Ch1 - The Equity Method of Accounting for Investments

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

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"

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.

Which of the following represent reasons why a firm's stock price differs from its underlying book value?

General economic conditions. Expected future profitability of the firm. Perceived worth of the firm's net assets.

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 Blank ___________ goodwill , Incorrect Unavailable recognized by the investor company over time.

Income or earnings

Which of the following explains why an investor company may pay an amount in excess of the percentage book value acquired of an investee?

Inventory costing methods may understate the fair value of the acquired firm's inventory. The historical amounts of the acquired firm's assets may be less than their fair values.

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.

What factors indicate if the equity method should be used for an investment in another firm's equity securities?

Technological dependency between the investor and investee. Investor representation on the investee's board of directors. Investor participation in the policy-making process of the investee.

Why does the equity method record investee dividends declared as reductions to the investment account?

The investment account mirrors changes to the investee's equity section resulting from income and dividends. The investor's equity in the investee decreases when it becomes entitled to receive a dividend.

Which of the following procedures are followed in applying the cost method of accounting for an investment in another firm's equity securities?

The investment must be periodically assessed for impairment. In limited circumstances, a cost method investment may be increased when similar securities experience price increases. 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?

Through its significant influence, an investor can influence the timing of investee dividends and thus manipulate income. Investee dividends provide for a cash basis of income recognition, not an accrual basis.

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

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

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

When firm A can use its voting shares in firm B to significantly affect firm B's decisions, transactions between A and B cannot be considered independent.

True

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

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

In employing the accrual basis, the equity method recognizes income for the investor

as earnings are reported by the investee.

If an investor firm controls another firm through variable interests, the investor must include the controlled firm's financial information in its Blank ___________ consolidated , Correct Unavailable financial statements.

consolidated

A criticism of the 20%-50% ownership guideline for applying the equity method is that

contractual agreements may be more indicative of significant influence or control than ownership percentage. a firm may argue that less than 50% ownership indicates a lack of control and thus avoid consolidation of an investee.

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.

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 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.

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.

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 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.

The equity method of accounting for investments is appropriate when the investor has the ability to exercise _____________ ____________ over the investee.

significant influence

The sole criterion for application of the equity method for an investment in the ownership shares of another company is

the ability to exercise significant influence over an investee even though the investor holds 50% or less of the common stock.

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

Under the equity method, after the initial investment is recorded,

the investment account increases as the investee earns and reports net income. an objective is to reflect the close relationship between the investor and investee. the investor recognizes investment income using the accrual method.

Even though a business firm owns 25% of another company's voting shares, the equity method should not be applied if

the investor is unable to exercise signficant influence over the investee. the 75% owners of the investee make decisions without consulting the investor. 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 investor purchases shares of the investee. the fair value of the investee's shares increases.

In applying the equity method,

the investor recognizes its proportionate share of the investee's income.

The fair-value option for reporting investments that would otherwise be accounted for under the equity method requires

the valuation of the equity method investment at fair value as of the investor's balance sheet date. an irrevocable election to elect fair value as the measurement attribute for an equity investment the inclusion in net income of changes in the fair value of an equity investment.

When financial control occurs though contractual relationships rather that voting stock ownership, the controlled firm is called special purpose or _____________ _____________ _____________.

variable interest entity