[Kairos]

I understand how the calculations are derived and I probably only know this problem because I’ve gotten it wrong so many times. could someone explain to me what is going on here conceptually?

The answer is A but why are we subtracting the excess fair values of inventory and the carrying amount that has been consumed from NI?

I would imagine that the values would be included in the goodwill calculation in the balance sheet but how do they pertain to the I/S?

Sage, Inc., bought 40% of Adams Corp.’s outstanding voting common stock on January 2 for $400,000, which equaled a proportionate share of the fair value of the net assets. The carrying amount of the net assets at the purchase date was $900,000. Fair values and carrying amounts were the same for all items except for plant and inventory, for which fair values exceeded their carrying amounts by $90,000 and $10,000, respectively. The plant has an 18-year life. All inventory was sold during the year. During the year, Adams reported net income of $120,000 and paid a $20,000 cash dividend. What amount should Sage report in its income statement from its investment in Adams for the year ended December 31?
A. $42,000
Answer (A) is correct.
Sage holds 40% of the investee’s voting common stock and is assumed to exercise significant influence. It should therefore account for the investment on the equity basis by recognizing its proportionate share of the investee’s net income. For this purpose, the investee’s net income of $120,000 should be adjusted for the $10,000 excess of fair value over the carrying amount of the inventory sold and for the portion of the difference between the fair value and carrying amount of the plant that has been consumed (depreciated). This adjustment equals $5,000 ($90,000 difference ÷ 18 years). Thus, Sage should report investment income of $42,000 [($120,000 – $10,000 – $5,000) × 40%].
B. $48,000
C. $36,000
D. $34,000

[Substantive Testing]

For this problem, you have to have a deep understanding of income statement, initial consolidation and the equity method.
First of all, this is a Bargain Purchase because company ABC (you) paid less than what the total company XYZ is worth in their books (Maybe due to fair value drops). Next, Inventory has to be subtracted because inventory are current assets and the difference of fair value and book value should be eliminated within the year of acquisition. As for depreciation, let’s say that the price you paid for XYZ was allocated to machinery for 80,000 instead of a 100,000 book value machinery XYZ had, and if its useful life is 5 years, then the XYZ Company will record a 20,000 depreciation. But because the ABC (your company) basis is only 80,000 your depreciation should have only been 16,000 and therefore, you have to adjust your depreciation expense to match the acquired company's depreciation expense by reducing NI by 4,000. You might ask why you have to match their books, and that is because you have real ownership on the company and wouldnt be fair (To the guy next door who bought the other 60% at a higher price per share) if you record a gain even though you bought your own company. You might only be able to go by your books if it’s a full consolidation or recognize a full gain if this investment were to be recorded using the fair market value method.

[Kairos]

Wow, really thorough explanation. Thanks a ton man! Really appreciate it!

[Author]

Replies