Exam 1: The Equity Method of Accounting for Investments

A company has been using the fair-value method to account for its investment. The company now has the ability to significantly control the investee and the equity method has been deemed appropriate. Which of the following statements is true?

You are auditing a company that owns twenty percent of the voting common stock of another corporation and uses the equity method to account for the investment. How would you verify that the equity method is appropriate in this case?

On January 2, 2010, Hull Corp. paid $516,000 for 24% (48,000 shares) of the outstanding common stock of Oliver Co. Hull used the equity method to account for the investment. At the end of 2010, the balance in the investment account was $620,000. On January 2, 2011, Hull sold 12,000 shares of Oliver stock for $12 per share. For 2011, Oliver reported income of $118,000 and paid dividends of $30,000. Required: (A) Prepare the journal entry to record the sale of the 12,000 shares. (B) After the sale has been recorded, what is the balance in the investment account? (C) What percentage of Oliver Co. stock does Hull own after selling the 12,000 shares? (D) Because of the sale of stock, Hull can no longer exercise significant influence over the operations of Oliver. What effect will this have on Hull's accounting for the investment? (E) Prepare Hull's journal entries related to the investment for the rest of 2011.

Steven Company owns 40% of the outstanding voting common stock of Nicole Corp. and has the ability to significantly influence the investee's operations. On January 3, 2011, the balance in the Investment in Nicole Corp. account was $503,000. Amortization associated with this acquisition is $12,000 per year. During 2011, Nicole earned net income of $120,000 and paid cash dividends of $40,000. Previously in 2010, Nicole had sold inventory costing $35,000 to Steven for $50,000. All but 25% of that inventory had been sold to outsiders by Steven during 2010. Additional sales were made to Steven in 2011 at a transfer price of $75,000 that had cost Nicole $54,000. Only 10% of the 2011 purchases had not been sold to outsiders by the end of 2011. -What was the balance in the Investment in Nicole Corp. account at December 31, 2011?

When an investor sells shares of its investee company, which of the following statements is true?

On January 1, 2010, Dawson, Incorporated, paid $100,000 for a 30% interest in Sacco Corporation. This investee had assets with a book value of $550,000 and liabilities of $300,000. A patent held by Sacco having a book value of $10,000 was actually worth $40,000 with a six year remaining life. Any goodwill associated with this acquisition is considered to have an indefinite life. During 2010, Sacco reported income of $50,000 and paid dividends of $20,000 while in 2011 it reported income of $75,000 and dividends of $30,000. Assume Dawson has the ability to significantly influence the operations of Sacco. -The amount allocated to goodwill at January 1, 2010, is

Figure: Acker Inc. bought 40% of Howell Co. on January 1, 2010 for $576,000. The equity method of accounting was used. The book value and fair value of the net assets of Howell on that date were $1,440,000. Acker began supplying inventory to Howell as follows: Year Cost to Acker Transfer Price Amount Held by Howell at Year-End 2010 \ 55,000 \ 75,000 \ 15,000 2011 \ 70,000 \ 110,000 \ 55,000 Howell reported net income of $100,000 in 2010 and $120,000 in 2011 while paying $40,000 in dividends each year. -What is the balance in Acker's Investment in Howell account at December 31, 2011?

How would a change be made from the equity method to the fair value method of accounting for investments?

Which of the following results in a decrease in the investment account when applying the equity method?

Tower Inc. owns 30% of Yale Co. and applies the equity method. During the current year, Tower bought inventory costing $66,000 and then sold it to Yale for $120,000. At year-end, only $24,000 of merchandise was still being held by Yale. What amount of intra-entity inventory profit must be deferred by Tower?

Figure: On January 1, 2010, Mehan, Incorporated purchased 15,000 shares of Cook Company for $150,000 giving Mehan a 15% ownership of Cook. On January 1, 2011 Mehan purchased an additional 25,000 shares (25%) of Cook for $300,000. This last purchase gave Mehan the ability to apply significant influence over Cook. The book value of Cook on January 1, 2010, was $1,000,000. The book value of Cook on January 1, 2011, was $1,150,000. Any excess of cost over book value for this second transaction is assigned to a database and amortized over five years. Cook reports net income and dividends as follows. These amounts are assumed to have occurred evenly throughout the years: Net Income Dividends 2010 \ 200,000 \ 50,000 2011 225,000 50,000 2012 250,000 60,000 On April 1, 2012, just after its first dividend receipt, Mehan sells 10,000 shares of its investment. -How much income did Mehan report from Cook during 2011?

Figure: Cayman Inc. bought 30% of Maya Company on January 1, 2011 for $450,000. The equity method of accounting was used. The book value and fair value of the net assets of Maya on that date were $1,500,000. Maya began supplying inventory to Cayman as follows: Year Cost to Maya Transfer Price Amount Held by Cayman at Year-End 2011 \ 30,000 \ 45,000 \ 9,000 2012 \ 48,000 \ 80,000 \ 20,000 Maya reported net income of $100,000 in 2011 and $120,000 in 2012 while paying $40,000 in dividends each year. -What is the Equity in Maya Income that should be reported by Cayman in 2011?

In a situation where the investor exercises significant influence over the investee, which of the following entries is not actually posted to the books of the investor? 1) Debit to the Investment account, and a Credit to the Equity in Investee Income account. 2) Debit to Cash (for dividends received from the investee), and a Credit to Dividend Revenue. 3) Debit to Cash (for dividends received from the investee), and a Credit to the Investment account.

A company should always use the equity method to account for an investment if:

Figure: Cayman Inc. bought 30% of Maya Company on January 1, 2011 for $450,000. The equity method of accounting was used. The book value and fair value of the net assets of Maya on that date were $1,500,000. Maya began supplying inventory to Cayman as follows: Year Cost to Maya Transfer Price Amount Held by Cayman at Year-End 2011 \ 30,000 \ 45,000 \ 9,000 2012 \ 48,000 \ 80,000 \ 20,000 Maya reported net income of $100,000 in 2011 and $120,000 in 2012 while paying $40,000 in dividends each year. -What is the amount of unrealized inventory profit to be deferred on December 31, 2012?

What is the primary objective of the fair value method of accounting for an investment?

On January 1, 2011, Pacer Company paid $1,920,000 for 60,000 shares of Lennon Co.'s voting common stock which represents a 45% investment. No allocation to goodwill or other specific account was made. Significant influence over Lennon was achieved by this acquisition. Lennon distributed a dividend of $2.50 per share during 2011 and reported net income of $670,000. What was the balance in the Investment in Lennon Co. account found in the financial records of Pacer as of December 31, 2011?

How would a change be made from the fair value method to the equity method of accounting for investments?

On January 1, 2010, Pond Co. acquired 40% of the outstanding voting common shares of Ramp Co. for $700,000. On that date, Ramp reported assets and liabilities with book values of $2.2 million and $700,000, respectively. A building owned by Ramp had an appraised value of $300,000, although it had a book value of only $120,000. This building had a 12-year remaining life and no salvage value. It was being depreciated on the straight-line basis. Ramp generated net income of $300,000 in 2010 and a loss of $120,000 in 2011. In each of these two years, Ramp paid a cash dividend of $70,000 to its stockholders. During 2010, Ramp sold inventory to Pond that had an original cost of $60,000. The merchandise was sold to Pond for $96,000. Of this balance, $72,000 was resold to outsiders during 2010 and the remainder was sold during 2011. In 2011, Ramp sold inventory to Pond for $180,000. This inventory had cost only $108,000. Pond resold $120,000 of the inventory during 2011 and the rest during 2012. Required: For 2010 and then for 2011, calculate the equity income to be reported by Pond for external reporting purposes.

On January 1, 2011, Deuce Inc. acquired 15% of Wiz Co.'s outstanding common stock for $62,400 and categorized the investment as an available-for-sale security. Wiz earned net income of $96,000 in 2011 and paid dividends of $36,000. On January 1, 2012, Deuce bought an additional 10% of Wiz for $54,000. This second purchase gave Deuce the ability to significantly influence the decision making of Wiz. During 2012, Wiz earned $120,000 and paid $48,000 in dividends. As of December 31, 2012, Wiz reported a net book value of $468,000. For both purchases, Deuce concluded that Wiz Co.'s book values approximated fair values and attributed any excess cost to goodwill. -On Deuce's December 31, 2012 balance sheet, what balance was reported for the Investment in Wiz Co. account?