Solution manual introduction to management accounting 14e by horngren ch17

Assets =Liab.+ Stockholders' Equity Investment Cash Accounts in and Other Payable, Stockholders' Calgary + Assets = etc... Reflect on the changes in Alberta’s balance sheet equation i

CHAPTER 17 COVERAGE OF LEARNING OBJECTIVES

LEARNING

OBJECTIVE

FUNDAMENTAL ASSIGNMENT MATERIAL

ADDITIONAL ASSIGNMENT MATERIAL

EXCEL, COLLAB.,

&

INTERNET EXERCISES LO1: Contrast

accounting for

investments using the

equity method and the

market-value method

49

55

LO2: Explain the basic

ideas and methods used

LO3: Describe how

goodwill arises and how

to account for it

efficient stock markets

have for accounting

LO6: Explain and

illustrate four methods

CHAPTER 17 Understanding and Analyzing Consolidated Financial Statements 17-A1 (15-20 min.) Answers are in millions of dollars

Assets = Liab + Stk Eq

Invest- Liabil- Stock

Cash ments ities Equity

c Dividends from Akron + 7 - 7 =

The journal entries that would accompany this table are:

Under the equity method, Reo Motors recognizes income as Akron earns it rather than when Reo receives dividends Cash dividends do not affect net income; they increase cash and decrease the investment balance In a sense, the dividend is a partial

liquidation of the investor's "claim" against the investee The

receipt of a dividend is similar to the collection of an account

receivable The revenue from a sale of merchandise on account is recognized when the receivable is created; to include the collection also as revenue would be double-counting Similarly, it would be double-counting to include the $7 million of dividends as income after the $12 million of income is already recognized as it is earned

Assets = Liab + Stk Eq

Invest- Liabil- Stock

Cash ments ities Equity

c Increase in market value + 8 = + 8 (Other com-

prehensive income)

The journal entries that would accompany this table are:

17-A2 (25-35 min.) A common mistake is to think that the $50

million is additional money flowing into the Calgary Company

rather than into the pockets of the Calgary shareholders as

individuals Amounts are in millions

1 Assets =Liab.+ Stockholders' Equity

Investment Cash Accounts

in and Other Payable, Stockholders' Calgary + Assets = etc + Equity Alberta’s accounts,

3 Alberta’s parent-company-only income statement would show

its own sales and expenses plus its pro-rata share of Calgary's net income, as the equity method requires Reflect on the

changes in Alberta’s balance sheet equation (in millions):

Assets = Liab.+Stockholders' Equity Invest- Cash

in Other Payable, Stockholders' Calgary + Assets = etc + Equity Alberta’s accounts:

Beginning of the year 50 + 300 = 110 + 240

Consolidated, end of year 0 + 465 = 130 + 335

Calgary’s balance sheet accounts would have increased by $10 million

At this point, review to see that consolidated statements are the summation of the individual accounts of two or more separate legal entities These statements are prepared periodically via worksheets A consolidated entity does not have a separate continuous set of books like its legal entities Moreover, a

consolidated income statement is merely the summation of the revenue and expenses of the separate legal entities being

4 Consolidated accounts would be unaffected Calgary’s cash

and stockholders' equity would decline by $7 million

Alberta’s investment in Calgary would decline by $7 million, but Alberta’s cash would rise by $7 million

17-A3 (30-45 min.) A common error is to think that the $40 million

is additional money flowing into the Calgary Company rather than into the pockets of the Calgary shareholders Amounts are in

millions

1 Assets = Liab.+Stockholders' Equity

Invest- Cash ment and Accounts

in Other Payable, Minority Stockholders' Calgary + Assets = etc + Interest + Equity Alberta’s accounts,

2 The same basic procedures are followed by Alberta and

Calgary regardless of whether Calgary is 100% owned or

80% owned However, the presence of a minority interest

changes the consolidated statements slightly The income

statements would include:

Alberta Calgary Consolidated

Net income to consolidated entity $ 93

3 Assets = Liab.+Stockholders' Equity

Invest- Cash ment and Accounts

in Other Payable, Minority Stockholders' Calgary + Assets = etc + Interest + Equity Alberta’s accounts:

a

350 beginning of year - 40 for acquisition = 310

b

4 Consolidated accounts would be affected because the minority

interest's claim would be partially liquidated in the amount of 20% of $7 million, or $1.4 million Calgary’s cash would

decline by $7 million, Alberta’s investment in Calgary would decline by 80 x $7 million = $5.6 million, but Alberta’s cash would rise by $5.6 million See following balance sheet

equations:

Assets = Liab.+Stockholders' Equity Invest- Cash

ment and Accounts

in Other Payable, Minority Stockholders' Calgary +Assets = etc + Interest + Equity End of year balances:

Alberta’s accounts 48.0 + 395.0 = 110 + 333 Effect of Calgary

17-A4 (25-35 min.)

1 Assets = Liab.+Stockholders' Equity

Invest- Cash

in Good- Other Payable, Stockholders' Calgary + will +Assets = etc + Equity Alberta’s accounts,

* The $30 million "goodwill" would appear in the consolidated balance sheet

as a separate intangible asset account It often is shown as the final item in a listing of assets It remains on the books until its value is impaired

2 a If the book values of the Calgary’s individual assets are

not equal to their fair values, the usual procedures are: (1) Calgary continues as a going concern and keeps its accounts on the same basis as before

(2) Alberta records its investment at its acquisition cost (the agreed purchase price)

(3) For consolidated reporting purposes, the excess of the acquisition cost over the book values of Calgary is identified with the individual assets, item by item (In effect, they are revalued at the current market prices prevailing when Alberta acquired Calgary.) Any remaining excess that cannot be identified is labeled

The balance sheet accounts immediately after acquisition

would be the same as in Requirement 1, except that goodwill would be $18 million instead of $30 million (that is, $27 million

- $15 million = $12 million less), and other assets would be higher by $12 million The $12 million would appear in the consolidated balance sheet as an integral part of the "other assets." That is, Calgary’s equipment would be shown at $12 million higher in the consolidated balance sheet than the

carrying amount on Calgary’s books Similarly, the

depreciation expense on the consolidated income statement would be higher For instance, if the equipment had four

years of useful life remaining, the straight-line depreciation would be $12 ÷ 4 = $3 million higher per year As in the

preceding tabulation, the $18 million "goodwill" would

appear in the consolidated balance sheet as a separate

intangible asset account

b Consolidated income would be lower by the amount of

depreciation on the additional individual assets:

Extra annual depreciation, $12,000,000 ÷ 4 years = $3,000,000

The assigning of a "basket purchase price" to the various

assets can have a dramatic effect on income Every dollar

assigned to individual assets rather than goodwill will become

an expense sometime, but dollars assigned to goodwill might remain indefinitely on the books unless the value of the

goodwill becomes impaired

1 Assets =Liab.+Stockholders' Equity

Stockholders' Cash +Investments = Liabilities + Equity Equity Method:

Journal entries (not required):

** Frequently called "dividend income"

Microsoft would be required to use the equity method because its ownership of 33% is between 20% and 50%

17-B2 (25-40 min.) Amounts are in millions of dollars

A common mistake is to think that the $400 million is

additional money flowing into Bayliner rather than into the pockets

of Bayliner shareholders as individuals

1 Assets = Liab.+Stockholders' Equity

Invest- Cash

in Other Payable, Stockholders' Bayliner + Assets = etc + Equity Brunswick's accounts,

3 Brunswick's parent-company-only income statement would

show its own sales and expenses plus its pro-rata share of

Bayliner's net income (as the equity method requires) Reflect

on the changes in Brunswick's balance sheet equation (in

millions of dollars):

Assets = Liab.+Stockholders' Equity Invest- Cash

in Other Payable, Stockholders' Bayliner + Assets = etc + Equity Brunswick's accounts:

Consolidated, end of year 0 + 2,100 = 1,000+ 1,100

4 The important point to see is that the consolidated accounts

would be unaffected Bayliner's cash and stockholders' equity would decline by $15 million Brunswick's investment in

Bayliner would decline by $15 million, but Brunswick's cash would rise by $15 million

17-B3 (15-20 min.)

1 Under the equity method Ford will recognize 34% of Mazda's

net income: 34% x $566,000,000 = $192,440,000

2 The balance is increased by Ford's share of Mazda's net

income ($192,440,000 from requirement 1) and decreased by the cash dividends received from Mazda (34% x $32,000,000 =

$10,880,000):

$768,000,000 + $192,440,000 - $10,880,000 = $949,560,000

Using a T account might help:

Beginning bal 768,000,000 Dividends received

net income 192,440,000

Ending balance 949,560,000

3 (a) Of course, the market-value method is not an acceptable

accounting method under these circumstances If it were, the dividends received from Mazda would be recognized

as income by Ford:

34% x $32,000,000 = $10,880,000

(b) The account balance would be adjusted to market value,

$2.5 billion

(c) The $400 million increase would be added to a

comprehensive income account in stockholders’ equity

4 Ford is obliged to follow the generally accepted accounting

principles for investments:

(a) Investments that represent more than a 50% ownership interest must be consolidated A subsidiary is a

corporation controlled by another corporation The usual condition for control is ownership of a majority (more than 50%) of the outstanding voting stock In parent- company-only statements, the equity method is used

(b) The equity method is generally used for a 20% through 50% interest because such a level of ownership creates the presumption that the owner has the ability to exert significant influence However, consolidated statements are not reported

(c) All other investments in marketable equity securities

must be accounted for using the market-value method 17-B4 (10-20 min.) Amounts are in millions

1 a Operating return on sales = operating income ÷ sales

Operating income = sales x operating return on sales

Operating income = €34,191 x 13.567% = €4,639

b Oper return on ave total assets = oper income ÷ ave total assets

Ave total assets = operating income ÷ oper return on ave total assets Ave total assets = €4,639 ÷ 20.632% = €22,484

c Return on shareholders’ equity = net income ÷ ave shareholders’ equity Ave shareholders’ equity = net income ÷ return on shareholders’ equity Ave shareholders’ equity = €3,616 ÷ 27.408% = €13,193

2 Shareholders are most concerned with return on shareholders’ equity It shows the amount of net income generated by the

shareholders’ claims Return on sales can vary greatly by industry, and it does not necessarily show how profitable a company is to its investors

17-2 No Other comprehensive income is a separate account in stockholders’ equity Items that end up in other comprehensive income do not appear in the income statement – they are carried directly to stockholders’ equity

17-3 Under the equity method, investments are carried in the

balance sheet at original cost plus the investor's share of

accumulated retained income since acquisition (that is, original cost

17-4 The equity method recognizes income as it is earned by the investee and accounts for dividends as a reduction of the investment The market-value method recognizes income or loss from changes in market value and income from the receipt of cash dividends from the investee

17-5 The equity method is usually appropriate for long-term

investments where the investor has an ownership interest of 20% or more, because the owner would usually have the ability to exert

significant influence over the investee

17-6 A parent-subsidiary relationship exists when one corporation owns more than 50% of the outstanding voting shares of another corporation

17-7 The reasons for establishing subsidiaries include limiting the liabilities in a risky venture, saving income taxes, conforming with government regulations with respect to a part of the business, doing business in a foreign country, and expanding in an orderly way

17-8 No After adding together the separate statements,

intercompany eliminations must be undertaken to avoid

double-counting

17-9 If the parent owns less than 100% of the subsidiary stock, then outsiders to the consolidated group own the remainder The account Minority Interest in Subsidiaries is a measure of the outside

shareholders’ interest Note that this minority interest is in the

subsidiary, not in the parent company or the consolidated company

17-10 Goodwill is measured by the excess of purchase price over the fair-value, not the book value, of the net assets (assets less liabilities) acquired

17-11 Not necessarily Rules require that assets in a consolidated statement reflect the fair market value at the time of the acquisition When leeway exists, recording goodwill avoids the depreciation

charges incurred on the individual assets

17-12 No Pro forma statements are hypothetical (“as if”) amounts Formal financial statements report historical results following

GAAP

17-13 It is difficult to compare financial statements of firms that differ in size Using component percentages (or common-size

statements) allows direct comparison of percentages across

companies that differ in size

17-14 Three types of comparisons are: 1) time-series comparisons, 2) comparisons with benchmarks, and 3) cross-sectional

conjunction with further information

17-17 No An efficient capital market is one in which market prices

"fully reflect" all information publicly available at a given time Therefore, searching for "underpriced" securities using public

information is fruitless

17-18 Three sources of information include dividend

17-19 The quote assumes that the market applies a fixed

price-earnings ratio to income, regardless of the accounting methods used

to calculate net income There is much evidence that this is not so

If software development costs are already disclosed, it is highly

unlikely that requiring them to be capitalized will affect IBM's share price

17-20 There is much evidence showing that the stock market is not likely to be "fooled" by manipulating reported income Only an accounting change that discloses new information will affect stock prices

17-21 Return on capital is essentially a rental charge for the use of money It is a return received in addition to getting back the

original investment Return of capital is the recoupment of the

original investment itself

17-22 The physical concept of capital maintenance is that no income can emerge until provisions are made for replacing the physical

assets (for example, inventories and equipment) used to generate revenue In contrast, the financial concept of capital maintenance is that no income can emerge until the amount of money invested in generating revenue is recovered

17-23 Although the choice is often expressed that way, there are actually four major concepts The fourth arises because constant- dollar (general-price-level) accounting may be combined with either historical-cost accounting or current-cost accounting

17-24 The major reason for excluding holding gains from income is that no income can emerge unless a company can replace the

physical capital devoted to operations during the current period

17-25 The amount that P pays above the book value of the net assets

of S consists of two parts The first part is an adjustment of the

book values of S’s net assets to market values This amount becomes part of the depreciation of S’s assets in the consolidated statements, although it is not charged on S’s books The second part is the

amount that P must have paid in excess of the market value of the net assets This additional amount is goodwill It was initially

recorded as an asset Because some of the goodwill was written off, management must have determined that the value of the goodwill asset had declined since the purchase

17-26 A purchase of about 20% of another company is right at the borderline of allowing the market-value or equity methods More than 20% and the equity method should be used; less than 20% and Disney should use the market-value method Under the equity

method, changes in market value are ignored The book value of the investment will increase only by Disney’s share of the company’s profits less any dividends, which is likely to result in only a very

small increase in the reported asset value In contrast, the value method would record the asset at its market value, which

market-Disney expects to increase significantly Thus, if market-Disney’s

expectations are met, the market-value method would result in much larger asset value recorded in Disney’s investment account on its balance sheet

17-27 If a company reduces its inventories (a component of current assets), and everything else remains unchanged, its current ratio will decrease Because holding inventories costs resources, both for the capital invested in them and for costs of handling and storing the inventories, it is often good to reduce inventories However, many analysts think that a higher current ratio is better This seems to generate a conflict In general, analysts will look at the current ratio differently for companies that use a just-in-time inventory system They will expect such companies to have a lower current ratio and thus will not downgrade their estimate of the liquidity of such

companies An old rule of thumb was that most companies should have a current ratio of about 2.0 to have sufficient liquidity

However, recently that standard has been lowered, especially for companies using just-in-time inventory methods

17-28 To maintain financial capital, the Treasurer can pay out to investors all of the net income as measured by the traditional

historical cost method That leaves the company an amount equal to the historical cost of the assets consumed during the period to use to replace those resources The company will have maintained the

dollar value of its investments In contrast, if the Treasurer wants to maintain physical capital, he can pay out only the amount of net income measured by the current cost method This method

maintains enough capital to replace assets consumed at their current prices For example, if a unit of inventory was purchased for $4 but costs $5 to replace today, and if it is sold for $6, financial capital maintenance would allow payment of $2 to investors; the company would still have the $4 financial measure it started with, although it

is now $4 of cash and not $4 of inventory However, since it costs $5

to buy a new unit of inventory, the company cannot maintain its physical capital with that $4 – it now requires $5 to buy the

inventory that keeps the company in the same physical position as before the sale of the unit Thus, only $1 is available to pay to

Which measure an investor might prefer depends on the investor’s objectives, especially income versus capital appreciation An

investor who wants current income would probably prefer the

financial capital maintenance method even though it might imply a decreasing investment in the firm as the financial resources buy less and less in an inflationary environment An investor who seeks

appreciation wants the company to grow, so a measure that implies

a positive income even though the company cannot maintain its

physical capital often does not lead to the needed reinvestment in the company for the capital to grow substantially

17-29 (15 min.) The year-end balance in Investment in Y is $43

million under the equity method, and $50 million under the value method:

Assets = Liab.+Stockholders' Equity Cash +Investments = Liabilities + Stk Equity Equity Method:

The year-end balance is $43 million under the equity method and

$50 million under the market-value method If this were a trading security, the $10 million increase in market price would be included

in income If it were an available-for-sale security, the $10 million

17-30 (35-50 min.) The formal statements are not presented here because the following tabulations are easier to understand (in

thousands of dollars):

Sales (other income reclassified below) 5,300* 1,100 6,400

ment and Accounts

in Other Payable, Stockholders' Long Peak + Assets = etc + Equity Boulder’s accounts:

2 Boulder Long Peak Consolidated Sales (other income reclassified below) 5,300* 1,100 6,400

The consolidated balance sheet would be as follows:

Assets = Liab.+Stockholders' Equity Invest- Cash

in Other Payable, Minority holders' Long Peak + Assets = etc Interest + Equity Boulder’s accounts:

600 Investment in Long Peak +150 + - 150 =

Net income 150 = 150

Consolidated, end of year 0 + 1,700 = 650 + 160 +

890

* Beginning minority interest (.40 x $250 = 100) plus minority interest in net income (.40 x 150)