRS requires that OCI items be classified according to whether or not they can be reclassified to income or if they remain in AOCI indefinitely.
IFRS for impairment losses focuses on specific objective evidence of the decline in fair value, citing observance of particular “loss events,” such as a decline in credit rating or if the investee misses scheduled debt payments. U.S. GAAP requires loss recognition when the decline is “other than temporary,” which may involve more judgment. Unlike U.S. GAAP, IFRS allows impairment losses on held-tomaturity debt investments to be reversed, thereby increasing income, if a subsequent event reduces the previously recognized impairment loss. The maximum impairment reversal is the amount that increases book value to amortized cost without impairment. Like U.S. GAAP, IFRS does not allow reversal of impairment losses on equity investments.
IFRS 9 changes the measurement and classification of financial assets that do not give the investor significant influence or control over the investee. The default for all investments in marketable debt and equity financial instruments is to report these investments at fair value, with all value changes reported in income (FV-NI). Changes in the value of equity investments not held for trading may be reported in other comprehensive income (FV-OCI). The gains and losses reported in OCI are not reclassified to income when realized. Debt instruments held for principal and interest payments, with no intent to sell, may be reported at amortized cost.
A 2013 IASB Exposure Draft addresses recognition of credit losses on investments in financial instruments. Current IAS 39 guidance looks to “loss events” to identify when impairment losses should be reported. No losses are reported until a loss event occurs. The proposal requires continuing

LO4 Discuss
International
Financial Reporting Standards (IFRS) for intercorporate investments.

18

Chapter 1 • Intercorporate Investments: An Overview

recognition of expected credit losses, measured as the present value of expected payment defaults. The proposal therefore should lead to more timely recognition of impairment losses. However, loss recognition differs depending on if the financial instrument has “significantly deteriorated” or not. The loss is based on lifetime losses only if there is significant deterioration of credit quality. If not, the loss is based on expected credit losses over the next twelve months. The FASB proposal looks at lifetime expected losses for all investments. The FASB proposal would likely require earlier recognition of credit losses.
As of 2014, no convergence between U.S. GAAP and IFRS has been achieved on this topic.

Investments with Significant Influence
IFRS for investments providing the investor with a significant influence over the investee are found in
IAS 28. The investee in this case is defined as an associate. Circumstances that indicate significant influence, can take one of the following forms (para 7):

• representation on the board of directors or equivalent governing body of the investee;
• participation in the policy-making process;
• material transactions between the investor and the investee;
• interchange of managerial personnel; or
• provision of essential technical information.

IFRS requires the equity method for significant influence investments, using procedures very similar to
U.S. GAAP. IAS 36 and IAS 39 provide guidance for impairment recognition. IAS 39 states that impairment testing is performed if one or more significant events occur that indicate the investment has become impaired. The quantitative impairment test, found in IAS 36, compares the investment’s book value to its recoverable amount, which is the higher of its market value or value-in-use. Value-in-use is the present value of the investment’s future expected cash flows while held by the investor. Current U.S. GAAP requires impairment recognition only when the decline in value is other than temporary. This difference in criteria is likely to result in differences in impairment loss recognition between IFRS and U.S. GAAP.

Joint Ventures
IFRS 11 defines joint arrangements as investments in which contractual agreements require the investors to unanimously consent to decisions concerning the investee. For example, if decisions regarding the activities of an entity are made by majority vote, and two parties each have a 50 percent interest in the entity, it is a joint arrangement. Joint arrangements may be joint operations or joint ventures, with joint operations giving the investors rights to the entity’s individual assets and obligations for its liabilities, and joint ventures giving the investors rights to the entity’s net assets. Most joint arrangements are joint ventures, involving rights to the entity’s returns and amounts received on disposal. Similar to U.S. GAAP,
IFRS 11 requires that joint ventures be reported using the equity method.

Controlling Investments
IFRS 3(R), “Business Combinations,” describes IFRS for assets and liabilities acquired in mergers, consolidations, and asset acquisitions, and consolidation of controlling stock investments. These standards are similar to U.S. GAAP.
IFRS for determining when an entity should be consolidated are in IFRS 10, “Consolidated Financial Statements.” This standard applies to any entities with which the reporting entity has a relationship, whether it involves ownership of stock or some sort of contractual relationship. IFRS 10 requires consolidation of an entity when it controls the entity. Control occurs when the investor has all of the following (IFRS 10, para 7):

• power over the investee—the investor has existing rights that give it the ability to direct the activities that significantly affect the investee’s returns
• exposure, or rights, to variable returns from its involvement with the investee
• the ability to use its power over the investee to affect the amount of the investor’s returns.

Chapter 1 • Intercorporate Investments: An Overview

The IFRS consolidation standard requires qualitative analysis of the reporting entity’s relationship with another entity. Although U.S. GAAP is also based on the concept of control, U.S. GAAP is more likely to focus on the “bright line” of majority equity ownership. There is also a separate set of conditions for consolidation of entities controlled through legal relationships. As a result, IFRS and U.S.
GAAP can disagree on whether a particular entity should be consolidated.
B u si n e ss App l ic a ti o n Orange S.A.
Orange S.A. (formerly France Telecom) is an international telecommunications company with headquarters in France. Its 2013 annual report lists the following major interests in associates and joint ventures:

% interest

Country of operation Deutsche Telekom (50%)
Groupe Caisse de Dépôt et de Gestion (30%),
Groupe FinanceCom (30%)

50%
40%

UK
Morocco

Agility (24%), CS Ltd (56%)

20%

Iraq

Entity

Co-shareholder(s)

EE
Médi Telecom
Korek Telecom

Orange reports investments in associates on its balance sheet as a noncurrent asset, totaling €6,525 million at December 31, 2013. Orange reported impairment losses of €186 million in 2013, mostly related to Médi Telecom. Once a loss event is identified, book value is compared to value-in-use, measured as the present value of future expected cash flows generated by the associate. Orange’s strategic business planning process is used to generate expected future cash flows. Orange discloses the key assumptions used in this calculation:
Basis of recoverable amount��
Source used ��
Methodology��
Growth rate to perpetuity ��
Post-tax discount rate��
Pre-tax discount rate��

Value-in-use
Internal plan
Discounted cash flow
1.0%
7.8%
9.0%

In 2012, Orange used a post-tax discount rate of 8.0% and a pre-tax discount rate of 9.7% to measure its associates’ value-in-use. Small changes in discount rates can have significant effects on present value. As Orange’s auditor, how would you evaluate the appropriateness of the discount rates used to measure impairment? Source: Orange 2013 annual report.

Review of Key Concepts
Describe the reporting for trading, available-for-sale, and held-to-maturity intercorporate investments. (p. 5)

Investments in securities held for income and value increases are classified as trading, available-for-sale, and held-to-maturity. Trading and available-for-sale investments in debt and equity securities appear on the balance sheet at fair value. Unrealized gains and losses on trading securities are reported in income. Unrealized gains and losses on AFS debt and equity securities are reported in other comprehensive income, and are reclassified to income when the securities are sold. Held-to-maturity debt securities are reported at amortized cost. AFS and HTM securities are regularly tested for impairment. The FASB is currently deliberating significant changes in standards for financial instruments.

Explain the reporting for equity method intercorporate investments. (p. 9) The equity method is used to report equity investments that enable the investor to significantly influence the investee’s operating and financial decisions. The investor’s equity in the investee’s net income or loss appears on the investor’s income statement, increasing or decreasing the investment balance, and dividends received reduce the balance. Equity in the investee’s net income is the investor’s share of the investee’s reported income, net of amortization of the excess of investment cost over the investee’s book value and unconfirmed profits on intercompany transactions. Other-than-temporary

LO 1

LO 2

19

20

Chapter 1 • Intercorporate Investments: An Overview

impairment losses are reported in income. Some companies pool resources and create a business enterprise to complete a particular project or expand into new markets. This enterprise is a joint venture if control is shared by the participating companies. Investors use the equity method to report joint ventures.

LO 3

LO 4

Describe the reporting for controlling interests in other companies. (p. 15) Controlling investments in other companies take the form of mergers, consolidations, asset acquisitions, stock investments, and variable interest entities. The acquisition structures of mergers, consolidations and asset acquisitions differ, but they all involve investors acquiring the assets and liabilities of another company. The investor reports each acquired asset and liability at fair value. With controlling stock investments and variable interest entities controlled through legal financial agreements, the investor and investee remain legal entities with separate books, and the investor accounts for its investment as a noncurrent asset on its own books. Consolidation procedures bring the financial statements of the investor and investee together at the end of each reporting period for external reporting purposes.

Discuss International Financial Reporting Standards (IFRS) for intercorporate investments. (p. 17)

International Financial Reporting Standards (IFRS) for intercorporate investments currently parallel U.S.
GAAP on many dimensions. Criteria for impairment loss recognition differ, and in some cases IFRS allows reversal of impairment losses. The decision to use the equity method of reporting focuses on whether the investor has significant influence. The decision to consolidate the investee under IFRS depends on whether the investor controls the investee. IFRS 9, effective in 2018, significantly changes financial instrument classification, valuation, and impairment recognition. in the margin are available in
Assignments with the
See the Preface of the book for details.

.

Multiple Choice Questions
U
se the following information to answer questions 1–4:

On January 1, 2016, a company’s balance sheet reports its investments in financial instruments as follows:
Assets
Investment in trading securities ��
Investment in AFS securities��
Investment in HTM securities��

$160,000
100,000
207,544

Equity
Accumulated other comprehensive income: Unrealized gains (losses) on AFS securities ��

$ 4,000

A dditional information:
a. The HTM securities are $200,000 face value debt securities purchased on January 1, 2014, at a yield of
4%. The securities have a 4-year total life and pay interest annually on December 31, at a coupon rate of 6%.
b. The trading securities on hand on January 1 were sold in 2016 for $180,000.
c. More trading securities were purchased for $100,000. They are still on hand at December 31, 2016, and have a fair value of $125,000.
d. AFS securities, originally purchased for $26,000 with a carrying value of $25,000 as of January 1, 2016, were sold for $29,000.
e. AFS securities on hand at December 31, 2016, have a fair value of $81,000.
LO 1

1. The total gain on trading securities reported on the 2016 income statement is
a.
b.
c.
d.

LO 1

$20,000
$25,000
$45,000
$60,000

2. The gain on AFS securities reported on the 2016 income statement is
a.
b.
c.
d.

$ 3,000
$ 4,000
$ 9,000
$10,000

Chapter 1 • Intercorporate Investments: An Overview

3. Investment in HTM securities reported on the December 31, 2016 balance sheet is
a.
b.
c.
d.

LO 1

$203,846
$204,938
$207,544
$207,997

4. What is the amount of the net gain related to AFS securities reported on the 2016 Statement of Comprehensive Income?
a.
b.
c.
d.

$1,000
$5,000
$6,000
$7,000

5. ABC Company uses the equity method to account for its 40% interest in the voting stock of XYZ Company.

ABC paid $5,000,000 for the investment at the beginning of the current year, and XYZ’s total book value at the time was $6,000,000. The discrepancy between acquisition cost and share of book value acquired was attributed to goodwill. XYZ reported income of $600,000 and paid dividends of $200,000 during the year.
ABC will report its investment in XYZ on its end-of-year balance sheet at what amount?
a.
b.
c.
d.

stock of another company, following U.S. GAAP and IFRS?
U.S. GAAP

Other than temporary impairment
Book value > higher of market value or value-in-use
Not reported
If a “loss event” occurs

an amount equal to 35% of National’s book value. Fizzy reports its investment using the equity method. In
2017, National reported net income of $7,000,000 and declared and paid dividends of $2,000,000. National sells product to Fizzy at a markup of 25% on cost. Fizzy had $6,000,000 of product purchased from National in its ending inventory, measured at cost to Fizzy. What is Fizzy’s Investment in National balance reported on its December 31, 2017 balance sheet?

LO 2

$50,000,000
$51,330,000
$52,030,000
$51,750,000

8. Fizzy Cola acquires Juicee Ltd. for $25,000,000 in cash, and accounts for its investment as a merger. Juicee’s balance sheet at the date of acquisition is as follows:
Current assets . . . . . . . . . . . . . . . . . . . . .
Property, net . . . . . . . . . . . . . . . . . . . . . .

$ 100,000
4,000,000

Liabilities . . . . . . . . . . . . . . . . . . . . . . .
Equity . . . . . . . . . . . . . . . . . . . . . . . . .

$3,000,000
1,100,000

Total . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

$4,100,000

Total . . . . . . . . . . . . . . . . . . . . . . . . . . .

$4,100,000

The fair value of Juicee’s current assets is $75,000 less than book value. The fair value of its property is

$1,500,000 less than book value. The book value of its liabilities approximates fair value. There are no unreported assets or liabilities. How much goodwill does Fizzy report for this acquisition?
a.
b.
c.
d.

LO 2, 4

IFRS

Book value > higher of market value or value-in-use
Other than temporary impairment
If a “loss event” occurs
Other than temporary impairment

7. Fizzy Cola acquired 35% of the voting stock of National Bottlers on January 1, 2017, at a cost of $50,000,000,

a.
b.
c.
d.

LO 2

$4,920,000
$5,240,000
$5,000,000
$5,160,000

6. Under current standards, when is an impairment loss reported on a significant influence investment in the
a.
b.
c.
d.

LO 1

$19,475,000
$22,325,000
$22,475,000
$25,475,000

LO 3

21

22

Chapter 1 • Intercorporate Investments: An Overview

LO 4

9. Under IFRS 9, companies that invest in equity securities will be able to generally choose from which of the following options for reporting their investment?
a.
b.
c.
d.

LO 4

FV-NI only
FV-NI or FV-OCI
Amortized cost or FV-NI
Amortized cost or FV-OCI

0. Following both U.S. GAAP and IFRS, when should a company use the equity method to report an intercor1 porate investment?
a.
b.
c.
d.

The company significantly influences the decisions of the investee.
The investee is the company’s major supplier.
The company owns 20–50% of the investee’s voting stock.
The company is holding the investment in its long-term portfolio.

Exercises
LO 1

E1.1

The Coca-Cola
COmpany

Required
a. How much did Coca-Cola pay for the trading securities reported on its 2013 balance sheet?
b. Where are unrealized gains and losses on trading securities reported in Coca-Cola’s financial statements? c. Assume the trading securities on hand at the end of 2013 were acquired during 2013. Prepare the summary journal entries made by Coca-Cola to record events related to these trading securities.
d. Assume the securities are sold for $370 million in 2014. Prepare the journal entry to record the sale.

[KO]

LO 1

Investment in Trading Securities The Coca-Cola Company’s December 31, 2013, balance sheet reports investments in trading securities at $372 million, with net unrealized gains of $12 million.

E1.2

Investment in Trading and AFS Securities In 2016, a company purchases securities at a cost of $450,000. Their year-end value is $475,000. In 2017, these securities are sold for $460,000 and new securities are purchased for $610,000. At the end of 2017, the securities have not yet been sold, and have a value of $580,000.
Required
Prepare the journal entries to record the above information for 2016 and 2017, assuming that:
a. The securities are categorized as trading securities.
b. The securities are categorized as AFS securities, and the securities on hand at the end of 2017 are considered (1) not impaired, or (2) impaired.

LO 1

E1.3

Held-to-Maturity Investments On January 1, 2016, a company pays $5,222,591 for a 5-year corporate bond with a face value of $5 million. The bond pays interest at 5 percent on December 31 of each year, and the principal is due on December 31, 2020. The investment yields a 4 percent compound annual return to maturity. The company classifies the bond as a held-to-maturity investment.
Required
Prepare the journal entries to record the investment on January 1, 2016, receipt of the interest payments on December 31 of each year 2016 through 2020, and receipt of the bond principal on December 31,
2020, using the effective interest method.

LO 1

E1.4

Investment in Trading, AFS and HTM Securities Zyggy Corporation has the following investment activity during 2015, 2016, and 2017:

• Purchased trading investment of $200,000 in the stock of Allen Corporation on February 3, 2015. The investment was sold on June 18, 2015, for $210,000.
• Purchased trading investment of $400,000 in the stock of Becker Corporation on October 29, 2015.
The investment had a December 31, 2015, fair value of $380,000 and was sold on March 1, 2016, for
$405,000.

Chapter 1 • Intercorporate Investments: An Overview

• Purchased AFS investment of $600,000 in the stock of Corey Corporation on November 1, 2015.
•
•

Its fair value on December 31, 2015 and 2016 was $640,000 and $510,000, respectively. The 2016 decline in value was determined to be other than temporary. The investment was sold on February 15,
2017, for $500,000.
Purchased AFS investment of $500,000 in the stock of Donata Corporation on April 4, 2017. Its fair value on December 31, 2017, was $535,000.
Purchased HTM investment on January 2, 2016, of $194,449 in Eiffel Corporation’s $200,000 face value, 3 percent bond, yielding 4 percent to maturity, interest paid annually on December 31. On
December 31, 2017, the fair value of the bond is $150,000, and the decline is determined to be other than temporary.

Required
For each of the above investments, prepare the journal entries and determine the accounts and balances reported on Zyggy’s December 31, 2015, 2016, and 2017 balance sheets and its 2015, 2016, and 2017 income statements and statements of comprehensive income.

E1.5

Equity Method Investment with Intercompany Sales The Coca-Cola Company owns 28 percent of the voting stock of Coca-Cola FEMSA, acquired at book value. Assume that Coca-Cola FEMSA reports income of $5 million for 2016. Coca-Cola FEMSA regularly sells canned beverages to Coca-Cola at a markup of 35 percent on cost. During 2016 Coca-Cola FEMSA’s sales to Coca-Cola totaled $25 million. Coca-Cola’s January 1, 2016, inventories include $1,350,000 purchased from Coca-Cola FEMSA.
Coca-Cola’s December 31, 2016, inventories include $1,215,000 purchased from Coca-Cola FEMSA.

LO 2

Required
Prepare the 2016 journal entry on Coca-Cola’s books to recognize its income from Coca-Cola FEMSA under the equity method.

E1.6

Equity Method Investment with Cost in Excess of Book Value Revco Corporation purchases
40 percent of the voting stock of Ronco Pharmaceuticals on January 1, 2016, for $15 million in cash.
Ronco’s book value at the date of acquisition is $6 million. Investigation reveals that Ronco’s reported patents (10-year life) are undervalued by $1 million and it has unreported technology (5-year life) valued at $2 million. Ronco pays dividends of $250,000 and reports net income of $900,000 for 2016.

LO 2

Required
Prepare the journal entries on Revco’s books to report the above information assuming Revco accounts for its investment in Ronco using the equity method. At what amount does Revco report the investment in Ronco on its December 31, 2016, balance sheet?

E1.7

Equity Method and Other Comprehensive Income Mitchell Corporation pays $6 million to acquire a 25 percent interest in Turner Corporation’s stock on January 1, 2017, and reports the investment using the equity method. Any basis difference is attributed to goodwill. During 2017, Turner reports net income of $900,000, which includes $25,000 in realized and unrealized gains on trading securities and
$40,000 in realized gains on sales of AFS securities. Turner also reports $30,000 in unrealized losses on
AFS securities and pays dividends of $240,000 in 2017.

LO 2

Required
Prepare Mitchell’s journal entries to record the above events for 2017.

E1.8

Equity Method Investment Cost Computation Traynor Corporation reports its 40 percent investment in Victor Company on its December 31, 2017 balance sheet at $14,608,000. Traynor acquired its interest in Victor on January 2, 2015 and uses the equity method to account for the investment. Victor’s assets and liabilities were fairly stated on January 2, 2015 except for unreported technology (5-year life) of $4 million. Victor reported net income of $1.2 million, $1.5 million, and $1.4 million, and paid dividends of $200,000, $250,000, and $230,000 in 2015, 2016, and 2017, respectively.

LO 2

Required
How much did Traynor Corporation pay for its investment in Victor Company on January 2, 2015?

E1.9 Joint Venture On January 2, 2017, Adena Corporation and Dillon Company form a joint venture to develop a new product. Each contributes $2.5 million and has a 50 percent interest in the venture. At
December 31, 2017, the joint venture’s balance sheet is as follows (in millions):

LO 2

23

24

Chapter 1 • Intercorporate Investments: An Overview
Cash ��
Equipment��

$ 1.8
12.2

Debt��
Equity ��

$ 8.4
5.6

Total��

$14.0

Total��

$14.0

The joint venture reported net income of $600,000 during 2017. Each investor uses the equity method to report its interest in the joint venture.
Required
Show how the joint venture is reported on each investor’s financial statements for 2017. Where are the joint venture’s individual assets and liabilities reported by the venturers?
LO 2

E1.10 Equity Method Investment with Basis Differences Several Years Later Saxton Corporation

purchased 25 percent of Taylor Company’s voting stock on January 1, 2013, for $3 million in cash. At the date of acquisition, Taylor reported its total assets at $60 million and its total liabilities at $56 million.
Investigation revealed that Taylor’s plant and equipment (15-year life) was overvalued by $1.8 million and it had an unreported customer database (2-year life) valued at $500,000. Taylor declares and pays
$100,000 in dividends and reports net income of $250,000 in 2016.
Required
Prepare the necessary journal entries on Saxton’s books to report the above information for 2016 assuming Saxton uses the equity method to report its investment.

LO 3

E1.11 Merger and Stock Investment (see related E1.10) Saxton Corporation purchases all of Taylor

Company’s assets and liabilities on January 1, 2013, for $12 million in cash. At the date of acquisition,
Taylor’s reported assets consist of current assets of $10 million and plant and equipment of $50 million.
It reports current liabilities of $16 million and long-term debt of $40 million. Investigation reveals that
Taylor’s plant and equipment is overvalued by $1.8 million and it has an unreported customer database valued at $500,000.
Required
a. Prepare the necessary journal entry on Saxton’s books to record its acquisition of Taylor on January
1, 2013.
b. Assume that Saxton purchases all of Taylor’s voting stock on January 1, 2013, for $12 million in cash. Prepare the necessary journal entry on Saxton’s books to record the acquisition.

LO 3

E1.12 Merger Organic Juices, Inc. acquires Healthy Snax Corporation for $100 million in cash, in a merger.
Healthy Snax’s balance sheet at the date of acquisition is as follows (in millions):
Current assets��
Plant and equipment��
Intangible assets��

$10
65
5

Current liabilities��
Long-term debt��
Capital stock��
Retained earnings��
Treasury stock��

$12
36
18
24
(10)

Total assets��

$80

Total liabilities and equity ��

$80

A consulting firm values Healthy Snax’s plant and equipment at $20 million and its reported intangibles at $15 million. Due to declining interest rates, long-term debt has a fair value of $38 million. There are no unreported identifiable intangibles, and all other assets and liabilities are reported at amounts approximating fair value.
Required
Prepare the journal entry Organic Juices makes to record its acquisition of Healthy Snax.
LO 1

E1.13 Investment in AFS Securities The following information appears on Anderson Corporation’s balance sheet at December 31, 2017, with comparative information for December 31, 2016:

Chapter 1 • Intercorporate Investments: An Overview

2017
Noncurrent assets: AFS securities��
Equity:
Accumulated other comprehensive income (AOCI) Unrealized gains (losses) on AFS securities��

2016

$460,000

$500,000

(50,000)

(60,000)

Anderson’s 2017 income statement reports the following:
Losses on sale of AFS securities ��

20,000

Anderson’s 2017 statement of comprehensive income reports the following information:
Unrealized gains on AFS securities��
Reclassification of unrealized gains on AFS securities��

15,000
(5,000)

Anderson did not make any new investments in AFS securities in 2017.
Required
a. Calculate the original cost of the AFS securities held on December 31, 2017.
b. Calculate the cash Anderson received on the sale of AFS securities in 2017.

E1.14 Impairment of AFS and HTM Investments, U.S. GAAP and IFRS Assume The Coca-Cola
Company reports the following investments at December 31, 2016, prior to any required end-of-year valuation adjustments:
Investment in equity securities��
Investment in debt securities ��

LO 1, 4

$1,500,000
600,000

Coca-Cola classifies its investment in equity securities as AFS, and its investment in debt securities as
HTM. The December 31, 2016, fair value of the equity securities is $1,000,000, and the fair value of the debt securities is $400,000. The equity securities were originally purchased for $1,600,000.
Required
a. Record any required journal entries to reflect fair values at year-end, assuming the investments are
(1) not impaired, and (2) impaired, following U.S. GAAP.
b. If Coca-Cola follows IFRS, are there any differences in how the value changes are recorded? Are there differences in the decision to treat an investment as impaired? Explain.
c. It is now December 31, 2017. Coca-Cola still holds both investments. The fair value of the equity securities is $1,400,000 and the fair value of the debt securities is $640,000. On an amortized cost basis, the debt securities balance would be $590,000 if no impairment loss had been recorded. Record any required journal entries at year-end, following (1) U.S. GAAP, and (2) IFRS, assuming the securities were impaired in 2016.

E1.15 Consequences of Investment Reporting Choices Assume The Coca-Cola Company acquires all of the stock of Bubbly Bottler on January 1, 2016, at a cost of $950 million in cash. Bubbly’s balance sheet on that date is as follows (in millions):
Tangible assets��

$1,000

Liabilities��
Equity ��

$ 900
100

Total assets��

$1,000

Total liabilities and equity ��

$1,000

LO 2, 3

25

26

Chapter 1 • Intercorporate Investments: An Overview

Bubbly’s tangible assets and liabilities are reported at amounts approximating fair value, and the excess paid over book value is attributed entirely to goodwill.
Required
a. Assume that Coca-Cola reports its investment in Bubbly as a significant influence investment, because although it owns all of Bubbly’s stock, the decision-making structure at Bubbly does not allow
Coca-Cola to control Bubbly. How does Coca-Cola record the investment at January 1, 2016?
b. Now assume that Coca-Cola controls Bubbly and reports the acquisition as a merger. How does
Coca-Cola record the investment at January 1, 2016?
c. Assume Coca-Cola’s balance sheet just prior to the acquisition consists of $80,000 million in assets and $20,000 million in liabilities. Calculate Coca-Cola’s leverage, measured as total liabilities divided by total assets, if Coca-Cola reports its investment in Bubbly as a significant influence investment and as a merger.
d. Which reporting choice allows Coca-Cola to appear more financially viable? As Coca-Cola’s auditor, how do you evaluate Coca-Cola’s reporting choice?

Problems
LO 1

P1.1

Investments in Trading and AFS Securities A company has the following investment activity during 2016 and 2017:

Security
A ��
B ��
C ��
D ��
E ��
F ��

Type

Date of
Acquisition

Cost

Fair value at
12/31/16

Date of
Sale

Selling
Price

Fair value at
12/31/17

Trading
Trading
Trading
AFS
AFS
AFS

3/5/16
7/14/16
9/1/17
8/2/16
11/20/16
4/6/17

$350,000
225,000
400,000
175,000
300,000
710,000

N/A
$252,000
N/A
190,000
250,000
N/A

6/3/16
1/15/17
N/A
4/2/17
N/A
N/A

$325,000
235,000
N/A
213,000
N/A
N/A

N/A
N/A
$410,000
N/A
215,000
690,000

Security E is impaired in 2017, but is not impaired in 2016. Security F is not impaired in 2017.
Required
a. Prepare the journal entries to record the above information for 2016 and 2017, assuming the company’s reporting year ends December 31.
b. Show how this information is presented in the company’s balance sheet, income statement, and statement of comprehensive income for 2016 and 2017.
LO 1

P1.2

Held-to-Maturity Intercorporate Debt Investments On January 2, 2016, a U.S. company invests in the following corporate debt securities, classified as held-to-maturity per ASC Topic 320:
1. 5-year $1,000,000 face value corporate bond paying 6 percent interest annually on December 31.
The bond is priced to yield 5 percent to maturity.
2. 4-year $500,000 face value corporate bond paying 4 percent interest annually on December 31. The bond is priced to yield 5 percent to maturity.
Required
a. Calculate the cost of each investment.
b. Calculate interest income for 2016 and 2017.
c. At what value are these investments reported on the company’s December 31, 2018, balance sheet?
d. On December 31, 2019, the company determines that an impairment loss should be reported on the
$1,000,000 bond. What factors indicate impairment loss? If the bond is estimated to have a value of
$500,000 on December 31, 2019, what is the amount of the impairment loss, and where will it be reported on the 2019 financial statements?

LO 1

MONSTER
BEVERAGE
CORPORATION
[MNST]

P1.3

Held-to-Maturity Intercorporate Debt Investment, Impairment Losses Monster Beverage
Corporation is a public U.S. company that produces and distributes “alternative” energy drinks. Its 2013 balance sheet includes $396 million in held-to-maturity bonds. Monster reports its HTM securities as follows: Chapter 1 • Intercorporate Investments: An Overview

Held-to-maturity securities are recorded at amortized cost which approximates fair market value. The
Company evaluates whether the decline in fair value of its investments is other-than-temporary at each quarter-end. This evaluation consists of a review by management, and includes market pricing information and maturity dates for the securities held, market and economic trends in the industry and information on the issuer’s financial condition and, if applicable, information on the guarantors’ financial condition. Factors considered in determining whether a loss is temporary include the length of time and extent to which the investment’s fair value has been less than its cost basis, the financial condition and near-term prospects of the issuer and guarantors, including any specific events which may influence the operations of the issuer and our intent and ability to retain the investment for a reasonable period of time sufficient to allow for any anticipated recovery of fair value. (Note 1 to Monster
Beverage Corporation 2013 financial statements)

Assume that the HTM bonds on Monster’s 2013 balance sheet have a 2-year remaining life, were acquired at par, and pay interest each December 31 at 4 percent. Monster determines that due to an otherthan-temporary decline in the issuer’s liquidity, no additional interest payments are expected, but $325 million of principal is recoverable at maturity.
Required
a. Calculate Monster’s impairment loss for 2013. Round to the nearest million.
b. Assume that on December 31, 2014, the issuer’s financial health has improved and the bonds’ fair value is now $396 million. How does Monster report this information?
c. If Monster receives all contractual principal and interest payments, what is the actual yield on the bond investment for 2014 and 2015?

P1.4

Equity Method Investment Several Years After Acquisition On January 2, 2014, Best Beverages acquired 45 percent of the stock of Better Bottlers for $30 million in cash. Best Beverages accounts for its investment using the equity method. At the time of acquisition, Better Bottlers’ balance sheet was as follows (in millions):
Better Bottlers Balance Sheet, January 2, 2014
Assets
Current assets��
Property and equipment, net ��
Patents and trademarks ��

$ 20
415
150

Total assets��

$585

Liabilities and equity
Current liabilities��
Long-term debt��

$ 42
518

Total liabilities��

560

Capital stock��
Retained earnings��

12
13

Total equity��

25

Total liabilities and equity ��

$585

Valuation of Better Bottlers’ assets and liabilities revealed that its reported patents and trademarks
(10-year life) had a fair value of $160 million and it had unrecognized brand names (15-year life) worth
$9 million. Better Bottlers’ December 31, 2017, retained earnings balance is $25 million. For 2017, it reported net income of $2.5 million and paid $650,000 in dividends.
Required
a. Prepare the 2017 entries to report the above information on Best Beverages’ books.
b. Calculate the Investment in Better Bottlers balance, reported on Best Beverages’ December 31,
2017, balance sheet.

LO 2

27

28

Chapter 1 • Intercorporate Investments: An Overview

LO 2

P1.5

Equity Method Investment Several Years After Acquisition Rance Corporation paid $10 million in cash to acquire 30 percent of the voting stock of Seaway Company on January 2, 2015. Rance uses the equity method to report its investment. Seaway’s book value at date of acquisition was $25 million.
Analysis of Seaway’s assets and liabilities reveals that Seaway’s property and equipment (10-year life) was overvalued by $4 million, and its reported intangibles (2-year life) were undervalued by $6 million. During the years 2015 and 2016, Seaway reported total income of $14 million, paid dividends of $5 million, and reported net unrealized gains on AFS securities of $1 million. During 2017, Seaway reported income of $4 million, paid dividends of $1.5 million, and reported net unrealized losses on AFS securities of $800,000. Rance sells merchandise to Seaway at a markup of 20 percent on cost. Seaway sells merchandise to
Rance at a markup of 25 percent on cost. Below are the inventories on hand at each balance sheet date, related to these sales.
December 31

2015

Ending inventory held by Rance Corporation��
Ending inventory held by Seaway Company��

2016

2017

$750,000
480,000

$925,000
420,000

$625,000
696,000

Required
a. Calculate Rance’s equity in net income of Seaway for 2017.
b. Prepare Rance’s journal entries to report its investment in Seaway for 2017.
c. Calculate the investment balance, reported on Rance Corporation’s balance sheet at December 31,
2017.
LO 2

P1.6

Equity Method Investment with Basis Differences Bristol Corporation acquired 40 percent of the voting stock of Manchester Corporation on January 2, 2016, for $3.2 million in cash. Manchester’s balance sheet and estimated fair values of its assets and liabilities on January 2, 2016, are as follows:
Manchester Corporation
Balance Sheet
January 2, 2016
(in thousands)

Book Value

Fair Value

Assets
Cash and receivables ��
Inventory (FIFO)��
Investments��
Land ��
Property and equipment��
Less: Accumulated depreciation��

$ 400
1,200
300
800
4,200
(1,300)

$ 400
800
300
2,000
1,500

Total assets��

$5,600

Liabilities and Equity
Current liabilities��
Long-term liabilities��
Common stock, $2.00 par��
Additional paid-in capital��
Retained earnings��
Accumulated other comprehensive income��

$ 900
3,000
500
1,000
800
(600)

Total liabilities and equity ��

$5,600

$ 900
3,000

In addition to its reported assets, Manchester has unreported franchise agreements (5-year life) valued at
$1 million. Its property and equipment has a 20-year average remaining life. Manchester reported income of $1.8 million for 2016.
Required
a. How many shares of Manchester stock did Bristol acquire?
b. Compute Bristol’s equity in Manchester’s net income for 2016.

P1.7

Chapter 1 • Intercorporate Investments: An Overview

Equity Method Investment, Intercompany Sales Harcker Corporation acquires 40 percent of
Jackson Corporation’s voting stock on January 3, 2017, for $40 million in cash. Jackson’s net assets were fairly reported at $100 million at the date of acquisition. During 2017, Harcker sells $130 million in merchandise to Jackson at a markup of 30 percent on cost. Jackson still holds $26 million of this merchandise in its ending inventory. Also during 2017, Jackson sells $54 million in merchandise to Harcker at a markup of 20 percent on cost. Harcker still holds $12 million of this merchandise in its ending inventory.
Jackson reports 2017 net income of $10 million.

LO 2

Required
a. Calculate Harcker’s equity in Jackson’s net income for 2017.
b. Assume Harcker reports total 2017 sales revenue and cost of sales of $310 million and $262 million, respectively, while Jackson reports total 2017 sales revenue and cost of sales of $254 million and
$235 million, respectively. Compute each company’s gross margin on sales as reported following
U.S. GAAP. Now compute gross margin on sales again, excluding intercompany sales. Comment on the results.

P1.8

Equity Investments, Various Reporting Methods On January 2, 2016, Parker Corporation invests in the stock of Quarry Corporation. Quarry’s book value is $4 million and its assets and liabilities are reported at amounts approximating fair value. Quarry reports income of $3 million in 2016. Parker’s
December 31, 2016, balance sheet and 2016 income statement, ignoring its investment in Quarry’s stock, follow. Parker Corporation
Balance Sheet (in thousands)
December 31, 2016
Current assets��
Property, net��
Identifiable intangibles��

$ 40,000
450,000
5,000

Current liabilities��
Long-term liabilities��
Capital stock��
Retained earnings��

$ 20,000
200,000
90,000
185,000

Total assets��

$495,000

Total liabilities and equity ��

$495,000

Parker Corporation
Income Statement (in thousands)
Year ended December 31, 2016
Sales revenue ��
Cost of sales��
Operating expenses ��

$900,000
(750,000)
(140,000)

Net income ��

$ 10,000

Quarry Corporation’s financial statements for 2016 are as follows:
Quarry Corporation
Balance Sheet (in thousands)
December 31, 2016
Current assets��
Property, net��

$ 5,000
85,000

Current liabilities��
Long-term liabilities��
Capital stock, $1 par��
Retained earnings��

$ 2,000
81,000
1,000
6,000

Total assets��

$90,000

Total liabilities and equity ��

$90,000

LO 2, 3

29

30

Chapter 1 • Intercorporate Investments: An Overview

Quarry Corporation
Income Statement (in thousands)
Year ended December 31, 2016
Sales revenue ��
Cost of sales��
Operating expenses ��

$60,000
(20,000)
(37,000)

Net income ��

$ 3,000

Required
Prepare Parker’s December 31, 2016, balance sheet and 2016 income statement under each of the following circumstances:
a. Parker’s investment consists of 100,000 shares costing $15/share, and Parker classifies it as an AFS investment. The shares have a market value of $12/share on December 31, 2016.
b. Parker’s investment consists of 400,000 shares costing $15/share, and Parker accounts for it using the equity method.
c. Parker acquires all of Quarry’s shares for $15 million in cash, retires the shares and merges with
Quarry. Goodwill is unimpaired in 2016.
LO 2

P1.9

Joint Venture On January 3, 2016, Allen Corporation and Barkely Corporation invested $5 million each in cash to form Albar Enterprises, a joint venture that develops new products benefitting both corporations. Each corporation holds an equal ownership interest in Albar Enterprises. Albar Enterprises’ balance sheet on December 31, 2016, follows (in millions):
Cash ��
Merchandise��
Equipment��
Patents ��

$ 2.5
12.0
120.0
50.0

Current payables��
Long-term debt��
Capital stock��
Retained earnings��

$ 26.9
150.0
10.0
(2.4)

Total��

$184.5

Total��

$184.5

The joint venture distributed $0.2 million in cash to each of its investors at the end of 2016. December 31, 2016, balance sheets for each corporation are below. Each shows its investment in
Albar Enterprises at original cost less the cash distribution.
Balance Sheet (in millions)

Allen
Corp.

Barkely
Corp.

Current assets��
Plant and equipment, net ��
Investment in Albar Enterprises��
Intangibles��

$ 1.2
150.0
4.8
200.0

$ 0.6
65.0
4.8
3.5

Total assets��

$356.0

$73.9

Current liabilities��
Noncurrent liabilities��
Capital stock��
Retained earnings��

$ 14.0
265.0
10.0
67.0

$ 0.2
55.0
1.0
17.7

Total liabilities and equity ��

$356.0

$73.9

Both corporations use the equity method to report their investment in Albar Enterprises. Barkely estimates that the fair value of its investment in Albar declined to $0.5 million as of December 31, 2016, and that the decline is other-than-temporary. Allen does not report a decline in the value of its investment.
Required
a. Prepare the adjusting entry or entries Allen and Barkely make at the end of 2016.
b. Present the December 31, 2016, balance sheets of each corporation, after appropriate adjustments for their joint venture investment.
c. Is it appropriate for Barkely to report an impairment loss on its investment in the joint venture, while
Allen does not? Explain.

Chapter 1 • Intercorporate Investments: An Overview

P1.10 Balance Sheet After Business Acquisition Wilson Corporation acquires Greatbatch Company for $50 million cash in a merger. The balance sheets of both companies at the date of acquisition are as follows: Balance Sheet (in millions)

Wilson

LO 3

Greatbatch

Current assets��
Property and equipment��
Intangibles��

$ 60
500
20

$ 5
90
3

Total assets��

$580

$98

Current liabilities��
Long-term debt��
Capital stock��
Retained earnings��
Accumulated other comprehensive income��

$ 25
400
50
120
(15)

$ 2
65
12
15
4

Total liabilities and equity ��

$580

$98

Greatbatch’s property and equipment is overvalued by $30 million, its reported intangibles are undervalued by $20 million, and it has unreported intangibles, in the form of customer databases and marketing agreements, valued at $7 million.
Required
Prepare Wilson’s balance sheet immediately following the merger.

P1.11 Merger Nestlé is a Swiss multinational food and beverage company. Its financial statement balances are reported in Swiss francs (CHF). In late 2012 Nestlé acquired Wyeth Nutrition, an infant nutrition business focusing on emerging markets. The total purchase price consisted of CHF 11,078 million in cash and CHF 190 million in consideration payable in future years. The acquisition date fair values of Wyeth’s acquired identifiable assets and liabilities were as follows (in millions of CHF):
Property, plant and equipment��
Brands and intellectual property rights��
Inventories and other assets��
Assets held for sale��
Financial debt ��
Employee benefits, deferred taxes and provisions��
Other liabilities��

LO 3, 4

NESTLé
[NESN]

CHF 1,144
4,510
1,092
357
(6)
(118)
(371)

Required
Assuming Nestlé records this acquisition as a merger, prepare the journal entry it made in 2012 to record its acquisition of Wyeth Nutrition.

P1.12 Trading and AFS Investments, Impairment On its January 1, 2016, balance sheet, Ericsson Corporation reports the following balances related to its investments:

Trading investments ��
AFS investments��
Accumulated other comprehensive gains (losses) (unrealized losses on AFS investments) ��

$ 56,000
160,000
(30,000)

During 2016, Ericsson sold for $43,000 trading securities carried at $40,000 on its beginning balance sheet. It sold the remaining trading securities held at the beginning of the year for $20,000. It purchased trading securities costing $60,000; their fair value at the end of 2016 was $52,000. Ericsson sold for
$52,000 AFS securities carried at $50,000, with unrealized gains of $1,000 included in the beginning
AOCI balance. It did not purchase any new AFS securities. At the end of 2016, AFS securities with a book value of $85,000 have a fair value of $88,000. It is determined that AFS securities with a book value of $25,000 and unrealized losses of $5,000 have a fair value of $10,000; this decline in value is determined to be other-than-temporary.

LO 1

31

32

Chapter 1 • Intercorporate Investments: An Overview

Required
Prepare journal entries to record the events of 2016, and determine the balances related to trading and
AFS securities reported on Ericsson’s 2016 income statement and December 31, 2016, balance sheet.
LO 1

The Coca-Cola
COmpany
[KO]

P1.13 Investment in AFS Securities The Coca-Cola Company’s 2013 annual report discloses the following information regarding its investments in AFS securities:

• 2013 net loss on AFS securities, from the 2013 statement of comprehensive income: $80 million
• Investment in AFS securities balances at December 31, 2013 and 2012, from the balance sheet: $4,842 million and $4,593 million, respectively
• Proceeds from 2013 sales or maturities of AFS securities: $4,212 million
• Gains and losses from 2013 sales or maturities of AFS securities, from the 2013 income statement: gross gains $12 million, gross losses $24 million

Required
Based on the above information, reconstruct Coca-Cola’s 2013 journal entries, as follows:
a. Assume 2013 reclassifications to income for disposal of AFS securities increased 2013 OCI by $20 million. Prepare the summary entry to record the sale of the securities.
b. Prepare the adjusting entry to record unrealized gains or losses on AFS securities on hand at year-end.
c. Prepare the entry to record new investments in AFS securities in 2013.
LO 2, 3

The Coca-Cola
COmpany
[KO]

P1.14 Change from Significant Interest to Control In 2013, The Coca-Cola Company acquired the remaining outstanding shares of Fresh Trading Ltd. Coca-Cola had previously reported its investment using the equity method. Assume the following information:

• Coca-Cola paid $350 million in cash for Fresh Trading’s remaining shares, and reports the acquisition as a merger.
• Coca-Cola’s equity method investment in Fresh Trading was carried at $4 million and had a fair value of $10 million when the transaction took place.
• At the date of the transaction, the fair values of Fresh Trading’s identifiable assets were $250 million, and the fair values of its liabilities were $100 million.

Required
a. Explain why Coca-Cola carried its equity method investment at an amount that was considerably below fair value.
b. Prepare Coca-Cola’s journal entry or entries to record its acquisition of the remaining shares of Fresh
Trading Ltd., assuming Coca-Cola reports the acquisition as a merger.
LO 2, 3, 4

AB INBEV
[ABI]

P1.15 Merger with Associate In 2013, AB InBev completed its acquisition of Grupo Modelo. AB In-

Bev had previously held a significant interest in Grupo Modelo. Although AB InBev is headquartered in
Belgium, its financial statements are reported in U.S. dollars. The footnotes to AB InBev’s 2013 annual report reveal the following information on this acquisition:

• Consideration paid: Cash, $20,103 million; fair value of previously held equity interest, $12,946 million. • AB InBev revalued the previously held equity interest to fair value at the date of acquisition, and
•

recycled $199 million in gains from AOCI to income, resulting in a net non-recurring non-cash gain of $6,410 million.
The fair values of Grupo Modelo’s identifiable assets and liabilities at the date of acquisition were as follows: Noncurrent assets��
Current assets��
Noncurrent liabilities��
Current liabilities��

$9,779 million
8,231
1,975
2,578

Required
a. Calculate the amount of goodwill AB InBev reported for this acquisition.
b. Why did AB InBev recycle $199 million in gains from AOCI to income?
c. Prepare the summary journal entries AB InBev made to record the acquisition as a merger.
d. At what amount did AB InBev report its investment in Grupo Modelo just prior to the acquisition?

Chapter 1 • Intercorporate Investments: An Overview

Review Solutions
Review 1 Solution
2016

Jan. 2

Investment in trading securities ��
Investment in AFS securities��
Investment in HTM securities�� Cash��

300,000
1,000,000
486,384

Cash ��
Loss on trading securities (income)�� Investment in trading securities��

265,000
35,000

Investment in trading securities �� Cash��

250,000

Cash �� Dividend income��

12,000

Investment in trading securities ��
Loss on AFS securities (OCI)�� Gain on trading securities (income) �� Investment in AFS securities ��

10,000
80,000

Cash ��
Investment in HTM securities�� Interest income�� $20,000 5 4% 3 $500,000; $24,319 5 5% 3 $486,384.

20,000
4,319

1,786,384

2016

June 15

300,000

2016

Oct. 15

250,000

2016

Dec. 1

12,000

2016

Dec. 31

Dec. 31

10,000
80,000

24,319

Review 2 Solution
2017

Jan. 5

Investment in Armadillo Bottlers�� Cash�� To record investment in Armadillo.

15,000,000

Cash �� Investment in Armadillo Bottlers�� To record dividends received; $125,000 5 25% 3 $500,000.

125,000

Investment in Armadillo Bottlers�� Equity in net income of Armadillo Bottlers (income)�� To record equity in Armadillo’s net income for 2017.

211,250

15,000,000

2017

Dec. 1

125,000

2017

Dec. 31

211,250

Equity in net income for 2017 is calculated as follows:
Fizzy Cola’s share of Armadillo’s reported net income (25% 3 $3 million) ��
Amortization of previously unreported intangibles (25% 3 $10 million/5)��
Unconfirmed profit on downstream sales (25% 3 ($480,000 2 ($480,000/1.2)))��
Unconfirmed profit on upstream sales (25% 3 ($325,000 2 ($325,000/1.3)))��

$750,000
(500,000)
(20,000)
(18,750)

Equity in net income��

$211,250

33

Advanced Accounting Chapter1

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