Evaluating Future Results under the Purchase Method in a Business Combination with a Troubled Savings and Loan You are the auditor for Pyramid Savings and Loan Association, which recently acquired 100% of the outstanding common stock of Sham Savings and Loan Association. Sham had incurred losses for approximately two years prior to the combination as a result of paying a higher interest rate to its depositors than it was earning on its loans. Federal regulators arranged the combination to prevent Sham’s liquidation because it had exhausted its net worth. Selected data for Sham as of the 1/1/06 combination date are as follows:

Book Value Current Value Assets . $300,000,000= $260,000,000 Liabilities . 300,000,000 300,000,000 Common stock . 12,000,000 Accumulated deficit . (12,000,000)

= Includes real estate loans of $270 million.

The current value of the assets is lower than the book value because the current lending rate on home mortgages is roughly 14%, whereas the yield on its loans (which have an average remaining life of 10 years) is only 10%. Accordingly, a $40 million ofervaluation component exists and will be amortized to interest income to report a 14% yield on the loan portfolio’s $230 million current value instead of reporting a 10% yield on the portfolio’s $270 million book value. Pyramid did not have to pay any consideration — it merely took title to all of Sham’s outstanding common stock.

Management intends to amortize goodwill over 20 years (which you are to assume is GAAP for the purpose of this problem). For simplicity, assume that the debtors on the notes will make 10 an¬

nual payments of $43,941,000 at the end of each of the next 10 years.

1. Analyze the Investment account at the acquisition date.

2. Prepare all consolidation entries as of the acquisition date. (Assume that non-push-down ac¬

counting was used.)

3. For Years 1-10 (in total) and for Years 11-20 (in total), show in T accounts the effect on in¬

come of amortization’s made from the parent’s Investment account.

4. Evaluate the soundness of the results that are reported under the purchase method at the acqui¬

sition date and for future periods.

5. What, if anything, should be done differently to better reflect the economics of the situation?

6. Using Excel, prepare an amortization table for the $40 million oyei-valuation (use 13.911% — not 14%).

7. Optional (Chapter 6 material): Prepare the parent’s amortization entries at 12/31/06 assuming that the amortization pertaining to the $40 million overvaluation component is $5 million for 2006.