Financial 4 - Equity Method

Question 1

What is Significant Influence?

Answer 1

• A company owning a 22% investment in another company in which the equity method is used is considered as having “significant influence”. The company is required to disclose the accounting policy for the investment

** When significant influence is acquired, the equity method is adopted from that date and going forward. Retroactive adjustments are NOT required

*** When two or more purchases of stock cause ownership in an investee to go from less than 20% to more than 20%, the cost of acquiring the additional interest in the investee is added to the carrying value of the investment. MOST IMPORTANTLY, the equity method treatment is adopted the day that the significant influence is acquired. Until then, the carrying value of the investment is used to value the investment on the Balance sheet

Question 2

When does a company report investment income?

Answer 2

RULE: Investor records as revenue its “share of the investee’s earning” (NOT dividends received) under the equity method

Dividends from an investee company are recorded by the investor as a REDUCTION in the carrying amount of the investment on the balance sheet of the investor. Changes in the market value of investee’s common stock are not considered income to the parent under the equity method.

FAIR VALUE Rule: receipt of a dividend is recorded as income and does not affect the investment account

Application: The investment account will be INCREASED by the investor’s share of investee’s net income (% of equity * earnings) and DECREASED by any dividends declared (% of equity * dividends paid)

** If undervalued equipment is involved (FV > CV), the company must factor in the amortized amount of FV over the life of the equipment. This amortization will reduce the share of earnings for the period in question

** Income from an investee is recognized only from date of purchase (READ THE DATES CAREFULLY)

Question 3

Recording Stock Dividends

Answer 3

• When a stock dividend in received, a memorandum entry that reduces the unit cost of ALL of the company’s stock must be made. The total investment will be spread over the larger amount of shares, thereby reducing the unit cost off all of the company’s shares owned