SOLUTION MANUAL
ADVANCED ACCOUNTING
,SOLUTION MANUAL FOR
ADVANCED ACCOUNTING 15TH EDITION BY JOE BEN HOYLE, THOMAS
SCHAEFER AND TIMOTHY DOUPNIK
CHAPTER 1-19
CHAPTER 1
THE EQUITY METHOD OF ACCOUNTING FOR INVESTMENTS
Chapter Outline
I. Four Methods Are Principally Used To Account For An Investment In Equity Securities
Along With A Fair Value Option.
A. Fair Value Method: Applied By An Investor When Only A Small Percentage
Of A Company‘S Voting Stock Is Held.
1. The Investor Recognizes Income When The Investee Declares A Dividend.
2. Portfolios Are Reported At Fair Value. If Fair Values Are Unavailable,
Investment Is Reported At Cost.
B. Cost Method: Applied To Investments Without A Readily Determinable Fair Value.
When The Fair Value Of An Investment In Equity Securities Is Not Readily
Determinable, And The Investment Provides Neither Significant Influence Nor
Control, The Investment May Be Measured At Cost. The Investment Remains At
Cost Unless
1. A Demonstrable Impairment Occurs For The Investment, Or
2. An Observable Price Change Occurs For Identical Or Similar Investments Of The
Same Issuer.
The Investor Typically Recognizes Its Share Of Investee Dividends Declared As
Dividend Income.
C. Consolidation: When One Firm Controls Another (E.G., When A Parent Has A
Majority Interest In The Voting Stock Of A Subsidiary Or Control Through Variable
Interests, Their Financial Statements Are Consolidated And Reported For The
Combined Entity.
D. Equity Method: Applied When The Investor Has The Ability To Exercise
Significant Influence Over Operating And Financial Policies Of The Investee.
1. Ability To Significantly Influence Investee Is Indicated By Several Factors
Including Representation On The Board Of Directors, Participation In Policy-
Making, Etc.
2. GAAP Guidelines Presume The Equity Method Is Applicable If 20 To 50 Percent Of The
, Outstanding Voting Stock Of The Investee Is Held By The Investor.
Current Financial Reporting Standards Allow Firms To Elect To Use Fair Value For Any
New Investment In Equity Shares Including Those Where The Equity Method Would
Otherwise Apply. However, The Option, Once Taken, Is Irrevocable. The Investor
Recognizes Both Investee Dividends And Changes In Fair Value Over Time As Income.
II. Accounting For An Investment: The Equity Method
A. The Investor Adjusts The Investment Account To Reflect All Changes In The Equity
Of The Investee Company.
B. The Investor Accrues Investee Income When It Is Reported In The Investee‘S
Financial Statements.
C. Dividends Declared By The Investee Create A Reduction In The Carrying Amount Of
The Investment Account. This Book Assumes All Investee Dividends Are Declared
And Paid In The Same Reporting Period.
III. Special Accounting Procedures Used In The Application Of The Equity Method
A. Reporting A Change To The Equity Method When The Ability To Significantly
Influence An Investee Is Achieved Through A Series Of Acquisitions.
1. Initial Purchase(S) Will Be Accounted For By Means Of The Fair Value Method
(Or At Cost) Until The Ability To Significantly Influence Is Attained.
2. When The Ability To Exercise Significant Influence Occurs Following A Series Of
Stock Purchases, The Investor Applies The Equity Method Prospectively. The
Total Fair Value At The Date Significant Influence Is Attained Is Compared To
The Investee‘S Book Value To Determine Future Excess Fair Value
Amortizations.
B. Investee Income From Other Than Continuing Operations
1. The Investor Recognizes Its Share Of Investee Reported Other
Comprehensive Income (OCI) Through The Investment Account And The
Investor‘S Own OCI.
2. Income Items Such As Discontinued Operations That Are Reported Separately By
The Investee Should Be Shown In The Same Manner By The Investor. The
Materiality Of These Other Investee Income Elements (As It Affects The Investor)
Continues To Be A Criterion For Separate Disclosure.
C. Investee Losses
1. Losses Reported By The Investee Create Corresponding Losses For The Investor.
2. A Permanent Decline In The Fair Value Of An Investee‘S Stock Should Be
Recognized Immediately By The Investor As An Impairment Loss.
3. Investee Losses Can Possibly Reduce The Carrying Value Of The Investment
Account To A Zero Balance. At That Point, The Equity Method Ceases To Be
Applicable And The Fair-Value Method Is Subsequently Used.
D. Reporting The Sale Of An Equity Investment
1. The Investor Applies The Equity Method Until The Disposal Date To Establish A
Proper Book Value.
2. Following The Sale, The Equity Method Continues To Be Appropriate If Enough
Shares Are Still Held To Maintain The Investor‘S Ability To Significantly Influence
The Investee. If That Ability Has Been Lost, The Fair-Value Method Is
Subsequently Used.
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,Solution Manual For All Chapters
IV. Excess Investment Cost Over Book Value Acquired
A. The Price An Investor Pays For Equity Securities Often Differs Significantly
From The Investee‘S Underlying Book Value Primarily Because The Historical
Cost Based Accounting Model Does Not Keep Track Of Changes In A Firm‘S
Fair Value.
B. Payments Made In Excess Of Underlying Book Value Can Sometimes Be Identified
With Specific Investee Accounts Such As Inventory Or Equipment.
C. An Extra Acquisition Price Can Also Be Assigned To Anticipated Benefits That Are
Expected To Be Derived From The Investment. In Accounting, These Amounts Are
Presumed To Reflect An Intangible Asset Referred To As Goodwill. Goodwill Is
Calculated As Any Excess Payment That Is Not Attributable To Specific Identifiable
Assets And Liabilities Of The Investee. Because Goodwill Is An Indefinite-Lived
Asset, It Is Not Amortized.
V. Deferral Of Intra-Entity Gross Profit In Inventory
A. The Investor‘S Share Of Intra-Entity Profits In Ending Inventory Are Not Recognized
Until The Transferred Goods Are Either Consumed Or Until They Are Resold To
Unrelated Parties.
B. Downstream Sales Of Inventory
1. ―Downstream‖ Refers To Transfers Made By The Investor To The Investee.
2. Intra-Entity Gross Profits From Sales Are Initially Deferred Under The Equity
Method And Then Recognized As Income At The Time Of The Inventory‘S
Eventual Disposal.
3. The Amount Of Gross Profit To Be Deferred Is The Investor‘S Ownership
Percentage Multiplied By The Markup On The Merchandise Remaining At The
End Of The Year.
C. Upstream Sales Of Inventory
1. ―Upstream‖ Refers To Transfers Made By The Investee To The Investor.
2. Under The Equity Method, The Deferral Process For Intra-Entity Gross Profits Is
Identical For Upstream And Downstream Transfers. The Procedures Are
Separately Identified In Chapter One Because The Handling Does Vary Within
The Consolidation Process.
Answers To Discussion Questions
The Textbook Includes Discussion Questions To Stimulate Student Thought And Discussion.
These Questions Are Also Designed To Allow Students To Consider Relevant Issues That Might
Otherwise Be Overlooked. Some Of These Questions May Be Addressed By The Instructor In
Class To Motivate Student Discussion. Students Should Be Encouraged To Begin By Defining
The Issue(S) In Each Case. Next, Authoritative Accounting Literature (FASB ASC) Or Other
Relevant Literature Can Be Consulted As A Preliminary Step In Arriving At Logical Actions.
Frequently, The FASB Accounting Standards Codification Will Provide The Necessary Support.
Unfortunately, In Accounting, Definitive Resolutions To Financial Reporting Questions Are Not
Always Available. Students Often Seem To Believe That All Accounting Issues Have Been
Resolved In The Past So That Accounting Education Is Only A Matter Of Learning To Apply
Historically Prescribed Procedures. However, In Actual Practice, The Only Real Answer Is Often
The One That Provides The Fairest Representation Of The Firm‘S Transactions. If An
Authoritative Solution Is Not Available, Students Should Be Directed To List All Of The Issues
Involved And The Consequences Of Possible Alternative Actions. The Various Factors Presented
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,Can Be Weighed To Produce A Viable Solution.
The Discussion Questions Are Designed To Help Students Develop Research And Critical
Thinking Skills In Addressing Issues That Go Beyond The Purely Mechanical Elements Of
Accounting.
Did The Cost Method Invite Manipulation?
The Cost Method Of Accounting For Investments Often Caused A Lack Of Objectivity In
Reported Income Figures. With A Large Block Of The Investee‘S Voting Shares, An Investor
Could Influence The Amount And Timing Of The Investee‘S Dividend Declarations. Thus, When
Enjoying A Good Earnings Year, An Investor Might Influence The Investee To Withhold Declaring
A Dividend Until Needed In A Subsequent Year. Alternatively, If The Investor Judged That Its
Current Year Earnings ―Needed A Boost,‖ It Might Influence The Investee To Declare A Current
Year Dividend. The Equity Method Effectively Removes Managers‘ Ability To Increase Current
Income (Or Defer Income To Future Periods) Through Their Influence Over The Timing And
Amounts Of Investee Dividend Declarations.
At First Glance It May Seem That The Fair Value Method Allows Managers To Manipulate
Income Because Investee Dividends Are Recorded As Income By The Investor. However,
Dividends Paid Typically Are Accompanied By A Decrease In Fair Value (Also Recognized In
Income), Thus Leaving Reported Net Income Unaffected.
Does The Equity Method Really Apply Here?
The Discussion In The Case Between The Two Accountants Is Limited To The Reason For The
Investment Acquisition And The Current Percentage Of Ownership. Instead, They Should Be
Examining The Actual Interaction That Currently Exists Between The Two Companies. Although
The Ability To Exercise Significant Influence Over Operating And Financial Policies Appears To
Be A Rather Vague Criterion, ASC 323 "Investments—Equity Method And Joint Ventures," Clearly
Specifies Actual Events That Indicate This Level Of Authority (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
Concentration Of Other Shareholdings, But Substantial Or Majority Ownership Of The Voting
Stock Of An Investee Company By Another Investor Does Not Necessarily Preclude The Ability
To Exercise Significant Influence By The Investor.
In This Case, The Accountants Would Be Wise To Determine Whether Dennis Bostitch Or Any
Other Member Of The Highland Laboratories Administration Is Participating In The Management
Of Abraham, Inc. If Any Individual From Highland's Organization Is On Abraham‘S Board Of
Directors Or Is Participating In Management Decisions, The Equity Method Would Seem To Be
Appropriate.
Likewise, If Significant Transactions Have Occurred Between The Companies (Such As Loans By
Highland To Abraham), The Ability To Apply Significant Influence Becomes Much More Evident.
However, If James Abraham Continues To Operate Abraham, Inc., With Little Or No Regard For
Highland, The Equity Method Should Not Be Applied. This Possibility Seems Especially Likely In
This Case Since One Stockholder, James Abraham, Continues To Hold A Majority (2/3) Of The
Voting Stock. Thus, Evidence Of The Ability To Apply Significant Influence Must Be Present
Before The Equity Method Is Viewed As Applicable. The Mere Holding Of 1/3 Of The Stock Is Not
Conclusive.
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,Solution Manual For All Chapters
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
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, 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.
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
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 Value 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
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, Accounting, Any Permanent Losses In Value Should Also Be Recorded Immediately.
Because The Investee's Stock 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 Gain 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 Fair Value Accounting. Dividends Are Not Recognized In Income But Instead Reduce
The Investment
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, Account Under The Equity Method. Also, Under The Equity Method, Firms Recognize Their
Ownership Share Of Investee Profits Adjusted For Excess Cost Amortizations And Intra-Entity
Profits.
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: 2023—$170,000 × 20%..................................... 34,000
2024—$210,000 × 20%..................................... 42,000
Amortization (See Below): 2023 .................................................... (10,000)
Amortization: 2024 ........................................................................ (10,000)
Dividends: 2023—$70,000 × 20% ................................................. (14,000)
2024—$70,000 × 20% ................................................. (14,000)
Investment In Martes, December 31, 2024................................... $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
Payment Identified With Undervalued Remaining Annual
Life Amortization
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, Building ($140,000 × 40%) ................ 56,000 7 Yrs. $ 8,000
2-84
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ADVANCED ACCOUNTING
,SOLUTION MANUAL FOR
ADVANCED ACCOUNTING 15TH EDITION BY JOE BEN HOYLE, THOMAS
SCHAEFER AND TIMOTHY DOUPNIK
CHAPTER 1-19
CHAPTER 1
THE EQUITY METHOD OF ACCOUNTING FOR INVESTMENTS
Chapter Outline
I. Four Methods Are Principally Used To Account For An Investment In Equity Securities
Along With A Fair Value Option.
A. Fair Value Method: Applied By An Investor When Only A Small Percentage
Of A Company‘S Voting Stock Is Held.
1. The Investor Recognizes Income When The Investee Declares A Dividend.
2. Portfolios Are Reported At Fair Value. If Fair Values Are Unavailable,
Investment Is Reported At Cost.
B. Cost Method: Applied To Investments Without A Readily Determinable Fair Value.
When The Fair Value Of An Investment In Equity Securities Is Not Readily
Determinable, And The Investment Provides Neither Significant Influence Nor
Control, The Investment May Be Measured At Cost. The Investment Remains At
Cost Unless
1. A Demonstrable Impairment Occurs For The Investment, Or
2. An Observable Price Change Occurs For Identical Or Similar Investments Of The
Same Issuer.
The Investor Typically Recognizes Its Share Of Investee Dividends Declared As
Dividend Income.
C. Consolidation: When One Firm Controls Another (E.G., When A Parent Has A
Majority Interest In The Voting Stock Of A Subsidiary Or Control Through Variable
Interests, Their Financial Statements Are Consolidated And Reported For The
Combined Entity.
D. Equity Method: Applied When The Investor Has The Ability To Exercise
Significant Influence Over Operating And Financial Policies Of The Investee.
1. Ability To Significantly Influence Investee Is Indicated By Several Factors
Including Representation On The Board Of Directors, Participation In Policy-
Making, Etc.
2. GAAP Guidelines Presume The Equity Method Is Applicable If 20 To 50 Percent Of The
, Outstanding Voting Stock Of The Investee Is Held By The Investor.
Current Financial Reporting Standards Allow Firms To Elect To Use Fair Value For Any
New Investment In Equity Shares Including Those Where The Equity Method Would
Otherwise Apply. However, The Option, Once Taken, Is Irrevocable. The Investor
Recognizes Both Investee Dividends And Changes In Fair Value Over Time As Income.
II. Accounting For An Investment: The Equity Method
A. The Investor Adjusts The Investment Account To Reflect All Changes In The Equity
Of The Investee Company.
B. The Investor Accrues Investee Income When It Is Reported In The Investee‘S
Financial Statements.
C. Dividends Declared By The Investee Create A Reduction In The Carrying Amount Of
The Investment Account. This Book Assumes All Investee Dividends Are Declared
And Paid In The Same Reporting Period.
III. Special Accounting Procedures Used In The Application Of The Equity Method
A. Reporting A Change To The Equity Method When The Ability To Significantly
Influence An Investee Is Achieved Through A Series Of Acquisitions.
1. Initial Purchase(S) Will Be Accounted For By Means Of The Fair Value Method
(Or At Cost) Until The Ability To Significantly Influence Is Attained.
2. When The Ability To Exercise Significant Influence Occurs Following A Series Of
Stock Purchases, The Investor Applies The Equity Method Prospectively. The
Total Fair Value At The Date Significant Influence Is Attained Is Compared To
The Investee‘S Book Value To Determine Future Excess Fair Value
Amortizations.
B. Investee Income From Other Than Continuing Operations
1. The Investor Recognizes Its Share Of Investee Reported Other
Comprehensive Income (OCI) Through The Investment Account And The
Investor‘S Own OCI.
2. Income Items Such As Discontinued Operations That Are Reported Separately By
The Investee Should Be Shown In The Same Manner By The Investor. The
Materiality Of These Other Investee Income Elements (As It Affects The Investor)
Continues To Be A Criterion For Separate Disclosure.
C. Investee Losses
1. Losses Reported By The Investee Create Corresponding Losses For The Investor.
2. A Permanent Decline In The Fair Value Of An Investee‘S Stock Should Be
Recognized Immediately By The Investor As An Impairment Loss.
3. Investee Losses Can Possibly Reduce The Carrying Value Of The Investment
Account To A Zero Balance. At That Point, The Equity Method Ceases To Be
Applicable And The Fair-Value Method Is Subsequently Used.
D. Reporting The Sale Of An Equity Investment
1. The Investor Applies The Equity Method Until The Disposal Date To Establish A
Proper Book Value.
2. Following The Sale, The Equity Method Continues To Be Appropriate If Enough
Shares Are Still Held To Maintain The Investor‘S Ability To Significantly Influence
The Investee. If That Ability Has Been Lost, The Fair-Value Method Is
Subsequently Used.
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,Solution Manual For All Chapters
IV. Excess Investment Cost Over Book Value Acquired
A. The Price An Investor Pays For Equity Securities Often Differs Significantly
From The Investee‘S Underlying Book Value Primarily Because The Historical
Cost Based Accounting Model Does Not Keep Track Of Changes In A Firm‘S
Fair Value.
B. Payments Made In Excess Of Underlying Book Value Can Sometimes Be Identified
With Specific Investee Accounts Such As Inventory Or Equipment.
C. An Extra Acquisition Price Can Also Be Assigned To Anticipated Benefits That Are
Expected To Be Derived From The Investment. In Accounting, These Amounts Are
Presumed To Reflect An Intangible Asset Referred To As Goodwill. Goodwill Is
Calculated As Any Excess Payment That Is Not Attributable To Specific Identifiable
Assets And Liabilities Of The Investee. Because Goodwill Is An Indefinite-Lived
Asset, It Is Not Amortized.
V. Deferral Of Intra-Entity Gross Profit In Inventory
A. The Investor‘S Share Of Intra-Entity Profits In Ending Inventory Are Not Recognized
Until The Transferred Goods Are Either Consumed Or Until They Are Resold To
Unrelated Parties.
B. Downstream Sales Of Inventory
1. ―Downstream‖ Refers To Transfers Made By The Investor To The Investee.
2. Intra-Entity Gross Profits From Sales Are Initially Deferred Under The Equity
Method And Then Recognized As Income At The Time Of The Inventory‘S
Eventual Disposal.
3. The Amount Of Gross Profit To Be Deferred Is The Investor‘S Ownership
Percentage Multiplied By The Markup On The Merchandise Remaining At The
End Of The Year.
C. Upstream Sales Of Inventory
1. ―Upstream‖ Refers To Transfers Made By The Investee To The Investor.
2. Under The Equity Method, The Deferral Process For Intra-Entity Gross Profits Is
Identical For Upstream And Downstream Transfers. The Procedures Are
Separately Identified In Chapter One Because The Handling Does Vary Within
The Consolidation Process.
Answers To Discussion Questions
The Textbook Includes Discussion Questions To Stimulate Student Thought And Discussion.
These Questions Are Also Designed To Allow Students To Consider Relevant Issues That Might
Otherwise Be Overlooked. Some Of These Questions May Be Addressed By The Instructor In
Class To Motivate Student Discussion. Students Should Be Encouraged To Begin By Defining
The Issue(S) In Each Case. Next, Authoritative Accounting Literature (FASB ASC) Or Other
Relevant Literature Can Be Consulted As A Preliminary Step In Arriving At Logical Actions.
Frequently, The FASB Accounting Standards Codification Will Provide The Necessary Support.
Unfortunately, In Accounting, Definitive Resolutions To Financial Reporting Questions Are Not
Always Available. Students Often Seem To Believe That All Accounting Issues Have Been
Resolved In The Past So That Accounting Education Is Only A Matter Of Learning To Apply
Historically Prescribed Procedures. However, In Actual Practice, The Only Real Answer Is Often
The One That Provides The Fairest Representation Of The Firm‘S Transactions. If An
Authoritative Solution Is Not Available, Students Should Be Directed To List All Of The Issues
Involved And The Consequences Of Possible Alternative Actions. The Various Factors Presented
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,Can Be Weighed To Produce A Viable Solution.
The Discussion Questions Are Designed To Help Students Develop Research And Critical
Thinking Skills In Addressing Issues That Go Beyond The Purely Mechanical Elements Of
Accounting.
Did The Cost Method Invite Manipulation?
The Cost Method Of Accounting For Investments Often Caused A Lack Of Objectivity In
Reported Income Figures. With A Large Block Of The Investee‘S Voting Shares, An Investor
Could Influence The Amount And Timing Of The Investee‘S Dividend Declarations. Thus, When
Enjoying A Good Earnings Year, An Investor Might Influence The Investee To Withhold Declaring
A Dividend Until Needed In A Subsequent Year. Alternatively, If The Investor Judged That Its
Current Year Earnings ―Needed A Boost,‖ It Might Influence The Investee To Declare A Current
Year Dividend. The Equity Method Effectively Removes Managers‘ Ability To Increase Current
Income (Or Defer Income To Future Periods) Through Their Influence Over The Timing And
Amounts Of Investee Dividend Declarations.
At First Glance It May Seem That The Fair Value Method Allows Managers To Manipulate
Income Because Investee Dividends Are Recorded As Income By The Investor. However,
Dividends Paid Typically Are Accompanied By A Decrease In Fair Value (Also Recognized In
Income), Thus Leaving Reported Net Income Unaffected.
Does The Equity Method Really Apply Here?
The Discussion In The Case Between The Two Accountants Is Limited To The Reason For The
Investment Acquisition And The Current Percentage Of Ownership. Instead, They Should Be
Examining The Actual Interaction That Currently Exists Between The Two Companies. Although
The Ability To Exercise Significant Influence Over Operating And Financial Policies Appears To
Be A Rather Vague Criterion, ASC 323 "Investments—Equity Method And Joint Ventures," Clearly
Specifies Actual Events That Indicate This Level Of Authority (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
Concentration Of Other Shareholdings, But Substantial Or Majority Ownership Of The Voting
Stock Of An Investee Company By Another Investor Does Not Necessarily Preclude The Ability
To Exercise Significant Influence By The Investor.
In This Case, The Accountants Would Be Wise To Determine Whether Dennis Bostitch Or Any
Other Member Of The Highland Laboratories Administration Is Participating In The Management
Of Abraham, Inc. If Any Individual From Highland's Organization Is On Abraham‘S Board Of
Directors Or Is Participating In Management Decisions, The Equity Method Would Seem To Be
Appropriate.
Likewise, If Significant Transactions Have Occurred Between The Companies (Such As Loans By
Highland To Abraham), The Ability To Apply Significant Influence Becomes Much More Evident.
However, If James Abraham Continues To Operate Abraham, Inc., With Little Or No Regard For
Highland, The Equity Method Should Not Be Applied. This Possibility Seems Especially Likely In
This Case Since One Stockholder, James Abraham, Continues To Hold A Majority (2/3) Of The
Voting Stock. Thus, Evidence Of The Ability To Apply Significant Influence Must Be Present
Before The Equity Method Is Viewed As Applicable. The Mere Holding Of 1/3 Of The Stock Is Not
Conclusive.
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,Solution Manual For All Chapters
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
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, 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.
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
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 Value 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
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, Accounting, Any Permanent Losses In Value Should Also Be Recorded Immediately.
Because The Investee's Stock 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 Gain 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 Fair Value Accounting. Dividends Are Not Recognized In Income But Instead Reduce
The Investment
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, Account Under The Equity Method. Also, Under The Equity Method, Firms Recognize Their
Ownership Share Of Investee Profits Adjusted For Excess Cost Amortizations And Intra-Entity
Profits.
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: 2023—$170,000 × 20%..................................... 34,000
2024—$210,000 × 20%..................................... 42,000
Amortization (See Below): 2023 .................................................... (10,000)
Amortization: 2024 ........................................................................ (10,000)
Dividends: 2023—$70,000 × 20% ................................................. (14,000)
2024—$70,000 × 20% ................................................. (14,000)
Investment In Martes, December 31, 2024................................... $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
Payment Identified With Undervalued Remaining Annual
Life Amortization
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, Building ($140,000 × 40%) ................ 56,000 7 Yrs. $ 8,000
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