FAR · Select balance sheet accounts · 10 practice questions
Equity Method: When Significant Influence Starts and Stops
The equity method starts when significant influence begins and stops when it ends, not when ownership crosses 20%. Compare the same investment with one change to its ownership or governance rights.
Try one first
Hint
Identify the event that changes the accounting model (what triggers the change) and whether that change is applied prospectively or retrospectively.
Answer B. Alder obtained significant influence on March 31 (board representation and combined 25% ownership). Under U.S. GAAP, when significant influence is newly obtained the investor switches to the equity method prospectively at that date; the carrying amount equals the carrying amount of the previously held interest (as reported under ASC 321) plus the cost of the newly acquired shares. Prior periods are not restated and no remeasurement gain/loss is recognized.
Why not A: Tempting because many students equate 'less than 50%' with no change in accounting. It fails because GAAP uses significant influence (not solely a 50% control threshold) to determine equity-method application; board representation and 25% ownership indicate significant influence, so the equity method applies.
Why not C: Tempting because some accounting transitions are applied retrospectively. It fails because the change in accounting model upon obtaining significant influence is applied prospectively from the date influence is obtained; prior periods are not restated to equity method accounting.
Why not D: Tempting because step-acquisitions that result in control require remeasurement to fair value with gain/loss recognition. It fails here because Alder did not obtain control, only significant influence, so the previously held interest is not remeasured to fair value and no immediate gain or loss is recognized.
Same scenario, one fact changes
Base case
Cedar holds 15% of Pine under ASC 321 at fair value. On June 30, Cedar buys another 10% for $130,000; the existing stake's carrying amount is $170,000. Governance rights grant board representation and policy participation effective June 30. Until then, Cedar is legally barred from both and has no other influence indicators. Cedar has no control or fair value option election.
Answer: Begin the equity method June 30 at $300,000.
Governance rights give Cedar significant influence on June 30. Carry forward $170,000 and add $130,000; apply the change prospectively without a separate fair value remeasurement.
Before you open each one, predict the answer.
Change 1Governance rights become effective August 15 instead of June 30.
Answer: Begin the equity method August 15. Continue ASC 321 until then.
The purchase does not overcome the legal restrictions. Influence begins only when the board and policy rights become effective.
Change 2Cedar buys an additional 3% instead of 10%, bringing total ownership to 18%.
Answer: Still begin the equity method June 30 at $300,000.
The lower percentage does not change the answer. Effective board and policy rights establish influence despite ownership below 20%.
Change 3The agreement permanently bars board representation and policy participation instead of granting those rights.
Answer: Continue ASC 321 fair value accounting. Do not begin the equity method.
The permanent restrictions rebut the 20% presumption. Cedar cannot exercise significant influence even with 25% ownership.
Key points
- Remember: Effective influence rights, not ownership percentage alone, determine when the equity method starts or stops.
- Board representation, policy participation, material transactions, and managerial interchange can indicate influence.
- On gaining influence, use the prior carrying amount plus additional share cost; do not restate prior periods.
- On losing influence, measure retained shares with readily determinable fair value at fair value, with changes in earnings.
How the exam traps you
- Treating 20% ownership as an automatic equity method trigger. Assess the ability to exercise significant influence. Rights can establish influence below 20%; restrictions can rebut it above 20%.
- Starting the equity method when shares are purchased or an agreement is signed. Start when significant influence becomes effective. A purchase or signature may precede that date.
- Remeasuring the original stake solely because significant influence is obtained. Carry forward its current carrying amount and add the new shares' cost. Obtaining influence is not obtaining control.
Now the same facts as questions
Each question changes one fact from the one before. Watch which change flips the answer.
Question 1
Answer B. $170,000 plus $130,000 equals $300,000; influence starts June 30.
Why not A: Significant influence, not majority ownership, triggers the equity method.
Why not C: Newly obtained influence changes accounting prospectively, not retrospectively.
Why not D: The existing carrying amount carries forward; gaining influence requires no separate remeasurement.
Question 2
Answer D. The rights establish significant influence on August 15.
Why not A: Legal restrictions prevent influence on June 30 despite 25% ownership.
Why not B: The start of a reporting period does not establish significant influence.
Why not C: Equity method adoption does not wait until year-end.
Question 3
Answer A. Governance rights establish influence below 20%; the basis remains $170,000 plus $130,000.
Why not B: Ownership below 20% does not prevent significant influence.
Why not C: The equity method applies to the entire investment, not just the new shares.
Why not D: Cedar lacked significant influence when it acquired the original stake.
Question 4
Answer C. Without significant influence, this fair value investment remains under ASC 321.
Why not A: Permanent restrictions rebut the presumption of influence at 25% ownership.
Why not B: Waiting until year-end does not remove the restrictions or create influence.
Why not D: Cedar does not control Pine; 20% is not a consolidation threshold.
Question 2
Hint
Do not stop at the ownership percentage. Determine whether the facts show significant influence for each investee.
Answer B. Equity method accounting is appropriate when the investor has significant influence over the investee; ownership percentage is only a rebuttable presumption. River shows strong indicators of significant influence (a board seat and participation in operating and dividend policy) despite 18% ownership. Stone's >20% ownership presumption is rebutted because another shareholder can unilaterally control the board and policies and Hark has no board representation or policy influence.
Why not A: This is tempting because Stone's 24% ownership exceeds the common 20% benchmark. However, ownership above 20% is only a rebuttable presumption of significant influence; here it is explicitly rebutted by the shareholder agreement giving another investor unilateral control and by Hark's lack of board representation or policy participation.
Why not C: A candidate might pair River's board seat with Stone's >20% ownership to pick both. But you must apply the significant‑influence analysis separately: River shows influence, while Stone's circumstances (a controlling shareholder with unilateral board and policy control and no Hark representation) rebut the presumption.
Why not D: This reflects overreliance on the 20% guideline. Under U.S. GAAP, ownership below 20% does not preclude equity method treatment when other evidence (board representation and participation in policy decisions) indicates significant influence, as is the case for River.
Question 3
Hint
Do not treat 20% ownership as an automatic rule. Focus on what actually drives the accounting model for this type of stock investment.
Answer C. The equity method is used when the investor can exercise significant influence over the investee's operating and financial policies. Ownership of 20% or more creates a common presumption of significant influence but is not determinative. In this case, board representation and participation in policy-making indicate significant influence exists despite only 18% ownership.
Why not A: Holding intent is relevant for certain classifications of securities or for impairment/intent considerations, but it does not determine whether the equity method applies, the investor's ability to exercise significant influence is the governing issue.
Why not B: This is tempting because 20% is a commonly cited guideline, but it is only a rebuttable presumption. Significant influence can exist with less than 20% ownership (or be absent above 20%) depending on the facts.
Why not D: Dividend policy affects subsequent accounting (for example, how dividends are recorded) but does not determine whether the equity method is the correct measurement model. The choice of method depends on the investor-investee relationship and significant influence.
Question 4
Hint
Focus on what removes an equity investment from the normal fair-value-through-net-income model, not on whether management plans to hold it short term or long term.
Answer B. An investment over which the investor can exercise significant influence is generally accounted for under the equity method rather than as an equity security measured at fair value through net income. The board seat and stated ability to exercise significant influence indicate significant influence even though Moss does not control Lake Inc. The other listed investments lack significant influence and are therefore measured at fair value with changes recognized in net income.
Why not A: Small ownership alone (e.g., 5%) does not create an exception; without significant influence, a publicly traded equity security is generally measured at fair value with changes recognized in net income. Candidates who focus only on percentage may miss the influence test.
Why not C: Short-term trading intent might seem like a special category from older frameworks, but under current GAAP a publicly traded equity security without significant influence is measured at fair value with changes recognized in net income. Intent to sell short term does not by itself move the investment out of the FV-through-net-income model.
Why not D: Long-term holding intent does not create an exception for publicly traded equity securities. Absent significant influence, the investment is still generally measured at fair value with changes recognized in net income.
Question 5
Hint
Do not stop at ownership percentage. Consider indicators of significant influence (board representation, participation in policy decisions, access to information) versus legal/practical barriers or majority voting power that indicate control.
Answer B. Significant influence can exist without a majority interest and may be present even with ownership below 20% when other indicators exist. Redd's contractual right to appoint a director and its regular participation in budgeting and dividend-policy discussions are strong indicators of significant influence. Because these facts point to significant influence but not control, the equity method is indicated.
Why not A: Although ownership of 20% or more generally creates a presumption of significant influence, that presumption is rebuttable. Court-imposed or similar legal/practical restrictions that deny access to information, board participation, and policy involvement indicate Redd cannot exercise significant influence, so the equity method would not be appropriate here.
Why not C: A majority voting interest ordinarily indicates control and requires consolidation rather than equity-method accounting. The management contract does not negate Redd's controlling financial interest because Redd retains the unilateral power to remove the manager, so consolidation, not the equity method, is indicated.
Why not D: Being the largest outside shareholder and receiving audited financial statements do not by themselves establish significant influence. Absent board representation, policy participation, or other indicators of influence, the facts support a passive investment classification rather than the equity method.
Question 6
Hint
Focus on when the rights to appoint a director and participate in policy decisions actually begin, not when the agreement was signed; ownership percentage alone is not decisive.
Answer D. The equity method is applied when the investor obtains the ability to exercise significant influence, which here results from governance and policy‑participation rights that do not become effective until August 15, Year 2. The equity method is applied from the date significant influence begins (and recognized in interim and annual reporting from that date), not simply from the date an agreement is signed or only at year‑end. Ownership below 20% does not automatically preclude the equity method when other evidence of influence exists.
Why not A: Tempting because the purchase and signing occurred on July 1. It fails because the agreement's rights were not effective until August 15, and Cline had no board representation or contractual participatory rights before that effective date, so significant influence did not exist on July 1.
Why not B: Tempting because 20% is a common presumptive benchmark for significant influence. It fails because the 20% rule is a rebuttable presumption, not an absolute threshold; other evidence (board representation and participatory rights) can establish significant influence even when ownership is below 20%.
Why not C: Tempting because some may assume accounting-method changes are applied only at period end. It fails because GAAP requires the equity method to be applied from the date significant influence is obtained (August 15 here); effects are recognized from that date, including in interim statements, not postponed until year‑end.
Common questions
Can the equity method apply below 20% ownership?
Yes. Board representation and participation in operating and financial policies can establish significant influence below 20%. Restrictions can also rebut the presumption above 20%.
When do you switch from ASC 321 to the equity method?
Switch prospectively when significant influence becomes effective, not when an agreement is signed. Carry forward the existing investment's current carrying amount and add the cost of additional shares; do not separately remeasure it or restate earlier periods.
What happens when significant influence is lost?
Stop the equity method on that date. If the retained stake has a readily determinable fair value, measure it at fair value and recognize the resulting gain or loss in earnings.
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