advanced financial accounting 7e (baker lembre king).chap002
TRANSCRIPT
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cGraw-Hill/Irwin 2008 The McGraw-Hill Companies, Inc. All rights reserved
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Reporting Intercorporate Interests
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Reporting Intercorporate Interest
This chapter presents the accounting and
reporting procedures for investments incommon stock and for selected other typesof interests in other entities.
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Reporting Intercorporate Interest
Some companies invest in other companiessimply to earn a favorable return by taking
advantage of potentially profitable situations.
As indicated in the next slide, there are
various other reasons that companiesinvest in other companies.
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Reporting Intercorporate Interest
Reasons Companies Invest in OtherCompanies:
Gain control over other companies
Enter new market or product areasthrough companies established in those
areas Ensure a supply of raw materials or
other production inputs
[continued on next slide]
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Reporting Intercorporate Interest
Ensure a customer for production output
Gain economies associated with greatersize
Diversity
Gain new technology
Lessen competition
Limit risk
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Reporting Intercorporate Interest
Examples of intercorporate investments include:
IBMs acquisition of a sizable portion of
Intels stock to ensure a supply ofcomponents.
AT&Ts purchase of the stock of McCaw
Cellular Communications to gain afoothold in the cellular phone market.
Texacos acquisition of Getty Oils stockto acquire oil and gas reserves.
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Investments in Common Stock
The method used to account for investmentsin common stock depends on the level of
influence or control that the investor is able toexercise over the investee.
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Investments in Common Stock
The level of influence is the primary factordetermining whether the investor and
investee will present consolidated financialstatements or the investor will report theinvestment in common stock in its balance
sheet using either the cost method (adjustedto market value, if appropriate) or the equitymethod.
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Investments in Common Stock
Consolidation involves the combining for
financial reporting the individual assets,liabilities, revenues, and expenses of two ormore related companies as if they were part
of a single company.
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Investments in Common Stock
This process includes the elimination of all
intercompany ownership and activities (suchas intercompany sales and purchases, and
intercompany loans).
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Investments in Common Stock
Consolidation is normally appropriate where
one company, referred to as the parent,controls another company, referred to as thesubsidiary.
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Investments in Common Stock
An unconsolidated subsidiary should be
reported as an investment on the parentsbalance sheet. Unconsolidated subsidiariesare relatively rare.
The specific requirements for consolidationare discussed in Chapter 3.
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Investments in Common Stock
The equity method is used for externalreporting when the investor exercises
significant influence over the operating andfinancial policies of the investee andconsolidation is not appropriate.
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Investments in Common Stock
The equity method may not be used in place
of consolidation when consolidation isappropriate, and therefore its primary use isin reporting nonsubsidiary investments.
The equity method is used most often whenone company holds between 20 and 50percent of another companys common stock.
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Investments in Common Stock
The cost method is used for reportinginvestments in equity securities when both
consolidation and equity-method reportingare inappropriate underFASB 115.
If cost-method equity securities have readilydeterminable fair values, they must beadjusted to market value at year-end.
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Accounting During the Year
Versus Reporting at Year End
Under normal circumstances, companies
using the cost or equity method for financialreporting purposes at year end also use thatmethod for accounting for the investment on
their books during the year.
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Accounting During the Year
Versus Reporting at Year End
As discussed next, this is not the case with
respect to companies required to consolidatetheir investments in subsidiaries for financialreporting purposes.
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Accounting During the Year Versus
Reporting at Year End--Continued
When consolidated financial statements are
prepared for financial reporting purposes atyear end, the parent still must account forthe investment in the subsidiary during the
year (on its books)
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Accounting During the Year Versus
Reporting at Year End--Continued
Using the cost or equity method even though
the intercorporate investment and relatedincome must be eliminated in preparing theconsolidated statements at year end.
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Cost MethodInfluence Not Significant
(0 to 20 percent)
Intercorporate investments accounted for by
the cost method are carried by the investor athistorical cost.
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Cost MethodInfluence Not Significant(0 to 20 percent)
Income is recorded by the investor when
dividends are declared by the investee.
The cost method is used when the investorlacks the ability either to control or to exercise
significant influence over the investee.
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Cost Methodinfluence Not Significant
(0 to 20 percent)
At the time of purchase, the investor records
its investment in common stock at the totalcost incurred in making the purchase.
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Cost Methodinfluence Not Significant
(0 to 20 percent)
After the time of purchase, the carrying
amount of the investment (i.e., the originalcost) remains unchanged under the costmethod until the time of sale (or unless there
is a liquidating dividendmore on this later).
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Cost MethodInfluence Not Significant(0 to 20 percent)
Once the investee declares a dividend, theinvestor has a legal claim against the
investee for a proportionate share of thedividend and realization of the income isconsidered certain enough to be recognized.
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Cost MethodInfluence Not Significant(0 to 20 percent)
Recognition of investment income before a
dividend declaration is consideredinappropriate because the investees incomeis not available to the owners until a dividend
is declareddividends do not accrue!!!
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Cost MethodExample
ABC Company purchases 20 percent of XYZCompanys common stock for $100,000 at the
beginning of the year but does not gainsignificant influence over XYZ.
Investment in XYZ
Company Stock $100,000
Cash $100,000
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Cost MethodExample
During the year, XYZ has net income of $50,000 andpays dividends of $20,000.
Cash ($20,000 X .20) $4,000
Dividend Income $4,000
NOTE: Liquidating dividends are discussed next.
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Cost MethodLiquidating Dividends
All dividends declared by the investee--in excessof its earnings since acquisition by the investor--are viewed by the investor as liquidatingdividends.
In the previous example, if XYZ had no earnings,
all dividends would have been viewed by ABCas liquidating dividends.
[Continued on next slide.]
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Cost MethodLiquidating Dividends
In turn, Investment in XYZ Company Stockwould be credited in lieu of Dividend Income.
Cash ($20,000 X .20) $4,000
Investment in XYZ
Common Stock $4,000
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The Equity MethodSignificant
Influence (20 to 50 percent)
APB 18 (as amended) provides theprofessional guidance regarding the equitymethod. The equity method of accounting forintercorporate investments in common stock
is intended to reflect the investors changingequity or interest in the investee.
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The Equity MethodSignificant
Influence (20 to 50 percent)
APB 18 establishes a 20 percent rulebecause assessing the degree of influencemay be difficult in some cases.
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Equity MethodSignificant Influence
Because of the ability to exercise significantinfluence over the policies of the investee,
realization of income from the investment isconsidered to be sufficiently assured towarrant recognition by the investor as theincome is earned by the investee.
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Equity MethodSignificant Influence
This differs from the case in which theinvestor does not have the ability to
significantly influence the investee and theinvestment must be reported using the costmethod; in that case, income form theinvestment is recognized only upondeclaration of a dividend by the investee.
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The Equity MethodSignificant
Influence (20 to 50 percent)
Unless proven otherwise, an investor holding20 percent or more of the voting stock ispresumed to have the ability to influence theinvestee.
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The Equity MethodSignificant
Influence (20 to 50 percent)
The equity method is a rather curious one in
that the balance in the investment accountgenerally does not reflect either cost ormarket value, nor does the balancenecessarily represent a pro rata share of the
investees book value.
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The Equity MethodSignificant
Influence (20 to 50 percent) Under the equity method, the investor
records its investment at the original cost.
This amount is adjusted periodically forchanges in the investees stockholders
equity occasioned by the investees profits (orlosses) and dividend declarations.
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The Equity MethodSignificant
Influence (20 to 50 percent) Reported by
Investee:
Net Income(Loss)
DividendDeclaration
Effect On Investor:
Record income (loss)
from investment andincrease (decrease)
investment account.
Record asset (cash orreceivable) and decrease
investment account.
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The Equity MethodEquity Accrual
Assume ABC Company acquires significantinfluence over XYZ Company by purchasing
20 percent of the common stock of the XYZCompany at the beginning of the year. XYZCompany reports income for the year of$60,000. ABC records its $12,000 share ofXYZs income with the following entry:
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The Equity MethodEquity Accrual
Investment in XYZ
Company Stock ($60,000 X .2) $12,000
Income from Investee $12,000
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Equity MethodRecognition of
Dividends Dividends from an investment are not
recognized as income under the equity
method because the investors share ofthe investees income is recognized as
it is earned by the investee.
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Equity MethodRecognition of
Dividends Instead, such dividends are viewed as
distributions of previously recognized
income that already has been capitalizedin the carrying amount of the investment.
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Equity MethodRecognition of
Dividends
In effect, all dividends from the investee are
treated as liquidating dividends under theequity method. Thus, if ABC Company owns20 percent of XYZs common stock and XYZ
declares and pays a $20,000 dividend, thefollowing entry is recorded on the books ofABC to record its share of the dividend:
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Equity MethodRecognition of
Dividends
Cash ($20,000 X .20) $4,000Investment in XYZ
Company Stock $4,000
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Equity MethodAcquisition at Interim Date
When an investment is purchased, theinvestor begins accruing income from the
investee under the equity method at the dateof acquisition.
No income earned by the investee before thedate of acquisition of the investment may beaccrued by the investor.
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Equity MethodAcquisition at InterimDate (Continued)
When the purchase occurs between balance
sheet dates, the amount of income earned bythe investee from the date of the acquisitionto the end of the fiscal period may need to be
estimated by the investor in recording theequity accrual.
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Equity MethodAcquisition at InterimDate (Continued)
For example, if the acquisition (20 percent
interest) was transacted on October 1 andthe investee earned $60,000 for the entireyear, the investor would have an equity
accrual of $3,000 (i.e., $60,000 X .20 X 3/12= $3,000).
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Equity MethodAcquisition at InterimDate (Continued)
WARNING: Watch out for liquidating
dividends when acquisitions
are transacted at interim dates.
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Investment Cost VersusUnderlying Book Value
When one corporation buys the commonstock of another, the purchase price normally
is based on the market price of the sharesacquired rather than the book values of theinvestees assets and liabilities.
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Investment Cost VersusUnderlying Book Value
As a result, there often is a differencebetween the cost of the investment to the
investor and the book value of the investorsproportionate share of the underlying netassets of the investee.
This difference is referred to as a differential.
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Investment Cost VersusUnderlying Book Value
The differential represents the amount paid
by the investor in excess of the book value ofthe investment and is included in theinvestment amount.
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Investment Cost VersusUnderlying Book Value
Hence, the amortization or reduction of thedifferential involves the reduction of the
investment account. At the same time, the investors net income
must be reduced by an equal amount to
recognize that a portion of the amount paidfor the investment has expired.
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Investment Cost VersusUnderlying Book Value
There are several reasons the cost of aninvestment might exceed the book valueof the underlying net assets and give riseto a positive differential.
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Investment Cost VersusUnderlying Book Value
One reason is that the investees assets
may be worth more than their book value. Another reason could be the existence of
unrecorded goodwill associated with theexcess earning power of the investee.
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Investment Cost VersusUnderlying Book Value
Purchase differentials related to a limited life
asset (e.g., equipment) should be amortizedover the life of the related asset.
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Investment Cost VersusUnderlying Book Value
If the purchase differential has a debit
balance, the equity method entry to amortizethe purchase differential will be the oppositeof the equity accrual entry, that is, withrespect to the accounts debited or credited.
Examples are provided on next slide.
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Investment Cost VersusUnderlying Book Value
To record equity method income of $9,000(assumed).
Investment in Investee Company $9,000Income from Investee Company $9,000
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Investment Cost VersusUnderlying Book Value
To amortize debit purchase differential of$4,000 (assumed).
Income from Investee Company $4,000Investment in Investee Company $4,000
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Investment Cost VersusUnderlying Book Value
Any portion of the differential that is related toland is not amortized since land has an
unlimited life. Any portion of the differential that represents
goodwill (referred to as equity method
goodwill) is neither amortized nor writtendown for impairment.
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Investment Cost VersusUnderlying Book Value
However, an impairment loss on theinvestment itself should be recognized if it
suffers a decline in the value that is otherthan temporary.
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Disposal of Differential-RelatedAssets
If the investee disposes of any asset to which
the differential relates, that portion of thedifferential must be removed from theinvestment account on the investors books.
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Disposal of Differential-RelatedAssets
When this is done, the investors share of the
investees gain or loss on disposal of theasset must be adjusted to reflect the fact thatthe investor paid more for its proportionateshare of that asset than did the investee.
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Impairment of Investment Value
As with many assets, accounting standardsrequire that equity-method investments bewritten down if their value is impaired.
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Impairment of Investment Value
If the market value of the investment declines
materially below its equity-method carryingamount, and the decline in value isconsidered other than temporary, the carryingamount of the investment should be writtendown to the market value and a lossrecognized.
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Impairment of Investment Value-cont
The new lower value serves as a startingpoint for continued application of the equity
method.
Subsequent recoveries in the value of the
investment may not be recognized.
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Changes in Number of Shares Held
A change in the number of common shares
held by an investor resulting from a stockdividend, split, or reverse split is treated inthe same way as under the cost method.
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Changes in Number of Shares Held
No formal accounting recognition is required
on the books of the investor. On the other hand, purchases and sales of
shares do require formal recognition.
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Purchases of Additional Shares
A purchase of additional shares of commonstock already held by an investor andaccounted for using the equity method simplyinvolves adding the cost of the new shares tothe investment account and applying theequity method in the normal manner from the
date of acquisition forward.
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Purchases of Additional Shares-Cont
The new and old investments in the same
stock are combined for financial reportingpurposes.
Income accruing to the new shares can berecognized by the investor only from the date
of acquisition forward.
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Determination of Significant Influence
The general rule established in APB 18 isthat the equity method is appropriate where
the investor, by virtue of its common stockinterest in an investee, is able to exercisesignificant influence over the operating andfinancial policies of the investee.
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Determination of Significant Influence
In the absence of other evidence, commonstock ownership of 20 percent or more is
viewed as indicating that the investor is ableto exercise significant influence over theinvestee.
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Investments in Partnerships
Pronouncements of the FASB generally
relate to corporations rather thanpartnerships. Thus, companies holding equityinvestments in partnerships generally havemore flexibility but less guidance in reportingtheir investments.
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Investments in Partnerships
Companies with ownership interests in
partnerships typically choose one of thefollowing methods for reporting investments:cost method, equity method, consolidation, orpro-rata consolidation.
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Unrealized Intercompany Profits
UnderAPB 18, intercompany sales do not
result in the realization of income until theintercompany profit is confirmed in someway, usually through a transaction with anunrelated party.
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Unrealized Intercompany Profits
Thus, unrealized intercompany profits must
be eliminated from both consolidatedfinancial statement amounts as well as equitymethod amounts.
The term for the application of the equity
method that includes the adjustment forunrealized intercompany profits is fullyadjusted equity method.
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Unrealized Intercompany Profits
Unrealized intercompany profits overstateearnings. Thus the equity method entry to
remove the unrealized profit will be theopposite of the equity accrual entry, thatis, with respect to the accounts debited or
credited.
Examples are provided on the next slide.
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Unrealized Intercompany Profits
To record equity method income of $9,000
(assumed).Investment in Investee Company $9,000
Income from Investee Company
$9,000
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Unrealized Intercompany Profits
To remove unrealized intercompany profit of$2,000 (assumed).
Income from Investee Company $2,000
Investment in Investee Company $2,000
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Tax Allocation Procedures
Intercompany income accruals and dividend
transfers must be considered in computingincome tax expense for the period.
If separate tax returns are filed, the invester
is taxed on the dividends received rather thanthe tax reported.
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Tax Allocation Procedures
Deferred tax accruals are not needed even
though temporary differences occur betweenthe recognition of investment income by theinvestor and realization through dividendtransfers from the investee whenconsolidated tax returns are filed.
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Chapter Three to Chapter Ten
Three different approaches are followed bycompanies (in practice) in accounting for their
consolidated subsidiary during the year:
The fully adjusted equity method(a.k.a., the equity method).
The basic equity method.
The cost method.
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Chapter Three to Chapter Ten
The cost method and the fully adjusted
equity method (a.k.a., the equity method)were previously discussed in this chapter.
The basic equity method is used in Chapters3 to 10 and is discussed in the next slide.
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Chapter Three to Chapter Ten
In essence, the basic equity method is a
modified version of the equity methoddiscussed in this chapter.
Specifically, the basic equity method avoids
unrealized profit transactions that will beeliminated during the consolidation process.
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Chapter Three to Chapter Ten
While the basic equity method is Not GAAP,
use of the basic equity method may helpprovide some clerical savings for the parentcompanyas well as students and teachers.
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You Will Survive Chapter 2 !!!
There are two sets of accounting
records (i.e., books) to analyze.
You should always ask yourself
does the information relate to theinvestor or the investee or both ?
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You Will Survive Chapter 2 !!!
If consolidation is required, the investor may bereferred to as the parent company and the
investee may be referred to as the subsidiarycompany.
The cost method and the equity method are bothaccounting methods and reporting methods, that is,
they are used during the year as well as at year-end, respectively.
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You Will Survive Chapter 2 !!!
Unless consolidation is required, the investor
would usually use the same method foraccounting and reporting purposes.
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You Will Survive Chapter 2 !!!
If consolidation is required, all balancesrelated to either the cost method or the equity
method are eliminated when preparing theconsolidated financial statementsthuseither method may be used during the year.
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You Will Survive Chapter 2 !!!
There is only one trick to the cost method
liquidating dividends. Rememberdividends do not accrue.
Rememberonly use post-acquisition earnings.
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You Will Survive Chapter 2 !!!
Think of the equity method in terms of threelevels (and start with the bottom
level):
Top level--Unrealized profits
Middle levelDifferential Base or bottom level--Book value
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2
End of ChapterEnd of Chapter