Question #35
Reading: Reading 8 Intercorporate Investments
PDF File: Reading 8 Intercorporate Investments.pdf
Page: 15
Status: Incorrect
Correct Answer: A
Your Answer: B
Question
Alpha Inc. owns 70% of the outstanding shares of Beta Inc. Compared to the debt-to-equity ratio under the partial goodwill method, Alpha's debt-to-equity ratio under the full goodwill method is most likely be:
Answer Choices:
A. the same
B. lower
C. higher. Birch Corporation is a large conglomerate based in the U.S. that has grown primarily through acquisition. On the first day of this reporting year, January 1, 2012, Birch acquired 1,500,000 shares of the common stock of TRQ Inc. TRQ Inc. produces high quality fabrics for use in the fashion industry. Exhibit 1 shows key numbers from TRQ Inc.'s accounts. Exhibit 1 - TRQ Financial Statement Extracts TRQ Inc Income – year ending 31 Dec 12 $700,000 Dividend paid $210,000 Number of common shares in issue 6,000,000 Number preferred shares in issue 3,000,000 Total number of shares in issue 9,000,000 Both Birch and TRQ prepare their accounts using US GAAP. Dan Fitzroy is the CFO of Birch, and is currently preparing with a meeting with the auditors to discuss the correct treatment of the TRQ investment in Birch's group accounts. Fitzroy is of the opinion that the equity method of accounting should be used for the following reasons: 1. The proportion of TRQ's common shares owned by Birch suggests that Birch has significant influence over TRQ's operations 2. The lack of ownership of preferred shares suggests that Birch has no significant influence over TRQ's operations 3. The proportion of TRQ's total shares owned by Birch suggests that Birch has significant influence over TRQ's operations
Explanation
The choice of full vs. partial goodwill will not impact consolidated debt. Compared to
partial goodwill method, Alpha's equity will be higher under the full goodwill method (due
to a higher minority interest value). Hence, full goodwill will report a lower debt-to-equity
ratio (due to the higher denominator).
(Module 8.7, LOS 8.a)
Birch Corporation is a large conglomerate based in the U.S. that has grown primarily
through acquisition. On the first day of this reporting year, January 1, 2012, Birch acquired
1,500,000 shares of the common stock of TRQ Inc. TRQ Inc. produces high quality fabrics for
use in the fashion industry. Exhibit 1 shows key numbers from TRQ Inc.'s accounts.
Exhibit 1 - TRQ Financial Statement Extracts
TRQ Inc
Income – year ending 31 Dec 12
$700,000
Dividend paid
$210,000
Number of common shares in issue
6,000,000
Number preferred shares in issue
3,000,000
Total number of shares in issue
9,000,000
Both Birch and TRQ prepare their accounts using US GAAP.
Dan Fitzroy is the CFO of Birch, and is currently preparing with a meeting with the auditors
to discuss the correct treatment of the TRQ investment in Birch's group accounts. Fitzroy is
of the opinion that the equity method of accounting should be used for the following
reasons:
1. The proportion of TRQ's common shares owned by Birch suggests that Birch has
significant influence over TRQ's operations
2. The lack of ownership of preferred shares suggests that Birch has no significant
influence over TRQ's operations
3. The proportion of TRQ's total shares owned by Birch suggests that Birch has
significant influence over TRQ's operations