Ch2
Accounting for business
combination
By: Nada Magdy
If part of an investment is sold during the period:
➢ The equity method is applied up to the transaction
date.
➢ At the transaction date, the Investment account
balance is reduced by the percentage of shares sold.
➢ If significant influence is lost, NO RETROACTIVE
ADJUSTMENT is recorded if the investor is required to
change FROM the equity method to the fair-value
method.
➢ Note: A change TO the equity method is also treated
prospectively.
Reporting the sale of an equity investment
Top Company owns 40% of the 100,000 outstanding shares of Bottom
Company, an investment accounted for by the equity method. Any excess
investment cost over Top’s share of Bottom’s book value is considered
goodwill.
➢ Although these 40,000 shares were acquired some years ago for
$200,000, application of the equity method has increased the asset
balance to $320,000 as of January 1, 2021.
➢ On July 1, 2021, Top elects to sell 10,000 of these shares (one-fourth of
its investment) for $110,000 in cash.
➢ Bottom Company reports net income of $70,000 during the first six
months of 2021 and declares and pays cash dividends of $30,000.
The investment account balance on July 1,2021 = investment account balance on Jan
1,2021 + % in Net income - % in dividend
320000+28000-12000= 336000
The sale of one-fourth of these shares:
Cash 110000
investment in B (336000*0.25) 84000
Gain 26000
How much equity income does Top Company recognize from Bottom Company for the first six months
of 2021?
a) 14000
b) 28000
c) 40000
d) 70000
Answer: b
What is the adjusted investment balance in Bottom Company before the sale on July 1, 2021?
e) 336000
f) 320000
g) 328000
h) 340000
Answer: a
What is the carrying amount of the shares sold on July 1, 2021?
i) 80000
j) 84000
k) 110000
l) 92000
Answer: b
What is the gain or loss on the sale of shares on July 1, 2021?
a) 26000 gain
b) 20000 gain
c) 26000 loss
d) No gain or loss
Answer: a
After selling one-fourth of its investment, what percentage of Bottom Company does Top still own?
e) 40%
f) 30%
g) 25%
h) 35%
Answer: b
Jabiru Corporation purchased a 20% interest in Fish Company common stock on January 1, 2013
for $300,000. This investment was accounted for using the equity method and the correct balance in the
Investment in Fish account on December 31, 2015 was $440,000. The original excess purchase
transaction included $60,000 for a patent amortized at a rate of $6,000 per year. In 2016, Fish
Corporation had net income of $4,000 per month earned uniformly throughout the year and paid
$20,000 of dividends in May. If Jabiru sold one-half of its investment in Fish on August 1, 2016 for
$500,000, how much gain was recognized on this transaction?
a) 278950
b) 280000
c) 280950
d) 282000
Answer: c
Reporting a Change to the Equity Method
An investment that was recorded using the cost or fair value method reaches the point
where significant influence is established.
When an investment qualifies for use of the equity method, the investor adds the cost
of acquiring additional interest in the investee to the current basis and adopts the
equity method of accounting
This prospective approach (requiring that the cost of any new share acquired simply be
added to the current investment carrying amount) avoids the complexity of restating
prior period amounts.
Lecture example
➢ Alpha Co. acquires a 10 percent ownership in Bailey Co. on
January 1, 2023, for $84,000. Alpha company does not have the
ability to exert significant influence over Bailey.
➢ Alpha properly records the investment using the fair value
method and recognizes in net income its 10 percent ownership
share of changes in Bailey’s fair value.
➢ Fair values of Bailey’s common stock and book value of
company appear in the following table:
Date Fair Value Book Value
January 1,
$84,000 $670,000
2023
December
89,000 715,000
31, 2023
On January 1, 2024, Alpha purchases an additional 30 percent of
Bailey’s outstanding voting stock for $267,000.
On January 1, 2024, Alpha achieves the ability to exercise significant
influence over Bailey, and will now apply the equity method to
account for its investment in Bailey
on Jan 1, 2024:
Investment in B 267000
cash 267000
On January 1, 2024, Bailey’s carrying amounts for its assets and
liabilities equaled their fair values except for a patent, which was
undervalued by $175,000 and had a 10-year remaining useful life.
Fair value of 40 % of B company (267000+89000) 356000
40% of Book value of B company (40%*715000) (286000)
________
Excess fair value 70000
Excess fair value attributable to Bailey’s patent (175000*40%) 70000
Journal entry:
Equity income (70000/ 10) 7000
investment in B company 7000
Bailey reports net income of $130,000
and declares and pays a $50,000 dividend at the end of
2024.
% in Net income
Investment in B 52000
equity income 52000
% in dividend
Cash 20000
investment in B 20000
What is the balance of an investment account on Dec 31, 2024?
a) 381000
b) 292000
c) 376000
d) 300000
Answer: a
Investment Account=Initial Investment+Equity Income−Dividends Received−Amortization
What amount of investment income will be reported by Alpha for the year 2024?
e) 7000
f) 52000
g) 45000
h) 50000
Answer: c
Investment Income=Alpha’s Share of Net Income−Amortization of Patent
Thank You