Sample Problem Postings: Module 2 – Investments in Equity Securities (Chapter 2)

and Business Combinations (Chapter 3)

Chapter 2 – Investments in Equity Securities

Sample Problem #1 Increasing Ownership from FVTPL to Significant Influence (like Text Self
Study #1, Chapter 2)

On January 1, Year 5, High Inc. purchased 18% of the outstanding common shares of Lowe Corp. for
$200,000. From High’s perspective, Lowe was a FVTPL investment. The fair value of High’s investment
was $275,000 at December 31, Year 5.

On January 1, Year 6, High purchased an additional 27% of Lowe’s shares for $600,000. This second
purchase allowed High to exert significant influence over Lowe. There was no acquisition differential on
the date of the 27% acquisition.

During the two years, Lowe reported the following:

Profit Dividends
Year 5 $320,000 $180,000
Year 6 350,000 175,000

Required:

Part A: Prepare High’s journal entries with respect to this investment for both Year 5 and Year 6. Find
the value of the Investment in Lowe on High’s separate entity balance sheet at December 31, year 6

Part B: The following are summarized income statements for the two companies for Year 7:
High Inc. Lowe Corp.
Operating income before income taxes $ 500,000 $380,000
Income tax expense 100,000 76,000
Net income before discontinued operations 400,000 304,000
Discontinued operations Gain (Loss) (net of tax) 20,000 (18,000)
Net income $ 420,000* $286,000

* High has not yet included any investment income from Lowe on its books

Lowe paid dividends of $15,000 in Year 7.

Required
(a) Prepare the journal entries that High should make at the end of Year 7 with respect to its
investment in Lowe.
(b) Prepare High’s income statement for Year 7, taking into consideration the journal entries in part (a).

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SOLUTION:
Part A

The 18% purchase is accounted for under the FVTPL method. High’s journal entries during Year 5 are as follows:

Investment in Lowe 200,000

Cash 200,000
Purchase of 18% of shares of Lowe

Cash (18% ×180,000) 32,400

Dividend income 32,400

Investment in Lowe (275,000−200,000) 75,000

Unrealized gain on FVTPL investment 75,000

The 27% purchase in Year 6 changes the investment to one of significant influence, which is accounted for
prospectively under the equity method.

The journal entries in Year 6 are as follows:

Investment in Lowe 600,000

Cash 600,000
Purchase of additional 27% of shares of Lowe

Investment in Lowe (45% × 350,000 profit) 157,500

Equity method income 157,500

Cash (45% × 175,000 dividends) 78,750

Investment in Lowe 78,750

At Dec 31 year 6, the Investment in Lowe account has a balance of:

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Part B
(a) Applying the equity method, High makes the following journal entries in Year 7:

Investment in Lowe (45% × 286,000) 128,700

Discontinued operations−associate loss (45% × 18,000) 8,100
Equity method income (45% × 304,000) 136,800

OR do these as separate entries:

Investment in Lowe (45% x 304,000) 136,800

Equity Method Income – associate 136,800

Disc Operations Loss (associate) 8,100

Investment in Lowe 8,100

Cash (15,000 x .45) 6,750

Investment in Lowe 6,750

HIGH INC.
INCOME STATEMENT
Year ended December 31, Year 7
Operating income $500,000
Equity method income* 136,800
Income before income taxes 636,800
Income tax expense 100,000
Net income before discontinued operations 536,800
Discontinued operations Loss - associate (net of (8,100)
tax)*
Discontinued Operations Gain (net of tax) 20,000

Net income $548,700

*a note would disclose that this occurred as a result of a 45% significant influence investment in Lowe using the
equity method
Investment in Lowe account balance on High’s balance sheet at Dec 31 year 7 is $1,075,700

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Problem 2-3
(a)

January 1, Year 5

Investment in Stergis 1,850,000

Cash 1, 850,000
To record purchase of 25% of Stergis.

December 31, Year 5

Investment in Stergis 12,950

Equity method income 12,950
To record 25% of Stergis’s Year 5 net income.
25% x $51,800 = $12,950

Investment in Stergis 2,850

OCI - Equity method income 2,850
To record 25% of Stergis’s Year 5 OCI
25% x $11,400 = $2,850

Cash 18,500
Investment in Stergis 18,500
To record 25% of Stergis’s Year 5 dividends.
25% x $74,000 = $18,500

December 31, Year 6

Investment in Stergis 37,000

Equity method income 37,000
To record 25% of Stergis’s Year 6 net income.
25% x $148,000 = $37,000

Investment in Stergis 7,400

OCI - Equity method income 7,400
To record 25% of Stergis’s Year 6 OCI
25% x $29,600 = $7,400

Cash 18,500
Investment in Stergis 18, 500
To record 25% of Stergis’s Year 6 dividends.
25% x $74,000 = $18,500

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

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• 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 1,850,000

Cash 1, 850,000
To record purchase of 25% of Stergis.

December 31, Year 5

Cash 18,500*
Dividend income** 18,500

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

*25% x $74,000 = $18,500

December 31, Year 6

Cash 18,500
Dividend income 18,500
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.

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Problem 2-4
Part (a) Equity method

(i) Investment in Saltspring 285,000

Cash 285,000
To record 30% investment in Saltspring

Cash (30% x 110,000) 33,000

Investment in Saltspring 33,000
Dividends received

Investment in Saltspring (30% x 306,000) 91,800

Equity method loss – discontinued operations (30% x 33,000) 9,900
Equity method income (30% x 339,000) 101,700
To record 30% of Saltspring’s profit and discontinued operations

(ii) Investment cost Jan. 1, Year 6 $285,000

Dividends received (33,000)
Share of income 91,800
Investment account Dec. 31, Year 6 $343,800

(iii)
Pender Corp
Statement of Operations
Year ended December 31, Year 6

Sales $990,000
Equity method income 101,700
1,091,700
Operating expenses (110,000)
Income before income tax 981,700
Income tax expense (352,000)
Net income before discontinued operations 629,700
Disc. Operations – Equity method loss (9,900)
Profit $619,800

Part (b) Cost method

(i) Investment in Saltspring 285,000

Cash 285,000
To record 30% investment in Saltspring

Cash 33,000
Dividend income 33,000
Dividends received

(ii) Investment account balance December 31, Year 6 $285,000

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 (iii)
Pender Corp
Statement of Operations
Year ended December 31, Year 6
Sales $990,000
Dividend income 33,000
1,023,000
Operating expenses (110,000)
Income before income tax 913,000
Income tax expense (352,000)
Profit $561,000

Part (c) Pender would want to use the equity method if its bias were to show the highest return on
investment since the equity method considers the full increase in value of the investee (i.e. recognizes
proportion of income earned for the year) whereas the cost method only recognizes income to the extent of
dividends received.
Cost method return on investment = $33,000/ $285,000 = 11.58%
Equity method return on investment = ($101,700 - $9,900)/ $285,000 = 32.21%

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Chapter 3 – Business Combinations
Problem 3-1 (Purchase of Net Assets for Cash)
(a)
Journal entry on Abdul’s books

Cash and receivables 20,150

Inventory 10,050
Plant assets 70,100
Goodwill (plug) 19,100
Current liabilities 27,600
Long-term debt 33,800
Cash 58,000

Journal entry on Lana’s books

Cash 58,000
Current liabilities 27,600
Long-term debt 40,100
Cash and receivables 20,150
Inventory 8,150
Plant assets 66,350
Gain on sale of net assets 31,050
(b) Abdul Lana

Cash and receivables $ 55,150 $ 58,000

Inventory 70,550 0
Plant assets (net) 306,100 0
Goodwill 19,100 0
$450,900 $58,000
Current liabilities $ 93,100 $ 0
Long-term debt 128,050 0
Common shares 140,500 40,050
Retained earnings (deficit) 89,250 17,950
$450,900 $58,000

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Let’s change the question a bit to assume a Purchase of Shares:
What if Abdul paid $58,00 cash to buy all of the outstanding voting (common) shares of Lana from Lana’s
investors. (note: now the transaction is between Abdul and Lana’s investors so Lana makes no entry on its
books)

Required:
a) Make the entry on Abdul’s books to record the Investment in Lana at acquisition.
b) Calculate the acquisition differential and goodwill created at acquisition
c) Prepare the consolidation worksheet entry at acquisition to facilitate the preparation of the consolidated
balance sheet at acquisition.
d) Prepare the consolidated balance sheet immediately after the acquisition on June 30 Year 2 using the
direct method

SOLUTION:
a) Investment in Lana 58,000
Cash 58,000
b) Follows exhibit 3.3 page 109

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c) You can follow the “adjustment and eliminations” columns in Exhibit 3.4 as follows:

OR use a bit of a shortcut entry (since acquisition differential is merely debited and then credited):

d)
Abdul Ltd
Consolidated Balance Sheet
June 30, Year 2

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Note:
a) I find fair value of Lana’s assets and liabilities now controlled by Abdul by taking their book value and
adding fair value increments/decrements. I do this since I know later in the course you will isolate the
increments and decrements and amortize them once we are beyond acquisition date so better to
practice this now. Also it aligns better with calculation of goodwill above; however the result it the
same.
b) There is no Investment in Lana account on the consolidated statements since you eliminated it at
acquisition and distributed it among the fair values of Lana that show in the consolidated balance
sheet.

Problem 3-7 a, b, c only

(a)
Acquisition cost: 82,500 shares @ $20 $1,650,000 (a)
Fair value of Hanson assets (as listed) $1,531,200
Unrecorded customer service contracts 150,000
1,681,200
Fair value of Hanson liabilities (137,500 + 129,800) -267,300 1,413,900
Goodwill $ 236,100 (b)
Direct costs associated with acquisition:
Costs of issuing shares $44,000 (c)
Professional fees 38,500 (d)
Total $82,500 (e)

Drake Enterprises
Consolidated Balance Sheet

January 1, Year 6
Cash (99,000 – (e) 82,500 + 55,000) $71,500
Accounts receivable (143,000 + 280,500) 423,500
Inventory (191,400 + 178,200) 369,600
Property, plant and equipment (1,692,000 + 1,017,500) 2,709,500
Accumulated depreciation (900,000 + 0) (900,000)
Customer service contracts 150,000
Goodwill (b) 236,100

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 $3,060,200
Current liabilities (242,000 + 137,500) $379,500
Liability for warranties 129,800
Bonds payable 352,000
Common shares (220,000 + 1,650,000 (a) – (c) 44,000) 1,826,000
Retained earnings (411,400 – (d) 38,500) 372,900
$3,060,200
(b)
Drake Enterprises
Balance Sheet

January 2, Year 6
Assets
Cash (99,000 –82,500) $16,500
Accounts receivable 143,000
Inventory 191,400
Property, plant and equipment 1,692,000
Accumulated depreciation (900,000)
Investment in Hanson (82,500 shares x 20) 1,650,000
$2,792,900
Liabilities and Equity
Current liabilities $ 242,000
Bonds payable 352,000
Common shares (220,000 + 1,650,000 – 44,000) 1,826,000
Retained earnings (411,400 – 38,500) 372,900
$2,792,900

(c) Consolidated Equity

Method
Total Debt $861,300 $594,000
Equity 2,198,900 2,198,900
Debt-to-equity ratio 0.39 0.27

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The consolidated balance sheet shows the highest debt-to-equity ratio. It also better reflects the solvency risk
because it shows the total debt of the economic entity.

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