Case $8-1$

LO$3$

On December $31,$ Year $7,$ Pepper Company, a public company, agreed to a business combination with Salt Limited, an unrelated

private company. Pepper issued $82$ of its common shares for all $50$ of the outstanding common shares of Salt. This transaction

increased the number of outstanding Pepper shares from $100$ to $182.$ Pepper's shares were trading at around $$16$ per share in days

leading up to the business combination. The condensed balance sheets for the two companies on this date prior to the transaction

were as follows:

On January $1,$ Year $8,$ Pepper sold $40\%$ of its investment in Salt to an unrelated third party for $$600$ in cash. The CFO at Pepper

stated that Salt must have been worth $$1,500$ if the unrelated third party was willing to pay $$600$ for a $40\%$ interest in Salt. If so$,$

Pepper saved $$188$ by buying Salt for only $$1,312.$ Accordingly, the CFO wants to recognize a gain of $$188$ in the Year $7$ income

statement to reflect the true value of the Salt shares.

You have been asked by Cheryl Wozniak, the CFO, to prepare a presentation to senior management on the accounting implications

for the business combination and subsequent sale of $40\%$ of the investment. She would like you to consider two alternative methods

of valuing Salt on the consolidated balance at the date of acquisition$-$one based on cost purchase and one based on the implied

value of the subsidiary based on the sales price on January $1,$ Year $8.$

Required

Prepare this presentation, answering the following questions:

$($a$)$ How would Pepper's consolidated balance sheet differ at the date of acquisition under the two different valuation alternatives?

Which method best reflects economic reality? Which method is required by GAAP?

$($b$)$ How would Pepper's consolidated balance sheet look after the sale of the $40\%$ interest in Salt to the unrelated third party under

the two alternatives?