CHAPTER 2 REPORTING INTERCORPORATE INTERESTS IN COMMON STOCK ANSWERS TO QUESTIONS Q2-1 (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) The cost method normally is used for investments in common stock when the investor does not have significant influence and for investments in preferred stock and other securities. The amounts reported in the financial statements may require adjustment to fair value if they fall under the provisions of FASB Statement No. 115 . Q2-2 Significant influence occurs when the investor has the ability to influence the operating and financial policies of the investee. Representation on the board of directors of the investee is perhaps the strongest evidence, but other evidence such as routine participation in management decisions or entering into formal agreements that give the investor some degree of influence over the investee also may be used. Q2-3 Equity-method reporting should not be used when (a) an investee is in reorganization or liquidation, (b) the investee has initiated litigation or complaints challenging the investor's ability to exercise significant influence, (c) the investor signs an agreement surrendering its ability to exercise significant influence, (d) majority ownership is concentrated in a small group that operates the company without regard to the investor's desires, (e) the investor is not able to acquire the information needed to use equity-method reporting, or (f) the investor tries and fails to gain representation on the board of directors. Q2-4 The balances will be the same at the date of acquisition and in the periods that follow whenever the cumulative dividends paid by the investee equal or exceed the investee's cumulative earnings since the date of acquisition. The latter case assumes there are no other adjustments needed under the equity method for amortization of differential or other factors. Q2-5 When a company has used the cost method and purchases additional shares which cause it to gain significant influence, a retroactive adjustment is recorded to move from a cost basis to an equity-method basis in the preceding periods. Dividend income is replaced by income from the investee and dividends received are treated as an adjustment to the investment account. Solutions Manual- Baker/Lembke/King, Advanced Financial Accounting, 6/e 47
Chapter 2 Q2-6 An investor considers a dividend to be a liquidating dividend when the cumulative dividends received from the investee exceed a proportionate share of the cumulative earnings of the investee from the date ownership was acquired. For example, an investor would consider a dividend to be liquidating if it purchases shares of another company in early December and receives a dividend at year-end substantially in excess of its portion of the investee's net income for December. On the other hand, the investee may have
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