Chapter 9
Accounting in Action: CM 2
CM 2 purchased some shares of one of its suppliers, Infrared Co., as an investment. CM 2 paid $140,186 for the shares. Although management plans to hold this investment for the long-term, the company may need to sell it in the future for liquidity purposes. Conner and Martin also think that making investments in some of their other suppliers can be a good way to ensure quality and consistency in the components they buy from these suppliers. Because many of its suppliers are public companies, it should be fairly easy for CM 2 to buy shares on the open market.
Conner and Martin mention that they might go so far as to buy 10–15% of the common stock of one of their main suppliers and up to 30% of the common stock of another supplier of routers, which are a critical piece in the CM 2 system. They want you to help them understand whether it makes a difference if they buy just 10–15% or if they buy 30% of these suppliers' shares. Both these suppliers have been around for awhile, and with very few exceptions, the parts ordered from them have been of high quality and delivered on time; Conner and Martin tell you that if they do buy these stocks, they anticipate holding them for a long time.
Instructions
• Use the investment in Infrared Co. to illustrate the accounting and financial reporting implications of an equity investment in a supplier. While the growth prospects for Infrared are quite good, in the current year it reported a net loss of $120,000 and paid cash dividends of $24,000. The fair value of the Infrared shares is $150,000 at year-end. Prepare journal entries for the Infrared investment, assuming:
• CM 2 's investment represents 10% of Infrared shares.
• CM 2 's investment represents 30% of Infrared shares.
Indicate the differential effect on income between the accounting for the conditions under assumptions 1 and 2.
•Conner and Martin have heard that as long as they do not hold more than 20% of the shares of one of these suppliers, they are able to recognize the unrealized gains on these equity investments in income. Prepare a memorandum to Conner and Martin with references to the authoritative literature on the accounting for equity investments of less than 20% ownership. Discuss other factors beyond the percentage of shares owned that should be considered in determining the accounting for investments if they hold at least 20% but less than or equal to 50% of the stock of another company.