Slanted Building Supplies purchased 32 percent of the voting shares of Flat Flooring Company in March 20X3. On December 31, 20X3, the officers of Slanted Building Supplies indicated they needed advice on whether to use the equity method or cost method in reporting their ownership in Flat Flooring.
a. What factors should be considered in determining whether equity-method reporting is appropriate?
The equity method is considered when involving “investment in another company in which the book value of the investment reflects a share of the acquired firm's increases in retained earnings.”(Equity method, 2009) Since Slanted Building Supplies bought 32% of the shares, it has reasonable leverage in voting. SBS should also make sure FFC is not filing for bankruptcy nor has any other restrictions on earnings before recommending the equity method.
b. Which of the two methods is likely to show the larger reported contribution to Slanted’s earnings in 20X4? Explain.
The equity method will show the larger contributions. If “the investor does not have the ability to significantly influence the investee, the investment must be reported using the cost method and income is recognized only upon declaration of a dividend by the investee.” (Baker, Lembke, and King, 2004)
c. Why might the use of the equity method become more appropriate as the percentage of ownership increases?
Until SBS owns more than 50% of FFC, continuing to report using the equity method will continue to keep income and investments separate on the financial statements, showing the exact benefits (or losses) of investing in the second company. After more than half of FFC is owned, it is then considered a subsidiary and financial statements are then combined.
C2-4 Use of the Cost or Equity Method [AICPA Adapted]
Since Boomer Company’s inception, Madison Company has owned 18 percent of Boomer’s outstanding common stock....