Cost vs Equity Method

Question 1

What is the Cost Method?

Answer 1

Method of accounting for an investment in nonmarketable equity securities when the investor has no significant influence over the investee (typically ownership < 20%).

Question 2

What is the Equity Method?

Answer 2

Method of accounting for investment in nonmarketable equity securities when the investor has “significant influence,” but not outright control over the investee (typically ownership btw. 20-50%).

Question 3

What are Consolidations?

Answer 3

Preparation of financial statements for two or more entities as if they were a single entity, applied when one entity has a controlling financial interest in another, typically when ownership exceeds 50%

Question 4

Under the Cost Method, as the investee earns money, do any of the investor’s accounts get affected?

Answer 4

They are unaffected. NO journal entry is recorded

Question 5

Under the Cost Method, how are MOST dividends treated?

Answer 5

As Dividend Income on the income statement. **Not a reduction of the Investment!!

Question 6

Under the Cost Method, if the investee declares dividends which exceed the cumulative income it has earned since the date of the investment, how are these excess dividends treated?

Answer 6

As a “return of capital” (or liquidating dividend) to the investor; thus, a reduction of the Investor’s Investment (similar to Equity Method dividends for return of capital portion)

Question 7

If no significant influence exists and the Investment has a market value, what method of accounting for the Investment is used?

Answer 7

Trick question! There are three methods based on the Investment’s appropriate circumstance: Trading, Available-for-Sale, or Held-to-Maturity

Question 8

Under the Equity Method, is the excess of the cost of the Investment’s assets over their book value reported separately on the financial statement?

Answer 8

No. It is included with the Investment

Question 9

Under the Equity Method, what happens each year to any Fair Market Value excesses attributable to depreciable or amortizable assets? What accounts are affected?

Answer 9

Any Fair Market Value excesses will be amortized based on their appropriate useful lives of the asset. The Equity in Earnings and Investment accounts will be reduced accordingly:

Dr. Equity in Earnings
Cr. Investment

Question 10

Under the Equity Method, is it is possible to have an excess of payment for an Investment beyond Fair Market Value of the Investment’s assets? How is it treated?

Answer 10

Yes! It is known as goodwill, which cannot be depreciated or amortized…it can only be reduced via impairment.

Question 11

Under the Equity Method, what happens when there is a recognized impairment of goodwill?

Answer 11

The Investment will be written down accordingly:

Dr. Equity in Earnings
Cr. Investment

Question 12

Under the Equity Method, how are investee earnings treated? Which investor accounts are affected?

Answer 12

The investor records the proportionate share of investee earnings that it owns by debiting the Investment account and crediting the Equity in Earnings (revenue) account.

Question 13

Under the Equity Method, how are dividends treated?

Answer 13

As a reduction of the Investor’s Investment (by its proportionate ownership of the total amount of dividends paid). **Does not show up on the Income Statement!!!

Question 14

Under the Equity Method, how are Fair Market Value exesses attributable to Inventory treated?

Answer 14

They are effectively written off once sold (usually within the year):

Dr. Equity in Earnings
Cr. Investment

Question 15

Under the Equity Method, how are Fair Market Value exesses attributable to Land treated?

Answer 15

They remain until the land is sold as land is not depreciable/amortizable.

Question 16

If another investor has control (>50%), what method of accounting for the investment will the other investors use?

Answer 16

Cost method as significant influence is not possible when someone else has control

Question 17

When the Percentage of ownership decreases, prompting a move from the equity method to the cost method, is a prior period adjustment/retrospective treatment required?

Answer 17

No. Only prospective treatment is required.

Question 18

When the Percentage of ownership increases, prompting a move from the cost method to the equity method, what type of treatment is applicable?

Answer 18

Retrospective treatment. Apply equity method applicable to % ownership in the prior period, to adjust reported net income.

Question 19

When the Percentage of ownership increases, prompting a move from the cost method to the equity method, is there any fair value excess or goodwill derived in the prior period?

Answer 19

No. Only worry about Fair Market Value and Goodwill prospectively.

Question 20

What is meant by “Applied Prospectively”?

Answer 20

Applied in the current and future periods requiring no adjustment to prior periods (Ex: Change in estimate)

Question 21

What is meant by “Applied Retrospectively”?

Answer 21

Applied to prior periods requiring adjustment to reflect how financial statements would have appeared if the method had been used originally (Ex: Change in accounting principle)

Question 22

Can ownership in preferred stock give an investor significant influence?

Answer 22

No, but the investor may have influence due to other causes, and as such may use the Equity Method for the preferred stock investment.

Question 23

How is Term Life Insurance treated?

Answer 23

As an on-going services expense over the negotiated contract term.

Question 24

How is Whole Life Insurance treated?

Answer 24

Part of the cash being paid for the insurance goes to a “cash surrender value” (investment-type account) in addition to the usual service expense

Question 25

If the Fair Value Election is made for an Investment, is it revocable?

Answer 25

No. It is irrevocable.

Question 26

If the Fair Value Election is made for an Investment, the eligible item is measured on what date?

Answer 26

Each balance sheet date

Question 27

If the Fair Value Election is made for an Investment, unrealized gains or losses are recognized as a component of what?

Answer 27

Income (as opposed to OCI for Available-For-Sale)

Question 28

If the Fair Value Election is made for an Equity Method Investment, how are dividends treated?

Answer 28

Same as Equity Method. It still reduces the Investor’s Investment (by its proportionate ownership of the total amount of dividends paid). **Remember: Dividends under the equity method do affect the Income Statement!!!

Question 29

If the Fair Value Election is made for an “Available for Sale” Investment, how are unrealized gains or losses reported?

Answer 29

As a component of income (as opposed to OCI).