CHAPTER 2 HOMEWORK SOLUTIONS

SOLUTIONS TO REVIEW QUESTIONS

1. Over the past 15 years, there has been a move from using historical cost to using fair values for
reporting investments in equity securities including investments in private companies.
2. IFRS 9 requires that all nonstrategic equity investments be measured at fair value including
investments in private companies. However, an entity can elect on initial recognition to
present the fair value changes on an equity investment that is not held for short-term trading
in other comprehensive income (OCI). The gains or losses are cleared out of accumulated
OCI and transferred directly to retained earnings and are never recycled through net
income. Under IAS 39, investments that did not have a quoted market price in an active
market and whose fair value could not be reliably measured were reported at cost. This
provision no longer exists under IFRS 9.
3. A FVTPL investment is reported at fair value with the fair value adjustment reported in net income
whereas an investment in an associate is reported using the equity method.
4. The equity method should normally be used to report an investment when the investor has
significant influence over or has joint control of the investee. The ability to exercise
significant influence or joint control may be indicated by, for example, representation on the
board of directors, participation in policy-making processes, material intercompany
transactions, interchange of managerial personnel or provision of technical information.
5. The Ralston Company could determine that it was inappropriate to use the equity method to
report a 35% investment in Purina in two separate types of circumstances. For example, if
another shareholder group owned up to 65% of Purina’s voting shares, Ralston could argue
that its ownership did not provide significant influence over Purina. In this case, Ralston
would likely classify the investment as a FVTPL investment and report it at fair value.
Alternatively, Ralston might argue that its 35% ownership established control over Purina.
This would occur if, for example, Ralston also owned convertible preferred shares that, if
converted, would increase its voting share ownership to greater than 50%. In this case,
Ralston would argue that it should consolidate Purina.
6. The equity method records the investor’s share of changes in the investee’s equity. The
investee’s equity is increased by income and decreased by dividends. Therefore, the
investor records an increase in its equity account balance when the investee earns income
and records a decrease when the investee pays dividends.
7. An investor should report its share of an investee’s other comprehensive income in the
same manner that it would report its own other comprehensive income. Thus, the investor’s
percentage of the investee’s OCI should be reported on a separate line below operating
profit, net of tax, and full disclosure should be provided. However, the investor’s measure of
materiality should be used to determine if the item is sufficiently material to warrant separate
presentation.
8. The FVTPL would have been reported at fair value. The previous investment should be
adjusted to fair value on the date of the change. The cost of the new shares is added to the
fair value of the previously held shares. The sum of the two values becomes the total cost
of shares when calculating the acquisition differential.
9. In this case, Ashton’s share of the loss of Villa ($280,000) exceeds the cost of its investment
in Villa ($200,000). The extent of loss recognized by Ashton depends on whether it has
legal or constructive obligations to make payments on behalf of Villa.
a) Assume that Ashton has constructive obligations on behalf of Villa because it has
guaranteed the liabilities of Villa such that if not paid by Villa Ashton would have to pay on
their behalf. In this case, Ashton would record 40% x $700,000 or $280,000 as a reduction
of the investment account and as a recognized loss on the statement of operations. The
investment account will now have an $80,000 credit balance and should be reported as a
liability.
b) However, if Ashton does not have constructive obligations with respect to the liabilities of
Villa, losses would only be recognized to the extent of the investment account balance. That
is, a $200,000 loss would be recognized, and the investment account balance would be
reduced to zero.
Ashton would resume recognizing its share of the profits of Villa only after its share of the
profits equal the share of losses not recognized ($80,000 in this case).
10. Able would reduce its investment account by the percentage that was sold and record a gain
or loss on disposition. It would then reevaluate its reporting method for the investment. If
significant influence still exists, it should report using the equity method. If it no longer exists,
Able should report using the fair value method and would measure any remaining interest in
the investee at fair value.
11. The FVTPL reporting method would typically show the highest current ratio because a
FVTPL investment could be classified as a current asset if the intention were to actively
trade in this company or to sell it within a year. For the other reporting methods, the
 investment would likely be classified as a noncurrent asset based on management’s
intention to likely hold the investment for more than one year.
12. The cost method would report the highest debt-to equity ratio. The debt would be the same
for all methods. The cost method would show the lowest equity because dividend income
would be lower than the income under the other methods.
13. The FVTPL method would typically report the highest return on equity because it would
report the highest income. Under the FVTPL method, the fair value adjustment is reported in
net income, which directly affects the ratio. Under the FVTOCI method, the fair value
adjustment goes to OCI and is not included in net income. Shareholders’ equity is the same
for the two FV methods.
14. Private enterprises may elect to account for investments in associates using either the
equity method or the cost method. The method chosen must be applied consistently to all
similar investments. When the shares of the associate are traded in an active market, the
investor cannot use the cost method; it must use either the equity method or the fair value
method.
Problem 2-3
(a)
Investment account at end of Year 6 under cost method = Original cost of $42,000
Investment account at end of Year 6 under equity method:
Year 5 Year 6
Investment, beginning of year 0 44,400
Cost 42,000 -
Equity method income (20%) 5,000 5,600
Unrealized gain (1,300)
Dividends received (20%) (2,600) (2,800)
Investment, end of year 44,400 45,900

(b)
Investment income for Year 6 under cost method = Dividend income of $2,800
Investment income for Year 6 under equity method: = 5,600 – 1,300 = $4,300

(c) Cost Equity

Cash 47,000 47,000
Investment in Raymore (42,000) (45,900)
Gain on sale of investment (5,000) (1,100)

Problem 2-4

(a)

January 1, Year 5

Investment in Stergis 1,950,000

Cash 1,950,000
To record purchase of 25% of Stergis.

December 31, Year 5

Investment in Stergis 13,650

Equity method income 13,650
To record 25% of Stergis’s Year 5 net income.
25% x $54,600 = $13,650

Investment in Stergis 2,950

OCI - Equity method income 2,950
To record 25% of Stergis’s Year 5 OCI
25% x $11,800 = $2,950

Cash 19,500
Investment in Stergis 19,500
To record 25% of Stergis’s Year 5 dividends.
25% x $78,000 = $19,500
December 31, Year 6

Investment in Stergis 39,000

Equity method income 39,000
To record 25% of Stergis’s Year 6 net income.
25% x $156,000 = $39,000

Investment in Stergis 7,800

OCI - Equity method income 7,800
To record 25% of Stergis’s Year 6 OCI
25% x $31,200 = $7,800

Cash 19,500
Investment in Stergis 19, 500
To record 25% of Stergis’s Year 6 dividends.
25% x $78,000 = $19,500

Blake should disclose the following with respect to its investment in Stergis:
 The name and principal place of business of the associate
 The method used to report the investment in the associate
 Equity method income from Blake’s investment in Stergis should be reported separately on
the income statement and the carrying amount of this investment should be reported
separately on the balance sheet
 The nature of its relationship with Stergis and its percentage ownership
 Summarized financial information for Stergis, including the aggregated amounts of assets,
liabilities, revenues, and net income
 Nature and extent of any significant restrictions on the ability of Stergis to transfer funds to
Blake in the form of cash dividends, or to repay loans or advances made by the entity; and
 Contingent liabilities incurred relating to its interests in associates

(b)

January 1, Year 5

Investment in Stergis 1,950,000

Cash 1,950,000
To record purchase of 25% of Stergis.

December 31, Year 5

Cash 19,500*
Dividend income** 19,500

To record 25% of Stergis’s Year 5 dividends*

*25% x $78,000 = $19,500

December 31, Year 6

 Cash 19,500
Dividend income 19,500
To record 25% of Stergis’s Year 6 dividends.

** Note that under the guidance of the Section 3051, when applying the cost method, all dividends are
recorded as revenue when received or receivable regardless of whether they represent liquidating
dividends.
(c)
Blake would prefer to use the equity method. Since Stergis’ comprehensive income for Years 5 and 6 is
greater than dividends paid for Year 5 and 6, Blake’s comprehensive income would be higher under the
equity method. In turn, shareholders’ equity will be higher and total debt will remain the same.
Therefore, the debt-to-equity ratio will be lowest under the equity method.

Problem 2-7
(a)
(i) 26,000 shares x $20 $520,000
(ii) Original cost $442,000
Share of income (20% x (260,000 + 292,500)) 110,500
Less: share of dividends (20% x (195,000 + 208,000)) (80,600)
$471,900
(iii) 26,000 shares x $20 $520,000

(b)
(i) Year 4 Year 5 Year 6 Total
Dividend income (1) $39,000 $41,600 $45,500 $126,100
Unrealized gains (2) 26,000 52,000 0 78,000
Gain on sale (2) 0 0 78,000 78,000
Net income $65,000 $93,600 $123,500 $282,100
Total OCI 0 0 0 0

(ii) Year 4 Year 5 Year 6 Total

Equity income (3) $52,000 $58,500 $62,400 $172,900
Gain on sale (4) 0 0 109,200 109,200
Net income $52,000 $58,500 $171,600 $282,100
Total OCI 0 0 0 0

(iii) Year 4 Year 5 Year 6 Total

Dividend income (1) $39,000 $41,600 $45,500 $126,100
Gain on sale 0 0 0 0
Net income $39,000 $41,600 $45,500 $166,100
Other comprehensive income
Unrealized gain (2) $26,000 $52,000 $78,000
Gain on sale (5) 0 0 $78,000 78,000
Total other comprehensive income 26,000 52,000 78,000 156,000
Comprehensive income $65,000 $93,600 $123,500 $282,100

Notes:
1. 20% x Dividends paid during year
2. 26,000 Shares x change in share price during year
3. 20% x Net income for the year
4. $598,000 – [$442,000 + ($52,000 + $58,500 + $62,400) – ($39,000 + $41,600 + $45,500)] =
$109,200
5. 26,000 Shares x $23 – 26,000 shares x $20 = $78,000

(c) The total comprehensive income over the three-year period in total is the same for all three
situations. However, the split between net income and OCI is not the same in total for the three
situations. This is not unusual in accounting. Although the different methods report different income
each year, in the long run, the total income is the same under all methods. The total income is usually
equal to the difference between cash received and cash paid over the life of the investment which is
$282,100 calculated as follows:

Cash received
Proceeds from sale $598,000
Dividends received (39,000 + 41,600 + 45,500) 126,100
Total proceeds 724,100
Cash disbursed
Cost of investment 442,000
Change in cash $282,100
Problem 2-8
(a & b)

Period Investment Profit OCI

Year 4 20,000 x 14.00 90,000 x 20% 20,000 x (14 -13)

= 280,000 = 18,000 = 20,000

Jan-Sept Year 5 20,000 x 14.60 70,000 x 20% 20,000 x (14.6 -14)

= 292,000 = 14,000 = 12,000

Oct-Dec Year 5 292,000 + (50,000 50,000 x 20%

– 20,000) x 20%= 10,000

= 298,000

(c)

Cash (20,000 x 15) 300,000

Investment in Carlyle 298,000

Gain on sale 2,000

Accumulated OCI (20,000 + 12,000) 32,000

Retained earnings 32,000