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Substantial Influence: Equity and Cost Methods in Accounting

Complete the following exercise. Create an Excel spreadsheet provided via the link below to provide your answers to parts a and b. Then paste the Excel data into a Word document on which you can also write the answer to part c.

Label each exercise or problem clearly.

2011
Jan 1 Investor Corporation purchased 8,000 shares (20%) of Investee Company's outstanding stock at a cost of $150,000.

May 31 Investee Company declared and paid a cash dividend of $1.50 per share.

Dec 31 Investee Company announced that its net income for the year was $100,000.

2012
Oct 1 Investee Company declared and paid a cash dividend of $1.00 per share.

Dec 31 Investee Company announced that its net income for the year was $80,000.

2011
Jan 1 Investor Corporation sold all of its shares of Investee Company for $178,000 cash.

Required:

1a. Prepare journal entries on Investor Corporation's books using the equity method, which assumes that Investor has significant influence over Investee Company.
2b. Prepare journal entries on Investor Corporation's books using the cost method, which assumes that even though Investor owns 20% of Investee's stock, Investor does not have significant influence over Investee (for example, another corporation owns 70% of Investee Company's stock).
3c. Write a brief report between 200-300 words in length outlining your recommendations to senior management based on the information presented here.

Solution Preview

As you can see from the contrasting exhibits below showing the equity method versus the cost method, the purchase in 2011 and sale in 2013 results in the investor making money. The question is how to record the favorable results.

Current income versus later gain.

The equity method adjusts the historical cost account for the proportionate share of the investee's earnings, less dividends paid, while the cost method does not. As a result, the equity method increases Net Income in 2011 and 2012 more than the cost method, which only includes the portion of earnings that is paid in dividends. Since the investment account is written up annually for the investee's results, the gain on sale in 2013 is smaller than with the cost method. So, the two methods allocate the income/gains differently across the many year span that the investment ...

Solution Summary

Your tutorial is 475 words and explains the main differences and how these differences may influence reporting, performance review and cash flow planning.

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