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Equity Method quiz #1

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  • What is the equity method of accounting for investments, and when is it used?
    The equity method is used when an investor has significant influence, but not control, over an investee—typically owning between 20% and 50% of the company's voting stock. Under this method, the investment is initially recorded at cost, and the investor recognizes their proportional share of the investee's net income or loss, which adjusts the carrying value of the investment. Dividends received reduce the investment account rather than being recognized as income.
  • When is the equity method of accounting for investments used?
    The equity method is used when an investor has significant influence over an investee, typically owning between 20% and 50% of the voting stock.
  • How is the initial purchase of an investment recorded under the equity method?
    The initial purchase is recorded by debiting the Equity Method Investment account and crediting cash for the total cost paid.
  • How does an investor recognize their share of the investee’s net income under the equity method?
    The investor increases the investment account by their proportional share of the investee’s net income and credits investment income on the income statement.
  • What happens to the investment account when the investee reports a net loss?
    The investment account is decreased by the investor’s share of the net loss, and an investment loss is recognized on the income statement.
  • How are dividends received from the investee treated under the equity method?
    Dividends received reduce the carrying amount of the investment account and are not recognized as dividend income.
  • What is the key difference in accounting for dividends between the equity method and the cost method?
    Under the equity method, dividends reduce the investment account, while under the cost method, dividends are recognized as income.
  • How is a gain or loss on the sale of an equity method investment determined?
    A gain or loss is calculated as the difference between the selling price and the book value of the investment at the time of sale.
  • What does the T-account for the equity method investment resemble, and why?
    The T-account resembles retained earnings because it increases with net income, decreases with dividends and losses, and tracks the investor’s equity in the investee.
  • Why is it important to calculate the percentage of ownership when using the equity method?
    The ownership percentage determines the investor’s share of the investee’s net income, losses, and dividends, which are used in all related journal entries.