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Solution Manual For Advanced Accounting, 4th Edition

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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 asset s 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 . I t 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., 200 8 $1,200,000 Subtract: Additi onal depreciation on building ($960,000  30%) (288,000) Target’s adjusted earnings, 200 8 912,000 Pretax income of Condominiums, Inc., 200 9 $1,500,000 Subtract: Additional depreciation on building (288,000) Target’s adjusted earnings, 200 9 1,212,000 Pretax income of Condominiums, Inc., 20 10 $950,000 Add: Extraordinary loss 300,000 Subtract: Additional depreciation on building (288,000) Target’s adjusted earnings, 20 10 962,000 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 Im plied value of goodwill of Beta $127,129 Part B Actual purcha se 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 indicated for a question, exercise, or problem means that the question, exercise, or problem relates to a c hapter a ppendix. 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 R specifies that equity should not be adjusted. The reason is t hat the valuation was determin ed 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 wa s a ny 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).

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    2 - 2 ANSWERS TO BUSINESS ETHICS CASE a and b. 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 - 3 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 - 4 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 S tock (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) = 1,4 52,000 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 p resent 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 - 5 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 C ontingent C onsideration 360 ,000 Exercise 2 - 6 The amount of the contingency is $ 500 ,000 ( 10 ,000 shares at $ 5 0 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 P latz Company does not adjust the original amount recorded as equity. Exercise 2 - 7 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 - 8 Current Assets 362,000 Long - term A ssets ($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

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    2 - 6 Total shares issued       + 5 000 20 5 000 700 $ , $ $ , $ = 144,000 Fair value of stock issued (144,000  $15) = $2,160,000 Exercise 2 - 9 Case A Cost (Pur chase 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) 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

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    2 - 7 Exercise 2 - 1 0 Part A. 20 11 : 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 c arrying 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 v alue of goodwill 60,000 Recorded v alue of goodwill ($450,000 - $375,000) 75,000 Impairment l oss $ 15,000 20 12 : 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 f air value over c arrying value $ 20,000 The excess of fair value over carrying value means that step 2 is not required. 20 1 3 : 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 f air value $ 10,000 The excess of carrying value over fair value means that step 2 is required. Step 2 : Fair value of the reporting unit $350,000 Fair value of identifiable net assets 325,000 Implied value of goodwill 25,000 Recorded v alue of goodwill ($75,000 - $15,000) 60,000 Impairment loss $ 35,000

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    2 - 8 Part B. 20 11 : Impairment L oss — G oodwill 15,000 Goodwill 15,000 20 12 : No entry 20 1 3 : Impairment L oss — G oodwill 35,000 Goodwill 35,000 Part C. SFAS No. 142 specifies the presentation of goodwill in the balance sheet and income statement (if impairment occurs) as follows: • The aggregate amount of goodwill should be a separate line item in the balance sheet. • The aggregate amount of losses from goodwill impairment should be shown as a separate line item in the operating section of the income statement unless some of the impairment is associated with a discontinued operation (in which case it is shown net - of - tax in the discontinued operation section). Part D. In a period in which an impairment loss occurs, SFAS No. 142 mandates the following disclosures in the notes: (1) A description of the facts and circumstances leading to the impairment; (2) The amount of the impairment loss and the method of determining the fair value of the reporting unit; (3) The nature and amounts of any adjustments made to impairment estimates from earlier periods, if significant. Exercise 2 - 1 1 a. Fair Val ue of Identifiable Net Assets Book values $500,000 – $ 100,000 = $400,000 Write up of Inventory and Equipment: ($20,000 + $30,000) = 50,000 Purchase p rice above which goodwill would result $450,000 b. Equipment would not be written down , regardless of the purchase price, unless it was reviewed and determined to be overvalued originally . c. A gain would be shown if the purchase price was below $450,000 . d. Anything below $450,000 is technically considered a bargain. e. Goodwill would be $50,000 at a purchase price of $500,000 or ($450,000 + $50,000).

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    2 - 9 Exercise 2 - 1 2 A Cash 20,000 Accounts Receivable 112,000 Inventory 134,000 Land 55,000 Plant Assets 463,000 Discount on Bonds Payable 20,000 Goodwill * 127,200 Allowance for Uncollectible Accounts 10,000 Accounts Payable 54,000 Bonds Payable 200,000 Deferred Income Tax Liability 67,200 Cash 6 00,000 Cost of acquisition $600,000 Book value of net assets acquired ($80,000 + $132,000 + $160,000) 372,000 Difference between cost and book value 228,000 Allocated to: Increase inventory, land, and plant assets to fair value ($52,000 + $25,000 + $71,000) (148,000) Decrease bonds payable to fair value (20,000) Establish deferred income tax liability ($168,000  40%) 67,200 Balance assigned to goodwill $127,200 ANSWERS TO PROBLEMS Problem 2 - 1 Current Assets 85,000 Plant and Equipment 150,000 Goodwill* 100,000 Liabilities 35,000 Common Stock [(20,000 shares @ $10/share)] 200,000 Other Contributed Capital [(20,000  ($15 – $10))] 100,000 Acquisition Costs Expense 20,000 Cash 20,000 Other Contributed Capital 6,000 Cash 6,000 To record the direct acquisition costs and stock issue costs * Goodwill = Excess of Consideration of $ 335, 000 (stock valued at $ 300,000 plus debt assumed of $ 35 ,000) over Fair Value of Identifiable Assets of $ 235 ,000 ( total assets of $ 225 ,000 plus PPE fair value adjustment of $ 1 0 ,000)

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    2 - 10 Problem 2 - 2 Acme Company Balance Sheet October 1, 20 11 (000) Part A . Assets (except goodwill) ( $ 3,900 + $ 9,000 + $ 1,300) $14,200 Goodwill (1) 1,160 Total Assets $15,360 Liabilities ( $ 2,030 + $ 2,200 + $ 260) $4,490 Common Stock (180  $20) + $ 2,000 5,600 Other Contributed Capital (180  ($50 – $20)) 5,400 Retained Earnings (130 ) Total Liabilities and Equity $15,360 (1) Cost (180  $50) $9,000 Fair value of net assets acquired: Fair value of assets of Baltic and Colt $ 10,300 Less liabilities a ssumed 2,460 7,840 Goodwill $1,160

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    2 - 11 Problem 2 - 2 (continued) Part B. Baltic 20 12 : Step1 : Fair value of the reporting unit $6,500,000 Carrying value of unit : Carrying value of identifiable net assets 6,340,000 Carrying value of goodwill 200,000 * Total carrying value 6,540,000 * [(140,000 x $50) – ($9,000,000 – $2,200,000)] The excess of carrying value over fair value means that step 2 is required. Step 2: Fair value of the reporting unit $6,500,000 Fair value of identifiable net assets 6,350,000 Implied value of goodwill 150,000 Recorded value of goodwill 200,000 Impairment loss $ 50,000 (because $ 150,000 < $ 200,000) Colt 20 12 : Step1 : Fair value of the reporting unit $1,900,000 Carrying value of unit : Carrying value of identifiable net assets $1,200,000 Carrying value of goodwill 960,000 * Total carrying value 2,160,000 *[(40,000 x $50) – ($ 1 , 3 00,000 – $2 60 ,000)] The excess of carrying value over fair value means that step 2 is required. Step 2: Fair value of the reporting unit $1,900,000 Fair value of identifiable net assets 1,000,000 Implied value of goodwill 900,000 Recorded value of goodwill 960 ,000 Impairment loss $ 60,000 (because $ 900,000 < $ 960,000) Total impairment loss is $110,000. Journal entry: Impairment L oss $110,000 Goodwill $110,000

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    2 - 12 Problem 2 - 3 Present value of maturity value, 20 periods @ 6%: 0.3118  $600,000 = $187,080 Present value of interest annuity, 20 periods @ 6%: 11.46992  $30,000 = 344,098 Total Present value 531,178 Par value 600,000 Discount on bonds payable $68,822 Cas h 114,000 Accounts Receivable 135,000 Inventory 310,000 Land 315,000 Buildings 54,900 Equipment 39 , 450 Bond Discount ( $ 40,000 + $ 68,822) 108,822 Current Liabilities 95,300 Bonds Payable ( $ 300,000 + $ 600,000) 900,000 Gain on Purchase of Business 81,872 Computation of Excess of Net Assets Received Over Cost Cost (Purchase Price) ($531,178 plus liabilities assumed of $95,300 and $260,000) $886,478 Less: Total fair value of assets received $968,350 Excess of fair value of net assets over cost ($ 81,872 ) Problem 2 - 4 Part A January 1, 20 11 Accounts Receivable 72,000 Inventory 99,000 Land 162,000 Buildings 450,000 Equipment 288,000 Goodwill * 54,000 Allowance for U ncollectible A ccounts 7,000 Accounts Payable 83,000 Note Payable 180,000 Cash 720,000 Liability for Contingent Consideration 135 ,000 * Computation of Goodwill Cash paid ($720,000 + $135,000) $855,000 Total fair value of net assets acquired ( $ 1,064 ,000 - $ 263 ,000) 801 ,000 Goodwill $ 54 ,000

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    2 - 13 Problem 2 - 4 (continued) Part B January 2 , 20 1 3 Liability for Contingent Consideration 135,000 Cash 135 ,000 Part C January 2 , 20 1 3 Liability for Contingent Consideration 135,000 Income from Change in Estimate 135,000 Problem 2 - 5 Pepper Company Pro Forma Balance Sheet Giving Effect to Proposed Issue of Common Stock and Note Payable for All of the Common Stock of Salt Company under Purchase Accounting December 31, 20 10 Audited Pro Forma Balance Sheet Adjustments Balance Sheet Cash $180,000 405,000 $585,000 Receivables 230,000 (60,000) 287,000 117,000 Inventories 231,400 134,000 365,400 Plant Assets 1,236,500 905,000 (1) 2,141,500 Goodwill _________ 181,500 181,500 Total Assets $1,877,900 $3,560,400 Accounts Payable $255,900 (60,000) $375,900 180,000 Notes Payable , 8% 0 300,000 300,000 Mortgage Payable 180,000 152,500 332,500 Common Stock, $20 par 900,000 600,000 1,500,000 Additional Paid - in Capital 270,000 510,000 (2 ) 780,000 Retained Earnings 272,000 272,000 Total Liabilities and Equity $1,877,900 $3,560,400

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    2 - 14 Problem 2 - 5 (continued) Change in Cash Cash from s tock issue ($37  30,000) $1,110,000 Less: Cash paid for acquisition (800,000) Plus: Cash acquired in acquisition 95,0 00 Total change in cash $ 405,000 Goodwill: Cost of acquisition $1,100,000 Net assets acquired ( $ 340,000 + $ 179,500 + $ 184,000) 703,500 Excess co st over net assets acquired $396 ,500 Assigned to plant assets 215,000 Goodwill $ 181,500 (1) $690,000 + $215,000 (2 ) ($37 - $20)  30,000 Problem 2 - 6 Ping Company Pro Forma Income Statement for the Year 20 11 Assuming a Merger of Ping Company and Spalding Company Sales (1) $6,345,972 Cost of goods sold: Fixed Costs (2) $ 824,706 Variable Costs (3) 2,464,095 3,288,801 G ross Margin 3,057,171 Selling Expenses (4) $785,910 Other Expenses (5) 319,310 1,105,220 Net Income $1, 951,951 $1,951,951 – ($952,640 + $499,900) = = $2,497,055 0.20 Since $2,497,055 is greater than $1,800,000 Ping should buy Spalding. (1) $3,510,100 + $2,365,800 = $5,875,900  1.2  .9 = $6,345,972 (2) ($1,752,360  .30 ) + ($1,423,800  .30  .70) = $824,706 (3) $1,752,360  .70  = $2,464,095 (4) ($632,500 + $292,100)  .85 = $785,910 (5) $172,600  1.85 = $319,310 20 . 0 411 , 499 $ 100 510 3 2 1 900 875 5 , , $ . , , $ 

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    2 - 15 Problem 2 - 7 A Part A Receivables 125,000 Invento ry 195,000 Land 120,000 Plant Assets 567,000 Patents 200,000 Deferred Tax Asset ( $ 60,000 x 35%) 21,000 Goodwill * 154,775 Current Liabilities 89,500 Bonds Payable 300,000 Premium on Bonds Payable 60,000 Deferred Tax Liability 93,275 Common Stock (30,000  $2) 60,000 Other Contributed Capital (30,000  $26) 780,000 Cost of acquisition (30,000  $28) $840,000 Book value of net assets acquired ( $ 120,000 + $ 164,000 + $ 267,000) 551,000 Difference between cost and book value 289,000 Allocated to: Increase inventory, land, plant assets, and patents to fair value (266,500) Deferred income tax liability (35%  $266,500) 93,275 Increase bo nds payable to fair value 60,000 Deferred income tax asset (35%  $60,000) (21,000 ) Balance assigned to goodwill $154,775 Part B Income Tax Expense (Balancing amount) 148,006 Deferred Tax Liability ($51,125  35%)* 17,894 Deferred Tax Asset ($6,000  35%) 2,100 Income Tax Payable ($468,000  35%) 163,800 * Inventory: $28,000 Plant Assets , 10 000 100 , $ 10,000 Patents , 8 000 105 , $ 13,125 Total $51,125

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    3 - 1 CHAPTER 3 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. (1) Stock acquisition is greatly simplified by avoiding the lengthy negotiations required in an exchange of stock for stock in a complete takeover. (2) Effective control can be accomplished with more than 50% but less than all of the voting stock of a subsidiary; thus the necessary investment is smaller. (3) An individual affiliate’s legal existence provides a measure of protection of the parent’s assets from attachment by creditors of the subsidiary. 2. The purpose of consolidated financial statements is to present, primarily for the benefit of the shareholders and creditors of the parent company, the results of operations and the financial position of a parent company and its subsidiaries essentially as if the group were a single company with one or more branches or divisions. The presumption is that these consolidated statements are more meaningful than separate statements and necessary for fair presentation. Emphasis then is on substance rather than legal form, and the legal aspects of the separate entities are therefore ignored in light of economic aspects. 3. Each legal entity must prepare financial statements for use by those who look to the legal entity for analysis. Creditors of the subsidiary will use the separate statements in assessing the degree of protection related to their claims. Noncontrolling shareholders, too, use these individual statements in determining risk and the amounts available for dividends. Regulatory agencies are concerned with the net resources and results of operations of the individual legal entities. 4. (1) Control should exist in fact, through ownership of more than 50% of the voting stock of the subsidiary. (2) The intent of control should be permanent. If there are current plans to dispose of a subsidiary, then the entity should not be consolidated. (3) Majority owners must have control. Such would not be the case if the subsidiary were in bankruptcy or legal reorganization, or if the subsidiary were in a foreign country where political forces were such that control by majority owners was significantly curtailed. 5. Consolidated workpapers are used as a tool to facilitate the preparation of consolidated financial statements. Adjusting and eliminating entries are entered on the workpaper so that the resulting consolidated data reflect the operations and financial position of two or more companies under common control. 6. Noncontrolling interest represents the equity in a partially owned subsidiary by those shareholders who are not members in the affiliation and should be accounted and presented in equity, separately from the parents’ shareholders equity. Alternative views have included: presenting the noncontrolling interest as a liability from the perspective of the controlling shareholders; presenting the noncontrolling interest between liabilities and shareholders’ equity to acknowledge its hybrid status; presenting it as a contra - asset so that total assets reflect only the parent’s share; and

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    3 - 2 presenting it as a component of owners’ equity (the choice approved by FASB in its most recent exposure drafts). 7. The fair, or current, value of one or more specific subsidiary assets may exceed its recorded value, or specific liabilities may be overvalued. In either case, an acquiring company might be willing to pay more than book value. Also, goodwill might exist in the form of above normal earning s . Finally, the parent may be willing to pay a premium for the right to acquire control and the related economic advantages gained. 8. The determination of the percentage interest acquired, as well as the total equity acquired, is based on shares outstanding; thus, treasury shares must be excluded. The treasury stock account should be eliminated by offsetting it against subsidiary stockholder equity accounts. The accounts affected as well as the amounts involved will depend upon whether the cost or par method is used to account for the treasury stock. 9. None. The full amount of all intercompany receivables and payables is eliminated without regard to the percentage of control held by the parent. 10A . The decision in SFAS No. 109 and SFAS No. 141R [ topics 740 and 805] is primarily a display issue and would only affect the calculation of consolidated net income if there were changes in expected future tax rates that resulted in an adjustment to the balance of deferred tax assets or deferred tax liabilities. Prior to SFAS No. 109 and SFAS No. 141R , purchased assets and liabilities were displayed at their net of tax amounts and related figures for amortization and depreciation were based on the net of tax amounts. With the adoption of SFAS No. 109 and SFAS No. 141R , assets and liabilities are displayed at fair values and the tax consequences for differences between their assigned values and their tax bases are displayed separately as deferred tax assets or deferred tax liabilities. Although the amounts shown for depreciation, amortization and income tax expense are different under SFAS No. 109 and SFAS No. 141R , absent a change in expected future tax rates, the amount of consolidated net income will be the same. ANSWERS TO BUSINESS ETHICS CASE Part 1 Even though the suggested changes by the CFO lie within GAAP, the proposed changes will unfairly increase the EPS of the company, misleading the common investor s and other users. It is evident that the CFO is doing it for his or her personal gain rather than for the transparency of financial reporting. Thus, manipulating the reserve in this case comes under the heading of unethical behavior. Taking a stand in such a situation is a difficult and challenging test for an employee who reports to the CFO. Part 2 The tax laws permit individuals to minimize taxes by means that are within the law like using tax deductions , changing one's tax status through incorporation , or setting up a charitable trust or foundation . In the given case the losses reported were phony and the whole scheme was fabricated to illegally benefit certain individuals; hence there appears to be a criminal intent in the scheme. Although there is no reason to pay more tax than necessary, the lack of risk in these types of shelters makes participation in such schemes of questionable ethics, at the best.

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    3 - 3 ANSWERS TO EXERCISES Exercise 3 - 1 a. Common Stock – Saltez 160,000 Other Contributed Capital - Saltez 92,000 Retained Earnings - Saltez 43,000 Property,Plant, and E quipment 56,000 Investment in Saltez 351,000 b. Common S tock – Saltez 1 90 ,000 Other Contributed Capital – Saltez 75 , 0 00 Property, Plant, and E quipment 21 , 778 ( $ 232,000/0.9 - [ $ 190,000+ $ 75,000 - $ 29,000]) Retained Earnings – Saltez 2 9 , 0 00 Investment in Saltez 232,000 Noncontrolling Interest 25,778 c. Common Stock – Saltez 1 80 ,000 Other Contributed Capital – Saltez 40 ,000 Retained Earnings – Saltez 4 , 0 00 Investment in Saltez 159,000 Gain on Purchase of Business – Prancer ** 13,800 Noncontrolling Interest (.2) ($198,750) + $3,450* 43,200 ** The ordinary gain to Prancer is $159,000 – (.80)($216,000) = $13,800 * Noncontrolling interest reflects the noncontrolling share of implied value (.20 x $198,750, or $39,750), plus the NCI portion of the bargain (.20 x $17,250) NOTE: We know this is a bargain acquisition in part c because the investment cost of $159,000 implies a total value of $198,750. Since this value is less than the book value of equity of $216,000 [$180,000+$40,000 - $4,000], the difference is a bargain of $17,250. This bargain is allocated between the parent (this portion is reflected as a gain) and the NCI. Exercise 3 - 2 Part A Investment in Save ( 40 ,000  $17.50 ) 700,000 Common Stock 400,000 Other Contributed Capital ($700,00 0 – $20,000 – $400,000) 280,000 Cash 20,000 Part B Common Stock – Save 320,000 Other Contributed Capital – Save 175,000 Retained Earnings – Save 205,000 Investment in Save 700,000

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    3 - 4 Exercise 3 - 3 Part A Investment in Sun Company 192,000 Cash 192,000 Part B PRUNCE COMPANY AND SUBSIDIARY Consolidated Balance Sheet January 2, 20 11 Assets Cash ($260,000 + $64,000 – $192,000) $132,000 Accounts R eceivable 165,000 Inventory 171,000 Plant and Equipment (net) 484,000 Land ($63,000 + $32,000 + $ 2 8 , 333 * ) 12 3 , 333 Total Assets $1, 07 5 , 333 Liabilities and Stockholders’ Equity Accounts P ayable $151,000 Mortgage P ayable 111,000 Total L iabilities 262,000 Noncontrolling Interest ($192,000/0.9  0.1) $21 , 333 Common Stock 400 ,000 Other Contributed Capital 208,000 Retained Earnings 184,000 Total Stockholders’ Equity 813,333 Total Liabilities and Stockholders’ Equity $1, 07 5 , 333 * [ $192,000 /0.9 – ($70,000 + $20,000 + $95,000) ] = $ 28 , 333 Exercise 3 - 4 Part A Investment in Swartz Company ($60  1,500) 90,000 Common Stock ($20  1,500) 30,000 Other Contributed Capital ($40  1,500) 60,000 Other Contributed Capital 1,700 Cash 1,700 Part B Computation and Allocation of Difference Parent Non - Entire Share Controlling Value Share Purchase price and implied value $ 9 0,000 0 9 0,000 Less : Book value of equity acquired 83,000 * 0 83,000 Difference between implied and book value 7,000 0 7,000 Goodwill (7,000) (0) ( 7,000 ) Balance - 0 - - 0 - - 0 - * $40,000 + $24,000 + $19,000 = $83,000

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    3 - 5 Exercise 3 - 4 (continued) Part C Peach Company and Subsidiary Consolidated Balance Sheet January 1, 20 10 Assets Cash ($73,000 + $13,000 - $1,700) $ 84,300 Accounts R eceivable 114,000 Inventory 83,000 Plant and E quipment 138,000 Land 48,000 Goodwill* 7,000 Total Assets $ 474,300 Liabilities and Stockholders’ Equity Accounts P ayable $84,000 Notes P ayable 103,000 Total Liabilities $ 187,000 Common S tock ($100,000 + $30,000) $130,000 Other Contributed C apital ($60,000 + $60,000 - $1,700) 118,300 Retained E arnings 39,000 Total Stockholders’ Equity 287,300 Total Liabilities and Stockholders’ Equity $ 474,300 * Cost of investment less fair value acquired equals goodwill or ($90,000 – $83,000 = $7,000). Recall that the book value of net assets equals the fair value of net assets in this problem. Exercise 3 - 5 (1) Common Stock – Spruce 90 0 ,000 Other Contributed Capital – Spruce 440 ,000 Retained Earnings – Spruce 150 ,000 Land [ $1,400,000 /.90 – ($900,000 + $440,000 + $150,000 - $100,000)] 1 65 , 556 Investment in Spruce Company 1,400,000 Treasury Stock 10 0 ,000 Non c ontrolling Interest ($1,400,000/.90  .10) 1 5 5,556 (2) Common Stock – Spruce 900 ,000 Other Contributed Capital – Spruce 440 ,000 Retained Earnings – Spruce 150 ,000 Land 10,000 Investment in Spruce Company 1,160,000 Treasury Stock 10 0 ,000 G ain on Purchase of B usiness - Pool * 100 ,000 Noncontrolling I nterest [ ($1 ,050 ,000 + $990,000 + $1 8 0,000 - $820,000 ) x .10 ] 140,000 * [$1,160,000 – ($1,050,000 + $990,000 + $180,000 – $820,000) x .90] = $100,000

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    3 - 6 Exercise 3 - 6 Part A $37 , 412 Noncontrolling Interest = 15 % Noncontrolling Interest $ 249 , 412 Implied Value* * Implied Value = Parent’s value $212,000 + NCI $ 37 , 412 = $ 249 , 412 Common Stock - Shipley 90 , 0 00 Other Contributed Capital - Shipley 90 , 0 00 Retained Earnings - Shipley 56 , 0 00 Land $ 249 , 412 - $236,000 13 , 412 Investment in Shipley Company 212,000 Noncontrolling Interest 37 , 412 Part B SHIPLEY COMPANY Balance Sheet December 31, 20 10 Cash $ 15,900 Accounts R eceivable 22,000 Inventory 34,600 Plant and Equipment 147,000 Land ($ 220 , 412 - $ 13 , 412 - $120,000) 87,000 Total Assets $ 306,500 Accounts P ayable $ 70,500 Common Stock 90,000 Other Contributed Capital 90,000 Retained Earnings 56,000 Total Equities $ 306,500 Exercise 3 - 7 Part A. Long - term receivable from subsidiary $500,000 Current assets: interest receivable from subsidiary $50,000 Part B. None Exercise 3 - 8 Investment in Shy Inc. [$2,500,000 + (15,000  $40)] 3,100,000 Cash 2,500,000 Common Stock 30,000 Other Contributed Capital ($40 - $2)  15,000 570,000

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    3 - 7 Exercise 3 - 9 Investment in Shy Inc. [$2,500,000 + (15,000  $40)] 3, 1 00 ,000 Cash 2,500,000 Common Stock 30,000 Other Contributed Capital ($40 - $2)  15,000 570,000 Ac quisition Expense 97,000 Deferred Acquisition Charges 90 ,000 Acquisition Costs Payable 7,000 Exercise 3 - 10 A Note: This solution assumes a difference between the basis of acquired assets for accounting and tax purposes for this stock acquisition. Part A Investment in Seely Company 570,000 Common Stock*** 95,000 Additional P aid - in - C apital 475,000 ***Note: Depending on the wording of this exercise, the credit may be cash instead of common stock and additional paid - in - capital. If cash is paid, the credit to cash is $570,000. Part B Common Stock - Seely 80 ,000 Other Contributed Capital – Seely 132,000 Retained Earnings - Seely 1 60 ,000 Difference b etween Implied and Book Value * 228,000 Investment in Seely Company 570,000 Noncontrolling I nterest [($570,000/.95) x .05] 30,000 * [ $570,000/.95 – ($80,000 + $132,000 + $160,000) ] Inventory 52,0 00 Land 2 5,00 0 Plant Assets 71,00 0 Discount on Bonds Payable 20 ,000 Goodwill ** 127,200 Deferred Income Tax Liability* 67,200 Difference b etween Cost and Book Value 228,000 * (.40  ($ 52,000 + $ 25,000 + $ 71,000 + $ 20,000 )) **228,000 – [( $ 52,000 + $ 25,000 + $ 71,000 + $ 20,000) x 60%]

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    3 - 8 Exercise 3 - 11 A Investment in Starless Company 700,000 Common Stock 50,000 Other Contributed Capital ( ( $70 – $5)  10 ,000) 650,000 Because the combination is consummated as a stock acquisition, the entry on the books of the acquirer is no different than in the absence of deferred taxes. However, in the elimination entries, a deferred tax liability will be recognized and the amount of goodwill will be altered accordingly.

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