ANSWERS TO QUESTIONS

• - 1

CHAPTER 2

Note: The letter A indicated for a question, exercise, or problem means that the question, exercise, or problem relates to a chapter appendix.

ANSWERS TO QUESTIONS

1(J). At the acquisition date, the fair value of the contingent consideration must be recorded on the parent’s books regardless of whether stock or cash is used to settle the earnout. Whether contingent consideration (based on stock issuance) is classified as a liability or as equity depends on the characteristics of the earnout. Earnouts that are settled with a fixed number of shares will be classified as equity if the earnout target is based solely on the buyer’s operations (which includes the operations of the acquired company) and cannot be based on any external index or comparisons with other companies or industries. If the earnout is settled with a variable number of shares, equity classification is possible if the earnout is based on the parent’s stock price. However, if the number of shares offered in the earnout is inversely related to the parent’s stock price, the earnout would be classified as a liability. Very few earnouts using stock will qualify for equity classification.

Changes in the value of stock earnouts classified as a liability will be reflected in earnings, while changes in the value of the stock earnouts classified as equity are not remeasured. .

• Pro forma financial statements (sometimes referred to as “as if” statements) are financial

statements that are prepared to show the effect of planned or contemplated transactions.

• For purposes of the goodwill impairment test, all goodwill must be assigned to a reporting unit.

Goodwill impairment for each reporting unit should be tested in a two-step process. In the first step, the fair value of a reporting unit is compared to its carrying amount (goodwill included) at the date of the periodic review. The fair value of the unit may be based on quoted market prices, prices of comparable businesses, or a present value or other valuation technique. If the fair value at the review date is less than the carrying amount, then the second step is necessary. In the second step, the carrying value of the goodwill is compared to its implied fair value. (The calculation of the implied fair value of goodwill used in the impairment test is similar to the method illustrated throughout this chapter for valuing the goodwill at the date of the combination.)

• The expected increase was due to the elimination of goodwill amortization expense. However, the

impairment loss under the new rules was potentially larger than a periodic amortization charge, and this is in fact what materialized within the first year after adoption (a large impairment loss). If there was any initial stock price impact from elimination of goodwill amortization, it was only a short-term or momentum effect. Another issue is how the stock market responds to the goodwill impairment charge. Some users claim that this charge is a non-cash charge and should be disregarded by the market. However, others argue that the charge is an admission that the price paid was too high, and might result in a stock price decline (unless the market had already adjusted for this overpayment prior to the actual writedown).

Advanced Accounting 6th Edition Jeter Solutions Manual Visit TestBankDeal.com to get complete for all chapters

• - 2

ANSWERS TO BUSINESS ETHICS CASE

a and b. The board has responsibility to look into anything that might suggest malfeasance or inappropriate conduct. Such incidents might suggest broader problems with integrity, honesty, and judgment. In other words, can you trust any reports from the CEO? If the CEO is not fired, does this send a message to other employees that ethical lapses are okay? Employees might feel that top executives are treated differently.

ANSWERS TO ANALYZING FINANCIAL STATEMENTS EXERCISES

AFS2-1 eBay acquires Skype (A) Goodwill computation

Acquisition price $ 2,593 million Net tangible and intangible assets 262 million Goodwill $ 2,331 million

(B) Factors used to determine in the contingent consideration is part of the exchange or not. (FASB ASC paragraphs 805-10-55-24 and 25)

The acquirer should consider the following if the contingent payments are made to employees or selling shareholders.

• Is the selling shareholder a continuing employee? If the contingent payment is canceled if

the employee’s employment is terminated, then the consideration might be post-acquisition compensation for services.

• If the selling shareholder is a continuing employee and the period of required continuing

employment is longer than the contingent payment period, the contingent payments might, in substance, be compensation.

• If the selling shareholder is a continuing employee and the employee’s compensation is

reasonable in comparison to other key employees, the contingent payment may indicate additional consideration rather than compensation.

• If the contingent payment for non-employees is less than the contingent payments for

continuing employees, the additional contingent payments for employees may indicated compensation rather than additional consideration.

(C) It is not clear why eBay would settle the earnout for $530.3 million when the conditions for having to make the additional contingent payments (up to $1.3 billion) were probably not going to be met.Under current GAAP, if the amount of the contingent payment exceeded the previously expected amount, the difference is reflected in earnings. Under the rules in effect for the Skype transaction the contingent payment was simply an adjustment of goodwill. Because eBay was settling the earnout for approximately a third of the total potential payments indicates that Skype was not performing well.Notice that eBay wrote down$1.39 billion in goodwill at the same time. One potential reason that eBay might have agreed to the payment is that the former CEO of Skype was stepping down and the contingent payment may have been incentive for him to step down. In addition, the earnout may have prevented eBay from selling Skype.

• - 3

AFS2-2 eBay Sells Skype As Reported

Adjustments

Adjusted

eBay's Income Statement 2007 2008 2009

2007 2008 2009 2007 2008 2009

Net revenues $7,672,329 $8,541,261 $8,727,362

-364,564 -550,841 -620,403

$7,307,765 $7,990,420 $8,106,959

Cost of net revenues 1,762,972 2,228,069 2,479,762 -337,338 -434,588 -462,701

1,425,634 1,793,481 2,017,061

Gross profit 5,909,357 6,313,192 6,247,600 (27,226) (116,253) (157,702) 5,882,131 6,196,939 6,089,898

Operating expenses:

Sales and marketing 1,882,810 1,881,551 1,885,677

1,882,810 1,881,551 1,885,677

Product development 619,727 725,600 803,070

619,727 725,600 803,070

General & administrative 904,681 998,871 1,418,389

(343,200)

904,681 998,871 1,075,189

Provision for trans. & loan losses 293,917 347,453 382,825

293,917 347,453 382,825

Amortization of acquired intangible assets 204,104 234,916 262,686

204,104 234,916 262,686

Restructuring

49,119 38,187

- 49,119 38,187

Impairment of goodwill 1,390,938

(1,390,938)

- - -

Total operating expenses 5,296,177 4,237,510 4,790,834 (1,390,938) (343,200) 3,905,239 4,237,510 4,447,634 Income from operations 613,180 2,075,682 1,456,766

1,363,712 (116,253) 185,498

1,976,892 1,959,429 1,642,264

Interest and other income 137,671 107,882 1,422,385 (1,400,000) 137,671 107,882 22,385 Income before income taxes

750,851

2,183,564

2,879,151

1,363,712

(116,253) (1,214,502)

2,114,563

2,067,311

1,664,649

Provision for income taxes

(402,600)

(404,090)

(490,054)

Net income $348,251 $1,779,474 $2,389,097

Ratios 2007 2008 2009

2007 2008 2009

Gross Margin Percentage 77.0% 73.9% 71.6%

7.5% 21.1% 25.4%

80.5% 77.6% 75.1%

Operating Margin Percentage 8.0% 24.3% 16.7%

27.1% 24.5% 20.3%

Income before taxes % 9.8% 25.6% 33.0%

28.9% 25.9% 20.5%

There are four adjustments to eliminate the effect of Skype from eBay’s books. First, we eliminate the revenues and the direct expenses

• - 4

AFS2-2 solution continued:

from each year. We eliminated 100% of Skype’s revenues and direct expenses disclosed in the footnotes in 2009 because it was not clear from the disclosure whether those amounts were the amounts included on eBay’s statements or whether they were for the entire year. An acceptable solution would be to eliminate 11.5/12 or 95.8%. Second, the impairment of goodwill was added back in 2007. Third, the gain on the sale of $1.4 million was subtracted from interest and other income in 2009. And finally, the charge from the legal settlement was added back (or subtracted from costs) in 2009.

Performance: Including Skype, eBay’s gross margin declined from 77% to 71.6%. Without Skype, the gross margin still declined, but the decline was smaller (80.5% to 75.1%). Including Skype, income before taxes showed a rather large increase in absolute dollars increasing to $2,879,151 from $648,251 (283% increase). After Skype is eliminated we find a decreasing trend from $2,114,563 to 1,664,649 (a 21.3% decline). A similar trend exists for the income before tax as a percentage of revenues. The unadjusted percentage increased from 9.8% to 33% while the adjusted percentage decreased from 28.9% to 20.5%. The most interesting aspect of the numbers is that eBay recorded an impairment charge of $1.4 million in 2007 and then in 2009 recorded an $1.4 million gain on the sale.