Jason Bennett is an analyst for Valley Airlines (Valley), a U.S. firm. Valley owns a stake in Southwest Air Cargo (Southwest), also a U.S. firm. The two firms have had a long-standing relationship. The relationship has become even closer because several of Valley's top executives hold seats on Southwest's Board of Directors.
Valley acquired a 45% ownership stake in Southwest on December 31, 2007. Acquisition of the ownership stake cost $9 million and was paid in cash. Valley's stake in Southwest is such that management can account for the investment using either the equity method or the acquisition method. While Valley's management desires to fairly represent the firm's operating results, they have assigned Bennett to assess the impact of each method on reported financial statements.
Immediately prior to the acquisition. Valley's current asset balance and total equity were $96 million and $80 million, respectively. Southwest's current assets and total equity were $32 million and $16 million, respectively.
While analyzing the use of the equity method versus the acquisition method, Bennett calculates the return on assets (ROA) ratio. He arrives at two conclusions:
Statement 1: Compared to the acquisition method, the equity method results in a higher ROA because of the higher net income under the equity method.
Statement 2: Compared to the acquisition method, the equity method results in a higher ROA because of the smaller level of total assets under the equity method.
In order to get a better picture of Valley's operating condition, Bennett is also considering the use of proportionate consolidation to account for Southwest. He makes the following statements regarding the acquisition method and a proportionate consolidation:
Statement 3: Both methods are widely accepted under the provisions of U.S. GAAP and International Financial Reporting Standards (IFRS).
Statement 4: Both methods report the same level of assets on the parent's balance sheet. Statement 5: Both methods report all of Southwest's liabilities on the parent's balance sheet.
In addition. Valley has always wanted to pursue its goal of vertical integration by expanding its scope of operations to include the manufacturing of airline parts for its own airplanes. Therefore, it established a subsidiary, Mountain Air Parts (Mountain), in Switzerland on January 1,2008.
Switzerland was chosen as the location for economic and geographical diversification reasons. Mountain will operate as a self-contained, independent subsidiary. Local management in Switzerland will make the majority of operating, financing, and investing decisions.
The Swiss franc (CHF) is the official currency in Switzerland. On January 1, 2008, the USD/CHF exchange rate was 0.77. At December 31, 2008, the exchange rate had changed to 0.85 USD/CHF. The average exchange rate in 2008 was 0.80 USD/CHF. In its first year of operations. Mountain paid no dividends and no taxes. Mountain uses the FIFO assumption for its flow of inventory.
For this question only, assume that Mountain is operating in a highly inflationary environment. Which of the following statements is least correct? Mountain's:
- nonmonetary assets and nonmonetary liabilities are adjusted for inflation in accordance with U.S. GAAP.
- functional currency is the U.S. dollar.
- financial statements are adjusted for inflation, and the net purchasing power gain or loss is recognized in the income statement in accordance with IFRS.
Answer(s): A
Explanation:
Under U.S. GAAP, the nonmonetary assets and liabilities of the foreign subsidiary are not restated for inflation. Under IFRS, the subsidiary's financial statements are adjusted for inflation, and the net purchasing power gain or loss is recognized in the income statement. Then, the subsidiary is translated into U.S. dollars using the all-current method. If Mountain operates in a highly inflationary environment, the appropriate method is the temporal method. Under the temporal method, the functional currency is considered to be the-parent's presentation currency. Thus, Mountain's functional currency is the U.S. dollar. (Study Session 6, LOS 23.0