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CFA Level II Item-set - Question
Study Session 5
June 2017
Donald Sweeney works as the chief investment officer at Exquisite Interiors (EI), a firm
that offers top quality home renovation services to its customers. As part of its expansion
strategy, EI acquired Home Decorators (HD), a large firm in Virginia. EI paid $1 billion
to acquire 35% of the company and the ability to exert influence on the firms financial
and operating decisions. Exhibit 1 displays information concerning Home Decorators
assets and liabilities on January 1, 2010.
Exhibit 1
Book Value Fair Value
Current Assets $198.50 million $198.50 million
Plant and Equipment $2,500 million $2,800 million
Liabilities $375.47 million 375.47 million
The plant and equipment are depreciated on a straight line basis with a useful life
estimate of 10 years. Exquisite Interiors share of the residual value of the P&E is
$500,000. During 2010, Home Decorators reported net income of $200 million and paid
dividends of $98 million.
Ethan Anderson is a close friend of Sweeney who works as a financial consultant for
firms with merger and acquisition motives. Sweeney invited Anderson for lunch to
discuss the various methods of reporting investments in financial assets. During their
conversation, Anderson mentioned that he is currently analyzing the financial statements
of Walter Company (WC). Walter Company owns 30% of Wood Company, and
Anderson has determined that the equity method would be appropriate to report this
acquisition. At the time of acquisition, the excess purchase price attributable to
identifiable assets equaled $65,000, which is amortized using straight line depreciation
and a useful life estimate of 8 years. During 2009, Walter sold Wood inventory for
$250,000, with a cost of $165,000. Wood resold $180,000 of this inventory during the
year to an outside party. Wood reported income from operations of $975,500 in 2009.
Statement 1: On the acquisition date, the acquirer must recognize any contingent
liability assumed in the acquisition if it is a present obligation that arises
from past events and its fair value can be reliably measured. This is true
for companies either following the IFRS or the U.S. GAAP.
Statement 2: Under either IFRS or the U.S. GAAP, FLC would have reported the
difference between the fair value of REMs net assets and the purchase
price immediately at the time of acquisition as a gain in the profit or loss
statement. Also, both IFRS and the U.S. GAAP now require
noncontrolling interests to be presented on the consolidated balance
sheets as a separate component of stockholders equity.
Anderson has just been hired by the Red Corporation (Red-Corp) to analyze their
acquisition of the Blue Company (Blue-Co). Red-Corp acquired 85% of Blue-Co on
1stJan, 2009. The transaction was stock based with the fair value of Red-Corp common
stock offered equal to $85,500,000. The fair market value of Blue-Cos shares on the date
of the acquisition was $105,500,000. Anderson gathered the following information as of
1stJan, 2009.
Exhibit 2
Blue Company
Book Value Fair Value
Cash and receivables 5,350,000 5,350,000
Inventory 47,000,000 47,000,000
Property, plant and equipment 67,800,000 75,500,000
Payables and long term debt 45,200,000 45,200,000
Statement 4: Both U.S. GAAP and IFRS require that held-to-maturity securities be
initially recognized at fair value including transaction costs.
A. $1,025,200,000.
B. $1,025,250,000.
C. $1,059,550,000.
A. $283,072.
B. $260,725.
C. $277,385.
A. Statement 3 only.
B. Statement 4 only.
C. neither Statement 3 nor Statement 4.
15743
Questions 7(15744) to 12(15749) relate to Reading 16
Woodrow Foster, CFA is an equity analyst working for Thuraiya. Foster routinely
engages in the financial statement analysis of the companies he covers. His recent
assignment is Rigor, a sound systems manufacturer. Rigor is situated in the U.K. and uses
the IFRS to compile its financial statements.
Exhibit 1
Rigors Investment Portfolio For the Year ending
31st December 2010 (in 000)
Monsieur
Jador Inc. LePelle
Vito
Acquisition cost (Par
3,000 2,875 2,825
value)
Fair value 1 January 4,500 2,875 2,825
Fair value 31
3,895 3,240 3,000
December
Stated rate* 8.0% 2.5% N/A
Held-to- Held for
Classification Unclassified
Maturity trading
Type of investment Debt Equity Equity
*The stated rate quoted for the Jador Inc. investment represents the annual rate of
interest paid on the investments par value. The stated rate quoted for the
LePelle investment represents its annual dividend rate. The market rate in effect
when the bonds were issued was 3.5%.
In a discussion with Rigors CEO, the CEO tells Foster that the acquisition cost paid for
the Monsieur Vito investment (Exhibit 1) represents the fair value of Rigors shares
which were exchanged with Vitos shares to acquire a 70% controlling interest in Vito.
The total market value of Vitos common stock at the time of acquisition was 2,080,000.
Following their discussion, Foster collects pre-acquisition selected balance sheet
information on the target (Exhibit 2).
Exhibit 2
Monsieur Vitos Pre-Acquisition Selected Balance Sheet
Information Book Values and Fair Values (in 000)
Book Fair
Value Value
Current assets 2,325 2,455
PPE (net) 1,440 1,546
Total assets 3,765 4,001
Shareholders
equity:
Capital stock (1 1,560
par)
Retained earnings 394
Next, Foster engages in a discussion with one of Vitos senior manager. The manager
informs him that the increase in net PPE was solely due to a revaluation of one of Vitos
machinery at the time of the firms acquisition. The machinery was purchased eight years
ago at a cost of 500,000. At the time of revaluation, it had a remaining useful life of five
years. The machine is depreciated using a straight line method and has an expected
salvage value of zero.
A. 3,000.
B. 3,042.
C. 4,500.
A. 2,760.
B. 4,448.
C. 4,418
A. 365.
B. 437.
C. 446.
A. 110,000.
B. + 547,000.
C. + 1,292,000.
A. equity method.
B. proportionate consolidation method.
C. acquisition method.
A. 304,800
B. 334,800
C. 356,000
16067
Questions 13(16068) through 18(16073) relate to Reading 16
Abdul Ibrahim, CFA, has been hired by Green Corp - a manufacturer of environmentally
safe detergents, to undertake an equity analysis of Green Corp Group. The group
comprises of two corporations - Ester Corp and Poly Corp, situated in France and the
U.K., respectively. Green Corp is headquartered in the U.S. and complies with U.S.
GAAP for financial reporting purposes. The reporting period for all three firms ends on
December 31.
Green Corp purchased a 25% stake (with voting rights) in Ester Corp for 150 million at
an exchange rate of US$0.6435 per 1 on March 15, 2007. Green Corp has classified this
investment as significant influence and accounts for it under the equity method of
accounting based on the following criteria:
Criteria 1: Green Corp heavily relies on key employees, serving Ester Corps
compliance department, to provide legal advice concerning relevant
French tax and income remittance laws. Compliance department
employees of the two corporations often relocate within the groups
corporations.
Criteria 2: Green Corps board members must hold a minimum of two executive
positions on Ester Corps board at any one time.
Criteria 3: Inter-corporate transactions between Green Corp and Ester Corp are
restricted to a maximum amount of 1 million per transaction to ensure
they remain immaterial.
On March 1, 2008, Ester Corp purchases 0.5 million worth of detergents from Green
Corp at a total cost of 5 million. By December 31, 2008, the subsidiary has sold 35% of
these detergents for 350,000. Ester Corps reported income for the year was 12 million.
For its 75% stake in Poly Corp, Green Corp paid 500 million in cash on January 1,
2009. The purchase granted the parent control over the target. For his analysis, Ibrahim
has collected relevant financial information on the subsidiary and parent immediately
prior to acquisition (Exhibit 1). The difference in fair value between the assets was solely
due to an item of machinery, which had a net book value of 15 million immediately
prior to the acquisition. The machinery has a total useful life of 15 years of which 8 years
have passed and is being depreciated on a straight line basis with a zero salvage value.
On January 1, 2011 Green Corp creates a trust with the aid of a legal firm. The trust has
been created to purchase and refurbish defunct factories which are later leased to Green
Corp. The purchases are usually financed by long-term loan notes linked to long-term
treasury securities. These long-term notes are collateralized by the defunct factories
which are marketable after being refurbished.
Although Green Corp holds a 10% stake in the trust, which entitles it to voting rights
commensurate with its proportion of stockholding. The remainder of the trusts stock is
held by external corporations who retain the remainder of the voting rights over the trust,
commensurate with their stockholdings. Any defaults on principal and monthly interest
payments are to be covered by Green Corp.
Exhibit 1
Green Corps and Poly Corps Pre-Acquisition
Balance Sheet Information on January 1, 2009
(In US$ millions and millions, respectively)
Green Poly Corp Poly
Corp Book Book Corp
Value Value () Fair
($) Value
()
Cash and receivables 500 95 95
Inventory 450 125 125
Property plant and equipment 1,250 345 550
(net)
Total Assets 2,200 565 770
*At the date of acquisition, the fair value of Poly Corps shares was 650 million
A. 1
B. 2
C. 3
A. 29.
B. 78.
C. 205.
A. 2.27.
B. 2.61.
C. 3.00.
A. 55.
B. 95.
C. 271.
For its investment in Tire-Go, the corporation is willing to offer $60 million in cash. The
book value of Tire-Gos assets and liabilities equal their fair values with the exception of
Tire-Gos manufacturing plant whose fair value is $15 million upon acquisition with a
book value of $8 million and a useful life of 10 years. The investment will enable Fisher
Corp. to gain 30% control of the target. Fisher Corp.s chief executive believes the level
of control acquired will help enable it to achieve a level of representation on the board of
directors to participate in the targets policy-making process. Pre-investment balance
sheet and income statements for both organizations are illustrated below (exhibit 1).
Exhibit 1
Fisher Corp. and Tire-Go Pre-Acquisition Balance Sheets and Income Statements
Fisher
Corp. Tire-Go
($ 000) ($ 000)
Income Statement
Sales $400,000 $250,000
Cost of Sales (225,000) (100,000)
Other Expenses (45,000) (20,0000)
Net Income $130,000 $130,000
Balance Sheet
Cash $35,000 $15,000
Inventory 110,000 85,000
Accounts Receivable 55,000 40,000
Other assets 15,000 10,000
$215,000 $150,000
With respect to C.S. Corp. Fisher Corp. is planning to acquire 100% of the outstanding
shares of the former corporation by issuing 2 million of its own equity that has $1 par
value and a current market value of $10 million. The pre-acquisition balance sheet
information for C.S. Corp. using book values and fair values is illustrated below (exhibit
2). The shareholders equity figure included in Fisher Corps pre-acquisition balance
sheet (exhibit 1) includes $30 million additional paid in capital with the remainder
attributable to common stock with a $1 par value.
Exhibit 2
C.S. Corp. Pre-Acquisition Balance Sheet using Book Values and Fair Values
Shareholders Equity:
Common Stock ($1 par) 4,500
Additional paid in capital 2,000
Retained Earnings 1,500
One year following the investment in C.S. Corp., the carrying value of its steel
conversion unit is $1,500,000 and fair value is $1,250,000. An in-house analyst estimates
the units recoverable amount to be worth $900,000 and the fair value of its identifiable
net assets to be worth $1,180,000. The steel conversion unit is an independent reporting
unit.
A. $0.
B. $15 million.
C. $32 million.
A. Fisher Corp. will not record its proportionate share in Tire-Gos profit as part of
the carrying value of the investment reported on its balance sheet.
B. Fisher Corp. will not amortize the excess of cost over the fair value of Tire-Gos
identifiable net assets.
C. Fisher Corp. will record any changes in the fair value of the investment in Tire-
Go as part of comprehensive income.
A. $43.88 million.
B. $43.95 million.
C. $44.72 million.
A. $0.
B. $130,000.
C. $600,000.
Hidden Solutions acquired 25% of DeltInds stock that was trading at $15 per share at the
time of acquisition. The bulk purchase of a quarter of the associates stock required an
additional premium of $2 per share to be paid to the institutional investor Hidden
Solutions acquired the stock from. At the time of investment, DeltInd had 20 million
shares outstanding. Exhibit 1 provides summarized data on the fair values of the net
assets on the acquisition date.
Assumption: Book values of the assets and the liabilities are insignificantly different
from the fair values.
Four years after the original investment, the cost of investment was reduced to zero due
to heavy losses incurred by the associate. Subsequent to this null figure, further losses of
$12 million were not deducted from Hidden Solutions income statement. Following
major operational reconstruction, six years after the original investment, DeltInd reported
a profit of $50 million.
Andersons assistant found old files that had been compiled by Brockdale Securities
analysts at the time of acquisition. Anderson delegated the browsing of these files to his
assistant, to ensure that no important facts were overlooked. Some of the statements
highlighted in the files were:
Statement 1: Voting shares acquired are the sole determinant in calculating the
investors stock interest.
Statement 2: The impairment losses from associates charged to the income statement
may be reversed granted the associates meet certain criteria.
Statement 3: As DeltInd is not a venture capital organization, a mutual fund, a unit trust
or an investment-related insurance fund, it cannot be reported at fair value
in Hidden Solutions balance sheet.
A. $0.
B. $9 million.
C. $59 million.
A. $0.5 million.
B. $12.5 million.
C. $28.0 million.
A. correct.
B. incorrect, impairment losses from the associates charged to the income statement
cannot be reversed under any circumstances.
C. incorrect, impairment losses from the associates charged to the income statement
may be reversed without the application of any criteria.
A. correct.
B. incorrect, as DeltInd is not a venture capital organization, a mutual fund, a unit
trust or an investment-related insurance fund, it can be reported at fair values as
the equity method allows it.
C. incorrect, venture capital organizations, mutual funds, unit trusts and investment-
related insurance funds cannot be reported at fair value.
The balance sheet of Quantum Solutions carries a contingent liability of $25 million in
anticipation of the outcome of a court case filed by a senior employee for wrongful
termination. Quantum Solutions lawyers hold the opinion that the company would most
probably lose the case to the prosecuting party. In light of this matter, Quantum
Solutions investors have assured CoverTech that any amount payable to the prosecutors
would be compensated by the formers shareholders.
CoverTech also holds 35% of the common equity of The Embilon Enterprise (TEE).
However, it has been unable to exert any significant impact on the policy making
processes of the entity.
Brian Course, a financial analyst at CoverTech recently read the following statement in a
published article:
Statement 1: Under U.S. GAAP, the voting interest component and the variable interest
component need to be jointly considered to ascertain viability of the
consolidation of the two entities.
A. correct.
B. incorrect, under the IFRS, the voting interest component and the variable interest
component need to be jointly considered to ascertain viability of the consolidation
of the two entities.
C. incorrect, under U.S. GAAP, the voting interest component ascertains the
consolidation of the two entities. The variable interest component is disregarded.
Edward Gray is the head of the financial instrument valuation team at ProLif Investments
located in Fresno, California. Gray and his team are currently evaluating the financial
instruments carried by Stowaway Inc. Stowaway is a cargo shipping giant with
headquarters in London, Great Britain. The entity uses the International Financial
Reporting Standards to draft its financial statements. Exhibit 1 outlines some of the
passive financial instruments carried by Stowaway Inc. All investments are accounted for
according to the current IAS 39 Financial Instruments standard.
Note:
During the last three years, Stowaway Inc. has reclassified 22% of its held-to-maturity
investments to available-for-sale, without meeting the required criteria.
Robert Wright, a junior member of the team, made the following statements during an
interim meeting held a week after the initiation of the analysis:
Statement 2: Any unrealized gains or losses arising from the changes in the fair value
of Pitbull are to be charged to other comprehensive income.
A. $48,500.
B. $52,000.
C. $55,500.
A. $17,200.
B. $18,000.
C. $25,000.
A. correct.
B. incorrect, any unrealized gains or losses reported to other comprehensive income
from Beagle should be gross of tax.
C. incorrect, any unrealized gains or losses reported to the income statement from
Beagle should be gross of tax.
A. correct.
B. incorrect, any unrealized gains or losses arising from the changes in the fair value
of Pitbull are to be charged to the income statement.
C. incorrect, no unrealized gains or losses arise in held-for-trading securities as they
are constantly adjusted to fair value.
A. $3,200 loss.
B. $12,000 gain.
C. $12,800 loss.
GumDrop Inc. is a market leader in the sweets and confectionary industry with reputed
goodwill in most countries. It is headquartered in Lincoln, Nebraska. The entity has
recently purchased a 20% holding in one of its competitors stock for the purpose of
acquiring significant control over the associates supply chain network. Its associate,
Surprises Galore (SG), has issued fifty million shares to date. GumDrop Inc. paid $23 for
each share acquired.
Exhibit 1 displays the data relevant on the date of acquiring the holding in SG.
Exhibit 1
Book Value of Net Assets $900 million
Plant and Equipment-Fair Value $35 million
Plant and Equipment-Carrying Value $18 million
Plant and Equipment-Life 6 years
Land-Fair Value $15 million
Land-Carrying Value $12 million
In the first year of investment, SG sold partially processed direct material to GumDrop
Inc. Exhibit 2 displays the figures relevant to the inter-company transaction.
Exhibit 2
Manufacturing Costs for SG $2,000,000
Purchase Price for GumDrop Inc. $2,800,000
A. $30 million.
B. $46 million.
C. $50 million.
44. If the fair value of the associates identifiable net assets exceeds the cost of initial
investment, the difference between the fair value and the investment cost would most
likely be:
Kim Bailey is a senior financial analyst at Hart and Harper Investments located in
Denver, Colorado. She is currently carrying out an analysis of a ten year held-for-
maturity debt security in the financial statements of MaiCoal Inc. All investments are
accounted for according to the current IAS 39 Financial Instruments standard.
MaiCoal is a chain of art studios internationally recognized for their modern and
contemporary exhibitions. The entity follows the International Financial Reporting
Standards for the preparation of its financial statements. The security was bought eight
years ago at a price of $960 (with par value of $1,000) and offers a stated return of 8% on
annual basis. One year after the purchase, the security was trading in the market at $970.
Three years after the purchase, the issuing company was declared bankrupt with only
50% of the par value recoverable at maturity. The recovery policy eliminated the
payments of any coupons till maturity.
A. $83.
B. $85.
C. $90.
A. $0.
B. $7.
C. $10.
A. $280.
B. $468.
C. $688.
A. $0.
B. $8.
C. $12.
A. correct.
B. incorrect, impairment loss reversal is only allowed by IFRS when there is a debt
security involved.
C. incorrect, had the company been following the policies outlined by U.S. GAAP,
the suggested treatment would have been correct.
Eric Gonzalez is a recently hired financial analyst at Index Solutions located in Dallas,
Texas. Five years ago, Index Solutions acquired a 25% ownership interest in a mutual
fund entity, BenSol Advisory. Index Solutions opted to report its investment under the
fair value method allowed by the International Financial Reporting Standards. Gonzalez,
while reviewing old investment notes, questions some of the techniques applied in the
treatment of different line-items. Tracy Morgan, Gonzalezs supervisor, made the
following statements as answers to his queries:
Statement 1: Following the reporting of the investment at fair value, any unrealized
gains/losses should be charged to the investors income statement.
Statement 2: If the price paid for the target exceeds the fair value of the associate's net
assets, the excess purchase price is amortized over the remaining life of
the asset.
A sharp decrease in the fair value of BenSol Advisory in the third year was due to the
lossof a major client by the associate because of which estimates of the entitys future
cash flows had dropped dramatically to $80 million per year and were expected to remain
so in the foreseeable future. Exhibit 1 displays the data relevant to the third year of
investment:
A. correct.
B. incorrect, following the reporting of the investment at fair value, any unrealized
gains/losses should be charged to the investors other comprehensive income.
C. incorrect, following the reporting of the investment at fair value, any unrealized
gains/losses should not be reported.
A. correct.
B. incorrect, if the price paid for the target exceeds the fair value of identifiable net
assets, no amortization takes place.
C. incorrect, if the price paid for the target exceeds the fair value of identifiable net
assets, the excess amount is recognized as goodwill.
A. charged an impairment loss as the decrease in future cash flows qualifies as a loss
event.
B. not charged an impairment loss as the decrease in future cash flows does not
qualify as a loss event.
C. not charged an impairment loss, as the fair value option does not allow
impairment loss charges.
A. $800 million.
B. $889 million.
C. $969 million.
A. $300 million.
B. $308 million.
C. $911 million.
Statement 1: Securities designated at fair value can only be reclassified under U.S.
GAAP.
One of the securities Connor is valuing has been recorded at historical cost as no reliable
fair value was available at the time of acquisition. This debt instrument was bought by
Alkal Inc. with the intention to sell but no formal plan was made for its sale. Three years
after acquisition, the listing of the underlying company led to the possibility of a reliable
fair value to be measured for the instrument.
A. correct.
B. incorrect, securities designated at fair value can only be reclassified under the
International Financial Reporting Standards.
C. incorrect, securities designated at fair value can be reclassified under neither the
U.S. GAAP nor the International Financial Reporting Standards.
A. correct.
B. incorrect, reclassification of securities out of the held-for-trading category can be
accomplished more easily under U.S. GAAP.
C. incorrect, reclassification of securities out of the held-for-trading category is
allowed under both the International Financial Reporting Standards and U.S.
GAAP.
A. correct.
B. incorrect, when an available-for-sale security is reclassified as held-to-maturity,
any previous unrealized gains are amortized to the income statement over the
remaining life of the security.
C. incorrect, when an available-for-sale security is reclassified as held-to-maturity,
any previous unrealized gains remain a part of other comprehensive income until
the security is sold.
A. reclassified as available-for-sale.
B. reclassified as held-to-maturity.
C. maintained at historical cost.
Larry Hill is a senior financial analyst at Beaver Inc. located in Madison, Wisconsin. He
is assessing the classification procedure of a debt security issued by Apparel Inc. which
has twenty years remaining to maturity. Apparel Inc. is a globally recognized clothing
line specializing in denim wear. The management of Beaver Inc. intends to hold this
security till its maturity date and is using the International Financial Reporting Standards
(IAS 39 Financial Instruments) for classification of all financial instruments. Exhibit 1
displays the data which has been compiled relevant to this security.
Exhibit 1
Fair Value @ Acquisition $250,000
Transaction Costs $2,200
Expected Market Value @ Maturity $350,000
Unamortized Discount @ 31st December, 2012 $2,500
Carrying Value @ 31st December, 2011 $275,000
Carrying Value @ 31st December, 2012 $282,000
Exhibit 2 displays the prevailing market interest rates for the relevant dates:
Exhibit 2
Market Rate
At the time of Security Purchase 10.8%
On 31st December, 2011 10.5%
On 31st December, 2012 11.2%
In the beginning of 2013, IGeniX, one of the primary competitors of Apparel Inc,
approached Beaver Inc. with the intention to buy the debt security for $297,500. IGeniX
applies US GAAP policies to compile its financial statements.
IGeniX intends to hold this security as available-for-sale. Stacy Meyers, a junior analyst
at IGeniX, made the following statement regarding the prospective transaction and its
subsequent classification at an analyst meeting in the company:
Statement 1: Any realized gains from changes in fair value will be reported in the
income statement, while any unrealized gains will be recognized in equity
through other comprehensive income.
IGeniX plans to sell the debt security in five years. Meyers and her colleagues have
compiled the following hypothetical data for the prospective sale:
Exhibit 3
Sale Proceeds $310,000
Fair Value @ 31st December, 2017 $302,000
Unrealized Gain $15,000
Discount $1,500
A. $28,875.
B. $29,700.
C. $31,584.
A. $13,300.
B. $15,500.
C. $18,000.
A. correct.
B. incorrect, all changes in fair value will be reported to the income statement.
C. incorrect, all changes in fair value will be recognized in other comprehensive
income.
A. $8,000.
B. $9,500.
C. $23,000.
Petroleum Pipes Inc. (PPI) is a private oil and gas exploration entity with headquarters in
Dallas, Texas. PPI has recently installed a pipeline, which runs from Mexico to the U.S.
The portion of the pipeline in Mexico is controlled by another private entity with
headquarters in Mexico City, Mexico. The two private parties, jointly controlling the
pipeline operations present their financial statements under the International Financial
Reporting Standards framework.
Francis Stewart, the chief financial officer of PPI is signing off the finalized contracts of
an acquisition to be made in Texas Petroleum Technicians (TPT). This acquisition would
give PPI significant control over TPT and give the parent firsthand access to the highly
specialized workforce of the subsidiary. A day ago, Stewart had attended an analyst
meeting which took place at the companys headquarters. At the meeting, Mariah
Hawthorne, a junior accountant at PPI, made the following statements:
A. correct.
B. incorrect, direct costs of business combinations are expensed in the investors
income statement as they are incurred.
C. incorrect, direct costs of business combinations are capitalized as miscellaneous
items and amortized over the life of the services rendered.
A. correct.
B. incorrect, in the previously acceptable pooling of interests method, goodwill was
calculated using the fair values of the assets and the liabilities.
C. incorrect, in the previously acceptable pooling of interests method, goodwill was
not calculated.