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Chapter 1

When an investor uses the equity method to account for investments in common stock, cash dividends received by the investor from the investee should be recorded as

A deduction from the investment account

What indicates an investor company's ability to significantly influence an invested?

Investor representation on the board of directors of the invested
Investor participation in the policymaking process of the investee
Material intra-entity transactions
Interchange of managerial personnel
Technological dependency
Extent of ownership by the investor in relation to the size and concentration of other ownership interests in the investee

What is the general test of control that the FASB provides?

20%-50% ownership

What happens when an investment where significant influence was not relevant, becomes significant, and the equity method must then be applied?

A retrospective adjustment is made to restate all prior years presented using the equity method

Under the fair-value option, what affect the income the investor recognizes as a result of its ownership in the investee

Changes in the fair value of the investor's ownership shares of the investee

When an investor elects the fair-value option for a significant influence investment, cash dividend received by the investor from the investee should be recorded as

Dividend income

When an investor elects to use the fair-value option instead of the equity method, can the investor choose to use the equity method after this election is made?

No

What is the objective of the equity method of accounting?

it attempts to reflect the relationship between the investor and the investee in two ways. First, the investor recognizes investment income as soon as it is earned by the investee. Second, the Investment account reported by the investor is increased and decreased to indicate changes in the underlying book value of the investee.

What criticisms have been leveled at the equity method?

 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 same as reported under consolidation. Therefore, the company that can use the equity method, and avoid consolidation, is often able to improve its debt-to equity ratios, as well as ratios for returns on assets and sales.

How is the allocation of an investee acquisition made?

The price paid for each purchase is first compared to the equivalent book value on the date of acquisition. Any excess payment is then assigned to specific assets and liabilities based on differences between book value and fair value. If any residual amount of the purchase price remains unexplained, it is assigned to goodwill.

What benefits arise from reducing the investment account by the dividend paid?

1. prevents double counting of revenue
2. mirrors the book value of the investee

What is a benefit to switching to the fair value method?

Fair values for financial assets and liabilities provide more relevant and interpretable information than cost or cost-based measures.

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