F5: M2 Equity Method

Question 1

Equity Securities include

Answer 1

• common shares
• preferred shares
• options and warrants on common and preferred shares

Question 2

Equity investors use either the

Answer 2

• Fair Value Method
  or
• equity method
  depending upon percentage of ownership and control

Question 3

Investor will use the Fair Value method if the investor holds an equity security like common stock and does not have

Answer 3

significant influence.
- Record the invest at cost on the trade date

Question 4

Ownership that is < 20%

Answer 4

does not have significant influence

Question 5

Subsequent Measurement - Fair Value Method

Answer 5

• measured at FV through Net income (FV-NI)
• Changes i FV are recorded in the income statement, not OCI
• Less than 20% ownership, no significan influence, FVNI method, FV method

Question 6

Fair Value Method/Equity Methold JE recording Purchase of Security

Answer 6

Question 7

Equity securities without significant influence are accounted for using the fair value method and unrealized gains and losses from changes in Fair value are reported in

Answer 7

net income (trading securities) in the period of change.

credit loss consideration apply only to AFS and HTM debt securities not to equity securities.

Question 8

Fair Value Method - Dividend Income

Answer 8

• Cash dividends are considered income under the FV method and result in the following entry
• DR Cash
• Cr Dividend Income ( income statement) (No income on the investment account)
• ## Dividends recvd in shares of stock are not considered income but they do increase the number of shares owned which often result in more cash dividends.

Question 9

Liquiding dividends under the Fair Value Method

Answer 9

• dividends distributed in excess of corporate earnings, should be subtracted from the investment if you recieve more cash than earnings

Question 10

The value of investment accounts under the Fair Value Method does not change for

Answer 10

• dividends received or for profits and losses on the investee

Question 11

Under the Fair Value Method, the sale of securities would result in a _________ to the investment account.

Answer 11

decrease

Question 12

How do you treat liquidating dividends under the Fair Value Through Net Income method?

**

(Example: Investor owns 5%. Investee declares an $8M dividend but has only $6M in Retained Earnings.)

Answer 12

Step 1 — Determine normal dividend income:
- Normal dividends are limited to the investee’s retained earnings.
- Multiply retained earnings × ownership %
- $6M x 5% = $300k dividend income (reported on I/S)
Step 2 — Determine liquidating (return of capital) portion:
- Any dividends in** excess of retained earnings = liquidating dividend.**
- Excess = $8M-$6M = $2M
- Investor’s share: $2M x 5% =$100M return of capital
Step 3 — Accounting treatment:
- Dividend income → Report on Income Statement
- Return of capital → Reduce the Investment account (NOT on I/S)

Summary Rule to Memorize:

✔ Normal dividends (up to RE) →** Dividend income**
✔ Excess dividends → Return of capital (reduce investment)

Question 13

An investor typically has significant influence over the investee if the investor owns between

Answer 13

20% to 50% of the voting stock.
- Usually recorded at cost, which includes the purchase price, any other direct costs such as commissions associated with the acquisition of the investment.
-

Question 14

Subsequent Measurement - Equity Method

Answer 14

• Investor adjusts the carrying amount of the investment to recognize its share of earnings or losses of the investee after the date of acquisition.
• The investor’s proportionate share of the investee’s earnings or losses is recognized in the investors income statement. Increasing (for gains) or decreasing for (losses) the carrying amount of the investment.

Question 15

Equity Method - Dividends

Answer 15

• ## dividends received result in a reduction of the carrying amount of the investment, considered a return of investment, rather then dividend income.

Question 16

Investments in Preferred stock are accounted for under the

Answer 16

Fair Value Method

Question 17

Equity Method - Goodwill

Answer 17

Question 18

Equity Method Goodwill Calculation

Answer 18

Purchase Price minus (Fair Value of Net assets X % acquired)

Question 19

Equity Method Goodwill Amortization Calculation (Undervalued equipment)

Answer 19

• (Fair Value minus Book Value ) / remaining life x % acquired
• Annual amortization to reduce equity income

Dr Equity in Investee
Cr Investment in Investee

Question 20

Equity Method GoodWill Amortization of inventory?

Answer 20

We take all amortization in the first year

Question 21

When should an investor resume applying the equity method after suspending it due to the investment carrying amount being reduced to zero from investee losses?

Answer 21

The investor resumes the equity method when its share of the investee’s net income equals the net losses not recognized during the suspension period, effectively restoring the carrying amount above zero

Question 22

Which factor is not an indicator of an investor’s ability to exercise significant influence over an investee?

Answer 22

Investor recommendation for the investee to hire a specific executive.