WALKTHROUGH. Chapter One The Equity Method of Accounting for Investments 1. Chapter Three Consolidations Subsequent to the Date of Acquisition 85

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1 Fifth Edition Joe B. Hoyle Associate Professor of Accounting Robins School of Business University of Richmond Thomas F. Schaefer KPMG Professor of Accountancy Mendoza College of Business University of Notre Dame Timothy S. Doupnik Professor of Accounting Darla Moore School of Business University of South Carolina I McGraw-Hill I Irwin

2 WALKTHROUGH Chapter One The Equity Method of Accounting for Investments 1 VI The Reporting of Investments in Corporate Equity Securities 1 Fair- Value Method 2 Consolidation of Financial Statements 2 Equity Method 3 Discussion Question: Did the Cost Method Invite Earnings Manipulation? 4 International Accounting Standard 28 Investments in Associates 4 Application of the Equity Method 5 Criteria for Utilizing the Equity Method 5 Accounting for an Investment The Equity Method 7 Equity Method Accounting Procedures 9 Excess of Investment Cost Over Book Value Acquired 9 Discussion Question: Does the Equity Method Really Apply Here? 10! The Amortization Process 11 Equity Method Additional Issues 14 Reporting a Change to the Equity Method 14 Reporting Investee Income from Sources Other Than Continuing Operations 15 Reporting Investee Losses 16 Reporting the Sale of an Equity Investment 17 Deferral of Unrealized Profits in Inventory 18 Downstream Sales of Inventory 19 Upstream Sales of Inventory 20 Financial Reporting Effects and Equity Method Criticisms 21 Equity Method Reporting Effects 21 Criticisms of the Equity Method 22 Fair-Value Reporting Option for Equity Method Investments 22 Discussion Question: Should Investor-Investee Relations Determine Investor Accounting for Investee? 24 Summary 24 Chapter Two Consolidation of Financial Information 39 Expansion through Corporate Takeovers 40 Reasons for Firms to Combine 40 United Airlines and Continental Airlines 42 Merck and Schering-Plough 42 Nike and Umbro 43 The Consolidation Process 43 Business Combinations Creating a Single Economic Entity 44 Control An Elusive Quality 45 Consolidation of Financial Information 46 Financial Reporting for Business Combinations 47 The Acquisition Method 47 Consideration Transferred for the Acquired Business 47 Assets Acquired and Liabilities Assumed 48 Goodwill, and Gains on Bargain Purchases 49 Procedures for Consolidating Financial Information 49 Acquisition Method When Dissolution Takes Place 50 Related Costs of Business Combinations 53 The Acquisition Method When Separate Incorporation Is Maintained 54 Acquisition-Date Fair-Value Allocations Additional Issues 58 Intangibles 58? Preexisting Goodwill on Subsidiary's Books 59 Acquired In-Process Research and Development 60 Convergence between U.S. and International Accounting Standards 62 Summary 62 Appendix: Legacy Methods of Accounting for Business Combinations 67 Chapter Three Consolidations Subsequent to the Date of Acquisition 85 Consolidation The Effects Created by the Passage of Time 85 Investment Accounting by the Acquiring Company 86 Internal Investment Accounting Alternatives The Equity Method, Initial Value Method, and Partial Equity Method 86 Subsequent Consolidation Investment Recorded by the Equity Method 88 Acquisition Made during the Current Year 88 Determination of Consolidated Totals 90 Consolidation Worksheet 92 Consolidation Subsequent to Year of Acquisition Equity Method 95 Subsequent Consolidations Investment Recorded Using Initial Value or Partial Equity Method 98 Acquisition Made during the Current Year 98 Consolidation Subsequent to Year of Acquisition Initial Value and Partial Equity Methods 102 Goodwill Impairment 107

3 xvi Contents Discussion Question: How Does a Company Really Decide Which Investment Method to Apply? 109 Assigning Goodwill to Reporting Units 109 Qualitative Assessment Option 110 Testing Goodwill for Impairment Steps 1 and Illustration Accounting and Reporting for a Goodwill Impairment Loss 112 Reporting Units with Zero or Negative Carrying Amounts 113 Comparisons with International Accounting Standards 113 Goodwill Allocation 113 Impairment Testing 114 Determination of the Impairment Loss 114 Amortization and Impairment of Other Intangibles 114 Contingent Consideration 115 Accounting for Contingent Consideration in Business Combinations 115 Push-Down Accounting 116 External Reporting 116 Internal Reporting 117 Summary 118 Chapter Four Consolidated Financial Statements and Outside Ownership 145 Consolidated Financial Reporting in the Presence of a Noncontrolling Interest 146 Subsidiary Acquisition-Date Fair Value in the Presence of a Noncontrolling Interest 147 Allocating the Subsidiary's Net Income to the Parent and Noncontrolling Interests 150 Partial Ownership Consolidations (Acquisition Method) 150 Discussion Question 151 Consolidated Financial Statement Presentations of Noncontrolling Interest 160 Alternative Fair-Value Specification Evidence of a Control Premium 160 Effects Created by Alternative Investment Methods 164 Revenue and Expense Reporting for Midyear Acquisitions 165 Consolidating Postacquisition Subsidiary Revenue and Expenses 165 Acquisition Following an Equity Method Investment 167 Step Acquisitions 167 Control Achieved in Steps Acquisition Method 167 Example: Step Acquisition Resulting in Control Acquisition Method 168 Worksheet Consolidation for a Step Acquisition (Acquisition Method) 170 Example: Step Acquisition Resulting After Control Is Obtained 170 Parent Company Sales of Subsidiary Stock Acquisition Method 172 Cost-Flow Assumptions 173 Accounting for Shares That Remain 173 Comparisons with International Accounting Standards 174 Summary 174 Chapter Five Consolidated Financial Statements Intra-Entity Asset Transactions 199 Intra-Entity Inventory Transactions 200 The Sales and Purchases Accounts 200 Unrealized Gross Profit Year of Transfer ( Year 1) 201 Discussion Question: Earnings Management 202 Unrealized Gross Profit Year Following Transfer (Year 2) 203 Unrealized Gross Profit Effect on Noncontrolling Interest 205 Intra-Entity Inventory Transfers Summarized 206 Intra-Entity Inventory Transfers Illustrated: Parent Uses Equity Method 207 Effects of Alternative Investment Methods on Consolidation 215 'Discussion Question: What Price Should We Charge Ourselves? 218 Intra-Entity Land Transfers 220 Accounting for Land Transactions 220 Eliminating Unrealized Gains Land Transfers 220 Recognizing the Effect on Noncontrolling Interest Land Transfers 222 Intra-Entity Transfer of Depreciable Assets 222 Deferral of Unrealized Gains 223 Depreciable Asset Transfers Illustrated 223 Depreciable Intra-Entity Asset Transfers Downstream Transfers When the Parent Uses the Equity Method 225 Effect on Noncontrolling Interest Depreciable Asset Transfers 226 Summary 226 Chapter Six Variable Interest Entities, Intra-Entity Debt, Consolidated Cash Flows, and Other Issues 247 Consolidation of Variable Interest Entities 247 What Is a VIE? 248 Consolidation of Variable Interest Entities 249 Procedures to Consolidate Variable Interest Entities 253 Consolidation of a VIE Illustrated 253 Other Variable Interest Entity Disclosure Requirements 255 Proposed Accounting Standards Update on Variable Interest Entities 255 Comparisons with International Accounting Standards 256

4 Contents xvii Intra-Entity Debt Transactions 256 Acquisition of Affiliate's Debt from an Outside Party 257 Accounting for Intra-Entity Debt Transactions Individual Financial Records 258 Effects on Consolidation Process 259 Assignment of Retirement Gain or Loss 260 Intra-Entity Debt Transactions Subsequent to Year of Acquisition 260 Discussion Question: Who Lost This $300,000? 261 Subsidiary Preferred Stock 264 Consolidated Statement of Cash Flows 266 Acquisition Period Statement of Cash Flows 266 Statement of Cash Flows in Periods Subsequent to Acquisition 267 Consolidated Earnings per Share 270 Subsidiary Stock Transactions 273 Changes in Subsidiary Value Stock Transactions 273 Subsidiary Stock Transactions Illustrated 276 Summary 280 Chapter Seven Foreign Currency Transactions and Hedging Foreign Exchange Risk 301 Foreign Exchange Markets 301 Exchange Rate Mechanisms 302 Foreign Exchange Rates 302 Spot and Forward Rates 304 Option Contracts 304 Foreign Currency Transactions 305 Accounting Issue 306 Accounting Alternatives 306 Balance Sheet Date before Date of Payment 307 Hedges of Foreign Exchange Risk 309 Derivatives Accounting 309 Fundamental Requirement of Derivatives Accounting 310 (Determination of Fair Value of Derivatives 310 / Accounting for Changes in the Fair Value of Derivatives 310 Hedge Accounting 311 Nature of the Hedged Risk 311 Hedge Effectiveness 312 Hedge Documentation 312 Hedging Combinations 312 Hedges of Foreign Currency Denominated Assets and Liabilities 315 Cash Flow Hedge 315 Fair Value Hedge 315 Forward Contract Used to Hedge a Foreign Currency Denominated Asset 315 Forward Contract Designated as Cash Flow Hedge 317 Forward Contract Designated as Fair Value Hedge 320 Discussion Question: Do We Have a Gain or What? 322 Cash Flow Hedge versus Fair Value Hedge 323 Foreign Currency Option Used to Hedge a Foreign Currency Denominated Asset 324 Option Designated as Cash Flow Hedge 325 Option Designated as Fair Value Hedge 327 Hedges of Unrecognized Foreign Currency Firm Commitments 329 Forward Contract Used as Fair Value Hedge of a Firm Commitment 330 Option Used as Fair Value Hedge of Firm Commitment 332 Hedge of Forecasted Foreign Currency Denominated Transaction 334 Forward Contract Cash Flow Hedge of a Forecasted Transaction 334 Option Designated as a Cash Flow Hedge of a Forecasted Transaction 336 Use of Hedging Instruments 338 The Euro 339 Foreign Currency Borrowing 339 Foreign Currency Loan 340 IFRS Foreign Currency Transactions and Hedges 340 Summary 341 Chapter Eight Translation of Foreign Currency Financial Statements 365 Exchange Rates Used in Translation 366 Discussion Question: How Do We Report This? 367 Translation Adjustments 368 Balance Sheet Exposure 368 Translation Methods 369 Current Rate Method 369 Temporal Method 369 Translation of Retained Earnings 3 71 Complicating Aspects of the Temporal Method 372 Calculation of Cost of Goods Sold 3 72 Application of the Lower-of- Cost-or-Market Rule 3 72 Fixed Assets, Depreciation, and Accumulated Depreciation 373 Gain or Loss on the Sale of an Asset 373 Treatment of Translation Adjustment 374 U.S. Rules 374 Two Translation Combinations 375 Highly Inflationary Economies 376 Appropriate Exchange Rate 378 The Process Illustrated 378 Translation of Financial Statements Current Rate Method 380 Translation of the Balance Sheet 381 Translation of the Statement of Cash Flows 382 Remeasurement of Financial Statements Temporal Method 383

5 xviii Contents Remeasurement of the Income Statement 383 Remeasurement of the Statement of Cash Flows 385 Nonlocal Currency Balances 386 Comparison of the Results from Applying the Two Different Methods 387 Underlying Valuation Method 388 Underlying Relationships 388 Hedging Balance Sheet Exposure 388 Disclosures Related to Translation 390 Consolidation of a Foreign Subsidiary 390 Translation of Foreign Subsidiary Trial Balance 391 Determination of Balance in Investment Account Equity Method 392 Consolidation Worksheet 393 IFRS Translation of Foreign Currency Financial Statements 394 Summary 396 Chapter Nine Partnerships: Formation and Operation 421 Partnerships Advantages and Disadvantages 422 Alternative Legal Forms 423 Subchapter S Corporation 423 Limited Partnerships (LPs) 424 Limited Liability Partnerships (LLPs) 424 Limited Liability Companies (LLCs) 424 Partnership Accounting Capital Accounts 424 Articles of Partnership 425 Discussion Question: What Kind of Business Is This? 426 Accounting for Capital Contributions 426 Additional Capital Contributions and Withdrawals 429 Discussion Question: How Will the Profits Be /^ Split? 430 Allocation of Income 430 Accounting for Partnership Dissolution 434 Dissolution Admission of a New Partner 435 Dissolution Withdrawal of a Partner 440 Summary 442 Chapter Ten Partnerships: Termination and Liquidation 459 Termination and Liquidation Protecting the Interests of All Parties 460 Termination and Liquidation Procedures Illustrated 461 Schedule of Liquidation 463 Deficit Capital Balance Contribution by Partner 464 Deficit Capital Balance Loss to Remaining Partners 465 Discussion Question: What Happens If a Partner Becomes Insolvent? 470 Preliminary Distribution of Partnership Assets 471 Predistribution Plan 474 Summary 477 ^ Chapter Eleven Accounting for State and Local Governments (Part 1) 493 Introduction to the Accounting for State and Local Governments 494 Governmental Accounting User Needs 495 Two Sets of Financial Statements 496 The Need for Two Sets of Financial Statements 497 Internal Record-Keeping Fund Accounting 498 Fund Accounting Classifications 499 Overview of State and Local Government Financial Statements 502 Government- Wide Financial Statements 502 Fund Financial Statements 503 Accounting for Governmental Funds 508 The Importance of Budgets and the Recording of Budgetary Entries 508 Encumbrances 510 Recognition of Expenditures for Operations and Capital Additions 512 Discussion Question: Is It an Asset or a Liability? 514 Recognition of Revenues Overview 516 Derived Tax Revenues Such as Income Taxes and Sales Taxes 517 Imposed Nonexchange Revenues Such as Property Taxes and Fines 517 Government-Mandated Nonexchange Transactions and Voluntary Nonexchange Transactions 519 Issuance of Bonds 519 Special Assessments 521 Interfund Transactions 523 Summary 526 Chapter Twelve Accounting for State and Local Governments (Part 2) 547 Capital Leases 547 Leases Government- Wide Financial Statements 548 Leases Fund Financial Statements 549 Solid Waste Landfill 550 Landfills Government- Wide Financial Statements 551 Landfills Fund Financial Statements 552 Compensated Absences 552 Works of Art and Historical Treasures 553 Infrastructure Assets and Depreciation 554 Expanded Financial Reporting 556 The Primary Government and Component Units 557 Primary Government 557 Component Units 558 Discussion Question: Is It Part of the County? 560 Special Purpose Governments 561

6 Contents xix Government-Wide and Fund Financial Statements Statement of Net Assets Proprietary Funds Fund Illustrated 562 Statements 570 Statement of Net Assets Government- Wide Financial Statement of Revenues, Expenses, and Changes in Fund Net Statements 562 Assets Proprietary Funds Fund Statements 571 Statement of Activities Government- Wide Financial Statement of Cash Flows Proprietary Funds Fund Statements 564 Statements 571 Balance Sheet Governmental Funds Fund Financial Reporting Public Colleges and Universities 580 Statements 565 Summary 585 Statement of Revenues, Expenditures, and Changes in Fund Balances Governmental Funds Fund Statements 570 INDEX 605