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1.a
.^ (i)
Dividend income: X:^
(100,000 x $.10)
Z:^
Total
Dividends are not recorded as income for Y (40% owned), but are included in“equity in income of affiliates” instead.) (ii)^
Unrealized gains/losses included in stockholders' equity (all before deferred
tax): Firm^
2001 Change
X^
Z^
Total
Y:^
market value changes not recognized under equity method. (iii)^ Equity in income of affiliates: Y:^ .40 x $900,
b.^ The investments are accounted for as follows: Y using the equity method, as ownership exceeds 20% X and Z at market value as “available-for-sale” securities under SFAS 115 c.^ Dividend income
Equity income
Total income
d.^
X:^
100,000 x $49 = $4,900, Z:^
150,000 x 30 = 4,500, Y:^
carried at original cost plus equity in undistributed earnings subsequentto acquisition. Carrying amount at 1/1/2001 cannot be determined but would be calculated as: Carrying amount at 1/1/2000: 800,000 x $35 =
Plus 2000 undistributed earnings (data not available) Plus 2001 earnings: $.40 x $900,000 =
Less 2001 dividends: $.09 x $800,000 =
e.^ Mark to market returns for 2001: Firm^
Dividends +
MV Change =
Total Return
X^
Y^
Z^
Total
For firms X and Z, the total return is reported in the financial statements, but that
return is reported primarily as an adjustment to stockholders' equity. f.^ If consolidation were required for 40% ownership, Bart would consolidate firm Y.^ While
consolidation
does
not
change
reported
income,
Bart’s
equity
in^ the
earnings of firm Y would be replaced by all revenues and expenses of firm Y.Similarly, Bart’s investment in firm Y would be replaced by all of the assets andliabilities of firm Y. The 60% of firm Y equity (and income) not owned by Bart wouldbe shown as minority interest. 2.a.
The held-to-maturity fixed maturities are measured at amortized cost. The available-for-sale fixed maturities and equity securities are measured at marketvalue. b.^ 2000 Reported ROA by Portfolio Component ($ millions) Total
Fixed
Equity
Total
Maturities
Securities
Portfolio
Opening balance
Investment income
Return on assets
Note:
Opening balances from Exhibit 13-3A (p. 463). Investment income includes realized gains All returns are below the corresponding reported 1999 returns shown in Exhibit 13-3B. c.^
First, compute the mark-to-market returns, using the analysis on p. 465 as a guide. 2000 Change in MVA ($ in millions) Fixed Maturity Securities
Held-to-
Available
Equity
Maturity
for-Sale
Total
Securities
Market value
Cost^
MVA^
$ 69^
1999 Market value
Cost^
MVA^
$ 59^
Change in MVA Fixed maturities
Equity securities
Total portfolio
Fixed maturities
Calculation of 2000 Mark-to-Market Return
Equity securities
94 /^
Fixed
Equities
Total
Total portfolio
Maturities
Dividends and interest
$ 24^
where return equals dividend and interest income plus realized gains or losses.
Realized gains (losses)
(1)^
These data suggest that the return on the fixed income portfolio improved in 2000,but was partly offset by a reduced return on the equity portfolio.
Reported income
$ 23^
Change in MVA
(64)^
Mark-to-market return
b.^
First, compute the mark-to-market returns for 1999 and 2000, using the analysis on p. 465 as a guide.
Calculation of 2000 Mark-to-Market ROA
Fixed
Total
Change in MVA ($ in millions)
Maturities
Equities
Portfolio
Opening balance
Fixed Maturity Portfolios
Mark-to-market return
(41)^
Held-to-
Available
Equity
Return on assets
Maturity
for-Sale
Total
Securities
These
returns
are quite
different
from
the
reported
returns.
The
fixed
maturity portfolio returns are higher whereas the equity return is lower. Theseresults reflect the 2000 stock market decline and the rise in the debt markets asinterest rates fell. The mark-to-market returns also contrast with 1999. In 1999equity
securities
showed
a^ positive
return
as^
stock
prices
rose
whereas
fixed
maturities showed a negligible return as interest income was offset by capital losses.During
fixed-income
securities’
prices
fell^
as^ interest
rates
rose.
These
comparisons show that mark-to-market returns, while they report actual marketresults,
are
more
volatile
than
reported
returns
that
can
be^
smoothed
by
management decisions.
Market value$
Cost^
MVA^
`^
1999 Market value
Cost^
MVA^
1998 Market value$
d.^
The^
mark-to-market
returns
clearly
report
the
effect
of^
market
performance on Chubb’s investment portfolios. To fully evaluate the performance ofChubb’s portfolios, we need benchmarks. For the bond portfolio, an appropriatebenchmark would be a weighted average of market returns (with weights equal tothe proportion of U.S. government, corporate, tax-exempt, etc.) held in Chubb’sportfolio. The benchmark should also be adjusted for any differences in duration,quality, or other bond characteristics.
Cost^
MVA^
2000 Change in MVA Fixed maturities
Equity securities
Total portfolio
1999 Change in MVA
The equity benchmark should also reflect the composition of Chubb’s portfolio,reflecting such characteristics as type of stock (preferred vs. common), capitalization(large vs. small), and any international representation.
Fixed maturities
Equity securities
Total portfolio
Calculation of 2000 Mark-to-Market Return
Fixed
Equities
Total
3. a
.^ Reported ROA by portfolio segment:
Maturities
Dividends and interest
$ 31^
Fixed maturities
Realized gains (losses)
(51)^
Equity securities
6.^
Reported income
$ 94^
Total portfolio
Change in MVA
(93)^
Mark-to-market return
$ 1^
The pattern of income recognition, however, differs. 5.a.
Cost
method,
unless
Burry
can
argue
that
it^ has
"significant
influence" over Bowman. SFAS 115 does not apply as Bowman shares are notmarketable securities. 2001: Equity method, unless Burry does not have "significant influence." If theequity method is appropriate, retroactive restatement of the Investment in Bowmanaccount and retained earnings is required. b.^
2000: Income and Cash from Operations both equal the dividends received during the year: $152,000 (.19 x $800,000). Cash for investment equals $(10)million. There is no effect on the carrying amount of Burry's investment in Bowman, whichremains at the acquisition cost of $10 million. 2001:
Because
Burry
acquired
an^
additional
for^
a^ total
share
of^
a
retroactive restatement of the investment account and retained earnings is required: Acquisition cost:
Less: Share of 2000 loss (.19 x $600,000)
Dividends received (.19 x $800,000)
Restated carrying amount, 1/1/
Note: The $266,000 reduction is charged to retained earnings. 2001 transactions and entries: Restated carrying amount, 1/1/
Plus: Additional acquisition cost
Share of 2001 income (.20 x $2,000,000)
Less: dividends received (.20 x $1,000,000)
Carrying amount, December 31, 2001
Income equals Burry's proportionate interest in the earnings of Bowman: $400,000(.2 x $2,000,000). Cash from operations equals the amount of dividends received from Bowman:$200,000 (.2 x $1,000,000). Cash for investing equals $(500,000). c.^
2000: same as b Income = $152,000 (.19 x $800,000) No effect on investment 2001:
income
equal
to^
cash flow
from
dividend
payments
of^
(.^
x
1,000,000). The investment account at 12/31/01 would equal the total cost of $10,500,000($10,000,000 + $500,000). d.^
2000: Burry would recognize its proportionate share of Bowman's loss: ($114,000) =.19 x $(600,000)
Investment account would be $9,734,000 a decrease of $266,000 ($152,000 +$114,000) reflecting the share of loss and the dividends received. [See part b.] [Alternate calculation: share of undistributed loss for 2000 =.19 x [($600,000) -$800,000] =.19 x ($1,400,000) = $(266,000)] Cash from operations equals $152,000. Cash for investment equals $(10,000,000). 2001: Income equal to $400,000 (.2 x $2,000,000) Cash from operations equal to $200,000 (.2 x $1,000,000). Cash for investing equals$(500,000). Investment account equals $10,434,000, an increase of $700,000 including the$200,000 difference between income and cash flow and the additional investment of$500,000. e.^
The answer depends on the relationship between Burry and Bowman. It is
unlikely that the purchase of an additional 1% interest changed that relationship.Thus B, which uses different methods for the two years, does not provide usefulinformation. The choice is between the cost method (c) and the equity method (d). The advantage of the cost method is that Burry's income statement records only thecash flow (dividends) received. If Burry is a passive investor in Bowman, the costmethod provides the best information. The equity method is more appropriate when Burry is actively involved in managingBowman and thus earning its share of the profits of Bowman. The payment ofdividends may be discretionary on the part of the major shareholders. 6.a.
Cost method is used for 2001:
No effect on sales. Income recognized = dividends received of $10 (.01 x $1,000) Cash from operations = dividends received
Cash for investment = cost of shares
Net cash flow
Equity method is used for 2002: No effect on sales Income recognized
= proportionate share of earnings
= $660 (.30 x $2,200). Cash from operations = dividends received
Cash for investment = cost of shares
Net cash flow
b.^
2001: December 31, 2001 (cost method)
2002: The equity method must be applied retroactively to 2001: Initial acquisition cost
Plus share of 2001 earnings (1% of $2,000)
Less dividends received
Adjusted carrying amount, January 1, 2002
January 1, 2002 shares purchased
Equity in 2002 earnings
Less: 2002 dividends received
Carrying amount, December 31, 2002
c.^
The^
additional
share
purchases
require
that
Potter
consolidate
San
Francisco, for two reasons: (i)^
It owns 100% of San Francisco’s shares (ii)^
It controls San Francisco. Potter must use the purchase method of accounting (see Chapter 14) to reflect itsownership of San Francisco.
The assets and liabilities of San Francisco must be
consolidated with those of Potter using fair market values at January 1, 2003 (SanFrancisco
only).
Off-balance-sheet
items
(such
as
contingencies
and
postemployment benefits) may also be recognized. Information on fair values andoff-balance-sheet items, as well as full financial statements for San Francisco, wouldbe needed to evaluate the effect of the acquisition on Potter's 2003 financialstatements. 7.a
.^ The market method is used for the “available-for-sale” portfolio and the
cost/equity method is used for the “affiliate on the equity method”($ thousands)
METHO
D
Available for sale
Market
Affiliate on equity method
Equity
Investment in marketablesecurities
b.^
Disaggregate HP's earnings: ($ thousands)
Operating income1 Marketable securities Affiliates Total
$57,181 x.604^ = $34,546^ $ 7,757 x.
$104,790 x.
= $60,592 $31,973 x.578^ = 18,487^ = 3,221^ $82,
1 Income before taxes and equity in affiliate income less income frominvestments, multiplied by (1 - tax rate).
c.^
Disaggregate HP’s assets:
($ thousands)
Operating
Available for sale
Affiliate
Total assets
Now, compute ROA on opening asset values, for each segment:
Operations
Available-for-sale
Affiliate
Total
d.^
The results are not very useful as the asset values are a hybrid of historical costs and market values and income amounts are not actual mark-to-market returns.
e.(i)^
Dividends and interest
(Income from investments less realized gains) (ii)^
Realized gains and losses
(iii)^
Unrealized gains and losses
[Change during year] Market value adjustments (MVA)
Market - Cost =
MVA
Chang
e
The mark-to-market return equals dividend and interest income plus realized gainsplus the change in MVA (from e (iii) above):
Dividends and interest
Realized gains and losses
Unrealized gains and losses
Pretax mark-to-market return
Aftertax return [pretax x (1-
t)]^
Times interest earned: Again, the parent's stockholders are better served by theconsolidated ratio that reflects the total cost of amounts borrowed whether thedebt is reported on MMF's books or those of the parent. The equity methodexcludes the subsidiary's interest expense as it reports only the parent's share ofthe net income of its subsidiary. Debt-to-equity: The consolidated ratio is more informative; it reflects the debt ofthe^ parent
as^
well^
as^ that
of^ its^ affiliate,
MMF.
The
equity
method
ratio
is
misleadingly low as it excludes the debt of MMF.Exhibit 13S-1 Moore Motors-Equity Method Balance Sheets, December 31, 2001-2002 ($ thousands)
Cash and cash equivalents Accounts receivable--trade --subsidiary Finance receivables Inventories Fixed assets (net) Investment in finance subsidiary Miscellaneous assets Total assets Accounts payable--trade --subsidiary Bank debt Accrued liabilities Accrued income tax Total liabilities Stockholders' equity Total liabilities and equity
$ 6,909^ 4,541^ 3,515^ 13,246^ 10,020^ 30,238^ 7,271^ 14,908 $ 90,648 $ 7,897^ 14,840^ 6,255^ 21,054^ 4,930 $ 54,976^ 35,672 $ 90,
$ 7,070^ 5,447^ 2,898^ 13,235^ 10,065^ 32,286^ 7,782^ 16,092 $ 94,875 $ 7,708^ 14,460^ 6,557^ 23,847^ 5,671 $ 58,243^ 36,632 $ 94,
Exhibit 13S-2 Moore Motors - Equity Method Income Statement, Year Ended December 31, 2002 Sales Equity in income of finance subsidiary Interest income Total revenues Cost-of-goods-sold Selling and administrative expense Interest expense Depreciation and amortization Total expenses
$110,448^ 1,111^ 1,980 $113,539^ (94,683)^ (6,386)^ (849)^ (5,664) $(107,582)
Pretax income Income tax expense Net income
10.a.
The cash flow consequences of finance or credit receivable transactions are reported as components of investment cash flows. Because MMF's creditreceivables
are generated
by^
the^ long-term
financing
it^ provides for Moore's
customers,
i.e.,
for
Moore's
essential
operating
activities,
their
cash
flow
consequences should be reported as components of cash flow from operations. The net cash flow impact of these transactions should be reported as operatingcash flows. For the year ended December 31, 2002, the reported operating cashflow^
of^ $13,006,
should
be^
reduced
by^
(cash
inflow
of
from
liquidation
of^
finance
receivables
less
cash
outflow
for
investment in finance receivables of $100,689,000) for an adjusted operating cashflow of $7,711,000 and adjusted investing cash flow of $9,710,000. b.^
Interest
payments
of^
manufacturing
and
retailing
firms
should
be
components of financing cash flows because they reflect firms' leverage choices.The analysis of a firm's ability to generate cash from operations should not beconfused
by^
its^ financing
decisions.
Interest
payments
reported
by^
Moore's
manufacturing units should therefore be reflected in its financing cash flows (seeChapter 3). However, interest incurred by MMF is an operating cost and should beconsidered a component of its operating cash flow. c.^
Exhibit 13S-3 contains the 2002 direct method cash flows of MMF and Moore's manufacturing operations. d.^
Cash flow from MMF to Moore's manufacturing operations $ thousands): Decrease in intercompany receivables
Dividends paid
Decrease in intercompany payables
Total
Note that this computation does not consider the cash flow effects of transactionsinvolving the purchase of and payments for finance receivables. Data required toevaluate these transactions has not been provided in the problem. e.^
The^
segmentation
allows
the
analyst
to^
separately
determine
the
leverage, profitability, and cash flows generated by the manufacturing unit andthe finance operations and to understand the impact of each segment on theconsolidated entity. Trends in these critical performance indices can be evaluatedin the light of the industry and
economic conditions that affect manufacturing
operations and those (different) conditions that influence the financing business.
Exhibit 13S-3 Moore Motors-Equity Method Statement of Cash Flows, Year Ended December 31, 2002 Page 1 of 2 Indirect Method:^ ($ thousands)
Moore Motors
Finance
Moore Motors (Equity Method)
Net income Depreciation and amortization (accounts receivable (inventories (accrued liabilities (accrued income taxes (accounts payable (intercompany receivables (intercompany payables Miscellaneous operating cash flow Cash Flow from Operations Net change in fixed assets2 Net change in finance receivables2 Cash flow for investment Net change in bank debt2 Repurchase of equity New equity issued Dividends paid Cash flow for financing Net cash flow
$ 1,111^ 1,
$ 2,012^ (1,645)^ (4,889) $(6,534)^ 4,
$ 4,393^ $ (129)
$ 3,7131^ 5,664^ (906)
(45) 2,793^741 (189) (380)^617 (414)
$ 11,594^ (8,065)^ (406) $ (8,471)
$ (2,962)^ $ 161
1 Net income less equity in earnings of finance subsidiary plus dividendsreceived. 2 Only net entries possible from data provided. Exhibit 13S-
Moore Motors--Equity Method
Statement of Cash Flows Direct Method:^ Sales^ (accounts receivable^ Cash collections^ Cost-of-goods-sold^ (inventories^ (accounts payable^ Cash inputs^ Selling and administrative
(906) (94,683)^ (45) (189) (6,386)
$109,542^ (94,917)
(accrued liabilities Cash administration Interest expense Interest income Dividend from MMF Miscellaneous operating cash flow Income tax expense (accrued income tax Income taxes paid (intercompany receivable (payables Cash flow from operations
2,793 (1,733)^741
(3,593)^ (849)^ 1,980^600 (414)^ (992)^ (380)^617 $ 11,
Moore Motors Finance Direct Method: Finance revenues (finance receivables Cash collections Interest expense Cash inputs Net cash collections Selling and administrative (accrued liabilities Cash administration Income tax expense (intercompany receivable (intercompany payables Cash flow from operations
$ 14,504^ (4,889)^ (7,908)^ (3,540)^ (366)
$ 9,615^ (7,908) $ 1,707^ (3,906)^ (441)^380 (617) $ (2,877)
1 Cash flow from operations reported under the indirect method is $2,012.The difference of $4,889 [$2,012 - ($2,877)] results from reclassificationof the change in finance receivables from investment to operating cashflow. 11.a
.^ Under current U.S. GAAP, the increase in ownership from 25 to 33% would have no effect; Ford would continue to use the equity method to accountfor its investment in Mazda. b.^
Under the proposed FASB standard, it is likely that Ford would have to consolidate Mazda as it now has management control (including substantial boardrepresentation). If there is no other significant shareholder, the presumption ofcontrol
would
be^
strengthened.
Possible
Japanese
government
restriction
on
control of Japanese firms by foreign firms would also have to be considered. c.^
(i)Proportionate consolidation would replace Ford’s investment in Mazda with its proportionate share of Mazda’s assets and liabilities. The resulting balance
liabilities of the venture. If each party is responsible only for its share of jointventure debt, there is a strong argument for reflecting only that portion of thedebt on Nucor's balance sheet (and only its share of the assets as well). d.^
(i)From
the
point
of^
view of^
Nucor
management,
proportionate
consolidation has two advantages. First, it can hide the profitability of the jointventure, as the analysis in part b would no longer be possible. This may be acompetitive advantage. The second advantage is that reported debt and debt-based
ratios
decline
under
proportionate
consolidation.
The
only
possible
disadvantage is that reported sales and assets also decline under proportionateconsolidation. (ii)^
From the point of view of a financial analyst, full consolidation is better
in that the analysis in part a can determine the profitability of the joint ventureand thus help the analyst understand the source of Nucor earnings. 15a.
See Exhibit 13S- b.
Lumex Segment:
Modest but relatively stable operating profit margin No trend in ROA or asset turnover Capex
rose
from
half
of^
depreciation
in^
to^
approximately
equal
for
1993/1994Cybex Segment: Erratic operating profit margin, declining in 1993-4 Erratic ROA; negative in 1993 Rising asset turnover but below Lumex segment Capex relative to depreciation over 1 and rising c.^
Segment results are affected by allocation of parent overhead. Trends are affected by acquisitions and divestitures, price changes, and exchange ratechanges. Comparisons with other companies are affected by the same factors. In addition,seemingly similar segments of different firms may have different customer bases,product mixes, or production processes that limit their comparability. d.^
Improved
segment
analysis
requires
better
understanding
of^
the
economic factors that affect segment sales and profitability, as well as the impactof acquisitions and divestitures, and price and exchange rate changes. e.^
Sale of the Lumex segment, with its stable profitability, left the company exposed to the volatile Cybex segment. The segment data permitted analysts tosee^
that^
sale^
of^ the
Lumex
segment
would
force
the firm
to^
confront
the
operating difficulties of Cybex. In early 1997, the company merged with a better managed company in theexercise equipment field, expecting that the combined firms would prove more
profitable.
Exhibit 13S-5 Lumex Industry Segments Ratio Computations, 1992to 1994$ in thousands
Years Ended December 31 ($000)
Lumex Segment
Sales
Operating profit
Identifiable assets
Capital expenditures
Depreciation andamortization
Operating profit margin
Return on ending assets
Asset turnover
2.^
2.^
Capex-to-depreciation
0.^
1.^
Cybex Segment Sales
Operating profit
Identifiable assets
Capital expenditures
Depreciation andamortization
Operating profit margin
Return on ending assets
Asset turnover
1.^
1.^
Capex-to-depreciation
1.^
1.^
