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Chapter 17

Understanding and Analyzing


Consolidated Financial Statements

LEARNING OBJECTIVES:

When your students have finished studying this chapter, they should be
able to:

1. Contrast accounting for investments using the equity method and


the market–value method.

2. Explain the basic ideas and methods used to prepare consolidated


financial statements.

3. Describe how goodwill arises and how to account for it.

4. Explain and use a variety of popular financial ratios.

5. Identify the major implications that efficient stock markets have for
accounting.

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CHAPTER 17: ASSIGNMENTS
CRITICAL THINKING EXERCISES
21. Depreciation in Consolidated Financial Statements
22. Market Method, Equity Method, and Total Assets
23. Just-in-Time (JIT) Inventory and Current Ratio
24. Market Efficiency

GENERAL EXERCISES and PROBLEMS


25. Equity Method
26. Consolidated Financial Statements
27. Determination of Goodwill
28. Purchased Goodwill
29. Amortization and Depreciation
30. Allocating Total Purchase Price to Assets
31. Preparation of Consolidated Financial Statements
32. Intercorporate Investments and Ethics
33. Profitability Ratios
34. Financial Ratio

UNDERSTANDING PUBLISHED FINANCIAL REPORTS


35. Meaning of Account Descriptions
36. Classification on Balance Sheet
37. Effects of Transactions Under the Equity Method
38. Consolidations in Japan
39. Noncontrolling Interests
40. General Electric and GECS
41. Goodwill
42. Accounting for Goodwill
43. Income Ratios and Asset Turnover
44. Financial Ratios
45. Nike 10-K Problem: Using Consolidated Financial
Statements

EXCEL APPLICATION EXERCISE


46. Calculating Financial Ratios

COLLABORATIVE LEARNING EXERCISE


47. Financial Ratios

INTERNET EXERCISE
48. General Electric’s Annual Report

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(http://www.ge.com)
CHAPTER 17: OUTLINE
Part One: Intercorporate Investments Including
Consolidations
Firms often invest in the equity securities of other companies. The
investor may be simply investing excess cash, or he may be
seeking some degree of control over the investee. There are three
methods of accounting for intercorporate investments: the equity
and market methods and consolidation.

An investor that holds less than 20% of another company is


assumed to be a passive investor - it cannot significantly influence
the decisions of the investee - and it uses the market method.
Investors with between 20% and 50% interest use the equity
method. At this level of ownership, the investor has the ability to
exert significant influence on the investee. Firms with an interest in
excess of 50% must use the consolidation approach.

I. Market Value and Equity Methods {L. O. 1}


A. Market-Value Method - records the initial investment
on the balance sheet at fair market value (FMV). Such
investments are often called marketable securities in
the financial statements. Trading Securities -
investments that the company buys only with the intent
to resell them shortly. Available-for-Sale Securities -
investments that the company does not intend to sell in
the near future. Changes in market value of trading
securities are reported as gains (increase in FMV) or
losses (decrease in FMV), while available-for-sale
securities have their unrealized gains or losses shown in
a separate valuation allowance account in the
stockholders’ equity section of the balance sheet. (See
EXHIBIT 17-1)

B. Equity Method - accounts for the investment at the


acquisition cost adjusted for the investor's share of
dividends and earnings or losses of the investee after
the date of investment. Investors increase the carrying

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amount of the investment by their share of investee's
earnings and reduce the carrying amount by dividends
received from the investee and by their share in
investee's losses.

II. Consolidated Financial Statements {L. O. 2}


Parent Company - the company owning more than 50% of the
other business's stock. Subsidiary - the company whose stock is
owned by the other business. Although parent and subsidiary
companies typically are separate legal entities, in many regards
they function as one unit. Consolidated Financial Statements -
financial statements that combine the financial statements of the
parent company with those of various subsidiaries.

A. The Acquisition

When a parent acquires a subsidiary, the evidence of interest


is recorded as Investment in Subsidiary. When the
consolidated statements are prepared, they cannot show both
the evidence of interest and the underlying assets and
liabilities of the subsidiary. To avoid such double-counting, the
reciprocal evidence of ownership present is eliminated in two
places: (1) the Investment in Subsidiary on the parent
company's books and (2) the Stockholders' Equity on the
subsidiary company's books. The entries necessary to
accomplish this are called eliminating entries.

III. Recognizing Income After Acquisition

Long-term investments in equity securities (e.g., the investments in


a subsidiary) are carried in the investor's balance sheet by the
equity method. The income generated by a subsidiary is
recognized by the parent company as an increase in an account
titled Investment in Subsidiary.

A. Noncontrolling Interests

When a parent holds less than 100% of the stock of a


subsidiary, a consolidated balance sheet includes an account
on the equities side called Noncontrolling Interests in
Subsidiaries, or simply Noncontrolling Interests - the

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account that shows the outside stockholders' interest, as
opposed to the parent's interest, in a subsidiary corporation.

B. Perspective on Consolidated Statements

See EXHIBIT 17-2 and EXHIBIT 17-3 for an illustration of


how investments in subsidiaries are presented in companies'
annual reports. The headings of the statements indicate that
they are consolidated statements. On balance sheets, the
minority interest typically appears just above the
stockholders' equity section. On income statements, the
minority interest in the net income is deducted as if it were
an expense of the consolidated entity after all the other
expenses are listed. Investments in Affiliates (or
Investments in Associates) - listed as an asset on the
balance sheet and reflect the purchase cost and interests in
income or loss of investees. The FASB requires all
subsidiaries to be consolidated. The major reason for forcing
consolidation is to provide a more complete picture of the
economic entity. See EXHIBIT 17-4 for a summary of the
accounting for different levels of investment in subsidiaries.

C. Accounting for Goodwill {L. O. 3}


In CHAPTER 16, goodwill is defined as the excess of cost
over fair value of net identifiable assets of businesses
acquired. The purchase price of a subsidiary often exceeds its
book value. In fact, it frequently exceeds the sum of the fair
market values of the identifiable individual assets less the
liabilities. When the amount paid exceeds the book values,
the assets will be valued at their fair market values for the
consolidated statements. Any amounts paid above the fair
market values of the individual assets are carried as goodwill
in the consolidated financial statements.

A purchaser may be willing to pay more than the current


values of the individual assets received because the
acquired company is able to generate abnormally high
earnings. The causes of this excess earnings power may be
traced to personalities, skills, locations, operating methods,
and so forth.

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"Goodwill" is originally generated internally. For example, a
happy combination of advertising, research, management
talent, and timing may give a particular company a dominant
market position for which another company is willing to pay
dearly. This ability to command a premium price for the total
business is goodwill. The selling company will never record
goodwill. Therefore, the only goodwill recognized as an asset
is that identified when one company is purchased by another.

Part Two: Analysis of Financial Statements


Careful analysis of financial statements can help decision makers
evaluate an organization's past performance and predict its future
performance. Financial statements of Microsoft Corporation in
EXHIBIT 17-5 and EXHIBIT 17-6 are used to focus on financial
statement analysis.

Investors analyze financial statements in order to decide whether to


buy, sell, or hold common stock. Managers and the financial
community (e.g., bank officers and stockholders) use them as clues
to help evaluate the operating and financial outlook for an
organization. Budgets or pro forma statements, carefully
formulated expressions of predicted results including a schedule of
the amounts and timings of cash repayments, are helpful to
creditors. They want assurances of being paid in full and on time.

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IV. Component Percentages

Component Percentages - analysis and presentation of financial


statements in percentage form to aid comparability, and is
frequently used when comparing companies that differ in size (see
EXHIBIT 17-7). The resulting statements are called Common-
Size Statements.

Income statement percentages are usually based on sales = 100%.


Comparing the gross margin rate or the net income percentage
with those of other firms in the industry or with prior years may be
useful. Better yet, a comparison of these percentages (along with
those for other items on the income statement) with what was
budgeted for the current year may help in diagnosing what changes
created better or worse results.

Balance sheet percentages are usually based on total assets =


100%. One can see the shifts in the composition of assets between
current and long term. In addition, one can see shifts in the
equities side of the balance sheet between current liabilities,
noncurrent liabilities, and stockholders' equity.

V. Use of Ratios {L. O. 4}


See EXHIBIT 17-8 for how typical ratios are computed from
financial statements. Many more ratios could be computed. For
example, Standard & Poor's Corporation sells a COMPUSTAT
service. Via computer, COMPUSTAT can provide financial and
statistical information for thousands of companies. The information
includes 175 financial statement items on an annual basis and 100
items on a quarterly basis, plus limited footnote information. The
SEC makes annual financial statements available online in its Edgar
database (http://www.sec.gov/edgar.shtml). The ratios shown in
EXHIBIT 17-8 are as follows:

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TYPICAL NAME NUMERATOR DENOMINATOR
OF RATIO

Short-Term Ratios:

Current ratio Current assets Current


liabilities

Avg. collection period


in days Avg. A/R x 365 Sales on account

Debt-to-Equity Ratios:

Current debt to equity Current liabilities Stockholders'


equity

Total debt to equity Total liabilities Stockholders'


equity

Profitability Ratios:

Gross profit rate or Gross profit or


percentage gross margin Sales

Return on sales Net income Sales

Return on stockholders' Net income Average


equity stockholders'
equity

Earnings per share Net income less Avg. common


shares
dividends on P/S outstanding

Price earnings Market price per Earnings per share


share of common stock

Dividend Ratios:

Dividend yield Dividends per Market price per


common share common share

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Dividend payout Dividends per Earnings per
share
common share

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A. Comparisons

Evaluation of a financial ratio requires a comparison. There


are three main types of comparisons: (1) Time Series
Comparisons - with a company's own historical ratios (e.g.,
for 5 to 10 years); (2) Benchmark Comparisons - general
rules of thumb (e.g., there is trouble if a company’s current
debt is at least 80% of its tangible net worth); and (3) Cross-
Sectional Comparisons - ratios of other companies or with
industry averages from Dun and Bradstreet. Comparisons for
the Microsoft Company data across years, against
benchmarks, and to the industry are presented.

B. Discussion of Specific Ratios

The current ratio is a widely used statistic. Other things being


equal, the higher the current ratio, the more assurance the
creditor has about being paid in full and on time. The average
collection period in days is another important short-term ratio.
An increase in this ratio might indicate increasing acceptance
of poor credit risks or less energetic collection efforts.

Both creditors and shareholders watch the debt-to-equity


ratios to judge the degree of risk of insolvency and stability of
profits. Companies with heavy debt in relation to ownership
capital are in greater danger of suffering net losses or even
bankruptcy when business conditions sour, revenues and
many expenses decline, but interest expenses and maturity
dates do not change.

Investors find profitability ratios especially helpful. The gross


profit rate and return on sales are both measures of operating
success. Shareholders view the return on their invested
capital as more important. The return on equity provides a
measure of overall accomplishment.

The final four ratios in EXHIBIT 17-8 are based on earnings


and dividends. The first, earnings per share of common stock
(EPS), is the most popular of all ratios. This is the only ratio
that is required as part of the body of the financial statements
of publicly held companies in the United States. The EPS
must be presented on the face of the income statement. The

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calculation of EPS can be more complicated than is indicated
in EXHIBIT 17-8 depending on the capital structure of the
firm and the presence of common-stock equivalents. The
price earnings, dividend yield, and dividend payout ratios are
especially useful to investors in the common stock of the
company.

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C. Operating Performance Ratios

Businesspeople often look at invested capital’s rate of return


as an important measure of overall accomplishment:

rate of return on investment = income / invested


capital

The measurement of operating performance (i.e., how


profitably assets are employed) should not be influenced by
the management's financial decisions (i.e., how assets are
obtained). Operating performance is best measured by
pretax operating rate of return on average total assets:

pretax operating rate = operating income


of return on average total assets average total
assets

The right-hand side of the equation above consists of two


important ratios:

operating inc. = operating income x


sales
avg. total assets sales
avg. tot. assets

The right-hand side terms in the equation above are often


called the operating income percentage on sales and total
asset turnover (i.e., the two basic factors in profit making).
An improvement in either will, by itself, increase the rate of
return on total assets.

If ratios are used to evaluate operating performance, they


should exclude extraordinary items. Such items are not
expected to recur, and therefore they should not be included
in measures of normal performance.

VI. Efficient Markets and Investor Decisions {L. O.


5}
Much research in accounting and finance has concentrated on

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whether the stock markets are "efficient." Efficient Capital
Market - market prices "fully reflect" all information available to
the public. Therefore, searching for "underpriced" securities in such
a market would be fruitless, unless an investor has information that
is not generally available. If the real-world markets are indeed
efficient, a relatively inactive portfolio approach would be an
appropriate investment strategy for most investors. The hallmarks
of the approach are risk control, high diversification, and low
turnover of securities. The role of accounting information would
mainly be in identifying the different degrees of risk among various
stocks so that investors can maintain desired levels of risk and
diversification.

Many ratios are used simultaneously rather than one at a time for
such predictions. Research showed that accounting reports are
only one source of information. In the aggregate, companies that
choose the least-conservative accounting policies do not fool the
market. In sum, the market as a whole generally sees through any
attempts by companies to gain favor through the choice of
accounting policies that tend to boost immediate income.

Some alternative sources of financial information are the following:


company press releases, trade association publications, brokerage
house analyses, and government economic reports. If accounting
reports are to be useful, they must have some advantage over
alternative sources in disclosing new information. Financial
statement information may be more directly related to the item of
interest, more reliable, lower in cost, and/or more timely than
alternative sources.

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CHAPTER 17: Quiz/Demonstration Exercises
Learning Objective 1

1. The Lakers Corporation has acquired a 10% interest in the shares of


Dodgers Corporation. Dodgers reported income for 20X1 of $25
million and issued dividends of $10 million during the year. Since
Lakers use the available for sale method of accounting for their
investment in Dodgers, for 20X1 the value of their income will
_____.

a. increase by $25 million, the amount of Dodgers earnings


b. decrease by $10 million, the amount Dodgers paid out in
dividends
c. increase by $1 million, the dividends paid by Dodgers to
Lakers
d. increase by $1.5 million, Lakers’ share in the earnings of
Dodgers reduced by their share of the dividends paid out

2. The Rams Corporation owns 40% of the outstanding shares of the


Kings Corporation. During 20X1, Kings reported income of $25
million and paid dividends of $10 million to shareholders. Rams
uses the equity method to account for their investment in Kings.
Accordingly, the value of their Kings investment during 20X1 will
increase by _____.

a. $6 million, Rams' share in the earnings of Kings reduced by


the dividends received
b. $14 million, the sum of the dividends received by Rams and
their share in the earnings of Kings
c. $4 million, the dividends paid by Kings to Rams
d. $10 million, Rams' share in the earnings of Kings

Learning Objective 2

3. When a company purchases greater than 50% of the stock of


another business, the two companies’ financial statements must be
presented _____.

a. separately in the same annual report with the nature of the


ownership interest fully disclosed

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b. in two separate sets of financial statements that cannot
appear in the same annual report
c. together regardless of whether the ownership interest
continues
d. in the form of consolidated financial statements after
eliminating entries are recorded to avoid the double-counting
of assets and equity

4. James Company owns 90% of the outstanding shares of Kobe


Company. If Kobe Company reports earnings for the year of $20
million, the consolidated financial statements will show a _____
million increase in the _____.

a. $2; noncontrolling interest in Kobe


b. $20; consolidated shareholders’ equity
c. $20; consolidated net assets
d. $20; noncontrolling interest in Kobe

Learning Objective 3

5. Goodwill is recognized for accounting purposes _____.

a. every year as long as the IRS does not object


b. when a business is purchased for a price that exceeds the fair
market value of its assets less liabilities
c. when the value of a business exceeds its historical cost book
value
d. when a business is purchased for a price that exceeds the
book value of its assets less liabilities

6. Goodwill may be caused by _____.

a. excellent general management skills


b. potential efficiency by rearrangement
c. dominant market position
d. all of the above
e. none of the above

Learning Objective 4

Use the comparative balance sheets and income


statements below for the Cool Hand Luke Company in

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answering questions 7 through 10:

Boston Rob Company


Comparative Balance Sheets
December 31, 20X1 and 20X2

20X1 20X2
Assets
Cash $ 61,100 $ 27,200
Accounts Receivable (net) 72,500 142,700
Inventory 122,600 107,800
Property, Plant, and Equipment (net) 577,700 507,500
Total Assets $833,900 $785,200

Liabilities and Stockholders' Equity

Accounts Payable $104,700 $ 72,300


Notes Payable within one year 50,000 50,000
Bonds Payable 200,000 210,000
Common Stock -- $10 par value 300,000 300,000
Retained Earnings 179,200 152,900
Total Liabilities and Stockholders' Equity $833,900 $785,200

Boston Rob Company


Comparative Income Statements
For the Years Ended 12/31/X1 and 12/31/X2

20X2 20X1

Sales $ 800,400 $ 900,000


Cost of Goods Sold 454,100 396,200
Gross Profit $ 346,300 $ 503,800
Operating Expenses
Selling Expenses $ 130,100 $ 104,600
Administrative Expenses 40,300 115,500
Interest Expense 25,000 20,000
Income Tax Expense 14,000 35,000
Total Operating Expenses $ 209,400 $ 275,100
Net Income $ 136,900 $ 71,300

7. The Boston Rob Company's current ratio for 20X2 was _____.

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a. 5.39 b. 1.66 c. 1.23 d. 1.00

8. Boston Rob Company's total debt to equity ratio has _____.

a. decreased from .74 to .73 from 20X1 to 20X2


b. decreased from .32 to .27 from 20X1 to 20X2
c. increased from .73 to .74 from 20X1 to 20X2
d. increased from .27 to .32 from 20X1 to 20X2

9. Boston Rob Company's gross profit rate for 20X1 was _____.

a. 20.58% b. 46.65% c. 55.98% d. 61.92%

10. In 20X2, Boston Rob Company's return on sales was _____.

a. 2.39% b. 4.61% c. 17.10% d. 23.27%

Learning Objective 5

11. An efficient capital market _____.

a. is one in which market prices "fully reflect" all information to


the public
b. creates an opportunity for investors to spot "underpriced"
securities using publicly available information
c. has no bearing on accounting statements and procedures
d. explains why some individuals are able to "beat the market"
through the use of publicly available information

12. If markets are truly efficient, then the proper portfolio includes
which of the following characteristics?

a. risk control
b. high diversification
c. low turnover of securities
d. all of the above
e. none of the above

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CHAPTER 17: Solutions to
Quiz/Demonstration Exercises

1. [c] The amount of dividends received will increase the


dividend income account.

2. [a] With the equity method, the investor recognizes his


share in earnings, but reduces the investment by the amount
of dividends received.

3. [d] Consolidated financial statements must be issued when


ownership exceeds 50%.

4. [a] The noncontrolling interest will be increased by its share


in the earnings of the subsidiary.

5. [b] Goodwill is recorded for the amount by which the


purchase cost exceeds the fair market value of the net assets
obtained. First, the assets are written up to their fair market
values. Then any excess is recorded as goodwill, which is
amortized over a period not exceeding 40 years.

6. [d]

7. [b] The current ratio is found by dividing the current assets


by the current liabilities. Here current assets are $256,200
[$61,100 + $72,500 + $122,600] and current liabilities are
$154,700 [$104,700 + $50,000]. Therefore, the current ratio
is 1.66 [$256,200/$154,700].

8. [c] In 20X1 the total debt-to-equity ratio was .73, which was
computed as [($72,300 + $50,000 + $210,000) / ($300,000 +
$152,900)]. In 20X2, the total debt-to-equity ratio has
increased to .74 [($104,700 + $50,000 + $200,000) /
($300,000 + $179,200)].

9. [c] The gross profit rate is found by dividing the gross profit
by sales. For 20X1, that would be $503,800/$900,000 =
55.98%.

10. [c] The return on sales is found by dividing the net income

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by sales. For 20X2, that was $136,900/$800,400 = 17.10%.

11. [a] 12. [d]

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