CHAPTER 2 REPORTING INTERCORPORATE INVESTMENTS 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 investment is temporary, (c) the investee has initiated litigation or complaints challenging the investor's ability to exercise significant influence, (d) the investor signs an agreement surrendering its ability to exercise significant influence, (e) majority ownership is concentrated in a small group that operates the company without regard to the investor's desires, (f) the investor is not able to acquire the information needed to use equity-method reporting, or (g) 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.

McGraw-Hill/Irwin The McGraw-Hill Companies, Inc., 2002

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 A corporate joint venture is a company that is established a small group of investors, none of whom hold a majority of Because there are only a few owners and each investor normally have significant influence, equity-method reporting generally is accounting for ownership in a corporate joint venture. Q2-9 A differential occurs when an investor pays more underlying book value in acquiring ownership of an investee. than and operated by the ownership. is expected to appropriate in

or

less

than

(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. Q2-10 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.

McGraw-Hill/Irwin The McGraw-Hill Companies, Inc., 2002

Q2-11 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. Q2-12* 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. Q2-13* 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. Q2-14* The equity method is applied in the same basic manner following either purchase or pooling of interests treatment of a business combination. When pooling treatment is used there will be no purchase differential and therefore no amortization of the differential in computing income from the investee. Q2-15* 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. Q2-16* 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.

McGraw-Hill/Irwin The McGraw-Hill Companies, Inc., 2002

Q2-17* 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 fullyadjusted 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. Q2-18* The investor reports a proportionate share of an investee's extraordinary item as an extraordinary item in its own income statement.

McGraw-Hill/Irwin The McGraw-Hill Companies, Inc., 2002

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 equitymethod 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.

McGraw-Hill/Irwin The McGraw-Hill Companies, Inc., 2002

C2-2

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.

McGraw-Hill/Irwin The McGraw-Hill Companies, Inc., 2002

C2-3

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 Accountants 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.

McGraw-Hill/Irwin The McGraw-Hill Companies, Inc., 2002

C2-4

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 of the 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, equitymethod 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.

McGraw-Hill/Irwin The McGraw-Hill Companies, Inc., 2002

SOLUTIONS TO EXERCISES E2-1 Multiple-Choice Questions on Use of Cost and Equity Methods [AICPA Adapted] a a d a b d d

1. 2. 3. 4. 5. 6. 7.

E2-2

Multiple-Choice Questions on Applying Equity Method [AICPA Adapted] c d c d d $250,000 + ($100,000 x .30) - $4,000

1. 2. 3. 4. 5.

E2-3

Multiple-Choice Questions on Equity-Method Reporting [AICPA Adapted] c a b Investment balance at July 1, 20X4 = $239,000 = $200,000 + [($80,000 - $50,000 + $100,000) x .30] Gain = $30,500 = $150,000 - ($239,000 / 2)

1. 2. 3.

4. 5.

c b

McGraw-Hill/Irwin The McGraw-Hill Companies, Inc., 2002

E2-4 a.

Cost versus Equity Reporting Cost-method journal entries recorded by Roller Corporation:

20X5

Investment in Steam Company Stock Cash Record purchase of Steam Company stock. Cash Dividend Income Record dividend income from Steam Company: $5,000 x .20

70,000 70,000

1,000 1,000

20X6

Cash Dividend Income Record dividend income from Steam Company: $15,000 x .20

3,000 3,000

20X7

Cash Dividend Income Record dividend income from Steam Company: $35,000 x .20 Note: Cumulative dividends do not exceed cumulative earnings to date.

7,000 7,000

McGraw-Hill/Irwin The McGraw-Hill Companies, Inc., 2002

E2-4 b.

(continued) Equity-method journal entries recorded by Roller Corporation:

20X5

Investment in Steam Company Stock Cash Record purchase of Steam Company stock. Investment in Steam Company Stock Income from Steam Company Record equity-method income. Cash Investment in Steam Company Stock Record dividend from Steam Company. Income from Steam Company Investment in Steam Company Stock Amortize purchase differential: [$70,000 - ($200,000 x .20)] / 10 years

70,000 70,000

4,000 4,000

1,000 1,000

3,000 3,000

20X6

Investment in Steam Company Stock Income from Steam Company Record equity-method income. Cash Investment in Steam Company Stock Record dividend from Steam Company. Income from Steam Company Investment in Steam Company Stock Amortize purchase differential.

8,000 8,000

3,000 3,000

3,000 3,000

20X7

Investment in Steam Company Stock Income from Steam Company Record equity-method income. Cash Investment in Steam Company Stock Record dividend from Steam Company. Income from Steam Company Investment in Steam Company Stock Amortize purchase differential.

4,000 4,000

7,000 7,000

3,000 3,000

McGraw-Hill/Irwin The McGraw-Hill Companies, Inc., 2002

E2-5 a.

Cost versus Equity Reporting Winston Corporation net income__cost method: 20X2 20X3 20X4
a

$100,000 + .40($30,000) $60,000 + .40($60,000) $250,000 + .40($20,000 + $25,000)a

$112,000 84,000 268,000

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 20X3 20X4 $100,000 + .40($70,000) $60,000 + .40($40,000) $250,000 + .40($25,000) $128,000 76,000 260,000

E2-6

Acquisition Price

Balance at date of purchase: a. b. Cost method Equity method $54,000 + $2,800 = $56,800 $54,000 - $2,000 = $52,000 Change in Investment Account Cost Method Equity Method $(2,800) $(2,800) 800 4,000 $ 2,000

Year

Net Income

Dividends

20X1 $ 8,000 $15,000 20X2 12,000 10,000 20X3 20,000 10,000 Change in account balance

$(2,800)

McGraw-Hill/Irwin The McGraw-Hill Companies, Inc., 2002

E2-7 a.

Investment Income (1) Ravine Corporation net income under Cost Method: 20X6 20X7 20X8 20X9 $140,000 $80,000 $220,000 $160,000 + + + + .30($20,000) .30($40,000) .30($30,000) .30($20,000) = = = = $146,000 $92,000 $229,000 $166,000

(2)

Ravine Corporation net income under Equity Method: 20X6 20X7 20X8 20X9 $140,000 $80,000 $220,000 $160,000 + + + + .30($30,000) .30($50,000) .30($10,000) .30($40,000) = = = = $149,000 $95,000 $223,000 $172,000

b.

Journal entries recorded by Ravine Corporation in 20X8:

(1)

Cost method: Cash Dividend Income Investment in Valley Stock 12,000 9,000 3,000

(2)

Equity method: Investment in Valley Stock Income from Valley Cash Investment in Valley Stock 3,000 3,000 12,000 12,000

McGraw-Hill/Irwin The McGraw-Hill Companies, Inc., 2002

E2-8

Differential Assigned to Patents

Journal entries recorded by Power Corporation: 20X2 Investment in Snow Corporation Stock 360,000 Common Stock Capital in Excess of Par Value Record purchase of Snow Corporation stock. Investment in Snow Corporation Stock Income from Snow Corporation Record equity-method income: $56,000 x .35 Cash Investment in Snow Corporation Stock Record dividend from Snow Corporation: $20,000 x .35 Income from Snow Corporation Investment in Snow Corporation Stock Amortize purchase differential: [$360,000 - ($980,000 x .35)] / 8 years 20X3 Loss from Snow Corporation Investment in Snow Corporation Stock Record equity-method loss: $44,000 x .35 Cash Investment in Snow Corporation Stock Record dividend from Snow Corporation: $10,000 x .35 Loss from Snow Corporation Investment in Snow Corporation Stock Amortize purchase differential. 2,125 2,125 2,125 2,125 19,600 19,600

90,000 270,000

7,000 7,000

15,400 15,400

3,500 3,500

McGraw-Hill/Irwin The McGraw-Hill Companies, Inc., 2002

E2-9

Differential Assigned to Copyrights

Journal entries recorded by Best Corporation: 20X7 Investment in Flair Company Stock Cash Bonds Payable Record purchase of Flair Company stock. Loss from Flair Company Investment in Flair Company Stock Record equity-method loss: $88,000 x .25 Cash Investment in Flair Company Stock Record dividend from Flair Company: $24,000 x .25 Loss from Flair Company Investment in Flair Company Stock Amortize purchase differential: 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 5,250 5,250 196,000 26,000 170,000

22,000 22,000

6,000 6,000

20X8

Investment in Flair Company Stock Income from Flair Company Record equity-method income: $120,000 x .25 Cash Investment in Flair Company Stock Record dividend from Flair Company: $24,000 x .25 Income from Flair Company Investment in Flair Company Stock Amortize purchase differential.

30,000 30,000

6,000 6,000

5,250 5,250

McGraw-Hill/Irwin The McGraw-Hill Companies, Inc., 2002

E2-10 a.

Purchase Differential Attributable to Depreciable Assets

Journal entries recorded by Capital Corporation using the equity method: 20X4 Investment in Cook Company Stock Cash Record purchase of Cook Company Stock. Investment in Cook Company Stock Income from Cook Company Record equity-method income: $10,000 x .40 Cash Investment in Cook Company Stock Record dividend from Cook Company: $6,000 x .40 Income from Cook Company Investment in Cook Company Stock Amortize purchase differential: $16,000 / 10 years 20X5 Investment in Cook Company Stock Income from Cook Company Record equity-method income: $20,000 x .40 Cash Investment in Cook Company Stock Record dividend from Cook Company: $9,000 x .40 Income from Cook Company Investment in Cook Company Stock Amortize purchase differential. 1,600 1,600 1,600 1,600 136,000 136,000

4,000 4,000

2,400 2,400

8,000 8,000

3,600 3,600

b.

Journal entries recorded by Capital Corporation using the cost method: 20X4 Investment in Cook Company Stock Cash Record purchase of Cook Company Stock. Cash Dividend Income Record dividend income from Cook Company. 20X5 Cash Dividend Income Record dividend income from Cook Company. 3,600 3,600 136,000 136,000

2,400 2,400

McGraw-Hill/Irwin The McGraw-Hill Companies, Inc., 2002

E2-11

Investment Income

Brindle Corporation reported equity-method income of $13,000, computed as follows: Proportionate share of reported income ($68,000 x .25) Amortization of purchase differential: Land ($7,500: not amortized) Equipment ($20,000 / 5 years) Goodwill ($19,500: not amortized) Investment Income

$17,000 $ -04,000 -0-

(4,000) $13,000

Assignment of purchase differential Purchase price Proportionate share of book value of net assets [($690,000 - $230,000) x .25] Differential Differential assigned to land ($30,000 x .25) Differential assigned to equipment ($80,000 x .25) Differential assigned to goodwill $162,000 (115,000) $ 47,000 (7,500) (20,000) $ 19,500

E2-12

Income from Investee

Spone Corporation reported investment income of $18,000, computed as follows: Proportionate share of reported income ($55,000 x .40) Amortization of purchase differential: Buildings ($24,000 / 10 years) Equipment ($8,000 / 5 years) Goodwill ($5,400: not amortized) Investment income Assignment of purchase differential Purchase price Proportionate share of book value of net assets [($345,000 - 105,000) x .40] Differential Differential assigned to building Differential assigned to equipment Differential assigned to goodwill

$22,000 $2,400 1,600 -0-

(4,000) $18,000

$133,400 (96,000) $ 37,400 (24,000) (8,000) $ 5,400

McGraw-Hill/Irwin The McGraw-Hill Companies, Inc., 2002

E2-13

Determination of Purchase Price $161,000

Investment account balance December 31, 20X6 Increase in account balance during 20X5: Proportionate share of income ($110,000 x .30) Amortize differential ($28,000 / 8 years) Dividend received ($50,000 x .30) Decrease in account balance during 20X6: Proportionate share of income ($20,000 x .30) Amortize differential ($28,000 / 8 years) Dividend received ($40,000 x .30) Investment account balance at date of purchase

$ 33,000 (3,500) (15,000)

(14,500)

6,000 (3,500) (12,000)

9,500 $156,000

E2-14

Computation of Purchase Price $135,000

Investment account balance December 31, 20X3 Increase in account balance during 20X2: Proportionate share of income ($60,000 x .30) Dividend received ($15,000 x .30) Decrease in account balance during 20X3: Proportionate share of loss ($40,000 x .30) Dividend received ($35,000 x .30) Investment account balance at date of purchase

$ 18,000 (4,500)

(13,500)

$(12,000) (10,500)

22,500 $144,000

McGraw-Hill/Irwin The McGraw-Hill Companies, Inc., 2002

E2-15

Correction of Error

Required correcting entry: Investment in Case Products Stock Dividend Income Income from Case Products Retained Earnings 44,000 8,000 30,000 22,000

Computation of correction of investment account Addition to account for investment income: 20X6: $40,000 x .40 20X7: $60,000 x .40 20X8: $80,000 x .40 Deduction for dividends received: 20X6: $15,000 x .40 20X7: $20,000 x .40 20X8: $20,000 x .40 Amortization of purchase differential: Purchase price Proportionate share of book value of net assets [.40($60,000 + $40,000)] Amount of purchase differential Amortization for 3 years [($16,000 / 8) x 3] Required correction of investment account

$16,000 24,000 32,000

$72,000

$ 6,000 8,000 8,000

(22,000)

$56,000 (40,000) $16,000 (6,000) $44,000

Computation of correction of retained earnings of Grand Corporation Dividend income recorded in 20X6: $15,000 x .40 20X7: $20,000 x .40 Equity-method income in 20X6: ($16,000 - $2,000) 20X7: ($24,000 - $2,000) Required correction of retained earnings $ 6,000 8,000 $14,000 22,000

($14,000)

36,000 $22,000

McGraw-Hill/Irwin The McGraw-Hill Companies, Inc., 2002

E2-16

Purchase Differential Assigned to Land and Equipment

Journal entries recorded by Rod Corporation: (1) Investment in Stafford Stock Cash Record purchase of Stafford Stock. Investment in Stafford Stock Income from Stafford Record equity-method income: $40,000 x .30 Cash Investment in Stafford Stock Record dividend from Stafford: $15,000 x .30 (4) Income from Stafford Investment in Stafford Stock Amortize purchase differential assigned to equipment. 1,000 1,000 65,000 65,000

(2)

12,000 12,000

(3)

4,500 4,500

McGraw-Hill/Irwin The McGraw-Hill Companies, Inc., 2002

E2-17 a.

Equity Entries with Positive and Negative Goodwill

Journal entries recorded following purchase for $175,000: (1) Investment in Turner Corporation Cash Record purchase of Turner stock. Investment in Turner Corporation Income from Turner Corporation Record equity-method income: $40,000 x .40 Cash Investment in Turner Corporation Record dividend from Turner: $8,000 x .40 (4) Income from Turner Corporation Investment in Turner Corporation Write off purchase differential assigned to inventory carried on FIFO basis: $10,000 x .40 Income from Turner Corporation Investment in Turner Corporation Amortize purchase differential assigned to buildings and equipment: [$240,000 - ($300,000 - $150,000)] x .40 10 years 4,000 4,000 175,000 175,000

(2)

16,000 16,000

(3)

3,200 3,200

(5)

3,600 3,600

McGraw-Hill/Irwin The McGraw-Hill Companies, Inc., 2002

E2-17 b.

(continued)

Journal entries recorded following purchase for $140,000: (1) Investment in Turner Corporation Cash Record purchase of Turner stock. Investment in Turner Corporation Income from Turner Corporation Record equity-method income: $40,000 x .40 Cash Investment in Turner Corporation Record dividend from Turner: $8,000 x .40 (4) Income from Turner Corporation Investment in Turner Corporation Write off purchase differential assigned to inventory carried on FIFO basis: $10,000 x .40 Income from Turner Corporation Investment in Turner Corporation Amortize purchase differential assigned to buildings and equipment: $16,000 / 10 years 4,000 4,000 140,000 140,000

(2)

16,000 16,000

(3)

3,200 3,200

(5)

1,600 1,600

Computation of amortization of differential Amount paid for ownership 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 Purchase differential Differential assigned to inventory Differential assigned to buildings and equipment

$140,000

(120,000) $ 20,000 (4,000) $ 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].

McGraw-Hill/Irwin The McGraw-Hill Companies, Inc., 2002

E2-18 a.

Equity-Method Computations [AICPA Adapted] North Company Investments Account December 31, 20X5

Investment in York: Original investment Equity-method income ($750,000 x .40) Dividends received (500,000 x .40 x $.50) Investment balance on December 31, 1985 Investment in Minor: Original investment and investment balance on December 31, 20X5 Total investment balance on December 31, 20X5

$2,400,000 300,000 (100,000) $2,600,000

450,000 $3,050,000

b.

North Company Income from Investments For the Year Ended December 31, 20X5

Investment income from York: Net income ($750,000 x .40) Investment income from Minor: Dividends received for third quarter (15,000 x $.30) Dividends received for fourth quarter (15,000 x $.30) Total investment income for 20X5

$300,000

$4,500 4,500 9,000 $309,000

McGraw-Hill/Irwin The McGraw-Hill Companies, Inc., 2002

E2-19*

Income Reporting

Journal entry recorded by Grandview Company: Investment in Spinet Corporation Income from Spinet Corporation Extraordinary Gain on Bond Retirement (from Spinet Corporation) 36,000 24,000 12,000

E2-20*

Investee with Preferred Stock Outstanding

Journal entries recorded by Reden Corporation: (1) Investment in Montgomery Co. Stock Cash Record purchase of Montgomery Co. stock. Investment in Montgomery Co. Stock Income from Montgomery Co. Record equity-method income: [$95,000 - ($250,000 x .10)] x .45 Cash Investment in Montgomery Co. Stock Record dividend from Montgomery Co.: [$40,000 - ($250,000 x .10)] x .45 288,000 288,000

(2)

31,500 31,500

(3)

6,750 6,750

McGraw-Hill/Irwin The McGraw-Hill Companies, Inc., 2002

E2-21*

Other Comprehensive Income Reported by Investee

Journal entries recorded by Callas Corp. during 20X9: (1) Investment in Thinbill Co. Stock Cash Investment in Thinbill Co. Stock Income from Thinbill Co. Record equity-method income: $22,000 = ($45,000 + $10,000) x .40 Cash Investment in Thinbill Co. Stock Record dividend from Thinbill: $9,000 x .40 (4) Investment in Thinbill Co. Stock Unrealized Gain on Investments of Investee (OCI) Record share of OCI reported by Thinbill: $8,000 = $20,000 x .40 8,000 8,000 380,000 380,000 22,000 22,000

(2)

(3)

3,600 3,600

Closing entries recorded at December 31, 20X9: (5) Income from Thinbill Co. Retained Earnings Unrealized Gain on Investments of Investee (OCI) Accumulated Other Comprehensive Income from Investee-Unrealized Gain on Investments 22,000 22,000

(6)

8,000

8,000

E2-22*

Other Comprehensive Income Reported by Investee $67,000

Investment account balance reported by Baldwin Corp. Add decrease in account recorded in 20X8: Equity-method loss ($20,000 x .25) Dividend received ($10,000 x .25) Deduct increase in account recorded in 20X9: Equity-method income ($68,000 x .25) Dividend received ($16,000 x .25) Other comprehensive income reported by Gwin Company ($12,000 x .25) Purchase price

$(5,000) (2,500)

7,500

$17,000 (4,000) 3,000 (16,000) $58,500

McGraw-Hill/Irwin The McGraw-Hill Companies, Inc., 2002

E2-23* a.

Investment Acquired in a Pooling of Interests

Equity-method entries for 20X0: Investment in Glenco Common Stock 988,000 Common Stock Additional Paid-In Capital Retained Earnings Record acquisition of Glenco common stock: $988,000 = .95($400,000 + $500,000 + $140,000) $410,000 = $5 x 82,000 shares $445,000 = ($500,000 x .95) - [$410,000 - ($400,000 x .95)] $133,000 = $140,000 x .95 Cash Investment in Glenco Common Stock Record dividends from Glenco: $20,000 x .95 Investment in Glenco Common Stock Income from Glenco Record equity-method income: $68,000 x .95 64,600 64,600 19,000 19,000

410,000 445,000 133,000

b.

Cost-method entries for 20X0: Investment in Glenco Common Stock 988,000 Common Stock Additional Paid-In Capital Retained Earnings Record acquisition of Glenco common stock. Cash Dividend Income Record dividend income from Glenco. 19,000 19,000

410,000 445,000 133,000

E2-24*

Deferred Income Taxes

Computation of Crabapple's net income: Deferred income tax reported by Denbow Divide by Denbow's effective tax rate Denbow's temporary tax difference Divide by taxable portion Denbow's portion of undistributed earnings Denbow's portion of dividend payments Denbow's portion of Crabapple's new income Divide by proportion of ownership held by Denbow Crabapple's net income for period $ $ $ $ 37,800 .45 84,000 .20 420,000 25,000 445,000

.25 $1,780,000

McGraw-Hill/Irwin The McGraw-Hill Companies, Inc., 2002

SOLUTIONS TO PROBLEMS P2-25 Multiple-Choice Questions on Applying Equity Method [AICPA Adapted]

1. 2. 3. 4.

a a c d

P2-26 a.

Cost versus Equity Reporting

Dagger Company net income using the cost method: 20X6 20X7 20X8 20X9
a

$50,000 $50,000 $50,000 $50,000

+ + + +

($4,000 x .25) = ($20,000 x .25) = ($30,000 x .25)a = ($20,000 x .25) =

$51,000 $55,000 $57,500 $55,000

Dividends are paid $22,000 from current earnings and $8,000 from undistributed earnings of prior years. Undistributed prior years' earnings are $11,000 [($10,000 / 2) - $4,000 + $30,000 - $20,000].

b.

Dagger Company net income using the equity method: 20X6 20X7 20X8 20X9 $50,000 $50,000 $50,000 $50,000 + + + + [($10,000 / 2)* ($30,000 x .25) ($22,000 x .25) ($40,000 x .25) x .25] $1,000 $1,000 $1,000 $500* = = = = $50,750 $56,500 $54,500 $59,000

*Earnings and amortization of differential for one-half year Amortization of differential: $10,000 / 10 years = $1,000 per year

McGraw-Hill/Irwin The McGraw-Hill Companies, Inc., 2002

P2-27

Amortization of Purchase Differential

Journal entries recorded by Ball Corporation: (1) Investment in Krown Company Stock Preferred Stock Additional Paid-In Capital__ Preferred Stock Record purchase of Krown Company stock. Investment in Krown Company Stock Income from Krown Company Record equity-method income. Cash Investment in Krown Company Stock Record dividend from Krown Company: $10,000 x .30 (4) Income from Krown Company Investment in Krown Company Stock Amortize purchase differential assigned to buildings and equipment: [($360,000 - $300,000) x .30] / 15 years Income from Krown Company Investment in Krown Company Amortize purchase differential assigned to copyrights: $27,000 / 8 years 1,200 1,200 120,000 50,000 70,000

(2)

12,000 12,000

(3)

3,000 3,000

(5)

3,375 3,375

Computation of copyrights Purchase price Fair value of Krown's: Total assets Total liabilities Proportion of stock held by Ball Amount assigned to copyrights $120,000 $560,000 (250,000) $310,000 x .30

(93,000) $ 27,000

McGraw-Hill/Irwin The McGraw-Hill Companies, Inc., 2002

P2-28 a.

Computation of Account Balances

Easy Chair Company 20X1 equity-method income: Proportionate share of reported income ($30,000 x .40) Amortization of purchase differential assigned to: Buildings and equipment [($35,000 x .40) / 5 years] Goodwill ($8,000: not amortized) Investment Income $ 12,000 (2,800) -0$ 9,200

Assignment of purchase differential Purchase price Proportionate share of book value of net assets ($320,000 x .40) Proportionate share of fair value increase in buildings and equipment ($35,000 x .40) Goodwill $150,000 (128,000) (14,000) 8,000

b.

Dividend income, 20X1 ($9,000 x .40)

3,600

c.

Cost-method account balance (unchanged): Equity-method account balance: Balance, January 1, 20X1 Investment income Dividends received Balance, December 31, 20X1

$150,000

$150,000 9,200 (3,600) $155,600

McGraw-Hill/Irwin The McGraw-Hill Companies, Inc., 2002

P2-29

Retroactive Recognition

Journal entries recorded by Idle Corporation: Investment in Fast Track Enterprises Stock Cash Record purchase of Fast Track stock. (2) Investment in Fast Track Enterprises Stock Retained Earnings Record pick-up of difference between cost and equity income: 20X2 .10($40,000 - $20,000) 20X3 .10($60,000 / 2) $3,000 .15[($60,000 / 2) - $20,000] 1,500 20X4 .15($40,000 - $10,000) Amount of increase Investment in Fast Track Enterprises Stock Income from Fast Track Enterprises Record equity-method income: $50,000 x .25 Cash Investment in Fast Track Enterprises Record dividend from Fast Track Enterprises: $20,000 x .25 (1) 34,000 34,000

11,000 11,000

$ 2,000 4,500 4,500 $11,000 12,500 12,500

(3)

(4)

5,000 5,000

McGraw-Hill/Irwin The McGraw-Hill Companies, Inc., 2002

P2-30

Multistep Acquisition

Journal entries recorded by Jackson Corp. in 20X9: (1) Investment in Phillips Corp. Stock Cash Record purchase of Phillips stock. Investment in Phillips Corp. Stock Retained Earnings Record pick-up of difference between cost and equity income. Computation of equity pick-up 20X6 .10($70,000 - $20,000) 20X7 .10($70,000 - $20,000) 20X8 .15($70,000 - $20,000) 20X6 amortization of differential 20X7 amortization of differential 20X8 amortization of differential Amount of increase 70,000 70,000

(2)

14,500 14,500

$ 5,000 5,000 7,500 (1,000) (1,000) (1,000) $14,500

Amortization of differential 20X6 purchase [$25,000 - ($200,000 x .10)] 5 years 20X8 purchase [$15,000 - ($300,000 x .05)] 20X9 purchase [$70,000 - ($350,000 x .20)] Total annual amortization (3) Investment in Phillips Corp. Stock Income from Phillips Corp. Record equity-method income: $70,000 x .35 Cash Investment in Phillips Corp. Stock Record dividend from Phillips Corp. $20,000 x .35 (5) Income from Phillips Corp. Investment in Phillips Corp. Stock Amortize purchase differential.

$1,000 0 0 $1,000 24,500 24,500

(4)

7,000 7,000

1,000 1,000

McGraw-Hill/Irwin The McGraw-Hill Companies, Inc., 2002

P2-31 a.

Complex Differential

Essex Company 20X2 equity-method income: Proportionate share of reported net income ($80,000 x .30) Deduct increase in cost of goods sold for purchase differential assigned to inventory ($30,000 x .30) Deduct amortization of purchase differential assigned to: Buildings and equipment [($320,000 - $260,000) x .30] / 12 years] Patent [($25,000 x .30) / 10 years] Equity-method income for 20X2

$24,000 (9,000)

(1,500) (750) $12,750

b.

Computation of investment account balance on December 31, 20X2: Purchase Price Investment income for 20X2 Dividends received in 20X2 ($9,000 x .30) Investment account balance on December 31, 20X2 $165,000 $12,750 (2,700) 10,050 $175,050

McGraw-Hill/Irwin The McGraw-Hill Companies, Inc., 2002

P2-32 a.

Equity Entries with Differential

Journal entry recorded by Hunter Corporation: Investment in Arrow Manufacturing Stock Common Stock Additional Paid-In Capital Record acquisition of Arrow Manufacturing stock. 210,000 60,000 150,000

b.

Equity-method journal entries recorded by Hunter Corporation in 20X0: (1) Investment in Arrow Manufacturing Stock Common Stock Additional Paid-In Capital Record acquisition of Arrow Manufacturing stock. Investment in Arrow Manufacturing Stock Income from Arrow Manufacturing Record equity-method income: $80,000 x .45 Cash Investment in Arrow Manufacturing Stock Record dividends from Arrow Manufacturing: $20,000 x .45 (4) Income from Arrow Manufacturing Investment in Arrow Manufacturing Stock Amortize purchase differential assigned to buildings and equipment: ($30,000 x .45) / 10 years 1,350 1,350 210,000 60,000 150,000

(2)

36,000 36,000

(3)

9,000 9,000

McGraw-Hill/Irwin The McGraw-Hill Companies, Inc., 2002

P2-32

(continued)

Equity-method journal entries recorded by Hunter Corporation in 20X1: (1) Investment in Arrow Manufacturing Stock Income from Arrow Manufacturing Record equity-method income for period: $50,000 x .45 Cash Investment in Arrow Manufacturing Stock Record dividends from Arrow Manufacturing: $40,000 x .45 (3) Income from Arrow Manufacturing Investment in Arrow Manufacturing Stock Amortize purchase differential assigned to buildings and equipment. 1,350 1,350 22,500 22,500

(2)

18,000 18,000

c.

Investment account balance, December 31, 20X1: Purchase price on January 1, 20X0 20X0: Income from Arrow Manufacturing ($36,000 - $1,350) Dividends received 20X1: Income from Arrow Manufacturing ($22,500 - $1,350) Dividends received Investment account balance, December 31, 20X1 $210,000

$34,650 (9,000)

25,650

$21,150 (18,000)

3,150 $238,800

McGraw-Hill/Irwin The McGraw-Hill Companies, Inc., 2002

P2-33 a.

Equity Entries with Differential

Equity-method journal entries recorded by Ennis Corporation: (1) Investment in Jackson Corporation Stock Common Stock Additional Paid-In Capital Record acquisition of Jackson Corporation stock. Investment in Jackson Corporation Stock Income from Jackson Corporation Record equity-method income: $70,000 x .35 Cash Investment in Jackson Corporation Stock Record dividend from Jackson Corporation: $10,000 x .35 (4) Income from Jackson Corporation Investment in Jackson Corporation Stock Record expiration of purchase differential assigned to inventory: $20,000 x .35 7,000 7,000 200,000 50,000 150,000

(2)

24,500 24,500

(3)

3,500 3,500

(5)

Income from Jackson Corporation 1,400 Investment in Jackson Corporation Stock Record amortization of purchase differential assigned to buildings and equipment (net): ($80,000 x .35) / 20 years

1,400

b.

$212,600 = $200,000 + $24,500 - $3,500 - $7,000 - $1,400

McGraw-Hill/Irwin The McGraw-Hill Companies, Inc., 2002

P2-34 a.

Additional Ownership Level $220,000 $100,000 11,000 $111,000 x .40

Operating income of Amber for 20X3 Operating income of Blair for 20X3 Add: Equity income from Carmen [($50,000 - $6,000) x .25) Blair net income for 20X3 Proportion of stock held by Amber Amortization of purchase differential: Equipment [($30,000 x .40) / 8 years] Patents [($25,000 x .40 / 5 years) Net income of Amber for 20X3

44,400 (1,500) (2,000) $260,900

b.

Investment in Blair Corporation Stock Common Stock Capital in Excess of Par Value Purchase of Blair Corporation Stock. Investment in Blair Corporation Stock Income from Blair Corporation Record equity-method income: $111,000 x .40 Cash Investment in Blair Corporation Stock Record dividend from Blair: $30,000 x .40 Income from Blair Corporation Investment in Blair Corporation Stock Amortize purchase differential: $3,500 = $1,500 + $2,000

130,000 40,000 90,000

44,400 44,400

12,000 12,000

3,500 3,500

McGraw-Hill/Irwin The McGraw-Hill Companies, Inc., 2002

P2-35 a.

Error in Recording Investment Income

Cost method entries for 20X4: Cash Dividend Income Record dividend income: $16,000 x .25 4,000 4,000

b.

Equity method entries for 20X4: Investment in Chadwick Corporation Income from Chadwick Corporation Record equity-method income: $62,000 x .25 Cash Investment in Chadwick Corporation Record dividend from Chadwick. $16,000 x .25 Income from Chadwick Corporation Investment in Chadwick Corporation Amortize purchase differential assigned to buildings and equipment: [($300,000 - $240,000) x .25] / 10 years Income from Chadwick Corporation Investment in Chadwick Corporation Amortize purchase differential assigned to other identifiable intangible assets: Purchase price $80,600 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 1,500 1,500 15,500 15,500

4,000 4,000

700 700

McGraw-Hill/Irwin The McGraw-Hill Companies, Inc., 2002

P2-35 c.

(continued)

Required correcting entry: Investment in Chadwick Corporation Investment Income Retained Earnings 56,900 24,800 32,100

Adjustments to be recorded by Blanch Corporation on December 31, 20X4: 20X4 Retained InvestInvestment Earnings ment 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 $56,000 x .25 $14,000 $38,000 x .25 $62,000 x .25 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) Intangible assets ($5,600 / 8 years) (700) Investment income $ 9,300 20X3 $9,500 $15,500 20X4

(1,500) (1,500) (700) (700) $7,300 $13,300

McGraw-Hill/Irwin The McGraw-Hill Companies, Inc., 2002

P2-36

Correction of Error

Required correcting entry: Retained Earnings Income from Dale Company Investment in Dale Company Stock 17,000 11,500 28,500

Adjustments to current books of Hill Company: Dale Company Investment 20X4 Balance Income 12/31/20X4

Item Adjustment to remove dividends included in investment income and not removed from investment account Adjustment to annual amortization of purchase differential: 20X2 and 20X3 20X4 Required adjustment to account balance

Retained Earnings 1/1/20X4

$(14,000)

$(10,000)

$(24,000)

(3,000) (1,500) $(17,000) $(11,500)

(3,000) (1,500) $(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 Patents: Amount paid Fair value of identifiable net assets ($300,000 + $50,000) x .40 Amount assigned Number of years to be amortized Annual amortization Correct amount to be amortized annually Amount amortized by Hill [($164,000 - ($300,000 x .40)] / 8 years Adjustment to annual amortization

$4,000 $164,000 (140,000) $ 24,000 8 3,000 $7,000 (5,500) $1,500

McGraw-Hill/Irwin The McGraw-Hill Companies, Inc., 2002

P2-37* a.

Other Comprehensive Income Reported by Investee

Equity-method income reported by Dewey Corporation in 20X5: Amounts reported by Jimm Co. for 20X5: Operating income Dividend income Gain on investment in trading securities Net income Ownership held by Dewey Investment income reported by Dewey

$70,000 7,000 18,000 $95,000 x .30 $28,500

b.

Computation of amount added to investment account in 20X5: Balance in investment account reported by Dewey: December 31, 20X5 January 1, 20X5 Increase in investment account in 20X5 Dividends received by Dewey during 20X5 Amount added to investment account in 20X5

$276,800 (245,000) $ 31,800 6,000 $ 37,800

c.

Computation of other comprehensive income reported by Jimm Co.: Amount added to investment account in 20X5 Investment income reported by Dewey in 20X5 Increase due to other comprehensive income reported by Jimm Co. Proportion of ownership held by Dewey Other comprehensive income reported by Jimm Co. $ 37,800 (28,500) $ 9,300 .30 $ 31,000

d.

Computation of market value of securities held by Jimm Co. Amount paid by Jimm Co. to purchase securities Increase in market value reported as other comprehensive income in 20X5 Market value of available-for-sale securities at December 31, 20X5 $130,000 31,000 $161,000

McGraw-Hill/Irwin The McGraw-Hill Companies, Inc., 2002

P2-38*

Equity-Method Income Statement

a.

Diversified Products Corporation Income Statement Year Ended December 31, 20X8 $400,000 (320,000) $ 80,000 $(25,000) 10,000 (15,000) $ 65,000

Net Sales Cost of Goods Sold Gross Profit Other Expenses Gain on Sale of Truck Income from Continuing Operations Discontinued Operations: Operating Loss from Discontinued Division Gain on Sale of Division Income before Extraordinary Item and Cumulative Adjustment Extraordinary Item: Gain on Bond Retirement Cumulative Adjustment: Cumulative Effect of Change in Inventory Method Net Income

$(15,000) 44,000

29,000 $ 94,000 5,000

(20,000) $ 79,000

Diversified Products Corporation Retained Earnings Statement Year Ended December 31, 20X8 Retained Earnings, January 1, 20X8 20X8 Net Income Dividends Declared Retained Earnings, December 31, 20X8 $260,000 79,000 $339,000 (10,000) $329,000

McGraw-Hill/Irwin The McGraw-Hill Companies, Inc., 2002

P2-38* b.

(continued) Wealthy Manufacturing Company Income Statement Year Ended December 31, 20X8

Net Sales Cost of Goods Sold Gross Profit Other Expenses Income from Continuing Operations of Diversified Products Corporation Income from Continuing Operations Discontinued Operations: Share of Operating Loss Reported by Diversified Products on Discontinued Division Share of Gain on Sale of Division Reported by Diversified Products Income before Extraordinary Item and Cumulative Adjustment Extraordinary Item: Share of Gain on Bond Retirement Reported by Diversified Products Cumulative Adjustment: Share of Cumulative Effect of Change in Inventory Method Reported by Diversified Products Net Income

$850,000 (670,000) $180,000 $(90,000) 26,000 (64,000) $116,000

$(6,000) 17,600 11,600 $127,600

2,000

(8,000) $121,600

Wealthy Manufacturing Company Retained Earnings Statement Year Ended December 31, 20X8 Retained Earnings, January 1, 20X8 20X8 Net Income Dividends Declared Retained Earnings, December 31, 20X8 $420,000 121,600 $541,600 (30,000) $511,600

McGraw-Hill/Irwin The McGraw-Hill Companies, Inc., 2002

P2-39* a.

Computing Income Tax Expense

Income tax expense reported by Swan Products: (1) Cost method (Dividends received net of 80 percent dividend deduction, times effective tax rate): 20X4 20X5 20X6 (2) [($4,000 x .25) x (1 - .80)] x .40 [($10,000 x .25) x (1 - .80)] x .40 [($12,000 x .25) x (1 - .80)] x .40 = = = $ 80 200 240

Equity method: 20X4 Computech dividends Swan Product's share Dividends received by Swan Dividend deduction (80%) Taxable dividend income Taxable dividend income Effective tax rate Income taxes payable Computech's net income Swan Product's share Swan's investment income Assumed dividend deduction (80%) Investment income subject to tax accrual Taxable dividend income Temporary difference Temporary difference Effective tax rate Tax effect of temporary difference Income taxes payable Income tax expense $ 4,000 x .25 $ 1,000 (800) $ 200 $ x $ 200 .40 80 20X5 $10,000 x .25 $ 2,500 (2,000) $ 500 $ x $ 500 .40 200 20X6 $12,000 x .25 $ 3,000 (2,400) $ 600 $ x $ 600 .40 240

$20,000 x .25 $ 5,000 (4,000) $ 1,000 (200) $ 800 $ x $ $ 800 .40 320 80 400

$ 8,000 x .25 $ 2,000 (1,600) $ $ $ x $ $ 400 (500) (100) (100) .40 (40) 200 160

$40,000 x .25 $10,000 (8,000) $ 2,000 (600) $ 1,400 $ 1,400 x .40 $ $ 560 240 800

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 20X5 20X6 [($20,000 x .25) x .20] x .40 [($8,000 x .25) x .20] x .40 [($40,000 x .25) x .20] x .40 = = = $400 160 800

McGraw-Hill/Irwin The McGraw-Hill Companies, Inc., 2002

P2-39* b.

(continued)

Cost method entries: 20X4: Cash Dividend Income Record dividends from Computech: $4,000 x .25 Income Tax Expense Income Taxes Payable Accrue taxes on dividend income. 20X5: Cash Dividend Income Record dividends from Computech: $10,000 x .25 Income Tax Expense Income Taxes Payable Accrue taxes on dividend income. 20X6: Cash Dividend Income Record dividends from Computech: $12,000 x .25 Income Tax Expense Income Taxes Payable Accrue taxes on dividend income. 240 240 3,000 3,000 200 200 2,500 2,500 80 80 1,000 1,000

McGraw-Hill/Irwin The McGraw-Hill Companies, Inc., 2002

P2-39* c.

(continued)

Equity method entries: 20X4: Cash Investment in Computech Stock Record dividends from Computech: $4,000 x .25 Investment in Computech Stock Income from Computech Record income from Computech: $20,000 x .25 Income Tax Expense Income Taxes Payable Deferred Tax Liability Accrue taxes on investment income: $320 = $800 temporary difference x .40 5,000 5,000 1,000 1,000

400 80 320

20X5: Cash Investment in Computech Stock Record dividends from Computech: $10,000 x .25 Investment in Computech Stock Income from Computech Record income from Computech: $8,000 x .25 Income Tax Expense Deferred Tax Liability Income Taxes Payable Accrue taxes on investment income: $40 = $100 reversal of temporary difference x .40 2,000 2,000 2,500 2,500

160 40 200

McGraw-Hill/Irwin The McGraw-Hill Companies, Inc., 2002

P2-39*

(continued)

20X6: Cash Investment in Computech Stock Record dividends from Computech: $12,000 x .25 Investment in Computech Stock Income from Computech Record income from Computech: $40,000 x .25 Income Tax Expense Income Taxes Payable Deferred Tax Liability Accrue taxes on investment income: $560 = $1400 temporary difference x .40 10,000 10,000 3,000 3,000

800 240 560

McGraw-Hill/Irwin The McGraw-Hill Companies, Inc., 2002