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Chapter 2
STOCK INVESTMENTS — INVESTOR ACCOUNTING AND REPORTING
Answers to Questions
1 Only the investor’s accounts are affected when outstanding stock is acquired from existing stockholders. The
investor records the investment at its cost. Since the investee company is not a party to the transaction, its
accounts are not affected.
Both investor and investee accounts are affected when unissued stock is acquired directly from the
investee. The investor records the investment at its cost and the investee adjusts its asset and owners’ equity
accounts to reflect the issuance of previously unissued stock.
2 Goodwill arising from an equity investment of 20 percent or more is not recorded separately from the
investment account. Under the equity method, the investment is presented on one line of the balance sheet in
accordance with the one-line consolidation concept.
3 Dividends received from earnings accumulated before an investment is acquired are treated as decreases in
the investment account balance under the fair value/cost method. Such dividends are considered a return of
a part of the original investment.
4 The equity method of accounting for investments increases the investment account for the investor’s share
of the investee’s income and decreases it for the investor’s share of the investee’s losses and for dividends
received from the investee. In addition, the investment and investment income accounts are adjusted for
amortization of any investment cost-book value differentials related to the interest acquired. Adjustments to
the investment and investment income accounts are also needed for unrealized profits and losses from
transactions between the investor and investee companies. A fair value adjustment is optional under SFAS
No. 159.
5 The equity method is referred to as a one-line consolidation because the investment account is reported on
one line of the investor’s balance sheet and investment income is reported on one line of the investor’s income
statement (except when the investee has discontinued operations). In addition, the investment income is
computed such that the parent company’s income and stockholders’ equity are equal to the consolidated net
income and consolidated stockholders’ equity that would result if the statements of the investor and investee
were consolidated.
6 If the equity method is applied correctly, the income of the parent company will generally equal the
controlling interest share of consolidated net income.
7 The difference in the equity method and consolidation lies in the detail reported, but not in the amount of
income reported. The equity method reports investment income on one line of the income statement whereas
the details of revenues and expenses are reported in a consolidated income statement.
8 The investment account balance of the investor will equal underlying book value of the investee if (a) the
equity method is correctly applied, (b) the investment was acquired at book value which was equal to fair
value, the pooling method was used, or the cost-book value differentials have all been amortized, and (c)
there have been no intercompany transactions between the affiliated companies that have created investment
account-book value differences.
9 The investment account balance must be converted from the cost to the equity method when acquisitions
increase the interest held to 20 percent or more. The amount of the adjustment is the difference between the
investment income reported under the cost method in prior years and the income that would have been
reported if the equity method of accounting had been used. Changes from the cost to the equity method of
accounting for equity investments are changes in the reporting entity that require restatement of prior years’
financial statements when the effect is material.
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2-1
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2-2 Stock Investments — Investor Accounting and Reporting
10 The one-line consolidation is adjusted when the investee’s income includes gains or losses from discontinued
operations. In this case, the investor’s share of the investee’s ordinary income is reported as investment
income under a one-line consolidation, but the investor’s share of gains and losses from discontinued
operations is combined with similar items of the investor.
11 The remaining 15 percent interest in the investee is accounted for under the fair value/cost method, and the
investment account balance immediately after the sale becomes the new cost basis.
12 Yes. When an investee has preferred stock in its capital structure, the investor has to allocate the investee’s
income to preferred and common stockholders. Then, the investor takes up its share of the investee’s income
allocated to common stockholders in applying the equity method. The allocation is not necessary when the
investee has only common stock outstanding.
13 Goodwill impairment losses are calculated by business reporting units. For each reporting unit, the company
must first determine the fair values of the net assets. The fair value of the reporting unit is the amount at
which it could be purchased in a current market transaction. This may be based on market prices, discounted
cash flow analyses, or similar current transactions. This is done in the same manner as is done to originally
record a combination. The first step requires a comparison of the carrying value and fair value of all the net
assets at the business reporting level. If the fair value exceeds the carrying value, goodwill is not impaired
and no further tests are needed. If the carrying value exceeds the fair value, then we proceed to step two. In
step two, we calculate the implied value of goodwill. Any excess measured fair value over the net identifiable
assets is the implied fair value of goodwill. The company then compares the goodwill’s implied fair value
estimate to the carrying value of goodwill to determine if there has been an impairment during the period.
14 Yes. Impairment losses for subsidiaries are computed as outlined in the solution to question 13. Companies
compare fair values to book values for equity method investments as a whole. Firms may recognize
impairments for equity method investments as a whole, but perform no separate goodwill impairment tests.
SOLUTIONS TO EXERCISES
Solution E2-1
1 d
2 c
3 c
4 d
5 b
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Chapter 2 2-3
Solution E2-2 [AICPA adapted]
1 d
2 b
3 d
4 b
Pop’s investment is reported at its $600,000 cost because the equity
method is not appropriate and because Pop’s share of Son’s income
exceeds dividends received since acquisition [($520,000 × 15%) >
$40,000].
5 c
Dividends received from Sun for the two years were $10,500 ($70,000 ×
15% - all in 2017), but only $9,000 (15% of Sun’s income of $60,000 for
the two years) can be shown on Pam’s income statement as dividend
income from the Sun investment. The remaining $1,500 reduces the
investment account balance.
6 c
[$100,000 + $300,000 + ($600,000 × 10%)]
7 a
8 d
Investment balance January 2 $250,000
Add: Income from Sun ($100,000 × 30%) 30,000
Investment in Sun December 31 $280,000
Solution E2-3
1 Pop’s percentage ownership in Son
Pop’s 20,000 shares/(60,000 + 20,000) shares = 25%
2 Goodwill
Investment cost $500,000
Book value ($1,000,000 + $500,000) × 25% (375,000)
Goodwill $125,000
Solution E2-4
Income from Sun for 2016
Share of Sun’s income ($100,000 × 1/2 year × 30%) $ 15,000
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