ACCT 4022 Ch 1
Under the equity method, the investor records its share of investee dividends as
a decrease to the investment account.
As opposed to the cash basis of accounting, the equity method follows the _____ basis for recognizing investment income.
accrual
Because certain intangible assets are considered to have indefinite lives, they are not subject to _____.
amortization
An upstream sales refers to a situation where
an investor company purchases inventory from its investee.
An intra-entity inventory sale occurs between an investor and its equity-method investee. What factors determine the amount of gross profit from the sale to be deferred as of the end of the year?
- The seller's gross profit percentage. - The amount of the intra-entity sale remaining in ending inventory. - The investor's proportionate ownership of the investee.
All of the following would require use of the equity method for investments except: - Material intra-entity transactions. - Investor participation in the policy-making process of the investee. - Valuation at fair value. - Technological dependency. - Interchange of managerial personnel.
- Valuation at fair value.
A criticism of the 20%-50% ownership guideline for applying the equity method is that
- a firm may argue that less than 50% ownership indicates a lack of control and thus avoid consolidation of an investee. - contractual agreements may be more indicative of significant influence or control than ownership percentage.
The fair-value option for reporting investments that would otherwise be accounted for under the equity method requires
- an irrevocable election to elect fair value as the measurement attribute for an equity investment - the valuation of the equity method investment at fair value as of the investor's balance sheet date. - the inclusion in net income of changes in the fair value of an equity investment.
When an equity-method investment account balance is reduced to zero due to a current year investee loss, the investor should
- discontinue use of the equity method and not establish a negative balance. - accrue no additional losses. - leave the investment account balance at zero until subsequent investee profits eliminate all unrecognized losses.
When one firm controls the entire decision making process of another firm,
- for reporting purposes the two companies are considered to be a single economic entity. - one set of financial statements are created for the combined assets, liabilities, revenues and expenses of both firms. - such control may result from majority voting stock ownership or contracts with a variable interest entity.
The equity method in accounting for an equity investment is applied when the investor company:
- participates in policy-making decisions of the investee - has representation on the investee's board of directors
The IASB and FASB standards on equity method accounting are similar in that they both
- rely on the notion of significant influence. - treat investee dividend distributions to the investor as a decrease in the carrying amount of the investment. - recognize the investor's share of the profit or loss of the investee as a part of the investor's earnings.
Even though a business firm owns 25% of another company's voting shares, the equity method should not be applied if
- the 75% owners of the investee make decisions without consulting the investor. - the investor is unable to exercise signficant influence over the investee. - after several tries, the investor is unable to gain a seat on the investee's board of directors.
Under the fair-value method of accounting for an investment in another firm's ownership shares, the investor increases its investment account when
- the fair value of the investee's shares increases. - the investor purchases shares of the investee.
Under the fair-value method of accounting for an investment in another firm's ownership shares, the investor recognizes income when
- the investee pays a dividend. - the fair value of the investee's shares increase.
When an investor sells a portion of an equity-method investment,
- the investor continues to apply the equity method if the investor continues to have the ability to exercise significant influence over the investee. - the investment account should reflect a balance current as of the date of sale. - the investor recognizes a gain or loss on the sale.
When an investor sells inventory to its 40%-owned investee (an intra-entity sale), why is 40% of the profit recognition delayed until the inventory is sold to an outside party?
40% of the investor's sale is effectively with itself.
When an investor uses the equity method to account for investments in common stock, the investor's share of cash dividends from the investee should be recorded as
A deduction from the investment account.
An investor originally purchased 5% of an investee and appropriately applied the fair-value method to account for its investment. Later, the investor purchased sufficient additional shares to qualify the investment for the equity method. How should the investor account for the newly qualified equity investment?
Add the cost of the shares to the current basis of its previous 5% investment.
Which of the following describes a circumstance when the equity method is appropriate for financial reporting?
An investor has the ability to exercise significant influence over an investee's decisions and operations.
How does an investor record income from its investment in an equity-method investee?
As a credit to "Equity in Investee Income"
When an equity method investee declares a dividend, how should the investor company record the event?
As a credit to the Investment account.
When an equity-method investee company's activities require recognition of other comprehensive income (OCI), the investor company
records its proportionate share of the investee's OCI as AOCI on its financial records.
The accounting objective underlying the equity method for investments is to
report the investment and related income reflecting the close relationship between the investor and investee.
True or false: When an investor sells inventory to an outside party that had been purchased from its equity-method investee, the investor recognizes any related deferred gross profit.
True [Reason: The gross profit from intra-entity sales between and investor and investee are initially deferred and then recognized when sold to an outsider or consumed in operations.]
Under the equity method, the investment account increases when
the investee recognizes and reports net income.
In applying the equity method,
the investor recognizes its proportionate share of the investee's income.
True or false: For investments accounted for under the equity method, the direction of any intra-entity sales (upstream or downstream) does not affect reported income statement balances.
True [Reason: Upstream and downstream intra-entity sales have the same effect on the investor's equity method accounts.]
When does a company like Coca-Cola account for its investment using the equity method?
When the investment provides the company with the ability to exercise significant influence over the decisions of the investee.
When an investee sells inventory to its investor company, such intra-entity sales are commonly referred to as _____ sales.
upstream
When financial control occurs though contractual relationships rather that voting stock ownership, the controlled firm is called special purpose or _____ _____ _____.
variable interest entities
The term used to describe inventory sales between an investor company and its equity-method investee is _____-_____ sales.
intra-entity
Rather than recording dividend revenue, under the equity method an investor records an investee dividend declaration as a reduction in its _____ in subsidiary account.
investment
When an equity method investee sells inventory to its investor at a gross profit and a portion of the inventory remains unsold to outside parties at year end, the investor's Equity in Investee Income account
is decreased for the investor's ownership percentage of the gross profit on intra-entity inventories that have not been resold to outside entities.
The Coca-Cola Company accounts for its investment in Monster Beverage Corporation using the equity method because
it possessed significant influence over Monster Beverage.
Under the equity method, the investor records a credit to the investment account if a net _____ is reported on the investee's income statement.
loss
When an equity-method investment account balance is reduced to zero, the investor should discontinue use of the equity method rather than establish a _____ balance.
negative
Under the equity method, the amount of gross profit deferred from an intra-entity sale is limited to the investor's _____ share of the investee.
ownership (or percentage, proportional, proportionate)
Although goodwill arising from a business combination is subject to periodic impairment reviews, goodwill implicit in an equity method investment is not. Equity method investments are tested in their entirety for _____ declines in value.
permanent
If an increase in an investment now provides an investor with the ability to exercise significant influence over an investee, the change to the equity method of investment accounting is applied on a _____ basis.
prospective
Zell Company sells inventory at a $10,000 gross profit to its equity method investee, Aaron Company. Before the end of the year, Aaron resells all of this inventory to an outside, unrelated entity. As a result of these activities, Zell Company should
recognize the entire $10,000 gross profit on its income statement. [Reason: The investor's proportional ownership interest is only used to defer (and subsequently recognize) intra-entity gross profits in ending inventory. Once the goods are sold to outsiders, all of the gross profit can be recognized.]
What are some general criticisms of the equity method for investments in the ownership shares of another firm?
- By not including the investee's assets and liabilities in the investor's financial statement amounts, performance metric may be biased. - Significant influence and control may not be properly defined by existing quantitative guidelines.
Which of the following procedures are followed in applying the fair-value method of accounting for an investment in another firm's equity securities?
- Changes in the fair value of equity securities owned during a period are reported as income. - The initial investment in equity securities is recorded at cost.
Which of the following represent reasons why a firm's stock price differs from its underlying book value?
- Expected future profitability of the firm. - Perceived worth of the firm's net assets. - General economic conditions.
After allocating cost in excess of book value, which asset or liability would not be amortized over a useful life? - COGS - Property, plant & equipment - Patents - Goodwill - Bonds payable
- Goodwill
Which of the following procedures are followed in applying the cost method of accounting for an investment in another firm's equity securities?
- In limited circumstances, a cost method investment may be increased when similar securities experience price increases. - The investment must be periodically assessed for impairment. - The investor's share of the investee's dividend declarations is recorded as income.
Why does the equity method consider investee dividends as an inappropriate measure of investment income to an investor?
- Investee dividends provide for a cash basis of income recognition, not an accrual basis. - Through its significant influence, an investor can influence the timing of investee dividends and thus manipulate income.
The deferral of gross profits from sales from an investor (Company A) to its equity-method investee (Company B) affects which of the following accounts on the books of the investor.
- Investment in Company B - Equity in Investee Income
What factors indicate if the equity method should be used for an investment in another firm's equity securities?
- Investor participation in the policy-making process of the investee. - Technological dependency between the investor and investee. - Investor representation on the investee's board of directors.
What are some common economic consequences of financial reporting on the reporting firm?
- Managerial compensation may depend on reported net income. - Failure to maintain certain financial statement ratios may cause a firm to violate debt covenants. - Certain financial statement performance metrics may affect the ability of a firm to raise capital in debt or equity markets.
Holden company pays $340,000 for a 40% investment in Sparrow Company. The investment provides Holden with the ability to exercise significant influence over Sparrow's operations. At the date of the investment, Sparrow has a book value of $600,000. Sparrow has a patent (5-year remaining life) with a zero carrying amount but a fair value of $250,000. How much goodwill should Holden record as a result of this transaction?
$0 [Reason: ($600K + $250K) x 40% = $340K so goodwill = $0]
At the beginning of the current year, Martin Corporation purchases 20% of the outstanding shares of Foster Company for $200,000 which gave Martin the ability to significantly influence Foster. The price paid reflected Foster's book and fair values of its assets and liabilities. During the current year, Foster reports net income of $25,000 and declares dividends of $15,000. At the end of the current year, what amount should Martin report as investment income from its ownership of Foster's shares?
$5,000 [Reason: $25,000 x 20% = $5,000.]
Alex, Inc., buys 40 percent of Steinbart Company on January 1, 2020, for $648,000. The equity method of accounting is to be used. Steinbart's net assets on that date were $1.40 million. Any excess of cost over book value is attributable to a trade name with a 20-year remaining life. Steinbart immediately begins supplying inventory to Alex as follows: Year: 2020 Cost to Steinbart: $159,040 Tfr Price: $224K Amt Held by Alex @ Yr-End (@ tfr price): $56K Year: 2021 Cost to Steinbart: $127,360 Tfr Price: $199K Amt Held by Alex @ Yr-End (@ tfr price): $63K Inventory held at the end of one year by Alex is sold at the beginning of the next. Steinbart reports net income of $82,000 in 2020 and $116,400 in 2021 and declares $30,000 in dividends each year. What is the equity income in Steinbart to be reported by Alex in 2021?
*****
A company has been using the equity method to account for its investment. The company sells shares and does not continue to have significant influence. Which of the following statements is true? - A cumulative effect change in accounting principle must occur. - A prospective changes in accounting principle must occur. - A retrospective change in accounting principle must occur. - The investor will not receive future dividends from the investee. - Future dividends will continue to reduce the investment account.
- A prospective changes in accounting principle must occur.
Which of the following explains why an investor company may pay an amount in excess of the percentage book value acquired of an investee?
- The historical amounts of the acquired firm's assets may be less than their fair values. - Inventory costing methods may understate the fair value of the acquired firm's inventory.
An investor sells inventory to its investee, at a profit. At year end, the investee has not disposed of this inventory. How should the investor account for the gross profit from this intra-entity inventory sale?
Defer the investor's proportionate ownership share of the intra-entity gross profit.
Which of the following are included in net income for an investment in equity shares accounted for under the fair-value method?
Dividends from the investee.
What account should an investor use to defer its proportional share of intra-entity gross profits remaining in ending inventory from sales to an investee?
Equity in Investee Income
In the absence of any significant influence, which of the following investment accounting methods might be appropriate?
Fair-value method.
When provisions and contracts grant Firm A decision-making power over Firm B's operating and financing policies
Firm A must include Firm B in its consolidated financial statements.
When an investor purchases an investment for an amount in excess of the investee's book value, how is the excess amount allocated?
First to specifically identified assets and liabilities with any remainder allocated to goodwill.
When should an investor recognize an impairment loss for its equity method investment?
If evidence exists that the investor will not be able to recover the investment's carrying amount and the decline in value is other than temporary.
An upstream sale of inventory is a sale:
Made by the investee to the investor.
Town Co. appropriately uses the equity method to account for its investment in Country Corp. As of the end of 2021, Country's common stock had suffered a significant decline in fair value, which is expected to recover over the next several months. How should Town account for the decline in value?
No accounting because the decline in fair value is temporary.
To provide consistency in application, what is the FASB's general quantitative guideline for application of the equity method?
Ownership of 20-50% of the voting stock of an investee.
Which of the following accounting approaches is used when an investment share is increased and the investment now qualifies for the equity method.
Prospective approach
An excess price paid by an investor company over the percentage book value of the investee attributable to a depreciable asset will likely affect the equity method ______ recognized by the investor company over time.
income
An investor's excess investment cost over its percentage of investee book value is attributable to a limited-lived tangible asset. How should the investor account for this excess cost in recognizing investment income under the equity method?
The equity in investee income is reduced by the depreciation associated with the excess cost attributable to the limited-lived tangible asset.
Under the equity method, why does the investor not recognize its share of dividends declared by an investee as income?
The equity method embraces the accrual model for income recognition. [Reason: The investor recognizes his or her share of income, not dividends.]
Why is it necessary to identify the sources of the difference between the price paid for an investment and its underlying book value in applying the equity method?
The equity method will likely expense excess costs allocated to different asset categories over different useful lives.
When an equity method investment account is reduced to a zero balance
The investment retains a zero balance until subsequent investee profits eliminate all unrecognized losses.
If an investment qualifies for the equity method following a series of purchases, what valuation basis should the investor employ in applying the equity method?
The investment's total fair value as of the date the investment qualifies for the equity method.
When an investor sells inventory to its equity-method investee, how is the reported sales balance on the investor's income statement affected?
The sales account remains unaffected.
How should an investor recognize previously deferred gross profits from purchases from its equity-method investee?
Through a credit to Equity in Investee Income
True or false: Equity method accounting requires that the investor recognize its share of investee other comprehensive income and accumulated other comprehensive income.
True [Reason: Both OCI and AOCI of an investee must be recognized by the investor.]
True or false: Regardless of its ownership level, if entity A has the ability to exercise control over entity B, financial statement consolidation (and not the equity method) is appropriate.
True [Reason: Consolidation is appropriate when one entity controls another. The equity method is applied when one entity can significantly influence (but not control) another.]
True or false: Despite a majority voting stock ownership, the equity method may be appropriate if noncontrolling rights are so restrictive that control may not reside with the majority owner.
True [Reason: Consolidation is only appropriate when one firm can control another. The existence of restrictive noncontrolling rights may question the existence of control.]
True or false: Because reported income can affect market perceptions of the underlying value of publicly traded shares, managers will often assess prospective effects of equity method income prior to making an equity-method investment in another firm's shares.
True [Reason: Equity-method income directly affects the reported net income of the investor firm.]
True or false: If an investor sells sufficient shares to cause it to lose its ability to exercise significant influence over an investee, the equity method would cease to be applicable.
True [Reason: The ability to exercise significant ability over an investee is a necessary condition for applying the equity method.]
Under the equity method, as the owners' equity of an investee company increases through the earnings process, the investment account of the investor company
increases.
If an investor firm controls another firm through variable interests, the investor must include the controlled firm's financial information in its _____ financial statements.
consolidated
Under the equity method, the investor's amortization of the excess of cost over investee book value will
decrease the investor's net income.
An investor that accounts for an equity investment under the cost method records income from the investment based on its share of _____ declared from the investee.
dividends
When one firm can significantly influence the decisions of another firm through its ownership of voting shares, transactions between the two firms
do not provide an objective basis for financial reporting. [Reason: Transactions with outside parties must be used to provide a basis for accounting valuation.]
According to International Accounting Standards, when an investor has significant influence over an investee, the investor must account for its investment using the _____ method.
equity
The ability to exercise significant influence over the operating and financial policies of an investee company is the sole criterion for application of the _____ method.
equity
When a company invests in the the actively-traded equity shares of another company, but cannot influence the decisions of the investee, the investor company accounts for its investment using the _____ value method.
fair
When an equity method investment suffers a permanent decline in value, the investor recognizes an impairment loss and writes down the investment account to _____ value.
fair
As of the date the equity method become applicable for an investment, the investor allocates its purchase price to its share of the investee's assets and liabilities based on their individual _____ _____ values.
fair market
Under the equity method, the excess of the investment cost over the proportionately-owned acquisition-date fair value of the investee's net identifiable assets is allocated to the asset _____.
goodwill
A necessary condition to use the equity method of reporting for an equity investment is that the investor company must
have the ability to exercise significant influence over the operating and financial policies of the investee.