[Kairos]

Not too sure what is even meant by excesses in this question. Can anyone walk me through this one? Thanks!

Park Co. uses the equity method to account for its January 1, 20X3 purchase of Tun Inc.’s common stock. On January 1, 20X3, the fair values of Tun’s FIFO inventory and land exceeded their carrying amounts. How do these excesses of fair values over carrying amounts affect Park’s reported equity in Tun’s 20X3 earnings?

a

Decreases inventory excess and land excess.

b

Increases inventory excess and land excess.

c

Decreases inventory excess, no effect on land excess.

d

Increases inventory excess, no effect on land excess.

[Anonymous]

When accounting for an equity method investment (or acquisition method), you look at the fair value of assets and liabilities rather than their book value. So we're essentially booking for ourselves that inventory and land is worth more (excess of carrying value = worth more), and that is reflected in the investment account which is booked at price paid.

If I'm following the question correctly, it's asking how those self-noted fair value adjustments affect our equity earnings from the investee. So what I think they're asking is do the inventory and land excesses (fair value over carrying value) increase, decrease, or have no effect on equity earnings. We can't just simply take our share of the investee's net income, we have to adjust it for any added depreciation or amortization necessary based on the fair value adjustments originally made.

Well, if inventory is worth more than it's booked at and it's sold during the year 20X3 (which it must have been since it's FIFO) then that means COGS should be higher than recorded by the investee for our purposes, which would mean earnings decrease. Land on the other hand isn't amortized or depreciated, it remains at a fixed cost so it would have no effect on earnings for any period. Based on that, the answer should be C.

You'll have to let me know if that's not the answer they have. I don't know if it's the way the question was copied and pasted or if it's the question itself, but the formatting is a bit strange.

[spatel15]

Agreed, but I think it has more to do with the amortization of definite-lived fixed assets valued above fair value. In a sense, the COGS “would” be higher, but it's more about “amortizing your equity investment” due to definite-lived fair value adjustments. Inventory is one of those items items that's so short lived, you amortize it all within the first year. Buildings may have a longer amortization period if fair value at investment was above book. (Investee would depreciate the building still so that'd be reflected in your share of the earnings, but you'd amortize that difference between what was depreciated and what fair value was at acquisition). <–Inventory and Land are the two odd ones out lol. One's really short-lived so it's amortize all immediately, and one never amortizes.

Land, however, is NOT definite-lived so you don't need to amortize.

Good section in FAR(Becker) on it, if you have the book and wanna check it out: Marketable Securities and Combinations

[Anonymous]

COGS is what an inventory differential flows into in this scenario, it's not amortization.

For your reference: “In the period in which the inventory units are sold, the inventory-related differential is assigned to Cost of Goods Sold.” That's a quote taken from a McGraw Hill PowerPoint on consolidations that a quick Google search turned up.

I think this clarification is worth noting, because if you were drawing up a consolidation entry it's important to recognize what income statement item is affected. Although admittedly I wouldn't expect this specific point to be tested.

[spatel15]

A wee bit out of context though. Equity Method doesn't imply control. If you owned 30% you wouldn't have a COGS account(other than your own to adjust). But in the accounting for the equity method, not the adjustments to consolidation, you “amortize” your share of equity earnings, I.e. debit Equity Income(revenues usually credit) and credit Equity Investment Balance(asset).

You are right but that quote pertains only to consolidation where investors owns/controls the company. No investee books are kept if you don't own it, but are still using equity method both internally and probably externally. Consolidation doesn't allow external reporting using the equity method, and that's where the idea of adjusting COGS is totally correct.

[Anonymous]

That's a totally fair point, I did end up tailoring my last response to the consolidation side of things which was kind of tangential. Consolidated investment account balances are still often maintained using the equity method (other methods being cost and partial equity). I'm not sure how much consolidated investment account balance methods are covered in review courses (I don't recall seeing it in Becker) so that's got to be outside the scope of the CPA exam.

The original question does presumably refer to a non-consolidated equity method investment, so there wouldn't be any consolidation entries just as you pointed out. I think referring to it as amortization is fair, although ultimately the same principles are at play here (minus the consolidation entries — which are “phantom” entries anyway). I still view it as the excess inventory cost should have flowed through COGS, so the equity investment decreases to reflect that. But that's really just semantics; whether you call it COGS or amortization you're getting the same result.

[Author]

Replies