Solution manual advanced financial accounting, 8th edition by baker chap002

CHAPTER 2 REPORTING INTERCORPORATE INTERESTSANSWERS TO QUESTIONS Q2-1 a An investment in the voting common stock of another company is reported on an equity-method basis when the investo

CHAPTER 2 REPORTING INTERCORPORATE INTERESTS

ANSWERS TO QUESTIONS

Q2-1 (a) An investment in the voting common stock of another company is reported on an

equity-method basis when the investor is able to significantly influence the operating andfinancial policies of the investee

(b) The cost method normally is used for investments in common stock when the investordoes not have significant influence and for investments in preferred stock and othersecurities The amounts reported in the financial statements may require adjustment to fair

value if they fall under the provisions of FASB Statement No 115.

Q2-2 Significant influence occurs when the investor has the ability to influence the operating

and financial policies of the investee Representation on the board of directors of theinvestee is perhaps the strongest evidence, but other evidence such as routine participation

in management decisions or entering into formal agreements that give the investor somedegree of influence over the investee also may be used

Q2-3 Equity-method reporting should not be used when (a) an investee is in reorganization

or liquidation, (b) the investee has initiated litigation or complaints challenging the investor'sability to exercise significant influence, (c) the investor signs an agreement surrendering itsability to exercise significant influence, (d) majority ownership is concentrated in a smallgroup that operates the company without regard to the investor's desires, (e) the investor isnot able to acquire the information needed to use equity-method reporting, or (f) the investortries and fails to gain representation on the board of directors

Q2-4 The balances will be the same at the date of acquisition and in the periods that follow

whenever the cumulative dividends paid by the investee equal or exceed the investee'scumulative earnings since the date of acquisition The latter case assumes there are no otheradjustments needed under the equity method for amortization of differential or other factors

Q2-5 When a company has used the cost method and purchases additional shares which

cause it to gain significant influence, a retroactive adjustment is recorded to move from acost basis to an equity-method basis in the preceding periods Dividend income is replaced

by income from the investee and dividends received are treated as an adjustment to theinvestment account

Q2-6 An investor considers a dividend to be a liquidating dividend when the cumulative

dividends received from the investee exceed a proportionate share of the cumulativeearnings of the investee from the date ownership was acquired For example, an investorwould consider a dividend to be liquidating if it purchases shares of another company in earlyDecember and receives a dividend at year-end substantially in excess of its portion of theinvestee's net income for December On the other hand, the investee may have reported netincome well in excess of the total dividends paid for the year and would not consider thedividends to be liquidating dividends

Q2-7 Liquidating dividends decrease the investment account in both cases All dividends

are treated as a reduction of the investment account when equity-method reporting is used.When the cost method is used and dividends are received in excess of a proportionate share

of investee earnings since acquisition, they are treated as a reduction of the investmentaccount as well

Q2-8 The carrying value of the investment is reduced under equity method reporting when

(a) a dividend is received from the investee, (b) a differential is amortized, (c) an impairment

of goodwill occurs, and (d) the market value of the investment declines and is less than thecarrying value and it is concluded the decline is other than temporary

Q2-9 A corporate joint venture is a company that is established and operated by a small

group of investors, none of whom holds a majority of the ownership Because there are only

a few owners and each investor normally is expected to have significant influence, method reporting generally is appropriate in accounting for ownership in a corporate jointventure

equity-Q2-10 A differential occurs when an investor pays more than or less than underlying book

value in acquiring ownership of an investee

(a) In the case of the cost method, no adjustments are made for amortization of thedifferential on the investor's books

(b) Under equity-method reporting the difference between the amount paid and book valuemust be assigned to appropriate asset and liability accounts of the acquired company If anyportion of the differential is assigned to an amortizable or depreciable asset, that amountmust be charged against income from the investee over the remaining economic life of theasset

Q2-11 A dividend is treated as a reduction of the investment account under equity-method

reporting Unless it is a liquidating dividend, it is treated as dividend income under the costmethod

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Q2-12 Amortization of a differential is the most common reason for investment income to be

lower than a proportionate share of reported income of the investee If Turner Company haspaid more than book value for the shares of Straight Lace Company, the differential must beassigned to identifiable assets and liabilities of the investee, or to goodwill Those amountsassigned to depreciable and identifiable intangible assets must be amortized and will reduceequity-method income over the remaining economic lives of the underlying assets Amountsattributable to other items such as land or inventories must be treated as a reduction ofincome in the period in which Straight Lace disposes of the item Income also will be lower ifthe investee has been involved in sales to related companies during the period and there areunrealized profits from those intercompany sales; the income of the selling affiliate must bereduced by the unrealized profits before equity-method income is computed Finally, ifStraight Lace has preferred stock outstanding, preferred dividends must be deducted beforeassigning earnings to common shareholders

Q2-13 Dividends received by the investor are recorded as dividend income under both the

cost and fair value methods The change in the fair value of the shares held by the investor isrecorded as an unrealized gain or loss under the fair value method The fair value methoddiffers from the equity method in two respects Under the equity method the investor’s share

of the earnings of the investee are included as investment income and dividends receivedfrom the investee are treated as a reduction of the investment account

Q2-14 The change in the fair value of the shares held by the investor is reported as an

unrealized gain or loss and dividends received from the investee are reported as dividendincome

Q2-15 Clear-cut measures of control are not always readily available For example, a

partner contributing a specified share of the partnership’s capital may have a different share

of profits or losses, a different proportion of distributions, or a greater or lesser degree ofcontrol than indicated by the capital share

Q2-16 There may be situations in which a company has significant influence over another

without holding voting common stock For example, a company might use operatingagreements or other contracts to share in the profits of another company, guarantee a certainlevel of profitability of another company, or participate in the operating decisions of anothercompany

Q2-17* In general, tax allocation procedures should be used whenever there is a difference

between dividends received from the investee and the amount of investment incomerecorded by the investor Tax allocation is not needed if the companies file a joint tax return

or if the investee's earnings can be transferred to the investor in a tax-free transfer

Q2-18* The amount should be larger under the equity method There should be no need to

use tax allocation when the cost method is used in accounting for the investee Dividendsreceived and taxable income are likely to be the same Tax allocation normally is neededunder the equity method, due to the difference between income recorded and dividendsreceived

Q2-19* When the basic equity method is used, a proportionate share of subsidiary net

income and dividends is recorded on the parent's books and an appropriate amount of anydifferential is amortized each period No other adjustments are recorded Under the fully-adjusted equity method, the parent's books also are adjusted for unrealized profits and anyother items that are needed to bring the investor's net income into agreement with theincome to the controlling interest that would be reported if consolidation were used

Q2-20* One-line consolidation implies that under equity-method reporting the investor's net

income and stockholders' equity will be the same as if the investee were consolidated.Income from the investee is included in a single line in the investor's income statement andthe investment is reported as a single line in the investor's balance sheet

Q2-21* The term basic equity method generally is used when the investor records its portion

of the reported net income and dividends of the investee and amortizes an appropriateportion of any differential Unlike the fully-adjusted equity method, no adjustment forunrealized profit on intercompany transfers normally is made on the investor's books When

an investee is consolidated for financial reporting purposes, the investor may not feel it isnecessary to record fully-adjusted equity method entries on its books since income from theinvestee and the balance in the investment account must be eliminated in preparing theconsolidated statements

Q2-22* The investor reports a proportionate share of an investee's extraordinary item as an

extraordinary item in its own income statement

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SOLUTIONS TO CASES

C2-1 Choice of Accounting Method

a The equity method is to be used when an investor has significant influence over aninvestee Significant influence normally is assumed when more than 20 percent ownership isheld Factors to be considered in determining whether to apply equity-method reportinginclude the following:

1 Is the investee under the control of the courts or other parties as a result of filing forreorganization or entering into liquidation procedures?

2 Does the investor have representation on the board of directors, or has it attempted

to gain representation and been unable to do so?

3 Has the investee initiated litigation or complaints challenging the investor's ability toexercise significant influence?

4 Has the investor signed an agreement surrendering its ability to exercise significantinfluence?

5 Is majority ownership concentrated in a small group that operates the companywithout regard of the wishes of the investor?

6 Is the investor able to acquire the information needed to use equity-methodreporting?

b When subsidiary net income is greater than dividends paid, equity-method reporting islikely to show a larger reported contribution to the earnings of Slanted Building Supplies If20X4 earnings are negative or less than dividends distributed in 20X4, the cost basis is likely

to result in a larger contribution to Slanted's reported earnings

c As the investor uses more of its resources to acquire ownership of the investee, and asthe investor has a greater share of the investee's profits and losses, the success of theinvestee's operations may have more of an impact on the overall financial well-being of theinvestor In many cases, the investor will want to participate in key decisions of the investeeonce the investor's ownership share reaches a certain level Also, use of the equity methodeliminates the possibility of the investor manipulating its own income by influencing investeedividend distributions, as might occur under the cost method

Re: Equity Method Reporting for Investment in Adams Company

The equity method should be used in reporting investments in which the reporting companyhas a significant influence over the operating and financing decisions of another company Inthis case, Most Company holds 15 percent of the voting common stock of Adams Companyand Port Company holds an additional 10 percent During the course of the year, both Mostand Port are likely to use the cost method in recording their respective investments inAdams However, when consolidated statements are prepared for Most, the combinedownership must be used in determining whether significant influence exists Both direct and

indirect ownership must be taken into consideration [APB 18, Par 17]

A total of 15 percent of the voting common stock of Adams is held directly by Most Companyand an additional 10 percent is controlled indirectly though Most’s ownership of PortCompany Equity-method reporting for the investment in Adams Company therefore appears

to be required

If the cost method has been used by Most and Port in recording their investments during theyear, at the time consolidated statements are prepared, adjustments must be made to (a)increase the balance in the investment account for a proportionate share of the investee’sreported net income (25 percent) and reduce the balance in the investment account for aproportionate share of the dividend paid by the investee, (b) include a proportionate share ofthe investee’s net income in the consolidated income statement, (c) delete any dividendincome recorded by Most and Port, and (d) if ownership was purchased at an amount greaterthan a proportionate share of the fair value of the investee’s net assets at the date ofpurchase, it may be necessary to amortize a portion of the differential assigned todepreciable or amortizable assets

Primary citation

APB 18, par 17

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C2-3 Application of the Equity Method

MEMO

To: Controller

Forth Company

From: , CPA

Re: Equity Method Reporting for Investment in Brown Company

This memo is prepared in response to your request regarding use of the cost or equitymethods in accounting for Forth’s investment in Brown Company

Forth Company held 85 percent of the common stock of Brown Company prior to January 1,20X2, and was required to fully consolidate Brown Company in its financial statements

prepared prior to that date [FASB 94] Forth now holds only 15 percent of the common stock

of Brown The cost method is normally used in accounting for ownership when less than 20percent of the stock is directly or indirectly held by the investor

Equity-method reporting should be used when the investor has “significant influence overoperating and financing policies of the investee.” While 20 percent ownership is regarded asthe level at which the investor is presumed to have significant influence, other factors must

be considered as well [APB 18, Par 17]

Although Forth currently holds only 15 percent of Brown’s common stock, the other factorsassociated with its ownership indicate that Forth does exercise significant influence overBrown Forth has two members on Brown’s board of directors, it purchases a substantialportion of Brown’s output, and Forth appears to be the largest single shareholder by virtue ofits sale of 10,000 shares to each of 7 other investors

These factors provide strong evidence that Forth has significant influence over Brown andpoints to the need to use equity-method reporting for its investment in Brown Your officeshould monitor the activities of the FASB with respect to consolidation standards[www.fasb.org] Active consideration is being given to situations in which control may beexercised even though the investor does not hold majority ownership It is conceivable thatyour situation might be one in which consolidation could be required

Primary citations

APB 18, par 17

FASB 94

C2-4 Complex Organizational Structures

a Atlas America is a corporation Its operations involve the development, production, anddistribution of natural gas, and to a lesser extent, oil It also offers tax-advantaged investmentprograms for gas and oil investors

b The subsidiaries of Atlas America include corporations, limited liability companies (LLCs),and both general and limited partnerships The company fully consolidates its subsidiaries

In accordance with industry practice, the company reflects its interests in energy partnerships

in its consolidated statements using pro rata consolidation

c Atlas Pipeline Holdings is a subsidiary of Atlas America It has complete ownership ofAtlas Pipeline Partners GP, LLC, a limited liability company that is the general partner of AtlasPipeline Partners, L.P The only cash generating assets of Atlas Pipeline Holdings are itsindirect interests in Atlas Pipeline Partners, L.P

d Atlas Pipeline Partners, L.P is a partnership, specifically a publicly-traded limitedpartnership A limited partnership must have at least one general partner with unlimitedliability, and it may have numerous limited partners whose liability is limited and may notparticipate in the management of the partnership Atlas Pipeline Partners, L.P has a number

of subsidiaries, including general and limited partnerships, corporations, and limited liabilitycompanies Limited liability companies, in general, have the advantages of corporations withless of the formalities They often have certain tax advantages over corporations AtlasPipeline Partners, L.P is managed by its general partner, Atlas Pipeline Partners GP, LLC.The executives responsible for Atlas Pipeline’s management are employees of Atlas America,

as indicated in Atlas Pipeline’s Form 10-K, in the item entitled Directors and ExecutiveOfficers of the Registrant These employees not only manage Atlas Pipeline Partners, L.P.,but also Atlas America and its other affiliates

e Atlas Pipeline Partners, L.P presents consolidated financial statements in which itconsolidates all of its wholly-owned and majority-owned subsidiaries NOARK PipelineSystem is a limited partnership that is 100 percent owned by Atlas Pipeline Partners Prior to

2006, Atlas Pipeline Partners owned 75 percent of NOARK Atlas consolidates 100 percent

of NOARK, and previously also consolidated 100 percent of NOARK even though it was only

75 percent owned

f Prior to 2004, Atlas America was a wholly owned subsidiary of Resource America, Inc In

2004, Atlas America had an initial public offering of common stock, with the proceedsdistributed to Resource America Subsequently, Resource America spun off Atlas America bydistributing its shares to its stockholders

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b Dow reports investments in nonconsolidated affiliates using the equity method It includesjoint ventures, partnerships, and companies that are 20 to 50 percent owned in the category

of nonconsolidated affiliates Several of Dow’s nonconsolidated affiliates are 50-percentowned and several are 49-percent owned Excluding several special-situation investments,the total differential was $65 million at December 31, 2006, and $61 million at December 31,

2005 The differentials relating to MEGlobal, Equipolymers, and EQUATE Petrochemicalwere negative differentials resulting from a difference in valuations between U.S and foreignaccounting principles

c The evaluation of Dow’s goodwill for impairment is performed in conjunction with thecompany’s annual budgeting process

d Dow Chemical’s 50-percent investment in Dow Corning suffered a significant loss in valuejudged to be other than temporary in 1995 when Dow Corning declared bankruptcy Asdiscussed in Dow’s 2005 Form 10-K, the company wrote down the investment andrecognized a loss at the time of the bankruptcy

C2-6 Reporting Significant Investments in Common Stock

Answers to this case can be found in the annual reports to stockholders of the companiesmentioned and in their 10-K filings with the SEC (available at www.sec.gov)

a Before 1998, Harley-Davidson reported its investment in the common stock of BuellMotorcycle Company using the equity method The 49 percent investment that Harley heldsince 1993 gave it the ability to significantly influence Buell In 1998, Harley purchasedsubstantially all remaining shares of Buell and, therefore, Harley fully consolidates Buell in itsgeneral-purpose financial statements

b Chevron fully consolidates its controlled subsidiaries that are majority owned and variableinterest entities of which it is the primary beneficiary The company uses pro rataconsolidation in reporting its undivided interests in oil and gas joint ventures Chevron usesthe equity method to report its investments in affiliates over which the company exercisessignificant influence or has an ownership interest of 20 to 50 percent In applying the equitymethod, Chevron recognizes in income gains and losses from changes in its proportionatedollar share of an affiliate’s equity resulting from issuance of additional stock by the affiliate.Chevron analyses any difference between the carrying value of an equity-method investmentand its underlying book value and, to the extent that it can, assigns that differential to specificassets and liabilities The company adjusts quarterly its equity-method income recognizedfrom affiliates for any write-off or amortization of the differential

Chevron assesses it equity investments for possible impairment when events indicate apossible impairment If an investment has declined in value, the company evaluates thesituation to determine if the decline is other than temporary If the decline in value is judged

to be other than temporary, the investment is written down to its fair value and a lossrecognized in income Subsequent recoveries in value are not recognized

Chevron owns approximately 19 percent (as of December 31, 2006) of Dynegy’s commonstock It accounts for its investment using the equity method The carrying amount ofChevron’s investment in Dynegy’s common stock is less that its proportionate interest inDynegy’s net assets because the investment was written down in 2002 for a decline in valuethat was judged to be other than temporary

c PepsiCo reports investments in unconsolidated affiliates over which it exercises significantinfluence using the equity method Prior to 1999, equity-method income or loss from theseaffiliates was included in selling, general and administrative expenses Obviously, this is not

an appropriate classification for equity-method income from affiliates, but it could be justified

if the amounts are considered to be immaterial In 1999, PepsiCo started reporting its incomefrom equity-method investments separately in the income statement Equity-method incomefrom affiliates currently is reported in the consolidated income statement as bottling equityincome

d Sears has investments in the voting securities of a number of companies that it accountsfor using the equity method Where these investments are reported is difficult to tell from thefinancial statements and notes Apparently the amounts involved are relatively small, and theinvestments are included in other assets on the balance sheet, with the income reported inother income on the income statement

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E2-4 Cost versus Equity Reporting

a Cost-method journal entries recorded by Roller Corporation:

E2-4 (continued)

b Equity-method journal entries recorded by Roller Corporation:

Record purchase of Steam Company stock

Record dividend from Steam Company

Record equity-method income

Amortize differential:

[$70,000 - ($200,000 x 20)] / 10 years

Record dividend from Steam Company

Record equity-method income

Investment in Steam Company Stock 3,000 Amortize differential

Record dividend from Steam Company

Record equity-method income

Amortize differential

E2-5 Cost versus Equity Reporting

a Winston Corporation net income – cost method:

and $25,000 earnings of current period

b Winston Corporation net income – equity method:

E2-6 Acquisition Price

Balance at date of acquisition:

a Cost method $54,000 + $2,800 = $56,800

b Equity method $54,000 - $2,000 = $52,000

Change in Investment Account

E2-7 Investment Income

a (1) Ravine Corporation net income under Cost Method:

E2-8 Impairment of Investment Value

The following amounts would be reported as the carrying value of Port’s investment in Sund:

20X4 $135,000 = $4.50 x 30,000 shares; prior to adjustment, the

carrying value at the end of 20X4 would be $195,000 [$193,500 + ($5,000 x 30)]

E2-9 Alternative Reporting for Investment in Partnership

Moss Company Balance SheetCost Method Equity Method ConsolidationPro Rata ConsolidationFull

E2-10 Differential Assigned to Patents

Journal entries recorded by Power Corporation:

Record purchase of Snow Corporation stock

Record dividend from Snow Corporation:

$20,000 x 35

Record equity-method income:

$56,000 x 35

Amortize differential:

[$360,000 - ($980,000 x 35)] / 8 years

Record dividend from Snow Corporation:

$10,000 x 35

Record equity-method loss:

$44,000 x 35

Amortize differential

E2-11 Differential Assigned to Copyrights

Journal entries recorded by Best Corporation:

Record purchase of Flair Company stock

Record dividend from Flair Company:

$24,000 x 25

Record equity-method loss:

$88,000 x 25

Amortize differential:

Portion of ownership purchased .25 x

Period of amortization (years) ÷ 8

Record dividend from Flair Company:

$24,000 x 25

Record equity-method income:

$120,000 x 25

Amortize differential

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E2-12 Differential Attributable to Depreciable Assets

a Journal entries recorded by Capital Corporation using the equity

Record dividend from Cook Company:

$6,000 x 40

Record equity-method income:

$10,000 x 40

Amortize differential:

$16,000 / 10 years

Record dividend from Cook Company:

$9,000 x 40

Record equity-method income:

$20,000 x 40

E2-13 Investment Income

Brindle Company reported equity-method income of $13,000, computed as follows:Proportionate share of reported income

E2-14 Determination of Purchase Price

Increase in account balance during 20X5:

Proportionate share of income

Decrease in account balance during 20X6:

Proportionate share of income ($20,000 x 30) $ 6,000

Dividend received ($40,000 x 30) (12,000) 9,500

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E2-15 Correction of Error

Required correcting entry:

Computation of correction of investment account

Addition to account for investment income:

Computation of correction of retained earnings of Grand Corporation

E2-16 Differential Assigned to Land and Equipment

Journal entries recorded by Rod Corporation:

Record purchase of Stafford Stock

Record dividend from Stafford:

$15,000 x 30

Record equity-method income:

$40,000 x 30

Amortize differential assigned to equipment

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