4. The Adjusted Cost Method & the Equity Method Flashcards
If Company A invests in Company B, how does Company A account for differences between book value and fair value of Company B’s total assets when reporting equity in Company B’s earnings on its income statement?
For assets that are sold during the year (e.g. inventory), Company A reduces equity in earnings by its percentage of the difference between BV and FV on the investment date.
For depreciable assets, Company A amortizes its percentage of the difference between BV and FV over the assets’ depreciable life, reducing equity in earnings each year by the annual depreciation expense.
Example: Company A buys 40% of Company B’s common stock during 2017. The FV of Company B’s plant and inventory exceed their BV by $90,000 and $10,000, respectively. The plant has an 18-year life. All inventory was sold in 2017. Company B reports net income of $120,000. Company A records unadjusted equity in Company B’s earnings of $48,000 (40% of $120,000). Then it reduces the equity in earnings by $2,000 for the plant (($90,000 / 18) x 40%) and by $4,000 for the inventory ($10,000 x 40%). $48,000 - $2,000 - $4,000 = $42,000.
When changing from the cost method to the equity method, the investor applies the equity method: A) retrospectively B) prospectively
B) prospectively
Under the equity method, when calculating an investor’s share of an investee’s net income, the investee’s net income must be adjusted for what?
Fair value differences–i.e. differences between the carrying amounts and fair values of the investee’s assets on the date the investor bought the stock. E.g., fair value of investee’s inventory exceeded carrying amount by $40,000 on purchase date, and investee sold all inventory during the year. Therefore, investee’s net income is reduced by $40,000 before calculating investor’s share. E.g., fair value of investee’s plant exceeded carrying amount by $80,000 on purchase date, and plant has 10 years of remaining useful life. Therefore, investee’s net income is reduced by $80,000/10=$8,000 before calculating investor’s share.
Under GAAP and IFRS, the equity method is applied when the investor has what amount of control over the investee?
When the investor has “significant influence” over the investee.
Under IFRS, what degree of control constitutes “significant influence” over an investee, requiring the investor to apply the equity method?
Power to participate in decisions of the investee.
Under the equity method, how does an investor recognize dividends from common stock of an investee?
Dividends reduce the carrying amount of the investment on the balance sheet and are not recognized in income. Dr. Cash Cr. Investment
Under the equity method, how does an investor recognize dividends from preferred stock of an investee?
The dividends are recognized in income.
When an investor elects the fair value option instead of the equity method for an investment, how does it recognize income from the investment?
The investor recognizes only 1) gains and losses from changes in fair value of the stock and 2) dividend income from the stock. The investor does not recognize any of the investee’s net income.
When an investor accounts for an acquisition of stock under the equity method, what amount should the investor record as goodwill?
The amount of the purchase price that exceeds a proportionate amount of the fair value of the investee’s net assets. E.g., investor buys 30% of investee for $200,000. Fair value of investee’s net assets is $600,000. Because 30% of $600,000 = $180,000, $20,000 of investor’s investment should be recorded as goodwill.
Under the cost method, how does an investor account for dividends paid by an investee?
The dividends are recognized as dividend income on the income statement.
What must an investor disclose when it accounts for investments in common stock under the equity method?
- The name of each investee and percentage of each investee’s common stock that investor owns 2. Investor’s accounting policies for investments in common stock 3. Accounting treatment of any difference between carrying amount of an investment and investor’s equity in investee’s net assets (e.g. goodwill for price paid in excess of fair value of net assets)
Under the equity method, how does an investor adjust its reported share of an investee’s net income if the carrying amounts of the investee’s assets or liabilities exceeded, or were less than, their fair values on the acquisition date?
Investor adjusts its reported share of investee’s net income as if assets and liabilities had been reported at fair value on acquisition date. E.g., if inventory was carried below fair value, the difference is subtracted from net income since COGS would have been higher at fair value.
How is a stock dividend recognized in financial statements?
The cost basis of the stock on which the dividend was paid is spread across the increased number of shares, but no amount is recognized in income or the carrying value of the stock. E.g., investor pays $50,000 for 10,000 shares of investee at $5/share. Stock pays dividend of 2,500 shares. Cost basis of the 12,500 shares is now $4/share, but carrying value remains $50,000, and no income is recognized.
Under GAAP, what factors indicate “significant influence” over an investee, requiring the investor to apply the equity method?
- Representation on the board of directors 2. Participation in policy-making processes 3. Material inter-entity transactions 4. Interchange of managerial personnel 5. Technological dependency
Under IFRS, the equity method used to account for joint operations is called…
Proportionate consolidation
