Equity Method Calculation

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					                                                   2
            WHOLLY OWNED
             SUBSIDIARIES:
         POSTCREATION PERIODS
                      LEVEL OF        TIME
      DIFFICULTY              (MINUTES)
REVIEW QUESTIONS
EXERCISES
     2-1     Investment valuation: Cost and equity         Simple 10
     2-2     Journal entries: Cost and equity              Simple 10
     2-3     Conceptualizing consolidated amounts          Simple 5
     2-4     Consolidated dividends                 Simple 5
     2-5     Consolidation entries: Cost and equity        Simple 15
     2-6     Investment valuation: Cost and equity—All debt guaranteed         Simple 15
     2-7     Investment valuation: Cost and equity—No debt guaranteed          Simple 15
     2-8     Investment valuation: Cost and equity—Some debt guaranteed        Simple 15
     2-9     Mini Review: Consolidation (no worksheet): Cost method            Moderate          20
 2-10 Mini Review: Consolidation (no worksheet): Equity method          Moderate      20

PROBLEMS
      2-1    Consolidation worksheet: Cost method         Moderate      20
      2-2    Consolidation worksheet: Equity method              Moderate          25
      2-3    Consolidation worksheet: Cost method         Moderate      30
      2-4    Consolidation worksheet: Equity method              Moderate          35
  2-5 Consolidation worksheet: Equity method              Moderate      40
      2-6    Comprehensive Review: Consolidation entries—Cost method and
                     convesion to equity           Moderate      40
      2-7    Comprehensive Review: Consolidation entries—Equity method and
                     convesion to cost             Moderate      40

SPREADSHEET INTEGRATION PROBLEM
  2-8 Creating a consolidation template and two
                      keystroke macros (stored instructions)        Complex        1-4 hrs.

                                     THINKING CRITICALLY 
CASES
      2-1     My goodness: Not disclosing an accounting method!               Simple 5
      2-2     Assessing impairment of value—Time to bite the bullet?          Moderate      15
      2-3     Cost method: Maybe the parent can write its investment back up!        Simple 10
2-2 •    ADVANCED ACCOUNTING: Concepts and Practice


   2-4    Cost method: Reformatting the consolidation worksheet so that
                       elimination entries are unnecessary            Simple 15
          2-5 Equity method: Reformatting the consolidation worksheet so that
                       elimination entries are unnecessary            Simple 30
       2-6      Do we need both valuation methods?             Simple 5
       2-7      Spin away               Simple 5
   2-8 Theory Review: “Give Me Ten”             Moderate        20
   2-9 Investee’s ownership in investor’s stock which has appreciated
          in value             Simple 15

FINANCIAL ANALYSIS PROBLEMS
         2-1    How much can the parent legally pay in cash dividends?             Moderate      15
         2-2    How much did the parent really earn on its investment?             Moderate      30
         2-3    Cost method: Reporting the sale of a subsidiary can be tricky!            Moderate         40

PERSONAL SITUATIONS: INTERPERSONAL SKILLS
         2-1    Interpersonal Skills: Who is right?               Simple 10

CHAPTER ETHICS QUESTION
               Bankruptcy on the horizon—Start draining the subsidiary (page 58)                   Simple 10


                                       ASSIGNMENT MATERIAL
REVIEW QUESTIONS
         1.      Generally, if neither significant influence nor control exists, the fair value method (FAS 115) is
used but only if the fair value can be readily determined; otherwise, the cost method is used. If significant
influence but not control exists, the equity method must be used (APBO 18). If control exists (the subsidiary must
be consolidated), either the equity method or the cost method may be used. (Special rules apply if a subsidiary is
not consolidated, as discussed in Chapter 3.)
         2.      The general idea of the equity method is that a subsidiary’s earnings belong to the parent and
should be accrued on the parent’s books as an asset. Likewise, the subsidiary’s earnings constitute the parent’s
investment income. The general idea of the cost method is that the parent should not report investment income
until that income is realized (cash received).
         3.      The equity method is analogous to the accrual basis of accounting; the cost method is analogous
to the cash basis of accounting.
         4.      Under the equity method, the income statement account Equity in Net Income (or Loss) of
Subsidiary is used. Under the cost method, the account Dividend Income is used.
         5.      Under the equity method, dividends declared by a subsidiary are reported as a liquidation of the
parent’s investment in the subsidiary. Under the cost method, dividends declared by a subsidiary are reported as
dividend income.
         6.      Under the equity method, a subsidiary’s dividend declaration impacts the parent’s carrying value
of the investment—not the actual dividend payment. Under the cost method, neither the dividend declaration nor
the actual dividend payment impacts the parent’s carrying value of the investment.
         7.      Under the equity method, a subsidiary’s dividend declaration has no impact on the parent’s
Retained Earnings account. Under the cost method, however, the dividend declaration results in increasing the
parent’s Retained Earnings account.
         8.      The consolidated amounts are the same whether the parent uses the equity method or the cost
method because the Investment account is eliminated in consolidation.
         9.      Yes. A parent can lose more than it has invested in a subsidiary if it has guaranteed any of the
subsidiary’s debt.
                                                         Wholly Owned Subsidiaries: Postcreation Periods      • 2-3

         10.     Under the equity method, a parent’s Investment account may be written back up after it has been
written down. Under the cost method, it may not be written back up after a write-down.
         11.     A subsidiary’s dividends are not reported in the consolidated statement of retained earnings
because such dividends have never left the consolidated group.
         12.     The two built-in checking features under the equity method are that (1) consolidated net income
will be the same as the parent’s net income and (2) consolidated retained earnings will be the same as the parent’s
retained earnings.
         13.     The advantages of the equity method are that (1) it has the two built-in checking features, (2) the
parent’s financial statements are more meaningful, and (3) it facilitates return on investment calculations. The
advantage of the cost method is that it entails much less bookkeeping than the equity method does.
         14.     No. The FASB deals with external reporting issues—not internal reporting issues.
         15.     The IRS primarily uses the cash basis of accounting in determining whether to tax a foreign
subsidiary’s income at the parent level—this is the same as the cost method of accounting. In some situations
(foreign subsidiary has substantial passive income), the IRS taxes that income on the accrual basis—this is the
same as the equity method of accounting.
         16.     SEC-required parent-company-only (PCO) statements are generally presented (1) in notes to the
consolidated statements, (2) in a condensed manner, and (3) using the equity method of accounting so that the
financial statements articulate with the consolidated statements.
         17.     The SEC’s primary detailed disclosure for PCO statements is to split apart the subsidiary’s
earnings as to (1) how much has been distributed and (2) how much has not been distributed.
         18.     The maximum amount of retained earnings that a parent can pay is based on its separate retained
earnings balance—not the consolidated retained earnings balance.
         19.     A parent resumes applying the equity method of accounting when the subsidiary’s equity
becomes positive.
         20.     A negative balance in the parent’s Investment account is reported as a liability to the subsidiary in
the parent’s separate financial statements.




                                                  EXERCISES

E 2-1 (Estimated time: 10 minutes)
                               Parent’s Carrying Value Under the Equity Method
                                             Investment in Subsidiary
                                             Balance, 6/1/05. . . . . . . . . . . . . $300,000
         Equity in net income                . . . . . . 45,000 15,000 Dividends declared
        Balance, 12/31/05. . . . . ………$330,000
                                                                20,000 Dividends declared (first quarter)
                                                                60,000 Equity in net loss
        Balance, 12/31/06. . . . . . . . . . $250,000

Parent’s Carrying Value Under the Cost Method
Answer: $300,000 (original cost) or $250,000 (an amount equal to the subsidiary’s net assets), or some other
amount below $300,000.
  It depends on whether management believes an impairment in value has occurred.
2-4 •     ADVANCED ACCOUNTING: Concepts and Practice


E 2-2 (Estimated time: 10 minutes)
Parent’s Entries Under the Cost Method
2005
  Dividends Receivable               80,000
       Dividend Income                      80,000
Cash           60,000
       Dividends Receivable                 60,000

                                                          2006
  Cash          20,000
         Dividends Receivable                    20,000

Parent’s Entries Under the Equity Method
                                                          2005
  Investment in Subsidiary             140,000
     Equity in Net Income (of subsidiary)                        140,000

  Dividends Receivable                  80,000
      Investment in Subsidiary                   80,000

  Cash          60,000
         Dividends Receivable                    60,000

                                                          2006
  Equity in Net Loss (of subsidiary)             90,000
      Investment in Subsidiary                   90,000

  Cash          20,000
         Dividends Receivable                    20,000

E 2-3 (Estimated time: 5 minutes)
Requirement 1:
Consolidated net income for 2005                 $250,000

Requirement 2:
  Dividends            reported           in          the           consolidated         statement           of
   retained earnings for 2005 (only the parent’s)                $140,000

E 2-4 (Estimated time: 5 minutes)
Dividends reported in the consolidated statement of
retained earnings for 2005 (only the parent’s)            $100,000

Explanation: Only dividends declared by the parent are reported in the consolidated statement of retained
earnings. Dividends declared by the subsidiary never left the consolidated group and are merely an intercompany
transaction that is always eliminated in consolidation.
                                                                              Wholly Owned Subsidiaries: Postcreation Periods                             • 2-5

E 2-5 (Estimated time: 15 minutes)
Requirement 1:
The basic elimination entry—the cost method:
Common Stock            100,000
  Additional Paid-in Capital           400,000
       Investment in Subsidiary                500,000

The intercompany dividend elimination entry:
  Dividend Income             50,000
        Dividends Declared                                           50,000
Requirement 2
The basic elimination entry—the equity method:
   Common Stock                 100,000
   Additional Paid-in Capital           400,000
   Retained Earnings, 1/1/05 (12/31/05 balance of                                                  $240,000               -     $80,000          net      income
for 2005 + 50,000 dividends declared in 2005)           210,000
   Equity in Net Income (of subsidiary)         80,000
        Dividends Declared                      50,000
        Investment in Subsidiary                740,000

E 2-6 (Estimated time: 15 minutes)
Requirement 1:
                                                  Parent’s Carrying Value—Cost Method
  12/31/05 ........................................................................................................................................ $200,000
  12/31/06 ........................................................................................................................................ $200,000
Note: The $200,000 amount is what the parent believed it could recover of its investment at 12/31/05.
                                           Parent’s Carrying Value—Equity Method
                                 (no suspension occurs in the application of the equity method)
                                                Investment in Subsidiary
         Balance, 4/1/05. . . . . . . . . . . . . $600,000
                                                                                650,000 Equity in net loss
                                                                               $ 50,000 Balance, 12/31/05.
         Equity in net income . . . . . …                 770,000
                                                                                  40,000 Dividends declared
         Balance, 12/31/06. . . . . . . . . . $680,000

Note: The subsidiary’s equity accounts at 12/31/06 are:
Common stock & additional paid-in capital (the parent’ initial capital investment)    $600,000
  Retained earnings (2006 net income of $770,000 - $650,000 2005 net loss - $40,000 div.)
     80,000
               $680,000
Requirement 2:
                                                                    The Cost Method
Amount reported in the parent’s income statement for:
  2005 (the write-down made at 12/31/05)                                         $(400,000)
2006 (the dividend income)            $ 40,000
2-6 •   ADVANCED ACCOUNTING: Concepts and Practice
                                                                              Wholly Owned Subsidiaries: Postcreation Periods                            • 2-7

E 2-6 (continued)
Requirement 2: (continued)

Note: There can be no reversal in 2006 of any portion of the $400,000 write-down made in 2005.

                                                      The Equity Method
                                 (no suspension occurs in the application of the equity method)
Amount reported in the parent’s income statement for:
 2005
                                                                                                                                               $(650,000)
2006                       770,000

E 2-7 (Estimated time: 15 minutes)
Requirement 1:
                                                  Parent’s Carrying Value—Cost Method
   12/31/05 ..................................................................................................................................... $200,000
  12/31/06 ...................................................................................................................................... 200,000

Note: The $200,000 amount is what the parent believed it could recover of its investment at 12/31/05.

                                  Parent’s Carrying Value—Equity Method
        (a suspension occurred in 2005 in the application of the equity method to the extent of $50,000)
                                                                 Investment in Subsidiary
  Balance, 4/1/05. . . . . . . . . . . . . . . . . . .             $600,000
                                                                                600,000 Equity in net loss
  Balance, 12/31/05 . . . . . . . . . . . . . . . .                $ -0-
  Equity in net income ($770,000 - $50,000
   of unrecognized 2006 loss) . . . . . . .                            720,000
                                                                                          40,000 Dividends declared
  Balance, 12/31/06. . . . . . . . . . . . . . . .                  $680,000

Note: The subsidiary’s equity accounts at 12/31/06 are:
  Common stock & Additional paid-in capital             $600,000
  Retained earnings               80,000
                        $680,000
Requirement 2:
                                                                    The Cost Method
Amount reported in the parent’s income statement for
 2005 (the write-down made at 12/31/05)                                          $(400,000)
 2006 (the dividend income)            40,000

Note: There can be no reversal in 2006 of any portion of the $400,000 write-down made in 2005.

                                                The Equity Method
              (a suspension occurred in 2005 in the application of the equity to the extent of $50,000)
Amount reported in the parent’s income statement for
 2005         $(600,000)
 2006 ($770,000 of net income – $50,000 of unrecognized 2005 loss)                                                  720,000
2-8 •      ADVANCED ACCOUNTING: Concepts and Practice


E 2-8 (Estimated time: 15 minutes)
Requirement 1:
                                               Parent’s Carrying Value—Cost Method
  12/31/07                     $30,000
  12/31/08                     $30,000

Note: The $30,000 amount is what the parent believed it could recover of its investment at 12/31/07.

                                   Parent’s Carrying Value—Equity Method
        (a suspension in the application of the equity method occurred in 2007 to the extent of $10,000)
       Investment in Subsidiary
  Balance, 5/1/07. . . . . . . . . . . . . . . . . . .   $100,000
                                                                     150,000 Equity in net loss
  Balance, 12/31/07 . . . . . . . . . . . . . . . .                 $ 50,000
  Equity in net income ($290,000 - $10,000
   of unrecognized 2008 loss) . . . . . . .               280,000
                                                                     40,000 Dividends declared
  Balance, 12/31/08. . . . . . . . . . . . . . . .       $190,000

Note: The subsidiary’s equity accounts at 12/31/08 are

Common stock & additional paid-in capital                       $100,000
  Retained earnings             90,000
               $190,000
Requirement 2:
                                                         The Cost Method
Amount reported in the parent’s income statement for
   2007 (the write-down made at 12/31/07)                       $(70,000)
   2008(the dividend income)             40,000

Note: There can be no reversal in 2008 of any portion of the $70,000 write-down made in 2007.

                                               The Equity Method
        (a suspension in the application of the equity method occurred in 2007 to the extent of $10,000)

Amount reported in the parent’s income statement for
   2007 ($160,000 - $10,000 of stockholder’s deficiency not guaranteed)
       by the parent [$60,000 - $50,000]             $(150,000)
   2008 ($290,000 of net income - $10,000 of unrecognized 2007 loss)                              280,000

E 2-9 (Estimated time: 20 minutes)
Requirement 1:
The basic elimination entry—the cost method:
Common Stock            20,000
  Additional Paid-in Capital          180,000
       Investment in Subsidiary               200,000
                                                         Wholly Owned Subsidiaries: Postcreation Periods   • 2-9

E 2-9 (continued)
The intercompany dividend elimination entry:
  Dividend Income             40,000
        Dividends Declared                         40,000

Requirement 2:

Consolidated retained earnings at the end of 2007:

        $750,000        ($660,000 + $90,000 for the subsidiary’s undistributed earnings at 12/31/07)

Requirement 3:
Dividends to be reported in consolidated statement of retained earnings for 2007:

        $123,000        (declared by the parent)

Requirement 4:
Subsidiary’s net loss for 2007:

         $(14,000)        See following analysis of the subsidiary’s Retained Earnings account for 2007, in which
this net loss amount is forced out.

        Retained Earnings (subsidiary)
                                                              $144,000 Balance 1/1/07
     Dividends ……………………………..                         40,000
                                                              $104,000 Subtotal
     Net loss (forced out) …………………..                 14,000
                                                               $ 90,000   Balance, 12/31/07

E 2-10 (Estimated time: 20 minutes)
Requirement 1:
The basic elimination entry—the equity method:

Common Stock           10,000
  Additional Paid-in Capital           340,000
  Equity in Net Income (of subsidiary)         33,000
  Retained Earnings, 1/1/07 (Ending balance at 12/31/07 of $130,000 [given]
      - $33,000 net income for 2007 + $11,000 dividend declared in 2007)                  108,000
       Dividends Declared                      11,000
       Investment in Subsidiary                480,000
2-10 •         ADVANCED ACCOUNTING: Concepts and Practice


E 2-10 (continued)
Requirement 2:
Consolidated retained earnings at the end of 2007:

           $550,000               (the parent’s retained earnings)

Requirement 3:
Dividends to be reported in the consolidated statement of retained earnings for 2007:
       $64,000          (declared by the parent)

Requirement 4:
Consolidated net income for 2007:

       $120,000                   See analysis of the parent’s retained earnings account for 2007, in which the net income
amount is forced out.

                                                                      Retained Earnings (parent)
                                                                               $494,000 Balance 1/1/07
       Dividends ..................................................    64,000
                                                                               $430,000 Subtotal
                                                                                 120,000    Net income (forced out)
                                                                                $550,000 Balance, 12/31/07

                                                                      PROBLEMS
PROBLEM 2-1, 2-2, 2-3, AND 2-4 ARE NOT SHOWN SINCE THESE ARE GRADED ASSIGNMENTS.




P 2-5 (MODULE 2—THE EQUITY METHOD) (Estimated time: 40 minutes)
Parrco and Subbco
Consolidation Worksheet as of December 31, 2006
           Parrco Subbco     Consolidation Entries                                 Consoli-
           Inc. Inc.     Dr. Cr.    dated
INCOME STATEMENT (2006):
Sales ............................................ 600,000240,000                                    840,000
Cost of sales ................................ (360,000)(110,000)                                   (470,000)
Expenses ..................................... (190,000)(100,000)                                   (290,000)
Equity in net income ................... 30,000....... 30,000(1)                              -0-
   Net Income ............................ 80,00030,00030,000                                        80,000

STMT. OF RET. EARNINGS:
Balances, 1/1/06 ......................... 200,00090,000 90,000 (1)            200,000
+ Net income ............................... 80,00030,00030,000BF               80,000
– Dividends declared................... (40,000)(10,000)           10,000 (1) (40,000)
Balances, 12/31/06 ..................... 240,000110,000 120,000         10, 000240,000

BALANCE SHEET:
Cash.............................................       60,00015,000                                 75,000
                                                               Wholly Owned Subsidiaries: Postcreation Periods   • 2-11

  Accounts receivable ................             70,00037,000                         107,000
  Interco. dividend receivable ....                10,000.......            10,000 (2)       -0-
  Inventory .................................     110,00055,000                         165,000
  Investment in subsidiary ......                 170,000.......           170,000 (1)       -0-
  Land .......................................    220,00036,000                         256,000
Bldg. and equipment ...................           500,000150,000                        650,000
Accumulated depreciation ..........              (320,000)(13,000)                     (333,000)
     Total Assets .......................         820,000280,000           180,000      920,000
Payables and accruals .................          230,00020,000                     250,000
  Interco. dividend payable ........                     10,00010,000 (2)               -0-
Long-term debt............................       150,00080,000                     230,000
Common stock, no par ................            200,000.......                    200,000
Common stock, $1 par ................                    5,000 5,000 (1)       -0-
Add’l paid-in capital ...................                55,00055,000 (1)               -0-
Retained earnings ........................        240,000110,000120,000 BF10,000 BF 240,000
     Total Liab. & Equity .......                820,000280,000190,000 10,000      920,000
       Proof of debit and credit postings.................. 190,000190,000
Explanation of entries:
 (1) The basic elimination entry.
 (2) The intercompany dividend receivable and payable elimination entry.
2-12 •     ADVANCED ACCOUNTING: Concepts and Practice


P 2-6 (Estimated time: 40 minutes)
Requirement 1:
The basic elimination entry—Cost Method:
Common Stock            30,000
  Additional Paid-in Capital           170,000
        Investment in Subsidiary                      200,000
The intercompany dividend elimination entry:
  Dividend Income               14,000
        Dividends Declared                     14,000
The intercompany dividend receivable and payable elimination entry:
  Dividends Payable             7,000
        Dividends Receivable                   7,000

Requirement 2:
Consolidated net income for 2006:
  Parent’s reported net income         $150,000
       Less: Parent’s dividend income            (14,000)
  Parent’s income from its own separate operations                $136,000
       Less: Subsidiary’s net loss               (23,000)
  Consolidated Net Income              $113,000

Requirement 3:
See analysis in requirement 2.

Requirement 4:
Consolidated retained earnings at the end of 2006:

        $381,000        ($330,000 + $51,000 for the subsidiary’s undistributed earnings at 12/31/06)

Requirement 5:
Dividends to be reported in the consolidated statement of retained earnings for 2006:

        $120,000        (declared by the parent)

Requirement 6:
Parent’s retained earnings at 12/31/06 under the equity method:

        $381,000        ($330,000 + $51,000 for the subsidiary’s undistributed earnings at 12/31/06)

Requirement 7:
Dividend Income              14,000
  Equity in Net Loss         23,000
  Investment in Subsidiary           51,000
       Retained Earnings—1/1/06 ($51,000 + $23,000 + $14,000)                           88,000
                                                      Wholly Owned Subsidiaries: Postcreation Periods   • 2-13

P 2-6 (continued)
Requirement 8:
The basic elimination entry—equity method:
Common Stock            30,000
  Additional Paid-in Capital            170,000
  Retained Earnings 1/1/06              88,000
       Equity in Net Loss (of subsidiary)                       23,000
       Dividends Declared                       14,000
       Investment in Subsidiary                 251,000

The intercompany dividend receivable and payable elimination entry:
  Dividends Payable           7,000
        Dividends Receivable                  7,000

P 2-7 (Estimated time: 40 minutes)
Requirement 1:
The basic elimination entry—the equity method:
  Common Stock                 20,000
  Additional Paid-in Capital            380,000
  Retained Earnings, 1/1/06 ($260,000 + $49,000 + $24,000)            333,000
        Equity in Net Loss (of subsidiary)                     49,000
        Dividends Declared                      24,000
        Investment in Subsidiary                       660,000

The intercompany dividend receivable and payable elimination entry:
  Dividends Payable           6,000
         Dividends Receivable                 6,000

Requirement 2:
Consolidated net income for 2006:

        $180,000        ($100,000 increase in the parent’s retained earnings during 2006 + $80,000 of dividends
declared by the parent during 2006)

Requirement 3:
Parent’s earnings from its own separate operations:

         $229,000       ($180,000 of consolidated net income [from requirement 2] + $49,000 [subsidiary’s 2006
loss])

Requirement 4:
Consolidated retained earnings at the end of 2006:

         $500,000       (the parent’s retained earnings)
2-14 •     ADVANCED ACCOUNTING: Concepts and Practice


P 2-7 (continued)
Requirement 5:
Dividends to be reported in the consolidated statement of retained earnings for 2006:

        $80,000(declared by the parent)

Requirement 6:
Parent’s retained earnings at 12/31/03 under the cost method:

        $240,000        ($500,000 – $260,000 for the subsidiary’s undistributed earnings at 12/31/06)

Requirement 7:
Retained Earnings, 1/1/06                 333,000
        Equity in Net Loss                          49,000
        Dividend Income                             24,000
        Investment in Subsidiary                             260,000

Requirement 8:
The basic elimination entry—the cost method:
  Common Stock                 20,000
  Additional Paid-in Capital          380,000
        Investment in Subsidiary                             400,000

The intercompany dividend elimination entry:
  Dividend Income             24,000
      Dividends Declared                            24,000

The intercompany dividend receivable and payable elimination entry:
  Dividends Payable           6,000
      Dividends Receivable                    6,000

P 2-8 (Estimated time: 1–4 hours)
Requirement 1:
Most of the time on this assignment involves creating the model as called for by this requirement (furnishing a
solution here is not possible).

Requirement 2:
The steps to create a macro (a stored instruction) on Excel (Excel 97 version) follow:
        1.       On the ―standard‖ toolbar, select Tools.
        2.       Then select Macro.
        3.       Then select Record New Macro.
                                                      Wholly Owned Subsidiaries: Postcreation Periods      • 2-15

P 2-8 (continued)

         4.     The Record Macro dialog box now appears. Do the following:
         a.     In the ―shortcut key‖ box, assign a letter of the alphabet to your macro, such as the letter ―a‖.
(This option enables you to later quickly execute this macro using the Control key and that letter, for example,
―Ctrl a‖.)
         b.     In the ―Store macro in‖ box, select the ―This Workbook‖ option (the default) if it is not displayed.
         c.     Then click on the OK button.
         5.     You are now ready to program (―record‖) your macro, which you do by performing the steps that
you want your macro to perform. (As you perform steps, Excel stores these instructions in a special ―off
worksheet‖ location that you may view as explained later.) For example, the step to change to a format that
displays formulas rather than values requires you to:
         a.     Select Tools on the standard toolbar.
         b.     Then select Options.
                c.       Then select the View tab (upper section of dialog box).
                d.       Then click in the Formulas box in the ―Window options‖ section so that a check-mark
now appears              in the box.
        e.      Then click on the OK button. If this were the only task you wanted your macro to perform, you
        would now want to stop recording your macro.
         6.     To stop recording your macro, perform the following:
         a.     Select Tools.          b. Select Macro.           c. Select the Stop Recording command.


                                                  CASES 

C 2-1 (Estimated time: 5 minutes)
Requirement 1

No. Disclosure of how the parent accounts for its investments in its subsidiaries is not necessary because the sub-
sidiaries are consolidated. Thus the Investment in Subsidiary account is eliminated in consolidation for each sub-
sidiary. Only if a subsidiary is not consolidated would disclosure have to be made.

Requirement 2
No. Disclosure would be required only if the subsidiary is not consolidated.

C 2-2 (MODULE 1—THE COST METHOD) (Estimated time: 15 minutes)
If management believes that no write-down is necessary because the investment’s carrying value has not been
impaired, it presumes that the investment can be sold to a willing buyer for at least the carrying value. To be
willing to pay an amount equal to the parent’s carrying value, the buyer would have to assume that the present
value of the future cash flows is at or above the purchase price. Accordingly, it is necessary to project future cash
flows in assessing whether the investment is recoverable.
   If the subsidiary were expected to have future annual profits of $30,000, it would be reporting a 10% return on
its stockholder’s equity of $300,000. From the parent’s perspective, this would be a 6.67% return on its initial
capital investment of $500,000.
2-16 •    ADVANCED ACCOUNTING: Concepts and Practice


Case 2-2 (continued)

   One approach is for the parent to estimate what a reasonable return on its investment would be considering the
business risk involved. Once that percentage, say 15%, is obtained, minimum dollar levels of expected future
earnings on which to make a judgment can be projected. For example, 15% of $300,000 is $45,000, and 15% of
$500,000 is $75,000. If the subsidiary’s expected future annual earnings are below $45,000, a write-down to at
least $300,000 seems appropriate. If the subsidiary’s expected future annual earnings are between $45,000 and
$75,000, then a write-down of less than $200,000 seems appropriate. If the subsidiary’s expected future annual
earnings are $75,000 or more, no write-down is suggested.

C 2-3 (MODULE 1—THE COST METHOD) (Estimated time: 10 minutes)
Requirement 1:
Whether the parent can write its investment back up depends on whether it had issued parent-company-only
financial statements in addition to the consolidated statements after it made the write-down. If parent-company-
only financial statements have not been issued (such as pursuant to a loan agreement), the parent could write the
investment back up. Otherwise, the parent could not do so because an outside party would have seen these
statements.

Requirement 2:
The parent debited an income statement account, such as Unrealized Loss on Investment in Subsidiary. To write
the investment back up, the parent would credit its Retained Earnings account.

Requirement 3:
Method 1: One way to value the Investment account at $1,500,000 is to (1) reverse the write-down using the
reasoning explained in Requirement 1 (if this option is available), (2) have the subsidiary pay a $500,000
dividend, and (3) have the parent make an additional $500,000 cash investment in the subsidiary.

Method 2: Another way to value the Investment account at $1,500,000 is to invest $1,500,000 in a newly created
subsidiary and have the new subsidiary acquire the old subsidiary.
                                                         
                                                                               Wholly Owned Subsidiaries: Postcreation Periods       • 2-17

C 2-4 (MODULE 1—THE COST METHOD) (Estimated time: 15 minutes)
Illustration 2-5 (Cost Method) Reformatted
So As to Avoid the Posting of Consolidation Entries
PARRCO COMPANY AND SUBBCO COMPANY
Consolidation Worksheet as of December 31, 2005
           Parrco Subbco                        Consolidation Entries                                Consoli-
                  Company                       Company Dr.         Cr.                    dated
INCOME STATEMENT:
Sales ................................................ 710,000282,000                                      992,000
Cost of sales .................................... (390,000) (130,000)                                               (520,000)
Expenses ......................................... (210,000) (120,000)                                               (330,000)
Dividend income (see R/E) ...........                         .
 Net Income .................................. 110,00032,000                                               142,000

STMT. OF RET. EARNINGS:
Balances, 1/1/05 .............................               103,00020,000                                 123,000
+ Net income (per above) ...............                     110,00032,000                                 142,000
– Dividends declared—Sub/
  Dividend income—Parent .........                            12,000(12,000)                                    -0-
– Dividends declared —Parent .......                         (85,000)                                              (85,000)
Balances, 12/31/05 .........................                 140,00040,000                                 180,000

BALANCE SHEET:
Cash.................................................         56,00041,000                                  97,000
Accounts receivable ........................                  82,00045,000                                 127,000
Interco. dividend rec./pay.............                       12,000(12,000)                                    -0-
Inventory .........................................          140,00082,000                                 222,000
(See equity section for
    parent’s investment acct.)
  Land         220,00030,000                                                               250,000
  Buildings and equipment                                  500,000150,000                                            650,000
Accumulated depreciation .............. (360,000)         (26,000)                                                   (386,000)
   Total Assets ............................. 650,000310,000                                               960,000
Payables and accruals .....................                  160,00090,000                                 250,000
Long-term debt................................               210,000120,000                                330,000
Parrco Company:
       Common stock                                10,000                                                  10,000
   Add’l paid-in capital ............................................             190,000
.................................................................... 190,000
       Retained earnings                           140,000                                                 140,000
   Subbco Company:
       Common stock—Sub/
         Investment in Sub—Par                                  (60,000)          60,000                                       -0-
 Retained earnings ..........................                       40,000                                  40,000
       Total Liab. & Equity .........                        650,000310,000                                960,000
                                           Recap of Retained Earnings: Parrco Company                                $140,000
           Sarrco Company                                               40,000
             Total                             $180,000
2-18 •         ADVANCED ACCOUNTING: Concepts and Practice


C 2-5 (MODULE 2—THE EQUITY METHOD) (Estimated time: 30 minutes)
Illustration 2-13 (Equity Method) Reformatted
So As to Avoid the Posting of Consolidation Entries
PARRCO COMPANY AND SUBBCO COMPANY
Consolidation Worksheet as of December 31, 2005
           Parrco Subbco     Consolidation Entries     Consoli-
           Company       Company Dr.      Cr.    dated
INCOME STATEMENT:
Sales ................................................ 710,000282,000992,000
Cost of sales .................................... (390,000) (130,000)                                          (520,000)
Expenses ......................................... (210,000) (120,000)                                          (330,000)
Equity in income (see R/E) ...........                        .
 Net Income .................................. 110,00032,000142,000

STMT. OF RET. EARNINGS:
Balances, 1/1/05--Parent ...............                123,000.                                             123,000
Balance, 1/1/05—Subsidiary ........                            20,000                             not cross-totaled
+ Net income (per above) ...............                110,00032,000                                        142,000
+ Equity in N.I. (of subsidiary) .......                 32,000.                                             not cross-totaled
– Dividends declared—Parent ........                    (85,000)                                                  (85,000)
– Dividend declared—Sub. .............                         (12,000)                                      not cross-totaled
Balances, 12/31/05—Sub. .............                          $40,000                                       not cross-totaled
Balances, 12/31/05--Parent ...........                  180,000.                                             180,000

BALANCE SHEET:
Cash.................................................    56,00041,000                                       97,000
Accounts receivable ........................             82,00045,000                                       127,000
Interco. dividend rec./pay.............                  12,000(12,000)                                                 -0-
Inventory .........................................     140,00082,000                                       222,000
(See equity section for
      parent’s investment acct.)
Land ......................................................................... 220,000   30,000
.................................................................... 250,000
   Buildings and equipment                                      500,000150,000                              650,000
Accumulated depreciation .............. (360,000)         (26,000)                                             (386,000)
   Total Assets ............................. 650,000310,000                                                960,000
Payables and accruals .....................             160,00090,000                                       250,000
Long-term debt                        210,000120,000                                           330,000
   Parrco Company:
       Common stock                                10,000                                              10,000
       Add’l paid-in capital                                    190,000                                       190,000
   Retained earnings .................................................           180,000
.................................................................... 180,000
   Subbco Company:
       Common stock—Sub/
         Investment in Sub—Parent                                         (100,000)     60,000
            (40,000)
 Retained earnings ..........................                  40,000                                       40,000
       Total Liab. & Equity .........                   650,000310,000                                      960,000
    Wholly Owned Subsidiaries: Postcreation Periods   • 2-19


2-20 •    ADVANCED ACCOUNTING: Concepts and Practice


C 2-6 (Estimated time: 5 minutes)

Whether to use the cost method or the equity method is a bookkeeping issue. The FASB deals with external
financial reporting (which would be on a consolidated basis if subsidiaries exist)—not internal bookkeeping
procedures.

C 2-7 (Estimated time: 5 minutes)

Dividends Declared (the fair value of the dividend)              1,000,000
  Loss on Disposal of Subsidiary                 2,000,000
        Investment in Subsidiary                         3,000,000

C 2-8 (Estimated time: 20 minutes)

Requirements 1 and 2:

  1. NET REALIZABLE VALUE:

     Short-term receivables (the nondiscounted amount of cash into which an asset is expected to be
      converted)

  2. NET SETTLEMENT VALUE:

     Trade payables (the nondiscounted amount of cash at which a liability is expected to be settled)
     Warranty obligations

  3. PRESENT (OR DISCOUNTED) VALUE OF FUTURE CASH FLOWS:

     Long-term receivables
     Long-term liabilities (including bonds and long-term lease obligations)

     Under current GAAP, the “implicit” or “historical” interest rate was used.

  4. FAIR VALUE:

     Investments in stocks having a readily determinable fair value when no significant influence exists
      (FAS 115)
     Investments in bonds when not classified as held-to-maturity (FAS 115)
     Derivative financial instruments (FAS 133)
     Fixed assets expected to be sold below their previous carrying value.

  5. CURRENT (REPLACEMENT COST) COST--WHEN USING "LOWER OF COST OR MARKET"
      RULE:

     Certain inventory (when market is below cost)

  6. HISTORICAL COST:

     Property, plant, and equipment
     Most inventory
     Investments in stocks that have no readily determinable fair value when no significant
       influence exists (ownership levels are usually below 20%)
                                                    Wholly Owned Subsidiaries: Postcreation Periods     • 2-21

Case 2-8 (continued)

 7. LOWER OF COST OR MARKET:

    Inventory

 8. HISTORICAL PROCEEDS:

    Liabilities that involve obligations to provide goods or services to customers--
      Deposits (received)

     This is the amount of cash (or its equivalent) received when the obligation was incurred.

 9. EQUITY METHOD:

    Investments in common stock in which significant influence exists (usually 20% ownership or more)

    [If control exists (usually more than 50% ownership), the cost method is also allowed.]

 10. FACE AMOUNT:

    Cash, CD accounts, money market investments.

    Reference: Statement of Financial Accounting Concepts No. 5 (1984), para. 67.

                                                     ASSETS

   Cash, CD and money market investments (face amount of currency)
   Accounts receivable (net realizable value)
   Notes receivable (present value—fixed interest rate)
   Inventory (lower of cost or market)
      [market is replacement cost, which must be between net realizable value and net realizable value less
       disposal costs]
    Property, Plant, and Equipment (historical cost)
       [in disposal situations, market value if below historical cost]
    Investments in Stocks:
        No significant influence exists and no readily determinable FV (FAS 115) (cost method)
        No significant influence exists and a readily determinable FV (FAS 115) (fair value)
        Significance influence exists and no control (APBO 18) (equity method)
        Control exists (ARB 51) (equity method or cost method)
    Investments in Bonds (FAS 115):
        Held-to-maturity (amortized cost)
        Trading or available-for-sale (fair value)
    Derivative Contracts (financial instruments) [favorable positions] (FAS 133) (fair value)
    Goodwill (FAS 142) (lower of cost or market)

                                                  LIABILITIES

    Accounts Payable (net settlement value)
    Accrued Liabilities (net settlement value)
    Accrued Warranty Obligations (net settlement value)
    6% Notes Payable (present value—fixed interest rate)
    8% Bonds Payable (present value—fixed interest rate)
    Deposits (historical proceeds)
2-22 •     ADVANCED ACCOUNTING: Concepts and Practice


Case 2-8 (continued)

     Unearned revenues (historical proceeds)
     Derivative Contracts (financial instruments) [unfavorable positions] (FAS 133) (fair value)
     Capitalized lease obligations (FAS 13) (present value--implicit interest rate)
                                                          
CASE 2-9 (Estimated time: 15 minutes)

Requirement 1 (the 25% investment)

Penron cannot report its 25% share of Talrex’s unrealized gain on its investment in Penron. Its 25% share of the
gain must be reported as a reduction of both its (1) Investment in Talrex and (2) Equity in Net Income account.
(Technically, Talrex should have reported the gain in Accumulated Other Comprehensive Income—not in its
income statement because the investment is in a marketable security having a readily determinable fair value.)

Requirement 2 (the 100% investment)

Senron’s unrealized gain on its investment in Penron must be eliminated in consolidation. To do otherwise,
would be the equivalent of reporting a gain on treasury shares held during a period when the market price of
Penron’s outstanding common stock went up. (Technically, Senron should have reported the gain in
Accumulated Other Comprehensive Income—not in its income statement because the investment is in a
marketable security having a readily determinable fair value.)

Enron Corp. had subsidiaries that had bought stock of Enron. The stock appreciated in value. Enron did not
eliminate the gain in consolidation, unfortunately, thus improperly overstating its consolidated net income.

                                             
                              FINANCIAL ANALYSIS PROBLEMS 

FAP 2-1 (Estimated time: 15 minutes)
Requirement 1 (equity method; no restrictions):
  Dividends that the parent can legally declare on its outstanding common stock            $500,000

  The parent has only $300,000 cash on hand, however, which would be an additional nonlegal limiting factor
on its ability to pay dividends (the amount could be increased to $550,000 if the parent directed the subsidiary to
pay a dividend equal to its cash on hand of $250,000).

Requirement 2 (cost method; no restrictions):
  Dividends that the parent can legally declare on its outstanding common stock            $100,000

   Under the cost method, the parent’s retained earnings is only $100,000 ($500,000 – $400,000 for the subsid-
iary’s retained earnings balance at year-end).

Requirement 3 (equity method; restrictions):
  Dividends that the parent can legally declare on its outstanding common stock            $500,000

   The parent has only $300,000 cash on hand, however, which would be an additional nonlegal limiting factor
on its ability to pay dividends. The fact that the subsidiary cannot pay cash dividends is not relevant from a legal
standpoint.
                                                                              Wholly Owned Subsidiaries: Postcreation Periods       • 2-23

FAP 2-1 (continued)

Requirement 4:
Disclosure should be made if the subsidiary’s restricted net assets are material in relation to the consolidated net
assets (25% or more is the level of materiality set forth by the SEC).
   Disclosure prevents the consolidated statement readers from erroneously assuming that the parent has the
financial ability to pay cash dividends equal to the consolidated retained earnings of $500,000 (an amount the
parent can legally distribute at dividends).

Requirement 5:
If the parent had $1,000,000 cash (instead of $300,000), it alone would have more than sufficient cash to pay the
maximum legal dividend distributable of $500,000. This fact suggests that any disclosure regarding cash transfer
restrictions would not serve a useful purpose. However, this cash may be needed internally so that operationally,
the parent would have to obtain some cash from the subsidiary before it would actually declare any cash
dividends. Therefore, the disclosure should still be made.

FAP 2-2 (Estimated time: 30 minutes)
Requirement 1:
                                     Calculation of Annual Return on Investment—Equity Method
                                    (beginning-of-year investment balance used in the denominator)

            2006           2007
Net income ....................................................................            $200,000    = 20%         $300,000    = 25%
Beginning investment ...................................................                  $1,000,000                $1,200,000

                                                                                                        2008
     Net income........................................................................        $330,000     = 30%
     Beginning investment .......................................................             $1,100,000a
a
    Balance on 1/1/06              $1,000,000
     + 2006 net income             200,000
     + 2007 net income             300,000
     – 2007 dividends (paid at the end of 2007)                                           (400,000)
     = Balance on 1/1/08           $1,100,000

Note that for 2007 when dividends are declared and paid at the end of the year, they do not have any impact on
the amount used in the denominator for that year.
Requirement 2:
                           Calculation of Annual Return on Investment—Cost Method
                       (beginning-of-year investment balance used in the denominator)
                                 2006 2007
     Net income           -0-             = 0% $400,000       = 40%
     Beginning investment                $1,000,000           $1,000,000
2-24 •          ADVANCED ACCOUNTING: Concepts and Practice


FAP 2-2 (continued)
Requirement 3:
The equity method reflects the correct return on the parent’s investment because the equity method is accrual
based whereas the cost method is cash based.

Requirement 4:

The internal rate of return is 24%. It was calculated using the following cash flow table—assuming that the
investment could be sold at the end of 2006 for its equity method carrying value of $1,300,000:

           End of Year                Amount
             2005                   $(1,000,000)         Initial investment on 1/1/06
             2006                        -0-
             2007                       400,000          Dividends received
             2008                       130,000          Dividends received
             2008                     1,300,000          Carrying value of investment at 12/31/08 (under the equity method)

Requirement 5:
                  Calculation of Annual Return on Investment—Equity Method for 2007
                    (adjusted beginning investment balance used in the denominator)
                         [$200,000 of dividends declared at the beginning of 2007
                           and $200,000 of dividends declared at the end of 2007]
                                      2007
  Net Income $300,000
                                                                     -------------- = 30%
Average investment balance    $1,000,000a
   a
    $1,200,000 – $200,000 of dividends declared and paid on 1/1/07 = $1,000,000. Declaring dividends at the beginning
  of a year is the equivalent of having declared them at the end of the prior year. Accordingly, they must be subtracted
  from the beginning-of-year investment balance to determine the true capital invested for the year.

Requirement 6:
                              Calculation of Annual Return on Investment—Equity Method for 2007
                                      (average investment balance used in the denominator)
                                           [$400,000 of dividends declared in mid-year]
                                                                                                                                    2007
Net Income                           $300,000
                                                                                                               ---------------        = 26.7%
Average investment balance                                      $1,125,000a
       a
    Beginning investment balance for the first six months ............................................................                               $1,200,000
   Beginning investment balance for the last six months ..........................................................
   ........................ ($1,200,000 – 400,000 [dividends] + $250,000 [net income for first 6 mo.])
1,050,000
      Subtotal ..................................................................................................................................   $2,250,000
           Divide by 2 to obtain the average balance ........................................................................                       ÷2
      Average investment balance for the year ..........................................................................                            $ 1,125,000
                                                       Wholly Owned Subsidiaries: Postcreation Periods       • 2-25

FAP 2-2 (continued)

Requirement 6 (continued)

   When dividends declared during a year (other than at the beginning or end of the year) exceed that year’s
earnings to date (as is the case here by $150,000 at 6/30/05 [$400,000 – $250,000]), a partial liquidation of the
investment has occurred. Accordingly, the excess must be subtracted from the Investment account balance at that
date to determine the capital at risk going into the remainder of the year. In such situations, an average investment
balance must be calculated.

Requirement 7:
                      Calculation of Annual Return on Investment—Equity Method for 2006
                              (average investment balance used in the denominator)

                                                                                     2006
Net Income                $200,000
                                                                            ---------------   = 18.2%
Average investment balance                $1,100,000
a
    $1,000,000 (beginning) + $1,200,000 (ending) ÷ 2 = $1,100,000.

   In our opinion, the parent’s true return on its investment is the 20% calculated in requirement 1. Accordingly,
the subsidiary’s 2006 earnings should be ignored even though it was assumed that these earnings accrued evenly
throughout the year. The rationale for ignoring these earnings is best explained using the following example:
        Amount Invested in Stated
        Financial Institution Interest             Interest
        On January 1, 2006 Rate Paid
           $100,000       10%     Semiannually
      Solution:
    Interest earned in first six months
        (10% × $100,000 × ½ yr.)            $ 5,000
       Interest earned in second six months
        (10% × $105,000 × ½ yr.)              5,250
           Total Interest Income            $10,250

Financial institutions quote not only a stated rate but also a ―yield.‖ In this example, the yield is 10.25% ($10,250
÷ $100,000). If the average investment balance were used, the ROE would be 10% ($10,250 ÷ $102,500). In
financial circles, the yield is generally considered the true return. It is worth noting that in computing earnings per
share under the now superseded APB Opinion No. 15, ―Earnings per Share,‖an ―effective yield test‖ (EYT) that
compounds interest was used to determine if convertible securities were common stock equivalents (an APBO 15
concept) [as required by FAS 85, which amended APBO 15].
    It should be noted, however, that some finance texts advocate using an average investment balance that consid-
ers the earnings of the business. This was not necessarily wrong; a difference of opinion merely exists as to which
is the more appropriate technique.
2-26 •        ADVANCED ACCOUNTING: Concepts and Practice


FAP 2-2 (continued)
Requirement 7: (continued)

Recap of How to Treat Dividends in AROI Calculations
Dividends should be ignored as long as they are declared and paid at year-end. If they are declared and paid near
the very beginning of the year (such as early January), the beginning investment balance should be reduced by the
dividends in determining the appropriate denominator. If the dividends are declared and paid at other than the be-
ginning or end of the year, they should be ignored unless the dividends exceed the current year earnings to date. If
the dividends exceed the current year earnings to date, a partial liquidation of the investment has occurred;
accordingly, an average investment balance must be calculated for the year.


FAP 2-3 (Estimated time: 40 minutes)
Requirement 1:
                                                 Parent’s General Ledger Entry on 4/1/06
Cash            700,000
  Loss on Sale of Subsidiary                             300,000
        Investment in Sarba                                          1,000,000
     To record sale of subsidiary.

Requirement 2:
                                               Calculation of Loss on Sale of Subsidiary
                                           to Be Reported in the 2006 Financial Statements
                                              to Be Provided to the Parent’s Stockholders

  Carrying value at time of sale, 4/1/06 ........................................................................................          $1,000,000
  Less—Proceeds from sale..........................................................................................................          (700,000)
    Loss recorded on Parba’s books ............................................................................................             $ (300,000)
  Less:
  Losses reported in consolidation prior to 2006 ($22,000 + $78,000) ........................................                              100,000
   Loss reported in consolidation of the income statement for the period 1/1/06 to 3/31/06 ......                                          110,000
   Loss on sale of subsidiary to be reported in the 2006 financial statements to be
      provided to Parba’s stockholders—the income statement is consolidated for the
     first quarter of 2006 . . .........................................................................................................   $ (90,000)

Requirement 3:

No. The subsidiary was in the same line of business as the parent. Thus this loss would not be reported as a ―loss
from discontinued operations.‖
Requirement 4:
                                           Entry Made in Consolidation at 12/31/06
                              (to consolidate the income statement for the first quarter of 2006)

Retained Earnings, 1/1/06              100,000
  Costs and Expenses           510,000
       Sales                   400,000
       Loss on Sale of Subsidiary                      210,000
   To consolidate the income statement of the subsidiary up to the date of sale (4/1/06).
                                                       Wholly Owned Subsidiaries: Postcreation Periods       • 2-27

                     PERSONAL SITUATIONS: INTERPERSONAL SKILLS

PS 2-1 (Estimated time: 10 minutes)
   The important thing is to maintain professionalism, so that the focus stays on what the proper accounting
treatment is rather than who is correct. Sometimes, this focus gets lost for various reasons. When the author was
in public accounting, for example, he saw some disagreements escalate unnecessarily because egos and ―saving
face‖ became a factor. (Such escalation is much more likely to occur when the parties have personality conflicts
rather than personality match-ups.)       The moral: Stay focused, stay professional, and ignore personality
differences.

                                     CHAPTER ETHICS QUESTION
Bankruptcy on the Horizon—Start Draining the Subsidiary (page 58 of text)
(Estimated time: 15 minutes)
Question 1:
Draining the subsidiary to the extent possible is probably not ethical. It is legal however, unless there is an intent
to defraud creditors. In 1995, Harley-Davidson Inc. concluded that the parent company, Loews Corp., was
draining Lorillard Tobacco Co.’s assets. Consequently, Harley-Davidson took action, described in the following
article from The Wall Street Journal (March 23, 1995):
     Harley-Davidson Inc. is fighting to break a nine-year-old licensing deal that put its name on cigarettes,
     citing fears that the cigarettes appeal to kids and the deal could draw the motorcycle maker into a
     liability quagmire.
        In a long-simmering war that burst into the open yesterday, Harley-Davidson sued Lorillard
     Tobacco Co., saying it’s worried that a growing number of liability suits against the cigarette maker
     could leave it too weak to honor its contract with Harley.
        ―Lorillard’s financial promises to us are worthless once litigation forces cigarette manufacturers into
     distress or bankruptcy,‖ says Richard Teerlink, Harley chief executive. ―We are not required to wait
     until Lorillard has declared bankruptcy before ending this relationship.‖
        Harley claimed that Lorillard has already ―depleted its assets‖ by paying large dividends to Loews
     Corp., its parent family. Harley alleges the dividends have caused Lorillard’s retained earnings, or ac-
     cumulated profit, to fall to $84 million in 1993 from $279 million in 1990.

Question 2:
Bankruptcy courts (under Section 548 of the Bankruptcy Reform Act of 1978) can nullify certain transfers by a
debtor with the intent to defraud creditors. (The recipient of the transfer must return the property.) Specifically,
the fraudulent transfer must have been made within one year prior to filing the bankruptcy petition. Creditors and
claimants would most likely contend that cash dividends paid to the parent within one year of filing the
bankruptcy petition were transfers with the intent to defraud creditors. Accordingly, the courts could nullify such
transfers.
   The Key Factor. Whether these transfers were ―made in the ordinary course of business‖ is of critical impor-
tance. The historical pattern is the focal point. If historically no dividends had been paid for many years except for
the last year or so when bankruptcy was a looming possibility, such transfers most likely would be nullified.
Requirement 3:
Existing creditors would be wise to try to have some of the debtor’s assets pledged as security on their exist
ing debts or debts created in the future. For this to be effective, securitization must be done 90 days before filing a
bankruptcy petition. Otherwise, the bankruptcy courts could nullify this securitization.

				
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