Chapter 17: Intercorporate Equity Investments Instructor Manual
Accounting Theory (9
th
edition) Page 1 of 9
CHAPTER HIGHLIGHTS
This chapter focuses on the general question of how to account for equity investments. Framed in
this way, one can see how there is an extensive structure of finite uniformity and how this
structure ties together the separate topics of equity versus fair value method for nonconsolidated
equity investments, plus consolidation ). The overriding relevant circumstance has to do with
“effective control” by the investor over the investee company. Exhibit 17-1 sets out the finite
uniformity framework for equity investments. Of course the elimination of pooling and the
elimination of goodwill but subject to impairment are the big issues in intercorporate equity
investments.
QUESTIONS
Q-1 Are there relevant circumstance differences between purchase and pooling of interests?
Explain
Q-2 The logic of pooling rests heavily on the assumption that no substantive economic
transaction occurs between the combinor and stockholders of the combinee. Evaluate this
assumption.
We suggest this is a weak argument. Clearly a transaction between the combinor and
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Q-3 Why may companies not be indifferent to purchase and pooling accounting, and what do
we know about this issue from research studies?
Pooling produces a better income statement because combinee assets aren’t written up and
goodwill is not recognized. ROI is also higher due to a lower asset base in the combined balance
Q-4 Why would proportionate consolidation result in rigid uniformity for intercorporate
equity investment accounting?
Q-5 Compare proportionate consolidation with capitalizing of all leases extending beyond a
year, another example of rigid uniformity.
The comparison is quite close between proportionate consolidation and capitalization of all
Q-6 The equity method reports neither the investor’s cost nor the market value of the
investment. Do you believe the equity method provides useful information? Why or why
not?
The equity method is a kind of perverse extension of the accrual concept to equity investments.
Q-7 Compare the present system involving consolidation, equity method, and fair value
accounting for intercorporate equity investments with finite uniformity as it exists in
lease accounting.
Leasing has a dichotomy: capital lease or operating lease. Inter-corporate equity investments
Chapter 17: Intercorporate Equity Investments Instructor Manual
Accounting Theory (9
th
edition) Page 3 of 9
Q-8 What is meant by the term one-line consolidation? What differences occur in financial
statements when a one-line consolidation rather than full consolidation is used?
The equity method essentially picks up the proportionate change in investee book value and
records this in the investment account and the income statement—hence, its name as a one-line
Q-9 What are some reasons why consolidated reports are thought to be relevant?
By custom, we have grown to uncritically accept the accounting fiction of consolidation as truly
Q-10 Discuss the limitations of consolidated financial statements and why dual reporting
(consolidated and separate entity statements) as well as other forms of disaggregated
reporting, such as SFAS No. 131, make sense.
Consolidations tell one story—indeed, a fictitious story at that. There are other possible
accounting stories that can also be told, including parent-only statements and disaggregated data
Q-11 Why does the FASB’s reporting entity project logically precede any conclusion regarding
consolidated financial reporting?
“…an entity for financial reporting purposes should not be limited to legal entities, such
as companies, trusts, and partnerships. Rather, an entity should be defined more broadly
to include other types of organizational structures, including a natural person, a sole
proprietorship, and, in some circumstances, a branch or segment of a legal entity.”
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Q-12 Describe the implicit assumption made in SFAS No. 94 about the reporting entity.
SFAS No. 94 presumes that the fiction of a consolidated entity is appropriate for financial
Q-13 What is push-down accounting? What problems would arise in connection with the
implementation?
Push down accounting refers to attempts to require firms that have been acquired in purchases to
Q-14 How are minority interests handled in consolidations?
Note that the term, minority interests, is an older one that is now called “noncontrolling
Q-15 What is an equity carve-out?
Equity carve-outs arise when a parent dilutes its interest in a subsidiary by setting a portion of its
Q-16 Distinguish among sell-offs, spin-offs, split-offs, and split-ups.
• Sell-offs occur when a subsidiary’s stock is sold for cash, other assets, or in settlement of
a debt.
• Spin-offs arise when the subsidiaries shares are distributed to the parent’s shareholders as
Q-17 Why does the elimination of poolings (SFAS No. 141) and the indefinite life of goodwill
subject to impairment (SFAS No. 142) represent a possible “quid pro quo?”
Chapter 17: Intercorporate Equity Investments Instructor Manual
Accounting Theory (9
th
edition) Page 5 of 9
Q-18 Why does the elimination of poolings improve representational faithfulness and
comparability
We do not believe that pooling was representationally faithful because a transaction occurred but
Q-19 What are the main issues surrounding the special purpose entity and its successor, the
variable interest entity.
Despite up to a 97% investment, the sponsoring firm can keep the SPE’s debts off the sponsors
Q-20 What are the differences between a foreign currency orientation and a U.S. dollar
orientation regarding the translation of foreign currency operations?
A U.S. dollar orientation attempts to make the foreign currency operations appear as if they
Q-21 How do accounting exposure and economic exposure differ?
Accounting exposure is the exposure to exchange gains and losses resulting from translating
foreign-currency-denominated financial statements into U.S. dollars. Basically, it is the result of
Q-22 Why would balance sheets prepared under SFAS No. 8 lack additivity?
Items carried on balance sheets at current price, such as monetary items and inventories and
investments at market (when lower than cost), were translated at current exchange prices.
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Accounting Theory (9
th
edition) Page 6 of 9
Q-23 Why does SFAS No. 52 provide an example of finite uniformity in terms of the use of
remeasurement?
If a subsidiary is really an extension of the parent, with frequent remissions of cash to the parent,
the U.S. dollar is the functional currency. If a subsidiary is self-contained, however, its own (or
Q-24 What is the disappearing asset problem?
The disappearing asset problem occurs whenever the current exchange rate is used for translation
purposes and the functional currency is experiencing rapid inflation much in excess of that
experienced in the reporting currency. The result is that the exchange rate deteriorates to such a
Q-25 What does the term functional currency mean?
The term, functional currency, refers to what might be called the main or primary national
Q-26 What prompted FASB Accounting Standards Update 2009-09?
This ASU makes a correction to the codification and includes SEC observer comments to the
standards.
Chapter 17: Intercorporate Equity Investments Instructor Manual
Accounting Theory (9
th
edition) Page 7 of 9
CASES, PROBLEMS, AND WRITING ASSIGNMENTS
1. Examine the 2001 and 2002 annual reports for a corporation having a financial
subsidiary. (Your instructor may suggest a corporation on the EDGAR Website.
http://www.sec.gov/edgarhp.htm). Determine the effect of SFAS No. 94 on operating
ratios, profitability ratios, liquidity ratios, and leverage ratios.
2. The following items pertain to a parent company and its 60 percent-owned subsidiary at
year end. There are no cross-guarantees of debt between the parent and subsidiary.
Parent Subsidiary
Current assets $ 500,000
$1,000,000
Noncurrent assets(excluding subsidiary investment)
5,000,000
2,000,000
Current liabilities 750,000
250,000
Noncurrent liabilities 2,000,000
750,000
Revenues 1,700,000
1,500,000
Expenses 1,600,000
900,000
Dividends 100,000
600,000
Required:
Explain and illustrate how consolidated reporting using the previous data can be
misleading.
Consolidation is misleading for several reasons: (a) The current debt-paying ability of the parent
does not appear good, while that of the subsidiary appears excellent; consolidated, it appears
Chapter 17: Intercorporate Equity Investments Instructor Manual
Accounting Theory (9
th
edition) Page 8 of 9
3. Acquirer Company bought Servile Company for $5,000,000 on January 2, 2004. The fair
market value of the individual net assets was $3,500,000. In succeeding years, the fair
market value of Servile’s costs and goodwill were as follows:
Year
Fair Market
Value of
Servile
Cost of Servile’s
Net Assets and
Goodwill
2005 $7,000,000
$7,100,000
2006 7,300,000
6,700,000
2007 8,000,000
9,300,000
Required:
a. What amount of goodwill should be recognized as a result of the
acquisition of Servile in 2004?
b. Determine the amounts of the goodwill write-offs (if any) in 2005, 2006,
and 2007.
a. Goodwill would be $1,500,000.
4. Why do the six criteria or guidelines for determining the functional currency in SFAS
No. 52 provide a good example of finite uniformity?
The six indicators are clearly grounded in distinctions involving cash flow differentials. The first
one, labeled cash flow indicators, concerns whether funds are rapidly transmitted to the parent or
stay with the subsidiary. Obviously, given fluctuations among currencies, the rapidity with which
funds are transmitted to the parent affects both the amount and timing of cash flows. Whether
Chapter 17: Intercorporate Equity Investments Instructor Manual
Accounting Theory (9
th
edition) Page 9 of 9
CRITICAL THINKING AND ANALYSIS
1. If you had to choose among the current method of consolidation for combinees where the
combinor owns at least 50 percent, the new entity approach, or proportionate
consolidation, which would you choose? Explain.
We would remain with the current approach; the subsidiary forms part of the combined entity
despite the presence of minority ownership. The new entity approach would be very appealing
but runs into verifiability issues relative to valuing all parts of the consolidated entity. It also has