Fair value option; equity method investments
Response to the following :
[This problem is an expanded version of Problem 1 that considers alternative ways in which a firm might apply the fair value option to account for significant-influence investments that would normally be accounted for under the equity method.]
Companies can choose the fair value option for investments that otherwise would be accounted for under the equity method. If the fair value option is chosen, the investment is shown at fair value in the balance sheet, and unrealized holding gains and losses are recognized in the income statement. However, exactly how a company complies with those broad requirements is up to the company. This problem requires you to consider alternative ways in which a company might apply the fair value option for investments that otherwise would be accounted for under the equity method.
On January 4, 2016, Runyan Bakery paid $324 million for 10 million shares of Lavery Labeling Company common stock. The investment represents a 30% interest in the net assets of Lavery and gave Runyan the ability to exercise significant influence over Lavery's operations. Runyan chose the fair value option to account for this investment. Runyan received dividends of $2.00 per share on December 15, 2016, and Lavery reported net income of $160 million for the year ended December 31, 2016. The market value of Lavery's common stock at December 31, 2016, was $31 per share. On the purchase date, the book value of Lavery's net assets was $800 million and:
a. The fair value of Lavery's depreciable assets, with an average remaining useful life of six years, exceeded their book value by $80 million.
b. The remainder of the excess of the cost of the investment over the book value of net assets purchased was attributable to goodwill.
Required:
1. Prepare all appropriate journal entries related to the investment during 2016, assuming Runyan accounts for this investment under the fair value option, and accounts for the Lavery investment in a manner similar to what it would use for trading securities. Indicate the effect of these journal entries on 2016 net income, and show the amount at which the investment is carried in the December 31, 2016, balance sheet.
2. Prepare all appropriate journal entries related to the investment during 2016, assuming Runyan accounts for this investment under the fair value option, but uses equity method accounting to account for Lavery's income and dividends, and then records a fair value adjustment at the end of the year that allows it to comply with GAAP. Indicate the effect of these journal entries on 2016 net income, and show the amount at which the investment is carried in the December 31, 2016, balance sheet. (Note: You should end up with the same total 2016 income effect and same carrying value on the balance sheet for requirements 1 and 2.)
Problem 1:
Fair value option; equity method investments
[This problem is a variation of Problem 2 focusing on the fair value option.]
On January 4, 2016, Runyan Bakery paid $324 million for 10 million shares of Lavery Labeling Company common stock. The investment represents a 30% interest in the net assets of Lavery and gave Runyan the ability to exercise significant influence over Lavery's operations. Runyan chose the fair value option to account for this investment. Runyan received dividends of $2.00 per share on December 15, 2016, and Lavery reported net income of $160 million for the year ended December 31, 2016. The market value of Lavery's common stock at December 31, 2016, was $31 per share. On the purchase date, the book value of Lavery's net assets was $800 million and:
a. The fair value of Lavery's depreciable assets, with an average remaining useful life of six years, exceeded their book value by $80 million.
b. The remainder of the excess of the cost of the investment over the book value of net assets purchased was attributable to goodwill.
Required:
1. Prepare all appropriate journal entries related to the investment during 2016, assuming Runyan accounts for this investment under the fair value option in a manner similar to what it would use for trading securities.
2. What would be the effect of this investment on Runyan's 2016 net income?
Problem 2:
Investment securities and equity method investments compared
On January 4, 2016, Runyan Bakery paid $324 million for 10 million shares of Lavery Labeling Company common stock. The investment represents a 30% interest in the net assets of Lavery and gave Runyan the ability to exercise significant influence over Lavery's operations. Runyan received dividends of $2.00 per share on December 15, 2016, and Lavery reported net income of $160 million for the year ended December 31, 2016. The market value of Lavery's common stock at December 31, 2016, was $31 per share. On the purchase date, the book value of Lavery's net assets was $800 million and:
a. The fair value of Lavery's depreciable assets, with an average remaining useful life of six years, exceeded their book value by $80 million.
b. The remainder of the excess of the cost of the investment over the book value of net assets purchased was attributable to goodwill.
Required:
1. Prepare all appropriate journal entries related to the investment during 2016, assuming Runyan accounts for this investment by the equity method.
2. Prepare the journal entries required by Runyan, assuming that the 10 million shares represent a 10% interest in the net assets of Lavery rather than a 30% interest.