Solution Manual Advanced Accounting 9th edition by Hoyle

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Solution Manual Advanced Accounting 9th edition by Hoyle

CHAPTER 1 THE EQUITY METHOD OF ACCOUNTING FOR INVESTMENTS

Chapter Outline

1. Three methods are principally used to account for an investment in equity securities.

1. 1. Fair-value method: applied by an investor when only a small percentage of a company’s voting stock is held.

1. 1. 1. Income is recognized when dividends are declared.

1. 1. 1. Portfolios are reported at market value. If market values are unavailable, investment is reported at cost.

1. 1. Consolidation: when one firm controls another (e.g., when a parent has a majority interest in the voting stock of a subsidiary or control through variable interests (FIN 46R), their financial statements are consolidated and reported for the combined entity.

1. 1. Equity method: applied when the investor has the ability to exercise significant influence over operating and financial policies of the investee.

1. 1. 1. Ability to significantly influence investee is indicated by several factors including representation on the board of directors, participation in policy-making, etc.

1. 1. 1. According to a guideline established by the Accounting Principles Board, the equity method is presumed to be applicable if 20 to 50 percent of the outstanding voting stock of the investee is held by the investor. SFAS 159, The Fair Value Option for Financial Assets and Financial Liabilities (effective 2008) allows firms to elect to use fair value

1. Accounting for an investment: the equity method

1. 1. The investment account is adjusted by the investor to reflect all changes in the equity of the investee company.

1. 1. Income is accrued by the investor as soon as it is earned by the investee.

1. 1. Dividends declared by the investee create a reduction in the carrying amount of the Investment account.

1. Special accounting procedures used in the application of the equity method

1. 1. Reporting a change to the equity method when the ability to significantly influence an investee is achieved through a series of acquisitions.

1. 1. 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.

1. 1. 1. At the point in time that the equity method becomes applicable, a retroactive adjustment is made by the investor to convert all previously reported figures to the equity method based on percentage of shares owned in those periods.

1. 1. 1. This restatement establishes comparability between the financial statements of all years.

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1. Investee income from other than continuing operations

1. 1. Income items such as extraordinary gains and losses and prior period adjustments that are reported separately by the investee should be shown in the same manner by the investor.

1. 1. The materiality of this income element (as it affects the investor) continues to be a criterion for this separate disclosure.

1. Investee losses

1. 1. Losses reported by the investee create corresponding losses for the investor.

1. 1. A permanent decline in the market value of an investee’s stock should also be recognized immediately by the investor.

1. 1. Investee losses can possibly reduce the carrying value of the investment account to a zero balance. At that point, the equity method ceases to be applicable and the fair-value method is subsequently used.

1. Reporting the sale of an equity investment

1. 1. The equity method is consistently applied until the date of disposal to establish the proper book value.

1. 1. 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 the investee.

If that ability has been lost, the fair-value method is subsequently used.

IV. Excess cost of investment over book value acquired

1. 1. The price paid by an investor for equity securities can vary significantly from the underlying book value of the investee company primarily because the historical cost based accounting model does not keep track of changes in a firm’s market value.

B. Payments made in excess of underlying book value can sometimes be identified with specific investee accounts such as inventory or equipment.

1. 1. 1. An extra acquisition price can also be assigned to anticipated benefits that are expected to be derived from the investment. For accounting purposes, these amounts are presumed to reflect an intangible asset referred to as goodwill. Goodwill is calculated as any excess payment that is not attributable to specific accounts. For the year 2002 and beyond, goodwill is no longer amortized.

V.Deferral of unrealized gains in inventory

A. Gains derived from intercompany transactions are not considered completely earned until the transferred goods are either consumed or resold to unrelated parties.

B.  Downstream sales of inventory

1. 1. 1. 1. “Downstream” refers to transfers made by the investor to the investee.

1. 1. 1. 1. Intercompany gains from sales are initially deferred under the equity method and then recognized as income at the time of the inventory’s eventual disposal.

1. 1. 1. 1. The amount of gain to be deferred is the investor’s ownership percentage multiplied by the markup on the merchandise remaining at the end of the year.

C.  Upstream sales of inventory

1. 1. 1. 1. “Upstream” refers to transfers made by the investee to the investor.

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1. Under the equity method, the deferral process for unrealized gains is identical for upstream and downstream transfers. The procedures are separately identified in Chapter One because the handling does vary within the consolidation process.

Learning Objectives

Having completed Chapter One, “The Equity Method of Accounting for Investments,” students should be able to fulfill each of the following learning objectives:

1. Identify the sole criterion for applying the equity method of accounting.

1. Understand the purpose of the 20 to 50 percent guideline as it is to be used by an investor.

1. Prepare the basic equity method journal entries for an investor.

1. Discuss the theoretical problems associated with an investor’s accrual of equity income where no asset has yet been received from the investment and may not be received in the foreseeable future.

1. Understand the appropriate means of recording a change from the market-value method to the equity method and the rationale for this handling.

1. Identify the proper reporting to be used in applying the equity method when an investee is disclosing items such as extraordinary gains and losses or prior period adjustments.

1. Know that any permanent decline in the fair market value of an investee’s stock must be immediately reflected in the financial records of the investor.

1. Record the sale of an equity investment and identify the accounting method to be applied to any remaining shares that are subsequently held.

1. Allocate the price paid to purchase an investment so that a determination can be made of amounts attributed to specific investee accounts and/or goodwill.

1. Compute the annual amortization to be recognized on any excess payments made by the investor and prepare the journal entry to record this expense.

1. Understand the rationale for deferring unrealized gains on intercompany transfers until the time period in which the goods are either consumed or sold to outside parties.

1. Compute the amount of an intercompany gain that is considered to be unrealized and make the journal entries to first defer the gain and then recognize it in the appropriate time period.

1. Identify the difference between upstream and downstream transfers.

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Answers to Discussion Questions

Discussion questions are included within this textbook to stimulate student thought and discussion. These questions are also designed to force the students to consider relevant issues that might otherwise be overlooked. Some of these questions may be addressed by the instructor in class to provide an outlet for student discussion. Students should be encouraged to begin by defining the actual problem or problems in each case. Next, official accounting pronouncements or other relevant literature can be consulted as a preliminary step in arriving at logical actions. Many times, a careful reading of the statements created by the FASB, GASB, APB, etc., will provide authoritative answers.

Unfortunately, in accounting, definitive resolutions to financial reporting questions are not always available. Students often seem to believe that all accounting issues have been resolved in the past so that accounting education is only a matter of learning to apply historically prescribed procedures. However, in actual practice, the only real answer is often the one that provides the fairest representation of the transactions being recorded. If an authoritative solution is not available, students should be directed to list all of the issues involved and the consequences of possible alternative actions. The various factors being presented should then be weighed as a means of producing a viable solution.

These discussion questions have been produced so that students must use research skills as well as their own reasoning to derive resolutions for a variety of issues that go beyond the purely mechanical elements of accounting.

Does the Equity Method Really Apply Here?

The discussion presented in the case between the two accountants is limited to the reason for the investment acquisition and the current percentage of ownership. Instead, they should be examining the actual interaction that currently exists between the two companies. Although the ability to exercise significant influence over operating and financial policies appears to be a rather vague criterion, APB Opinion 18, “The Equity Method of Accounting for Investments in Common Stock,” clearly specifies actual events that indicate this level of authority (paragraph

17):

Ability to exercise that influence may be indicated in several ways, such as representation on the board of directors, participation in policy-making processes, material intercompany transactions, interchange of managerial personnel, or technological dependency. Another important 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 stock of an investee company by another investor does not necessarily preclude the ability to exercise significant influence by the investor.

In this case, the accountants would be wise to determine whether Dennis Bostitch or any other member of the Highland Laboratories administration is participating in the management of Abraham, Inc. If any individual from Highland’s organization is on the board of directors of Abraham or is participating in management decisions, the equity method would seem to be appropriate. Likewise, if significant transactions have occurred between the companies (such as loans by Highland to Abraham), the ability to apply significant influence becomes much more evident.

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However, if James Abraham continues to operate Abraham, Inc., with little or no regard for Highland, the equity method should not be applied. This possibility seems especially likely in this case since James Abraham continues to hold a majority (2/3) of the voting stock. Thus, evidence of the ability to apply significant influence must be present before the equity method is viewed as applicable. The mere holding of 1/3 of the stock is not conclusive.

Is this Really only Significant Influence?

This case introduces students to an area of controversy at the present time: the distinction between the ability to exercise significant influence and actual control over a subsidiary. Accounting Research Bulletin No. 51, “Consolidated Financial Statements,” states in paragraph 2, “The usual condition for a controlling financial interest is ownership of a majority voting interest, and, therefore, as a general rule ownership by one company, directly or indirectly, of over 50 percent of the outstanding voting shares of another company is a condition pointing toward consolidation.” Companies have come to use this rule as a method for omitting some subsidiaries from consolidation. For example, joint ventures are created with two companies each owning exactly 50 percent of a third. Or, as in the case of the Coca-Cola Company and Coca-Cola Enterprises, the number of owned shares is below 50 percent. Thus, the equity method is used by the investor to account for the investment rather than consolidation.

The equity method and consolidation do not create different reported incomes for the parent company. However, under the equity method, instead of adding the revenues and expenses of the subsidiary to the parent company, a single equity income figure is included. In addition, the individual assets and liabilities of the subsidiary are also ignored in reporting the parent company’s financial position. According to the equity method, only an “Investment in Subsidiary” asset account is shown. Quite frequently, the opportunity to omit the subsidiary’s liabilities from the parent’s balance sheet is a strong incentive for this approach, a tactic often referred to as ”off-balance sheet financing.”

In the past, discussions concerning the wisdom of consolidation have tended to center on the exclusion of subsidiaries where over 50 percent of voting shares were held. Now, the reverse situation is being investigated: Is 50 percent ownership absolutely necessary for control (and, thus, consolidation)? Because of the dependency of Coca-Cola Enterprises on the Coca-Cola Company (as demonstrated by the amount of intercompany revenue), is control not present here despite the ownership of only 36 percent of the stock? If control has actually been established, does a single equity income figure recognized by the Coca-Cola Company as well as one “Investment in Subsidiary” account adequately reflect the relationship between these two companies? Chances seem likely that the FASB will eventually require the consolidation of less-than-majority-owned subsidiaries if the parent has rights, risks, and benefits equivalent to those of a majority ownership (see Chapter Two).

The instructor may want to take a class vote as to the best method for reporting Coca-Cola Enterprises within the Coca-Cola Company. If students opt to leave the rule at 50 percent, they should be asked to develop footnote disclosure information that will adequately reflect the relationship. They should also be asked if they truly believe the resulting financial statements are a fair representation of the financial reality. Conversely, if they decide to change the rule, they should be required to produce new guidelines. The problem then for the students is to develop workable rules to indicate the presence of control that might be used instead of pure ownership interest. For example, how should intercompany revenues and loans be factored

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into this decision? Or, how does marketing dependency influence the decision as to control (advertisements for the Coca-Cola Company clearly benefit Coca-Cola Enterprises)? Students will probably come to the conclusion that definitive guidelines are not always easily derived in the complex world of financial reporting. This lesson indicates the difficulty that groups such as the FASB and the GASB encounter and the reason why many official pronouncements are so lengthy and complicated.

Answers to Questions

1. The equity method should be applied if the ability to exercise significant influence over the operating and financial policies of the investee has been achieved by the investor. However, if actual control has been established, consolidating the financial information of the two companies will normally be the appropriate method for reporting the investment.

1. According to Paragraph 17 of APB Opinion 18, “Ability to exercise that influence may be indicated in several ways, such as representation on the board of directors, participation in policy-making processes, material intercompany transactions, interchange of managerial personnel, or technological dependency. Another important consideration is the extent of ownership by an investor in relation to the extent of ownership of other shareholdings.” The most objective of the criteria established by the Board is that holding (either directly or indirectly) 20 percent or more of the outstanding voting stock is presumed to constitute the ability to hold significant influence over the decision-making process of the investee.

1. The equity method is appropriate when an investor has the ability to exercise significant influence over the operating and financing decisions of an investee. Because dividends represent financing decisions, the investor may have the ability to influence the timing of the dividend. If dividends were recorded as income (cash basis of income recognition), managers could affect reported income in a way that does not reflect actual performance. Therefore, in reflecting the close relationship between the investor and investee, the equity method employs accrual accounting to record income as it is earned by the investee. The investment account is increased for the investee earned income and then appropriately decreased as the income is distributed. From the investor’s view, the decrease in the investment asset is offset by an increase in the asset cash.

1. If Jones does not have the ability to significantly influence the operating and financial policies of Sandridge, the equity method should not be applied regardless of the level of ownership. However, an owner of 25 percent of a company’s outstanding voting stock is assumed to possess this ability. FASB Interpretation 35 states that this presumption “. . . stands until overcome by predominant evidence to the contrary.”

“Examples of indications that an investor may be unable to exercise significant influence over the operating and financial policies of an investee include:

1. 1. Opposition by the investee, such as litigation or complaints to governmental regulatory authorities, challenges the investor’s ability to exercise significant influence.

1. 1. The investor and investee sign an agreement under which the investor surrenders significant rights as a shareholder.

1. 1. Majority ownership of the investee is concentrated among a small group of shareholders who operate the investee without regard to the views of the investor.