Chap 002

Chapter 2
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
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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 reported net income well in excess of the total dividends paid for the year and
would not consider the dividends to be liquidating dividends.
Q2-7 Liquidating dividends decrease the investment account in both cases. All
dividends are treated as a reduction of the investment account when equity-method
reporting is used. When the cost method is used and dividends are received in excess of
a proportionate share of investee earnings since acquisition, they are treated as a
reduction of the investment account as well.
Q2-8 The carrying value of the investment is reduced under equity method reporting
when (a) a dividend is received from the investee, (b) a purchase differential is
amortized, (c) an impairment of goodwill occurs, and (d) the market value of the
investment declines and is less than the carrying value and it is concluded the decline in
other than temporary.
Q2-9 A corporate joint venture is a company that is established and operated by a

small group of investors, none of whom hold a majority of the ownership. Because there
are only a few owners and each investor normally is expected to have significant
influence, equity-method reporting generally is appropriate in accounting for ownership
in a corporate joint venture.
Q2-10 A differential occurs when an investor pays more than or less than underlying
book value in acquiring ownership of an investee.
(a) In the case of the cost method, no adjustments are made for amortization of the
differential on the investor's books.
(b) Under equity-method reporting the difference between the amount paid and book
value must be assigned to appropriate asset and liability accounts of the acquired
company. If any portion of the differential is assigned to an amortizable or depreciable
asset, that amount must be charged against income from the investee over the
remaining economic life of the asset.
Q2-11 A dividend is treated as a reduction of the investment account under equity-

method reporting. Unless it is a liquidating dividend, it is treated as dividend income
under the cost method.
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Chapter 2
Q2-12 Amortization of a purchase differential is the most common reason for investment
income to be lower than a proportionate share of reported income of the investee. If
Turner Company has paid more than book value for the shares of Straight Lace
Company, the purchase differential must be assigned to identifiable assets and liabilities
of the investee, or to goodwill. Those amounts assigned to depreciable and identifiable
intangible assets must be amortized and will reduce equity-method income over the
remaining economic lives of the underlying assets. Amounts attributable to other items
such as land or inventories must be treated as a reduction of income in the period in
which Straight Lace disposes of the item. Income also will be lower if the investee has
been involved in sales to related companies during the period and there are unrealized
profits from those intercompany sales; the income of the selling affiliate must be reduced
by the unrealized profits before equity-method income is computed. Finally, if Straight
Lace has preferred stock outstanding, preferred dividends must be deducted before
assigning earnings to common shareholders.
Q2-13 Clear-cut measures of control are not always readily available. For example, a
partner contributing a specified share of the partnership=s capital may have a different
share of profits or losses, a different proportion of distributions, or a greater or lesser
degree of control than indicated by the capital share.
Q2-14 There may be situations in which a company has significant influence over
another without holding voting common stock. For example, a company might use
operating agreements or other contracts to share in the profits of another company,
guarantee a certain level of profitability of another company, or participate in the
operating decisions of another company.
Q2-15* In general, tax allocation procedures should be used whenever there is a

difference between dividends received from the investee and the amount of investment
income recorded by the investor. Tax allocation is not needed if the companies file a joint
tax return or if the investee's earnings can be transferred to the investor in a tax-free
transfer.
Q2-16* The amount should be larger under the equity method. There should be no need
to use tax allocation when the cost method is used in accounting for the investee.
Dividends received and taxable income are likely to be the same. Tax allocation normally
is needed under the equity method, due to the difference between income recorded and
dividends received.
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Chapter 2
Q2-17* When the basic equity method is used, a proportionate share of subsidiary net
income and dividends is recorded on the parent's books and an appropriate amount of
any purchase differential is amortized each period. No other adjustments are recorded.
Under the fully-adjusted equity method, the parent's books also are adjusted for
unrealized profits and any other items that are needed to bring the investor's net income
into agreement with the income that would be reported if consolidation were used.
Parent company and consolidated net income will always be the same when the fully-
adjusted equity method is used.
Q2-18* One-line consolidation implies that under equity-method reporting the investor's
net income and stockholders' equity will be the same as if the investee were
consolidated. Income from the investee is included in a single line in the investor's
income statement and the investment is reported as a single line in the investor's
balance sheet.
Q2-19* The term basic equity method generally is used when the investor records its
portion of the reported net income and dividends of the investee and amortizes an
appropriate portion of any purchase differential. Unlike the fully-adjusted equity method,
no adjustment for unrealized profit on intercompany transfers normally is made on the
investor's books. When an investee is consolidated for financial reporting purposes, the
investor may not feel it is necessary to record fully-adjusted equity method entries on its
books since income from the investee and the balance in the investment account must
be eliminated in preparing the consolidated statements.
Q2-20* The investor reports a proportionate share of an investee's extraordinary item as

an extraordinary item in its own income statement.
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Chapter 2
SOLUTIONS TO CASES
C2-1 Choice of Accounting Method
a. The equity method is to be used when an investor has significant influence over an
investee. Significant influence normally is assumed when more than 20 percent
ownership is held. Factors to be considered in determining whether to apply equity-
method reporting include the following:
1. Is the investee under the control of the courts or other parties as a result of filing
for reorganization or entering into liquidation procedures?
2. Does the investor have representation on the board of directors, or has it

attempted to gain representation and been unable to do so?
3. Has the investee initiated litigation or complaints challenging the investor's ability
to exercise significant influence?
4. Has the investor signed an agreement surrendering its ability to exercise

significant influence?
5. Is majority ownership concentrated in a small group that operates the company

without regard of the wishes of the investor?
6. Is the investor able to acquire the information needed to use equity-method

reporting?
b. When subsidiary net income is greater than dividends paid, equity-method reporting
is likely to show a larger reported contribution to the earnings of Slanted Building
Supplies. If 20X4 earnings are negative or less than dividends distributed in 20X4, the
cost basis is likely to result in a larger contribution to Slanted's reported earnings.
c. As the investor uses more of its resources to acquire ownership of the investee, and
as the investor has a greater share of the investee's profits and losses, the success of
the investee's operations may have more of an impact on the overall financial well-being
of the investor. In many cases, the investor will want to participate in key decisions of the
investee once the investor's ownership share reaches a certain level. Also, use of the
equity method eliminates the possibility of the investor manipulating its own income by
influencing investee dividend distributions, as might occur under the cost method.
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Chapter 2
C2-2 Intercorporate Ownership
MEMO
To: Chief Accountant

Most Company
From: , CPA
Re: Equity Method Reporting for Investment in Adams Company
The equity method should be used in reporting investments in which the reporting
company has a significant influence over the operating and financing decisions of
another company. In this case, Most Company holds 15 percent of the voting common
stock of Adams Company and Port Company holds an additional 10 percent. During the
course of the year, both Most and Port are likely to use the cost method in recording
their respective investments in Adams. However, when consolidated statements are
prepared for Most, the combined ownership must be used in determining whether
significant influence exists.
. . . an investment (direct or indirect) of 20% or more of the voting stock of

an investee should lead to a presumption that in the absence of evidence
to the contrary an investor has the ability to exercise significant influence
over the investee. [APB 18, Par. 17]
A total of 15 percent of the voting common stock of Adams is held directly by Most
Company and an additional 10 percent is controlled indirectly though Most=s ownership
of Port Company. Equity-method reporting for the investment in Adams Company
therefore appears to be required.
If the cost method has been used by Most and Port in recording their investments during
the year, at the time consolidated statements are prepared, adjustments must be made
to (a) increase the balance in the investment account for a proportionate share of the
investee=s reported net income (25 percent) and reduce the balance in the investment
account for a proportionate share of the dividend paid by the investee, (b) include a
proportionate share of the investee=s net income in the consolidated income statement,
(c) delete any dividend income recorded by Most and Port, and (d) if ownership was
purchased at an amount greater than a proportionate share of the fair value of the
investee=s net assets at the date of purchase, it may be necessary to amortize a portion
of the differential assigned to depreciable or amortizable assets.
Primary citation
APB 18, par. 17
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Chapter 2
C2-3 Application of the Equity Method
MEMO
To: Controller
Forth Company
From: , CPA
Re: Equity Method Reporting for Investment in Brown Company
This memo is prepared in response to your request regarding use of the cost or equity
methods in accounting for Forth=s investment in Brown Company.
Forth Company held 85 percent of the common stock of Brown Company prior to
January 1, 20X2, and was required to fully consolidate Brown Company in its financial
statements prepared prior to that date [FASB 94]. Forth now holds only 15 percent of the
common stock of Brown. The cost method is normally used in accounting for ownership
when less than 20 percent of the stock is directly or indirectly held by the investor.
Equity-method reporting should be used when the investor has “significant influence
over operating and financing policies of the investee.” While 20 percent ownership is
regarded as the level at which the investor is presumed to have significant influence,
other factors must be considered as well.
The ability to exercise significant influence may be indicated in several

ways, such as representation on the board of directors, participation in
policy making processes, material intercompany transactions,
interchange of managerial personnel, or technological dependency.
Another important consideration is the extent of ownership of other
shareholdings. [APB 18, Par. 17]
Although Forth currently holds only 15 percent of Brown=s common stock, the other
factors associated with its ownership indicate that Forth does exercise significant
influence over Brown. Forth has two members on Brown=s board of directors, it
purchases a substantial portion of Brown=s output, and Forth appears to be the largest
single shareholder by virtue of its sale of 10,000 shares to each of 7 other investors.
These factors provide strong evidence that Forth has significant influence over Brown
and points to the need to use equity-method reporting for its investment in Brown. Your
office should monitor the activities of the FASB with respect to consolidation standards
[www.fasb.org]. Active consideration is being given to situations in which control may be
exercised even though the investor does not hold majority ownership. It is conceivable
that your situation might be one in which consolidation could be required.
Primary citations
APB 18, par. 17
FASB 94
53
Chapter 2
C2-4 Use of the Cost or Equity Method [AICPA Adapted]
a. Under the cost method, the investor recognizes income as dividends are received
from the investee. Under the equity method, an investor recognizes as income its share
of an investee's earnings or losses in the periods in which they are reported by the
investee. The amount recognized as income under the equity method is adjusted for any
change in the remaining amount of the difference between original investment cost and
the investor's equity in net assets of the investee at the investment date. One could
argue that the equity method is more consistent with accrual accounting than is the cost
method because the equity method recognizes income when earned rather than when
dividends are received. On the other hand, one could argue that the cost method is more
consistent with the realization concept because the income is not recognized by the
investor until actually realized by the investor as it is distributed by the investee.
b. Madison should have assessed whether it could have exerted significant influence
over Boomer's operating and financial policies. Madison did not own 20 percent or more
of Boomer's voting stock (which would have led to the refutable presumption that it could
exercise significant influence); however, the ability to exercise significant influence may
be indicated by other factors such as Madison's provision of three key management
personnel and purchase of 25 percent of Boomer's output.
c. On becoming a 30 percent owner of Boomer, Madison should use the equity method
to account for its investment. As of January 2, 20X8, Madison's investment and retained
earnings accounts must be adjusted retroactively to show balances as if the equity
method had been used from the initial purchase date. Both accounts should be
increased by 18 percent of Boomer's undistributed income since formation.
54
Chapter 2
C2-5 Equity Method Accounting
a. An analysis of the four proposed alternatives in general can be developed with a

thoughtful reading of the materials in chapter 2. The unique aspects of the situations
presented in this case are the need for the acquiring company to consider (1) if it paid
too much and whether the amount paid is the appropriate basis for valuation, and (2)
whether or not the question of temporary ownership should influence the way in which
the company accounts for the investment.
If the purchase is considered to be only temporary and the equity method and
consolidation are ruled out, it would seem that alternative #1 may be the best choice. If
ownership for several years appears likely, alternative #4 would seem to be preferred.
The impact of the assumptions needed to support each alternative provides an excellent
means of discussing why the equity method and consolidation are considered superior
to use of the cost method for financial reporting purposes.
b. Not all industries and companies within an industry use the same reporting
procedures for a given situation. The company normally will first consult with its external
auditor to determine whether there is a difference of opinion between the way in which
the company feels this situation is best reported and the alternative recommended by
the auditor. A source often used to acquire information about specialized industries is
the AICPA industry audit guides. For regulated industries, the requirements set down by
regulatory boards should be examined. Contact with the research staff of the Financial
Accounting Standards Board and Chief Accountant=s Office of the Securities and
Exchange Commission may be needed to provide clarification in questionable cases.
c. An individual company may have little recourse in the near term. If the company
reports in a manner deemed to be inconsistent with generally accepted accounting
principles in the judgment of their external auditor, the company is likely to receive an
adverse opinion on its financial statements. This, in turn, can cause problems in filings
with the Securities and Exchange Commission and the ability to continue to have shares
traded on the major exchanges. It may be possible to appeal to the Securities and
Exchange Commission seeking approval before the financial statements are prepared. If
there are not clear accounting guidelines on the area, the company may wish to contact
the Emerging Issues Task Force of the Financial Accounting Standards Board to obtain
guidance in selecting the most appropriate alternative. If a conflict arises with the
existing external auditor, it may be possible that a change in audit firms would be
beneficial.
55
Chapter 2
C2-6 Reporting Significant Investments in Common Stock
Answers to this case can be found in the annual reports to stockholders of the
companies mentioned and in their 10-K filings with the SEC (available at www.sec.gov).
a. Before 1998, Harley-Davidson reported its investment in the common stock of Buell
Motorcycle Company using the equity method. The 49 percent investment that Harley
held since 1993 gave it the ability to significantly influence Buell. In 1998, Harley
purchased substantially all remaining shares of Buell and, therefore, Harley fully
consolidates Buell in its general-purpose financial statements.
b. Texaco reports its investment in Motiva Enterprises, LLC, within “Investments and
Advances” using the equity method. Motiva is a limited liability company. The owners of
Motiva are Texaco, Shell Oil, and Saudi Aramco.
c. Texaco reports its income from Motiva in revenues as a separate line-item labeled
“Equity in income of affiliates, interest, asset sales and other.” Revenues from
transactions with significant affiliates are reported in “Sales and services” under
Revenues, and the amounts are disclosed parenthetically.
d. PepsiCo reports investments in unconsolidated affiliates over which it exercises

significant influence using the equity method. Prior to 1999, equity-method income or
loss from these affiliates was included in selling, general and administrative expenses.
Obviously, this is not an appropriate classification for equity-method income from
affiliates, but it could be justified if the amounts are considered to be immaterial. In 1999,
PepsiCo started reporting its income from equity-method investments separately in the
income statement.
e. At December 31, 1999, Sears had investments in the voting securities of 37

companies that it accounted for using the equity method. Where these investments are
reported is difficult to tell from the financial statements and notes. Apparently the
amounts involved are relatively small, and the investments are included in other assets
on the balance sheet, with the income reported in other income on the income
statement.
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Chapter 2
SOLUTIONS TO EXERCISES
E2-1 Multiple-Choice Questions on Use of Cost and Equity Methods

[AICPA Adapted]
1. a
2. a
3. d
4. a
5. b
6. d
7. d
E2-2 Multiple-Choice Questions on Intercorporate Investments
1. b
2. c
3. d
4. a
5. a
E2-3 Multiple-Choice Questions on Applying Equity Method

[AICPA Adapted]
1. c
2. d $250,000 + ($100,000 x .30) - $4,000
3. c
4. d
5. d
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Chapter 2
E2-4 Cost versus Equity Reporting
a. Cost-method journal entries recorded by Roller Corporation:
20X5 Investment in Steam Company Stock 70,000

Cash 70,000
Record purchase of Steam Company stock.
Cash 1,000
Dividend Income 1,000
Record dividend income from Steam Company:
$5,000 x .20
20X6 Cash 3,000

$15,000 x .20
20X7 Cash 7,000

$35,000 x .20
Note: Cumulative dividends do not exceed cumulative
earnings to date.
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Chapter 2
E2-4 (continued)
b. Equity-method journal entries recorded by Roller Corporation:
20X5 Investment in Steam Company Stock 70,000

Cash 70,000
Record purchase of Steam Company stock.
Cash 1,000
Investment in Steam Company Stock 1,000
Record dividend from Steam Company.

Income from Steam Company 4,000
Record equity-method income.

Amortize purchase differential:
[$70,000 - ($200,000 x .20)] / 10 years
20X6 Cash 3,000



Amortize purchase differential.
20X7 Cash 7,000



59
Chapter 2
E2-5 Cost versus Equity Reporting
a. Winston Corporation net income – cost method:
20X2 $100,000 + .40($30,000) $112,000

20X3 $ 60,000 + .40($60,000) 84,000
a
20X4 $250,000 + .40($20,000 + $25,000) 268,000
a
Dividends paid from undistributed earnings of prior years
($70,000 + $40,000 - $30,000 - $60,000 = $20,000)
and $25,000 earnings of current period.
b. Winston Corporation net income – equity method:
20X2 $100,000 + .40($70,000) $128,000

20X3 $ 60,000 + .40($40,000) 76,000
20X4 $250,000 + .40($25,000) 260,000
E2-6 Acquisition Price
Balance at date of purchase:
a. Cost method $54,000 + $2,800 = $56,800
b. Equity method $54,000 - $2,000 = $52,000
Change in Investment Account

Year Net Income Dividends Cost Method Equity Method
20X1 $ 8,000 $15,000 $(2,800) $(2,800)
20X2 12,000 10,000 800
20X3 20,000 10,000 4,000
Change in account balance $(2,800) $ 2,000
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Chapter 2
E2-7 Investment Income
a. (1) Ravine Corporation net income under Cost Method:
20X6 $140,000 + .30($20,000) = $146,000

20X7 $ 80,000 + .30($40,000) = $ 92,000
20X8 $220,000 + .30($30,000) = $229,000
20X9 $160,000 + .30($20,000) = $166,000
(2) Ravine Corporation net income under Equity Method:
20X6 $140,000 + .30($30,000) = $149,000

20X7 $ 80,000 + .30($50,000) = $ 95,000
20X8 $220,000 + .30($10,000) = $223,000
20X9 $160,000 + .30($40,000) = $172,000
b. Journal entries recorded by Ravine Corporation in 20X8:
(1) Cost method:
Cash 12,000
Investment in Valley Stock 3,000
(2) Equity method:
Cash 12,000

Income from Valley 3,000
E2-8 Impairment of Investment Value
The following amounts would be reported as the carrying value of Port’s investment in
Sund:
20X2 $184,500 = $180,000 + ($40,000 x .30) - ($25,000 x .30)

20X3 $193,500 = $184,500 + ($30,000 x .30)
20X4 $135,000 = $4.50 x 30,000 shares; prior to adjustment, the
carrying value at the end of 20X4 would be $195,000
[$193,500 + ($5,000 x .30)]
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Chapter 2
E2-9 Alternative Reporting for Investment in Partnership
Moss Company Balance Sheet

Pro Rata Full
Cost Method Equity Method Consolidation Consolidation
Assets $510,000 $510,000 $622,500(d) $ 760,000 (f)
Investment in TF
Partnership 90,000 99,000(b)
Total Assets $600,000 $609,000 $622,500 $ 760,000
Liabilities $ 40,000 $ 40,000 $ 53,500(e) $ 70,000(g)

Interest of
Outside Partners 121,000(h)
Owners’ Equity 560,000(a) 569,000(c) 569,000(c) 569,000(c)
Total Liabilities and
Equity $600,000 $609,000 $622,500 $ 760,000
(a) $560,000 = $510,000 + $90,000 - $40,000

(b) $99,000 = $90,000 + [($220,000 - ($90,000/.45)) x .45]
(c) $569,000 = $560,000 + [($220,000 - ($90,000/.45)) x .45]
(d) $622,500 = $510,000 + ($250,000 x .45)
(e) $53,500 = $40,000 + ($30,000 x .45)
(f) $760,000 = $510,000 + $250,000
(g) $70,000 = $40,000 + $30,000
(h) $121,000 = [($250,000 - $30,000) x .55]
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Chapter 2
E2-10 Differential Assigned to Patents
Journal entries recorded by Power Corporation:
20X2 Investment in Snow Corporation Stock 360,000

Common Stock 90,000
Capital in Excess of Par Value 270,000
Record purchase of Snow Corporation stock.
Cash 7,000
Investment in Snow Corporation Stock 7,000
Record dividend from Snow Corporation:
$20,000 x .35

Income from Snow Corporation 19,600
Record equity-method income:
$56,000 x .35
Income from Snow Corporation 2,125

[$360,000 - ($980,000 x .35)] / 8 years
20X3 Cash 3,500

Record dividend from Snow Corporation:
$10,000 x .35
Loss from Snow Corporation 15,400

Record equity-method loss:
$44,000 x .35
Loss from Snow Corporation 2,125

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Chapter 2
E2-11 Differential Assigned to Copyrights
Journal entries recorded by Best Corporation:
20X7 Investment in Flair Company Stock 196,000

Cash 26,000
Bonds Payable 170,000
Record purchase of Flair Company stock.
Cash 6,000
Investment in Flair Company Stock 6,000
Record dividend from Flair Company:
$24,000 x .25
Loss from Flair Company 22,000

Record equity-method loss:
$88,000 x .25
Loss from Flair Company 5,250

Book value of assets $740,000
Book value of liabilities (140,000)
Net book value $600,000
Fair value increment 16,000
Fair value of net assets $616,000
Portion of ownership purchased x .25
Fair value of assets acquired $154,000
Amount paid 196,000
Differential $ 42,000
Period of amortization (years) ÷ 8
Amortization per period $ 5,250
20X8 Cash 6,000

Record dividend from Flair Company:
$24,000 x .25

Income from Flair Company 30,000
$120,000 x .25
Income from Flair Company 5,250

64
Chapter 2
E2-12 Purchase Differential Attributable to Depreciable Assets
a. Journal entries recorded by Capital Corporation using the equity

method:
20X4 Investment in Cook Company Stock 136,000

Cash 136,000
Record purchase of Cook Company Stock.
Cash 2,400
Investment in Cook Company Stock 2,400
Record dividend from Cook Company:
$6,000 x .40

Income from Cook Company 4,000
$10,000 x .40

$16,000 / 10 years
20X5 Cash 3,600

Record dividend from Cook Company:
$9,000 x .40

$20,000 x .40

b. Journal entries recorded by Capital Corporation using the cost

method:
20X4 Investment in Cook Company Stock 136,000

Cash 136,000
Record purchase of Cook Company Stock.
Cash 2,400
Record dividend income from Cook Company.
20X5 Cash 3,600

Record dividend income from Cook Company.
65
Chapter 2
E2-13 Investment Income
Brindle Corporation reported equity-method income of $13,000, computed as follows:
Proportionate share of reported income

($68,000 x .25) $17,000
Amortization of purchase differential:
Land ($7,500: not amortized) $ -0-
Equipment ($20,000 / 5 years) 4,000
Goodwill ($19,500: not amortized) -0- (4,000)
Investment Income $13,000
Assignment of purchase differential
Purchase price $162,000

Proportionate share of book value of net assets
[($690,000 - $230,000) x .25] (115,000)
Differential assigned to land ($30,000 x .25) (7,500)
Differential assigned to equipment ($80,000 x .25) (20,000)
Differential assigned to goodwill $ 19,500
E2-14 Income from Investee
Spone Corporation reported investment income of $18,000, computed as follows:
Proportionate share of reported income

($55,000 x .40) $22,000
Buildings ($24,000 / 10 years) $2,400

Equipment ($8,000 / 5 years) 1,600
Goodwill ($5,400: not amortized) -0- (4,000)
Investment income $18,000

[($345,000 - 105,000) x .40] (96,000)
Differential assigned to building (24,000)
Differential assigned to equipment (8,000)
Differential assigned to goodwill $ 5,400
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Chapter 2
E2-15 Determination of Purchase Price
Investment account balance December 31, 20X6 $161,000
Increase in account balance during 20X5:

Proportionate share of income
($110,000 x .30) $ 33,000
Amortize differential ($28,000 / 8 years) (3,500)
Dividend received ($50,000 x .30) (15,000) (14,500)
Decrease in account balance during 20X6:

Proportionate share of income ($20,000 x .30) $ 6,000
Amortize differential ($28,000 / 8 years) (3,500)
Dividend received ($40,000 x .30) (12,000) 9,500
Investment account balance at date of purchase $156,000
E2-16 Computation of Purchase Price
Investment account balance December 31, 20X3 $135,000
Increase in account balance during 20X2:

Proportionate share of income
($60,000 x .30) $ 18,000
Dividend received ($15,000 x .30) (4,500) (13,500)
Decrease in account balance during 20X3:

Proportionate share of loss ($40,000 x .30) $ (12,000)
Investment account balance at date of purchase $144,000
67
Chapter 2
E2-17 Correction of Error
Required correcting entry:
Investment in Case Products Stock 44,000

Income from Case Products 30,000
Retained Earnings 22,000
Computation of correction of investment account
Addition to account for investment income:

20X6: $40,000 x .40 $16,000
20X7: $60,000 x .40 24,000
20X8: $80,000 x .40 32,000 $72,000
Deduction for dividends received:

20X6: $15,000 x .40 $ 6,000
20X7: $20,000 x .40 8,000
20X8: $20,000 x .40 8,000 (22,000)

[.40($60,000 + $40,000)] (40,000)
Amount of purchase differential $16,000
Amortization for 3 years [($16,000 / 8) x 3] (6,000)

Required correction of investment account $44,000
Computation of correction of retained earnings of Grand Corporation
Dividend income recorded in 20X6: $15,000 x .40 $ 6,000

20X7: $20,000 x .40 8,000 ($14,000)
Equity-method income in 20X6: ($16,000 - $2,000) $14,000

20X7: ($24,000 - $2,000) 22,000 36,000
Required correction of retained earnings $22,000
68
Chapter 2
69
Chapter 2
E2-18 Purchase Differential Assigned to Land and Equipment
Journal entries recorded by Rod Corporation:
(1) Investment in Stafford Stock 65,000

Cash 65,000
Record purchase of Stafford Stock.
(2) Cash 4,500

Investment in Stafford Stock 4,500
Record dividend from Stafford:
$15,000 x .30
(3) Investment in Stafford Stock 12,000

Income from Stafford 12,000
$40,000 x .30
(4) Income from Stafford 1,000

Investment in Stafford Stock 1,000
Amortize purchase differential assigned to
equipment.
70
Chapter 2
E2-19 Equity Entries with Positive and Negative Goodwill
a. Journal entries recorded following purchase for $175,000:
(1) Investment in Turner Corporation 175,000

Cash 175,000
Record purchase of Turner stock.
(2) Cash 3,200

Investment in Turner Corporation 3,200
Record dividend from Turner:
$8,000 x .40

Income from Turner Corporation 16,000
$40,000 x .40
(4) Income from Turner Corporation 4,000

Write off purchase differential assigned to inventory
carried on FIFO basis:
$10,000 x .40

Amortize purchase differential assigned to buildings
and equipment:
[$240,000 - ($300,000 - $150,000)] x .40
10 years
71
Chapter 2
72
Chapter 2
E2-19 (continued)
b. Journal entries recorded following purchase for $140,000:

Cash 140,000
Record purchase of Turner stock.
(2) Cash 3,200

Record dividend from Turner:
$8,000 x .40

Income from Turner Corporation 16,000
$40,000 x .40

Write off purchase differential assigned
to inventory carried on FIFO basis:
$10,000 x .40

Amortize purchase differential assigned
to buildings and equipment:
$16,000 / 10 years
Computation of amortization of differential

Amount paid for ownership $140,000
Proportionate share of underlying book value:
Book value of total assets $375,000
Book value of liabilities (75,000)
Book value of net assets $300,000
Ownership acquired x .40
Book value of ownership acquired (120,000)
Purchase differential $ 20,000
Differential assigned to inventory (4,000)
Differential assigned to buildings and equipment $ 16,000
NOTE: In purchasing 40 percent of Turner Corporation for $140,000, Chad has

acquired its ownership for $20,000 less than a proportionate share of the fair value of
Turner's net assets [($400,000 x .40) - $140,000]. Negative goodwill is treated as a
reduction of the differential assigned to the noncurrent assets in such cases. Thus, a
differential of $16,000 is assigned to buildings and equipment rather than $36,000
[($240,000 - ($300,000 - $150,000)) x .40].
73
Chapter 2
74
Chapter 2
E2-20 Income Reporting
Journal entry recorded by Grandview Company:
Investment in Spinet Corporation 36,000

Income from Spinet Corporation 24,000
Extraordinary Gain (from Spinet Corporation) 12,000
E2-21* Investee with Preferred Stock Outstanding
Journal entries recorded by Reden Corporation:
(1) Investment in Montgomery Co. Stock 288,000

Cash 288,000
Record purchase of Montgomery Co. stock.
(2) Cash 6,750

Investment in Montgomery Co. Stock 6,750
Record dividend from Montgomery Co.:
[$40,000 - ($250,000 x .10)] x .45
(3) Investment in Montgomery Co. Stock 31,500

Income from Montgomery Co. 31,500
[$95,000 - ($250,000 x .10)] x .45
75
Chapter 2
E2-22* Other Comprehensive Income Reported by Investee
Journal entries recorded by Callas Corp. during 20X9:
(1) Investment in Thinbill Co. Stock 380,000

Cash 380,000
(2) Cash 3,600

Investment in Thinbill Co. Stock 3,600
Record dividend from Thinbill:
$9,000 x .40

Income from Thinbill Co. 22,000
$22,000 = ($45,000 + $10,000) x .40

Unrealized Gain on Investments of Investee (OCI) 8,000
Record share of OCI reported by Thinbill:
$8,000 = $20,000 x .40
Closing entries recorded at December 31, 20X9:
(5) Income from Thinbill Co. 22,000

(6) Unrealized Gain on Investments of Investee (OCI) 8,000

Accumulated Other Comprehensive Income from
Investee-Unrealized Gain on Investments 8,000
E2-23* Other Comprehensive Income Reported by Investee
Investment account balance reported by Baldwin Corp. $67,000
Add decrease in account recorded in 20X8:

Equity-method loss ($20,000 x .25) $ (5,000)
Deduct increase in account recorded in 20X9:

Equity-method income ($68,000 x .25) $ 17,000
Dividend received ($16,000 x .25) (4,000)
Other comprehensive income reported by Gwin
Company ($12,000 x .25) 3,000 (16,000)
76
Chapter 2
E2-24* Deferred Income Taxes
Computation of Crabapple's net income:
Deferred income tax reported by Denbow $ 37,800

Divide by Denbow's effective tax rate ÷ .45
Denbow's temporary tax difference $ 84,000
Divide by taxable portion ÷ .20
Denbow's portion of undistributed earnings $ 420,000
Denbow's portion of dividend payments 25,000
Denbow's portion of Crabapple's new income $ 445,000
Divide by proportion of ownership held by Denbow ÷ .25
Crabapple's net income for period $1,780,000
77
Chapter 2
SOLUTIONS TO PROBLEMS
P2-25 Multiple-Choice Questions on Applying the Equity Method

[AICPA Adapted]
1. a
2. a
3. c
4. d
P2-26 Amortization of Purchase Differential
Journal entries recorded by Ball Corporation:
(1) Investment in Krown Company Stock 120,000

Preferred Stock 50,000
Additional Paid-In Capital — Preferred Stock 70,000
Record purchase of Krown Company stock.
(2) Cash 3,000

Investment in Krown Company Stock 3,000
Record dividend from Krown Company:
$10,000 x .30
(3) Investment in Krown Company Stock 12,000

Income from Krown Company 12,000
(4) Income from Krown Company 1,200

Investment in Krown Company Stock 1,200
to buildings and equipment:
[($360,000 - $300,000) x .30] / 15 years
(5) Income from Krown Company 3,375

Investment in Krown Company 3,375
to copyrights: $27,000 / 8 years
Computation of copyrights
Fair value of Krown's:
Total assets $560,000
Total liabilities (250,000)
$310,000
Proportion of stock held by Ball x .30 (93,000)
Amount assigned to copyrights $ 27,000
78
Chapter 2
P2-27 Computation of Account Balances
a. Easy Chair Company 20X1 equity-method income:
Proportionate share of reported income ($30,000 x .40) $ 12,000

Amortization of purchase differential assigned to:
Buildings and equipment [($35,000 x .40) / 5 years] (2,800)
Goodwill ($8,000: not amortized) -0-
Investment Income $ 9,200

Proportionate share of book value of
net assets ($320,000 x .40) (128,000)
Proportionate share of fair value increase in
buildings and equipment ($35,000 x .40) (14,000)
Goodwill $ 8,000
b. Dividend income, 20X1 ($9,000 x .40) $ 3,600
c. Cost-method account balance (unchanged): $150,000
Equity-method account balance:

Balance, January 1, 20X1 $150,000
Investment income 9,200
Dividends received (3,600)
Balance, December 31, 20X1 $155,600
79
Chapter 2
P2-28 Retroactive Recognition
Journal entries recorded by Idle Corporation:
(1) Investment in Fast Track Enterprises Stock 34,000

Cash 34,000
Record purchase of Fast Track stock.

Record pick-up of difference between
cost and equity income:
20X2 .10($40,000 - $20,000) $ 2,000
20X3 .10($60,000 / 2) $3,000
.15[($60,000 / 2) - $20,000] 1,500 4,500
20X4 .15($40,000 - $10,000) 4,500
Amount of increase $11,000
(3) Cash 5,000

Investment in Fast Track Enterprises 5,000
Record dividend from Fast Track
Enterprises: $20,000 x .25

Income from Fast Track Enterprises 12,500
$50,000 x .25
80
Chapter 2
P2-29 Multistep Acquisition
Journal entries recorded by Jackson Corp. in 20X9:
(1) Investment in Phillips Corp. Stock 70,000

Cash 70,000
Record purchase of Phillips stock.

Record pick-up of difference between
cost and equity income.
Computation of equity pick-up

20X6 .10($70,000 - $20,000) $ 5,000
20X7 .10($70,000 - $20,000) 5,000
20X8 .15($70,000 - $20,000) 7,500
20X6 amortization of differential (1,000)
Amount of increase $14,500
Amortization of differential
20X6 purchase [$25,000 - ($200,000 x .10)]
5 years $1,000
20X8 purchase [$15,000 - ($300,000 x .05)] 0
20X9 purchase [$70,000 - ($350,000 x .20)] 0
Total annual amortization $1,000
(3) Cash 7,000

Investment in Phillips Corp. Stock 7,000
Record dividend from Phillips Corp:
$20,000 x .35

Income from Phillips Corp. 24,500
$70,000 x .35
(5) Income from Phillips Corp. 1,000

Investment in Phillips Corp. Stock 1,000
P2-30 Investment in Joint Venture
a. 25 percent = ($60,000 - $52,000) / [($330,000 - $50,000) –

($293,000 - $45,000)]
b. $782,500 = $700,000 + ($330,000 x .25)
81
Chapter 2
82
Chapter 2
P2-31 Investment in Partnership
Down Corporation Balance Sheet

Pro Rata Full
Assets $800,000 $800,000 $ 914,000(d) $1,180,000 (f)
Investment in DF
Partnership 84,000 105,000(b)
Total Assets $884,000 $905,000 $ 914,000 $1,180,000
Liabilities $175,000 $175,000 $ 184,000(e) $ 205,000(g)

Interest of
Outside Partners 245,000(h)
Owners’ Equity 709,000(a) 730,000(c) 730,000(c) 730,000(c)
Total Liabilities
and Equity $884,000 $905,000 $ 914,000 $1,180,000
(a) $709,000 = $730,000 - ($105,000 - $84,000)

(b) $105,000 = given
(c) $730,000 = given
(d) $914,000 = $800,000 + ($380,000 x .30)
(e) $184,000 = $175,000 + ($30,000 x .30)
(f) $1,180,000 = $800,000 + $380,000
(g) $205,000 = $175,000 + $30,000
(h) $245,000 = $350,000 x .70
Down Corporation Income Statement

Pro Rata Full
Sales Revenues $500,000 $ 500,000 $620,000 (b) $900,000 (d)
Expenses (345,000) (345,000) (456,000)(c) (715,000)(e)
Income from
Partnership 9,000(a)
Income to
Outside Partners (21,000) (f)
Net Income $155,000 $164,000 $164,000 $164,000
(a) $ 9,000 = [($400,000 - $370,000) x .30]

(b) $620,000 = $500,000 + ($400,000 x .30)
(c) $456,000 = $345,000 + ($370,000 x .30)
(d) $900,000 = $500,000 + $400,000
(e) $715,000 = $345,000 + $370,000
(f) $ 21,000 = [($400,000 - $370,000) x .70]
83
Chapter 2
P2-32 Complex Differential
a. Essex Company 20X2 equity-method income:
Proportionate share of reported net income

($80,000 x .30) $24,000
Deduct increase in cost of goods sold for purchase
differential assigned to inventory ($30,000 x .30) (9,000)
Deduct amortization of purchase differential
assigned to:
Buildings and equipment
[($320,000 - $260,000) x .30] / 12 years] (1,500)
Patent [($25,000 x .30) / 10 years] (750)
Equity-method income for 20X2 $12,750
b. Computation of investment account balance on December 31, 20X2:
Purchase Price $165,000

Investment income for 20X2 $12,750
Dividends received in 20X2 ($9,000 x .30) (2,700) 10,050
Investment account balance on December 31, 20X2 $175,050
84
Chapter 2
P2-33 Equity Entries with Differential
a. Journal entry recorded by Hunter Corporation:
Investment in Arrow Manufacturing Stock 210,000

Common Stock 60,000
Additional Paid-In Capital 150,000
Record acquisition of Arrow
Manufacturing stock.
b. Equity-method journal entries recorded by Hunter Corporation in 20X0:
(1) Investment in Arrow Manufacturing Stock 210,000

Common Stock 60,000
Record acquisition of Arrow Manufacturing stock.
(2) Cash 9,000

Record dividends from Arrow Manufacturing:
$20,000 x .45

Income from Arrow Manufacturing 36,000
$80,000 x .45
(4) Income from Arrow Manufacturing 1,350

and equipment:
($30,000 x .45) / 10 years
85
Chapter 2
P2-33 (continued)
Equity-method journal entries recorded by Hunter Corporation in 20X1:
(1) Cash 18,000

Record dividends from Arrow Manufacturing:
$40,000 x .45

Income from Arrow Manufacturing 22,500
Record equity-method income for period:
$50,000 x .45
(3) Income from Arrow Manufacturing 1,350

and equipment.
c. Investment account balance, December 31, 20X1:
Purchase price on January 1, 20X0 $210,000
20X0: Income from Arrow Manufacturing

($36,000 - $1,350) $34,650
Dividends received (9,000) 25,650
20X1: Income from Arrow Manufacturing

($22,500 - $1,350) $21,150
Dividends received (18,000) 3,150
Investment account balance, December 31, 20X1 $238,800
86
Chapter 2
P2-34 Equity Entries with Differential
a. Equity-method journal entries recorded by Ennis Corporation:
(1) Investment in Jackson Corporation Stock 200,000

Common Stock 50,000
Record acquisition of Jackson Corporation stock.
(2) Cash 3,500

Investment in Jackson Corporation Stock 3,500
Record dividend from Jackson Corporation:
$10,000 x .35
(3) Investment in Jackson Corporation Stock 24,500

Income from Jackson Corporation 24,500
$70,000 x .35
(4) Income from Jackson Corporation 7,000

Record expiration of purchase differential
assigned to inventory: $20,000 x .35
(5) Income from Jackson Corporation 1,400

Record amortization of purchase differential assigned
to buildings and equipment (net):
($80,000 x .35) / 20 years
b. $212,600 = $200,000 + $24,500 - $3,500 - $7,000 - $1,400
87
Chapter 2
P2-35 Additional Ownership Level
a. Operating income of Amber for 20X3 $220,000

Operating income of Blair for 20X3 $100,000
Add: Equity income from Carmen
[($50,000 - $6,000) x .25) 11,000
Blair net income for 20X3 $111,000
Proportion of stock held by Amber x .40 44,400
Equipment [($30,000 x .40) / 8 years] (1,500)
Patents [($25,000 x .40) / 5 years) (2,000)
Net income of Amber for 20X3 $260,900
b. Investment in Blair Corporation Stock 130,000

Common Stock 40,000
Capital in Excess of Par Value 90,000
Purchase of Blair Corporation Stock.
Cash 12,000
Investment in Blair Corporation Stock 12,000
Record dividend from Blair:
$30,000 x .40

Income from Blair Corporation 44,400
$111,000 x .40
Income from Blair Corporation 3,500

$3,500 = $1,500 + $2,000
88
Chapter 2
P2-36 Error in Recording Investment Income
a. Cost method entries for 20X4:

Cash 4,000
Record dividend income:
$16,000 x .25
b. Equity method entries for 20X4:

Cash 4,000
Investment in Chadwick Corporation 4,000
Record dividend from Chadwick:
$16,000 x .25

Income from Chadwick Corporation 15,500
$62,000 x .25
Income from Chadwick Corporation 1,500

Amortize purchase differential assigned to buildings and
equipment:
[($300,000 - $240,000) x .25] / 10 years
Income from Chadwick Corporation 700

Investment in Chadwick Corporation 700
to other identifiable intangible assets:
Fair value of net assets
($585,000 - $285,000) x .25 (75,000)
Other identifiable intangible assets $ 5,600
Number of years ÷ 8
Annual amortization $ 700
89
Chapter 2
P2-36 (continued)
c. Required correcting entry:

Investment Income 24,800
Adjustments to be recorded by Blanch Corporation on December 31, 20X4:
Retained 20X4 Investment

Earnings Investment Balance
Item 1/1/20X4 Income 12/31/20X4
Add back investment income
credited to investment account:
20X2 $14,000 $14,000
20X3 9,500 9,500
20X4 $15,500 15,500
Remove dividend income:
20X2 (4,000) (4,000)
20X3 (4,000) (4,000)
20X4 (4,000) (4,000)
Add correct investment income:
20X2 9,300 9,300
20X3 7,300 7,300
20X4 13,300 13,300
Required adjustment to
account balance $32,100 $24,800 $56,900
Computation of investment income
20X2 20X3 20X4

$56,000 x .25 $14,000
$38,000 x .25 $9,500
$62,000 x .25 $15,500
Amortize differential assigned to:
Inventory ($100,000 - $90,000) x .25 (2,500)
Buildings and equipment
[($300,000 - $240,000) x .25]/10 years (1,500) (1,500) (1,500)
Intangible assets ($5,600 / 8 years) (700) (700) (700)
Investment income $ 9,300 $7,300 $13,300
90
Chapter 2
P2-37 Correction of Error
Required correcting entry:

Income from Dale Company 11,500
Investment in Dale Company Stock 28,500
Adjustments to current books of Hill Company:
Dale Company
Retained Investment
Earnings 20X4 Balance
Item 1/1/20X4 Income 12/31/20X4
Adjustment to remove dividends
included in investment income and not
removed from investment account $(14,000) $(10,000) $(24,000)
Adjustment to annual amortization

of purchase differential:
20X2 and 20X3 (3,000) (3,000)
20X4 (1,500) (1,500)
Required adjustment to account balance $(17,000) $(11,500) $(28,500)
Computation of adjustment to annual amortization of purchase differential
Correct amortization of differential assigned to:

Equipment [($120,000 - $70,000) x .40] / 5 years $4,000
Patents:
Amount paid $164,000
Fair value of identifiable net assets
($300,000 + $50,000) x .40 (140,000)
Amount assigned $ 24,000
Number of years to be amortized ÷ 8
Annual amortization 3,000
Correct amount to be amortized annually $7,000
Amount amortized by Hill
[($164,000 - ($300,000 x .40)] / 8 years (5,500)
Adjustment to annual amortization $1,500
91
Chapter 2
P2-38* Other Comprehensive Income Reported by Investee
a. Equity-method income reported by Dewey Corporation in 20X5:
Amounts reported by Jimm Co. for 20X5:

Operating income $70,000
Dividend income 7,000
Gain on investment in trading securities 18,000
Net income $95,000
Ownership held by Dewey x .30
Investment income reported by Dewey $28,500
b. Computation of amount added to investment account in 20X5:
Balance in investment account reported by Dewey:

December 31, 20X5 $276,800
January 1, 20X5 (245,000)
Increase in investment account in 20X5 $ 31,800
Dividends received by Dewey during 20X5 6,000
Amount added to investment account in 20X5 $ 37,800
c. Computation of other comprehensive income reported by Jimm Co.:
Amount added to investment account in 20X5 $ 37,800

Investment income reported by Dewey in 20X5 (28,500)
Increase due to other comprehensive income reported by Jimm Co. $ 9,300
Proportion of ownership held by Dewey .30
Other comprehensive income reported by Jimm Co. $ 31,000
d. Computation of market value of securities held by Jimm Co.
Amount paid by Jimm Co. to purchase securities $130,000

Increase in market value reported as other comprehensive income in
20X5 31,000
Market value of available-for-sale securities at December 31, 20X5 $161,000
92
Chapter 2
P2-39* Equity-Method Income Statement
a.
Diversified Products Corporation
Income Statement
Year Ended December 31, 20X8
Net Sales $400,000

Cost of Goods Sold (320,000)
Gross Profit $ 80,000
Other Expenses $(25,000)
Gain on Sale of Truck 10,000 (15,000)
Income from Continuing Operations $ 65,000
Discontinued Operations:
Operating Loss from Discontinued Division $(15,000)
Gain on Sale of Division 44,000 29,000
Income before Extraordinary Item and Cumulative
Adjustment $ 94,000
Extraordinary Item:
Loss on Volcanic Activity (5,000)
Cumulative Adjustment:
Cumulative Effect of Change in Inventory Method (20,000)
Net Income $ 69,000
Diversified Products Corporation

Retained Earnings Statement
Retained Earnings, January 1, 20X8 $260,000

20X8 Net Income 69,000
$329,000
Dividends Declared (10,000)
Retained Earnings, December 31, 20X8 $319,000
93
Chapter 2
P2-39* (continued)
b.
Wealthy Manufacturing Company
Income Statement
Net Sales $850,000

Cost of Goods Sold (670,000)
Gross Profit $180,000
Other Expenses $(90,000)
Income from Continuing Operations of
Diversified Products Corporation 26,000 (64,000)
Income from Continuing Operations $116,000
Discontinued Operations:
Share of Operating Loss Reported by
Diversified Products on Discontinued
Division $ (6,000)
Share of Gain on Sale of Division
Reported by Diversified Products 17,600 11,600
Income before Extraordinary Item and
Cumulative Adjustment $127,600
Extraordinary Item:
Share of Loss on Volcanic Activity
Reported by Diversified Products (2,000)
Cumulative Adjustment:
Share of Cumulative Effect of Change in
Inventory Method Reported by
Diversified Products (8,000)
Net Income $117,600
Wealthy Manufacturing Company

Retained Earnings Statement
Retained Earnings, January 1, 20X8 $420,000

20X8 Net Income 117,600
$537,600
Dividends Declared (30,000)
Retained Earnings, December 31, 20X8 $507,600
94
Chapter 2
P2-40* Computing Income Tax Expense
a. Income tax expense reported by Swan Products:
(1) Cost method (Dividends received net of 80 percent dividend

deduction, times effective tax rate):
20X4 [($4,000 x .25) x (1 - .80)] x .40 = $ 80

20X5 [($10,000 x .25) x (1 - .80)] x .40 = 200
20X6 [($12,000 x .25) x (1 - .80)] x .40 = 240
(2) Equity method:
20X4 20X5 20X6
Computech dividends $ 4,000 $10,000 $12,000

Swan Product's share x .25 x .25 x .25
Dividends received by Swan $ 1,000 $ 2,500 $ 3,000
Dividend deduction (80%) (800) (2,000) (2,400)
Taxable dividend income $ 200 $ 500 $ 600
Taxable dividend income $ 200 $ 500 $ 600

Effective tax rate x .40 x .40 x .40
Income taxes payable $ 80 $ 200 $ 240
Computech's net income $20,000 $ 8,000 $40,000

Swan Product's share x .25 x .25 x .25
Swan's investment income $ 5,000 $ 2,000 $10,000
Assumed dividend deduction (80%) (4,000) (1,600) (8,000)
Investment income subject to
tax accrual $ 1,000 $ 400 $ 2,000
Taxable dividend income (200) (500) (600)
Temporary difference $ 800 $ (100) $ 1,400
Temporary difference $ 800 $ (100) $ 1,400

Effective tax rate x .40 x .40 x .40
Tax effect of temporary
difference $ 320 $ (40) $ 560
Income taxes payable 80 200 240
Income tax expense $ 400 $ 160 $ 800
Note: A simpler approach to reaching the same answers is to multiply the

equity-method income from Computech, minus the 80 percent assumed
dividend credit, times Swan's effective tax rate. While this approach works in
simple situations, it may not always give the same result in complex cases.
This approach is shown as follows:
20X4 [($20,000 x .25) x .20] x .40 = $400

20X5 [($8,000 x .25) x .20] x .40 = 160
20X6 [($40,000 x .25) x .20] x .40 = 800
95
Chapter 2
P2-40* (continued)
b. Cost method entries:
20X4:
Cash 1,000
Record dividends from Computech:
$4,000 x .25
Income Tax Expense 80

Income Taxes Payable 80
Accrue taxes on dividend income.
20X5:
Cash 2,500
$10,000 x .25

20X6:
Cash 3,000
$12,000 x .25

96
Chapter 2
P2-40* (continued)
c. Equity method entries:
20X4:
Cash 1,000
Investment in Computech Stock 1,000
$4,000 x .25

Income from Computech 5,000
Record income from Computech:
$20,000 x .25

Deferred Tax Liability 320
Accrue taxes on investment income:
$320 = $800 temporary difference x .40
20X5:
Cash 2,500
$10,000 x .25

$8,000 x .25

$40 = $100 reversal of temporary
difference x .40
97
Chapter 2
P2-40* (continued)
20X6:
Cash 3,000
$12,000 x .25

$40,000 x .25

$560 = $1400 temporary difference x .40
98

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Chapter 2

REPORTING INTERCORPORATE INTERESTS IN COMMON STOCK

Q2-3 Equity-method reporting should not be used when (a) an investee is in

Solutions Manual- Baker/Lembke/King, Advanced Financial Accounting, 6/e

Q2-6 An investor considers a dividend to be a liquidating dividend when the cumulative

Q2-9 A corporate joint venture is a company that is established and operated by a

Q2-11 A dividend is treated as a reduction of the investment account under equity-

Solutions Manual- Baker/Lembke/King, Advanced Financial Accounting, 6/e

Q2-15* In general, tax allocation procedures should be used whenever there is a

Solutions Manual- Baker/Lembke/King, Advanced Financial Accounting, 6/e

Q2-20* The investor reports a proportionate share of an investee's extraordinary item as

Solutions Manual- Baker/Lembke/King, Advanced Financial Accounting, 6/e

C2-1 Choice of Accounting Method

2. Does the investor have representation on the board of directors, or has it

4. Has the investor signed an agreement surrendering its ability to exercise

5. Is majority ownership concentrated in a small group that operates the company

6. Is the investor able to acquire the information needed to use equity-method

Solutions Manual- Baker/Lembke/King, Advanced Financial Accounting, 6/e

C2-2 Intercorporate Ownership

To: Chief Accountant

Re: Equity Method Reporting for Investment in Adams Company

. . . an investment (direct or indirect) of 20% or more of the voting stock of

Solutions Manual- Baker/Lembke/King, Advanced Financial Accounting, 6/e

C2-3 Application of the Equity Method

Re: Equity Method Reporting for Investment in Brown Company

The ability to exercise significant influence may be indicated in several

Solutions Manual- Baker/Lembke/King, Advanced Financial Accounting, 6/e

C2-4 Use of the Cost or Equity Method [AICPA Adapted]

Solutions Manual- Baker/Lembke/King, Advanced Financial Accounting, 6/e

C2-5 Equity Method Accounting

a. An analysis of the four proposed alternatives in general can be developed with a

Solutions Manual- Baker/Lembke/King, Advanced Financial Accounting, 6/e

C2-6 Reporting Significant Investments in Common Stock

d. PepsiCo reports investments in unconsolidated affiliates over which it exercises

e. At December 31, 1999, Sears had investments in the voting securities of 37

Solutions Manual- Baker/Lembke/King, Advanced Financial Accounting, 6/e

E2-1 Multiple-Choice Questions on Use of Cost and Equity Methods

E2-2 Multiple-Choice Questions on Intercorporate Investments

E2-3 Multiple-Choice Questions on Applying Equity Method

2. d $250,000 + ($100,000 x .30) - $4,000

Solutions Manual- Baker/Lembke/King, Advanced Financial Accounting, 6/e

E2-4 Cost versus Equity Reporting

a. Cost-method journal entries recorded by Roller Corporation:

20X5 Investment in Steam Company Stock 70,000

20X6 Cash 3,000

20X7 Cash 7,000

Solutions Manual- Baker/Lembke/King, Advanced Financial Accounting, 6/e

b. Equity-method journal entries recorded by Roller Corporation:

20X5 Investment in Steam Company Stock 70,000

Investment in Steam Company Stock 4,000

Income from Steam Company 3,000

20X6 Cash 3,000

Investment in Steam Company Stock 8,000

Income from Steam Company 3,000

20X7 Cash 7,000

Investment in Steam Company Stock 4,000

Income from Steam Company 3,000

Solutions Manual- Baker/Lembke/King, Advanced Financial Accounting, 6/e

E2-5 Cost versus Equity Reporting

a. Winston Corporation net income – cost method:

20X2 $100,000 + .40($30,000) $112,000

b. Winston Corporation net income – equity method:

20X2 $100,000 + .40($70,000) $128,000

E2-6 Acquisition Price