AnalystPrep’s Question Bank and Item Sets for the Level II CFA Exam

Smart Coffee Growers, SCG, is a U.S. based society specializing in coffee processing and value addition. In line with its recently approved policy that prioritizes diversification, the society is contemplating an investment in 2 local companies: A chocolate manufacturer – Yummy Bars, and a small scale groundnut company – Natural Nuts Ltd. SCG’s management would like to finalize investment decisions regarding the two entities by January 1 2017.

SCG wants a 30% stake in Yummy Bars, and the management feels the level of control acquired will be sufficient to allow SCG to be represented in the board. That means the society will be able to participate in decision making and policy making processes. As such, the society is willing to offer $180 million in cash. Now, the book values of Yummy Bar’s assets and liabilities equal their values, with the exception of a manufacturing plant. Just before the acquisition, the plant has a book value of $24 million, a fair value of $45 million, and a useful life of 10 years. The exhibit below provides pre-investment balance sheets and income statements of the two entities.

SCG plans to acquire 100% of the outstanding shares of Natural Nuts Ltd. The society will achieve this by issuing 6 million of its own equity that has $1 par value and $30 million current market value. Exhibit 2 below provides pre-acquisition balance sheet information for Natural Nuts Ltd using book values and fair values. The shareholders’ equity figure included in SCG’s pre-acquisition balance sheet (exhibit 1) includes $90 million additional paid in capital with the remainder attributable to $1 par value common stock.

One year following the investment in Natural Nuts Ltd., the carrying value of its steel conversion unit is $4,500,000, while the fair value is $3,750,000. An in-house analyst estimates the the fair value of its identifiable net assets to be worth $3,540,000. The steel conversion unit is an independent reporting unit.

What’s the amount of goodwill reported on Fisher SCG’s balance sheet immediately following the purchase of Yummy Bars?

A. $0.

B. $45 million.

C. $94 million.

The correct answer is A.

Since the investment in Yummy Bars will provide SCG with board representation in addition to the ability to participate in policy decision-making matters, SCG will have significant influence over the target. Thus, the investment in Yummy Bars should be accounted for via the equity method of accounting.

Under the equity method of accounting, goodwill is not reported separately in the acquirer’s balance sheet. Rather, it’s incorporated as part of the cost of investment. As such, the amount of goodwill to be reported in the balance sheet is $0.

Study Session 5, Reading 16, LOS 16(C): analyze how different methods used to account for intercorporate investments affect financial statements and ratios

Suppose SCG offered $50 million for the acquisition of Yummy Bars. SCG would most likely:

A. Subject itself to post-acquisition legal suits from Yummy Bars.

B. Recognize the difference between the fair value of Yummy Bars’ assets and the purchase price as a gain in profit and loss.

C. Recognize the difference between the fair value of Yummy Bars’ assets and the purchase price as a loss in profit and loss

The correct answer is B.

$50 million would be considerably less than the fair value of Yummy Bars’ net assets. As such, that would effectively make the acquisition a bargain acquisition. Under both IFRS and US GAAP, SCG would be required to recognize the difference between the fair value of Yummy Bars’ assets and the purchase price as a gain in profit and loss.

Study session 5, Reading 16, LOS 16(b): distinguish between IFRS and US GAAP in the classification, measurement, and disclosure of investments in financial assets, investments in associates, joint ventures, business combinations, and special purpose and variable interest entities

Suppose SCG acquired just 18% of Yummy Bars. Would the society have significant influence over the associate?

A. No, significant influence can only be exercised with a minimum of 30% of voting rights

B. Yes, provided SCG holds at least 50% of board positions

C. Yes, provided SCG is represented in the board

The correct answer is C.

Influence can be exercised with a 20%-50% of voting power. If an investor holds less than 20% of the voting rights, they cannot exert influence unless the such influence can be demonstrated. With 18% of voting power, SCG would be able to exert influence if and only if:

• It has representatives in the board of directors
• It can participate in policy formulation
• It is capable of pulling of material transactions between itself and Yummy Bars
• There’s interchange of managerial personnel
• There’s technological dependency

Study session 5, Reading 16, LOS 16(a): describe the classification, measurement, and disclosure under International Financial Reporting Standards (IFRS) for 1) investments in financial assets, 2) investments in associates, 3) joint ventures, 4) business combinations, and 5) special purpose and variable interest entities

A year into SCG’s investment in Yummy bars, SCG sold $7.5m of inventory to Yummy Bars for $12m. Yummy resold $8m of this inventory during the year. What was SCG’s share of the unrealized profit?

A. $4.5m

B. $1.4985m

C. $0.44955m

The correct answer is C.

SCG’s profit from the sale = $12 – $7.5 = $4.5m

Yummy Bars sells 8/12 = 66.7% of the goods purchased from SCG.

That means 33.3% remains unsold.

Total unrealized profit = 33.3% × $4.5m = $1.4985m

SCG’s share of the unrealized profit = 30% × $1.4985 = $0.44955m

Study session 5, Reading 16, LOS 16(b): distinguish between IFRS and US GAAP in the classification, measurement, and disclosure of investments in financial assets, investments in associates, joint ventures, business combinations, and special purpose and variable interest entities

If the acquisition method of accounting is used for the combination between SCG and Natural Nuts Ltd:

A. SCG will measure the identifiable tangible and intangible assets and liabilities of Natural Nuts Ltd at fair value

B. SCG must not recognize any assets and liabilities that were previously recognized by Natural Nuts Ltd, including patents and brand names

C. Costs that SCG expects (but not obliged) to incur must be recognized as liabilities as of the acquisition date

The correct answer is A.

The acquisition method replaces the purchase method of accounting. Under the new method, all identifiable assets and liabilities of the acquiree (Natural Nuts Ltd.) must be measured at fair (market) value.

Option B is incorrect: SCG would be expected to recognize any assets or liabilities that were previously not recognized by the Natural Nuts Ltd.

Option C is incorrect: SCG would be expected to recognize any contingent liability assumed in the acquisition provided it can be measured reliably and it’s a present obligation rooted in past events. However, costs that SCG expects but which are not an obligation would not be recognized as liabilities as of the acquisition date.

Study Session 5, Reading 16, LOS 16(C): analyze how different methods used to account for intercorporate investments affect financial statements and ratios

Assuming that one year following the investment in Natural Nuts, the carrying value of goodwill for the steel conversion unit is $600,000. The impairment loss on the unit would be closest to:

A. $0.39m

B. $0.60m

C. $0.21m

The correct answer is A.

The carrying amount of the unit (including goodwill) is higher ($4.5m) than its fair value ($3.75m). This implies that there has been impairment.