You are an intern in a CPA firm. Your manager walks into your cubicle and says,

Question

You are an intern in a CPA firm. Your manager walks into your cubicle and says, “One of our clients is thinking about investing in a company. He wants to know how he should account for this investment. Be prepared to discuss it with the client tomorrow.”

Write a memo of 500 words to your manager giving your thoughts on how this should be handled by the client.

The situation is the following:

Company F purchased 40% of the outstanding stock of company K on June 30, 20XX.

Both of the companies have a December 31st, year end.

Company K is a publicly traded company and reports its net income to company F.

Company K also pays a hefty dividend to the shareholders of company F.

How should company F report the above facts on its December 31, 20XX balance sheet and income statement?

Support your answer

Explanation / Answer

Company F has purchased 40% of the outstanding stock of company K on June 30, 20XX According to U.S. GAAP, Company F is an investor holding more than 20% but less than or equal to 50%of the shares of Company K and so is assumed to possess the ability to exert significant influence over the financial affairs of the latter.So, as per GAAP,in the event of nothing existing explicitly suggesting that there is no significant influence , the EQUITY method should be applied by Company F   to account all investments in the range of 20% to 50% ownership. Under this method, On purchase of shares in K, Company F should pass the following journal entry: Debit       Investment In K---------- Asset a/c in the Balance sheet Credit      Cash                     ------------ Current asset in the Balance sheet When Company K reports net income in Dec 20XX, Company F should immediately, recognise its share of income ,for the proportionate period (ie. 6 months' net income)of holding that 40%, by means of a journal entry as follows:(Total net income of K*40%*6/12) Debit        Investment in K---------- Investment account (Balance sheet a/c)increases by accruing income Credit       Investment Income -Co. K ------ Income statement account When Company K pays dividends to the shareholders of company F the investment account decreases by the amount of cash dividend received & the following entry needs to be passed in F's books: Debit         Cash ----------------------- for the amount of cash dividend received--current asset increases Credit        Investment in K------------ The balance sheet a/ c decreases When the above investment is sold by Company F, it makes the following entry: Debit        Cash ------------------ with the sale proceeds Credit       Investment in K ---------------- with the carrying value of the investment ,Ie.(Purchase price+Net income accrued-dividends received) Any balance is debited to Loss on sale of   Investment in K -equity securities         or                                credited to Gain on sale of   Investment in K -equity securities Thus this level(40%) of investment in equity of other companies , entails passing of the above - mentioned journal entries , in the books of the purchasing company.

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