,
,
,
,
,Chapter 01 - The Equity Method of Accounting for Investments – Hoyle, Schaefer, Doupnik, Advanced Accounting,
15e
Answers to Questions
1. Through its voting rights over an investee, an investor firm can elect members to the
investee’s board of directors and thus exercise power over the strategic direction of the
investee in ways that align with the investor’s own operating and financial interests.
2. An investor should apply the equity method when it has the ability to exercise significant
influence over the operating and financial policies of the investee. However, if the investor
controls the investee, consolidating the financial information of the two companies will
normally be the appropriate method for reporting the investment.
3. For equity securities without readily determinable fair values, ASC 321 allows the cost method
for the investment asset. The investor recognizes dividend income for its share of investee
dividends declared. Under the cost method, the investment account remains at cost unless
there is (a) a demonstrable impairment or (b) observable price changes for identical or similar
investments of the same issuer.
4. 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.
5. Dividends received from an investee reduce the investment account. The investor does not
record such dividends as revenue, to avoid reporting the income from the investee twice. 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 dividend timing. If investors
recorded dividends received as income, 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 when
reported by the investee. The investor increases its investment account for the investor’s
share of the investee’s net income and then decreases the investment accounts as the
investee distributes its net income through dividends. From the investor’s view, the decrease
in the investment asset (from investee dividends) is offset by an immediate increase in
dividends receivable and an eventual increase in cash.
6. If Jones cannot significantly influence the operating and financial policies of Sandridge, the
equity method should not be applied regardless of the ownership level. However, an owner of
25 percent of a company's outstanding common 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.
1-5
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,Chapter 01 - The Equity Method of Accounting for Investments – Hoyle, Schaefer, Doupnik, Fundamentals
15e
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.
7. 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 declared 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 gross profits created by sales between the investor and the investee must be
deferred until resale to outside parties or consumed by the purchasing affiliate. The initial
deferral entry made by the investor reduces the investment balance while the eventual
recognition of the gross profit increases this account.
8. The equity method has been criticized because it allows the investor to recognize income that
may not be received in any usable form in the foreseeable future. The investor accrues
income based on the investee's reported earnings, not on the investor’s share of investee
dividends. Frequently, equity income will exceed the investor’s share of investee cash
dividends with no assurance that the difference will ever be forthcoming.
Many companies have contractual provisions (e.g., debt covenants, managerial compensation
contracts) 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 such contractual provisions of may provide managers
incentives to maintain technical eligibility for the equity method rather than full consolidation.
9. Accounting standards require that an investor treat a change to the equity method
prospectively. Any new investment (or other investor or investee activity) that provides
significant influence requires application of the equity method. At the date the investor’s
influence becomes significant, the investor prepares an investment fair value allocation
schedule. The resulting excess fair over book value amortizations serve to compute future
equity in investee earnings.
10. In reporting equity earnings for the current year, Riggins must separate its accrual into two
components: (1) net income and (2) other comprehensive income or loss. This handling
enables the reader of the investor's financial statements to assess the nature of the change to
the investment account.
11. 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
1-6
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No reproduction or distribution without the prior written consent of McGraw-Hill Education.
,Chapter 01 - The Equity Method of Accounting for Investments – Hoyle, Schaefer, Doupnik, Advanced Accounting,
15e
has suffered a permanent impairment in this question, the investor recognizes the loss
applicable to its investment.
12. Following the guidelines established by the ASC, Wilson would 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 omitted. The investor will record subsequent income based on investee dividends. If
Andrews is ever able to generate sufficient future profits to offset the total unrecognized
losses, the investor will revert to the equity method.
13. In accounting, goodwill is derived as a residual figure. It is the investor's cost in excess of its
share of the fair value of the investee assets and liabilities. Although a portion of the
acquisition price may represent either goodwill or valuation adjustments to specific identifiable
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.
14. On June 19, Princeton removes the portion of this investment account that has been sold and
recognizes the resulting gross profit 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 fair-value method becomes applicable, based on the remaining
equity value after the sale.
15. Downstream sales occur when an investor sells to the investee while upstream sales are from
the investee to the investor. These titles reflect the traditional positions given to the two parties
when presented on an organization-type chart. Under the equity method, no accounting
distinction exists between downstream and upstream sales. Separate presentation is made in
this chapter only because the distinction becomes significant in the consolidation process as
demonstrated in Chapter Five.
16. The portion of an intra-entity gross profit 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 seller’s profit remaining in the buyer’s
ending inventory. The product of the ownership percentage and this profit figure is the
investor’s share of gross profit from the intra-entity transaction. The investor defers this gross
profit in the recognition of equity earnings until subsequently recognized following use or
resale to an unrelated party.
17. Intra-entity transfers do not affect the financial reporting of the investee except that the related
party transactions must be appropriately disclosed and labeled.
18. Under fair value accounting, firms report the investment’s fair value as an asset and changes
in fair value as earnings. Dividends from an investee are included in earnings under the fair
value accounting. Dividends are not recognized in income but instead reduce the investment
account under the equity method. Also, under the equity method, firms recognize their
1-7
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,Chapter 01 - The Equity Method of Accounting for Investments – Hoyle, Schaefer, Doupnik, Fundamentals
15e
ownership share of investee profits adjusted for excess cost amortizations and intra-entity
profits.
1-8
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, Chapter 01 - The Equity Method of Accounting for Investments – Hoyle, Schaefer, Doupnik, Advanced Accounting,
15e
Answers to Problems
1. D
2. B
3. C
4. B
5. D
6. B Acquisition price ........................................................................... $2,295,000
Equity income ($750,000 × 30%) .................................................. 225,000
Dividends (90,000 shares × $1.00)................................................ (90,000)
Investment in O’Fallon as of December 31.................................. $2.430,000
7. A Acquisition price ............................................................................. $700,000
Income accruals: 2020—$170,000 × 20%....................................... 34,000
2021—$210,000 × 20% ...................................... 42,000
Amortization (see below): 2020 ...................................................... (10,000)
Amortization: 2021 .......................................................................... (10,000)
Dividends: 2020—$70,000 × 20% ................................................... (14,000)
2021—$70,000 × 20% .................................................... (14,000)
Investment in Martes, December 31, 2021..................................... $728,000
Acquisition price of Martes............................................................. $700,000
Acquired net assets (book value) ($3,000,000 × 20%) ................. (600,000)
Excess cost over book value to patent ......................................... $100,000
Annual amortization (10 year remaining life) ............................... $10,000
8. B Purchase price of Johnson stock .................. $500,000
Book value of Johnson ($900,000 × 40%)...... (360,000)
Cost in excess of book value .................... $140,000
Remaining Annual
Payment identified with undervalued ............ life amortization
Building ($140,000 × 40%) ......................... 56,000 7 yrs. $8,000
Trademark ($210,000 × 40%) ..................... 84,000 10 yrs. 8,400
Total ................................................................. $ -0- $16,400
1-9
Copyright © 2021 McGraw-Hill Education. All rights reserved.
No reproduction or distribution without the prior written consent of McGraw-Hill Education.
,
,
,
,Chapter 01 - The Equity Method of Accounting for Investments – Hoyle, Schaefer, Doupnik, Advanced Accounting,
15e
Answers to Questions
1. Through its voting rights over an investee, an investor firm can elect members to the
investee’s board of directors and thus exercise power over the strategic direction of the
investee in ways that align with the investor’s own operating and financial interests.
2. An investor should apply the equity method when it has the ability to exercise significant
influence over the operating and financial policies of the investee. However, if the investor
controls the investee, consolidating the financial information of the two companies will
normally be the appropriate method for reporting the investment.
3. For equity securities without readily determinable fair values, ASC 321 allows the cost method
for the investment asset. The investor recognizes dividend income for its share of investee
dividends declared. Under the cost method, the investment account remains at cost unless
there is (a) a demonstrable impairment or (b) observable price changes for identical or similar
investments of the same issuer.
4. 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.
5. Dividends received from an investee reduce the investment account. The investor does not
record such dividends as revenue, to avoid reporting the income from the investee twice. 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 dividend timing. If investors
recorded dividends received as income, 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 when
reported by the investee. The investor increases its investment account for the investor’s
share of the investee’s net income and then decreases the investment accounts as the
investee distributes its net income through dividends. From the investor’s view, the decrease
in the investment asset (from investee dividends) is offset by an immediate increase in
dividends receivable and an eventual increase in cash.
6. If Jones cannot significantly influence the operating and financial policies of Sandridge, the
equity method should not be applied regardless of the ownership level. However, an owner of
25 percent of a company's outstanding common 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.
1-5
Copyright © 2021 McGraw-Hill Education. All rights reserved.
No reproduction or distribution without the prior written consent of McGraw-Hill Education.
,Chapter 01 - The Equity Method of Accounting for Investments – Hoyle, Schaefer, Doupnik, Fundamentals
15e
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.
7. 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 declared 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 gross profits created by sales between the investor and the investee must be
deferred until resale to outside parties or consumed by the purchasing affiliate. The initial
deferral entry made by the investor reduces the investment balance while the eventual
recognition of the gross profit increases this account.
8. The equity method has been criticized because it allows the investor to recognize income that
may not be received in any usable form in the foreseeable future. The investor accrues
income based on the investee's reported earnings, not on the investor’s share of investee
dividends. Frequently, equity income will exceed the investor’s share of investee cash
dividends with no assurance that the difference will ever be forthcoming.
Many companies have contractual provisions (e.g., debt covenants, managerial compensation
contracts) 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 such contractual provisions of may provide managers
incentives to maintain technical eligibility for the equity method rather than full consolidation.
9. Accounting standards require that an investor treat a change to the equity method
prospectively. Any new investment (or other investor or investee activity) that provides
significant influence requires application of the equity method. At the date the investor’s
influence becomes significant, the investor prepares an investment fair value allocation
schedule. The resulting excess fair over book value amortizations serve to compute future
equity in investee earnings.
10. In reporting equity earnings for the current year, Riggins must separate its accrual into two
components: (1) net income and (2) other comprehensive income or loss. This handling
enables the reader of the investor's financial statements to assess the nature of the change to
the investment account.
11. 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
1-6
Copyright © 2021 McGraw-Hill Education. All rights reserved.
No reproduction or distribution without the prior written consent of McGraw-Hill Education.
,Chapter 01 - The Equity Method of Accounting for Investments – Hoyle, Schaefer, Doupnik, Advanced Accounting,
15e
has suffered a permanent impairment in this question, the investor recognizes the loss
applicable to its investment.
12. Following the guidelines established by the ASC, Wilson would 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 omitted. The investor will record subsequent income based on investee dividends. If
Andrews is ever able to generate sufficient future profits to offset the total unrecognized
losses, the investor will revert to the equity method.
13. In accounting, goodwill is derived as a residual figure. It is the investor's cost in excess of its
share of the fair value of the investee assets and liabilities. Although a portion of the
acquisition price may represent either goodwill or valuation adjustments to specific identifiable
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.
14. On June 19, Princeton removes the portion of this investment account that has been sold and
recognizes the resulting gross profit 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 fair-value method becomes applicable, based on the remaining
equity value after the sale.
15. Downstream sales occur when an investor sells to the investee while upstream sales are from
the investee to the investor. These titles reflect the traditional positions given to the two parties
when presented on an organization-type chart. Under the equity method, no accounting
distinction exists between downstream and upstream sales. Separate presentation is made in
this chapter only because the distinction becomes significant in the consolidation process as
demonstrated in Chapter Five.
16. The portion of an intra-entity gross profit 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 seller’s profit remaining in the buyer’s
ending inventory. The product of the ownership percentage and this profit figure is the
investor’s share of gross profit from the intra-entity transaction. The investor defers this gross
profit in the recognition of equity earnings until subsequently recognized following use or
resale to an unrelated party.
17. Intra-entity transfers do not affect the financial reporting of the investee except that the related
party transactions must be appropriately disclosed and labeled.
18. Under fair value accounting, firms report the investment’s fair value as an asset and changes
in fair value as earnings. Dividends from an investee are included in earnings under the fair
value accounting. Dividends are not recognized in income but instead reduce the investment
account under the equity method. Also, under the equity method, firms recognize their
1-7
Copyright © 2021 McGraw-Hill Education. All rights reserved.
No reproduction or distribution without the prior written consent of McGraw-Hill Education.
,Chapter 01 - The Equity Method of Accounting for Investments – Hoyle, Schaefer, Doupnik, Fundamentals
15e
ownership share of investee profits adjusted for excess cost amortizations and intra-entity
profits.
1-8
Copyright © 2021 McGraw-Hill Education. All rights reserved.
No reproduction or distribution without the prior written consent of McGraw-Hill Education.
, Chapter 01 - The Equity Method of Accounting for Investments – Hoyle, Schaefer, Doupnik, Advanced Accounting,
15e
Answers to Problems
1. D
2. B
3. C
4. B
5. D
6. B Acquisition price ........................................................................... $2,295,000
Equity income ($750,000 × 30%) .................................................. 225,000
Dividends (90,000 shares × $1.00)................................................ (90,000)
Investment in O’Fallon as of December 31.................................. $2.430,000
7. A Acquisition price ............................................................................. $700,000
Income accruals: 2020—$170,000 × 20%....................................... 34,000
2021—$210,000 × 20% ...................................... 42,000
Amortization (see below): 2020 ...................................................... (10,000)
Amortization: 2021 .......................................................................... (10,000)
Dividends: 2020—$70,000 × 20% ................................................... (14,000)
2021—$70,000 × 20% .................................................... (14,000)
Investment in Martes, December 31, 2021..................................... $728,000
Acquisition price of Martes............................................................. $700,000
Acquired net assets (book value) ($3,000,000 × 20%) ................. (600,000)
Excess cost over book value to patent ......................................... $100,000
Annual amortization (10 year remaining life) ............................... $10,000
8. B Purchase price of Johnson stock .................. $500,000
Book value of Johnson ($900,000 × 40%)...... (360,000)
Cost in excess of book value .................... $140,000
Remaining Annual
Payment identified with undervalued ............ life amortization
Building ($140,000 × 40%) ......................... 56,000 7 yrs. $8,000
Trademark ($210,000 × 40%) ..................... 84,000 10 yrs. 8,400
Total ................................................................. $ -0- $16,400
1-9
Copyright © 2021 McGraw-Hill Education. All rights reserved.
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