1-1 . Solution Manual for Advanced Accounting, 14th Edition, Joe Ben Hoyle, Thomas Schaefer, Timothy Doupnik, ISBN10: 1260247821, ISBN13: 9781260247824 1-2 Chapter Outline I. Four methods are principally used to account for an investment in equity securities along with a fair value option. A. Fair value method: applied by an investor when only a small percentage of a company’s voting stock is held. 1. The investor recognizes income when the investee declares a dividend. 2. Portfolios are reported at fair value. If fair values are unavailable, investment is reported at cost. B. Cost Method: applied to investments without a readily determinable fair value. When the fair value of an investme nt in equity securities is not readily determinable, and the investment provides neither significant influence nor control, the investment may be measured at cost. The investment remains at cost unless 1. A demonstrable impairment occurs for the investment, or 2. An observable price change occurs for identical or similar investments of the same issuer. The investor typically recognizes its share of investee dividends declared as dividend income . C. 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, their financial statements are consolidated and reported for the combined entity. D. Equity method: applied when the investor has the ability to exercise signi ficant influence over operating and financial policies of the investee. 3. Ability to significantly influence investee is indicated by several factors including representation on the board of directors, participation in policy -making, etc. 4. GAAP guidelines pre sume the equity method is applicable if 20 to 50 percent of the outstanding voting stock of the investee is held by the investor. Current financial reporting standards allow firms to elect to use fair value for any new investment in equity shares includ ing those where the equity method would otherwise apply. However, the option, once taken, is irrevocable. The investor recognizes both i nvestee dividends and changes in fair value over time as income. II. Accounting for an investment: the equity method A. The investor adjusts the investment account to reflect all changes in the equity of the investee company. B. The investor accrues investee income when it is reported in the investee’s financial statements. C. Dividends declared by the investee create a reduction in the carrying amount of the Investment account. This book assumes all investee dividends are declared and paid in the same reporting period. 1-3 . III. Special accounting procedures used in the application of the equity method A. Reporting a change to the equity metho d when the ability to significantly influence an investee is achieved through a series of acquisitions. 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. 2. When the ability to exercise significant influence occurs following a series of stock purchases , the investor applies the equity method prospectively. The total fair value at the date significant influence is attained is compared to the investee’s book value to determine future excess fair value amortizations. B. Investee income from other than continuing operations 1. The investor recognizes its share of investee reported other comprehensive income (OCI) through the investment account and the investor’s own OCI. 2. Income items such as discontinued operations that are reported separately by the investee should be shown in the same manner by the investor. The materiality of these other investee income elements (as it affects the investor) continues to be a criterion for s eparate disclosure. C. Investee losses 1. Losses reported by the investee create corresponding losses for the investor. 2. A permanent decline in the fair value of an investee’s stock should be recognized immediately by the investor as an impairment loss. 3. 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. D. Reporting the sale of an equity investment 1. The investor ap plies the equity method until the disposal date to establish a proper book value. 2. 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 investment cost over book value acquired A. The price an investor pays for equity securities often differs significantly from the investee ’s underlying book value primarily because the historical cost based accounting model does not keep track of changes in a firm’s fair value. B. Payments made in excess of underlying book value can sometimes be identified with specific investee accounts such as inventory or equipment. C. An extra acquisition price can also be assigned to anticipated benefits that are expected to be derived from the investment. In accounting, these amounts are presumed to reflect an intangible asset referred to as goodwill. G oodwill is calculated as any excess payment that is not attributable to specific identifiable assets and liabilities of the investee. Because goodwill is an indefinite -lived asset, it is not amortized. 1-4 V. Deferral of intra -entity gross profit in inventory A. The investor’s share of intra -entity profits in ending inventory are not recognized until the transferred goods are either consumed or until they are resold to unrelated parties. B. Downstream sales of inventory 1. “Downstream” refers to transfers made by the i nvestor to the investee. 2. Intra-entity gross profits from sales are initially deferred under the equity method and then recognized as income at the time of the inventory’s eventual disposal. 3. The amount of gross profit to be deferred is the investor’s owners hip percentage multiplied by the markup on the merchandise remaining at the end of the year. C. Upstream sales of inventory 1. “Upstream” refers to transfers made by the investee to the investor. 2. Under the equity method, the deferral process for intra -entity gross profits is identical for upstream and downstream transfers. The procedures are separately identified in Chapter One because the handling does vary within the consolidation process. Answers to Discussion Questions The textbook includes discussion qu estions to stimulate student thought and discussion. These questions are also designed to allow students to consider relevant issues that might otherwise be overlooked. Some of these questions may be addressed by the instructor in class to motivate student discussion. Students should be encouraged to begin by defining the issue(s) in each case. Next, authoritative accounting literature (FASB ASC) or other relevant literature can be consulted as a preliminary step in arriving at logical actions. Frequently, the FASB Accounting Standards Codification will provide the necessary support. Unfortunately, in accounting, definitive resolutions to financial reporting questions are not always available. Students often seem to believe that all accounting issues have b een 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 representati on of the firm’s transa ctions. 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 presented can be weighed to produce a viable solution. The disc ussion questions are designed to help students develop research and critical thinking skills in addressing issues that go beyond the purely mechanical elements of accounting. Did the Cost Method Invite Manipulation? The cost method of accounting for investments often caused a lack of objectivity in reported income figures. With a large block of the investee’s voting shares, an investor could influence the amount and timing of the investee’s dividend declaration s. Thus , when enjoying a good earnings year, an investor might influence the investee to withhold declaring a dividend until needed in a subsequent year. Alternatively, if the investor judged that its current year earnings “needed a boost,” it might influence the investee t o declare a current year dividend. The equity method effectively removes managers’ ability to increase current income (or defer income to future periods) through their influence over the timing and amounts of investee dividend declarations . At first glance it may seem that the fair value method allows managers to manipulate income because investee dividends are recorded as income by the investor. However, dividends paid
