Advanced Accounting, First Edition

©Cambridge Business Publishers, 2012

Solutions Manual, Chapter 1 1‐1

Solution 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 expense 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).

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 their 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.


Advanced Accounting by Halsey & Hopkins, 1st Edition 1‐2

4. The accounting for CBS’ investment in Westwood One depends on the degree of influence or control it can exert over that company. A classification of “no influence” does not appear appropriate since CBS owns 18% of the outstanding common stock and also manages Westwood under a management agreement. CBS also does not appear to control Westwood. It only has one seat on the board of directors. Although we are not provided with the number of seats on the board of directors, control of one seat does not likely to control the board. 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 market

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 market value is other than temporary. The write‐down amounts to a prediction that the future market 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.

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, Interchange 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 market 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).

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. a.

Cash 1,000 Accounts receivable 2,000 Inventories 4,000 PPE. net 10,000 Accounts payable 2,000 Accrued liabilities 3,000 Long‐term liabilities 4,000 Cash 8,000 (to record purchase of the assets and assumption of the liabilities of a business)

b.

Equity investment 8,000 Cash 8,000 (to record purchase of the assets and assumption of the liabilities of a business)

12.

a. Cash 1,000 Accounts receivable 2,000 Inventories 4,000 PPE. net 14,000 Customer list 3,000 Accounts payable 2,000 Accrued liabilities 3,000 Long‐term liabilities 4,000 Cash 15,000(to record purchase of the assets and assumption of the liabilities of a business)

b. Equity investment 15,000 Cash 15,000(to record purchase of the assets and assumption of the liabilities of a business)



13. a. The investor reports equity income equal to its proportionate share of the net income of

the investee company: $430,000 x 30% = $129,000.

b. The balance of the Equity Investment account at the end of the year is $579,000 ($500,000 + $129,000 ‐ $50,000).

c. The market value of the investee company is not reflected in the financial statements of the investor company. Under the equity method, the Equity Investment account is reported at adjusted cost (adjusted for equity income and dividends). Changes in the market value of the investee company do not affect this reported amount (unless the market value declines below the carrying amount of the Equity Investment and the decline is deemed to be other than temporary).

d. Possibly, yes. APB 18, ¶19d provides the following guidance: “The investor's share of extraordinary items … should be classified in a similar manner unless they are immaterial in the income statement of the investor.” Provided that the extraordinary item is material for the investor, it would report the extraordinary component as extraordinary income in its own income statement.

14.

Equity investment 108,000 Cash 108,000 (to record the purchase of the Equity Investment) Equity investment 24,000 Equity income 24,000 (to record equity income) Cash 15,000 Equity investment 15,000 (to record receipt of the cash dividend) Cash 120,500 Equity investment* 117,000 Gain on sale 3,500 (to record the sale of the Equity Investment)

* Equity Investment balance on date of sale = $108,000 + $24,000 ‐ $15,000 = $117,000



15. a. The gross profit remaining in ending inventory = $40,000 x 20% = $8,000.

Equity income = ($100,000 ‐ $8,000) x 30% = $27,600

b. Beginning Equity Investment $300,000 Equity income 27,600 Dividends (20,000)

Ending Equity Investment $307,600

c. Equity income = ($150,000 + $8,000) x 30% = $47,400

16. Equity investment 200,000 Cash 200,000 (to record the purchase of the Equity investment) Equity investment 40,000 Equity income 40,000 (to record equity income) Cash 15,000 Equity investment 15,000 (to record receipt of the cash dividend) Equity income 4,000 Equity investment 4,000 (to record the amortization of the patent asset) Cash 230,000 Equity investment* 221,000 Gain on sale 9,000 (to record the sale of the Equity investment) *The Equity Investment balance on the date of sale is ($200,000 + $40,000 ‐ $15,000 ‐ $4,000 = $221,000)



17. a.

A change from the market method to equity method requires removing the cumulative fair value adjustments and recording the cumulative equity income less dividends. RETROACTIVE adjustment.

Here are the T accounts prior to the change in ownership and accounting:

Unrealized holding gain (AOCI)

125,000

Investment ‐ Fair value adjustment

125,000

(to remove the unrealized gain from stockholders’ equity and the fair value adjustment from the investment account)

Equity Investment 50,000 Retained earnings

(prior period adjustment) 50,000

(to adjust the Equity Investment to its correct amount at the beginning of the year and to increase the beginning of the year Retained Earnings for the cumulative equity income that would have been recognized)

b. Equity Investment 50,000 Retained earnings

(prior period adjustment) 50,000

Here are the T accounts after adjusting for the change in ownership and accounting:

Investment in S

Cost 300,000FMV adj 125,000

Bal prior to change 425,000

AOCI – Shareholder’s Equity

125,000 FMV adjust

Investment in S

Cost 300,000 FMV adj 125,000

Bal prior to change 425,000 125,000 Entry 1

Entry 2 50,000

Bal after change 350,000

AOCI – Shareholder’s Equity

125,000 FMV adjust

125,000 Balance Entry 1 125,000

0 Balance



18. a. The equity income is 46% ($1,122 / $2,464) of investee net income and 46% ($3,089 /

[$16,612 ‐ $9,865]). The average ownership percentage is approximately 46% of the investee companies.

b. No, the liabilities are not reported on Down Chemical’s balance sheet, only the balance of

the Equity Investment which represents Dow’s proportionate ownership in the investees’ Stockholders’ Equity. Although Dow most likely does not have legal obligation for the debts of its investee companies, were they to encounter financial difficulties, Dow might have to invest additional equity capital into those businesses in order to keep them solvent. Why? Because Dow uses these Equity Investments as a significant component of its business model (they represent 6% of total assets and 39% of net income). If Dow allows one of these investee companies to fail, it might find that the market will no longer finance future investments of this kind. It may have a real obligation for these investees even though it may have no legal obligation.

19.

a. Equity income of $498 = $996 million x 50%. b. Equity investment of $159 million = ($1,354 ‐ $1,037) x 50%, rounded to $159 million.

20. The equity income that Cummins reports is 43% ($192 / $451) of the net income of its investee companies. And, the Equity Investment is 43% ($514 / $1,182) of the Stockholders’ Equity of the investee companies. Cummins owns approximately 43% of these investee companies. (As an aside, this is typically the amount of information that companies provide in their Equity Investments footnotes).

21. a. Yes. The equity income that Corning reports of $345 million is 50% of Dow Corning’s net

income of $690 million. b. Yes. Dow Corning Stockholders’ Equity is equal to $2,361 million ($3,511 + $3,688 ‐ $24 ‐

$1,243 ‐ $43 ‐ $3,145 ‐ $383 = $2,361). One‐half of this amount is $1,180.5 million. Corning’s Equity investment balance is $931 million. The difference between these two amounts is $249.5 million. In its footnote, Corning “considers the $249 million difference between the carrying value of its investment in Dow Corning and its 50% share of Dow Corning’s equity to be permanent.” That is, Corning wrote down its Equity investment by that amount when Dow Corning petitioned for bankruptcy.

c. Corning “fully impaired its investment of Dow Corning upon its entry into bankruptcy

proceedings.” Fully impaired means that Corning wrote the Equity investment down to zero. The Equity investment balance cannot fall below zero. So, Corning discontinued recognition of equity losses once its Equity Investment reached zero. Subsequently, Dow



Corning began to report profits. Once Dow Corning’s Stockholders’ Equity is positive, Corning can begin to recognize equity income.

d. Corning is a shareholder in Dow Corning and accounts for its Equity investment using the

equity method. This footnote indicates that Corning has had to invest additional capital into Dow Corning in order to gain a release from the latter’s obligations. Corning has, in effect, been held liable for its investee’s obligations. One criticism of the equity method of accounting is that it only reports the net equity owned on the investor’s balance sheet, and does not provide useful information about the potential liability arising from that investment. Remember this example the next time you see an Equity investment on a balance sheet.

22.

a. AT&T’s investment in and advances to Cingular reported on AT&T’s balance sheet at December, 2005, total $31,404. AT&T’s advances to Cingular are $4,108 at December, 2005. The interest earned on these advances is $311. The equity investment is, therefore, $26,985 ($31,404 ‐ $4,108 ‐ $311). Cingular’s equity at 2005 is $6,049 million + $73,270 million ‐ $10,008 million ‐ $24,333 million = $44,978 million. The equity investment, thus, represents its 60% ($26,985 million / $44,978 million) equity interest.

b. Cingular paid no dividends during 2005. The receipt of dividends reduces the equity method investment on AT&T’s books. The reconciliation of the investment balance from 2004 to 2005 shows no reduction due to the payment of dividends.

c. AT&T reports equity income equal to its proportionate share of Cingular’s net income or

$200 million (60% $333 million).

d. Undistributed earnings are earnings that have not yet been paid out as dividends. This is retained earnings. Of Cingular’s $44,978 million of stockholders’ equity, $2,711 is, apparently, retained earnings.

23.

a. General Mills accounts for the investments in its joint ventures using the equity method. Consolidation is not appropriate because General Mills does not control these entities (General Mills does not have >50% equity interest). Also, the market method is inappropriate because General Mills is able to exert “significant influence” in the management of these businesses (Companies may take an irrevocable option to value each individual equity investment at fair value under ASC 825‐10‐25.). Under the equity method, these investments are reflected on General Mills’ balance sheet at adjusted cost (e.g., beginning balance plus proportionate share of investee company’s earnings less any dividends received). General Mills reports its proportionate



share of investee company earnings as income. Under the equity method of accounting, dividends are not income. Instead, they are treated as a return of the investment.

b. The $295 million investment balance on General Mills’ balance sheet represents the net

equity of its joint ventures (together with aggregate advances of $158 million). General Mills’ proportionate share of the assets of the joint ventures, as well as its proportionate share of the joint ventures’ liabilities, is not reflected on its balance sheet, only the net equity. As a result, General Mills’ balance sheet does not reflect the actual investment and liabilities required to conduct these operations. For example, the total joint venture assets of $1.713 billion less the investment balance of $295 million equal over $1.4 billion and these are not recorded on General Mills’ balance sheet. Similarly, the liabilities of $1.3 billion are also excluded. This is the primary criticism of equity method accounting.

c. Although General Mills may not have legal liability for the obligations of its joint

ventures, it might have an implicit obligation to stand behind the entities that it has created (which includes their financing). That is, General Mills would be hard‐pressed to walk away from one of these entities should it fail to pay its debts.

d. Equity method accounting presents at least two challenges for analysis purposes. (i) Equity method accounting obscures the actual assets and liabilities of the investee company on the books of the investor company. (ii) The equity investments are reported at adjusted cost. As a result, unrealized gains (say, from market value appreciation) are not reflected on the balance sheet or in the income statement.

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Advanced Accounting, First Edition