EXERCISE 5–1 The following data are taken from the December 31 annual report of Bailey Company:

($ in thousands) 2004 2005 2006 Sales.......................... $50,000 $60,000 $70,000 Net income................. 2,000 2,200 2,500 Dividends paid........... 1,000 1,200 1,500 Bailey had 1,000,000 common shares outstanding during this entire period and there is no public market for Bailey Company shares. Also during this period, Simpson Corp. bought Bailey shares for cash, as follows:

January 1, 2004 10,000 shares at $10 per share January 1, 2005 290,000 shares at $11 per share, increasing ownership to 300,000 shares January 1, 2006 700,000 shares at $15 per share, resulting in 100% ownership of Bailey Company Simpson assumed significant influence over Bailey’s management in 2005. Ignore income tax effects and the opportunity costs of making investments in Bailey for the requirements listed here.

Required:

a. Compute the effects of these investments on Simpson’s reported sales, net income, and cash flows for each of the years 2004 and 2005.

b. Compute the carrying (book) value of Simpson’s investment in Bailey as of December 31, 2004, and December 31, 2005.

c. Identify the U.S. GAAP-based accounting method Simpson would use to account for its intercorporate investment in Bailey for 2006. Give two reasons this accounting method must/should be used.