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Use of the Cost or Equity Method

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Since Boomer Company's inception, Madison Company has owned 18 percent of Boomer's outstanding common stock. Madison provides three key management personnel to Boomer and purchased 25 percent of Boomer's output during 20X7. Boomer is profitable. On January 2, 20X8, Madison purchased additionalcommon stock to finance Boomer's expansion, thereby becoming a 30 percent owner. Boomer's common stock does not have a quoted market price. The stock has always been issued at its book value,which is assumed to approximate its fair value.

a. In general, distinguish between investor-income reporting under the cost method and under the equity method. Which method is more consistent with accrual accounting? Why?

b. Prior to January 2, 20X8, what specific factors should Madison have considered in determining the appropriate method of accounting for its investment in Boomer?

c. Assume that Madison used the cost method in accounting for its investment in Boomer prior to January 2, 20X8. Describe the book adjustments required on January 2, 20X8, when Madison became
owner of 30 percent of Boomer's outstanding common stock.

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Solution Summary

The solution explains the use of cost of equity method in accounting for investments.

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a. Under the cost method, the investor recognizes income as dividends are received from the investee. Under the equity method, an investor recognizes as income its share of an investee's earnings or losses in the periods in which they are reported by the investee. The amount recognized as income under the equity method is adjusted for any change in the remaining amount of the difference between original investment cost and the investor's equity in net ...

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