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Chapter 01 - The Equity Method of Accounting for Investments

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1-1
Chapter 01 - The Equity Method of Accounting For Investments

Chapter 1
The Equity Method Of Accounting For Investments

Chapter Outline

I. Three 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. Income is recognized when dividends are declared.
2. Portfolios are reported at market value. If market values are unavailable, investment
is reported at cost.

B. 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.

C. Equity method: applied when the investor has the ability to exercise significant influence
over operating and financial policies of the investee.
1. Ability to significantly influence investee is indicated by several factors including
representation on the board of directors, participation in policy-making, etc.
2. According to a guideline established by the Accounting Principles Board, the equity
method is presumed to be 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 investment
in equity shares including those where the equity method would otherwise apply. However,
the option, once taken is irrevocable. After 2008, can make the election for fair value
treatment only upon acquisition of the equity shares. Dividends received and changes in
fair value over time are recognized as income.

II. Accounting for an investment: the equity method

A. The investment account is adjusted by the investor to reflect all changes in the equity of
the investee company.
B. Income is accrued by the investor as soon as it is earned by the investee.
C. Dividends declared by the investee create a reduction in the carrying amount of the
Investment account.

III. Special accounting procedures used in the application of the equity method
A. Reporting a change to the equity method 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.

1-2
Chapter 01 - The Equity Method of Accounting For Investments

2. At the point in time that the equity method becomes applicable, a retroactive
adjustment is made by the investor to convert all previously reported figures to the
equity method based on percentage of shares owned in those periods.
3. This restatement establishes comparability between the financial statements of all
years.
B. Investee income from other than continuing operations
1. Income items such as extraordinary gains and losses and prior period adjustments
that are reported separately by the investee should be shown in the same manner
by the investor.
2. The materiality of this income element (as it affects the investor) continues to be a
criterion for this separate disclosure.
C. Investee losses
1. Losses reported by the investee create corresponding losses for the investor.
2. A permanent decline in the market value of an investee’s stock should also be
recognized immediately by the investor.
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 equity method is consistently applied until the date of disposal to establish the
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 cost of investment over book value acquired

A. The price paid by an investor for equity securities can vary significantly from the
underlying book value of the investee company primarily because the historical cost
based accounting model does not keep track of changes in a firm’s market 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. For accounting purposes, these amounts
are presumed to reflect an intangible asset referred to as goodwill. Goodwill is
calculated as any excess payment that is not attributable to specific accounts. For the
year 2002 and beyond, goodwill is no longer amortized.
V. Deferral of unrealized gains in inventory
A. Gains derived from intra-entity transactions are not considered completely earned until
the transferred goods are either consumed or resold to unrelated parties.
B. Downstream sales of inventory
1. “Downstream” refers to transfers made by the investor to the investee.
2. Intra-entity gains from sales are initially deferred under the equity method and then
recognized as income at the time of the inventory’s eventual disposal.

1-3
Chapter 01 - The Equity Method of Accounting For Investments

3. The amount of gain to be deferred is the investor’s ownership 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 unrealized gains 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

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 Accounting Standards
Codification 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.

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 distributions. Thus, when
enjoying a good earnings year, an investor might influence the investee to withhold
dividend distributions until needed in a subsequent year. Alternatively, if the investor
judged that its current year earnings “needed a boost,” it might influence the investee to
pay 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 distributions.

1-4
Chapter 01 - The Equity Method of Accounting For Investments

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 typically are accompanied by a decrease in fair value (also recognized in
income), thus leaving reported net income unaffected.

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 intra-entity 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
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. FASB
ASC Topic 810, Consolidation, observes “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.

1-5
Chapter 01 - The Equity Method of Accounting For Investments

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 intra-entity revenue), is control not present here
despite the ownership of only 35 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, 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 intra-entity 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 FASB ASC paragraph 323-10-15-6 "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 intra-entity 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

1-6
Chapter 01 - The Equity Method of Accounting For Investments

3. 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.

4. 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.

5. 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. 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 (ASC 323-10-15-10):
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.
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. Intra-entity 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.

1-7
Chapter 01 - The Equity Method of Accounting For Investments

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. FASB ASC Topic 323 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.

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

1-8
Chapter 01 - The Equity Method of Accounting For Investments

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 intra-entity 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 intra-entity ending inventory gives the total profit. The product of
the ownership percentage and this profit figure is the unrealized gain from the intra-entity
transaction. This gain is deferred in the recognition of equity earnings until subsequently earned
through use or resale to an unrelated party.

15. Intra-entity transfers do not affect the financial reporting of the investee except that the related
party transactions must be appropriately disclosed and labeled.

16. Under the fair value option, firms report the investment’s fair value as an asset and changes in
fair value as earnings. Under the equity method, firms recognize their ownership share of
investee profits adjusted for excess cost amortizations and intra-entity profits. Dividends
received from an investee are included in earnings under the fair value option.

Answers to Problems
1. D

2. B

3. C

4. B

5. D

1-9
Chapter 01 - The Equity Method of Accounting For Investments

6. A Acquisition price ............................................................................. $1,600,000

Equity income ($560,000 × 40%) .................................................... 224,000
Dividends (50,000 shares × $2.00).................................................. (100,000)
Investment in Harrison Corporation as of December 31 .............. $1,724,000

7. A Acquisition price ....................................................... $700,000

Income accruals: 2010—$170,000 × 20%................. 34,000
2011—$210,000 × 20% ................ 42,000
Amortization (see below): 2010 ................................ (10,000)
Amortization: 2011 .................................................... (10,000)
Dividends: 2010—$70,000 × 20% ............................. (14,000)
2011—$70,000 × 20% .............................. (14,000)
Investment in Bremm, December 31, 2011 .............. $728,000

Acquisition price ....................................................... $700,000

Bremm’s net assets acquired ($3,000,000 × 20%) .. (600,000)
Excess cost to patent ................................................ $100,000
Annual amortization (10 year life) ........................... $10,000

8. B Purchase price of Baskett stock .................... $500,000

Book value of Baskett ($900,000 × 40%)........ (360,000)
Cost in excess of book value .................... $140,000 Life Annual
Payment identified with undervalued ............ Amortization
Building ($140,000 × 40%) ......................... 56,000 7 yrs. $8,000
Trademark ($210,000 × 40%) ..................... 84,000 10 yrs. 8,400
Total ................................................................. $ -0- $16,400

Cost of investment.......................................................... $500,000

Basic income accrual ($90,000 × 40%) .................... 36,000
Amortization (above) ................................................. (16,400)
Dividend collected ($30,000 × 40%) ........................ (12,000)
Investment in Baskett ..................................................... $507,600

9. D The 2010 purchase is reported using the equity method.

Purchase price of Goldman stock.................................................. $600,000

1-10
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Chapter 01 - The Equity Method of Accounting For Investments

Book value of Goldman stock ($1,200,000 × 40%) ........................ (480,000)

Goodwill ........................................................................................... $120,000
Life of goodwill ................................................................................ indefinite
Annual amortization ........................................................................ (-0-)

Cost on January 1, 2010 ................................................................. $600,000

2010 Income accrued ($140,000 x 40%) ......................................... 56,000
2010 Dividend collected ($50,000 × 40%) ...................................... (20,000)
2011 Income accrued ($140,000 × 40%) ......................................... 56,000
2011 Dividend collected ($50,000 × 40%) ...................................... (20,000)
2012 Income accrued ($140,000 × 40%) ......................................... 56,000
2012 Dividend collected ($50,000 × 40%) ...................................... (20,000)
Investment in Goldman, 12/31/12.............................................. $708,000

10. D

11. A Gross profit rate (GPR): $36,000 ÷ $90,000 = 40%

Inventory remaining at year-end .................................................... $20,000
GPR................................................................................................... × 40%
Unrealized gain........................................................................... $8,000
Ownership ........................................................................................ × 30%
Intra-entity unrealized gain—deferred ...................................... $2,400

12. B Purchase price of Steinbart shares ............................................... $530,000

Book value of Steinbart shares ($1,200,000 × 40%)...................... (480,000)
Trade name ...................................................................................... $50,000
Life of trade name............................................................................ 20 years
Annual amortization ........................................................................ $2,500
2010 Gross profit rate = $30,000 ÷ $100,000 = 30%
2011 Gross profit rate = $54,000 ÷ $150,000 = 36%
2011—Equity income in Steinbart:
Income accrual ($110,000 × 40%) ................................................... $44,000
Amortization (above) ....................................................................... (2,500)
Recognition of 2010 unrealized gain
($25,000 × 30% GPR × 40% ownership) .................................... 3,000
Deferral of 2011 unrealized gain

1-11
Chapter 01 - The Equity Method of Accounting For Investments

($45,000 × 36% GPR × 40% ownership ..................................... (6,480)

Equity income in Steinbart—2011 ............................................ $38,020

13. (6 minutes) (Investment account after one year)

Purchase price ..................................................................................... $ 990,000
Basic equity accrual ($260,000 × 40%) .............................................. 104,000
Amortization of patent:
Excess payment ($990,000 – $790,000 = $200,000)
Allocated over 10 year life .............................................................. (20,000)
Dividends (80,000 × 40%) .................................................................... (32,000)
Investment in Clem at December 31, 2011 ........................................ $1,042,000

14. (10 minutes) (Investment account after 2 years with fair value option included)
a. Acquisition price ................................................................................. $60,000
Book value—assets minus liabilities ($125,000 × 40%) ............... 50,000
Excess payment ......................................................................... $10,000
Value of patent in excess of book value ($15,000 × 40%) ............ 6,000
Goodwill ........................................................................................... $4,000
Amortization:
Patent ($6,000 ÷ 6) ...................................................................... $1,000
Goodwill ...................................................................................... -0-
Annual amortization ............................................................. $1,000
Acquisition price ............................................................................. $60,000
Basic equity accrual 2010 ($30,000 × 40%) ................................... 12,000
Dividends—2010 ($10,000 × 40%) .................................................. (4,000)
Amortization—2010 (above) ........................................................... (1,000)
Investment in Holister, 12/31/10 ..................................................... $67,000
Basic equity accrual —2011 ($50,000 × 40%) ................................ 20,000
Dividends—2011 .............................................................................. (6,000)
Amortization—2011 (above) ........................................................... (1,000)
Investment in Holister, 12/31/11 ..................................................... $80,000
b. Dividend income ($15,000 × 40%) .................................................. $6,000
Increase in fair value ($75,000 – $68,000) ...................................... 7,000

1-12
Chapter 01 - The Equity Method of Accounting For Investments

Investment income under fair value option—2011 ....................... $13,000

15. (10 minutes) (Equity entries for one year, includes intra-entity transfers but no
unearned gain)

Purchase price of Batson stock ..................................................... $210,000

Book value of Batson stock ($360,000 × 40%) .............................. (144,000)
Unidentified asset (goodwill) .......................................................... $66,000
Life .................................................................................................... Indefinite
Annual amortization ........................................................................ $ -0-

No unearned intra-entity gain exists at year’s end because all of the transferred
merchandise was used during the period.

15. (continued)

Investment in Batson, Inc. ........................................ 210,000

Cash (or a liability) ............................................... 210,000
To record acquisition of a 40 percent interest in Batson.

Investment in Batson, Inc. ........................................ 32,000

Equity in Investee Income ................................... 32,000
To recognize 40 percent income earned during period by Batson, an
investment recorded by means of the equity method.

Cash ............................................................................ 10,000

Investment in Batson, Inc. ................................... 10,000
To record collection of dividend from investee recorded by means of the
equity method.

16. (20 Minutes) (Equity entries for one year, includes conversion to equity
method)

The 2010 purchase must be restated to the equity method.

1-13
Chapter 01 - The Equity Method of Accounting For Investments

FIRST PURCHASE—JANUARY 1, 2010

Purchase price of Denton stock ....................................... $210,000
Book value of Denton stock ($1,700,000 × 10%) ............. (170,000)
Cost in excess of book value ........................................... $40,000
Excess cost assigned to undervalued land
($100,000 × 10%) ............................................................ (10,000)
Trademark .......................................................................... $30,000
Life of trademark ............................................................... 10 years
Annual amortization .......................................................... $3,000

BOOK VALUE—DENTON—JANUARY 1, 2010

January 1, 2010 book value (given) ................................. $1,700,000
2010 Net income ................................................................ 240,000
2010 Dividends .................................................................. (90,000)
January 1, 2011 book value .......................................... $1,850,000

16. (continued)
SECOND PURCHASE—JANUARY 1, 2011
Purchase price of Denton stock ................................... $600,000
Book value of Denton stock (above) ($1,850,000 × 30%) (555,000)
Cost in excess of book value ....................................... $45,000
Excess cost assigned to undervalued land
($120,000 × 30%) ........................................................ (36,000)
Trademark ...................................................................... $9,000
Life of trademark ........................................................... 9 years
Annual amortization ...................................................... $1,000

Entry One—To record second acquisition of Denton stock.

Investment in Denton ................................................ 600,000
Cash ...................................................................... 600,000

Entry Two—To restate reported figures for 2010 to the equity method for
comparability. Reported income will be $24,000 (10% of Denton’s income) less
$3,000 (amortization on first purchase) for a net figure of $21,000. Originally,
$9,000 would have been reported by Walters (10% of the dividends). The
adjustment increases the $9,000 to $21,000 for 2010.
Investment in Denton ................................................ 12,000

1-14
Chapter 01 - The Equity Method of Accounting For Investments

Retained Earnings—Prior Period Adjustment—

2010 Equity Income .............................................. 12,000

Entry Three—To record income for the year: 40% of the $300,000 reported
income.
Investment in Denton ................................................ 120,000
Equity Income—Investment in Denton ............... 120,000

Entry Four—To record collection of dividends from Denton (40%).

Cash ............................................................................ 44,000
Investment in Denton ........................................... 44,000

Entry Five—To record amortization for 2011: $3,000 from first purchase and
$1,000 from second.

Equity Income—Investment in Denton .................... 4,000

Investment in Denton ........................................... 4,000

17. (5 minutes) (Deferral of unrealized gain)

Ending inventory ($225,000 – $105,000) ............................................ $120,000
Gross profit percentage ($75,000 ÷ $225,000) ................................... × 33⅓%
Unrealized gain ................................................................................ $40,000
Ownership ............................................................................................ × 25%
Intra-entity unrealized gain—deferred ........................................... $10,000

Entry to Defer Unrealized Gain:

Equity Income from Schilling ....................................... 10,000

Investment in Schilling ............................................. 10,000

18. (10 minutes) (Reporting of equity income and transfers)

a. Equity in investee income:
Equity income accrual ($80,000 × 30%).................................... $24,000
Less: deferral of intra-entity unrealized gain (below) ............ (4,500)
Less: patent amortization (given) ............................................ (9,000)
Equity in investee income .................................................... $10,500

1-15
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