SOLUTION MANUAL
Advanced Accounting
2-1
©YMcGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LL
,Chapter 1-19
Chapter 1 The
Equity method Of Accounting For Investments
y
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. y
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. y
When T He Fair Value Of An Investment In Equity Securities Is Not Readily
Determinable, And The I Nvestment Provides Neither Significant influence Nor y
Control, The Investment May Be M Easured At Cost. The Investment Remains At
Cost Unless
1. A demonstrable Impairment Occurs For The investment, Or
y y
2. An Observable Price Change Occurs For Identical Or Similar Investments Of The
Same I Ssuer.
The Investor Typically Recognizes Its Share Of Investee Dividends Declared As Dividend I
Ncome.
C. Consolidation: When One Firm Controls Another (E.G., When A Parent Has A
Majority In Terest In The Voting Stock Of A Subsidiary Or Control Through Variable
Interests, Their Fi Nancial 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 y
2-1
©YMcGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LL
, Outstanding Voting Stock of The Investee Is Held By The Investor.
y
Current Financial Reporting Standards Allow Firms To Elect To Use fair Value For Any
y
New Inves Tment In Equity Shares Including Those Where The Equity Method Would
Otherwise apply. Ho Wever, The Option, Once Taken, Is Irrevocable. The Investor
y
Recognizes Both Investee Divide Nds 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
y
The I Nvestee 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 In Vestment 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 y
Influence An I Nvestee 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
y
Stock Purchases, The Investor Applies The Equity Method Prospectively. The
y
Total Fair Valu E At The Date Significant Influence Is Attained Is Compared To
The investee‘S Book Va Lue To Determine Future Excess Fair Value
y
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 y
Investor‘S Own Oci.
2. Income Items Such As Discontinued Operations That Are Reported Separately By
The I Nvestee Should Be Shown In The Same Manner By The Investor. The
Materiality Of Th Ese Other Investee Income Elements (As It Affects The Investor)
Continues To Be A Cri Terion 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
y y
Recognized I Mmediately By The Investor As An Impairment loss.y
3. Investee Losses Can Possibly Reduce The Carrying Value of The y
Investment account T O A Zero Balance. At that Point, The Equity Method Ceases
y y
To Be Applicable And The F Air-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
y y
The Investee. I F That Ability Has Been Lost, The Fair-Value Method Is
Subsequently Used.
, 2-24
©Ymcgraw Hill Llc. All Rights Reserved. No Reproduction Or Distribution Without Theyprior Written Consent Of Mcgraw Hill Ll
,Solution Manual For All Chapters
IV. Excess Investment cost Over Book value Acquired
y y
A. The Price An Investor Pays For Equity Securities Often Differs Significantly From
The i Nvestee‘S Underlying Book Value Primarily Because The Historical
y
Cost based Acco Unting Model Does Not Keep Track Of Changes In A Firm‘S
y
Fair Value.
B. Payments Made In Excess Of Underlying Book value Can Sometimes Be Identified
y
With Specific Investee Accounts Such As Inventory Or Equipment.
C. An Extra Acquisition Price Can Also Be Assigned To Anticipated Benefits That Are
Expect Ed To Be Derived From The Investment. In Accounting, These Amounts Are
Presumed To Reflect An Intangible Asset Referred To as Goodwill. Goodwill Is
y
Calculated As Any Exces S Payment That Is Not Attributable To Specific Identifiable
Assets And Liabilities Of The Inv Estee. Because Goodwill Is An Indefinite-Lived
Asset, It is Not Amortized.
y
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
y
Eith Er 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 T Hen Recognized As Income At the Time Of The Inventory‘S Eventual
y
Disposal.
3. The Amount Of Gross Profit To be Deferred Is The Investor‘S Ownership
y
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 proced Ures Are Separately Identified In Chapter One Because The handling
y y
Does Vary With In The Consolidation Process.
Answers To Discussion Questions
The Textbook includes Discussion Questions To Stimulate Student Thought and Discussion.
y y
These Q Uestions Are Also designed To Allow Students To Consider Relevant Issues That Might
y
Otherwise Be O Verlooked. Some Of These Questions May Be Addressed By The Instructor In
Class To Motivate stude Nt discussion. Students Should Be Encouraged To Begin By Defining
y y
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
Codific Ation Will Provide The Necessary Support.
Unfortunately, In Accounting, Definitive Resolutions To financial Reporting Questions Are
y
Not always A Vailable. Students Often Seem To Believe That All Accounting Issues Have Been
y
Resolved In The Past So That Accounting Education Is Only A Matter Of Learning To Apply
y
Historically Prescribed Procedure
S. However, In Actual Practice, The Only Real Answer Is Often The One That Provides The
Fairest repres Entation Of The Firm‘S Transactions. If An Authoritative Solution Is Not Available,
y
Students Should Be D Irected To List All Of The Issues Involved And The Consequences Of Possible
Alternative Actions. The Various Factors Presented Can Be Weighed To Produce A Viable Solution.
The Discussion Questions Are Designed To Help Students Develop Research And Critical
,Thinking Skill S In Addressing Issues That go Beyond The Purely Mechanical Elements Of
y
Accounting.
2-3
©Ymcgraw Hill Llc. All Rights Reserved. No Reproduction Or Distribution Without The Prior Written Consent Of Mcgraw Hill Ll
,Did the Cost method invite Manipulation?
y y y
The Cost Method Of Accounting For Investments Often Caused A Lack of Objectivity In Reported
y
Incom E Figures. With A Large Block Of The Investee‘S Voting Shares, An Investor Could
Influence The Amoun T And Timing Of The Investee‘S Dividend Declarations. Thus, When
Enjoying A Good Earnings Year, An Investor Might Influence The Investee to Withhold Declaring
y
A Dividend Until Needed In A Subseque Nt year. Alternatively, If The Investor Judged That its
y y
Current Year Earnings ―Needed A Boost,‖ It Migh T 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 Influ Ence Over The Timing And
y
Amounts Of Investee Dividend Declarations.
At first Glance It May Seem That The Fair Value Method Allows Managers To Manipulate Income
y
Beca Use Investee dividends Are Recorded As Income By The Investor. However, Dividends
y
Paid Typically Are Accompanied By A Decrease In Fair Value (Also Recognized In Income), Thus
Leaving Reported Ne T Income Unaffected.
Does The Equity method really apply here?
y y y y
The Discussion In The Case Between The Two Accountants Is Limited To the Reason For The
y
Investmen T Acquisition And The Current Percentage Of Ownership. Instead, They Should Be
Examining The Actu Al Interaction That currently Exists Between The Two Companies. Although
y
The Ability To Exercise Sig Nificant 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
Author Ity (Paragraph 323-10-15-6):
Ability To exercise That Influence May Be Indicated In Several Ways, Such As Representation On
y
The B Oard Of Directors, Participation In Policy-Making Processes, Material Intra-
Entity Transactions, Interchange Of Managerial Personnel, Or Technological Dependency.
Another I Mportant 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
y
Stock Of An Investee Comp Any By Another Investor Does Not Necessarily Preclude The Ability
To exercise Significant Influence B Y The Investor.
y
In This Case, The Accountants Would Be Wise To Determine Whether Dennis Bostitch Or Any
Other Me Mber Of The Highland Laboratories Administration Is Participating In The management
y
Of Abraham, Inc. If Any Individual From Highland's Organization Is On Abraham‘S Board Of
Directors Or Is Participa Ting In Management Decisions, The Equity Method Would Seem To Be
Appropriate.
Likewise, If Significant transactions Have Occurred Between The Companies (Such As Loans By
y
Highl And 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
Highlan D, The Equity Method Should Not Be Applied. This Possibility Seems Especially Likely In
This Case Sinc E One Stockholder, James Abraham, Continues To hold A Majority (2/3) Of The
y
Voting Stock. Thus, Ev Idence of The Ability To Apply Significant influence Must Be Present
y y
Before The Equity Method Is View Ed As Applicable. The Mere Holding Of 1/3 Of The Stock Is
Not conclusive.
y
, 2-44
©Ymcgraw Hill Llc. All Rights Reserved. No Reproduction Or Distribution Without Theyprior Written Consent Of Mcgraw Hill Ll
,Solution Manual For All Chapters
Answers To Questions
1. Through Its Voting Rights Over An Investee, An Investor Firm Can Elect Members To
The Inv Estee‘S Board Of Directors And Thus Exercise Power Over The Strategic
Direction Of The Inv Estee 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
y
Significant In Fluence Over The operating And Financial Policies Of The Investee.
y
However, If The Investor C Ontrols The Investee, Consolidating The Financial Information
Of The Two Companies Will Norm Ally Be the appropriate Method For Reporting The
y y
Investment.
3. For Equity Securities Without Readily Determinable Fair Values, Asc 321 Allows The Cost
Method F Or The Investment Asset. The Investor Recognizes Dividend Income For Its Share
Of Investee Divid Ends Declared. Under The cost method, The Investment Account Remains
y y
At Cost Unless There Is
(A) A Demonstrable Impairment Or (B) Observable Price Changes For Identical Or Similar
Investm Ents 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
Representatio N On The Board Of Directors, Participation In Policy-Making Processes,
Material Intra-
Entity Transactions, Interchange Of Managerial Personnel, Or Technological Dependency.
Ano Ther Important Consideration Is The extent Of Ownership By An Investor In Relation To
y
The Exten T Of Ownership Of Other Shareholdings." The Most Objective Of The criteria
y
Established By The Board Is That Holding (Either Directly Or Indirectly) 20 Percent Or
More Of The Outstanding Voti Ng Stock Is Presumed to Constitute The Ability To hold
y y
Significant Influence over The Decision- Making Process Of The Investee.
y
5. Dividends Received From An Investee Reduce The Investment account. The Investor Does
y
Not Rec Ord Such Dividends As Revenue, To Avoid Reporting The Income From The Investee
Twice. The Equi Ty Method Is Appropriate When An Investor Has The Ability To Exercise
Significant Influence Over T He Operating And Financing Decisions Of An Investee. Because
Dividends Represent Financing De Cisions, The Investor May Have The Ability To Influence
Dividend Timing. If Investors Recorded Divi Dends Received As Income, Managers Could
Affect Reported Income In A Way That does Not Refle Ct Actual Performance. Therefore, In
y
Reflecting The Close Relationship Between The Investor And I Nvestee, 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 Investe E‘S Net Income
And Then Decreases The Investment Accounts As The Investee Distributes Its Net I Ncome
Through Dividends. From The Investor‘S View, The Decrease In The Investment Asset (Fro M
Investee Dividends) Is Offset By An Immediate Increase In Dividends Receivable And An
Event Ual Increase In Cash.
6. If Jones Cannot Significantly Influence The Operating And Financial Policies Of Sandridge,
The Eq Uity 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 Pre Sumption Stands Until Overcome By Predominant Evidence
To the Contrary.
y
Examples Of Indications That An Investor May Be Unable To Exercise Significant Influence
Over T He Operating And Financial Policies Of An Investee Include (Asc 323-10-15-10):
a. Opposition By The Investee, Such As Litigation Or Complaints To Governmental
, Regulatory Authorities, Challenges The Investor's Ability To Exercise Significant
Influence.
b. The Investor And Investee Sign An Agreement Under Which The Investor Surrenders
2-5
©Ymcgraw Hill Llc. All Rights Reserved. No Reproduction Or Distribution Without The Prior Written Consent Of Mcgraw Hill Ll
Advanced Accounting
2-1
©YMcGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LL
,Chapter 1-19
Chapter 1 The
Equity method Of Accounting For Investments
y
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. y
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. y
When T He Fair Value Of An Investment In Equity Securities Is Not Readily
Determinable, And The I Nvestment Provides Neither Significant influence Nor y
Control, The Investment May Be M Easured At Cost. The Investment Remains At
Cost Unless
1. A demonstrable Impairment Occurs For The investment, Or
y y
2. An Observable Price Change Occurs For Identical Or Similar Investments Of The
Same I Ssuer.
The Investor Typically Recognizes Its Share Of Investee Dividends Declared As Dividend I
Ncome.
C. Consolidation: When One Firm Controls Another (E.G., When A Parent Has A
Majority In Terest In The Voting Stock Of A Subsidiary Or Control Through Variable
Interests, Their Fi Nancial 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 y
2-1
©YMcGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LL
, Outstanding Voting Stock of The Investee Is Held By The Investor.
y
Current Financial Reporting Standards Allow Firms To Elect To Use fair Value For Any
y
New Inves Tment In Equity Shares Including Those Where The Equity Method Would
Otherwise apply. Ho Wever, The Option, Once Taken, Is Irrevocable. The Investor
y
Recognizes Both Investee Divide Nds 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
y
The I Nvestee 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 In Vestment 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 y
Influence An I Nvestee 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
y
Stock Purchases, The Investor Applies The Equity Method Prospectively. The
y
Total Fair Valu E At The Date Significant Influence Is Attained Is Compared To
The investee‘S Book Va Lue To Determine Future Excess Fair Value
y
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 y
Investor‘S Own Oci.
2. Income Items Such As Discontinued Operations That Are Reported Separately By
The I Nvestee Should Be Shown In The Same Manner By The Investor. The
Materiality Of Th Ese Other Investee Income Elements (As It Affects The Investor)
Continues To Be A Cri Terion 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
y y
Recognized I Mmediately By The Investor As An Impairment loss.y
3. Investee Losses Can Possibly Reduce The Carrying Value of The y
Investment account T O A Zero Balance. At that Point, The Equity Method Ceases
y y
To Be Applicable And The F Air-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
y y
The Investee. I F That Ability Has Been Lost, The Fair-Value Method Is
Subsequently Used.
, 2-24
©Ymcgraw Hill Llc. All Rights Reserved. No Reproduction Or Distribution Without Theyprior Written Consent Of Mcgraw Hill Ll
,Solution Manual For All Chapters
IV. Excess Investment cost Over Book value Acquired
y y
A. The Price An Investor Pays For Equity Securities Often Differs Significantly From
The i Nvestee‘S Underlying Book Value Primarily Because The Historical
y
Cost based Acco Unting Model Does Not Keep Track Of Changes In A Firm‘S
y
Fair Value.
B. Payments Made In Excess Of Underlying Book value Can Sometimes Be Identified
y
With Specific Investee Accounts Such As Inventory Or Equipment.
C. An Extra Acquisition Price Can Also Be Assigned To Anticipated Benefits That Are
Expect Ed To Be Derived From The Investment. In Accounting, These Amounts Are
Presumed To Reflect An Intangible Asset Referred To as Goodwill. Goodwill Is
y
Calculated As Any Exces S Payment That Is Not Attributable To Specific Identifiable
Assets And Liabilities Of The Inv Estee. Because Goodwill Is An Indefinite-Lived
Asset, It is Not Amortized.
y
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
y
Eith Er 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 T Hen Recognized As Income At the Time Of The Inventory‘S Eventual
y
Disposal.
3. The Amount Of Gross Profit To be Deferred Is The Investor‘S Ownership
y
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 proced Ures Are Separately Identified In Chapter One Because The handling
y y
Does Vary With In The Consolidation Process.
Answers To Discussion Questions
The Textbook includes Discussion Questions To Stimulate Student Thought and Discussion.
y y
These Q Uestions Are Also designed To Allow Students To Consider Relevant Issues That Might
y
Otherwise Be O Verlooked. Some Of These Questions May Be Addressed By The Instructor In
Class To Motivate stude Nt discussion. Students Should Be Encouraged To Begin By Defining
y y
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
Codific Ation Will Provide The Necessary Support.
Unfortunately, In Accounting, Definitive Resolutions To financial Reporting Questions Are
y
Not always A Vailable. Students Often Seem To Believe That All Accounting Issues Have Been
y
Resolved In The Past So That Accounting Education Is Only A Matter Of Learning To Apply
y
Historically Prescribed Procedure
S. However, In Actual Practice, The Only Real Answer Is Often The One That Provides The
Fairest repres Entation Of The Firm‘S Transactions. If An Authoritative Solution Is Not Available,
y
Students Should Be D Irected To List All Of The Issues Involved And The Consequences Of Possible
Alternative Actions. The Various Factors Presented Can Be Weighed To Produce A Viable Solution.
The Discussion Questions Are Designed To Help Students Develop Research And Critical
,Thinking Skill S In Addressing Issues That go Beyond The Purely Mechanical Elements Of
y
Accounting.
2-3
©Ymcgraw Hill Llc. All Rights Reserved. No Reproduction Or Distribution Without The Prior Written Consent Of Mcgraw Hill Ll
,Did the Cost method invite Manipulation?
y y y
The Cost Method Of Accounting For Investments Often Caused A Lack of Objectivity In Reported
y
Incom E Figures. With A Large Block Of The Investee‘S Voting Shares, An Investor Could
Influence The Amoun T And Timing Of The Investee‘S Dividend Declarations. Thus, When
Enjoying A Good Earnings Year, An Investor Might Influence The Investee to Withhold Declaring
y
A Dividend Until Needed In A Subseque Nt year. Alternatively, If The Investor Judged That its
y y
Current Year Earnings ―Needed A Boost,‖ It Migh T 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 Influ Ence Over The Timing And
y
Amounts Of Investee Dividend Declarations.
At first Glance It May Seem That The Fair Value Method Allows Managers To Manipulate Income
y
Beca Use Investee dividends Are Recorded As Income By The Investor. However, Dividends
y
Paid Typically Are Accompanied By A Decrease In Fair Value (Also Recognized In Income), Thus
Leaving Reported Ne T Income Unaffected.
Does The Equity method really apply here?
y y y y
The Discussion In The Case Between The Two Accountants Is Limited To the Reason For The
y
Investmen T Acquisition And The Current Percentage Of Ownership. Instead, They Should Be
Examining The Actu Al Interaction That currently Exists Between The Two Companies. Although
y
The Ability To Exercise Sig Nificant 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
Author Ity (Paragraph 323-10-15-6):
Ability To exercise That Influence May Be Indicated In Several Ways, Such As Representation On
y
The B Oard Of Directors, Participation In Policy-Making Processes, Material Intra-
Entity Transactions, Interchange Of Managerial Personnel, Or Technological Dependency.
Another I Mportant 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
y
Stock Of An Investee Comp Any By Another Investor Does Not Necessarily Preclude The Ability
To exercise Significant Influence B Y The Investor.
y
In This Case, The Accountants Would Be Wise To Determine Whether Dennis Bostitch Or Any
Other Me Mber Of The Highland Laboratories Administration Is Participating In The management
y
Of Abraham, Inc. If Any Individual From Highland's Organization Is On Abraham‘S Board Of
Directors Or Is Participa Ting In Management Decisions, The Equity Method Would Seem To Be
Appropriate.
Likewise, If Significant transactions Have Occurred Between The Companies (Such As Loans By
y
Highl And 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
Highlan D, The Equity Method Should Not Be Applied. This Possibility Seems Especially Likely In
This Case Sinc E One Stockholder, James Abraham, Continues To hold A Majority (2/3) Of The
y
Voting Stock. Thus, Ev Idence of The Ability To Apply Significant influence Must Be Present
y y
Before The Equity Method Is View Ed As Applicable. The Mere Holding Of 1/3 Of The Stock Is
Not conclusive.
y
, 2-44
©Ymcgraw Hill Llc. All Rights Reserved. No Reproduction Or Distribution Without Theyprior Written Consent Of Mcgraw Hill Ll
,Solution Manual For All Chapters
Answers To Questions
1. Through Its Voting Rights Over An Investee, An Investor Firm Can Elect Members To
The Inv Estee‘S Board Of Directors And Thus Exercise Power Over The Strategic
Direction Of The Inv Estee 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
y
Significant In Fluence Over The operating And Financial Policies Of The Investee.
y
However, If The Investor C Ontrols The Investee, Consolidating The Financial Information
Of The Two Companies Will Norm Ally Be the appropriate Method For Reporting The
y y
Investment.
3. For Equity Securities Without Readily Determinable Fair Values, Asc 321 Allows The Cost
Method F Or The Investment Asset. The Investor Recognizes Dividend Income For Its Share
Of Investee Divid Ends Declared. Under The cost method, The Investment Account Remains
y y
At Cost Unless There Is
(A) A Demonstrable Impairment Or (B) Observable Price Changes For Identical Or Similar
Investm Ents 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
Representatio N On The Board Of Directors, Participation In Policy-Making Processes,
Material Intra-
Entity Transactions, Interchange Of Managerial Personnel, Or Technological Dependency.
Ano Ther Important Consideration Is The extent Of Ownership By An Investor In Relation To
y
The Exten T Of Ownership Of Other Shareholdings." The Most Objective Of The criteria
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Established By The Board Is That Holding (Either Directly Or Indirectly) 20 Percent Or
More Of The Outstanding Voti Ng Stock Is Presumed to Constitute The Ability To hold
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Significant Influence over The Decision- Making Process Of The Investee.
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5. Dividends Received From An Investee Reduce The Investment account. The Investor Does
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Not Rec Ord Such Dividends As Revenue, To Avoid Reporting The Income From The Investee
Twice. The Equi Ty Method Is Appropriate When An Investor Has The Ability To Exercise
Significant Influence Over T He Operating And Financing Decisions Of An Investee. Because
Dividends Represent Financing De Cisions, The Investor May Have The Ability To Influence
Dividend Timing. If Investors Recorded Divi Dends Received As Income, Managers Could
Affect Reported Income In A Way That does Not Refle Ct Actual Performance. Therefore, In
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Reflecting The Close Relationship Between The Investor And I Nvestee, 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 Investe E‘S Net Income
And Then Decreases The Investment Accounts As The Investee Distributes Its Net I Ncome
Through Dividends. From The Investor‘S View, The Decrease In The Investment Asset (Fro M
Investee Dividends) Is Offset By An Immediate Increase In Dividends Receivable And An
Event Ual Increase In Cash.
6. If Jones Cannot Significantly Influence The Operating And Financial Policies Of Sandridge,
The Eq Uity 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 Pre Sumption Stands Until Overcome By Predominant Evidence
To the Contrary.
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Examples Of Indications That An Investor May Be Unable To Exercise Significant Influence
Over T He Operating And Financial Policies Of An Investee Include (Asc 323-10-15-10):
a. Opposition By The Investee, Such As Litigation Or Complaints To Governmental
, Regulatory Authorities, Challenges The Investor's Ability To Exercise Significant
Influence.
b. The Investor And Investee Sign An Agreement Under Which The Investor Surrenders
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