Unit 6 Equity Accounting Practice Questions

Try the following selected end of chapter questions

from chapter 2 of Advanced Financial Accounting
Christensen.
1.What types of investments in common stock normally are
(a) accounted for using the equity method and (b) carried at fair value?

2.What types of investments in common stock normally are

(a) accounted for using the equity method and (b) carried at fair value?

3.Describe an investor’s treatment of an investment in common stock that was

previously carried at fair value, if the investment becomes qualified for use of
the equity method by an increase in the level of ownership.

4.How is the receipt of a dividend recorded under the equity method? When
investments are carried at fair value?

5.How does carrying securities at fair value differ from the equity method in
reporting income from nonsubsidiary investments?

6.Select the correct answer for each of the following questions.

i. On January 2, 20X3, Kean Company purchased a 30 percent interest in
Pod Company for $250,000. Pod reported net income of $100,000 for 20X3 and
declared and paid a dividend of $10,000. Kean accounts for this investment
using the equity method. In its December 31, 20X3, balance sheet, what amount
should Kean report as its investment in Pod?
a. $160,000
b. $223,000
c. $340,000
d. $277,000

ii. Investor Inc. owns 40 percent of Alimand Corporation. During the

calendar year 20X5, Alimand had net earnings of $100,000 and paid dividends
of $10,000. During 20X5, the market value of Alimand’s stock remained
unchanged. Investor mistakenly recorded these transactions by carrying the
investment at fair value rather than using the equity method of accounting. What
effect would this have on the investment account, net earnings, and retained
earnings, respectively?
a. Understate, overstate, overstate.
b. Overstate, understate, understate.
c. Overstate, overstate, overstate.
d. Understate, understate, understate.

iii. A corporation using the equity method of accounting for its investment in
a 40 percent-owned investee, which earned $20,000 and paid $5,000 in
dividends, made the following entries:
What effect will these entries have on the investor’s statement of financial
position?
a. Financial position will be fairly stated.
b. Investment in the investee will be overstated; retained earnings will be
understated.
c. Investment in the investee will be understated; retained earnings will be
understated.
d. Investment in the investee will be overstated; retained earnings will be
overstated.

7.Winston Corporation purchased 40 percent of the stock of Fullbright Company

on January 1, 20X2, at underlying book value. During the period of January 1,
20X2, through December 31, 20X4, the market value of Winston’s investment in
Fullbright’s stock increased by $20,000 each year. The companies reported the
following operating results and dividend payments during the first three years of
intercorporate ownership:

Required
Compute the net income reported by Winston for each of the three years,
assuming it accounts for its investment in Fullbright by (a) carrying the
investment at fair value or (b) using the equity method.

8.Small Company reported 20X7 net income of $40,000 and paid dividends of $15,000
during the year. Mock Corporation acquired 20 percent of Small’s shares on January 1,
20X7, for $105,000. At December 31, 20X7, Mock determined the fair value of the
shares of Small to be $121,000. Mock reported operating income of $90,000 for 20X7.
Required
Compute Mock’s net income for 20X7 assuming it
a. Carries the investment in Small at fair value.
b. Uses the equity method of accounting for its investment in Small.
9.Kent Company purchased 35 percent ownership of Lomm Company on January 1,
20X8, for $140,000. Lomm reported 20X8 net income of
$80,000 and paid dividends of $20,000. At December 31, 20X8, Kent determined the
fair value of its investment in Lomm to be $174,000.
Required
Give all journal entries recorded by Kent with respect to its investment in Lomm in 20X8
assuming it
a. Uses the equity method.
b. Carries the securities at fair value method.

Gant Company purchased 20 percent of the outstanding shares of Temp Company for
$70,000 on January 1, 20X6. The following results are reported for Temp Company:

Required
Determine the amounts reported by Gant as income from its investment in Temp for
each year and the balance in Gant’s investment in Temp at the end of each year
assuming that Gant uses the following options in accounting for its investment in Temp:
a. Carries the investment at fair value.
b. Uses the equity method.

Suggested ANSWERS TO QUESTIONS

-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) An investment in the voting common stock of another company is carried at fair value when
the investor is NOT able to significantly influence the operating and financial policies of the
investee.

-2 Under normal circumstances, the balance in the intercorporate investment account is

expected to be different if the investment is carried at fair value, or if the equity method of
accounting is used.

-3 At the time the investment qualifies for use of the equity method, the investor shall add the
cost of acquiring the additional interest in the investee (if any) to the current basis of the investor’s
previously held interest and adopt the equity method of accounting as of the date the investment
becomes qualified for equity method accounting

-4 A dividend is treated as a reduction of the investment account under equity-method reporting.

A dividend received on investments carried at fair value is recorded as dividend income.

-5 For securities carried at fair value, the change in the fair value of the shares held by the
investor is recorded as an unrealized gain or loss at the end of the period. Under the equity
method the investor’s share of the earnings of the investee are recorded as investment income
(and recorded as an increase to the investment account). Under the equity method any
dividends received from the investee are treated as a reduction of the investment account and
these dividends are not considered income to the investor.

6(i). a – Because the ownership in Amal Corporation is less than 20%, the investment should be
carried at fair value. Accordingly, the $1,500 dividend received from Amal is recorded as
dividend revenue.

(b) Incorrect. Stock dividends are not recorded as income.

(c) Incorrect. The cash dividend received from B&K is not recorded as dividend revenue
because it is accounted for under the equity method.
(d) Incorrect. The stock dividend and cash dividend from B&K are not recorded as
dividend revenue.

(ii). a – Under the equity method, net income increases the investment account while dividends
decrease it. Because net income was greater than the dividends declared, this results in
a net increase in the investment account. The problem information indicated that fair value
of the stock was unchanged during the year. Thus in this problem, the balance at year-end
would be lower if the investment was carried at fair value than it would be under the equity
method.

(b) Incorrect. This would only be true if the dividends were less than the net income.
(c) Incorrect. It doesn’t matter when the dividends are paid; as soon as they are declared
they act as a reduction to the investment under the equity method.
(d) Incorrect. It doesn’t matter when the dividends are paid; as soon as they are declared
they act as a reduction to the investment under the equity method.
(iii). b – Under the equity method the company records a share of the affiliate net income as
income for the company. This increases the net income of the company which increases
earnings per share.

(a) Incorrect. An increase in income affects long-term assets, not current assets or
current liabilities, so it would have no effect on the current ratio.
(c) Incorrect. The assets would be higher so asset turnover would decrease. No other
turnover ratios would be affected.
(d) Incorrect. The affiliate company’s profitability would not decrease the book value per
share of the company, it would increase it since retained earnings would increase with
the recognition of income from the subsidiary.

7(a). Winston Corporation net income – carried at fair value:

20X2 $100,000 + .40($30,000) + $20,000 $132,000

20X3 $ 60,000 + .40($60,000) + $20,000 104,000
20X4 $250,000 + .40($50,000a) + $20,000 290,000
a
A liquidating dividend can impact the entry made by the company declaring the dividend where
it may need to debit a paid-in-capital account instead of a retained earnings account.
In the past, if the recipient of the dividend was accounting for the equity investment under the
cost method, then the entry to record a liquidating dividend needed to be modified to exclude
the liquidating amount from dividend income. The liquidating amount received was recorded as
a reduction in the investment.
However, under current standards if the equity investment is being accounting for under the
equity method, then all dividends are treated as a return of investment (as opposed to a return
on investment). Therefore, all dividends are all dividends are effectively accounted for as
liquidating the investment (hopefully the investment is increasing through investee earnings).
If the investment is carried at fair value, then dividends received are recorded as income.
However, all changes in fair value are also recorded through income each period. If a company
is truly in the process of liquidating paid in capital, the fair value of that company will be
expected to be declining.

(b). Winston Corporation net income – equity method:

20X2 $100,000 + .40($70,000) $128,000
20X3 $ 60,000 + .40($40,000) 76,000
20X4 $250,000 + .40($25,000) 260,000

8.a. Fair value method:

Operating income reported by Mock $90,000

Unrealized gain on increase in value of Small stock 16,000
Dividend income from Small ($15,000 x 0.20) 3,000
Net income reported by Mock $ 109,000
b. Equity method:

Operating income reported by Mock $90,000

Income from investee ($40,000 x 0.20) 8,000
Net income reported by Mock $98,000

9. a. Journal entries under the equity method:

(1) Investment in Lomm Company Stock 140,000

Cash 140,000
Record purchase of Lomm Company stock.

(2) Cash 7,000

Investment in Lomm Company Stock 7,000
Record dividends from Lomm Company: $20,000 x 0.35

(3) Investment in Lomm Company Stock 28,000

Income from Lomm Company 28,000
Record equity-method income: $80,000 x 0.35

b. Journal entries for investment carried at fair value.

(1) Investment in Lomm Company Stock 140,000

Cash 140,000
Record purchase of Lomm Company stock.

(2) Cash 7,000

Dividend Income 7,000
Record dividends from Lomm Company: $20,000 x 0.35

(3) Investment in Lomm Company Stock 34,000

Unrealized Gain on Increase in Value of Lomm Stock 34,000
Record increase in value of Lomm stock: $174,000 - $140,000

10.

a. Fair value method:

20X6 20X7 20X8
Investment income:
Dividends received $ 3,000 $ 6,000 $ 4,000
Gain (loss) on fair value 19,000 (3,000) 11,000
Total income reported $22,000 $ 3,000 $15,000

Balance in investment account $89,000 $86,000 $97,000

b. Equity method:
Investment income:
$40,000 x .20 $ 8,000
$35,000 x .20 $ 7,000
$60,000 x .20 $12,000

Balance in investment account:

Balance at January 1 $70,000 $75,000 $76,000
Investment income 8,000 7,000 12,000
Dividends received (3,000) (6,000) (4,000)
Balance at December 31 $75,000 $76,000 $84,000