Question

On January 1, 2018, Acme Co. is considering purchasing a 40 percent ownership interest in PHC Co., a privately held enterprise, for $700,000. PHC predicts its profit will be $185,000 in 2018, projects a 10 percent annual increase in profits in each of the next four years, and expects to pay a steady annual dividend of $30,000 for the foreseeable future. Because PHC has on its books a patent that is undervalued by $375,000, Acme realizes that it will have an additional amortization expense of $15,000 per year over the next 10 years—the patent’s estimated remaining useful life. All of PHC’s other assets and liabilities have book values that approximate market values. Acme uses the equity method for its investment in PHC.

Instructions:

Write a professional business memo addressed to the instructor that includes the details above and an Excel spreadsheet. The spreadsheet should set the following values in cells:

• Acme’s cost of investment in PHC.

• Percentage acquired.

• First-year PHC reported income.

• Projected growth rate in income.

• PHC annual dividends.

• Annual excess patent amortization.

Referring to the values above, prepare the following schedules using columns for the years 2018 through 2022.

Acme’s equity in PHC earnings with rows showing these:

• Acme’s share of PHC reported income.

• Amortization expense.

• Acme’s equity in PHC earnings. Acme’s Investment in PHC balance with rows showing the following:

• Beginning balance.

• Equity earnings.

• Dividends.

• Ending balance.

• Return on beginning investment balance = Equity earnings/Beginning investment balance in each year.

Answer the following questions:

1. A company acquires a rather large investment in another corporation. What criteria determine whether the investor should apply the equity method of accounting to this investment?

2. What indicates an investor’s ability to significantly influence the decision-making process of an investee?

Answer 1

Answer 1:

Criteria to determine whether the investor should apply the equity method of accounting to this investment or not:

• Evaluation of whether “significant influence” exists: “Significant influence” is presumed to exist for investments of 20% or more of the voting stock of an investee and is presumed not to exist for investments of less than 20% of the voting stock.

Ability to exercise significant influence over operating and financial policies of an investee may be indicated in several ways, including the following:

a. Representation on the board of directors

b. Participation in policy-making processes

c. Material intra-entity transactions

d. Interchange of managerial personnel

e. Technological dependency

f. Extent of ownership by an investor in relation to the concentration of other shareholdings (but substantial or majority ownership of the voting stock of an investee by another investor does not necessarily preclude the ability to exercise significant influence by the investor).

Here, Acme Co. is considering purchasing a 40 percent ownership interest in PHC Co. Therefore, Acme co. may have "significance influence" over PHC co. as having more than 20% of ownership is not the only criteria to have significance influence.

Answer 2:

A number of circumstances indicate an investor’s ability to exercise significant influence over the decision making of an investee, including the following:

• Board of directors representation

• Policy-making participation

• Intra-entity transactions that are material

• Intra-entity management personnel interchange

• Technological dependence

• Proportion of ownership by the investor in comparison to that of other investors