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Chapter 02 - Reporting Intercorporate Interests
CHAPTER 2
ANSWERS TO QUESTIONS
Q2-1 (a) An investment in the voting common stock of another company is reported on an
equity-method basis when the investor is able to significantly influence the operating and
financial policies of the investee.
(b) The cost method normally is used for investments in common stock when the investor
does not have significant influence and for investments in preferred stock and other
securities. The amounts reported in the financial statements may require adjustment to fair
value if they fall under the provisions of FASB Statement No. 115.
Q2-2 Significant influence occurs when the investor has the ability to influence the operating
and financial policies of the investee. Representation on the board of directors of the
investee is perhaps the strongest evidence, but other evidence such as routine participation
in management decisions or entering into formal agreements that give the investor some
degree of influence over the investee also may be used.
Q2-3 Equity-method reporting should not be used when (a) an investee is in reorganization
or liquidation, (b) the investee has initiated litigation or complaints challenging the investor's
ability to exercise significant influence, (c) the investor signs an agreement surrendering its
ability to exercise significant influence, (d) majority ownership is concentrated in a small
group that operates the company without regard to the investor's desires, (e) the investor is
not able to acquire the information needed to use equity-method reporting, or (f) the investor
tries and fails to gain representation on the board of directors.
Q2-4 The balances will be the same at the date of acquisition and in the periods that follow
whenever the cumulative dividends paid by the investee equal or exceed the investee's
cumulative earnings since the date of acquisition. The latter case assumes there are no other
adjustments needed under the equity method for amortization of differential or other factors.
Q2-5 When a company has used the cost method and purchases additional shares which
cause it to gain significant influence, a retroactive adjustment is recorded to move from a
cost basis to an equity-method basis in the preceding periods. Dividend income is replaced
by income from the investee and dividends received are treated as an adjustment to the
investment account.
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Chapter 02 - Reporting Intercorporate Interests
Q2-7 Liquidating dividends decrease the investment account in both cases. All dividends
are treated as a reduction of the investment account when equity-method reporting is used.
When the cost method is used and dividends are received in excess of a proportionate share
of investee earnings since acquisition, they are treated as a reduction of the investment
account as well.
Q2-8 The carrying value of the investment is reduced under equity method reporting when
(a) a dividend is received from the investee, (b) a differential is amortized, (c) an impairment
of goodwill occurs, and (d) the market value of the investment declines and is less than the
carrying value and it is concluded the decline is other than temporary.
Q2-9 A corporate joint venture is a company that is established and operated by a small
group of investors, none of whom holds a majority of the ownership. Because there are only
a few owners and each investor normally is expected to have significant influence, equity-
method reporting generally is appropriate in accounting for ownership in a corporate joint
venture.
Q2-10 A differential occurs when an investor pays more than or less than underlying book
value in acquiring ownership of an investee.
(a) In the case of the cost method, no adjustments are made for amortization of the
differential on the investor's books.
(b) Under equity-method reporting the difference between the amount paid and book value
must be assigned to appropriate asset and liability accounts of the acquired company. If any
portion of the differential is assigned to an amortizable or depreciable asset, that amount
must be charged against income from the investee over the remaining economic life of the
asset.
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Chapter 02 - Reporting Intercorporate Interests
Q2-12 Amortization of a differential is the most common reason for investment income to be
lower than a proportionate share of reported income of the investee. If Turner Company has
paid more than book value for the shares of Straight Lace Company, the differential must be
assigned to identifiable assets and liabilities of the investee, or to goodwill. Those amounts
assigned to depreciable and identifiable intangible assets must be amortized and will reduce
equity-method income over the remaining economic lives of the underlying assets. Amounts
attributable to other items such as land or inventories must be treated as a reduction of
income in the period in which Straight Lace disposes of the item. Income also will be lower if
the investee has been involved in sales to related companies during the period and there are
unrealized profits from those intercompany sales; the income of the selling affiliate must be
reduced by the unrealized profits before equity-method income is computed. Finally, if
Straight Lace has preferred stock outstanding, preferred dividends must be deducted before
assigning earnings to common shareholders.
Q2-13 Dividends received by the investor are recorded as dividend income under both the
cost and fair value methods. The change in the fair value of the shares held by the investor is
recorded as an unrealized gain or loss under the fair value method. The fair value method
differs from the equity method in two respects. Under the equity method the investor’s share
of the earnings of the investee are included as investment income and dividends received
from the investee are treated as a reduction of the investment account.
Q2-14 The change in the fair value of the shares held by the investor is reported as an
unrealized gain or loss and dividends received from the investee are reported as dividend
income.
Q2-15 Clear-cut measures of control are not always readily available. For example, a
partner contributing a specified share of the partnership’s capital may have a different share
of profits or losses, a different proportion of distributions, or a greater or lesser degree of
control than indicated by the capital share.
Q2-16 There may be situations in which a company has significant influence over another
without holding voting common stock. For example, a company might use operating
agreements or other contracts to share in the profits of another company, guarantee a
certain level of profitability of another company, or participate in the operating decisions of
another company.
Q2-17* In general, tax allocation procedures should be used whenever there is a difference
between dividends received from the investee and the amount of investment income
recorded by the investor. Tax allocation is not needed if the companies file a joint tax return
or if the investee's earnings can be transferred to the investor in a tax-free transfer.
Q2-18* The amount should be larger under the equity method. There should be no need to
use tax allocation when the cost method is used in accounting for the investee. Dividends
received and taxable income are likely to be the same. Tax allocation normally is needed
under the equity method, due to the difference between income recorded and dividends
received.
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Chapter 02 - Reporting Intercorporate Interests
Q2-19* When the basic equity method is used, a proportionate share of subsidiary net
income and dividends is recorded on the parent's books and an appropriate amount of any
differential is amortized each period. No other adjustments are recorded. Under the fully-
adjusted equity method, the parent's books also are adjusted for unrealized profits and any
other items that are needed to bring the investor's net income into agreement with the
income to the controlling interest that would be reported if consolidation were used.
Q2-20* One-line consolidation implies that under equity-method reporting the investor's net
income and stockholders' equity will be the same as if the investee were consolidated.
Income from the investee is included in a single line in the investor's income statement and
the investment is reported as a single line in the investor's balance sheet.
Q2-21* The term basic equity method generally is used when the investor records its portion
of the reported net income and dividends of the investee and amortizes an appropriate
portion of any differential. Unlike the fully-adjusted equity method, no adjustment for
unrealized profit on intercompany transfers normally is made on the investor's books. When
an investee is consolidated for financial reporting purposes, the investor may not feel it is
necessary to record fully-adjusted equity method entries on its books since income from the
investee and the balance in the investment account must be eliminated in preparing the
consolidated statements.
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Chapter 02 - Reporting Intercorporate Interests
SOLUTIONS TO CASES
a. The equity method is to be used when an investor has significant influence over an
investee. Significant influence normally is assumed when more than 20 percent ownership is
held. Factors to be considered in determining whether to apply equity-method reporting
include the following:
1. Is the investee under the control of the courts or other parties as a result of filing for
reorganization or entering into liquidation procedures?
2. Does the investor have representation on the board of directors, or has it attempted
to gain representation and been unable to do so?
3. Has the investee initiated litigation or complaints challenging the investor's ability to
exercise significant influence?
4. Has the investor signed an agreement surrendering its ability to exercise significant
influence?
b. When subsidiary net income is greater than dividends paid, equity-method reporting is
likely to show a larger reported contribution to the earnings of Slanted Building Supplies. If
20X4 earnings are negative or less than dividends distributed in 20X4, the cost basis is likely
to result in a larger contribution to Slanted's reported earnings.
c. As the investor uses more of its resources to acquire ownership of the investee, and as
the investor has a greater share of the investee's profits and losses, the success of the
investee's operations may have more of an impact on the overall financial well-being of the
investor. In many cases, the investor will want to participate in key decisions of the investee
once the investor's ownership share reaches a certain level. Also, use of the equity method
eliminates the possibility of the investor manipulating its own income by influencing investee
dividend distributions, as might occur under the cost method.
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Chapter 02 - Reporting Intercorporate Interests
MEMO
From: , CPA
The equity method should be used in reporting investments in which the reporting company
has a significant influence over the operating and financing decisions of another company. In
this case, Most Company holds 15 percent of the voting common stock of Adams Company
and Port Company holds an additional 10 percent. During the course of the year, both Most
and Port are likely to use the cost method in recording their respective investments in
Adams. However, when consolidated statements are prepared for Most, the combined
ownership must be used in determining whether significant influence exists. Both direct and
indirect ownership must be taken into consideration. [APB 18, Par. 17]
A total of 15 percent of the voting common stock of Adams is held directly by Most Company
and an additional 10 percent is controlled indirectly though Most’s ownership of Port
Company. Equity-method reporting for the investment in Adams Company therefore appears
to be required.
If the cost method has been used by Most and Port in recording their investments during the
year, at the time consolidated statements are prepared, adjustments must be made to (a)
increase the balance in the investment account for a proportionate share of the investee’s
reported net income (25 percent) and reduce the balance in the investment account for a
proportionate share of the dividend paid by the investee, (b) include a proportionate share of
the investee’s net income in the consolidated income statement, (c) delete any dividend
income recorded by Most and Port, and (d) if ownership was purchased at an amount greater
than a proportionate share of the fair value of the investee’s net assets at the date of
purchase, it may be necessary to amortize a portion of the differential assigned to
depreciable or amortizable assets.
Primary citation
APB 18, par. 17
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Chapter 02 - Reporting Intercorporate Interests
MEMO
To: Controller
Forth Company
From: , CPA
This memo is prepared in response to your request regarding use of the cost or equity
methods in accounting for Forth’s investment in Brown Company.
Forth Company held 85 percent of the common stock of Brown Company prior to January 1,
20X2, and was required to fully consolidate Brown Company in its financial statements
prepared prior to that date [FASB 94]. Forth now holds only 15 percent of the common stock
of Brown. The cost method is normally used in accounting for ownership when less than 20
percent of the stock is directly or indirectly held by the investor.
Equity-method reporting should be used when the investor has ―significant influence over
operating and financing policies of the investee.‖ While 20 percent ownership is regarded as
the level at which the investor is presumed to have significant influence, other factors must
be considered as well. [APB 18, Par. 17]
Although Forth currently holds only 15 percent of Brown’s common stock, the other factors
associated with its ownership indicate that Forth does exercise significant influence over
Brown. Forth has two members on Brown’s board of directors, it purchases a substantial
portion of Brown’s output, and Forth appears to be the largest single shareholder by virtue of
its sale of 10,000 shares to each of 7 other investors.
These factors provide strong evidence that Forth has significant influence over Brown and
points to the need to use equity-method reporting for its investment in Brown. Your office
should monitor the activities of the FASB with respect to consolidation standards
[www.fasb.org]. Active consideration is being given to situations in which control may be
exercised even though the investor does not hold majority ownership. It is conceivable that
your situation might be one in which consolidation could be required.
Primary citations
APB 18, par. 17
FASB 94
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Chapter 02 - Reporting Intercorporate Interests
a. Atlas America is a corporation. Its operations involve the development, production, and
distribution of natural gas, and to a lesser extent, oil. It also offers tax-advantaged investment
programs for gas and oil investors.
b. The subsidiaries of Atlas America include corporations, limited liability companies (LLCs),
and both general and limited partnerships. The company fully consolidates its subsidiaries.
In accordance with industry practice, the company reflects its interests in energy partnerships
in its consolidated statements using pro rata consolidation.
f. Prior to 2004, Atlas America was a wholly owned subsidiary of Resource America, Inc. In
2004, Atlas America had an initial public offering of common stock, with the proceeds
distributed to Resource America. Subsequently, Resource America spun off Atlas America
by distributing its shares to its stockholders.
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Chapter 02 - Reporting Intercorporate Interests
a. Dow Chemical has well over 100 subsidiaries, as shown in its Form 10-K, Exhibit 21.
According to the company’s ―Principles of Consolidation and Basis of Presentation‖ in its 10-
K, Dow consolidates all majority-owned subsidiaries over which it has control and also
entities for which Dow has a controlling financial interest. Intercompany transactions and
balances are eliminated.
b. Dow reports investments in nonconsolidated affiliates using the equity method. It includes
joint ventures, partnerships, and companies that are 20 to 50 percent owned in the category
of nonconsolidated affiliates. Several of Dow’s nonconsolidated affiliates are 50-percent
owned and several are 49-percent owned. Excluding several special-situation investments,
the total differential was $65 million at December 31, 2006, and $61 million at December 31,
2005. The differentials relating to MEGlobal, Equipolymers, and EQUATE Petrochemical
were negative differentials resulting from a difference in valuations between U.S. and foreign
accounting principles.
c. The evaluation of Dow’s goodwill for impairment is performed in conjunction with the
company’s annual budgeting process.
d. Dow Chemical’s 50-percent investment in Dow Corning suffered a significant loss in value
judged to be other than temporary in 1995 when Dow Corning declared bankruptcy. As
discussed in Dow’s 2005 Form 10-K, the company wrote down the investment and
recognized a loss at the time of the bankruptcy.
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Chapter 02 - Reporting Intercorporate Interests
Answers to this case can be found in the annual reports to stockholders of the companies
mentioned and in their 10-K filings with the SEC (available at www.sec.gov).
a. Before 1998, Harley-Davidson reported its investment in the common stock of Buell
Motorcycle Company using the equity method. The 49 percent investment that Harley held
since 1993 gave it the ability to significantly influence Buell. In 1998, Harley purchased
substantially all remaining shares of Buell and, therefore, Harley fully consolidates Buell in its
general-purpose financial statements.
b. Chevron fully consolidates its controlled subsidiaries that are majority owned and variable
interest entities of which it is the primary beneficiary. The company uses pro rata
consolidation in reporting its undivided interests in oil and gas joint ventures. Chevron uses
the equity method to report its investments in affiliates over which the company exercises
significant influence or has an ownership interest of 20 to 50 percent. In applying the equity
method, Chevron recognizes in income gains and losses from changes in its proportionate
dollar share of an affiliate’s equity resulting from issuance of additional stock by the affiliate.
Chevron analyses any difference between the carrying value of an equity-method investment
and its underlying book value and, to the extent that it can, assigns that differential to specific
assets and liabilities. The company adjusts quarterly its equity-method income recognized
from affiliates for any write-off or amortization of the differential.
Chevron assesses it equity investments for possible impairment when events indicate a
possible impairment. If an investment has declined in value, the company evaluates the
situation to determine if the decline is other than temporary. If the decline in value is judged
to be other than temporary, the investment is written down to its fair value and a loss
recognized in income. Subsequent recoveries in value are not recognized.
Chevron owns approximately 19 percent (as of December 31, 2006) of Dynegy’s common
stock. It accounts for its investment using the equity method. The carrying amount of
Chevron’s investment in Dynegy’s common stock is less that its proportionate interest in
Dynegy’s net assets because the investment was written down in 2002 for a decline in value
that was judged to be other than temporary.
d. Sears has investments in the voting securities of a number of companies that it accounts
for using the equity method. Where these investments are reported is difficult to tell from the
financial statements and notes. Apparently the amounts involved are relatively small, and the
investments are included in other assets on the balance sheet, with the income reported in
other income on the income statement.
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Chapter 02 - Reporting Intercorporate Interests
SOLUTIONS TO EXERCISES
1. a
2. a
3. d
4. a
5. b
6. d
7. d
1. b
2. c
3. d
4. a
5. a
1. c
3. c
4. d
5. d
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Chapter 02 - Reporting Intercorporate Interests
Cash 1,000
Dividend Income 1,000
Record dividend income from Steam Company:
$5,000 x .20
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E2-4 (continued)
Cash 1,000
Investment in Steam Company Stock 1,000
Record dividend from Steam Company.
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Cash 12,000
Dividend Income 9,000
Investment in Valley Stock 3,000
Cash 12,000
Investment in Valley Stock 12,000
The following amounts would be reported as the carrying value of Port’s investment in Sund:
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Cash 7,000
Investment in Snow Corporation Stock 7,000
Record dividend from Snow Corporation:
$20,000 x .35
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Cash 6,000
Investment in Flair Company Stock 6,000
Record dividend from Flair Company:
$24,000 x .25
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Chapter 02 - Reporting Intercorporate Interests
Cash 2,400
Investment in Cook Company Stock 2,400
Record dividend from Cook Company:
$6,000 x .40
Cash 2,400
Dividend Income 2,400
Record dividend income from Cook Company.
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Chapter 02 - Reporting Intercorporate Interests
Assignment of differential
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Amortization of differential:
Purchase price $56,000
Proportionate share of book value of net assets
[.40($60,000 + $40,000)] (40,000)
Amount of differential $16,000
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a. Cost method:
b. Equity method:
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SOLUTIONS TO PROBLEMS
1. a
2. a
3. c
4. d
Computation of copyrights
Purchase price $120,000
Fair value of Krown's:
Total assets $560,000
Total liabilities (250,000)
$310,000
Proportion of stock held by Ball x .30 (93,000)
Amount assigned to copyrights $ 27,000
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Assignment of differential
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Amortization of differential
20X6 purchase [$25,000 - ($200,000 x .10)]
5 years $1,000
20X8 purchase [$15,000 - ($300,000 x .05)] 0
20X9 purchase [$70,000 - ($350,000 x .20)] 0
Total annual amortization $1,000
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P2-33 (continued)
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Cash 12,000
Investment in Blair Corporation Stock 12,000
Record dividend from Blair:
$30,000 x .40
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Chapter 02 - Reporting Intercorporate Interests
b. Equity method:
Investment income:
$40,000 x .20 $ 8,000
$35,000 x .20 $ 7,000
$60,000 x .20 $12,000
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Dale Company
Retained Investment
Earnings 20X4 Balance
Item 1/1/20X4 Income 12/31/20X4
Adjustment to remove dividends
included in investment income and not
removed from investment account $(14,000) $(10,000) $(24,000)
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Chapter 02 - Reporting Intercorporate Interests
a.
Diversified Products Corporation
Income Statement
Year Ended December 31, 20X8
(1) The Retained Earnings balance on January 1, 20X8, has been reduced by the
$20,000 cumulative adjustment for change in inventory method on January 1, 20X8.
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Chapter 02 - Reporting Intercorporate Interests
P2-40* (continued)
b.
Wealthy Manufacturing Company
Income Statement
Year Ended December 31, 20X8
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P2-42* (continued)
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