Advanced Accounting
5th Edition
By Patrick E. Hopkins
Solutions Manual
Chapter 1— Accounting for Intercorporate Investments
1. a. If the investor acquired 100% of the investee at book value, the Equity Investment
account is equal to the Stockholders’ Equity of the investee company. It, therefore,
includes the assets and liabilities of the investee company in one account. The
investor’s balance sheet, therefore, includes the Stockholders’ Equity of the investee
company, and, implicitly, its assets and liabilities. In the consolidation process, the
balance sheets of the investor and investee company are brought together.
Consolidated Stockholders’ Equity will be the same as that which the investor
currently reports; only total assets and total liabilities will change.
b. If the investor owns 100% of the investee, the equity income that the investor reports
is equal to the net income of the investee, thus implicitly including its revenues and
expenses. Replacing the equity income with the revenues and expenses of the
investee company in the consolidation process will yield the same net income.
2. FASB ASC 323-10 provides the following guidance with respect to the accounting for
receipt of dividends using the equity method:
The equity method tends to be most appropriate if an investment enables the
investor to influence the operating or financial decisions of the investee. The
investor then has a degree of responsibility for the return on its investment, and
it is appropriate to include in the results of operations of the investor its share of
the earnings or losses of the investee. (¶323-10-05-5)
The equity method is an appropriate means of recognizing increases or decreases
measured by generally accepted accounting principles (GAAP) in the economic resources
underlying the investments. Furthermore, the equity method of accounting more closely
meets the objectives of accrual accounting than does the cost method because the
investor recognizes its share of the earnings and losses of the investee in the periods in
which they are reflected in the accounts of the investee. (¶323-10-05-4)
Under the equity method, an investor shall recognize its share of the earnings or losses
of an investee in the periods for which they are reported by the investee in its financial
statements rather than in the period in which an investee declares a dividend (¶323-10-
35-4).
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,3. The recognition of equity income does not mean that cash has been received. In fact,
dividends paid by the investee to the investor are typically a small percentage of its
reported net income. The projection of future net income that includes equity income as
a significant component might not, therefore, imply significant generation of cash.
4. The accounting for Altria’s investment in ABI depends on the degree of influence or
control it can exert over that company. A classification of “no influence” does not appear
appropriate since Altria owns 10.1% of the outstanding common stock and also “active
representation on ABI’s Board of Directors (“ABI Board”) and certain ABI Board
committees. Through this representation, Altria participates in ABI policy making
processes.” A classification of “significant influence” seems most appropriate given the
facts, and this classification warrants accounting for the investment using the equity
method of accounting.
5. a. An investor may write down the carrying amount of its Equity Investment if the fair
value of that investment has declined below its carrying value and that decline is
deemed to be other than temporary.
b. There is considerable judgment in determining whether a decline in fair value is other
than temporary. The write-down amounts to a prediction that the future fair value of
the investment will not rise above the current carrying amount. If a company deems
the decline to be temporary, it does not write down the investment, and a loss is not
recognized in its income statement. If the decline is deemed to be other than
temporary, the investment is written down and a loss is reported. Companies can use
this flexibility to decide whether to recognize a loss in the current year or to postpone
it to a future year.
6. Under the equity method, an investor recognizes its share of the earnings or losses of an
investee in the periods for which they are reported by the investee in its financial
statements. FASB ASC 323-10-35-7 states that “Intra-entity profits and losses shall be
eliminated until realized by the investor or investee as if the investee were consolidated.”
These intercompany items are eliminated to avoid double counting and prematurely
recognizing income.
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,7. FASB ASC 323-10-15 requires the use of the equity method of accounting for an investor
whose investment in voting stock gives it the ability to exercise significant influence over
operating and financial policies of an investee. Section 15-6 states that “Ability to exercise
significant influence over operating and financial policies of an investee may be indicated
in several ways, including the following: Representation on the board of directors,
Participation in policy-making processes, Material intra-entity transactions, change of
managerial personnel, Technological dependency, and Extent of ownership by an investor
in relation to the concentration of other shareholdings (but substantial or majority
ownership of the voting stock of an investee by another investor does not necessarily
preclude the ability to exercise significant influence by the investor)” (emphasis added).
It is clear, in this case, that the investee is critically dependent upon the technology
licensed to it by the investor. The investor should, therefore, account for its investment
using the equity method.
8. Even though the investor owns 30% of the investee, it should not use the equity method
as it cannot exert significant influence over the investee. Further, since the investee is not
a public company (all of the remaining stock is privately held), the investor should use the
cost method to account for this investment as the fair value method presumes a publicly
traded stock with sufficient liquidity to reasonably determine a fair value.
9. a. The losses did not affect Enron’s income statement. Since the investees were
insolvent, Enron’s Equity Investment was reduced to zero (it had not made any loans
or other advances to the investee companies). As a result, Enron discontinued
reporting for these Equity Investments using the equity method and, therefore, did
not recognize its proportionate share of investee losses.
b. “… only after its share of that net income equals the share of net losses not recognized
during the period the equity method was suspended” means that the investee has
recouped all of the losses that have been reported. Since the investor ceases to
account for its Equity Investment using the equity method once the balance reaches
zero (assuming that it has not guaranteed the debts of the investee company), this
generally implies that the investee’s Stockholders’ Equity is below zero (i.e., a deficit).
The investor resumes its accounting for the Equity investment using the equity
method once the investee’s Stockholders’ Equity is positive. It is at that point when
the investee company has recouped all of its prior losses (assuming that the investee
company has not raised additional equity capital).
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, 10. FASB ASC 323 provides the following list of required disclosures for equity method
investments:
a. (1) the name of each investee and percentage of ownership of common stock, (2) the
accounting policies of the investor with respect to investments in common stock, and
(3) the difference, if any, between the amount at which an investment is carried and
the amount of underlying equity in net assets and the accounting treatment of the
difference.
b. For those investments in common stock for which a quoted market price is available,
the aggregate value of each identified investment based on the quoted market price
usually should be disclosed. This disclosure is not required for investments in common
stock of subsidiaries.
c. When investments in common stock of corporate joint ventures or other investments
accounted for under the equity method are, in the aggregate, material in relation to
the financial position or results of operations of an investor, it may be necessary for
summarized information as to assets, liabilities, and results of operations of the
investees to be presented in the notes or in separate statements, either individually
or in groups, as appropriate.
d. Conversion of outstanding convertible securities, exercise of outstanding options and
warrants and other contingent issuances of an investee may have a significant effect
on an investor's share of reported earnings or losses. Accordingly, material effects of
possible conversions, exercises or contingent issuances should be disclosed in notes
to the financial statements of an investor.
11. Answer: b
The fact that the investor has a 20% voting interest, representation on the investee’s
board of directors, participates in the investee’s policy making process and has material
business transactions with the investee all suggest that the investor has “significant
influence” over the investee. In the case of significant influence, the investor must use
the equity method of accounting for the investee. Under the equity method, the investee
recognizes as income a proportionate share of the net income recognized by the investee.
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