REPORTING INTERCORPORATE INVESTMENTS AND CONSOLIDATION OF WHOLLY

Chapter 02 - Reporting Intercorporate Investments and Consolidation of Wholly Owned Subsidiaries with no Differential

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CHAPTER 2

REPORTING INTERCORPORATE INVESTMENTS AND CONSOLIDATION OF WHOLLY

OWNED SUBSIDIARIES WITH NO DIFFERENTIAL

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 and financial policies of the investee.

(b) The cost method normally is used for investments in common stock when the investor does not have significant influence and for investments in preferred stock and other securities. The cost method may also be used by the parent company for bookkeeping purposes when the investor owns a controlling interest because the investment account is eliminated in the consolidation process.

Q2-2A 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 the investee is perhaps the strongest evidence, but other evidence such as routine participation in management decisions or entering into formal agreements that give the investor some degree of influence over the investee also may be used.

Q2-3A Equity-method reporting should not be used when (a) the investee has initiated litigation or complaints challenging the investor's ability to exercise significant influence, (b) the investor signs an agreement surrendering important shareholder rights, (c) majority ownership is concentrated in a small group that operates the company without regard to the investor's desires, (d) the investor is not able to acquire the information from the investee, or (e) the investor tries 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's cumulative earnings since the date of acquisition. The latter case assumes there are no other adjustments 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 a cost 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 the investment 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 cumulative earnings of the investee from the date ownership was acquired. For example, an investor would consider a dividend to be liquidating if it purchases shares of another company in early December and receives a dividend at year-end substantially in excess of its portion of the investee's net income for December.

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Chapter 02 - Reporting Intercorporate Investments and Consolidation of Wholly Owned Subsidiaries with no Differential

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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 investment account as well.

Q2-8 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 cost method.

Q2-9 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 is recorded as an unrealized gain or loss under the fair value method. The fair value method differs 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 received from the investee are treated as a reduction of the investment account.

Q2-10A When the modified 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 any differential is amortized each period. In some situations, companies also choose not to make adjustments for intercompany profits and the amortization of the differential. Under the fully adjusted equity method, the parent's books also are adjusted for unrealized profits and any other items that are needed to bring the investor's net income into agreement with the income to the controlling interest that would be reported if consolidation were used.

Q2-11 A 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 and the investment is reported as a single line in the investor's balance sheet.

Q2-12A The term modified equity method generally is used when the investor records its portion of the reported net income and dividends of the investee and amortizes an appropriate portion of any differential. Unlike the fully adjusted equity method, no adjustment for unrealized profit on intercompany transfers normally is made on the investor's books. (In some situations, companies also choose not to amortize the differential.) When an investee is consolidated for financial reporting purposes, the investor may not feel it is necessary to record fully adjusted equity method entries on its books since income from the investee and the balance in the investment account must be eliminated in preparing the consolidated statements.

Q2-13A The investor reports a proportionate share of an investee's extraordinary item as an extraordinary item in its own income statement.

Q2-14 An adjusting entry is recorded on the company's books and causes the balances reported by the parent or subsidiary company to change. Consolitation entries, on the other hand, are not recorded on the books of the companies. Instead, they are entered in the consolidation worksheet so that when the amounts included in the consolidation entries are applied, the appropriate balances for the consolidated entity are reported.

Chapter 02 - Reporting Intercorporate Investments and Consolidation of Wholly Owned Subsidiaries with no Differential

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Q2-15 Each of the stockholders' equity accounts of the subsidiary is eliminated in the consolidation process. Thus, none of the balances is included in the stockholders' equity accounts of the consolidated entity. That portion of the stockholders' equity claim assigned to the noncontrolling shareholders is reported indirectly in the balance assigned to the noncontrolling shareholders.

Q2-16 Additional entries are needed to eliminate all income statement and retained earnings statement effects of intercorporate ownership and any transfers of goods and services between related companies.

Q2-17 Separate parts of the consolidation worksheet are used to develop the consolidated income statement, retained earnings statement, and balance sheet. All consolidation entries needed to complete the entire worksheet normally are entered before any of the three statements are prepared. The income statement portion of the worksheet is completed first so that net income can be carried forward to the retained earnings statement portion of the worksheet. When the retained earnings portion is completed, the ending balances are carried forward and entered in the consolidated balance sheet portion of the worksheet.

Q2-18 None of the dividends declared by the subsidiary are included in the consolidated retained earnings statement. Those which are paid to the parent have not gone outside the consolidated entity and therefore must be eliminated in preparing the consolidated statements.

Q2-19 Consolidated net income includes 100 percent of the revenues and expenses of the individual consolidating companies arising from transactions with unaffiliated companies.

Q2-20 Consolidated retained earnings is that portion of the undistributed earnings of the consolidated entity accruing to the parent company shareholders.

Q2-21 Consolidated retained earnings at the end of the period is equal to the beginning consolidated retained earnings balance plus consolidated net income attributable to the controlling interest, less consolidated dividends. Under the fully adjusted equity method, consolidated retained earnings should equal the parent company’s retained earnings.

Q2-22 The retained earnings statement shows the increase or decrease in retained earnings during the period. Thus, income for the period is added to the beginning balance and dividends are deducted in deriving the ending balance in retained earnings. Because the consolidation worksheet includes the retained earnings statement, the beginning retained earnings balance must be entered in the worksheet.

Chapter 02 - Reporting Intercorporate Investments and Consolidation of Wholly Owned Subsidiaries with no Differential

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SOLUTIONS TO CASES

C2-1A Choice of Accounting Method

• The equity method is to be used when an investor has significant influence over an investee.

Significant influence normally is assumed when more than 20 percent ownership is held.Factors to be considered in determining whether to apply equity-method reporting include the

following:

• Is the investee under the control of the courts or other parties as a result of filing for

reorganization or entering into liquidation procedures?

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

gain representation and been unable to do so?

• Has the investee initiated litigation or complaints challenging the investor's ability to

exercise significant influence?

• Has the investor signed an agreement surrendering its ability to exercise significant

influence?

• Is majority ownership concentrated in a small group that operates the company without

regard of the wishes of the investor?

• Is the investor able to acquire the information needed to use equity-method reporting?

• When subsidiary net income is greater than dividends paid, equity-method reporting is likely

to show a larger reported contribution to the earnings of Slanted Building Supplies. If 20X4 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.

• As the investor uses more of its resources to acquire ownership of the investee, and as the

investor has a greater share of the investee's profits and losses, the success of the investee's operations may have more of an impact on the overall financial well-being of the investor. In many cases, the investor will want to participate in key decisions of the investee once the investor's ownership share reaches a certain level. Also, use of the equity method eliminates the possibility of the investor manipulating its own income by influencing investee dividend distributions, as might occur under the cost method.