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Equity Method Accounting

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Equity Method Accounting

Shoehorn Corp. owns 40 percent of the stock of Amalgamated leather Tanneries and is debating the proper procedures to use in reporting its ownership. Shoehorn Corporation produces high-quality leather products and purchases approximately 85 percent of Amalgamated Leather's annual production. Because of the importance of having a dependable source of supply and one which provides high quality leather of a uniform grade, Shoehorn paid a 15 percent premium over current market price to acquire its ownership in Amalgamated Leather. The price per share paid was approximately 250 percent of book value per share at that date. Shoehorn signed an agreement that gives the former owner the right to purchase back the share of Amalgamated Leather anytime during the next five years at the price paid by Shoehorn.

Several Corporations' corporate officers disagree on how best to account for the Amalgamated Leather shares. The following alternative means of accounting for the investment in Amalgamated Leather have been identified:

1. Adjust the carrying value of the shares to market value at the end of each period and report the cumulative change as an unrealized adjustment to stockholders' equity. Treat dividends received as dividend income.
2. Carry the investment at cost and tread dividends received as dividend income.
3. Carry the investment at cost plus Shoehorn's proportionate share of the undistributed earnings of Amalgamated Leather since the date of acquisition. Treat dividends received as dividend income.
4. Use the equity method.

Problem:
a) List the advantages and disadvantages of each proposed alternative. Choose the procedure you believe is the most desirable. What assumptions must be made to make the preferred approach work? Why is this method better than the other proposed alternatives?
b) How would you determine whether the procedure you have chosen can be used without violating generally accepted accounting principles?
c) Assume that the procedure you have chosen is not considered acceptable by the CPA firm doing the audit? How would you proceed?

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STEP 1

The proposed alternatives, their disadvantages and advantages:

1. Adjust the carrying value of the shares to market value at the end of each period and report the cumulative change as an unrealized adjustment to stockholders' equity. Treat dividends received as dividend income.
Advantages are that this method shows the stockholders equity at the market rate. That is if the stocks of Amalgamated Leather were sold in the market the value realizable would be expressed in the unrealized adjustment.
Disadvantages: This would keep on changing the value of stockholder's equity with every change in the market price; in addition it would lead to the manipulation of the market price of the stock. In practice if Shoehorn attempted to sell the stocks in the open market then the prices would fall sharply. So this value is not realistic.
2. Carry the investment at cost and tread dividends received as dividend income.

Advantage: The stockholder's equity would be at a stable value and dividends would be treated as dividend when received. The stock holder's value will not change with every change in the market price of shares.
Disadvantage: The cost at which the shares have been purchased is not the value of the stocks; these are 250% of the book value and 15% over the market price. So the stockholder's value is greatly inflated.
3. Carry the investment at cost plus Shoehorn's proportionate share of ...

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