Hi All, I seriously think that the explanations for questions 32, and 36 are wrong. Q32: Why is cash not subtracted when calculating the current assets for both acquisition and proportional consolidation methods? Q36: Why would you use the acquisition method when you have to use the Equity method under US GAAP Kindly help me with the above two and Goodluck to all.
Q32 - why would you remove cash? Cash is a current asset. Maybe you are confusing enterprise value, which is equal to mv of debt and equity minus cash and equivalents. Q36 - it says “If”. Just because you GAAP tells you to account for an investment in one manner, doesn’t mean you can’t do it for purposes of analysis… or if the CFA exam asks you to do it…
You might also be confusing “current asset” with “working capital”, which does indeed exclude cash, and is used to determine free cash flow.
Since cash was used to pay for the acquisition, the current asset must be reduced by that amount. If you are using Schweser , you can check it on Volume 2, page 22, the 2nd last paragraph (right after figure 4). Thats why i was confused.
I don’t have the stuff in front of me but i believe the balance sheet is “immediately following the acquisition”, so the cash would have already been spent and the pro forma balance sheet will already exclude the spent amount.
Excellent Observation MARKCFAIL. If it was prior to acquisition, cash would have been reduced. Thanks for clearing this mess.
I agree with MarCFAIL because the balance sheet said “immediately following the acquisition.” However, CFAI’s answer for #33 is inconsistent, because to calculate the long-term debt to total asset ratio they deduct the $500mm sales price of the acquisition from total assets. What gives? Here’s hoping the real exam isn’t full of so many problematic interpretations.
Just noticed how in the “fine print” of the passage, it says “The balance sheet was prepared immediately following the acquisition, but the projected income statements do not reflect the acquisition” I guess that doesn’t really address the balance sheet, but one way or the other, it seems like the answer to Q33 and Q34 are inconsistent with their treatment of the acquisition cost. Anyone think otherwise?
Yes… the cash is not subtracted since the balance sheet was prepared immediately following the acquisition… However, like gjertsen pointed out, CFAI’s answer for #33 is inconsistent, because to calculate the long-term debt to total asset ratio they deduct the $500mm sales price of the acquisition from total assets… I dont think $500 should be deducted for the long term debt capitalisation ratio
It should be deducted, because they are asking you to use proportionate consolidation INSTEAD of equity method. Equity method includes the purchase price, at cost, of $500 mm as a net asset, so you need to back this out before you apply proportionate. Then you apply proportionate which is 50% of total assets of the company (notice total assets, not total net assets).
Thanks, markCFAIL. That does clear the matter up.
Actually, on second thought, it doesn’t clear the matter up. The balance sheet shown is post-transaction, so cash is already $500mm lower, and the asset of the bought company is $500mm higher. So the net assets haven’t changed. To back this all out and look at it as a proportionate consolidation, there is no “parent”, or even in a regular acquisition consolidation, the cash would move from parent to acquired company. In either case, there is no need to back out the cash (or asset) again in order to come up with the debt/equity ratio.
For purposes of the question, forget about the cash portion completely, your only looking at the BS after the transaction, the cash is gone, forget the word cash. That cash that disappeared resurfaces as a Net Asset (investment in affiliate) on the balance sheet. If you are using Equity Method, all is well and this is correct as investments are recorded at cost and increased by their pro rata portion NI and decreased by pro rata dividends. However to use proportionate requires you record the portion of the company who you are consolidating TOTAL ASSETS (not net), which is 50% of 1500 or 750. Since you are no longer using equity method you need to deduct the $500 mm investment in affiliate.
but what about adding back the $500mm in cash? In the case of a proportionate consolidation, the cash wouldn’t have had to go anywhere, would it? If it went anywhere, it would just go to the acquired company and be included in the acquisition/prop. consolidation either way.
They still have to pay money for the company, it likely goes to shareholders if public. The money is spent either way, it doesn’t just sit on the balance sheet post transaction. If you go to the store and buy a gallon of milk, do you leave with the milk and your $5.00?
Once again, thanks, markCFAIL. But I still contend that a proportionate consolidation describes a joint venture, and it would be assuming too much to assume any cash changes hands. And, if, like you said, the money did go “to shareholders” then wouldn’t it wind up both in Shareholder’s Equity of the acquired company and ASSETS (as cash) so that the balance sheet remains in balance. And in that case, the cash would still come in on the other side of the consolidated entity. And whatever may be true of PPP, I’m glad I don’t live in a place where milk costs $5.00 a gallon. 
Cmon man, its pasteurized!
(lol… well, here in NC it’s pasteurized as well) I finally got around to looking at my Schweser notes on the subject. There’s an example of an acquisition where the cash departs from the parent company and… it never really says where it goes. I still think there could easily be a case where new shares are issued and there would be no cash transacted, but unless it explicitly says that, it looks like the curriculum (read: what we need to know for next Saturday) intends for you to take the cash out for any kind of intercorporate investment, and only in the case of Equity method do you get a solitary investment asset in return; the other methods involve subsequently combining parent & consolidated entity balance sheets. Thanks for your explanations, markCFAIL. Best of luck.
Hank Scorpio Wrote: ------------------------------------------------------- > Q32 - why would you remove cash? Cash is a > current asset. Maybe you are confusing enterprise > value, which is equal to mv of debt and equity > minus cash and equivalents. > > Q36 - it says “If”. Just because you GAAP tells > you to account for an investment in one manner, > doesn’t mean you can’t do it for purposes of > analysis… or if the CFA exam asks you to do > it… Hank- I took a look at question 36 and was just as stumped as shivster. Also, I read your answer (quoted above), but I feel like the question is asking for something different. Here is the question in its entirety: 36. If Merick prepared a consolidated balance sheet on the date of acquisition the total shareholders’ equity ($) under U.S. GAAP will be closest to: The question says “Under U.S. GAAP”, meaning, whatever the answer to the question, it must adhere to U.S. GAAP. In the problem, the parent has exactly 50% ownership in the subsidiary, which qualifies the subsidiary for equity method, AND, at the same time, disqualifies it for total consolidation into the parents financial statements. Under the equity method there is no “non-controlling interest”; that is only for fully consolidated subsidiaries where the parent does not own 100% of the subsidiary. Is the answer to question #36 wrong? Or what am i missing here? Thanks in advance!
lt1776 Wrote: ------------------------------------------------------- > Hank Scorpio Wrote: > -------------------------------------------------- > ----- > > Q32 - why would you remove cash? Cash is a > > current asset. Maybe you are confusing > enterprise > > value, which is equal to mv of debt and equity > > minus cash and equivalents. > > > > Q36 - it says “If”. Just because you GAAP > tells > > you to account for an investment in one manner, > > doesn’t mean you can’t do it for purposes of > > analysis… or if the CFA exam asks you to do > > it… > > Hank- I took a look at question 36 and was just as > stumped as shivster. > > Also, I read your answer (quoted above), but I > feel like the question is asking for something > different. Here is the question in its entirety: > > 36. If Merick prepared a consolidated balance > sheet on the date of acquisition the > total shareholders’ equity ($) under U.S. GAAP > will be closest to: > > The question says “Under U.S. GAAP”, meaning, > whatever the answer to the question, it must > adhere to U.S. GAAP. In the problem, the parent > has exactly 50% ownership in the subsidiary, which > qualifies the subsidiary for equity method, AND, > at the same time, disqualifies it for total > consolidation into the parents financial > statements. > > Under the equity method there is no > “non-controlling interest”; that is only for fully > consolidated subsidiaries where the parent does > not own 100% of the subsidiary. > > Is the answer to question #36 wrong? Or what am i > missing here? > > Thanks in advance! It says to prepare a consolidated balance sheet. There is no such thing under the equity method, so we must assume consolidation method is used.