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Accounting for Investments in Subsidiaries

1. Firm A purchased 100% of the outstanding stock of Firm B, paying 10$ a share. The purchase occurred on Sunday, January 31st and Firm A already paid for the deal using cash it had accumulated after a very profitable holiday sales season. Executives of Firm A were very satisfied with the deal, as the price they paid was significantly lower than the closing market price on the previous Friday. Choose the MOST CORRECT OPTION. This transaction affected Firm A's January income statement:

a) since Firm A bought the stock cheaper than the last market price, thus recording a gain.
b) since Firm A had the expense of buying the stock of Firm B.
c) both previous statements are true.
d) The transaction described does not affect Firm A's January income statement.
e) The transaction describe does directly affect Firm A's January income statement, but in a different fashion than the one described in a) and b).

2. Still referring to the same transaction described in question 1.
a) Operating cash flow was affected, as the purchase was already paid for.
b) Investing cash flow was affected, as the purchase was already paid for.
c) Operating cash flow was not affected, as the purchase involved no gain.
d) More than one of the above is true.
e) None of the above is true.

3. Still referring to the same transaction described in question 1:
a) Firm A's assets will now show a positive goodwill, since the firm made a great deal with this purchase.
b) Firm A's assets will show no goodwill, since the firm paid less than the last known
market price for Firm B.
c) Firm A's balance sheet will show a negative goodwill, since the firm paid less than the last known market price for Firm B.
d) There is not sufficient information provided on the exercise to ascertain whether positive or negative goodwill arose.
e) None of the above is true concerning this transaction.

Solution Preview

1. Under the "historical cost principle" of generally accepted accounting principles, companies account for their acquisitions at the actual costs of those purchases. The fact that the company bought the stock at less than its prior closing price does not impact its financial statements. ...

Solution Summary

This solution discusses how investments in subsidiaries are accounted for, such as their impacts on the acquirer's income statement, balance sheet, and statement of cash flows.

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