FAR-F4-M2-Equity Method Flashcards
When is the equity method used to value equity securities rather than the fair value method?
When the investor owns between 21% - 49% of the investee and / or the investor has SIGNIFICANT INFLUENCE over the investee, then the equity securities are accounted for using the equity method. If there is no significant influence or if the percentage owned is less than 21%, then the investor should use the fair value method to account for its equity securities. If investor owns 50% or more, then consolidated financial statements are required.
What is the JE to record the initial investment?
Recorded at cost
Dr. Investment in XYZ
Cr. Cash
What is the key difference between equity method and the fair value option?
The key difference is that with the fair value option, unrealized gains and losses are recorded. With the equity method, unrealized gains and losses are not recorded. Rather, investment income and investment loss are recorded.
What is the journal entry to record dividends received under the equity method or fair value option?
If under the equity method, dividends received are treated as a return of capital and therefore they reduce the investment account (the asset)
Dr. Cash
Cr. Investment in XYZ
Under the fair value option
Dr. Cash
Cr. Dividend Income
Under the equity method, When is income recognized by the investor and how is it accounted for?
Under the equity method, investment income is recognized as a proportion of earnings from the investee and that proportion is dependent on the percentage of equity owned by the investor.
Dr. Investment in XYZ
Cr. Investment Income XYZ
Same situation with losses. The JE would be:
Dr Investment loss in XYZ
Cr. Investment in XYZ
What occurs if the purchase price (investment) of common stock is more than the book value of net assets of the investee (investee’s stockholder’s equity)?
If the price paid for the investment is more than the book value of net assets of the investee, the excess is attributed to 1) the fair value difference of acquired net assets, which means there is a difference between the fair value and book value of the acquired net assets. The remaining excess is attributed to Goodwill. The key here is that the excess created because of “FV of net assets is greater than BV of net assets” is amortized by the useful life of the assets in question. And amortization expense in turn reduces the INVESTOR’s investment income (revenue account) and investment account (an asset account) by the amort of the amortization expense for a particular year. Goodwill in turn does not require any accounting by the investor, nor is it impaired. Rather the entire investment (which includes goodwill) is analyzed for impairment at least annually.
What is the main rule in relation to the transitions to the equity method?
The main rule is that when 2 or more purchases of stock cause ownership to go from less than 20% to more than 20%, the equity method should be used STARTING on the date SIGNIFICANT INFLUENCE is acquired and going forward. Retroactive adjustments are not required.
Under the equity method, how is impairment evaluated?
An equity method investment is evaluated for impairment, and if the change in FV is considered other than temporary, the investment is written down to FV and a loss is recognized in income.
During the acquisition of another company, how should goodwill be calculated using the equity method?
Purchase Price of Company’s Stock
Less Book value of company’s net assets
Equals Total Excess
This total excess can be attributed to 1. Differences between the book value of the purchased company’s net assets and the fair value of the purchased company’s net assets and 2. Differences between the purchase price of the company and the fair value of the purchased company’s net assets.
