the equity method of accounting for investments
Answers to Discussion Questions
The textbook includes discussion questions to stimulate student thought and discussion. These questions are also designed to allow students to consider relevant issues that might otherwise be overlooked. Some of these questions may be addressed by the instructor in class to motivate student discussion. Students should be encouraged to begin by defining the issue(s) in each case. Next, authoritative accounting literature (FASB ASC) or other relevant literature can be consulted as a preliminary step in arriving at logical actions. Frequently, the FASB Accounting Standards Codification will provide the necessary support.
Unfortunately, in accounting, definitive resolutions to financial reporting questions are not always available. Students often seem to believe that all accounting issues have been resolved in the past so that accounting education is only a matter of learning to apply historically prescribed procedures. However, in actual practice, the only real answer is often the one that provides the fairest representation of the transactions being recorded. If an authoritative solution is not available, students should be directed to list all of the issues involved and the consequences of possible alternative actions. The various factors presented can be weighed to produce a viable solution.
The discussion questions are designed to help students develop research and critical thinking skills in addressing issues that go beyond the purely mechanical elements of accounting.
Did the Cost Method Invite Manipulation?
The cost method of accounting for investments often caused a lack of objectivity in reported income figures. With a large block of the investee’s voting shares, an investor could influence the amount and timing of the investee’s dividend distributions. Thus, when enjoying a good earnings year, an investor might influence the investee to withhold dividend distributions until needed in a subsequent year. Alternatively, if the investor judged that its current year earnings “needed a boost,” it might influence the investee to pay a current year dividend. The equity method effectively removes managers’ ability to increase current income (or defer income to future periods) through their influence over the timing and amounts of investee dividend distributions. At first glance it may seem that the fair value method allows managers to manipulate income because investee dividends are recorded as income by the investor. However, dividends paid typically are accompanied by a decrease in fair value (also recognized in income), thus leaving reported net income unaffected.
Does the Equity Method Really Apply Here?
The discussion in the case between the two accountants is limited to the reason for the investment acquisition and the current percentage of ownership. Instead, they should be examining the actual interaction that currently exists between the two companies. Although the ability to exercise significant influence over operating and financial policies appears to be a rather vague criterion, ASC 323 "Investments—Equity Method and Joint Ventures," clearly specifies actual events that indicate this level of authority (paragraph 323-10-15-6):
Ability to exercise that influence may be indicated in several ways, such as representation on the board of directors, participation in policymaking processes, material intra-entity transactions, interchange of managerial personnel, or technological dependency. Another important consideration is the 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 company by another investor does not necessarily preclude the ability to exercise significant influence by the investor.
In this case, the accountants would be wise to determine whether...