CHAPTER 1 THE EQUITY METHOD OF ACCOUNTING FOR INVESTMENTS

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CHAPTER 1
   THE EQUITY METHOD OF ACCOUNTING FOR INVESTMENTS

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

McGraw-Hill/Irwin                                              The McGraw-Hill Companies, Inc., 2009
Hoyle, Schaefer, Doupnik, Advanced Accounting, 9/e                                                1-1
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.

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,

McGraw-Hill/Irwin                                               The McGraw-Hill Companies, Inc., 2009
1-2                                                                                 Solutions Manual
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
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.

2. 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.

3. 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.

4. 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:
    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
        significant rights as a shareholder.


McGraw-Hill/Irwin                                               The McGraw-Hill Companies, Inc., 2009
Hoyle, Schaefer, Doupnik, Advanced Accounting, 9/e                                                 1-3
   c. 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.
   d. The investor needs or wants more financial information to apply the equity method than is
      available to the investee's other shareholders (for example, the investor wants quarterly
      financial information from an investee that publicly reports only annually), tries to obtain
      that information, and fails.
   e. The investor tries and fails to obtain representation on the investee's board of directors."

5. The following events necessitate changes in this investment account.
   a. Net income earned by Watts would be reflected by an increase in the investment balance
      whereas a reported loss is shown as a reduction to that same account.
   b. Dividends paid by the investee decrease its book value, thus requiring a corresponding
      reduction to be recorded in the investment balance.
   c. If, in the initial acquisition price, Smith paid extra amounts because specific investee
      assets and liabilities had values differing from their book values, amortization of this
      portion of the investment account is subsequently required. As an exception, if the specific
      asset is land or goodwill, amortization is not appropriate.
   d. Intercompany gains created by sales between the investor and the investee must be
      deferred until earned through usage or resale to outside parties. The initial deferral entry
      made by the investor reduces the investment balance while the eventual recognition of the
      gain increases this account.

6. The equity method has been criticized because it allows the investor to recognize income that
   may not be received in any usable form during the foreseeable future. Income is being
   accrued based on the investee's reported earnings not on the dividends collected by the
   investor. Frequently, equity income will exceed the cash dividends received by the investor
   with no assurance that the difference will ever be forthcoming.

   Many companies have contractual provisions (e.g., debt covenants, managerial compensation
   agreements) based on ratios in the main body of the financial statements. Relative to
   consolidation, a firm employing the equity method will report smaller values for assets and
   liabilities. Consequently, higher rates of return for its assets and sales, as well as lower debt-
   to-equity ratios may result. Meeting the provisions of such contracts may provide managers
   strong incentives to maintain technical eligibility to use the equity method rather than full
   consolidation.

7. APB Opinion 18 requires that a change to the equity method be reflected by a retrospective
   adjustment. Although a different method may have been appropriate for the original
   investment, comparable balances will not be readily apparent if the equity method is now
   applied. For this reason, financial figures from all previous years are restated as if the equity
   method had been applied consistently since the date of initial acquisition.

8. In reporting equity earnings for the current year, Riggins must separate its accrual into two
   income components: (1) operating income and (2) extraordinary gain. This handling enables
   the reader of the investor's financial statements to assess the nature of the earnings that are
   being reported. As a prerequisite, any unusual and infrequent item recognized by the investee
   must also be judged as material to the operations of Riggins for separate disclosure by the
   investor to be necessary.



McGraw-Hill/Irwin                                              The McGraw-Hill Companies, Inc., 2009
1-4                                                                                Solutions Manual
9. Under the equity method, losses are recognized by an investor at the time that they are
   reported by the investee. However, because of the conservatism inherent in accounting, any
   permanent losses in value should also be recorded immediately. Because the investee's stock
   has suffered a permanent impairment in this question, the investor recognizes the loss
   applicable to its investment.

10. Following the guidelines established by the Accounting Principles Board, Wilson would be
    expected to recognize an equity loss of $120,000 (40 percent) stemming from Andrews'
    reported loss. However, since the book value of this investment is only $100,000, Wilson's
    loss is limited to that amount with the remaining $20,000 being omitted. Subsequent income
    will be recorded by the investor based on the dividends received. If Andrews is ever able to
    generate sufficient future profits to offset the total unrecognized losses, the investor will revert
    to the equity method.

11. In accounting, goodwill is derived as a residual figure. It refers to the investor's cost in excess
    of the fair market value of the underlying assets and liabilities of the investee. Goodwill is
    computed by first determining the amount of the purchase price that equates to the acquired
    portion of the investee's book value. Payments attributable to increases and decreases in the
    market value of specific assets or liabilities are then determined. If the price paid by the
    investor exceeds both the corresponding book value and the amounts assignable to specific
    accounts, the remainder is presumed to represent goodwill. Although a portion of the
    acquisition price may represent either goodwill or valuation adjustments to specific investee
    assets and liabilities, the investor records the entire cost in a single investment account. No
    separate identification of the cost components is made in the reporting process.
    Subsequently, the cost figures attributed to specific accounts (having a limited life), besides
    goodwill and other indefinite life assets, are amortized based on their anticipated lives. This
    amortization reduces the investment and the accrued income in future years.

12. On June 19, Princeton removes the portion of this investment account that has been sold and
    recognizes the resulting gain or loss. For proper valuation purposes, the equity method is
    applied (based on the 40 percent ownership) from the beginning of Princeton's fiscal year
    until June 19. Princeton's method of accounting for any remaining shares after June 19 will
    depend upon the degree of influence that is retained. If Princeton still has the ability to
    significantly influence the operating and financial policies of Yale, the equity method continues
    to be appropriate based on the reduced percentage of ownership. Conversely, if Princeton no
    longer holds this ability, the market-value method becomes applicable.

13. Downstream sales are made by the investor to the investee while upstream sales are from the
    investee to the investor. These titles have been derived from the traditional positions given to
    the two parties when presented on an organization-type chart. Under the equity method, no
    accounting distinction is actually drawn between downstream and upstream sales. Separate
    presentation is made in this chapter only because the distinction does become significant in
    the consolidation process as will be demonstrated in Chapter Five.

14. The unrealized portion of an intercompany gain is computed based on the markup on any
    transferred inventory retained by the buyer at year's end. The markup percentage (based on
    sales price) multiplied by the intercompany ending inventory gives the total profit. The product
    of the ownership percentage and this profit figure is the unrealized gain from the
    intercompany transaction. This gain is deferred in the recognition of equity earnings until
    subsequently earned through use or resale to an unrelated party.

McGraw-Hill/Irwin                                                 The McGraw-Hill Companies, Inc., 2009
Hoyle, Schaefer, Doupnik, Advanced Accounting, 9/e                                                   1-5
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