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Advanced Accounting Fifth Edition By Patrick E. Hopkins and Robert F. Halsey Solution Manual Chapter 1—Accounting for Intercorporate Investments

• a.If the investor acquired 100% of the investee at book value, the Equity Investment

account is equal to the Stockholders’ Equity of the investee company. It, therefore, includes the assets and liabilities of the investee company in one account. The investor’s balance sheet, therefore, includes the Stockholders’ Equity of the investee company, and, implicitly, its assets and liabilities. In the consolidation process, the balance sheets of the investor and investee company are brought together.Consolidated Stockholders’ Equity will be the same as that which the investor currently reports; only total assets and total liabilities will change.

• If the investor owns 100% of the investee, the equity income that the investor

reports is equal to the net income of the investee, thus implicitly including its revenues and expenses. Replacing the equity income with the revenues and expenses of the investee company in the consolidation process will yield the same net income.

• FASB ASC 323-10 provides the following guidance with respect to the accounting for

receipt of dividends using the equity method:

The equity method tends to be most appropriate if an investment enables the investor to influence the operating or financial decisions of the investee. The investor then has a degree of responsibility for the return on its investment, and it is appropriate to include in the results of operations of the investor its share of the earnings or losses of the investee. (¶323-10-05-5) The equity method is an appropriate means of recognizing increases or decreases measured by generally accepted accounting principles (GAAP) in the economic resources underlying the investments. Furthermore, the equity method of accounting more closely meets the objectives of accrual accounting than does the cost method because the investor recognizes its share of the earnings and losses of the investee in the periods in which they are reflected in the accounts of the investee. (¶323-10-05-4) Under the equity method, an investor shall recognize its share of the earnings or losses of an investee in the periods for which they are reported by the investee in its financial statements rather than in the period in which an investee declares a dividend (¶323-10-

35-4).

©Cambridge Business Publishers, 2023 Solutions Manual, Chapter 11-1 2 / 4

• The recognition of equity income does not mean that cash has been received. In fact,

dividends paid by the investee to the investor are typically a small percentage of its reported net income. The projection of future net income that includes equity income as a significant component might not, therefore, imply significant generation of cash.

• The accounting for Altria’s investment in ABI depends on the degree of influence or

control it can exert over that company. A classification of “no influence” does not appear appropriate since Altria owns 10.1% of the outstanding common stock and also “active representation on ABI’s Board of Directors (“ABI Board”) and certain ABI Board committees. Through this representation, Altria participates in ABI policy making processes.” A classification of “significant influence” seems most appropriate given the facts, and this classification warrants accounting for the investment using the equity method of accounting.

• a.An investor may write down the carrying amount of its Equity Investment if the fair

value of that investment has declined below its carrying value and that decline is deemed to be other than temporary.b.There is considerable judgment in determining whether a decline in fair value is other than temporary. The write-down amounts to a prediction that the future fair value of the investment will not rise above the current carrying amount. If a company deems the decline to be temporary, it does not write down the investment, and a loss is not recognized in its income statement. If the decline is deemed to be other than temporary, the investment is written down and a loss is reported.Companies can use this flexibility to decide whether to recognize a loss in the current year or to postpone it to a future year.

• Under the equity method, an investor recognizes its share of the earnings or losses of an

investee in the periods for which they are reported by the investee in its financial statements. FASB ASC 323-10-35-7 states that “Intra-entity profits and losses shall be eliminated until realized by the investor or investee as if the investee were consolidated.” These intercompany items are eliminated to avoid double counting and prematurely recognizing income.©Cambridge Business Publishers, 2023 1-2Advanced Accounting, 5th Edition 3 / 4

• FASB ASC 323-10-15 requires the use of the equity method of accounting for an investor

whose investment in voting stock gives it the ability to exercise significant influence over operating and financial policies of an investee. Section 15-6 states that “Ability to exercise significant influence over operating and financial policies of an investee may be indicated in several ways, including the following: Representation on the board of directors, Participation in policy-making processes, Material intra-entity transactions, change of managerial personnel, Technological dependency, and 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 by another investor does not necessarily preclude the ability to exercise significant influence by the investor)” (emphasis added). It is clear, in this case, that the investee is critically dependent upon the technology licensed to it by the investor. The investor should, therefore, account for its investment using the equity method.

• Even though the investor owns 30% of the investee, it should not use the equity method

as it cannot exert significant influence over the investee. Further, since the investee is not a public company (all of the remaining stock is privately held), the investor should use the cost method to account for this investment as the fair value method presumes a publicly traded stock with sufficient liquidity to reasonably determine a fair value.

• a.The losses did not affect Enron’s income statement. Since the investees were

insolvent, Enron’s Equity Investment was reduced to zero (it had not made any loans or other advances to the investee companies). As a result, Enron discontinued reporting for these Equity Investments using the equity method and, therefore, did not recognize its proportionate share of investee losses.b.“… only after its share of that net income equals the share of net losses not recognized during the period the equity method was suspended” means that the investee has recouped all of the losses that have been reported. Since the investor ceases to account for its Equity Investment using the equity method once the balance reaches zero (assuming that it has not guaranteed the debts of the investee company), this generally implies that the investee’s Stockholders’ Equity is below zero (i.e., a deficit). The investor resumes its accounting for the Equity investment using the equity method once the investee’s Stockholders’ Equity is positive. It is at that point when the investee company has recouped all of its prior losses (assuming that the investee company has not raised additional equity capital).©Cambridge Business Publishers, 2023 Solutions Manual, Chapter 11-3

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