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Answer |
Since Boomer Company’s inception, Madison Company has owned 18 percent of Boomer’s outstanding
common stock. Madison provides three key management personnel to Boomer and purchased 25 percent
of Boomer’s output during 20X7. Boomer is profitable. On January 2, 20X8, Madison purchased additional
common stock to finance Boomer’s expansion, thereby becoming a 30 percent owner. Boomer’s
common stock does not have a quoted market price. The stock has always been issued at its book value,
which is assumed to approximate its fair value.
a. In general, distinguish between investor-income reporting under the cost method and under the equity
method. Which method is more consistent with accrual accounting? Why?
b. Prior to January 2, 20X8, what specific factors should Madison have considered in determining the
appropriate method of accounting for its investment in Boomer?
c. Assume that Madison used the cost method in accounting for its investment in Boomer prior to January
2, 20X8. Describe the book adjustments required on January 2, 20X8, when Madison became
owner of 30 percent of Boomer’s outstanding common stock. |
| Answer |
a.
Cost method in which the investment account is always shown at purchase price of investments and an earnings from investment is recorded when dividend is received. While in equity method the investment account is adjusted due to any profit of loss, if company has made any profit it increases the value of investment otherwise not and when the dividend is paid it is adjusted from investment account not shown as earnings like cost method.
As an earnings of invested company is recorded whether it has been received or not in investment method therefore it is more consistent with accrual accounting method.
method. Which method is more consistent with accrual accounting? Why?
b. As the fair value of the Boomer company is its book value due to its status of unquoted company therefore it is preferable for Madison to show the investment at equity method to reflect the book value of the Boomer company in its account to make the financial position strong and fair.
c. If boomer has paid all its earnings as dividend in the previous year then there is no need for adjustments otherwise the investment account to be increased equal to share of Madison in Boomer Company
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