1 Problem 20 Beyond Essay

Chapter 1 the equity method of accounting for investments
20. (10 minutes) (Reporting of equity income and transfers)

a. Equity in investee income: Equity income accrual ($100,000 × 25%) $25,000 Less: deferral of intra-entity unrealized gross profit (below) (3,000) Less: patent amortization (given) (10,000) Equity in investee income $12,000

Deferral of intra-entity unrealized gross profit: Remaining inventory—end of year $32,000 Gross profit percentage (GP $30,000 ÷ Sales $80,000) × 37½% Profit within remaining inventory $12,000 Ownership percentage × 25% Intra-entity unrealized gross profit $ 3,000 b. In 2015, the deferral of $3,000 will likely become realized by BuyCo’s use or sale of this inventory. Thus, the equity accrual for 2015 will be increased by $3,000 in that year. Recognition of this amount is simply being delayed from 2014 until 2015, the year actually earned.

c. The direction (upstream versus downstream) of the intra-entity transfer does not affect the above answers. However as discussed in Chapter Five, a controlling interest calls for a 100% gross profit deferral for downstream intra-entity transfers. In the presence of only signification influence, however, equity method accounting is identical regardless of whether an intra-entity transfer is upstream or downstream.
21. (25 minutes) (Conversion from fair-value method to equity method with a subsequent sale of a portion of the investment)

Equity method income accrual for 2015 30 percent of $644,000 for ½ year = $ 96,600 24 percent of $644,000 for ½ year = 77,280 Total income accrual (no amort. or unearned gross profit) $173,880 Gain on sale (below) 31,000 Total income statement effect – 2015 $204,880

Gain on sale of 9,000 shares of Marion: Cost of initial acquisition—2013 $435,000 10% income accrual (conversion made to equity method) 35,900 10% of dividends (10,700) Cost of second acquisition—2014 1,000,000 30% income accrual—2014 150,300 30% of dividends—2014 (39,750) 30% income accrual for ½ year—2015 96,600 30% of dividends for ½ year—2015 (22,350) Book value of 45,000 shares on July 1, 2015 $1,645,000 Cash proceeds from the sale: 9,000 shares × $40 $360,000 Less: book value of shares sold: $1,645,000 × (9,000 ÷ 45,000) 329,000 Gain on sale $ 31,000

22. (25 minutes) (Verbal overview of equity method, includes conversion to equity method)

a. In 2014, the fair-value method (available-for-sale security) was appropriate. Thus, the only income recognized was the dividends declared. Collins should originally have reported dividend income equal to 10 percent of Merton’s dividends.

b. The assumption is that Collins’ level of ownership now provides the company with the ability to exercise significant influence over the operating and financial policies of Merton. Factors that indicate such a level of influence are described in the textbook and include representation on the investee’s board of directors, material intra-entity transactions, and interchange of managerial personnel.
22. (continued)

c. Despite holding 25 percent of Merton’s outstanding stock, application of the equity method is inappropriate absent the ability to apply significant influence. Factors that indicate a lack of such influence include: an agreement whereby the owner surrenders significant rights, a concentration of the remaining ownership, and failure to gain representation on the board of directors.

d. The equity method attempts to reflect the relationship between the investor and the investee in two ways. First, the investor recognizes investment income as soon as it is earned by the investee. Second, the Investment account reported by the investor is increased and decreased to indicate changes in the underlying book value of the investee.

e. Criticisms of the equity

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