Chapter 15 Investments and Fair Value Accounting 705

Special Activities

On August 16, 1995, Parson Corp. purchased 20 acres of land for $300,000. The land has

been held for a future plant site until the current date, December 31, 2010. On December 5,

2010, Mobile Air, Inc., purchased 20 acres of land for $2,000,000 to be used for a distri-

bution center. The Mobile Air land is located next to the Parson Corp. land. Thus, both

Parson Corp. and Mobile Air, Inc., own nearly identical pieces of land.

1. What are the valuations of land on the balance sheets of Parson Corp. and MobileAir, Inc., using generally accepted accounting principles?

2. How might fair value accounting aid comparability when evaluating these two com-panies?

SA 15-1Benefits of fair value

International Accounting Standard No. 16 provides companies the option of valuing prop-

erty, plant, and equipment at either historical cost or fair value. If fair value is selected,

then the property, plant, and equipment must be revalued periodically to fair value.

Under fair value, if there is an increase in the value of the property, plant, and equip-

ment over the reporting period, then the increase is credited to stockholders’ equity.

However, if there is a decrease in fair value, then the decrease is reported as an ex-

pense for the period.

1. Why do International Accounting Standards influence U.S. GAAP?2. What would be some of the disadvantages of using fair value accounting for prop-

erty, plant, and equipment?3. Why are there different treatments for increases and decreases in the fair value of

property, plant, and equipment over a period?

SA 15-2International fairvalue accounting

Financial assets include stocks and bonds. These are fairly simple securities that can

often be valued using quoted market prices. However, Wall Street has created many

complex and exotic securities that do not have quoted market prices. These securities,

such as structured investment vehicles (SIVs), must still be valued on the balance sheet

at fair value. Generally accepted accounting principles require that the reporting entity

use assumptions in valuing investments when market prices or critical valuation in-

puts are unobservable.

What are the ethical considerations in making subjective valuations of complex and

exotic investments?

SA 15-3Ethics and fair valuemeasurement

Berkshire Hathaway, the investment holding company of Warren Buffett, reports its “less

than 20% ownership” investments according to generally accepted accounting principles.

However, it also provides additional disclosures that it terms “look-through” earnings.

Warren Buffett states,

Many of these companies (in the less than 20% owned category) pay out relatively small propor-tions of their earnings in dividends. This means that only a small proportion of their earning poweris recorded in our own current operating earnings. But, while our reported operating earnings re-flect only the dividends received from such companies, our economic well-being is determined bytheir earnings, not their dividends.

The value to Berkshire Hathaway of retained earnings (of our investees) is not determined bywhether we own 100% , 50% , 20% , or 1% of the businesses in which they reside. . . . Our perspec-tive on such “forgotten-but-not-gone” earnings is simple: the way they are accounted for is of noimportance, but their ownership and subsequent utilization is all-important. We care not whetherthe auditors hear a tree fall in the forest; we do care who owns the tree and what’s next donewith it.

I believe the best way to think about our earnings is in terms of “look-through” results, calculated as follows: Take $250 million, which is roughly our share of the operating earnings retained by our investees (�20% ownership holdings); subtract . . . incremental taxes we wouldhave owed had that $250 million been paid to us in dividends; then add the remainder,

SA 15-4Warren Buffett and“look-through” earnings

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706 Chapter 15 Investments and Fair Value Accounting

In groups of three or four, find the latest annual report for Microsoft Corporation. The

annual report can be found on the company’s Web site at http://www.microsoft.com/msft/default.mspx.

The notes to the financial statements include details of Microsoft’s investments.

Find the notes that provide details of its investments (Note 3) and the income from its

investments (Note 4).

From these disclosures, answer the following questions:

1. What is the total cost of investments?2. What is the fair value of investments?3. What is the total unrealized gain from investments?4. What is the total unrealized loss from investments?5. What percent of total investments are:

a. Cash and equivalentsb. Short-term investmentsc. Equity and other investments (long term)

6. What was the total combined dividend and interest revenue?7. What was the realized net gain or loss from sale of investments?8. What was the total income (loss) from equity investees?

SA 15-5Reporting investments

Internet Project

Group Project

$220 million, to our reported earnings of $371 million. Thus our, “look-through” earnings wereabout $590 million.

Source: Warren Buffett, The Essays of Warren Buffett: Lessons for Corporate America, ed-

ited by Lawrence A. Cunningham, pp. 180–183 (excerpted).

1. What are “look-through” earnings?2. Why does Warren Buffett favor “look-through” earnings?

Answers to Self-Examination Questions

1. B ($50,000 � 5% � 54/360)2. C

Proceeds (800 shares � $20) � $50 $15,950Cost (800 shares � $23.05*) 18,440_______Loss on sale of investment $ 2,490______________

3. B

Income from Barnwell Inc. ($200,000 � 40%) $80,000Barnwell Inc. dividend ($60,000 � 40%) 24,000_______Increase in Investment in Barnwell Inc. Stock $56,000______________

4. A Answer C is the valuation allowance balanceon December 31, 2010, but not the adjustment toarrive at the balance. Answer D incorrectly addsthe beginning and ending debit balances of thevaluation allowance. Answer B incorrectly inter-prets the credit adjustment as an unrealized gain.The adjustment is the net decrease in the debitbalance, or answer A, as shown below.

(1,400 shares * $23) + $701,400 shares

Valuation allowance for trading investments, January 1, 2011 $32,000 Dr.

Trading investments at cost, December 31, 2011 $500,000Trading investments at fair value, December 31, 2011 520,000

Valuation allowance for trading investments, December 31, 2011 20,000 Dr._______

Adjustment $12,000 Cr.______________

5. A There is no income statement recognition ofchanges in the fair value of the available-for-sale portfolio; thus, Answers B, C, and D areincorrect. The accumulated change in fair valuefor the available-for-sale portfolio is recog-nized in the Stockholders’ Equity section of thebalance sheet.

*

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