Question

Discussion Questions

The accountant of Jane Ltd, Ms. Carmel, has been advised by her auditors that the entity’s investment in Doe Ltd should be accounted for using the equity method of accounting. Jane Ltd holds only 20.5% of the voting shares currently issued by Doe Ltd. The reason for Jane Ltd to invest in Doe Ltd was purely for cash flows in the form of potential dividends. Carmel does not believe that Jane Ltd exerts significant influence over Doe Ltd.

Required:

1. What factors should Carmel consider in investigating whether an investor-associate relationship exists?

2. Compare and contrast the impacts on the financial statements of applying the equity method to an investment with those of applying the cost method to the same investment.

Answer 1

1. As per general rule under US GAAP, if the investor has 20% or more of the voting stock of the investee, this creates a presumption that, in the absence of evidence to the contrary, the investor has the ability to exercise significant influence over the investee. Conversely, if the ownership percentage is less than 20%, there is a presumption that the investor does not have significant influence over the investee, unless it can otherwise demonstrate such ability.

If an investor owns 20% or more of an investee’s voting stock, it may still not exercise significant influence over the investee (though predominant evidence to the contrary is needed to prove the point). The following is a non-inclusive list of indicators that an investor may be unable to exercise significant influence:

• The investee’s opposition to the investor’s influence, as evidenced by lawsuits or complaints to regulatory authorities.
• The investor signs an agreement to surrender significant rights as a shareholder.
• Another group of shareholders has majority ownership, and operate it without regard to the investor’s views.
• The investor is unable to obtain sufficient information to apply the equity method.
• The investor is unable to obtain representation on the investee’s board of directors.

A number of circumstances indicate an investor’s ability to exercise significant influence over the operating and financial policies of an investee, including the following:

• Board of directors representation
• Policy-making participation
• Intra-entity transactions that are material
• Intra-entity management personnel interchange
• Technological dependence
• Proportion of ownership by the investor in comparison to that of other investors

Carmel should consider the above factors in investigating whether an investor-associate relationship exists.

2. You use the cost method when you make a passive but long-term investment in another company. You record the stock on a balance sheet account as a non-current asset at its historical purchase price. If an investment is less than 20% of investment, the investment should be recorded using cost method unless any indicator that the investee has significant influence over the investor.

Under the equity method, you book the stock purchase as you would under the cost method. You treat dividends as a return of investment by posting to a contra-asset account linked to investors account, thereby reducing the net carrying value of the investment. Dividends are not booked as income.