F5 - M2 - Equity Method

Question 1

What is the key determiner when deciding if the equity method is appropriate?

Answer 1

The key determiner for using the equity method is whether the investor has significant influence over the investee’s operating and financial policies.

• Ownership between 20% and 50% usually indicates significant influence, but the actual ability to exercise significant influence is the most important factor.
• If significant influence does not exist, even if ownership is in that range, the equity method is not appropriate.

Question 2

What are a company’s identifiable net assets?

Answer 2

identifiable net assets = fair value of all recognized assets minus fair value of all recognized liabilities that can be separately identified.

Question 3

What is the difference between fair value for trading investments and the equity method?

Answer 3

Trading investments = fair value changes hit income immediately.

Equity method = investment adjusted for investee’s earnings and dividends, no fair value adjustments.

Question 4

Why is a premium or discount amortized under the equity method?

Answer 4

Because it represents differences between the price paid and the fair value of specific investee assets, and those assets lose value over time — so your investment must decrease as they are consumed.

Question 5

What does a premium usually represent in equity method investments?

Answer 5

Payment for investee assets that are undervalued on the books (e.g., undervalued equipment, intangibles, customer lists, or goodwill).

Question 6

What does a discount usually represent in equity method investments?

Answer 6

Buying the investment for less because some investee assets are overvalued or expected to generate lower future earnings.

Question 7

Under the Equity Method, why not just leave the investment at purchase price and not amortize any discounts or premiums?

Answer 7

Because the equity method reflects your share of the investee’s assets, not the stock certificate — if the underlying assets decline with use, your investment must too.

Question 8

Under the Equity Method, what happens if the basis difference between purchase price and fair value (Premium) relates to goodwill?

Answer 8

Goodwill is not amortized, but it is tested for impairment.

Question 9

Under the Equity Method, what happens with a stock dividend is issued from the investor’s perspective?

Answer 9

Under the equity method, when the investor receives a stock dividend from the investee, the investor does not record dividend revenue. Instead, the investor makes a memorandum entry that reduces the unit cost of all shares owned.

In other words, the total investment cost stays the same but is spread over a larger number of shares, lowering the per-share cost. This reflects the increase in shares without changing the overall investment value.

Question 10

When a company uses the Equity Method for an investment, how are preferred dividends accounted for?

Answer 10

Preferred dividends are recognized as dividend income, not equity earnings, under the equity method.

DR Cash XXX
CR Dividend Income XXX

Question 11

When a company uses the Equity Method for an investment, how are common stock dividends accounted for?

Answer 11

Common stock dividends under the equity method are treated as a return of capital and reduce the investment account.

DR Cash XXX
CR Investment in investee XXX

Question 12

Using the Equity Method, how is Goodwill accounted for? (Specifically, how is is amortized and tested for impairment on an ongoing basis)

Answer 12

Any goodwill created in an investment accounted for under the equity method is ignored. It is neither amortized nor tested for impairment on a quarterly basis. The entire investment (using the equity method) is subject to the impairment test. The treatment for goodwill resulting from an equity method investment differs significantly on a quarterly basis from the treatment at year-end, when the entire investment should be evaluated both quantitatively and qualitatively for potential impairment.

Question 13

When does the equity method apply to an investment during the year if significant influence is acquired partway through the period?

Answer 13

Once significant influence is acquired and the equity method begins, all subsequent investee income and dividends from that date forward are accounted for using the equity method. No retroactive adjustment is required for earlier periods in the same year when another method (e.g., fair value) was used. Dividends reduce the investment balance, not income.