Ch. 1 the Equity Method of Accounting for Investments Solutions

8191 Words Jun 9th, 2011 33 Pages
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
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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
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