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Solution Manual For Advanced Accounting, 3rd Edition(2002 Fasb Update)

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    1-1 CHAPTER 1 ANSWERS TO QUESTIONS 1. Internal expansion involves a normal increase in business resulting from increased demand for products and services, achieved without acquisition of preexisting firms. Some companies expand internally by undertaking new product research to expand their total market, or by attempting to obtain a greater share of a given market through advertising and other promotional activities. Marketing can also be expanded into new geographical areas. External expansion is the bringing together of two or more firms under common control by acquisition. Referred to as business combinations, these combined operations may be integrated, or each firm may be left to operate intact. 2. Four advantages of business combinations as compared to internal expansion are: (1) Management is provided with an established operating unit with its own experienced personnel, regular suppliers, productive facilities and distribution channels. (2) Expanding by combination does not create new competition. (3) Permits rapid diversification into new markets. (4) Income tax benefits. 3. The primary legal constraint on business combinations is that of possible antitrust suits. The United States government is opposed to the concentration of economic power that may result from business combinations and has enacted two federal statutes, the Sherman Act and the Clayton Act to deal with antitrust problems. 4. (1) A horizontal combination involves companies within the same industry that have previously been competitors. (2) Vertical combinations involve a company and its suppliers and/or customers. (3) Conglomerate combinations involve companies in unrelated industries having little production or market similarities. 5. A statutory merger results when one company acquires all of the net assets of one or more other companies through an exchange of stock, payment of cash or property, or the issue of debt instruments. The acquiring company remains as the only legal entity, and the acquired company ceases to exist or remains as a separate division of the acquiring company. A statutory consolidation results when a new corporation is formed to acquire two or more corporations, through an exchange of voting stock, with the acquired corporations ceasing to exist as separate legal entities. A stock acquisition occurs when one corporation issues stock or debt or pays cash for all or part of the voting stock of another company. The stock may be acquired through market purchases or through direct purchase from or exchange with individual stockholders of the investee or subsidiary company. 6. A tender offer is an open offer to purchase up to a stated number of shares of a given corporation at a stipulated price per share. The offering price is generally set above the current market price of the shares to offer an additional incentive to the prospective sellers. 7. A stock exchange ratio is generally expressed as the number of shares of the acquiring company that are to be exchanged for each share of the acquired company.

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    1-2 8. Defensive tactics include: (1) Poison pill – when stock rights are issued to existing stockholders that enable them to purchase additional shares at a price below market value, but exercisable only in the event of a potential takeover. This tactic is effective in some cases. (2) Greenmail – when the shares held by a would-be acquiring firm are purchased at an amount substantially in excess of their fair value. The shares are then usually held in treasury. This tactic is generally ineffective. (3) White knight or white squire – when a third firm more acceptable to the target company management is encouraged to acquire or merge with the target firm. (4) Pac-man defense – when the target firm attempts an unfriendly takeover of the would-be acquiring company. (5) Selling the crown jewels – when the target firms sells valuable assets to others to make the firm less attractive to an acquirer. 9. In an asset acquisition, the firm must acquire 100% of the assets of the other firm, while in a stock acquisition, a firm may gain control by purchasing 50% or more of the voting stock. Also, in a stock acquisition, formal negotiations with the target’s management can sometimes be avoided. Further, in a stock acquisition, there might be advantages in keeping the firms as separate legal entities such as for tax purposes. 10. Does the merger increase or decrease expected earnings performance of the acquiring institution? From a financial and shareholder perspective, the price paid for a firm is hard to justify if earnings per share declines. When this happens, the acquisition is considered dilutive . Conversely, if the earnings per share increases as a result of the acquisition, it is referred to as an accretive acquisition. 11. Under the parent company concept, the writeup or writedown of the net assets of the subsidiary in the consolidated financial statements is restricted to the amount by which the cost of the investment is more or less than the book value of the net assets acquired. Noncontrolling interest in net assets is unaffected by such writeups or writedowns. The economic unit concept supports the writeup or writedown of the net assets of the subsidiary by an amount equal to the entire difference between the fair value and the book value of the net assets on the date of acquisition. In this case, noncontrolling interest in consolidated net assets is adjusted for its share of the writeup or writedown of the net assets of the subsidiary. 12. a) Under the parent company concept, noncontrolling interest is considered a liability of the consolidated entity whereas under the economic unit concept, noncontrolling interest is considered a separate equity interest in consolidated net assets. b) The parent company concept supports partial elimination of intercompany profit whereas the economic unit concept supports 100 percent elimination of intercompany profit. c) The parent company concept supports valuation of subsidiary net assets in the consolidated financial statements at book value plus an amount equal to the parent company’s percentage interest in the difference between fair value and book value. The economic unit concept supports valuation of subsidiary net assets in the consolidated financial statements at their fair value on the date of acquisition without regard to the parent company’s percentage ownership interest. d) Under the parent company concept, consolidated net income measures the interest of the shareholders of the parent company in the operating results of the consolidated entity. Under the

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    1-3 economic unit concept, consolidated net income measures the operating results of the consolidated entity which is then allocated between the controlling and noncontrolling interests. 13. The implied fair value based on the price may not be relevant or reliable since the price paid is a negotiated price which may be impacted by considerations other than or in addition to the fair value of the net assets of the acquired company. There may be practical difficulties in determining the fair value of the consideration given and in allocating the total implied fair value to specific assets and liabilities. In the case of a less than wholly owned company, valuation of net assets at implied fair value violates the cost principle of conventional accounting and results in the reporting of subsidiary assets and liabilities using a different valuation procedure than that used to report the assets and liabilities of the parent company. 14. The economic entity is more consistent with the principles addressed in the FASB’s conceptual framework. It is an integral part of the FASB’s conceptual framework and is named specifically in SFAC No. 5 as one of the basic assumptions in accounting. The economic entity assumption views economic activity as being related to a particular unit of accountability, and the standard indicates that a parent and its subsidiaries represent one economic entity even though they may include several legal entities. 15. The FASB’s conceptual framework provides the guidance for new standards. The quality of comparability was very much at stake in FASB’s decision in 2001 to eliminate the pooling of interests method for business combinations. This method was also argued to violate the historical cost principle as it essentially ignored the value of the consideration (stock) issued for the acquisition of another company. The issue of consistency plays a role in the recent proposal to shift from the parent concept to the economic entity concept, as the former method valued a portion (the noncontrolling interest) of a given asset at prior book values and another portion (the controlling interest) of that same asset at exchange-date market value. 16. Comprehensive income is a broader concept, and it includes some gains and losses explicitly stated by FASB to bypass earnings. The examples of such gains that bypass earnings are some changes in market values of investments, some foreign currency translation adjustments and certain gains and losses, related to minimum pension liability. In the absence of gains or losses designated to bypass earnings, earnings and comprehensive income are the same.

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    1-4 ANSWERS TO BUSINESS ETHICS CASE 1. The third item will lead to the reduction of net income of the acquired company before acquisition, and will increase the reported net income of the combined company subsequent to acquisition. The accelerated payment of liabilities should not have an effect on net income in current or future years, nor should the delaying of the collection of revenues (assuming those revenues have already been recorded). 2. The first two items will decrease cash from operations prior to acquisition and will increase cash from operations subsequent to acquisition. The third item will not affect cash from operations. 3. As the manager of the acquired company I would want to make it clear that my future performance (if I stay on with the consolidated company) should not be evaluated based upon a future decline that is perceived rather than real. Further, I would express a concern that shareholders and other users might view such accounting maneuvers as sketchy. 4. a) Earnings manipulation may be regarded as unethical behavior regardless of which side of the acquirer/acquiree equation you’re on. The benefits that you stand to reap may differ, and thus your potential liability may vary. But the ethics are essentially the same. Ultimately the company may be one unified whole as well, and the users that are affected by any kind of distorted information may view any participant in an unsavory light. b) See answer to (a).

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    1-5 ANSWERS TO EXERCISES Exercise 1-1 Part A Normal earnings for similar firms = ($15,000,000 - $8,800,000) x 15% = $930,000 Expected earnings of target: Pretax income of Condominiums, Inc., 2008 $1,200,000 Subtract: Additional depreciation on building ($960,000  30%) (288,000) Target’s adjusted earnings, 2008 912,000 Pretax income of Condominiums, Inc., 2009 $1,500,000 Subtract: Additional depreciation on building (288,000) Target’s adjusted earnings, 2009 1,212,000 Pretax income of Condominiums, Inc., 2010 $950,000 Add: Extraordinary loss 300,000 Subtract: Additional depreciation on building (288,000) Target’s adjusted earnings, 2010 962,000 Target’s three year total adjusted earnings 3,086,000 Target’s three year average adjusted earnings ($3,086,000  3) 1,028,667 Excess earnings of target = $1,028,667 - $930,000 = $98,667 per year Present value of excess earnings (perpetuity) at 25%: = $394,668 (Estimated Goodwill) Implied offering price = $15,000,000 – $8,800,000 + $394,668 = $6,594,668. Part B Excess earnings of target (same as in Part A) = $98,667 Present value of excess earnings (ordinary annuity) for three years at 15%: $98,667  2.28323 = $225,279 Implied offering price = $15,000,000 – $8,800,000 + $225,279 = $6,425,279. Note: The sales commissions and depreciation on equipment are expected to continue at the same rate, and thus do not necessitate adjustments. % , $ 25 667 98

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    1-6 Exercise 1-2 Part A Cumulative 5 years net cash earnings $850,000 Add nonrecurring losses 48,000 Subtract extraordinary gains (67,000) Five-years adjusted cash earnings $831,000 Average annual adjusted cash earnings $166,200 (a) Estimated purchase price = present value of ordinary annuity of $166,200 (n=5, rate= 15%) $166,200  3.35216 = $557,129 (b) Less: Market value of identifiable assets of Beta $750,000 Less: Liabilities of Beta 320,000 Market value of net identifiable assets 430,000 Implied value of goodwill of Beta $127,129 Part B Actual purchase price $625,000 Market value of identifiable net assets 430,000 Goodwill purchased $195,000 Exercise 1-3 Part A Normal earnings for similar firms (based on tangible assets only) = $1,000,000 x 12% = $120,000 Excess earnings = $150,000 – $120,000 = $30,000 (1) Goodwill based on five years excess earnings undiscounted. Goodwill = ($30,000)(5 years) = $150,000 (2) Goodwill based on five years discounted excess earnings Goodwill = ($30,000)(3.6048) = $108,144 (present value of an annuity factor for n=5, I=12% is 3.6048) (3) Goodwill based on a perpetuity Goodwill = ($30,000)/.20 = $150,000 Part B The second alternative is the strongest theoretically if five years is a reasonable representation of the excess earnings duration. It considers the time value of money and assigns a finite life. Alternative three also considers the time value of money but fails to assess a duration period for the excess earnings. Alternative one fails to account for the time value of money. Interestingly, alternatives one and three yield the same goodwill estimation and it might be noted that the assumption of an infinite life is not as absurd as it might sound since the present value becomes quite small beyond some horizon. Part C Goodwill = [Cost less (fair value of assets less the fair value of liabilities)],       5 000 831 , $

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    1-7 Or, Cost less fair value of net assets Goodwill = ($800,000 – ($1,000,000 - $400,000)) = $200,000

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    2 - 1 CHAPTER 2 Note: The letter A or B indicated for a question, exercise, or problem means that the question, exercise, or problem relates to a chapter appendix. ANSWERS TO QUESTIONS 1. At the acquisition date, the information available (and through the end of the measurement period) is used to estimate the expected total consideration at fair value. If the subsequent stock issue valuation differs from this assessment, the Exposure Draft (SFAS 1204-001) expected to replace FASB Statement No. 141 specifies that equity should not be adjusted. The reason is that the valuation was determined at the date of the exchange, and thus the impact on the firm’s equity was measured at that point based on the best information available then. 2. Pro forma financial statements (sometimes referred to as “as if” statements) are financial statements that are prepared to show the effect of planned or contemplated transactions. 3. For purposes of the goodwill impairment test, all goodwill must be assigned to a reporting unit. Goodwill impairment for each reporting unit should be tested in a two-step process. In the first step, the fair value of a reporting unit is compared to its carrying amount (goodwill included) at the date of the periodic review. The fair value of the unit may be based on quoted market prices, prices of comparable businesses, or a present value or other valuation technique. If the fair value at the review date is less than the carrying amount, then the second step is necessary. In the second step, the carrying value of the goodwill is compared to its implied fair value. (The calculation of the implied fair value of goodwill used in the impairment test is similar to the method illustrated throughout this chapter for valuing the goodwill at the date of the combination.) 4. The expected increase was due to the elimination of goodwill amortization expense. However, the impairment loss under the new rules was potentially larger than a periodic amortization charge, and this is in fact what materialized within the first year after adoption (a large impairment loss). If there was any initial stock price impact from elimination of goodwill amortization, it was only a short-term or momentum effect. Another issue is how the stock market responds to the goodwill impairment charge. Some users claim that this charge is a non-cash charge and should be disregarded by the market. However, others argue that the charge is an admission that the price paid was too high, and might result in a stock price decline (unless the market had already adjusted for this overpayment prior to the actual writedown). 5B. The acquisition method treats a combination as the acquisition of one or more companies by another. The pooling of interests method, in contrast, interprets a business combination as the process of two or more groups of stockholders uniting ownership interest by an exchange of equity securities. This method (pooling) is no longer allowed for acquisitions after June 30, 2001. However, accounts resulting from previous acquisitions that used the pooling method will continue to be carried forward under the valuations implied by that method. Under the acquisition method the identifiable assets acquired and liabilities assumed are recorded at their fair values at the date of acquisition. Any excess of total implied value over the sum of these fair values is recorded as goodwill. Under the pooling method fair values of assets and

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    2 - 2 liabilities were ignored, and the assets acquired and liabilities assumed were carried forward to the new or surviving entity at their recorded (book) values. Financial statement differences resulted from the use of one method rather than the other. The purchase method normally results in higher asset values. To the extent that these higher values relate to depreciable assets and inventories, future income charges are greater. (Also, bond discounts, under the purchase method, must be amortized to future periods, and in the past goodwill was amortized under the purchase method.) Thus, the use of the pooling method generally resulted in greater future earnings, lower asset values, and greater returns on assets. 6B.Net income would be the highest under the pooling method (no excess depreciation or goodwill amortization), lowest under the former purchase rules (before FASB Statement No. 141, both excess depreciation and goodwill amortization), and intermediate under the purchase rules after FASB Statement No. 141 (excess depreciation only). Assets would be higher under the purchase method, either old or new rules. In fact, under the new rules, total assets will remain higher than under the old purchase rules because goodwill, once recorded, is not amortized.

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    2 - 3 Business Ethics Solutions Business ethics solutions are merely suggestions of points to address. The objective is to raise the students' awareness of the topics, and to invite discussion. In most cases, there is clear room for disagreement or conflicting viewpoints. The board has responsibility to look into anything that might suggest malfeasance or inappropriate conduct. Such incidents might suggest broader problems with integrity, honesty, and judgment. In other words, can you trust any reports from the CEO? If the CEO is not fired, does this send a message to other employees that ethical lapses are okay? Employees might feel that top executives are treated differently. ANSWERS TO EXERCISES Exercise 2-1 Part A Receivables 228,000 Inventory 396,000 Plant and Equipment 540,000 Land 660,000 Goodwill ($2,154,000 - $1,824,000) 330,000 Liabilities 594,000 Cash 1,560,000 Part B Receivables 228,000 Inventory 396,000 Plant and Equipment 540,000 Land 660,000 Liabilities 594,000 Cash 990,000 Gain on Business Combination ($1,230,000 - $990,000) 240,000

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    2 - 4 Exercise 2-2 Cash $680,000 Receivables 720,000 Inventories 2,240,000 Plant and Equipment (net) ($3,840,000 + $720,000) 4,560,000 Goodwill 120,000 Total Assets $8,320,000 Liabilities 1,520,000 Common Stock, $16 par ($3,440,000 + (.50  $800,000)) 3,840,000 Other Contributed Capital ($400,000 + $800,000) 1,200,000 Retained Earnings 1,760,000 Total Equities $8,320,000 Entries on Petrello Company’s books would be: Cash 200,000 Receivables 240,000 Inventory 240,000 Plant and Equipment 720,000 Goodwill * 120,000 Liabilities 320,000 Common Stock (25,000  $16) 400,000 Other Contributed Capital ($48 - $16)  25,000 800,000 * ($48  25,000) – [($1,480,000 – ($800,000 – $720,000) – $320,000] = $1,200,000 – [$1,480,000 – $80,000 – $320,000] = $1,200,000 – $1,080,000 = $120,000

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    2 - 5 Exercise 2-3 Accounts Receivable 231,000 Inventory 330,000 Land 550,000 Buildings and Equipment 1,144,000 Goodwill 848,000 Allowance for Uncollectible Accounts ($231,000 - $198,000) 33,000 Current Liabilities 275,000 Bonds Payable 450,000 Premium on Bonds Payable ($495,000 - $450,000) 45,000 Preferred Stock (15,000  $100) 1,500,000 Common Stock (30,000  $10) 300,000 Other Contributed Capital ($25 - $10)  30,000 450,000 Cash 50,000 Cost paid ($1,500,000 + $750,000 + $50,000) = $2,300,000 Fair value of net assets (198,000 + 330,000 + 550,000 + 1,144,000 – 275,000 – 495,000) = 1,452,000 Goodwill = $848,000 Exercise 2-4 Cash 96,000 Receivables 55,200 Inventory 126,000 Land 198,000 Plant and Equipment 466,800 Goodwill* 137,450 Accounts Payable 44,400 Bonds Payable 480,000 Premium on Bonds Payable** 45,050 Cash 510,000 ** Present value of maturity value, 12 periods @ 4%: 0.6246  $480,000 = $299,808 Present value of interest annuity, 12 periods @ 4%: 9.38507  $24,000 = 225,242 Total present value 525,050 Par value 480,000 Premium on bonds payable $ 45,050 *Cash paid $510,000 Less: Book value of net assets acquired ($897,600 – $44,400 – $480,000) (373,200) Excess of cash paid over book value 136,800 Increase in inventory to fair value (15,600) Increase in land to fair value (28,800) Increase in bond to fair value 45,050 Total increase in net assets to fair value 650 Goodwill $137,450

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    2 - 6 Exercise 2-5 Current Assets 960,000 Plant and Equipment 1,440,000 Goodwill 336,000 Liabilities 216,000 Cash 2,160,000 Liability for Contingent Consideration 360,000 Exercise 2-6 The amount of the contingency is $500,000 (10,000 shares at $50 per share) Part A Goodwill 500,000 Paid-in-Capital for Contingent Consideration 500,000 Part B Paid-in-Capital for Contingent Consideration 500,000 Common Stock ($10 par) 100,000 Paid-In-Capital in Excess of Par 400,000 Platz Company does not adjust the original amount recorded as equity. Exercise 2-7 Current Assets $3,000 Plant Assets (1) 24,350 Goodwill (2) 23,400 Debt 50,000 Stockholders’ Equity (3) 750 (1) $12,000 + [.95  ($25,000 – $12,000)] = $24,350 (2) Cost of shares $50,000 Book value of net assets acquired (.95  $15,000) 14,250 Excess of cost over book value 35,750 Assigned to plant assets [.95  $25,000 - $12,000)] 12,350 Assigned to goodwill $23,400 (3) .05  $15,000 = 750

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    2 - 7 Exercise 2-8 1. (c) Cost (8,000 shares @ $30) $240,000 Fair value of net assets acquired 228,800 Excess of cost over fair value (goodwill) $ 11,200 2. (c) Cost (8,000 shares @ $30) $240,000 Fair value of net assets acquired ($90,000 + $242,000 – $56,000) 276,000 Excess of fair value over cost (gain) $ 36,000 Exercise 2-9 Current Assets 362,000 Long-term Assets ($1,890,000 + $20,000) + ($98,000 + $5,000) 2,013,000 Goodwill * 395,000 Liabilities 119,000 Long-term Debt 491,000 Common Stock (144,000  $5) 720,000 Other Contributed Capital (144,000  $15 - $5)) 1,440,000 * (144,000  $15) – [$362,000 + $2,013,000 – ($119,000 + $491,000)] = $395,000 Total shares issued        5 000 20 5 000 700 $ , $ $ , $ = 144,000 Fair value of stock issued (144,000  $15) = $2,160,000 Exercise 2-10 Case A Cost (Purchase Price) $130,000 Less: Fair Value of Net Assets 120,000 Goodwill $ 10,000 Case B Cost (Purchase Price) $110,000 Less: Fair Value of Net Assets 90,000 Goodwill $ 20,000 Case C Cost (Purchase Price) $15,000 Less: Fair Value of Net Assets 20,000 Gain ($ 5,000)

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    2 - 8 Exercise 2-10 (Continued) Assets Liabilities Retained Earnings (Gain) Goodwill Current Assets Long-Lived Assets Case A $10,000 $20,000 $130,000 $30,000 0 Case B 20,000 30,000 80,000 20,000 0 Case C 0 20,000 40,000 40,000 5,000 Exercise 2-11 Part A. 2008: Step 1 : Fair value of the reporting unit $400,000 Carrying value of unit: Carrying value of identifiable net assets $330,000 Carrying value of goodwill ($450,000 - $375,000) 75,000 405,000 Excess of carrying value over fair value $ 5,000 The excess of carrying value over fair value means that step 2 is required. Step 2: Fair value of the reporting unit $400,000 Fair value of identifiable net assets 340,000 Implied value of goodwill 60,000 Recorded value of goodwill ($450,000 - $375,000) 75,000 Impairment loss $ 15,000 2009: Step 1 : Fair value of the reporting unit $400,000 Carrying value of unit: Carrying value of identifiable net assets $320,000 Carrying value of goodwill ($75,000 - $15,000) 60,000 380,000 Excess of fair value over carrying value $ 20,000 The excess of fair value over carrying value means that step 2 is not required. 2010: Step 1 : Fair value of the reporting unit $350,000 Carrying value of unit: Carrying value of identifiable net assets $300,000 Carrying value of goodwill ($75,000 - $15,000) 60,000 360,000 Excess of carrying value over fair value $ 10,000 The excess of carrying value over fair value means that step 2 is required.

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