Equity Method

1. Describe the theoretical criterion for applying the equity method to an investment in stock and explain the alternative standard that is often used.

2. Compute the amount of income to be recognized under the equity method and make the journal entry for its recording.

3. Understand the handling of dividends that are received when the equity method is applied and make the related journal entry.

4. Indicate the impact that a change in fair value has on the reporting of an equity method investment.

5. Prepare the journal entry to record the sale of an equity method security.

Question: Not all investments in corporate stock are made solely for the possibility of gaining dividends and

share price appreciation. As mentioned earlier, The Coca-Cola Company holds 35 percent ownership of Coca-

Cola Enterprises. The relationship between that investor and investee is different. The investor has real power;

it can exert some amount of authority over the investee. The Coca-Cola Company owns a large enough stake in

CCE so that operating and financing decisions can be influenced. When one company holds a sizable portion of

another company, is classifying and accounting for the investment as an available-for-sale or trading security a

reasonable approach?

Answer: The answer to this question depends on the size of ownership. As the percentage of shares grows, the

investor gradually moves from having little or no authority over the investee to a position where significant

influence can be exerted. At that point, the investment no longer qualifies as a trading security or an available-for-sale security. Instead, the shares are reported by means of the equity method. The rationale for holding the

investment has changed.