Chapter 01 – The Equity Method of Accounting for Investments – Hoyle, Schaefer, Doupnik, 13e
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CHAPTER 1
THE EQUITY METHOD OF ACCOUNTING FOR INVESTMENTS
Chapter Outline
I. Four methods are principally used to account for an investment in equity securities along
with a fair value option.
A. Fair value method: applied by an investor when only a small percentage of a
company’s voting stock is held.
1. Income is recognized when the investee declares a dividend.
2. Portfolios are reported at fair value. If fair values are unavailable, investment is
reported at cost.
1. A demonstrable impairment occurs for the investment, or
2. An observable price change occurs for identical or similar investments of the same
issuer.
Income is typically recognized by the investor for its share of investee dividends
3. Ability to significantly influence investee is indicated by several factors including
representation on the board of directors, participation in policy-making, etc.
4. GAAP guidelines presume the equity method is applicable if 20 to 50 percent of the
outstanding voting stock of the investee is held by the investor.
Current financial reporting standards allow firms to elect to use fair value for any new
investment in equity shares including those where the equity method would otherwise
apply. However, the option, once taken, is irrevocable. Investee dividends and changes in
fair value over time are recognized as income.
II. Accounting for an investment: the equity method
A. The investment account is adjusted by the investor to reflect all changes in the equity
of the investee company.
B. Income is accrued by the investor when it is reported in the investee’s financial
statements.
C. Dividends declared by the investee create a reduction in the carrying amount of the
Investment account. This book assumes all investee dividends are declared and paid
in the same reporting period.
Chapter 01 – The Equity Method of Accounting for Investments – Hoyle, Schaefer, Doupnik, 13e
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III. Special accounting procedures used in the application of the equity method
A. Reporting a change to the equity method when the ability to significantly influence an
investee is achieved through a series of acquisitions.
1. Initial purchase(s) will be accounted for by means of the fair value method (or at
cost) until the ability to significantly influence is attained.
2. When the ability to exercise significant influence occurs following a series of stock
purchases, the investor applies the equity method prospectively. The total fair
1. The investor recognizes its share of investee reported other comprehensive
income (OCI) through the investment account and the investor’s own OCI.
2. Income items such as discontinued operations that are reported separately by the
investee should be shown in the same manner by the investor. The materiality of
1. Losses reported by the investee create corresponding losses for the investor.
2. A permanent decline in the fair value of an investee’s stock should be recognized
immediately by the investor as an impairment loss.
3. Investee losses can possibly reduce the carrying value of the investment account
1. The investor applies the equity method until the disposal date to establish a proper
book value.
2. Following the sale, the equity method continues to be appropriate if enough shares
are still held to maintain the investor’s ability to significantly influence the investee.
If that ability has been lost, the fair-value method is subsequently used.
IV. Excess investment cost over book value acquired
A. The price an investor pays for equity securities often differs significantly from the
investee’s underlying book value primarily because the historical cost based
accounting model does not keep track of changes in a firm’s fair value.
B. Payments made in excess of underlying book value can sometimes be identified with
specific investee accounts such as inventory or equipment.
C. An extra acquisition price can also be assigned to anticipated benefits that are
expected to be derived from the investment. In accounting, these amounts are
presumed to reflect an intangible asset referred to as goodwill. Goodwill is calculated
as any excess payment that is not attributable to specific identifiable assets and
liabilities of the investee. Because goodwill is an indefinite-lived asset, it is not
amortized.
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the transferred goods are either consumed or until they are resold to unrelated parties.
B. Downstream sales of inventory
1. “Downstream” refers to transfers made by the investor to the investee.
2. Intra-entity gross profits from sales are initially deferred under the equity method
and then recognized as income at the time of the inventory’s eventual disposal.
3. The amount of gross profit to be deferred is the investor’s ownership percentage
1. “Upstream” refers to transfers made by the investee to the investor.
2. Under the equity method, the deferral process for intra-entity gross profits is
identical for upstream and downstream transfers. The procedures are separately
identified in Chapter One because the handling does vary within the consolidation
process.
Answers to Discussion Questions
The textbook includes discussion questions to stimulate student thought and discussion. These
questions are also designed to allow students to consider relevant issues that might otherwise be
overlooked. Some of these questions may be addressed by the instructor in class to motivate
student discussion. Students should be encouraged to begin by defining the issue(s) in each
case. Next, authoritative accounting literature (FASB ASC) or other relevant literature can be
consulted as a preliminary step in arriving at logical actions. Frequently, the FASB Accounting
Standards Codification will provide the necessary support.
Unfortunately, in accounting, definitive resolutions to financial reporting questions are not always
available. Students often seem to believe that all accounting issues have been resolved in the
past so that accounting education is only a matter of learning to apply historically prescribed
procedures. However, in actual practice, the only real answer is often the one that provides the
fairest representation of the firm’s transactions. If an authoritative solution is not available,
students should be directed to list all of the issues involved and the consequences of possible
alternative actions. The various factors presented can be weighed to produce a viable solution.
The discussion questions are designed to help students develop research and critical thinking
skills in addressing issues that go beyond the purely mechanical elements of accounting.
Did the Cost Method Invite Manipulation?
The cost method of accounting for investments often caused a lack of objectivity in reported
income figures. With a large block of the investee’s voting shares, an investor could influence the
Chapter 01 – The Equity Method of Accounting for Investments – Hoyle, Schaefer, Doupnik, 13e
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typically are accompanied by a decrease in fair value (also recognized in income), thus leaving
reported net income unaffected.
Does the Equity Method Really Apply Here?
The discussion in the case between the two accountants is limited to the reason for the
investment acquisition and the current percentage of ownership. Instead, they should be
examining the actual interaction that currently exists between the two companies. Although the
ability to exercise significant influence over operating and financial policies appears to be a rather
vague criterion, ASC 323 “Investments—Equity Method and Joint Ventures,” clearly specifies
actual events that indicate this level of authority (paragraph 323-10–15-6):
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 intra-entity transactions,
Chapter 01 – The Equity Method of Accounting for Investments – Hoyle, Schaefer, Doupnik, 13e
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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
2. For equity securities without readily determinable fair values, ASC 321 allows the cost method
for the investment asset. Investment income is recognized for the investor’s share of investee
3. According to FASB ASC paragraph 323–10–15-6 “Ability to exercise that influence may be
indicated in several ways, such as representation on the board of directors, participation in
4. Dividends are reported as a deduction from the investment account, not revenue, to avoid
reporting the income from the investee twice. The equity method is appropriate when an
investor has the ability to exercise significant influence over the operating and financing
eventual increase in cash.
5. If Jones cannot significantly influence the operating and financial policies of Sandridge, the
equity method should not be applied regardless of the ownership level. However, an owner of
25 percent of a company’s outstanding common stock is assumed to possess this ability. 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 (ASC 323-10–15-10):
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6. 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 declared by the investee decrease its book value, thus requiring a
recognition of the gross profit increases this account.
7. The equity method has been criticized because it allows the investor to recognize income that
may not be received in any usable form during the foreseeable future. Income is being
accrued based on the investee’s reported earnings, not on the investor’s share of investee
8. Accounting standards require that a change to the equity method be treated prospectively.
Any new investment (or other investor or investee activity) that provides significant influence
9. In reporting equity earnings for the current year, Riggins must separate its accrual into two
components: (1) net income and (2) other comprehensive income or loss. This handling
10. Under the equity method, losses are recognized by an investor at the time that they are
reported by the investee. However, because of the conservatism inherent in accounting, any
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11. Following the guidelines established by the ASC, Wilson would recognize an equity loss of
$120,000 (40 percent) stemming from Andrews’ reported loss. However, since the book value
total unrecognized losses, the investor will revert to the equity method.
12. In accounting, goodwill is derived as a residual figure. It is the investor’s cost in excess of its
share of the fair value of the investee assets and liabilities. Although a portion of the
13. On June 19, Princeton removes the portion of this investment account that has been sold and
recognizes the resulting gross profit or loss. For proper valuation purposes, the equity method
is applied (based on the 40 percent ownership) from the beginning of Princeton’s fiscal year
14. Downstream sales are made by the investor to the investee while upstream sales are from the
investee to the investor. These titles have been derived from the traditional positions given to
15. The portion of an intra-entity gross profit is computed based on the markup on any transferred
inventory retained by the buyer at year’s end. The markup percentage (based on sales price)
16. Intra-entity transfers do not affect the financial reporting of the investee except that the related
party transactions must be appropriately disclosed and labeled.
17. Under fair value accounting, firms report the investment’s fair value as an asset and changes
profits.
Chapter 01 – The Equity Method of Accounting for Investments – Hoyle, Schaefer, Doupnik, 13e
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Answers to Problems
1. D
Investment in Harrison Corporation as of December 31 ………….. $1,724,000
7. A Acquisition price ………………………………………………………………….. $700,000
Income accruals: 2017—$170,000 × 20% ………………………………… 34,000
2018—$210,000 × 20% ……………………………….. 42,000
Annual amortization (10 year remaining life) …………………………. $10,000
8. B Purchase price of Johnson stock ……………… $500,000
Chapter 01 – The Equity Method of Accounting for Investments – Hoyle, Schaefer, Doupnik, 13e
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8. (continued)
Investment purchase price……………………………………… $500,000
Basic income accrual ($90,000 × 40%) ……………….. 36,000
Amortization (above) …………………………………………. (16,400)
Chapter 01 – The Equity Method of Accounting for Investments – Hoyle, Schaefer, Doupnik, 13e
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12. B Purchase price of Steinbart shares ……………………………………….. $530,000
Book value of Steinbart shares ($1,200,000 × 40%)…………………. (480,000)
Trade name ………………………………………………………………………….. $ 50,000
Remaining life of trade name …………………………………………………. 20 years
Annual amortization ……………………………………………………….…….. $ 2,500
2017 Gross profit rate = $30,000 ÷ $100,000 = 30%
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Chapter 01 – The Equity Method of Accounting for Investments – Hoyle, Schaefer, Doupnik, 13e
16. (10 minutes) (Investment account after 2 years with fair value accounting
included)
a. Acquisition price ……………………………………………………………………… $60,000
Book value—assets minus liabilities ($125,000 × 40%) …………… 50,000
Excess payment ………………………………………………………………. $10,000
Value of patent in excess of book value ($15,000 × 40%) ………… 6,000
17. (10 minutes) (Equity entries for one year, includes intra-entity transfers but no
gross profit deferral)
Purchase price of Burks stock ………………………………………………. $210,000
Book value of Burks stock ($360,000 × 40%) ………………………….. (144,000)
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17. (continued)
Investment in Burks, Inc. …………………………………… 210,000
Cash (or a Liability) ………………………………………. 210,000
To record acquisition of a 40 percent interest in Burks.
18. (25 Minutes) (Equity entries for one year, includes prospective application of
equity method)
JANUARY 1, 2018 (Date significant influence is attained)
Purchase price of 30% of Seida’s stock ……………………………….. $600,000
Fair value of original 10% investment in Seida ……………………… 200,000
Trademark ………………………………………………………………………….. $ 12,000
Remaining life of Trademark ……………………………………………….. 8 years
Annual Amortization …………………………………………………………… $ 1,500
Journal Entries:
To record acquisition of Seida stock.
Chapter 01 – The Equity Method of Accounting for Investments – Hoyle, Schaefer, Doupnik, 13e
Equity Income—Investment in Seida ………………….. 1,500
Cash …………………………………………………………………. 44,000
Dividend Receivable. ……………………………………. 44,000
To record collection of dividend from investee.
19. (7 minutes) (Deferral of intra-entity gross profit)
Ending inventory ($225,000 – $105,000) …………………………..…………. $120,000
Gross profit percentage (GP $75,000 ÷ Sales $225,000) ………………. × 33⅓%
20. (10 minutes) (Reporting of equity income and transfers)
a. Equity in investee income:
Equity income accrual ($100,000 × 25%) ………………………….... $25,000
Less: deferral of intra-entity gross profit (below)………………. (3,000)
Chapter 01 – The Equity Method of Accounting for Investments – Hoyle, Schaefer, Doupnik, 13e
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b. In 2018, the deferral of $3,000 can be recognized by BuyCo’s use or sale of
this inventory. Thus, the equity accrual for 2018 will be increased by $3,000
c. The direction (upstream versus downstream) of the intra–entity transfer
does not affect the above answers. However as discussed in Chapter Five,
21. (25 minutes) (Equity method with a subsequent partial investment sale)
Equity method income accrual for 2018
25 percent of $600,000 for ½ year = ……………………………….. $ 75,000
21 percent of $600,000 for ½ year = ……………………………….. 63,000
Chapter 01 – The Equity Method of Accounting for Investments – Hoyle, Schaefer, Doupnik, 13e
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22. (25 minutes) (Verbal overview of equity method.
a. In 2017, the fair-value method was appropriate. Thus, income recognized
includes dividends declared and the change in the investment’s fair value.
b. The assumption is that Echo’ level of ownership now provides the company
with the ability to exercise significant influence over the operating and
e. Criticisms of the equity method include
▪ its emphasis on the 20-50% of voting stock in determining significant
influence vs. control
▪ allowing off-balance sheet financing
▪ potential biasing of performance ratios
Relative to consolidation, the equity method will report smaller amounts for
assets, liabilities, revenues and expenses. However, income is typically the
Chapter 01 – The Equity Method of Accounting for Investments – Hoyle, Schaefer, Doupnik, 13e
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22. (continued)
h. Investee dividends reduce its book value. Because the investor’s
Investment account tracks the investee’s book value, Echo records the
dividend as a reduction in its Investment account. This method of recording
23. (20 minutes) (Verbal overview of intra-entity transfers and their impact on
application of the equity method)
a. An upstream transfer goes from investee to investor whereas a
downstream transfer is made by the investor to the investee.
b. The direction of an intra-entity transfer has no impact on reporting when
the equity method is applied. The direction of the transfers was introduced
in Chapter One because it does have an important impact on consolidation
accounting as explained in Chapter Five.
c. To determine the intra-entity gross profit when applying the equity method,
the transferred inventory that remains at year’s end is multiplied by the
Chapter 01 – The Equity Method of Accounting for Investments – Hoyle, Schaefer, Doupnik, 13e
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23. (continued)
e. In the second year, Parrot again records an equity accrual for 42 percent of
the income reported by Sunrise. The intra-entity portion gross profit
created by the transfers for that year are delayed in the same manner as for
24. (15 minutes) (Verbal overview of the sale of a portion of an investment being
reported on the equity method and the accounting for any shares that remain)
a. The equity method must be applied up to the date of the sale. Therefore, for
the current year until August 1, Einstein records an equity accrual
recognizing 40 percent of Brooks’ reported income for that period. In
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24. (continued)
d. No, the ability to apply significant influence to the investee was present
25. (12 minutes) (Equity balances for one year includes intra-entity transfers)
a. Equity income accrual—2018 ($90,000 × 30%) ……………………. $27,000
Amortization—2018 (given) ……………………………………………….. (9,000)
Intra-entity profit recognized on 2017 transfer* …………………… 1,200
Intra-entity profit deferred on 2018 transfer** ……………………… (2,640)
Equity income recognized by Matthew in 2018 ………………. $16,560
*Gross profit rate (GPR) on 2017 transfer ($16,000/$40,000) … 40%
Intra-entity gross profit:
Intra-entity profit deferred from 2018 until 2019……………… $ 2,640
b. Investment in Lindman, 1/1/18 …………………………………………… $335,000
Equity income—2018 (see [a] above) …………………………………. 16,560