Chapter 1: The Equity Method of Accounting for Investments Flashcards
A company acquires a rather large investment in another corporation. What criteria determine whether the investor should apply the equity method of accounting to this investment?
The equity method should be applied if the ability to exercise significant influence over the operating and financial policies of the investee has been achieved by the investor. However, if actual control has been established, consolidating the financial information of the two companies will normally be the appropriate method for reporting the investment.
What indicates an investor’s ability to significantly influence the decision-making process of an investee?
According to FASB ASC paragraph 323-10-15-6 “Ability to exercise that influence may be indicated in several ways, such as representation on the board of directors, participation in policy making processes, material intra-entity transactions, interchange of managerial personnel, or technological dependency. Another important consideration is the extent of ownership by an investor in relation to the extent of ownership of other shareholdings.” The most objective of the criteria established by the Board is that holding (either directly or indirectly) 20 percent or more of the outstanding voting stock is presumed to constitute the ability to hold significant influence over the decision making process of the investee.
Why does the equity method record dividends received from an investee as a reduction in the investment account, not as dividend income?
The equity method is appropriate when an investor has the ability to exercise significant influence over the operating and financing decisions of an investee. Because dividends represent financing decisions, the investor may have the ability to influence the timing of the dividend. If dividends were recorded as income (cash basis of income recognition), managers could affect reported income in a way that does not reflect actual performance. Therefore, in reflecting the close relationship between the investor and investee, the equity method employs accrual accounting to record income as it is earned by the investee. The investment account is increased for the investee earned income and then appropriately decreased as the income is distributed. From the investor’s view, the decrease in the investment asset is offset by an increase in the asset cash
Jones Company possesses a 25 percent interest in the outstanding voting shares of Sandridge Company. Under what circumstances might Jones decide that the equity method would not be appropriate to account for this investment?
If Jones does not have the ability to significantly influence the operating and financial policies of Sandridge, the equity method should not be applied regardless of the level of ownership. However, an owner of 25 percent of a company’s outstanding voting stock is assumed to possess this ability. This presumption stands until overcome by predominant evidence to the contrary.
Examples of indications that an investor may be unable to exercise significant influence over the operating and financial policies of an investee include (ASC 323-10-15-10):
a. Opposition by the investee, such as litigation or complaints to governmental regulatory authorities, challenges the investor’s ability to exercise significant influence.
b. The investor and investee sign an agreement under which the investor surrenders significant rights as a shareholder.
c. Majority ownership of the investee is concentrated among a small group of shareholders who operate the investee without regard to the views of the investor.
d. The investor needs or wants more financial information to apply the equity method than is available to the investee’s other shareholders (for example, the investor wants quarterly financial information from an investee that publicly reports only annually), tries to obtain that information, and fails.
e. The investor tries and fails to obtain representation on the investee’s board of directors.
Smith, Inc., has maintained an ownership interest in Watts Corporation for a number of years. This investment has been accounted for using the equity method. What transactions or events create changes in the Investment in Watts Corporation account being recorded by Smith?
The following events necessitate changes in this investment account.
a. Net income earned by Watts would be reflected by an increase in the investment balance whereas a reported loss is shown as a reduction to that same account.
b. Dividends paid by the investee decrease its book value, thus requiring a corresponding reduction to be recorded in the investment balance.
c. If, in the initial acquisition price, Smith paid extra amounts because specific investee assets and liabilities had values differing from their book values, amortization of this portion of the investment account is subsequently required. As an exception, if the specific asset is land or goodwill, amortization is not appropriate.
d. Intra-entity gains created by sales between the investor and the investee must be deferred until earned through usage or resale to outside parties. The initial deferral entry made by the investor reduces the investment balance while the eventual recognition of the gain increases this account.
Although the equity method is a generally accepted accounting principle (GAAP), recognition of equity income has been criticized. What theoretical problems can opponents of the equity method identify? What managerial incentives exist that could influence a firm’s percentage ownership interest in another firm?
The equity method has been criticized because it allows the investor to recognize income that may not be received in any usable form during the foreseeable future. Income is being accrued based on the investee’s reported earnings not on the dividends collected by the investor. Frequently, equity income will exceed the cash dividends received by the investor with no assurance that the difference will ever be forthcoming.
Many companies have contractual provisions (e.g., debt covenants, managerial compensation agreements) based on ratios in the main body of the financial statements. Relative to consolidation, a firm employing the equity method will report smaller values for assets and liabilities. Consequently, higher rates of return for its assets and sales, as well as lower debt-to-equity ratios may result. Meeting the provisions of such contracts may provide managers strong incentives to maintain technical eligibility to use the equity method rather than full consolidation.
Because of the acquisition of additional investee shares, an investor can choose to change from the fair-value method to the equity method. Which procedures are applied to effect this accounting change?
FASB ASC Topic 323 requires that a change to the equity method be reflected by a retrospective adjustment. Although a different method may have been appropriate for the original investment, comparable balances will not be readily apparent if the equity method is now applied. For this reason, financial figures from all previous years are restated as if the equity method had been applied consistently since the date of initial acquisition
Riggins Company accounts for its investment in Bostic Company using the equity method. During the past fiscal year, Bostic reported an extraordinary gain on its income statement. How would this extraordinary item affect the investor’s financial records?
In reporting equity earnings for the current year, Riggins must separate its accrual into two income components: (1) operating income and (2) extraordinary gain. This handling enables the reader of the investor’s financial statements to assess the nature of the earnings that are being reported. As a prerequisite, any unusual and infrequent item recognized by the investee must also be judged as material to the operations of Riggins for separate disclosure by the investor to be necessary.
During the current year, Davis Company’s common stock suffers a permanent drop in market value. In the past, Davis has made a significant portion of its sales to one customer. This buyer recently announced its decision to make no further purchases from Davis Company, an action that led to the loss of market value. Hawkins, Inc., owns 35 percent of the outstanding shares of Davis, an investment that is recorded according to the equity method. How would the loss in value affect this investor’s financial reporting?
Under the equity method, losses are recognized by an investor at the time that they are reported by the investee. However, because of the conservatism inherent in accounting, any permanent losses in value should also be recorded immediately. Because the investee’s stock has suffered a permanent impairment in this question, the investor recognizes the loss applicable to its investment.
Wilson Company acquired 40 percent of Andrews Company at a bargain price because of losses expected to result from Andrews’s failure in marketing several new products. Wilson paid only $100,000, although Andrews’s corresponding book value was much higher. In the first year after acquisition, Andrews lost $300,000. In applying the equity method, how should Wilson account for this loss?
Following the guidelines established by the Accounting Principles Board, Wilson would be expected to recognize an equity loss of $120,000 (40 percent) stemming from Andrews’ reported loss. However, since the book value of this investment is only $100,000, Wilson’s loss is limited to that amount with the remaining $20,000 being omitted. Subsequent income will be recorded by the investor based on the dividends received. If Andrews is ever able to generate sufficient future profits to offset the total unrecognized losses, the investor will revert to the equity method.
In a stock acquisition accounted for by the equity method, a portion of the purchase price often is attributed to goodwill or to specific assets or liabilities. How are these amounts deter- mined at acquisition? How are these amounts accounted for in subsequent periods?
In accounting, goodwill is derived as a residual figure. It refers to the investor’s cost in excess of the fair market value of the underlying assets and liabilities of the investee. Goodwill is computed by first determining the amount of the purchase price that equates to the acquired portion of the investee’s book value. Payments attributable to increases and decreases in the market value of specific assets or liabilities are then determined. If the price paid by the investor exceeds both the corresponding book value and the amounts assignable to specific accounts, the remainder is presumed to represent goodwill. Although a portion of the acquisition price may represent either goodwill or valuation adjustments to specific investee assets and liabilities, the investor records the entire cost in a single investment account. No separate identification of the cost components is made in the reporting process. Subsequently, the cost figures attributed to specific accounts (having a limited life), besides goodwill and other indefinite life assets, are amortized based on their anticipated lives. This amortization reduces the investment and the accrued income in future years.
Princeton Company holds a 40 percent interest in the outstanding voting stock of Yale Company. On June 19 of the current year, Princeton sells part of this investment. What ac- counting should Princeton make on June 19? What accounting will Princeton make for the remainder of the current year?
On June 19, Princeton removes the portion of this investment account that has been sold and recognizes the resulting gain or loss. For proper valuation purposes, the equity method is applied (based on the 40 percent ownership) from the beginning of Princeton’s fiscal year until June 19. Princeton’s method of accounting for any remaining shares after June 19 will depend upon the degree of influence that is retained. If Princeton still has the ability to significantly influence the operating and financial policies of Yale, the equity method continues to be appropriate based on the reduced percentage of ownership. Conversely, if Princeton no longer holds this ability, the market value method becomes applicable.
What is the difference between downstream and upstream sales? How does this difference impact application of the equity method?
Downstream sales are made by the investor to the investee while upstream sales are from the investee to the investor. These titles have been derived from the traditional positions given to the two parties when presented on an organization type chart. Under the equity method, no accounting distinction is actually drawn between downstream and upstream sales. Separate presentation is made in this chapter only because the distinction does become significant in the consolidation process as will be demonstrated in Chapter Five.
How is the unrealized gross profit on intra-entity sales calculated? What effect does an unrealized gross profit have on the recording of an investment if the equity method is applied?
The unrealized portion of an intra-entity gain is computed based on the markup on any transferred inventory retained by the buyer at year’s end. The markup percentage (based on sales price) multiplied by the intra-entity ending inventory gives the total profit. The product of the ownership percentage and this profit figure is the unrealized gain from the intra-entity transaction. This gain is deferred in the recognition of equity earnings until subsequently earned through use or resale to an unrelated party.
How are intra-entity transfers reported in an investee’s separate financial statements if the investor is using the equity method?
Intra-entity transfers do not affect the financial reporting of the investee except that the related party transactions must be appropriately disclosed and labeled.
