FAR 3 - Flashcards
FAR 3.04 - INVESTMENTS UNDER IFRS: COST AND EQUITY METHOD
During year 3, Gilman Co. purchased 5,000 shares of the 500,000 outstanding shares of Meteor Corp.’s common stock for $35,000.
During year 3, Gilman received $1,800 of dividends from its investment in Meteor’s stock.
The fair value of Gilman’s investment on December 31, year 3, is $32,000. Gilman has elected the fair value option for this investment.
What amount of income or loss that is attributable to the Meteor stock investment should be
reflected in Gilman’s earnings for year 3 ?
Income of $1,800.
Income of $4,800.
Loss of $1,200.
Loss of $3,000.
Loss of $1,200.
EXPLANATION:
With ownership of 1% of the total equity of Meteor, Gilman will apply the cost method of accounting resulting in the recognition of the $1,800 in dividends received being recognized as dividend income.
Since Gilman elected the fair value option, the carrying value of the investment will be written down from its cost of $35,000 to its year-end fair value of $32,000, recognizing a loss of $3,000.
The net effect on income is a loss of $1,200.
FAR 3.02 - COST METHOD, CHANGES IN OWNERSHIP AND FAIR VALUE ACCOUNTING
Sage, Inc. bought 40% of Adams Corp.’s outstanding common stock on January 2, 20X3, for $400,000.
The carrying amount of Adams’ net assets at the purchase date totaled $900,000.
Fair values and carrying amounts were the same for all items except for plant and inventory, for which fair values exceeded their carrying amounts by $90,000 and $10,000, respectively.
The plant has an eighteen-year life. All inventory was sold during 20X3.
During 20X3, Adams reported net income of $120,000 and paid a $20,000 cash dividend. Assume that Sage uses the equity method to account for this investment.
What amount should Sage report in its income statement from its investment in Adams for the year ended December 31, 20X3?
$32,000
$42,000
$36,000
$48,000
$42,000
EXPLANATION:
Sage’s unadjusted equity in Adams’ earnings is 40% x $120,000, or $48,000.
This amount must be adjusted for any differences between the book and fair values of Adams’ total assets at the time of Sage’s investment, prorated by Sage’s ownership percentage.
Since the fair values of Adams’ plant and inventory exceeded their book values by $90,000 and $10,000,
respectively, these differences will be prorated by Sage’s ownership percentage and either expensed in the year(s) sold, which is the case with inventory, or amortized over the depreciable life of the asset, which is the case with plant.
Therefore, Sage will reduce equity in earnings by $2,000 as an adjustment for plant (($90,000 / 18) x 40% = $2,000) and will reduce equity in earnings by $4,000 as an adjustment for inventory, which was all sold during the year ($10,000 x 40% = $4,000).
Sage will report equity in earnings from its investment in Adams of $48,000 - $2,000 - $4,000, or $42,000.
FAR 3.04 - INVESTMENTS UNDER IFRS: COST AND EQUITY METHOD
OK Co. uses the equity method to account for its January 1, 20X4 purchase of FDL Inc.’s common stock. On January 1, 20X4, the fair values of FDL’s FIFO inventory and plant exceeded their carrying amounts.
How do these excesses of fair values over carrying amounts affect OK’s reported equity in FDL’s 20X4 earnings?
Inventory excess/ Plant excess
Increase/ Increase
Increase / No effect
Decrease / Decrease
Decrease / No effect
Decrease / Decrease
EXPLANATION:
Under the equity method, the investor adjusts the portion of the investee’s income recognized to account for differences between the book values of the investee’s assets and liabilities and their fair values.
Under FIFO, it is assumed that inventory on hand is sold first and, if the fair value is greater than the carrying value, the difference increases cost of sales,
decreasing the investee’s income.
Likewise, if the fair value of plant assets is greater than the carrying value, the difference will be allocated over the asset’s depreciable life, increasing depreciation expense and further reducing the investee’s income.
The investor will then recognize a proportionate amount of the investee’s adjusted income.
FAR 3.02 - COST METHOD, CHANGES IN OWNERSHIP AND FAIR VALUE ACCOUNTING
Plack Co. purchased 10,000 shares (2% ownership) of Ty Corp. on February 14, 20X1.
Plack received a stock dividend of 2,000 shares on April 30, 20X1, when the market value per share was $35.
Ty paid a cash dividend of $2 per share on December 15, 20X1.
In its 20X1 income statement, what amount should Plack report as dividend income?
$24,000
$20,000
$90,000
$94,000
$24,000
EXPLANATION:
A stock dividend is the distribution of additional shares of stock, not a payment of cash, and is recognized by
spreading the existing basis over the increased number of shares.
It is not recognized as dividend income.
Cash dividends are recognized as dividend income.
Plack Co. will recognize $24,000 in dividend income as a result of the $2 per share cash distribution (12,000 shares * $2/share).
FAR 3.02 - COST METHOD, CHANGES IN OWNERSHIP AND FAIR VALUE ACCOUNTING
Puff Co. acquired 40% of Straw, Inc.’s voting common stock on January 2, 20X1, for $400,000.
The carrying amount of Straw’s net assets at the purchase date totaled $900,000.
Fair values equaled carrying amounts for all items except equipment, for which fair values exceeded carrying amounts by $100,000. The equipment has a five-year life.
Puff’s policy is to amortize goodwill over ten years. During 20X1, Straw reported net income of $150,000.
What amount of income from this investment should Puff report in its 20X1 income statement?
$40,000
$52,000
$60,000
$56,000
$52,000
EXPLANATION:
Puff’s income from its investment in Straw will be accounted for under the equity method by first prorating Straw’s income of $150,00 by Puff’s ownership percentage of 40%, resulting in $60,000 unadjusted income from investment.
Next, Puff will adjust this number by its prorated amount of amortization of the excess value of the equipment. With a total FMV - book excess of $100,000 in equipment, Puff’s share is $40,000, amortized over five years at $8,000 a year.
No other adjustments remain because there are no other FMV - book differences, nor any possible adjustments relating to goodwill.
Puff’s adjusted income from its equity investment in Straw is therefore $60,000 - $8,000, or $52,000
FAR 3.02 - COST METHOD, CHANGES IN OWNERSHIP AND FAIR VALUE ACCOUNTING
A company has a 22% investment in another company that it accounts for using the equity method. Which of the following disclosures should be included in the company’s annual financial statements?
The reason for the company’s decision to invest in the investee company.
The names and ownership percentages of the other stockholders in the investee company.
The company’s accounting policy for the investment.
Whether the investee company is involved in any litigation.
The company’s accounting policy for the investment.
EXPLANATION:
When an entity accounts for investments in common stock under the equity method, it is required by ASC 323 to disclose the following:
— The name of each investee (not investor) and percentage of the entity’s ownership of each investee’s common stock.
– The entity’s accounting policies for investments in common stock
– The difference, in any, between the carrying amount of the investment and the amount of the entity’s underlying equity in the investee’s net assets and the entity’s accounting treatment of the difference
The entity is not required to disclose the reason for having made the investment, whether the investee company is involved in any litigation, or the names or ownership percentages of other stockholders in the investee.
FAR 3.04 - INVESTMENTS UNDER IFRS: COST AND EQUITY METHOD
Under IFRS an equity investment is considered an investment in an associate if the investor has significant influence over the investee. Significant influence is indicated by…
Ownership of at least 20% but no more than 50%.
Ownership of at least 10%.
Having the power to participate in the decisions of the investee.
Having the power to direct the activities of the investee.
Having the power to participate in the decisions of the investee.
EXPLANATION:
Under both GAAP and IFRS, the equity method is applied when an entity has the ability to exercise significant
influence over the investee.
Under IFRS, that is considered to be the case when the investor has the power to participate in the decisions of the investee.
FAR 3.02 - COST METHOD, CHANGES IN OWNERSHIP AND FAIR VALUE ACCOUNTING
On January 1, year 1, Peabody Co. purchased an investment for $400,000 that represented 30% of Newman Corp.’s outstanding voting stock.
For year 1, Newman reported net income of $60,000 and paid dividends of $20,000.
At year end, the fair value of Peabody’s investment in Newman was $410,000.
Peabody elected the fair value option for this investment. What amount should Peabody recognize in net income for year 1 attributable to the investment?
$16,000
$18,000
$10,000
$6,000
$16,000
EXPLANATION:
Under the fair value option, an entity may report financial instruments, including investments in the stock of another
entity, at fair value provided consolidation is not required.
With 30% ownership, Peabody’s investment in Newman would normally require the equity method, but Peabody may, and did, elect the fair value option.
Peabody will recognize its $6,000 share of dividends ($20,000 x 30%) as dividend revenue, plus recognize the $10,000 gain in fair value at the balance sheet date, for a total of $16,000 in income recognized for the period.
FAR 3.04 - INVESTMENTS UNDER IFRS: COST AND EQUITY METHOD
Mr. Mercury, Inc. bought 25% of Hermes Corp.’s outstanding common stock on January 2, 20X4, for $500,000.
The carrying amount of Hermes’ net assets at the purchase date totaled $1,500,000.
Fair values and carrying amounts were the same for all items except for plant and inventory, for which fair values exceeded their carrying amounts by $80,000 and $40,000, respectively.
The plant has a ten-year remaining useful life and no salvage value. All inventory was sold during 20X4. During 20X4, Hermes reported net income of $200,000 and paid a $20,000 cash dividend.
There is no impairment of goodwill during 20X4.
Assume that Mr. Mercury uses the equity method to account for this investment. What amount should Mr.
Mercury report in its income statement from its
investment in Hermes for the year ended December 31, 20X4?
$38,000
$37,000
$32,000
$42,000
$38,000
EXPLANATION:
Under the equity method, Mercury will recognize its share of Hermes’ income and dividends in the same amounts that would be used in preparing consolidated financial statements.
As a result, Hermes’ net income of $200,000 must be adjusted for the fair value differences in plant, which will reduce income by $80,000/10 years or $8,000, and inventory, all of which was sold in 20X4, reducing income by $40,000.
As a result, Hermes’ adjusted net income would be $200,000 - $8,000 - $40,000 or $152,000. Mercury owns 25% and will recognize 25% of $152,000, or $38,000, as income.
FAR 3.04 - INVESTMENTS UNDER IFRS: COST AND EQUITY METHOD
When an entity acquires the debt or equity securities of another entity, it is considered an investment in financial assets. In addition, financial assets may be originated by the entity, such as when it makes a loan to another entity. IFRS provides for different methods of accounting for various investments, based on their natures.
There are three general approaches applied to investments in financial instruments.
- Amortized Cost Approach
- FVTOCI
- Equity Method
FAR 3.04 - INVESTMENTS UNDER IFRS: COST AND EQUITY METHOD
AMORTIZED COST APPROACH
AMORTIZED COST APPROACH - not appropriate for equity securities
When certain conditions are met, an investment in a financial instrument is reported at amortized cost. Under the amortized cost approach, any difference between the original cost and the face amount is treated as a discount or premium and the effective interest method of amortization is applied. The conditions are:
— The instrument calls for scheduled payments that consist exclusively of principal and interest.
— The entity’s business model has, as an objective, to hold until maturity such instruments in order to collect the contractual cash flows.
FAR 3.04 - INVESTMENTS UNDER IFRS: COST AND EQUITY METHOD
FVTOCI METHOD
FVTOCI - not appropriate for equity securities
A second type of investment in financial instrument is accounted for at fair value with unrealized gains and losses recognized in other comprehensive income (OCI.) This approach is referred to as fair value through other comprehensive income or FVTOCI.
It is applied to financial assets when two conditions are met. The applicable requirements for FVTOCI are:
— The instrument calls for scheduled payments that consist exclusively of principal and interest.
— The entity’s business model has, as an objective, to either hold such instruments in order to collect the contractual cash flows or to sell them.
FAR 3.04 - INVESTMENTS UNDER IFRS: COST AND EQUITY METHOD
EQUITY METHOD
EQUITY METHOD:
When an investment is made in an entity over which it has significant influence, it is considered an investment in an associate(affiliate). An investment in an associate is accounted for under the equity method of accounting. Significant influence ni dicTates that the investor has the authority and power to participate in policy decisions of the investee without having or sharing control of the entity.
— If the investor has control, consolidated financial statements are appropriate.
— If the investor shares control in a joint arrangement, the investment will be considered either a joint operation or a joint venture, which will determine the accounting
A joint arrangement is considered a joint venture if those who share control also have rights to the net assets of the arrangement. Such an arrangement is referred to as a joint venture and is accounted for under the equity method of accounting. When those with joint control do not also have rights to the net assets, the joint arrangement is referred to as a joint operation and is accounted for using a proportionate consolidation approach.
—The investor measures and recognizes a proportionate amount of the operation’s assets,
liabilities, revenues, and expenses for inclusion on its financial statements.
— Measurement and recognition is in accordance with the IFRS relevant to the particular
assets, liabilities, revenues, or expenses.
FAR 3.04 - INVESTMENTS UNDER IFRS: COST AND EQUITY METHOD
On January 2, 20X4, Crawford Co. purchased 15% of Cobb, Inc.’s outstanding common shares for $600,000.
Crawford is Cobb’s largest supplier and upon purchase owns 25% of the Cobb’s voting stock, the largest portion of Cobb’s voting stock held by any one entity or voting bloc.
Cobb reported net income of $400,000 for 20X4, and paid dividends of $100,000.
Crawford does not elect the fair value option to report its investment in Cobb. In its December 31, 20X4 balance sheet, what amount should Crawford report as investment in Cobb?
$585,000
$670,000
$645,000
$600,000
$645,000
EXPLANATION:
The equity method is used when the investor has significant influence over the operating and financial policies of the investee.
Here, due to being Cobb’s largest supplier and having control of 25% of Cobb’s voting stock, Crawford has significant influence over Cobb despite owning only 15% of Cobb.
Therefore, Crawford must use the equity method since the fair value option was not chosen.
During 20X4, Crawford’s balance sheet $600,000 Investment in Cobb account is increased by $60,000 to reflect equity in earnings (15% x 400,000 = 60,000) and decreased by $15,000 to reflect investee dividends received (15% x 100,000), to arrive at a net reported
investment of $645,000 (600,000 + 60,000 – 15,000 = 645,000).
Expanded explanation: The 15% is not a typo. Apparently, not all common stock in this company is voting stock. This nonvoting common stock is not preferred stock–the owners of the non-voting common stock get dividends when the owners of the
voting common stock get dividends; apparently, the only difference is the voting rights.
When using the equity method, Crawford records 15% of Cobb’s income because that is the percentage of Cobb’s total common stock that Crawford owns and, hence, how much income it may claim.
FAR 3.04 - INVESTMENTS UNDER IFRS: COST AND EQUITY METHOD
On January 1, 20X4, Grin, Inc. purchased 12% of Hydra Co.’s common stock. At that time Grin did not have the
ability to exert significant influence over Hydra.
On September 1, 20X4, Grin purchased additional Hydra shares, bringing its ownership up to 35% of Hydra’s common stock outstanding. During December 20X4, Hydradeclared and paid a cash dividend on all of its outstanding common stock.
Grin uses the equity method to account for its investment in Hydra. How much income from the Hydra investment should Grin’s 20X4 income statement report?
35% of Hydra’s 20X4 income.
Amount equal to dividends received from Hydra.
12% of Hydra’s income for January 1 to August 31, 20X4, plus 35% of Hydra’s income for September 1 to
December 31, 20X4.
35% of Hydra’s income for September 1 to December 31, 20X4 only.
35% of Hydra’s income for September 1 to December 31, 20X4 only.
EXPLANATION:
When changing from the cost to the equity method, the investor simply prospectively applies the equity method.
Therefore, the equity method only becomes effective September 1, when Griffin became a 35% owner of Hydra.
With 35% ownership, Griffin records equity in earnings of 35% of Hydra’s income from September 1.
