FR 3 Equity Investments Using Equity Method Accounting

Pal Corp.'s 2004 dividend income included only part of the dividend received from its Ima Corp. investment. The balance of the dividend reduced Pal's carrying amount for its Ima investment. This reflects that Pal accounts for its Ima investment by the: A) Fair Value method, and only a portion of Ima's 2004 dividends represent earnings after Pal's acquisition. B) Fair Value method, and its carrying amount, exceeded the proportionate share of Ima's market value. C) Equity method, and Ima incurred a loss in 2004. D) Equity method, and its carrying amount exceeded the proportionate share of Ima's market value.

A) Fair Value method, and only a portion of Ima's 2004 dividends represent earnings after Pal's acquisition. --> Reason: The portion of the dividend reducing the investment carrying value is a liquidating dividend. A liquidating dividend occurs when the investee pays more income than was earned during the period the investor owned the shares of the investee. For example, assume that Pal held 1% of Ima's outstanding stock from January 1-December 31 of 2004 only. Ima earned $40,000 during 2004 but paid $50,000 in dividends ($10,000 coming from earnings before 2004). Pal would receive $500 dividends in total (1%), but only $400 are attributable to earnings during the period Pal was a shareholder. Thus, $100 of the dividend is attributable to income earned by Ima before Pal became an investor. From Pal's viewpoint, this is a return of a portion of Pal's investment, a liquidating dividend. Under the cost method, liquidating dividends are treated as a reduction in the investment account whereas normal dividends are treated as income. The wording of the question implies that dividends are otherwise treated as income. Thus, the equity method could not be the method used by the firm. Under the equity method, all dividends are treated as a reduction in the investment account. No dividends received are treated as income under the equity method.

Peel Co. received a cash dividend from a common stock investment. Should Peel report an increase in the investment account if it accounts for the investment at fair value or uses the equity method of accounting? Fair value method/Equity method A) No/No B) Yes/Yes C) Yes/No D) No/Yes

A) No/No --> Reason: A dividend never increases the investment account under any accounting method. Under the fair value method, the investee dividends received are recorded by the investor as dividend income, provided that the dividend received is not a liquidating dividend. Since it is not stated otherwise, it can be assumed that the dividend is not liquidating and, under the fair value method, has no effect on the investment account. For the equity method, the dividend is recorded as a decrease in the investment account.

When an investor acquires sufficient voting common stock of an investee so that it has significant influence, which, if any, of the following kinds of investee data must the investor "capture" at the time the investment is made? Book values of assets & liabilities/Fair values of assets & liabilities A) Yes/Yes B) Yes/No C No/Yes D) No/No

A) Yes/Yes --> Reason: At the time an investor acquires sufficient voting stock of an investee to give it significant influence over the investee, it must "capture" both the book values and fair values of the investee's assets and liabilities in order to apply the equity method of accounting to the investment.

Lee, Inc. acquired 30% of Polk Corp.'s voting stock on January 1, year 1, for $100,000. During year 1, Polk earned $40,000 and paid dividends of $25,000. Lee's 30% interest in Polk gives Lee the ability to exercise significant influence over Polk's operating and financial policies. During year 2, Polk earned $50,000 and paid dividends of $15,000 on April 1 and $15,000 on October 1. On July 1, year 2, Lee sold half of its stock in Polk for $66,000 cash. The carrying amount of this investment in Lee's December 31, year 1 Balance Sheet should be: A) $100,000. B) $104,500. C) $112,000. D) $115,000.

B) $104,500. --> Reason: $104,500 = $100,000 + .30[$40,000-$25,000] because the equity method is used by Lee, who has significant influence over Polk. Under the equity method, the investor recognizes its share of undistributed earnings in the investee, since acquiring the investment, in its income.

Pare, Inc. purchased 10% of Tot Co.'s 100,000 outstanding shares of common stock on January 2, Year 1, for $50,000. On December 31, Year 1, Pare purchased an additional 20,000 shares of Tot for $150,000. There was no goodwill as a result of either acquisition, and Tot had not issued any additional stock during Year 1. Tot reported earnings of $300,000 for Year 1. What amount should Pare report in its December 31, Year 1, Balance Sheet as investment in Tot? A) $170,000 B) $200,000 C) $230,000 D) $290,000

B) $200,000 --> Reason: Once the investor has acquired a sufficient percentage of the stock to use the equity method, it is prospectively applied. In this question, the equity method becomes the required method only at the very end of the year, and Pare would begin applying the equity method beginning on December 31. The ending balance of the investment account is: $50,000 (original investment) + $150,000 (second investment).

Grant, Inc. acquired 30% of South Co.'s voting stock for $200,000 on January 2, 2015. Grant's 30% interest in South gave Grant the ability to exercise significant influence over South's operating and financial policies. During 2015, South earned $80,000 and paid dividends of $50,000. South reported earnings of $100,000 for the six months ended June 30, 2016, and $200,000 for the year ended December 31, 2016. On July 1, 2016, Grant sold half of its stock in South for $150,000 cash. South paid dividends of $60,000 on October 1, 2016. Before income taxes, what amount should Grant include in its 2015 Income Statement as a result of the investment? A) $15,000 B) $24,000 C) $50,000 D) $80,000

B) $24,000 --> Reason: Grant uses the equity method because it has significant influence over South. Under the equity method, the investor recognizes its share of the investee earnings in its own income. Thus, Grant will recognize $24,000 = .30 × $80,000 as equity in the earnings of South in its own income.

Sage, Inc. bought 40% of Adams Corp.'s outstanding common stock on January 2, Year 1 for $400,000. The investment gave Sage significant influence over Adams. 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 18-year life. All inventory was sold during Year 1. Goodwill, if any, is expected to have a useful life of 40 years. During Year 1, Adams reported net income of $120,000 and paid a $20,000 cash dividend. What amount should Sage report in its Income Statement from its investment in Adams for the year ended December 31, Year 1? A) $48,000 B) $42,000 C) $36,000 D) $32,000

B) $42,000 --> Reason: This is a question on the full equity method. Goodwill on the purchase = price of investment - 40%(fair value of Adams' net assets) $400,000 - .40($900,000 + $90,000 + $10,000) = $400,000 - $400,000 = 0 Goodwill Investment income: 40% of Adams' income: .40($120,000) = $48,000 Less 40% of excess of fair value of inventory over book value at acquisition. The inventory is sold, and therefore, the cost of goods sold of the investor must be increased by this amount: .40($10,000) = (4,000) Less depreciation on 40% of the excess of fair value over book value of equipment: .40($90,000) / 18 = (2,000) Equals amount Sage reports as investment income: $42,000 = 48,000 - 4,000 - 2,000

On October 1, 200X, Catco acquired 12% of the common stock of Dexco. The firms had no other relationships or transactions. On January 1, 200Y, Catco acquired an additional 18% of Dexco's common stock. There were no other transactions or relationships between the firms during 200Y. What method(s) of accounting would Catco have used for the investment during each of the following periods? October 1-December 31, 200X/January 1-December 31, 200Y A) Fair value/Fair value B) Fair value/Equity method C) Equity method/Fair value D) Equity method/Equity method

B) Fair value/Equity method --> Reason: Because Catco owned only 12% of Dexco's common stock during the period October 1-December 31, 200X, it would not have been able to exercise significant influence over Dexco and would have used the fair value method. Because the purchase of an additional 18% of Dexco's common stock would have given it a total of 30%, in the absence of other factors, it would be presumed to have significant influence over Dexco and, therefore, would have used the equity method during the period January 1-December 31, 200Y.

Which of the following kinds of investments can result in the investor obtaining significant influence over an investee? Equity investments/Debt investments A) Yes/Yes B) Yes/No C) No/Yes D) No/No

B) Yes/No --> Reason: An investment in equity securities of another entity gives the investor an ownership interest and, therefore, the ability to vote in corporate elections. An investment in the debt of another entity does not give the investor an ownership interest or the right to vote in corporate elections. An investment in the debt of another entity establishes a debtor-creditor relationship, not an ownership relationship.

Information pertaining to dividends from Wray Corp.'s common stock investments for the year ended December 31, 2017 are as follows: On September 8, 2017, Wray received a $50,000 cash dividend from Seco, Inc., in which Wray owns a 30% interest. A majority of Wray's directors are also directors of Seco. On October 15, 2017, Wray received a $6,000 dividend from King Co. Wray owns a 5% in King Co. Wray owns a 2% interest in Bow Corp., which declared a $200,000 cash dividend on November 27, 2017 to stockholders of record on December 15, 2017, payable on January 5, 2018. What amount should Wray report as dividend income in its Income Statement for the year ended December 31, 2017? A) $60,000 B) $56,000 C) $10,000 D) $4,000

C) $10,000 --> Reason: $0 - from Seco, Inc. Investment $6,000 - from King Co. Investment $4,000 - from Bow Corp. Investment --> 200,000 x .02 = 4,000 Total: 6,000 + 4,000 = $10,000

Lee, Inc. acquired 30% of Polk Corp.'s voting stock on January 1, Year 1 for $100,000. During Year 1, Polk earned $40,000 and paid dividends of $25,000. Lee's 30% interest in Polk gives Lee the ability to exercise significant influence over Polk's operating and financial policies. During Year 2, Polk earned $50,000 and paid dividends of $15,000 on April 1 and $15,000 on October 1.On July 1, Year 2, Lee sold half of its stock in Polk for $66,000 cash. Before income taxes, what amount should Lee include in its Year 1 Income Statement as a result of the investment? A) $40,000 B) $25,000 C) $12,000 D) $7,500

C) $12,000 --> Reason: $12,000 = .30($40,000). Under the equity method, the investor recognizes its share of investee earnings in its own income. The equity method is used because Lee has significant influence over Polk.

Larkin Co. has owned 25% of the common stock of Devon Co. for a number of years, and has the ability to exercise significant influence over Devon. The following information relates to Larkin's investment in Devon during the most recent year: Carrying amount of Larkin's investment in Devon at the beginning of the year -----> $200,000 Net income of Devon for the year -----> $600,000 Total dividends paid to Devon's stockholders during the year -----> $400,000 What is the carrying amount of Larkin's investment in Devon at year end? A) $100,000 B) $200,000 C) $250,000 D) $350,000

C) $250,000 --> Reason: Larkin's investment in Devon at year-end would be computed as the carrying amount of the investment at the beginning of the year ($200,000) + Larkin's share of Devon's reported net income for the year ($600,000 × .25 = $150,000)-Larkin's share of Devon's dividends paid during the year ($400,000 × .25 = $100,000), or $200,000 + $150,000 = $350,000-$100,000 = $250,000, the correct answer. ****((600,000 x 0.25) + 200,000 - (400,000 x .25) = $250,000)

Green Corp. owns 30% of the outstanding common stock and 100% of the outstanding noncumulative nonvoting preferred stock of Axel Corp. Green's 30% ownership of common stock gives it significant influence over Axel. In 2004, Axel declared dividends of $100,000 on its common stock and $60,000 on its preferred stock. Green exercises significant influence over Axel's operations. What amount of dividend revenue should Green report in its Income Statement for the year ended December 31, 2004? A) $0 B) $30,000 C) $60,000 D) $90,000

C) $60,000 --> Reason: Only the dividends received on the preferred stock are recognized as revenue: $60,000 = 100% × ($60,000). The common stock investment is accounted for under the equity method, which treats all dividends received as a return of capital. Dividends reduce the investment account under this method.

In which one of the following cases is an investor most likely to use the equity method to carry and report an investment in an investee? A) Investor owns 15% of the voting stock of the investee and has no other affiliation with the investee. B) Investor owns 40% of the voting stock of the investee, and the investee is in bankruptcy. C) Investor is a manufacturing firm that owns 25% of the voting stock of a consulting firm. D) Investor owns 30% of the voting stock of the investee but is unable to obtain representation on the investee's Board of Directors or obtain significant information from the investee.

C) Investor is a manufacturing firm that owns 25% of the voting stock of a consulting firm. --> Reason: An investor that owns 25% of the voting stock of an investee, in the absence of evidence to the contrary, is presumed to be able to exercise significant influence over the investee. The fact that the investor and the investee are in different lines of business generally does not mitigate the influence the investor is able to exercise.

When the equity method is used to account for investments in common stock, which of the following affects the investor's reported investment income? Goodwill amortization related to purchase/Cash dividends from investee A) Yes/Yes B) No/Yes C) No/No D) Yes/No

C) No/No --> Reason: Under the equity method of accounting for an investment, neither amortization of goodwill nor dividends from the investee affect the investor's investment income. Goodwill resulting from an investment in another entity (i.e., the excess of the cost of the investment over the investor's share of the fair value of the investee's identifiable assets) is not amortized. Dividends from the investee are not recognized as income; rather, they reduce the investment account.

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? A) The names and ownership percentages of the other stockholders in the investee company B) The reason for the company's decision to invest in the investee company C) The company's accounting policy for the investment D) Whether the investee company is involved in any litigation

C) The company's accounting policy for the investment --> Reason: The investor must disclose the accounting policy for the investee. It is possible for the investor to use equity method accounting or elect the fair value option to account for the investee. The users of the financial statement need to know the basis for the equity accounting and if the investment included intercompany profits or other items that could impact the carrying value.

In its financial statements, Pulham Corp. uses the equity method of accounting for its 30% ownership of Angles Corp. At December 31, Year 2, Pulham has a receivable from Angles. How should the receivable be reported in Pulham's Year 2 financial statements? A) None of the receivable should be reported, but the entire receivable should be offset against Angles' payable to Pulham. B) Seventy percent of the receivable should be separately reported, with the balance offset against 30% of Angles' payable to Pulham. C) The total receivable should be disclosed separately. D) The total receivable should be included as part of the investment in Angles without a separate disclosure.

C) The total receivable should be disclosed separately. --> Reason: Although the equity method is often called a "one-line" consolidation, intercompany receivables remain separate from the investment account. Intercompany profit or loss is eliminated but that affects the income recognized by Pulham, not the receivable.