7.
FASB ASC 323-10-15 requires the use of the equity method of accounting for an investor whose investment in voting stock gives it the ability to exercise significant influence over operating and financial policies of an investee. Section 15-6 states that “Ability to exercise significant influence over operating and financial policies of an investee may be indicated in several ways, including the following: Representation on the board of directors, Participation in policy-making processes, Material intra-entity transactions, change of managerial personnel, Technological dependency, and Extent of ownership by an investor in relation to the concentration of other shareholdings (but substantial or majority ownership of the voting stock of an investee by another investor does not necessarily preclude the ability to exercise significant influence by the investor)” (emphasis added). It is clear, in this case, that the investee is critically dependent upon the technology licensed to it by the investor. The investor should, therefore, account for its investment using the equity method.
8.
Even though the investor owns 30% of the investee, it should not use the equity method as it cannot exert significant influence over the investee. Further, since the investee is not a public company (all of the remaining stock is privately held), the investor should use the cost method to account for this investment as the fair value method presumes a publicly traded stock with sufficient liquidity to reasonably determine a fair value.
9.
a. The losses did not affect Enron’s income statement. Since the investees were insolvent, Enron’s Equity Investment was reduced to zero (it had not made any loans or other advances to the investee companies). As a result, Enron discontinued reporting for these Equity Investments using the equity method and, therefore, did not recognize its proportionate share of investee losses. b. “… only after its share of that net income equals the share of net losses not recognized during the period the equity method was suspended” means that the investee has recouped all of the losses that have been reported. Since the investor ceases to account for its Equity Investment using the equity method once the balance reaches zero (assuming that it has not guaranteed the debts of the investee company), this generally implies that the investee’s Stockholders’ Equity is below zero (i.e., a deficit). The investor resumes its accounting for the Equity investment using the equity method once the investee’s Stockholders’ Equity is positive. It is at that point when the investee company has recouped all of its prior losses (assuming that the investee company has not raised additional equity capital).
Solutions Manual, Chapter 1
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10.
FASB ASC 323 provides the following list of required disclosures for equity method investments: a. (1) the name of each investee and percentage of ownership of common stock, (2) the accounting policies of the investor with respect to investments in common stock, and (3) the difference, if any, between the amount at which an investment is carried and the amount of underlying equity in net assets and the accounting treatment of the difference. b. For those investments in common stock for which a quoted market price is available, the aggregate value of each identified investment based on the quoted market price usually should be disclosed. This disclosure is not required for investments in common stock of subsidiaries. c. When investments in common stock of corporate joint ventures or other investments accounted for under the equity method are, in the aggregate, material in relation to the financial position or results of operations of an investor, it may be necessary for summarized information as to assets, liabilities, and results of operations of the investees to be presented in the notes or in separate statements, either individually or in groups, as appropriate. d. Conversion of outstanding convertible securities, exercise of outstanding options and warrants and other contingent issuances of an investee may have a significant effect on an investor's share of reported earnings or losses. Accordingly, material effects of possible conversions, exercises or contingent issuances should be disclosed in notes to the financial statements of an investor.
11.
Answer: d The fact that the investor has a 20% voting interest, representation on the investee’s board of directors, participates in the investee’s policy making process and has material business transactions with the investee all suggest that the investor has “significant influence” over the investee. In the case of significant influence, the investor must use the equity method of accounting for the investee. Under the equity method, the investee recognizes as income a proportionate share of the net income recognized by the investee.
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Advanced Accounting, 4th Edition
12.
Answer: b The indicators of significant influence include: investor representation on the board of directors of the investee, investor participation in policy making processes of the investee, the extent of ownership of investee voting shares by the investor in relation to the concentration of other shareholdings, material intercompany transactions between the investor and the investee, interchange of managerial personnel between the investor and the investee, and technological dependency of the investee on the investor. Indications that an investor does not have significant influence includes the investor surrendering significant rights in the investee, a concentrated group of owners of the investee who do not consider the views of the investor and a lack of representation on the investee’s board of directors.
13.
Answer: a Application of the equity method of investment accounting results in an increase in the investment account for positive net income (i.e., a decrease of net losses) and a decrease in the investment account for dividends. The company paying dividends decreases retained earnings for dividends. A company applying the fair value method or the cost-based approach will recognize as income dividends received.
14.
Answer: b When an investor can exert significant influence over an investee, the investor must use the equity method for the Equity Investment. Under the equity method, the investee recognizes as income a proportionate share of the net income recognized by the investee. In addition, if the investor paid an amount different from a proportionate share of the book value of the investee and/or if the fair values of the individual investee net assets differ from their book values, then the investor might also have to adjust equity income for the amortization of the excess. In this case, the proportionate share of the investee book value (i.e., $2,000,000 x 30%) equals the amount paid for the 30% interest (i.e., $600,000), and all individual net assets had appraised fair values that equaled their reported book values. Thus, the Equity Investment carrying value at December 31, 2019 is determined as follows: Initial Equity Investment balance at 12/31/2018 2018 share of investee net income (30% x $120,000) 2018 share of investee dividends (30% x $50,000) 2019 share of investee net income (30% x $120,000) 2019 share of investee dividends (30% x $50,000) Equity Investment balance at 12/31/2019
Solutions Manual, Chapter 1
$ 600,000 36,000 (15,000) 36,000 (15,000) $ 642,000
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15.
Answer: c The fair value method is used for reporting noncontrolling investments in equity securities that (1) do not convey to the holder of the securities “significant influence” over the investee and (2) have a readily determinable fair value. Under the fair value method, the investment is reported by the investor at the fair value of the investment on the reporting date. (Assuming the investment is not considered impaired. There is no evidence of impairment in the present problem.) Thus, at December 31, 2019, the investment is reported at $288,000 (i.e., $16 x 18,000 shares on December 31, 2019). (The following is not addressed in the problem. We are providing this discussion for completeness. Noncontrolling investments in equity securities that do not have a readily determinable fair value and also do not convey to the holder of the securities “significant influence” over the investee are reported in the balance sheet at the original cost of the investment.)
16.
Answer: b The equity method is used for reporting noncontrolling investments in equity securities that convey to the holder of the securities “significant influence” over the investee. Under the equity method, the investment is reported by the investor at the original cost of the investment and then is adjusted for the investor’s ownership percentage of all of the items that change the stockholders’ equity of the investee. (Most textbook problems in intermediate accounting and advanced accounting assume that the only changes to the stockholders’ equity of the subsidiary are net income and dividends.) In addition, any unrecorded net assets implicit in the investment are amortized. In this case, the AAP is zero because the fair value of the consideration equals the book value of the proportionate share of the investee’s net assets, and fair values of the individual identifiable net assets approximate book values. The December 31, 2019 balance is determined as follows: Beginning Investment ($12 x 18,000 shares) Plus: p% x NI (20% x $50,000) Less: p% x Dividends (20% x $15,000) Ending Investment
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$ 216,000 10,000 (3,000) $ 223,000
Advanced Accounting, 4th Edition
17.
Answer: b A cost-based approach is used for reporting noncontrolling investments in equity securities that (1) do not convey to the holder of the securities “significant influence” over the investee and (2) do not have a readily determinable fair value. Under the costbased approach, the investment is reported by the investor at the original cost of the investment. (Assuming the investment is not considered impaired. There is no evidence of impairment in the present problem.) Thus, at December 31, 2019, the investment is reported at $352,000 (i.e., $11 x 32,000 shares purchased on January 1, 2019.). (The following is not addressed in the problem. We are providing this discussion for completeness. Noncontrolling investments in equity securities are reported in the balance sheet at fair value if they have a readily determinable fair value and also do not convey to the holder of the securities “significant influence” over the investee. The change in fair value is reported in net income.)
18.
Answer: c The equity method is used for reporting noncontrolling investments in equity securities that convey to the holder of the securities “significant influence” over the investee. Under the equity method, the investment is reported by the investor at the original cost of the investment and then is adjusted for the investor’s ownership percentage of all of the items that change the stockholders’ equity of the investee. (Most textbook problems in intermediate accounting and advanced accounting assume that the only changes to the stockholders’ equity of the subsidiary are net income and dividends.) In addition, any acquisition premium implicit in the investment is amortized if the asset net assets causing the premium are amortizable (e.g., property and equipment). In this case, the 24% AAP is equal to $88,000 ($352,000 fair value of consideration paid for 24% [see answer to #17] less 24% x book value of net assets (i.e., $264,000 = 24% x $1,100,000). The only depreciable asset in the 24% AAP is the customer list, which has $21,600 of AAP assigned to it (i.e., 24% x $90,000). This results in 24% AAP amortization of $4,320 per year (i.e., $21,600/5). The December 31, 2019 equity-method investment balance is determined as follows: Beginning Investment ($11 x 32,000 shares) Plus: p% x NI (24% x $120,000) Less: p% x Dividends (24% x $40,000) Less: p% AAP amortization Ending Investment
Solutions Manual, Chapter 1
$ 352,000 28,800 (9,600) (4,320) $ 366,880
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19.
Correct: b When an investor company has significant influence over an investee company, the investor must use the equity method. Under the equity method, the investor will recognize as part of its net income a proportionate share of the net income of the investor. The income recognized by the investor must be reduced for a proportionate share of the gross profit for intercompany transactions that occurred during the current period, but that will not be part of a transaction with an unaffiliated party until a future period. In this case, at the end of the period, the investee is still holding $20,000 of inventory it purchased from the investor. Given that the gross profit percentage is 40%, this means $8,000 of the inventory balance is intercompany profits. The investor must defer its proportionate share of this amount, so $2,400 will be deducted from the equity method income recognized by the investor. This means equity method income is equal to $9,600 (i.e., (30% x $40,000) - $2,400 = $9,600).
20.
Correct: a When an investor company has significant influence over an investee company, the investor must use the equity method. Under the equity method, the investor will recognize as part of its net income a proportionate share of the net income of the investor. The income recognized by the investor must be reduced for a proportionate share of the gross profit for intercompany transactions that occurred during the current period, but that will not be part of a transaction with an unaffiliated party until a future period. In addition, income of the current period will be increased by any gross profit from prior period intercompany transactions that are realized in the current period via transactions with unaffiliated parties. In this case, at the end of the period, the investee is still holding $40,000 of inventory it purchased from the investor. Given that the gross profit percentage is 25%, this means $10,000 of the ending inventory balance is intercompany profits. In addition, at the beginning of the period, the investee held $30,000 of inventory it purchased from the investor. Given that the gross profit percentage is 25%, this means $7,500 of the beginning inventory balance is intercompany profits. The investor must defer its proportionate share of the ending profits in inventory and recognize in the current year its proportionate share of the beginning profits in inventory; thus, $3,000 (i.e., 30% x $10,000) will be deducted from the equity method income recognized by the investor and $2,250 (i.e., 30% x $7,500) will be added to the equity method income recognized by the investor. This means equity method income is equal to $17,250 (i.e., (30% x $60,000) - $3,000 + $2,250 = $17,250).
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Advanced Accounting, 4th Edition
21.
Correct: b When an investor company has significant influence over an investee company, the investor must use the equity method. Under the equity method, the investor will recognize as part of its net income a proportionate share of the net income of the investor. The income recognized by the investor must be reduced for a proportionate share of the gross profit for intercompany transactions that occurred during the current period, but that will not be part of a transaction with an unaffiliated party until a future period. In addition, income of the current period will be increased by any gross profit from prior period intercompany transactions that are realized in the current period via transactions with unaffiliated parties. The investment account will be reduced by the dividends received from the investee. The investment account at December 31, 2019 is computed as follows:
+ + + -
22.
Beginning balance at January 1, 2018 30% x NI of Investee during 2018 (30% x $50,000) 30% of 2018 profit deferred to 2019 (30% x (25% x $30,000)) 2018 dividends received (30% x $10,000) 30% x NI of Investee during 2019 (30% x $60,000) 30% of 2019 profit deferred to 2020 (30% x (25% x $40,000)) 30% of profit from 2018 recognized in 2019 (30% x (25% x $30,000)) 2019 dividends received (30% x $15,000) Ending balance at December 31, 2019
$525,000 15,000 (2,250) (3,000) 18,000 (3,000) 2,250 (4,500) $547,500
Answer: d When an investor company has significant influence over and investee, it must use the equity method of accounting. When the investor ceases to have significant influence, it must determine if the investee company’s common stock has a readily determinable fair value. If it does not have a readily determinable fair value, the investor must use a costbased approach to account for the remaining Equity Investment. If it does have a readily determinable fair value, the investor must use the fair value method to account for the remaining Equity Investment. In this case, the investee has a readily determinable fair value, so the investment must be carried at its current fair value. Based on the information, the best proxy for the current fair value of the remaining 10% investment is the selling price of the 10% interest sold to an unaffiliated party.
Solutions Manual, Chapter 1
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23.
a. The investor reports equity income equal to its proportionate share of the net income of the investee company: $400,000 x 30% = $120,000. b. The balance of the Equity Investment account at the end of the year is $560,000 ($500,000 + $120,000 - $60,000). c. The fair value of the investee company is not reflected in the financial statements of the investor company. Under the equity method, the Equity Investment account is reported after adjusting for equity income and dividends. Changes in the fair value of the investee company do not affect this reported amount (unless the fair value declines below the carrying amount of the Equity Investment and the decline is deemed to be other than temporary). The fair value should be disclosed in the notes to the financial statements.
24.
FASB ASC 323-10-35-18 requires equity method investors to “record its proportionate share of the investee’s equity adjustments for other comprehensive income … as increases or decreases to the investment account with corresponding adjustments in equity.” Thus, the investee’s net income will affect the equity method income recognized as part of the investor’s net income, and the investee’s portion of other comprehensive income (OCI) items will directly affect the investor’s OCI items (i.e., not net income). Both the net income and OCI components (i.e., total comprehensive income) will affect the Equity Investment account. a. $600,000 x 40% = $240,000 b. $750,000 + (40% x $700,000) – $80,000 = $950,000
25.
a. Equity investment
120,000 Cash
120,000
(to record the purchase of the Equity Investment)
b. Equity investment
20,000 Equity income
20,000
(to record equity income)
c. Cash
12,000 Equity investment
12,000
(to record receipt of the cash dividend)
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Advanced Accounting, 4th Edition
d. Cash
150,000 Equity investment* Gain on sale
128,000 22,000
(to record the sale of the Equity Investment) * Equity Investment balance on date of sale = $120,000 + $20,000 - $12,000 = $128,000
26.
a. The gross profit remaining in ending inventory = $40,000 x 15% = $6,000. Equity income = ($100,000 - $6,000) x 30% = $28,200 b. Beginning Equity Investment Equity income Dividends Ending Equity Investment
$400,000 28,200 (18,000) $410,200
c. Equity income = ($150,000 + $6,000) x 30% = $46,800
27. a. Equity investment Equity Income (recognize 25% of net income = 25% x $400,000)
100,000 100,000
Equity Income Equity investment (Defer profits in ending inventory = 25% x 30% x $120,000)
9,000
Cash
25,000
9,000
Equity investment (record receipt of dividends)
25,000
b. Ending investment = $1,000,000 + $100,000 - $9,000 - $25,000 = $1,066,000 c. Equity income in following year = (25% x $450,000) + $9,000 = $121,500
Solutions Manual, Chapter 1
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28.
a. The change in the IMFT investment account was an increase of $656 million. Because IMFT is a research venture, it is currently incurring costs. Intel’s share of these costs is $415 million. Thus, in order for this negative income activity to reconcile with a $656 million increase in the investment account, it suggests that Intel made a capital contribution of $1,071 million (i.e., $656 million + $415 million). b. Intel owns 49% of IMFT. If Intel’s share of the costs is $415 million, then the total costs incurred by IMFT is $847 million (i.e., $415 million / 49%).
29.
a. Based solely on the book value of net assets of the investees, the equity method balance is equal to 24.9% x $20,171 million = $5,023 million. b. Based solely on the reported net income of the investees, the equity method income is equal to 24.9% x $1,800 million = $448 million. c. The ownership percentage changed from 23.2% to 24.9%. It's likely ADM made incremental investments in unconsolidated affiliates that is greater than the amount of dividends received from these affiliates.
30.
a. The balance of the Equity Investment in Pop decreased by $1.9 million (i.e., $96.8 million - $98.7 million) during the year ended March 31, 2017. The things that change Equity Investment are an investee’s reported income and dividends, capital contributions to the investee and/or disposal of ownership in the investee. According to Lionsgate’s disclosure, its share of Pop’s net losses equals $6.9 million. In addition, Lionsgate contributed $5.0 million to Pop. These two items reconcile to the $1.9 million decrease in the account, so there was no other activity in the account, including dividends. Thus, the amount of dividends declared and paid by Pop equals $0. b. If dividends for the year ended March 31, 2017 equals $0, then the change in the Equity investment account will be comprised of Lionsgate’s share of the net loss of Pop and Lionsgate’s capital contributions to Pop. The March 31, 2016 balance equals $98.7 million. After backing out the $8.8 million capital contribution and the $1.8 million share of Pop’s net loss, the March 31, 2015 balance equals $91.7 million.
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Advanced Accounting, 4th Edition
31. Equity investment
145,000
Cash (to record the purchase of the Equity investment) Equity investment
145,000
25,000
Equity income (to record equity income) Cash
25,000
20,000
Equity investment (to record receipt of the cash dividend) Equity income
20,000
2,000
Equity investment (to record the amortization of the patent asset) Cash Equity investment* Gain on sale (to record the sale of the Equity investment)
2,000
180,000 148,000 32,000
*The Equity Investment balance on the date of sale is ($145,000 + $25,000 - $20,000 - $2,000 = $148,000)
Solutions Manual, Chapter 1
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32.
a. If an investor holds an equity interest that does not convey control or significant influence over and investee, then the investor is required to use the fair value method to account for the Equity Investment if the investment securities have a readily determinable fair value. Upon acquiring an additional equity stake in the investee that increases the level of ownership to significant influence over the investee, then the investor must begin using the equity method to account for the Equity Investment. However, immediately before accounting for the investment under the equity method, the investor must mark the preexisting equity holding to fair value. Based on the March 1, 2019 transaction, the implied fair value of the entire investee entity is $4,500,000 (i.e., $765,000 / 17%). This suggests the original 8% investment has a fair value of $360,000, and the investor should recognize a $20,000 (i.e., $360,000 - $340,000) holding gain to write up the securities. Here are the journal entries for the facts in the problem: Equity investment 20,000 Unrealized holding gain (to mark the preexisting holding of equity securities to fair value.)
20,000
Equity investment Cash (to record the acquisition of additional equity securities)
765,000
765,000
b. If the equity securities did not have a readily determinable fair value, then the investor would have used a cost-based approach to account for the securities. Absent an other-than-temporary impairment, the Equity Investment account would have remained at the original cost up until the purchase of additional securities. If the transaction to purchase the additional interest is considered an observable price change in orderly transaction, then the original investment would have been marked up to fair value on the date the additional securities are obtained. In this case the amount of gain/loss that needs to be recognized is based on the implied fair value of the original 8% investment. Based on the March 1, 2019 transaction, the implied fair value of the entire investee entity is $4,500,000 (i.e., $765,000 / 17%). This suggests the original 8% investment has a fair value of $360,000, and the investor should recognize a $40,000 holding gain (i.e., $360,000 - $320,000) to write up the securities. Here are the journal entries for the facts in the problem: Equity investment 40,000 Unrealized holding gain (to mark the preexisting holding of equity securities to fair value.)
40,000
Equity investment Cash (to record the acquisition of additional equity securities)
765,000
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765,000
Advanced Accounting, 4th Edition