Chapter 1 the equity method of accounting for investments 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 Paragraph 17 of APB Opinion 18, "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 intercompany transactions, interchange of managerial personnel, or technological …show more content…
As an exception, if the specific asset is land or goodwill, amortization is not appropriate. d. Intercompany 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. 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. APB Opinion 18 requires that a change to the equity
This step involves short and long term debt equity analysis. The proportion of equity capital depends on the possessing and additional funds will be raised. The choice of the source of funds the company has are the issue of shares and debentures, loans to be taken from banks and financial institutions and public deposits to be drawn in form of bonds. The choice will depend on relative merits and demerits of each source and period of financing. The management of the investment funds is key in allocating that the funds are going in the correct place. The profits that are made can be down in two ways dividend declaration which includes identifying the rate of dividends and retained profits in which the volume has to be decided which will depend upon expansion and diversification of the company. The management of cash is another important function. Cash is needed for all different aspects of the company such as payment of salaries, overhead and bills. All of these are important in a company and how successful the financial aspect is going to be.The financial management practices include capital structure decision, investment appraisal techniques, dividend policy, working capital management and financial performance assessment. A company needs to have well financial in order to be successful. “A company that sells well but has poor financial management can fail.” (Johnston)
cognizant of the fact that the choices he makes can affect the price a buyer pays
Over the years, there are many controversies over equity method within IAS 28 Investments in Associates and Joint Ventures. The controversies basically lay on the vagueness of application on equity method; whether it serves as one-line consolidation (consolidation technique), measurement basis or a mixture of both. This paper divides into 3 parts. First part gives an illustration on this accounting issue in IAS 28 as well as the explanation, second part compares and contrasts the financial reports of two assigned entities and the final part discusses the qualitative characteristics of their financial reports.
It also reflect that there is cost of financing with debt reflecting the bankruptcy costs as well as the financial distress in the form of costs of debt. The marginal benefit is increased in decline of debt with the increase in debt leading to the increase in marginal cost. It further optimises the overall value focusing on the trade-off while selecting the amount of debt and equity to be used for financing. This theory can provide the explanation for differences in ratios for debt to equity between industries without reflecting any explanation on the differences within similar industry (Lee, et al., 2009).
One appreciates the recommendation of providing information on restructuring debt to help the company combat its recent financial troubles. Even though the company is in the process of reorganizing one believes this information will help a company in reporting the restructuring of debt. One will provide information on the requirements of reporting debt on bonds, notes, and capital leases. In performing this one will also provide the journal entries one would need to record to restructure the
Investments (equity, loan and advances) accounted for by the equity method while the investee has the activities in progress necessary to commence its
Distributions Received from Equity Method Investees – no guidance on determining how to classify a distributions received. Proposed solution is distributions received categorized as cash inflows from operating activities. If the distributions received less the distributions received in prior period exceed cumulative equity in earnings than the excess would be categorized as cash inflows from investing activities. Note that using fair value option does not applies to equity method investment measured.
In some cases, when the company seeks financing from landers, it gets committed to maintain certain financial ratios as set specified by the landing party. This commitment of maintaining the ratios is referred to as “Debt covenant”. This agreement works like a benchmark for the company that it has to achieve the set ratios within. Assessing the company’s position thru these ratios is important to ensure future repayment capability for the loan. In case of not achieving the same, which is called as “technical default” the landers are entitled to immediately clam their loan or increase the interest rate. Basic financial covenant are: return on asset ratio, equity ratio, interest coverage, current ratio, earnings management per share, and so on.
Along with market performance, a firm may need to adapt its financial activities as well. These activities all relate to the way the firm is organized, in particular, its capital structure. Included in capital structure is the aspect of convertible bonds. These bonds can be converted to a specified amount of common stock. The downside of these convertible stocks and bonds is that they have the potential of diluting the Earnings Per Share (EPS)
If the firms funding requirements are larger than their retained earnings, they must issue debt as this is preferred to issuing equity. Based on this theory, a firm’s financing policies could be viewed as signalling management’s view of the firm’s stock value (Wang & Lin 2010).Myers and Majluf (1984) also add that if firms issued no new securities but only used its retained earning to support the investment opportunities, the information asymmetric could be resolved. This suggests that issuing equity turn out to be more expensive as asymmetric information insiders and outsiders increase. Large firms should then issue debt to avoid selling under priced securities. As the requirement for external financing increases, businesses will work down the pecking order, from safe to riskier debt, perhaps to convertible securities or preferred stock, and finally to equity as a last resort. Each firm's debt ratio therefore reflects its cumulative requirement for external financing (Myers 2001).The pecking order theory clarifies why the bulk of external financing comes from debt. It also describes why organizations that are more profitable borrow less: since their goal debt ratio is, low-in the pecking order they do not have a goal since profitable firms have more internal financing available.
3)The third disadvantage of using common stocks is that it is less profitable than using debt when company has stable future earnings. Exhibit 3 indicates that at expected level of earnings after acquisition, earning
Already in 1958, Modigliani and Miller have pointed the discussion of capital structure towards the cost of debt and equity. According to their first proposition, in a world of no corporate taxes and with perfect markets, financial leverage has no effect on a firm’s value. In their second proposition, they state that the cost of equity equals a linear function defined by the required return on assets and the cost of debt (Modigliani and Miller, 1958).
Q4-1 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 the carrying value and it is concluded the decline is other than temporary.
Rajan and Zingales (1995) support this inverse relationship and suggest, that firms with high market-to-book ratios suffer under higher bankruptcy costs. The shares of such companies are overvalued and thus the company may prefer issuing stock. This equity may be raised at lower costs, due to the signals that a high market-to-book ratio is sending to the market. Therefore firms with a high
Distributions of Income. It tends to ignore the owners wish to receive a portion of earnings in the form of dividends.