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 dependency. Another important consideration is the extent of ownership by an investor in relation to the extent of ownership of other shareholdings." The most objective of the criteria established by the Board is that holding (either directly or indirectly) 20 percent or more of the outstanding voting stock is presumed to constitute the ability to hold significant influence over the decision-making process of the investee.
3. The equity method is appropriate when an investor has the ability to exercise significant influence over the operating and financing decisions of an investee. Because dividends represent financing decisions, the investor may have the ability to influence the timing of the dividend. If dividends were recorded as income (cash basis of income recognition), managers could affect reported income in a way that does not reflect actual performance. Therefore, in reflecting the close relationship between the investor and investee, the equity method employs accrual accounting to record income as it is earned by the investee. The investment account is increased for the investee earned income and then appropriately decreased as the income is distributed. From the investor’s view, the decrease in the investment asset is offset by an increase in the asset cash.
4. If Jones does not have the ability to significantly influence the operating and financial policies of Sandridge, the equity method should not be applied regardless of the level of ownership. However, an owner of 25 percent of a company's outstanding voting stock is assumed to possess this ability. FASB Interpretation 35 states that this presumption ". . . stands until overcome by predominant evidence to the contrary.”
"Examples of indications that an investor may be unable to exercise significant influence over the operating and financial policies of an investee include: a. Opposition by the investee, such as litigation or complaints to governmental regulatory authorities, challenges the investor's ability to exercise significant influence. b. The investor and investee sign an agreement under which the investor surrenders significant rights as a shareholder. c. Majority ownership of the investee is concentrated among a small group of shareholders who operate the investee without regard to the views of the investor. d. The investor needs or wants more financial information to apply the equity method than is available to the investee's other shareholders (for example, the investor wants quarterly financial information from an investee that publicly reports only annually), tries to obtain that information, and fails. e. The investor tries and fails to obtain representation on the investee's board of directors."
The following events necessitate changes in this investment account. a. Net income earned by Watts would be reflected by an increase in the investment balance whereas a reported loss is shown as a reduction to that same account. b. Dividends paid by the investee decrease its book value, thus requiring a corresponding reduction to be recorded in the investment balance. c. If, in the initial acquisition price, Smith paid extra amounts because specific investee assets and...
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