Equity Method example - Equity Method class problem Facts...

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Equity Method class problem Facts in the case. Investment date 1/1/2011 Price per share of stock $14.00 HES shares purchased 1,000,000 Percentage ownership 25% Balance sheet for HES on investment date ($000): Assets Book Fair Book Fair Cash $2,000 $2,000 A/P $1,000 $1,000 A/R (net) 5,000 4,900 L-T Debt 6,000 6,500 Inventory 10,000 12,000 $7,500 40,000 39,000 Cont. Capital 35,000 Ret. Earnings 15,000 Total assets $57,000 $57,900 Total L&E $57,000 2011 income statement from HES's books ($000): Sales $28,000 COGS (20,600) Gross Profit 7,400 Depreciation expense (2,800) Other operating expense (3,240) Interest expense (360) Income before taxes 1,000 Illini paid $14 million for 25% of the equity interest in HES, so HES's implied market value of the firm is $14 mil / 25% = $56.0 million. What makes up this $56 million? The Boards assume that the market prices all firm assets and liabilities at their fair values as of the the investment date, including any that we don't record under financial reporting standards. Under this assumption, the market value of HES equity breaks down as follows: Market value of equity (based on stock purchase price) $56,000 Fair value of recorded assets 57,900 - Fair value of recorded liabilities (7,500) Fair value of recorded items $50,400 Excess MVE over FV (unrecorded net assets: goodwill) $5,600 Illini's 25% investment in HES gives them a proportional interest in the fair values of all HES assets and liabilities (goodwill too), including the unrealized gains and losses on them. All of the unrealized gains and losses in HES's assets and liabilities before Illini invested are assumed to be reflected in the price Illini paid for the stock: the unrealized gains made the stock price higher, while unrealized losses made the stock price lower. So, the stockholder owning the stock before Illini bore their share of these gains and losses, and Illini does not. These gains and losses should not be included in Illini's investment income because they don't represent income Illini earns after it has invested in HES after the investment date. Let's do the 2011 investment income to see how this works. How should Illini and HES account for the investment-related items? First, the easy part: HES reports its own book income of $1 million and records nothing related to Illini's investment. HES is a publicly-traded entity, and reports to its stakeholders using the appropriate standards (GAAP/IFRS). HES does not record or report the fair values of its assets or liabilities (unless the appropriate standard for that asset or liability requires them to do so), and does not need to otherwise adjust its standards-compliant book balances for any of the items above. Now, the hard part.
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Equity Method example - Equity Method class problem Facts...

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