Question

The equity method records the initial purchase of an investment in voting common stock at _____ Each period, the investor treats as revenue its share of the _____, of the investee. The investor treats dividends declared by the investee as _____.

	A.	present value of future cash flows; dividends; a reduction of the investor’s investment in stock of the investee account
	B.	present value of future cash flows; periodic earnings; a reduction of the investor’s investment in stock of the investee account
	C.	future value of present cash flows; dividends; a reduction of the investor’s investment in stock of the investee account
	D.	acquisition cost; dividends; income
	E.	acquisition cost; periodic earnings; a reduction of the investor’s investment in stock of the investee account

Answer 1

The equity method type of accounting isused for intercorporate investments. This method is used when the investor have significant influence over the investee but does not have full control over it.

The equity method records the initial purchase of an investment in voting common stock at __________(acquisition cost). Each period, the investor treats as revenue its share of the _____ (periodic earnings). The investor treats dividends declared by the investee as _____(a reduction of the investor’s investment in stock of the investee account).

For example

ABC purchases 30% of XYZ for $500,000. At the end of the year, XYZ reports a net income of $100,000 and a dividend of $50,000 to its shareholders.

When ABC makes the purchase, it records its investment under “Investments in Associates/Affiliates”, a long-term asset account. The transaction is recorded at cost.

ABC records the net income from XYZ as an increase to its Investment account.

Finally, ABC receives dividends of $15,000, which is 30% of $50,000, and records a reduction in their investment account. The reason for this is that they have received money from their investee. In other words, there is an outflow of cash from the investee, as reflected in the reduced investment account.