Reading 8 Intercorporate Investments

CFA
CHAPTER 8
INTERCORPORATE INVESTMENTS
1. (C) $60,000.
Explanation
Because company X exerts significant influence over company S, the investment
will be treated using the equity method, even though the ownership is less than
the 20% guideline. The value of the investment account is equal to the beginning
balance plus the proportionate income of company S minus the dividends received
from company S, which equals 48,000 + (0.15 × 100,000) – (0.15 x 20,000) =
60,000.
(Module 8.2, LOS 8.a)
Related Material
SchweserNotes - Book 2
2. (A) I only.
Explanation
Minority interest is included in the parent's company's equity under consolidation
method only.
Related Material
Prior to 2007, Company X (reporting under U.S. GAAP) had never made any
acquisitions of other companies. However, on January 2, 2007, it went on a
buying spree, purchasing 10% of Company A for $10,000; 30% of Company B
for $20,000; 40% of Company C for $80,000; and 70% of Company D for
$168,000.
Below are the balance sheets for the five companies (in thousands) just prior to
the purchase.
Company X A B C D
Cash 400 10 20 30 40
Other assets 1,600 90 180 270 360
Total assets 2,000 100 200 300 400
Liabilities 300 40 80 120 160
Equity 1,700 60 120 180 240
Total 2,000 100 200 300 400
Quantitative Methods 1 Intercorporate Investments

CFA
During 2007, the companies generated the following sales, income and dividends:
Company X A B C D
Revenue 2,000 100 200 300 400
Net income 200 10 20 30 40
Dividends 4 8 12 16
The company accounts for the acquisitions based on typical ownership proportion
guidelines. Investment in financial assets are classified as FVOCI.
3. (C) $460,000.
Explanation
Liabilities will be equal to the starting balance plus the liability balance for
Company D, which equals 300,000 + 160,000 = 460,000.
Related Material
4. (C) $72,000.
Explanation
Minority interest will be equal to the proportion not owned of Company D
multiplied by the equity of Company D, which is (1 – 0.7) x 240,000 = 72,000.
Related Material
5. (C) $2,400,000.
Explanation
Revenues will equal the revenue of Company X and D, which is 2,000,000 +
400,000.
Related Material
6. (B) $10,800.
Explanation
The investment in the associates account will increase from the proportionate
income of Companies B and C, and will decrease from the dividends received from
Companies B and C. The changes will be (0.3 x 20,000) + (0.4 x 30,000) – (0.3 x
8,000) – (0.4 x 12,000) = 10,800.
Related Material

CFA
Joseph Haggs, CFA, is an analyst working for Garvess Jones, a large publicly
traded investment-banking firm. Haggs covers the internet sector. Recently, one of
the more successful companies Haggs covers, Simpson Corporation, made an
aggressive move to acquire another internet company, Bailey Corporation (BC). BC
is a company specializing in graphics and animation on the World Wide Web and
has 1,000,000 shares outstanding. Simpson also holds minimal investments in
other technology companies both public and private. In 1999 Simpson saw an
opportunity to substantially increase its share in BC. Simpson feels that their
sophisticated animation can greatly improve Simpson's market share and sees an
acquisition as an opportunity to expand their business. The relevant financial data
are in the following tables.
Bailey Corporation
Selected Financial Data, Years Ended December 31
(in Thousands)
Item 1998 1999 2000
Sales $50,000 $60,000 $70,000
Less: cost of goods sold (COGS) 37,000 43,700 47,250
Earnings before interest & taxes (EBIT) 13,000 16,300 22,750
Less: Interest 10,000 13,000 19,000
EBT 3,000 3,300 3,750
Less: Taxes 1,000 1,100 1,250
Net Income $2,000 $2,200 $2,500
Dividends Paid $1,000 $1,200 $1,500
Total Shares Outstanding 1,000,000
Simpson's Purchase Transactions in BC's Stock

Date January 1, 1998 January 1, 1999 January 1, 2000
Number of Shares 10,000 290,000 700,000
Price per share 10 11 15
Because this is the largest acquisition in Simpson's history, Mr. Haggs' supervisor
has asked him to prepare a report for Garvess Jones' clients detailing the effects of
the acquisition on Simpson's financial statements.
7. (B) Equity method.

Explanation
When a company owns an influential but non-controlling interest in another
company, commonly 20-50%, it must account for it under the equity method.
(Module 8.3, LOS 8.c)
Related Material

CFA
8. (A) Investment in Financial Assets method.
Explanation
When a company owns a non-influential and non-controlling interest in another
company the investment must be carried at fair value. Simpson must carry its BC
investment at fair value ford 1998.
Related Material
9. (A) Acquisition method.

Explanation
When a company's interest in another exceeds 50% it is considered to have
controlling interest and must consolidate the financial statements.
Related Material
10. (C) $-2,830,000.

Explanation
Simpson paid a total of $-3,190,000 (290,000 shares x $11) however, they also
received a dividend from BC of $360,000. For 1999 Bailey Corporation is paying
$1.20 in dividends per share (1,200,000 / 1,000,000). As of December 1999,
Simpson has purchased 300,000 shares of BC (= 290,000 + 10,000). So
dividends received is 300,000 x $1.20 = $360,000. This will make the total cash
flow for the year $-2,830,000.
Related Material
11. (C) Both methods report the same net income.

Explanation
Both methods will report the same net income.
Related Material

CFA
12. (C) Unrealized amounts reported on income Assets reported at fair value.
statement.
Explanation
Portfolio 1 contains FVPL. Therefore, the unrealized gains and losses would be
reported immediately in the income statement.
Portfolio 2 contains FVOCI. Therefore, the securities (assets) would be reported at
fair value.
Related Material
The Anderson Company acquired 100,000 shares of the Birschbach Company on

January 1, 2012, at $25 per share. The market price of a share of Birschbach
stock on December 31, 2012, was $35 per share. During 2012, Birschbach paid
dividends of $1.50 per share and had earnings of $2.50 per share.
The Anderson Company did not buy or sell any additional shares in 2013. The
market price of Birschbach stock on December 31, 2013 was $42.50 per share.
During 2013 Birschbach paid dividends of $1.75 per share and had earnings of
$2.25 per share.
13. (A) $3.5 million.

Explanation
Fair value through OCI securities are measured at fair market value.
(100,000)($35) = $3,500,000
Related Material
14. (B) $2.6 million.

Explanation
Under the equity method, market value is ignored. The carrying value of the shares
is: the original investment + proportional share of earnings - dividend received.
[(100,000)($25)] + [(100,000)($2.50 – 1.50)] = $2,600,000
Related Material

CFA
15. (B) $150,000.
Explanation
Under the fair value through OCI classification, unrealized gains and losses are not
recognized on the income statement, so the only impact on the income statement
is the dividend received:
(100,000 shares)($1.50 per share) = $150,000
Related Material
16. (B) +$50,000.

Explanation
For the equity method, the ending carrying value on the balance sheet is the
beginning carrying value plus a proportion of earnings minus a proportion of
dividends. For the Anderson Company, the change in the carrying value is the
difference between the earnings per share and the dividends per share. Dividends
per share in 2013 were $1.75 per share and the earnings per share were $2.25
per share. 100,000 shares x ($2.25 – $1.75) = +$50,000. The actual carrying
value on the balance sheet is $2,600,00 + $225,000 – $175,000 = $2,650,000.
Related Material
17. (A) carrying value (including goodwill) is greater than its fair value.
Explanation
To test goodwill for impairment under U.S. GAAP, the carrying value of the
reporting unit (including goodwill) is compared to the fair value of the reporting
unit. After an impairment has been detected, the loss is calculated as the
difference between the book value of goodwill and the implied value of goodwill.
Related Material
18. (B) the equity method results in a single line item on the income statement, and a
single line item on the balance sheet.
Explanation
On the income statement, the equity method results in a single line item (equity in
income of the joint venture). On the balance sheet, the equity method also results
in a single line item (investment in joint venture). Both IFRS and U.S. GAAP require
the equity method of accounting for joint ventures; only under rare circumstances
will proportionate consolidation be allowed for reporting of joint ventures under
IFRS and U.S. GAAP. Total net assets of the investor is identical under the two
methods.
Related Material
CFA
19. (C) same net income as the equity method but different shareholders' equity.
Explanation
Consolidation results in the SAME net income and higher equity as compared to
the equity method.
Related Material
20. (C) Acquisition method.

Explanation
It is possible to control with less than a 50% ownership interest. In this case, the
investment is still considered controlling and the acquisition method would be
most appropriate.
(Module 8.4, LOS 8.b)
Related Material
21. (C) more or less favorable depending on the leverage of the investee company.
Explanation
Under consolidation, the debt of the subsidiary is included in the parent company
balance sheet. Parent company's equity is also increased due to minority interest.
The impact on leverage will depend on the leverage employed by the subsidiary.
Related Material
22. (C) Acquisition.

Explanation
When the parent company has at least a 50% ownership stake and control over
the subsidiary, the acquisition method is used.
Related Material
Rocky Mountain Air Cargo is a privately held commercial aviation company serving
the western United States. It publishes financial statements in accordance with U.S.
GAAP and uses a fiscal year that matches the calendar year.
Rocky Mountain was in good financial shape heading into 2003, with assets of
$50 million at the beginning of the fiscal year. That year, it earned $3 million in
net income and was easily able to maintain its traditional 50% dividend payout
ratio. However, Rocky Mountain had a very difficult year in 2004, reporting a loss
of $800,000. It managed to pay $1 million in dividends, but the decision to pay
dividends in such a weak financial year further undermined the company's fiscal
stability.
CFA
Flitenight Air Lines, a publicly-traded aviation firm serving the central and
Midwestern United States, wanted to expand its range of service by coordinating
its flight schedule with airlines serving different geographic regions of North
America. One of these airlines was Rocky Mountain Air Cargo.
To cement the relationship, Flitenight's CEO, John "Bulldog" Basten, decided to
make a significant investment in Rocky Mountain Air Cargo. He was easily able to
convince both boards of the wisdom of the deal, and, in his usual brash style,
personally negotiated the terms with his counterpart at Rocky Mountain, Buck
Matthews. Flitenight Air Lines acquired a 20% stake in Rocky Mountain Air Cargo
(with an option to purchase 40% more) for $10 million cash. The deal closed on
January 1, 2003 and Flitenight accounted for the investment using the equity
method.
Basten was not happy to find that he had invested right at the peak of Rocky
Mountain's profitability and wound up with a money-losing airline. He had a
difficult conversation with Matthews in early 2005, complaining about the impact
of the Rocky Mountain investment on Flitenight's financials. Basten pointed out
that he had a loss on his books: the original $10 million investment in Rocky
Mountain was carried at only $9,940,000 on Flitenight's December 31, 2004
balance sheet. Matthews countered that this was just an accounting entry: on a
cash basis, Flitenight had a gain of 5% on its investment over the two years.
Matthews' insistence that the investment had earned money for Flitenight did not
sit well with Basten. Basten decided that Rocky Mountain was clearly being
mismanaged and concluded it was time to gain control of the company.
Basten notified Matthews and Rocky Mountain's board that Flitenight intended to
exercise its option. At the direction of Basten and Glenn, Flitenight purchased the
additional shares for cash and gained control of Rocky Mountain on December 31,
2004.
23. (B) $600,000.

Explanation
Under the equity method, Flitenight would record $600,000 (= $3 million x 0.2)
on its 2003 income statement as its share of Rocky Mountain's earnings. The
dividends received by Flitenight are already included as part of its share of Rocky
Mountain's net income in the equity method.
Related Material

CFA
24. (B) Only income of $200,000.
Explanation
If Flitenight accounted for its Rocky Mountain investment as an investment in
financial assets, in 2004 it would record on its income statement $200,000
(= $1 million x 0.2) in dividends. That method would not be a permissible choice
for Flitenight, however, since it controls more than 20% of Rocky Mountain.
Related Material
25. (C) equity under IFRS and US GAAP.

Explanation
Under the acquisition method, minority interest is now considered equity under
IFRS and US GAAP. Prior to SFAS 160 minority interest was considered either a
liability or a mezzanine(hybrid) item under US GAAP.
Related Material
26. (C) Basten's statement is correct and Matthews' statement is correct.

Explanation
If Flitenight accounted for its Rocky Mountain investment using the equity method,
the value of the investment as of December 31, 2004, would be:
Flitenight's original $10 million investment + (Flitenight's share of Rocky
Mountain's 2003 earnings less dividends Flitenight received in 2003) +
(Flitenight's share of Rocky Mountain's 2004 earnings less dividends Flitenight
received in 2004).
Since we know that Flitenight owns 20% of Rocky Mountain and consequently
receives 20% of the dividends that Rocky Mountain pays, we can calculate:
Value of Rocky Mountain on Flitenight's books at the end of 2004
= $10 million + (0.20 x $3 million in 2003 earnings - 0.20 x $1.5 million in 2003
dividends) + (0.20 x -$800,000 in 2004 earnings - 0.20 x $1 million in 2004
dividends)
= $10 million + ($600,000 – $300,000) + (-$160,000 – $200,000)
= $10,000,000 + $300,000 – $360,000 = $9,940,000
Basten's statement is correct.
On a cash basis, Flitenight spent $10 million to acquire its stake in Rocky
Mountain, and received $500,000 (= $300,000 in 2003 dividends + $200,000
in 2004 dividends) in dividends over the two years. $500,000 in cash return on a
$10,000,000 cash investment equals 5% over the two years. Matthews' statement
is also correct.
Related Material

CFA
27. (A) Both have a variable interest.
Explanation
A lease residual guarantee and subordinated debt are both examples of variable
interests. Firm A will experience a loss if the leased asset is worth less than
$100,000 at the end of the lease. Firm B will experience a loss if the senior debt
is not paid in full.
Related Material
28. (C) $5,375 $500 $125

Explanation
The carrying value on the balance sheet is $5,375, the income statement will show
$500 of income, and the cash recognized is equal to the dividend of $125.
Using the equity method, for 2008, Company P will:
• Recognize $500 ($2000 x 0.25) on its income statement as equity in the net
income of Company S.
• Increase the investment in the Company S account on the balance sheet to
$5,500, reflecting its share of the net assets of Company S.
• Receive $125 in cash dividends from Company S and reduce its investment
in Company S by that amount to reflect the decline in the net assets of
Company S due to the dividend payment.
At the end of 2008, the carrying value of Company S on Company P's balance
sheet will be ($5,000 original investment + $500 proportional share of Company
S earnings – $125 dividend received = $5,375).
Related Material
29. (A) Only one is correct.

Explanation
Statement #1 is a correct statement. A lower cost of capital is a potential benefit
of forming a VIE.
Statement #2 is an incorrect statement. The organizational form can be a
corporation, partnership, joint venture or trust. It is not necessary for the VIE to
have separate management and employees.
Related Material

CFA
30. (A) less favorable than those for a comparable firm using the equity method.
Explanation
All else being equal, return on asset measures for a firm using consolidation will
appear less favorable than those for a comparable firm using the equity method.
This is because the choice of accounting method will affect the book value of
assets, while the level of net income remains the same.
Related Material
31. (C) Acquisition method.

Explanation
The consolidation method will reflect the highest assets and liabilities. The equity
method would reflect the lowest.
Related Material
32. (C) Both are incorrect.

Explanation
Both statements are incorrect. The sponsor does not usually have voting control
over the SPE; the activities of an SPE are specifically detailed in governing
documents created at the origination of the SPE. The structure of the SPE transfers
the risks and rewards from the equity owners to the variable interest owners. In
return, the equity owners usually receive a fixed rate of return.
Related Material
33. (C) According to U.S. GAAP, a special purpose entity is classified as a variable interest
entity (VIE) if it has at-risk equity that is sufficient to finance its own activities
without additional financial support.
Explanation
Under U.S. GAAP rules, a VIE could include a SPE that has at-risk equity that is
insufficient to finance the entity's activities without additional financial support.
Related Material

CFA
34. (A) Maverick must consolidate the SPE.
Explanation
The 5% at-risk equity investment is not sufficient to support the activities of the
SPE without Maverick's guarantee. Thus, the SPE is considered a variable interest
entity (VIE). Since Maverick is responsible for the guarantee, Maverick is the
primary beneficiary and must consolidate the SPE.
Related Material
Assume that on the balance sheet date shown below TME Corporation acquires
70% of Abcor, Inc. common stock for $25,000 in cash.
Pre-acquisition Balance Sheets
December 31, 2001
TME Corp. Abcor, Inc.
Current assets $80,000 $38,000
Other assets 28,000 15,000
Total assets $108,000 $53,000
Current liabilities $60,000 $32,000
Common stock 15,000 14,000
Retained earnings 33,000 7,000
Total liabilities and equity $108,000 $53,000
35. (A) 1.01, 0.92.

Explanation
With the acquisition method: The current assets are ($80,000 + $38,000 –
$25,000) = $93,000. The current liabilities are ($60,000 + $32,000) = $92,000.
The current ratio is $93,000/$92,000 = 1.01.
With the equity method: The current assets are ($80,000 – $25,000) = $55,000.
The current liabilities are $60,000. The current ratio is $55,000/$60,000 = 0.92.
Related Material
36. (B) $93,000.

Explanation
Using the acquisition basis of accounting, the post-acquisition level of the current
assets is the amount of the current assets prior to acquisition minus the amount of
cash used for the acquisition. ($80,000 + 38,000 – 25,000)
= $93,000.
Related Material

CFA
37. (B) $10,700.
Explanation
Since only 70% of Abcor was purchased by TME there is a minority interest that
must be accounted for, equal to the percentage of Abcor not owned by TME times
Abcor's fair value.
Abcor's fair value = 25,000/0.7 = 35,714.29
Under US GAAP, only full goodwill.
Minority interest = 35,714.29 (0.3) = 10,714.29
Related Material
38. (B) $125,000.

Explanation
Parent reported acquisition goodwill of $300,000 ($2,000,000 purchase price –
$1,700,000 fair value of Sub's net assets). Since the carrying value of 1,980,000
exceeds the fair value of 1,950,000, an impairment exists.
New goodwill = fair value of subsidiary – fair value of subsidiary's assets
= 1,950,000 – 1,775,000 = 175,000
Impairment loss = 300,000 – 175,000 = $125,000
Related Material
On January 9, 2006, Company X paid $2,000,000 for 100,000 shares of stock in
Company S. Originally the company classified the shares as fair value through OCI.
As of December 31, the stocks were valued at $2,200,000. In 2006, Company S
had earnings per share of $0.90 and paid dividends per share of $0.20. In late
December 2006 the company wonders what would be the change if the company
had classified the shares as fair value through P&L.
39. (C) $0.00

Explanation
If the company had originally classified the shares as fair value through P&L, the
value of the assets would be the same (i.e., fair value) but the net income would
have been different.
Related Material
40. (B) Income will rise by $200,000, but stockholders' equity will not change.
Explanation
The unrealized gain of $200,000 would have been reported on the income
statement. Assets and equity would be the same under either classification.
Related Material
CFA
41. (B) Investment in financial assets.
Explanation
Investment in financial assets is the correct classification here because there is no
significant influence (i.e. no involvement in policy marking, no Board of Directors'
representation). Although the ownership interest level is significant at 39% (it is
between 20% and 50%), the lack of control classifies the investment as an
investment in financial assets.
Significant influence is not in investment classification per se. It is a measure of
relative degree of influence.
Related Material
42. (B) required under IFRS and under U.S. GAAP for jointly controlled entities.
Explanation
Equity method is required under both U.S. GAAP and IFRS for jointly controlled
entities.
Related Material
Omricon Capital Associates specializes in making investments in the small cap
market sector. In some cases the firm operates as a supplier of private equity for
restructurings. In this instance, the firm views itself as having a value investment
focus. In others, it acts as a venture capital firm. Here, the investment focus is
usually growth. Finally, in some cases it simply takes passive investment positions
in publicly-traded firms. The positions in marketable securities are sometimes
considered trading positions, and other times the view is to hold for a longer
period until valuation parameters are met or exceeded.
Omricon's chief compliance officer, Raymond "Buzz" Richards has recently become
concerned that the firm may not be correctly following the relevant accounting
standards for these investments. To ensure that the rules are being effectively
adhered to, he is seeking advice from the accounting firm of Merz-Brokaw and
Associates on the matter. Sally Lee is the Merz-Brokaw partner heading up the
consulting team assigned to review the situation.
The size of the investments ranges from a few percent of the firm's outstanding
equity, to positions of greater than 50%. Richards says that it has always been his
understanding that the percentage of the equity held is the major determinant
with respect to which accounting method applies. Lee reminds him that the firm's
intent for its investments also plays a role in determining how they are accounted
for.
Some of the firm's investments have not worked out as planned. Richards has
conferred with the firm's portfolio managers regarding securities being held by the
firm that are worth less than when they were acquired, and has presented a list of

CFA
these investments to Lee. His concern is what this implies for the accounting for
these investments. Lee tells him that the issue here is whether or not the security
can be considered impaired, and that designating a security as impaired implies
that the decline in value is permanent.
Top managers at Omricon have asked Lee to help them evaluate the impact of the
choice of accounting method on the firm's profitability. Some members of the
management team are of the belief that the accounting method does not affect
financial measures because these are driven by underlying economic factors.
Others believe that these measures can be affected by the accounting method
chosen.
43. (A) When the ownership is less than 20%, both US GAAP and IFRS require the
investment in financial assets method.
Explanation
When the percentage ownership is less than 20% (with no significant influence
over the investee firm), both US GAAP and IFRS require the investment in financial
assets method.
Related Material
44. (C) Both US GAAP and IFRS require that the equity method be used.
Explanation
Equity method is required accounting method under both IFRS and U.S. GAAP for
joint ventures.
Related Material
45. (A) ROA being higher than under consolidation.

Explanation
Since consolidation results in inclusion of investee's assets in the investor's
balance sheet, the total assets would be higher under consolidation as compared
to equity method. Net income is same under either methods. ROA would be higher
under equity method as compared to under consolidation. Leverage effects will
depend on the debt of the investee company. Under consolidation, all of investee's
debt would be included in investors balance sheet. However, total equity in the
consolidated balance sheet will also be higher due to inclusion of minority
interest.
Related Material

CFA
46. (B) Barrett's leverage as well as receivables turnover would remain the same.
Explanation
Under U.S. GAAP, the sponsor needs to consolidate SPEs using acquisition
method. The underlying loan and accounts receivable would then be included in
the consolidated balance sheet and none of the financial ratios would be affected.
Related Material
47. (A) Equity method.

Explanation
The 40% ownership stake would indicate that significant influence has been
gained over the affiliate company. The equity method would be used.
Related Material
48. (A) The SPE usually issues debt to purchase receivables from the sponsor.
Explanation
SPEs are often created to securitize assets, usually receivables of the sponsor.
Typically, the SPE issues debt to purchase the receivables from the sponsor and
the debt is repaid as the receivables are collected.
When the receivables are securitized, the sponsor removes the receivables from
the balance sheet and reports the cash inflow as an operating activity in the cash
flow statement. If the sponsor still has recourse, the transaction is nothing more
than a collateralized borrowing.
Related Material
Global Life Insurance (GLI) holds a wide range of assets in a range of different
portfolios across its various divisions. Some of these assets are held long term to
meet future liabilities, whereas others are held short term to make profits and
meet shorter term liquidity needs.
GLI set up a small portfolio of U.S. equities in one of its smaller divisions last year.
GLI's chief investment officer has recently contacted the accounting department to
discuss the correct treatment of the portfolio in the group accounts.
Details of the portfolio's transactions and results for the previous period are
shown below in Exhibit 1.

CFA
Exhibit 1 - Equity Portfolio Results
2013 Q1 2013 Q2 2013 Q3 2013 Q4
Shares purchased (sold) 1,000 (200) 700 0
Total shares quarter-end 1,000 800 1,500 1,500
Purchase price 50.00 45.00
Sale price 45.00
Quarter-end market price 52.00 43.00 52.00 60.00
Total dividends 500 400 750 750
The chief investment officer's also provides the following extract from the
portfolio's investment policy statement:
IPS Extract
(1) The portfolio should consist solely of U.S. mid-cap equities.
(2) The number of transactions in the portfolio should be kept to a minimum.
Shares should not be purchased on a speculative basis for short term profits.
(3) The anticipated average holding period for securities in the portfolio is 3.5 -
4 years.
(4) Securities should only be sold to meet urgent liquidity needs.
Another reporting issue the accounting department is looking at concerns a fixed

income portfolio. An overview of the portfolio is given in Exhibit 2:
Exhibit 2 - Fixed Income Portfolio

Par Value $25,000,000
Coupon rate 5% (paid semi-annually)
Current Market Value $27,000,000
The portfolio consists of $1000 par value, 5 year bonds issued by RTF Inc. They
were purchased on the date of issue 1st January 2012 for $25,893,577. For the
year ending 31st December the bonds were carried at amortized cost.
The chief investment officer believes a more appropriate classification would be
fair value through profit or loss, as he is not convinced the bonds will be held for
the remaining 3 years.
49. (A) $19,900.

Explanation
FVPL income is calculated as dividends plus all gains and losses (realized and
unrealized). Total dividends are 2,400. GLI realized a loss on the sale of 200
shares at 45.00 per share for a total realized loss of 1,000. GLI has an unrealized
gain of 8,000 (800 x (60 – 50)) on the shares purchased in Q1 and 10,500 (700
x (60 – 45)) the shares purchased in Q3, or total unrealized gains of 18,500.
Therefore, total income under the FVPL classification is 19,900 (2,400 –1,000
+18,500).
Related Material
CFA
50. (C) $90,000 $90,000
Explanation
Under the FVPL and FVOCI classifications the balance sheet carrying values are
the market values of the shares or 90,000 = (1,500 x 60).
Related Material
51. (A) $1,079,000.

Explanation
The bonds will be accounted for using the amortized cost method. Interest will be
calculated using the yield at the date of purchase.
Yield at date of purchase can be calculated as follows:

10 N, –25,893,577 PV, 625,000 PMT, 25,000,000 FV
CPT I/Y = 2.1%. This is semiannual. The annual yield is 4.2%.
Asset Interest (2.1%) Coupon
6m 25,893,577 543,765 625,000
1yr 25,812,342 542,059 625,000
18m 25,729,401 540,317 625,000
2yr 25,644,718 538,539 625,000
Total interest in 2013 (i.e., year 2) is $540,317 + $538,539 = $1,078,856.
Related Material
52. (B) The difference between the amortized cost and fair value will be shown in net
income.
Explanation
The bonds will be shown at amortized cost. When reclassified to FVPL, the bond
will be restated at fair value and the difference taken to the income statement.
Related Material

CFA
53. (C) $300.
Explanation
These securities are to be classified as FVOCI and hence, all unrealized gains and
losses are taken to OCI in shareholder's equity on the balance sheet. Hence, the only
income statement impact is the $300 dividend = 0.02 x $15 x 1,000.
Related Material
On January 9, 20X6, Company X, reporting under IFRS, purchased $1,000,000 of

government bonds at par and 100,000 shares of stock in Company S for
$2,000,000. The stock investment was held at fair value through OCI while the
bonds were held at amortized cost. As of December 31, the bonds were valued at
$900,000, and the stocks were valued at $2,200,000. The bonds paid $50,000
of interest and the stocks paid $20,000 of dividends. In 2006, Company S had
earnings per share of $0.90.
54. (C) $3,200,000.00.

Explanation
The bonds are classified as debt securities at amortized cost. Since the bonds
were purchased at par, the amortized cost = cost (par). The stocks are valued at
market value.
Related Material
55. (B) Reclassification would not be allowed.

Explanation
The initial choice of classification into fair value through OCI is irrevocable and
reclassification is not allowed for equity securities.
Related Material
56. (A) amortized cost, fair value through OCI, or fair value through profit or loss.
Explanation
Under IFRS 9 debt securities can be classified at amortized cost (if they meet
business model and cash flow characteristic test), fair value through OCI, or fair
value through profit or loss.
Related Material

CFA
57. (A) debt security only if the business model has changed.
Explanation
Reclassification of equity securities under the standards is not permitted as the
initial designation (FVPL or FVOCI) is irrevocable. Reclassification of debt securities
from amortized cost to FVPL (or vice versa) is permitted only if the business model
has changed.
Related Material
58. (C) $400.

Explanation
The unrealized gain on the 120 shares available for sale is $600 (26 – 21
= 5 x 120 shares). There is also an unrealized gain of $400 (5 x 80) related to the
80 shares that are classified as fair value through profit or loss which would be
reported on the income statement. For securities classified as fair value through
profit or loss, realized and unrealized gains and losses are reported on the income
statement. For securities classified as fair value through OCI, only realized gains
and 40 losses are reported on the income statement.
Related Material
59. (C) Equity method.

Explanation
Only equity method is now permitted under both IFRS and U.S. GAAP.
Related Material
60. (B) $15,000.

Explanation
Because company X exerts significant influence over company S, the investment
will be treated using the equity method, even though the ownership is less than
the 20% guideline. The impact on the income statement is the proportionate
income of company S, which is 0.15 x 100,000 = 15,000.
Related Material
61. (B) lower.

Explanation
The choice of full vs. partial goodwill will not impact consolidated debt. Compared
to partial goodwill method, Alpha's equity will be higher under the full goodwill
method (due to a higher minority interest value). Hence, full goodwill will report a
lower debt-to-equity ratio (due to the higher denominator).
Related Material
CFA
62. (B) equity method.
Explanation
Even though Acme's interest is low at only 3%, they have significant influence by
having a seat on Bandy's Board of Directors. As such, they must use the equity
method.
Related Material
63. (B) charge $2 million to its income statement.

Explanation
Reclassification of debt securities into FVPL is allowed if the business model has
changed. Unrealized gain or loss on reclassification is recognized in the income
statement.
Related Material
64. (C) and equity securities classified as fair value through OCl.
Explanation
If securities are designated as debt and equity securities classified as fair value
through OCI they are to be carried at fair value on the balance sheet with
unrealized gains and losses excluded from the income statement (but go into
equity via OCI).
Related Material
65. (A) $25,000.

Explanation
Under the equity method, the investor recognizes its pro-rata share of the
affiliate's income on the income statement. Since Mashburn owns 25,000 shares
of Humm and Humm earned $1, the income statement impact of the investment is
$25,000.
Related Material

CFA
66. (C) Yes ; No.
Explanation
Since the shareholders do not absorb the expected losses, the SPE is considered a
VIE. The unrelated firm (not Mustang) that absorbs the losses is the primary
beneficiary and must consolidate the VIE.
Related Material
Birch Corporation is a large conglomerate based in the U.S. that has grown
primarily through acquisition. On the first day of this reporting year, January 1,
2012, Birch acquired 1,500,000 shares of the common stock of TRQ Inc. TRQ Inc.
produces high quality fabrics for use in the fashion industry. Exhibit 1 shows key
numbers from TRQ Inc.'s accounts.
Exhibit 1 - TRQ Financial Statement Extracts

TRQ Inc
Income – year ending 31 Dec 12 $700,000
Dividend paid $210,000
Number of common shares in Issue 6,000,000
Number preferred shares in issue 3,000,000
Total number of shares in issue 9,000,000
Both Birch and TRQ prepare their accounts using US GAAP.
Dan Fitzroy is the CFO of Birch, and is currently preparing with a meeting with the
auditors to discuss the correct treatment of the TRQ investment in Birch's group
accounts. Fitzroy is of the opinion that the equity method of accounting should be
used for the following reasons:
(1) The proportion of TRQ's common shares owned by Birch suggests that Birch
has significant influence over TRQ's operations.
(2) The lack of ownership of preferred shares suggests that Birch has no
significant influence over TRQ's operations
(3) The proportion of TRQ's total shares owned by Birch suggests that Birch has
significant influence over TRQ's operations.
67. (B) $175,000.00.

Explanation
Under the equity method, dividends are not included as income to the acquirer.
($700,000 x 0.25) = $175,000 will be the reported investment income for Birch.
Related Material

CFA
68. (C) $52,500.
Explanation
The cash flow to Birch will be the dividend received ($700,000)(0.30)(0.25)
= $52,500.
Related Material
69. (B) $175,000.

Explanation
Birch would recognize 25% of the net income = $700,000 x 0.25 = $175,000.
This would be recognized line by line to include the full $700,000, then 75%
would be removed as belonging to the noncontrolling interest.
Related Material
70. (B) Reason 1.

Explanation
Birch owns 1,500/6,000 = 25% of the common shares of TRQ. This suggests
significant influence which would make equity accounting appropriate. The
percentage of preferred shares owned is not relevant.
Related Material
71. (A) —$4,700.

Explanation
Since these securities are to be classified as FVPL securities, both the dividend
received and the unrealized loss are posted to the income statement. The dividend
is computed as 0.02 x $15 x 1,000 = $300 whereas the unrealized loss is
$5,000 = ($15 – $20) x 1,000. The net income statement impact is
$300 - $5,000 = -$4,700.
Related Material

CFA
On December 15, 2009, the Zeisler Company faces a financial crisis. Zeisler's
industry has gone into recession and net income has declined to nearly zero.
Jeremiah Welch, the company's CFO, is extremely concerned that, when the final
figures for 2009 come in, the poor operating results will throw the firm into
violation of its debt covenants, which specify that it must meet a certain return on
assets (ROA) and not exceed a certain debt-to-asset ratio. A violation of either
covenant would trigger a provision in the lending agreement allowing lenders to
put Zeisler's debt back to the firm and likely force Zeisler into bankruptcy.
With only two weeks before the close of the firm's fiscal year on December 31,
there is no way to avoid bankruptcy through improved operations. Welch calls an
emergency meeting with Olivia Dupree, the firm's controller, to come up with a
plan of action to keep Zeisler out of bankruptcy. He explains to Dupree that they
need to increase Zeigler's reported ROA and reduce its reported debt-to-assets
ratio relative to the numbers that would otherwise be reported for 2009.
Dupree suggests that Zeisler's equity investments might be useful in staving off
bankruptcy. Zeisler acquired 100,000 shares of the Market Square Corporation on
January 1, 2009, at $25 per share.
Market Square paid dividends during 2009 of $1.50 per share and was expected
to have earnings for 2009 of $2.50 per share. Zeisler also holds 250,000 shares
of General Nuclear, purchased for $72 per share. General Nuclear has no
dividends and is expected to report a loss for 2009. Both securities are classified
on the financial statements as FVOCI.
Dupree left the meeting with Welch for a moment to check the stock market. She
found that Market Square was trading at $35 per share and General Nuclear was
at $43.
72. (A) $150,000.

Explanation
The investment income (for FVOCI securities) includes dividends and interest. In
this case, the investment income from Market Square Corporation would be the
dividends it paid to the number of shares Zeisler owns:
100,000 shares x $1.50 per share
= $150,000.
Related Material

CFA
73. (C) $3.50 million.
Explanation
Regardless of the FVOCI or FVPL classification, securities are carried at fair market
value:
100,000 shares x $35 per share = $3,500,000.
Related Material
74. (C) None, reclassification is prohibited under IFRS 9.

Explanation
Initial designation for equity securities is irrevocable under IFRS 9 and hence
reclassification is prohibited.
Related Material
75. (B) $2.60 million.

Explanation
Under the equity method the market value of the stock is ignored but the
proportionate share of the earnings are added to the original investment and the
proportionate share of the dividends are subtracted from the earnings. Hence, we
have the original investment + (earnings - dividends) = total value of the
investment.
[(100,000 shares)($25)] + [(100,000 shares)($2.50 earnings – 1.50 dividend)]
= $2,600,000.
Related Material
76. (B) $1,000,000 and $1,130,000.

Explanation
Using the equity method will result in a decrease of the current asset account to
$300,000 because of the cash outflow. However, a new non-current asset called
"Investment in Company T" will be added to the balance sheet. This amount will be
$100,000, so the total assets will remain unchanged. Under U.S. GAAP, only full
goodwill is allowed. Full goodwill = fair value of company T — Book value of
company T. Fair value of company T = (100,000 / 0.50 = 200,000). Book value
of company T = 130,000 (total stock holder's equity = common stock + retained
earnings). Goodwill = 70,000. Under acquisition, total assets will be $1,130,000
(70,000 + 400,000 + 60,000 + 600,000 + 100,000 — 100,000).
Related Material
CFA
77. (B) The use of the acquisition method by a company will generally report the less
favourable results.
Explanation
The equity method will provide more favourable results, while the acquisition
method will provide less favourable results. (Under the equity method, liabilities
and leverage are lower than under the acquisition method, while net profit margin,
ROE, and ROA are higher.)
Related Material
Evergreen Brothers is a large producer of bedding plants and shrubs that are sold
to various retail nurseries and home improvement stores located across the
western coast of the United States with approximately $85 million in annual sales.
Evergreen grows its products at two facilities, one in Northern California and the
other in the Southern part of the state. Each production facility currently
distributes its products within an approximate 150 mile radius of its location. All
aspects of the shipping and delivery of products have historically been provided
by an independent, third-party distribution company.
Because of impressive growth in the company's sales over the past several years,
management has decided to pursue plans to bring "in-house" the distribution of
the company's products. They believe that the projected decreased freight costs as
well as the increased efficiencies in more actively managing the distribution of
their production should immediately yield increased profit margins. As an initial
step, Evergreen has negotiated the price for ten delivery trucks, which could
provide all distribution capacity needed for the company's Northern production
facility for the upcoming season. Current plans are to continue the use of the
independent distribution company for the needs of the firm's Southern facility for
at least the next several years.
Under advice from the company's CFO, Evergreen has created a new special
purpose entity (SPE), QuickTime, Inc., which will serve as the entity that will
purchase the trucks from the dealer. The purchase will be financed through a
combination of debt and equity, with the dealer lending 75% of the total cost. The
loan is collateralized by both the trucks and Evergreen's guarantee of the debt, as
required by the dealer.
Evergreen has arranged for an outside investor to provide the remaining 25% of
the upfront costs of the equipment in exchange for 100% of QuickTime's
nonvoting stock. In addition, the outside investor is guaranteed an 8% annual
return for the life of the financing term. At the end of seven years, QuickTime will
be liquidated and Evergreen will have the option of purchasing the equipment for

CFA
its fair value at that time. The proceeds of the liquidation will be used to
repurchase the outside investor's stock at par value. In the event that the
liquidation value is insufficient to buy back the outside investor's, Evergren has
committed to fund the shortfall.
Management has given its tentative approval of the project and the proposed
structure. Questions remain, however, as to the effect of the creation of QuickTime
on Evergreen's financial statements. With the relatively recent issuance of FASB
Interpretation No. 46(R), "Consolidation of Variable Interest Entities" (FIN 46(R)),
the management of Evergreen has not had prior experience with the new
consolidation requirements for SPEs.
78. (A) An SPE can be established as one of several legal forms, such as corporations,
partnerships, or trusts, but must establish separate management from that of the
sponsor.
Explanation
An SPE can take on one of many legal forms, but does not necessarily have to
have separate management or employees from that of the sponsor.
Related Material
79. (C) The total at-risk equity of the SPE is not sufficient to finance the entity's activities
without additional subordinated financial support.
Explanation
To qualify as a VIE under US GAAP, any one of four conditions must be met, one of
which is the presence of an insufficient at-risk equity investment.
Related Material
80. (B) Has exposure to the majority of the loss risks or receives the majority of the
residual benefits of the VIE.
Explanation
Unlike past accounting treatments of VIEs where consolidation was based upon
voting control, FIN 46(R) recognizes the primary beneficiary of a VIE as that entity
that absorbs the majority of the risks and enjoys the majority of the benefits of the
VIE. The primary beneficiary is required to consolidate the VIE on their financial
statements.
CFA
81. (B) Evergreen is exposed to the majority of QuickTime's risks and rewards, so
Evergreen must consolidate QuickTime on its financial statements.
Explanation
Before the issuance of FIN 46(R), consolidation was based upon possession of
voting control of an entity. FIN 46(R) uses a risk/reward approach when
determining which firm must consolidate the VIE on its financial statements. Since
Evergreen is the sole entity exposed to variability in QuickTime's net income, as
well asset value, QuickTime should be consolidated on their financial statements.
Related Material
82. (B) equity method.

Explanation
Normally, due to the less than 20% ownership stake, investment in financial assets
accounting would be used to record this investment. However, percentage
ownership rules are guidelines only and the appropriate accounting method is
dependent on the degree of influence the acquirer intends to exert. In this case,
GTH has announced their desire to exert significant influence, hence, the equity
method is the appropriate choice.
Related Material
Luna Life Insurance is a publicly traded corporation with total assets in excess of
$500 million. Joy Manning, CFA, has served as Luna's chief investment officer for
the past decade. Recent poor performance of Luna investment portfolio has led to
the formation of a special task force to review Luna's investment holdings as well
as its operating policies. The task force is composed of two current Luna board
members (who are not employees of Luna) and three independent investment
professionals. Their assignment is to thoroughly review Luna's financial statements
for evidence of impropriety or mishandling of corporate assets. The task force is
expected to complete their review within one month and report back to Luna's
board of directors shortly thereafter.
Luna's most recent financial statements reflect approximately $200 million in
various equity holdings and $100 million in debt instruments. A broad
classification of the portfolio (in millions of $) as of December 31, 2006 is as
follows:
Held-to-Maturity Available-for-Sale Trading
Equity $0 $125 $75
Debt $50 $25 $25

CFA
In the footnotes, there is a reference to $10 million of available-for-sale securities
that were transferred to the held-to-maturity portfolio last year. The securities
were transferred at fair market value, and an unrealized loss of $1 million was
included in that period's income. Several members of the task force believe the
transaction deserves further analysis to determine if the securities' transfer
between portfolios was executed in accordance with SFAS 115, "Accounting for
Certain Investments in Debt and Equity Securities" as Manning has represented.
Also, in 2006, Luna transferred $5 million of shares in ABC Corp from the
available-for-sale portfolio to the trading portfolio. In association with this
transaction, $1 million in unrealized gains were included in the year's income. The
task force observes that after the transfer, there are $2.5 million of ABC Corp
remaining in the available-for-sale portfolio. Manning has stated that the firm's
desire to reduce exposure to the equity market was the reason for selling only a
portion of the position in ABC Corp.
In addition, the group is performing its own analysis on the impact of last year's
acquisition of a 20% stake in Instate, a regional provider of commercial insurance.
Instate reported $15 million in earnings for the year ending December 31, 2006,
and paid approximately $1 million in dividends. Manning directed Luna's
accountants to record the purchase using the equity method, and thus has
included a proportional share of Instate's net income for the year. The acquisition
was effective as of January 1st of 2006, and operating results for the investment
stake in Instate are incorporated into Luna's 2006 financial statements. The group
will perform basic analysis both with and without the operating results of Instate
in order to better evaluate what financial impact the inclusion of Luna's results had
on Instate's overall performance.
83. (C) An investment in 5% of the equity of an entity that gives the owner significant
influence over that entity.
Explanation
The parent-company must have significant influence over the management of the
affiliate. Control would require the consolidation method.
Related Material
84. (A) The investing firm can include a proportionate share of the investee's income in its
earnings, regardless of whether or not there are actual cash flows (i.e. dividends).
Explanation
The proportionate share of the investee's income is included in the parent's
income statement. Changes in the market value of the investee are not reflected in
the investing firm's income statement so long as the decline in value is not
considered to be permanent.
Related Material

Reading 8 Intercorporate Investments

Uploaded by

Copyright:

Available Formats

Reading 8 Intercorporate Investments

Uploaded by

Document Information

Original Title

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

Reading 8 Intercorporate Investments

Uploaded by

Copyright:

Available Formats

CFA

Quantitative Methods 1 Intercorporate Investments

Quantitative Methods 2 Intercorporate Investments

Simpson's Purchase Transactions in BC's Stock

7. (B) Equity method.

Quantitative Methods 3 Intercorporate Investments

9. (A) Acquisition method.

10. (C) $-2,830,000.

11. (C) Both methods report the same net income.

Quantitative Methods 4 Intercorporate Investments

The Anderson Company acquired 100,000 shares of the Birschbach Company on

13. (A) $3.5 million.

14. (B) $2.6 million.

Quantitative Methods 5 Intercorporate Investments

16. (B) +$50,000.

20. (C) Acquisition method.

22. (C) Acquisition.

23. (B) $600,000.

Quantitative Methods 8 Intercorporate Investments

25. (C) equity under IFRS and US GAAP.

26. (C) Basten's statement is correct and Matthews' statement is correct.

Quantitative Methods 9 Intercorporate Investments

28. (C) $5,375 $500 $125

29. (A) Only one is correct.

Quantitative Methods 10 Intercorporate Investments

31. (C) Acquisition method.

32. (C) Both are incorrect.

Quantitative Methods 11 Intercorporate Investments

35. (A) 1.01, 0.92.

36. (B) $93,000.

Quantitative Methods 12 Intercorporate Investments

38. (B) $125,000.

39. (C) $0.00

Quantitative Methods 14 Intercorporate Investments

45. (A) ROA being higher than under consolidation.

Quantitative Methods 15 Intercorporate Investments

47. (A) Equity method.

Quantitative Methods 16 Intercorporate Investments

Another reporting issue the accounting department is looking at concerns a fixed

Exhibit 2 - Fixed Income Portfolio

49. (A) $19,900.

51. (A) $1,079,000.

Yield at date of purchase can be calculated as follows:

Quantitative Methods 18 Intercorporate Investments

On January 9, 20X6, Company X, reporting under IFRS, purchased $1,000,000 of

54. (C) $3,200,000.00.

55. (B) Reclassification would not be allowed.

Quantitative Methods 19 Intercorporate Investments

58. (C) $400.

59. (C) Equity method.

60. (B) $15,000.

61. (B) lower.

63. (B) charge $2 million to its income statement.

65. (A) $25,000.

Quantitative Methods 21 Intercorporate Investments

Exhibit 1 - TRQ Financial Statement Extracts

67. (B) $175,000.00.

Quantitative Methods 22 Intercorporate Investments

69. (B) $175,000.