Summary

CHAPTER 1

1. A company acquires a rather large investment in another corporation. What criteria

determine whether the investor should apply the equity method of accounting to this
investment?
ANS: 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.

2. What accounting treatments are appropriate for investments in equity securities without
readily determinable fair values?
ANS: For equity securities without readily determinable fair values, ASC 321 allows the cost
method for the investment asset. Under the cost method, the investment account remains at cost
unless there is (a) a demonstrable impairment or (b) observable price changes.

3. What indicates an investor’s ability to significantly influence the decision-making process of an

investee?

ANS: If an investor holds at least 20 percent of the voting power of an investee, the investor is
presumed to have significant influence.

4. Why does the equity method record dividends from an investee as a reduction in the investment
account, not as dividend income?

ANS: the equity method employs accrual accounting to record income as it is earned by the
investee. The investment account is increased for the investees earned income and then decreased
as the income is distributed, through dividends.

14.What is the difference between downstream and upstream sales? How does this difference
affect application of the equity method?
ANS: Upstream and Downstream sales are normally associated with inter-company
sales. Upstream is a subsidiary selling into the parent entity; while downstream sales are from
parent to subsidiary. Under the equity method, no accounting distinction is actually drawn between
downstream and upstream sales.
15. How is the investor’s share of gross profit on intra-entity sales calculated? Under the equity
method, how does the deferral of gross profit affect the recognition of equity income?
ANS: 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) multiplied by the intra-entity ending inventory gives the seller’s profit remaining in the
buyer’s ending inventory. The product of the ownership percentage and this profit figure is the
investor’s share of gross profit from the intra-entity transaction. This profit is deferred in the
recognition of equity earnings until subsequently recognized following use or resale to an unrelated
party.

16. How are intra-entity transfers reported in an investee’s separate financial statements if the
investor is using the equity method?
ANS: 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. What is the fair-value option for reporting equity method investments? How do the equity
method
and fair-value accounting differ in recognizing income from an investee?
ANS: Under fair value accounting, firms report the investment’s fair value as an asset and changes
in fair value as earnings. Dividends from an investee are included in earnings under the fair value
accounting. Dividends are not recognized in income but instead reduce the investment account
under the equity method. Also, under the equity method, firms recognize their ownership share of
investee profits adjusted for excess cost amortizations and intra-entity profits.

CHAPTER 2

1. What is a business combination?

ANS: A business combination is the process of forming a single economic entity by the
uniting of two or more organizations under common ownership. The term also refers to the
entity that results from this process.
2. Describe the different types of legal arrangements that can take place to create a business
combination.
 ANS: A) A statutory merger is created whenever two or more companies come
together to form a business combination and only one remains in existence as an
identifiable entity.
B) A statutory merger can also be produced by the acquisition of a company’s
capital stock
C) A statutory consolidation results when two or more companies transfer all of
their assets or capital stock to a newly formed corporation. The original companies
are being “consolidated” into the new entity.
D) A business combination is also formed whenever one company gains control
over another through the acquisition of outstanding voting stock
3. What does the term consolidated financial statements mean?
ANS: Consolidated financial statements represent accounting information gathered from
two or more separate companies.
4. Within the consolidation process, what is the purpose of a worksheet?
ANS: Companies that form a business combination will often retain their separate legal
identities as well as their individual accounting systems, the business combination must
periodically produce consolidated financial statements encompassing all of the companies
within the single economic entity.so that The purpose of a worksheet is to organize and
structure this process.

5. Jones Company obtains all of the common stock of Hudson, Inc., by issuing 50,000 shares of
its own
stock. Under these circumstances, why might the determination of a fair value for the consideration
transferred be difficult?
ANS: Several situations can occur in which the fair value of the 50,000 shares being issued
might be difficult to ascertain. These examples include:
 The shares may be newly issued (if Jones has just been created) so that no accurate value
has yet been established;
 Jones may be a closely held corporation so that no fair value is available for its shares;
 The number of newly issued shares (especially if the amount is large in comparison to the
quantity of previously outstanding shares)
  Jones’ stock may have historically experienced drastic swings in price.

6. What is the accounting valuation basis for consolidating assets and liabilities in a business
combination?

ANS: For combinations resulting in complete ownership, the acquisition method allocates the fair
value of the consideration transferred to the separately recognized assets acquired and liabilities
assumed based on their individual fair values.

7. How should a parent consolidate its subsidiary’s revenues and expenses?

ANS: The revenues and expenses (both current and past) of the parent are included within reported
figures. However, the revenues and expenses of the subsidiary are consolidated from the date of
the acquisition forward within the worksheet consolidation process.

Chaper3

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