Galena Petrovich, CFA, is an analyst in the New York office of TRS Investment Management, Inc. Petrovich is an expert in the industrial electrical equipment sector and is analyzing Fisher Global. Fisher is a global market leader in designing, manufacturing, marketing, and servicing electrical systems and components, including fluid power systems and automotive engine air management systems.
Fisher has generated double-digit growth over the past ten years, primarily as the result of acquisitions, and has reported positive net income in each year. Fisher reports its financial results using International Financial Reporting Standards (IFRS).
Petrovich is particularly interested in a transaction that occurred seven years ago, before the change in accounting standards, in which Fisher used the pooling method to account for a large acquisition of Dartmouth Industries, an industry competitor. She would like to determine the effect of using the purchase method instead of the pooling method on the financial statements of Fisher. Fisher exchanged common stock for all of the outstanding shares of Dartmouth.
Fisher also has a 50% ownership interest in a joint venture with its major distributor, a U.S. company called Hydro Distribution. She determines that Fisher has reported its ownership interest under the proportioned consolidation method, and that the joint venture has been profitable since it was established three years ago. She decides to adjust the financial statements to show how the financial statements would be affected if Fisher had reported its ownership under the equity method. Fisher is also considering acquiring 80% to 100% of Brown and Sons Company. Petrovich must consider the effect of such an acquisition on Fisher's financial statements.
Petrovich determines from the financial statement footnotes that Fisher reported an unrealized gain in its most recent income statement related to debt securities that are designated at fair value. Competitor firms following U.S. GAAP classify similar debt securities as available-for-sale.
Finally, Petrovich finds a reference in Fisher's footnotes regarding a special purpose entity (SPE). Fisher has reported its investment in the SPE using the equity method, but Petrovich believes that the consolidation method more accurately reflects Fisher's true financial position, so she makes the appropriate adjustments to the financial statements.
For comparison purposes, Petrovich decides to reclassify Fisher GlobaPs debt securities as available-for-sale. Ignoring any effect on income taxes, which of the following best describes the effects of the necessary adjustments?
- Net income is lower and asset turnover is higher.
- Return on assets is lower and debt-to-cquity is lower.
- Return on equity is lower and debt-to-total capital is not affected.
Answer(s): C
Explanation:
U.S. GAAP requires that unrealized gains and losses on available-for-sale securities be reported in comprehensive income as part of shareholders' equity. The appropriate adjustment to Fishers statements is to decrease net income by the amount of the gain. Lower net income will result in lower ROA and ROE (lower numerators). Lower net income results in lower retained earnings. However, the gain increases other comprehensive income; thus, total equity does not change. In summary, assets, liabilities and total equity are not affected by the adjustment; thus, asset turnover, debt-to-equity and debt-to-total capital are not impacted. (Study Session 5, LOS 21.a,b)