Chap 001

Chapter One

The Equity Method of

Accounting for Investments

McGraw-Hill/Irwin Copyright © 2013 by The McGraw-Hill Companies, Inc. All rights reserved.

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Accounting for Investments in Corporate Equity Securities

GAAP recognizes 3 ways to report investments in other companies:

Fair-Value Method

Consolidation

Equity Method

The method selected depends upon the degree of influence the investor has over the investee.

LO 1

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Fair Value Method

Use when:investor holds a small percentage

(usually less than 20%) of equity securities of investee

Investor cannot significantly affect investee’s operations

Investment is made in anticipation of dividends or market appreciation.

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Fair Value Method

Investments classified as Trading Securities: Held for sale in the short term.Unrealized holding gains and losses are included in earnings (net income).

Investments classified as Available-for-SaleSecurities: Any Securities not classified as Trading.Unrealized holding gains and losses are reported in

shareholders’ equity as other comprehensive income (i. e., not included in net income).

Investments in equity securities are recorded at cost and subsequently adjusted to fair value.

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Fair-Value Method – Applied(FASB ASC Topic 320)

Step 1: Investor records investment in the investee at cost. Debit Credit

Investment in Investee XXXXCash (or other Assets/Stock) XXXX

Step 2: Investor recognizes dividend income for cash dividends received from investee.

Debit CreditCash XXXXIncome from Investment XXXX

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Fair-Value Method – Applied (continued…)

Step 3: Investor adjusts investment account to fair- market value (FMV) if readily determinable at reporting date

Journal entry if FMV > Cost: Debit Credit

Investment XXXXUnrealized Gain on Investment** XXXX

** Included in earnings on the income statement for Trading Securities or

in Other Comprehensive Income in Shareholders’ Equity for Available-for-Sale (excluded from earnings)

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Consolidation of Financial Statements

Required when: Investor’s ownership exceeds 50% of investee

except when control does not rest with the majority investor

One set of financial statements prepared to consolidate all accounts of the parent company and all of its controlled subsidiaries AS A SINGLE ENTITY.

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FASB ASC section 810-10-05, Variable Interest Entities

Includes entities controlled through special contractual arrangements (not through voting stock interests)

Intended to combat misuse of SPE’s (Special Purpose Entities) to keep large amounts of assets and liabilities off the balance sheet known as “off balance sheet financing”

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Equity Method

Use when: Investor has the ability to exercise significant influence on the investee operations (whether influence is applied or not)

Generally used when ownership is between 20% and 50%.

Significant Influence might be present with much lower ownership percentages.

LO 2

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International Standard 28 Investment in Associates

The International Accounting Standards Board (IASB), similar to FASB, defines “significant influence” as the power to participate in the financial and operating policy decisions of the investee, but it is not control or joint control over those policies.

If investor has 20% or more ownership, it is presumed to have significant influence, unless it is demonstrated not to be the case.

If investor holds less than 20% ownership, it is presumed it does not have significant influence, unless influence can be clearly demonstrated.

What is Significant Influence? (FASB ASC Topic 323)

Representation on the investee’s Board of Directors

Participation in the investee’s policy-making process

Material intra-entity transactions

Interchange of managerial personnel

Technological dependency

Other investor ownership percentages

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Investor Ownership of the Investee’s Shares Outstanding

0% 20% 50% 100%

Fair Value Equity Method Consolidated Financial Statements

General Ownership Guidelines

Significant influence generally

assumed (20% to 50%

ownership).

Usually lack of control or significant influence.

Financial statements of

all related companies

must be consolidated.

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Fair Value

Equity Method

Consolidated Financial Statements

General Reporting Guidelines

1: Same as Fair Value

2: Investor recognizes its share (% of owner-ship) of investee’s net income (net loss) as an increase (decrease) in the investment account and 3. Records dividends as a decrease.

1. Investor records investment at “cost”.

2. Investor recognizes cash dividends from investee as income.

One set of financial statements are prepared to combine accounts of the investor and all of its investees AS A SINGLE ENTITY.

LO 3

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Equity Method – Applied

Step 1 Investment in Investee XXXX Cash (or other Assets/Stock) XXXX Step 2

Debit CreditInvestment in Investee XXXXEquity in Investee Income XXXX

If net loss: Debit CreditEquity in Investee Income XXXX Investment in Investee XXXX

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Equity Method – Applied(Continued…)

Step 3: Investor reduces the investment account by the amount of cash dividends received from the investee.

Debit Credit

Cash XXXX

Investment in Investee XXXX

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Equity Method Example

Little Company reported net income of $200,000 during 2012 and paid cash dividends of $50,000. These figures indicate that Little’s net assets have increased by $150,000 during the year. Big owns 20% of Little and records the following entries.

Debit CreditInvestment in Little Company. . 40,000Equity in Investee Income .. . . . . . . . . . . . . .40,000To accrue earnings of a 20 percent owned investee.

Cash . . . . . . . . . . . . .. . . . . . . . . . .10,000Investment in Little Company . . . . . . . . . . .10,000To record receipt of cash dividend from investee.

Special Procedures for Special Situations

Reporting a change to the equity method.

Reporting investee income from sources

other than continuing operations.

Reporting investee losses.

Reporting the sale of an equity investment.

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Reporting a Change to the Equity Method

Report a change to the equity method if: An investment that was recorded using the fair-

value method reaches the point where significant influence is established.

All accounts are restated retroactively so the investor’s financial statements appear as if the equity method had been applied from the date of the first acquisition. (FASB ASC para. 323-10-35-33)

Reporting a Change to the Equity Method (Retroactive Adjustment)

Giant Company acquires a 10% ownership in Small Company on January 1, 2012.

Giant company does not have the ability to exert significant influence over Small.

Giant properly records the investment using the fair-value method as an available-for-sale security.

On January 1, 2014, Giant purchases another 30% of Small’s outstanding stock, thereby achieving the ability to significantly influence Small’s decisions.

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Reporting a Change to the Equity Method (Retroactive Adjustment)

YearEquity in Investee

Income (10%)Income Reported from Dividends

Retrospective Adjustment

2012 $7,000 $2,000 $5,000

2013 11,000 4,000 7,000

Total Adjustment to Retained Earnings: $12,000

The income restatement for these earlier years can be computed as follows:

Would have reported under the equity method

Did report under the fair-market value method

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Journal Entries to Report Change to Equity Method

Debit CreditInvestment in Small Company . . . . . . . . . . . . . . . . . 12,000 Retained Earnings - Prior Period Adjustment-Equity in Investee Income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12,000To adjust 2012 and 2013 records so that investment is accountedfor using the equity method in a consistent manner.

Unrealized Holding Gain-Shareholders’ Equity. . . . .13,000

Fair Value Adjustment (Available-for-Sale). . . . . . . . . . . . . . .13,000

To remove the investor’s percentage of the increase in fair value (10% $130,000) from stockholders’ equity and the available-for-sale portfolio valuation account.

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Reporting Investee Income from Sources other than Operations

When net income includes elements other than Operating Income, these elements should be presented separately on the investor’s income statement.

Examples include:Discontinued operationsExtraordinary itemsOther comprehensive income

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Reporting Investee Income from Other Sources

Large Company owns 40% of the voting stock of Tiny Company and accounts for this investment using the equity method. In 2012, Tiny reports net income of $200,000, resulting from $250,000 in income from continuing operations and a $50,000 extraordinary loss.

Large Company increases the value of its investment by $80,000, based on 40% of the $200,000 net figure.

Large’s Equity Method entry at year-end is:

Debit CreditInvestment in Tiny Company . . . . . . . . . . . 80,000Extraordinary Loss of Investee. . . . . . . . . . .20,000Equity in Investee Income . . . . . . . . . . . . . . . . . . . . . . .100,000To accrue operating income and extraordinary loss from equity investment.

Reporting Investee Losses

A permanent decline in the investee’s fair market value is recorded as an impairment loss and the investment account is reduced to the fair value.

A temporary decline is ignored!!!

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Reporting Investee Losses(Continued…)

Investment Reduced to ZeroWhen accumulated losses incurred and dividends paid by the investee reduce the investment account to $-0-, NO ADDITIONAL LOSSES are accrued (unless a further commitment has been made).

Balance remains at $-0-, until subsequent profits eliminate all UNREALIZED losses.

Investor discontinues using the equity method rather than record a negative balance.

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Excess of Cost Over Book Value of Acquired Investment

When Cost > Book Value of an investment acquired, the difference must be identified.

LO 4

Assets may be undervalued on the investee’s booksbecause:

1.The fair values (FV) of some assets and liabilities are different than their book values (BV).

2.The investor may be willing to pay extra because future benefits are expected to accrue from the investment.

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When Cost > BV of asset acquired, the difference must be identified and accounted for correctly in the accounting records.

Source of difference:Assets undervalued on the investee’s book

Goodwill

Accounting method:Amortize the difference (FV – BV) over the remaining useful life of the associated asset.Goodwill is carried forward without adjustment until the investment is sold or a permanent decline in value of the investment occurs.

Excess of Cost Over Book Value (Continued…)

Excess of Cost Over Book Value (Continued…)

ADDITIONAL amount paid in excess of book value not allocated to undervalued assets is attributed to an intangible future value and recorded as

GOODWILL

Equity method goodwill accounts are not separable from the investment, and are not separately tested for impairment.

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Excess of Cost Over Book Value (Continued…)

Tall Company purchased 20 percent of Short Company on January 1, 2013 for $200,000, and the equity method is applied. Short net assets have a book value of $700,000. A building (10-year life) is undervalued by $80,000 and equipment (5-year life) is undervalued by $120,000. Goodwill, if any, is considered to have an indefinite life. During 2013, Short reports a net income of $150,000 and pays a cash dividend at year’s end of $60,000. Allocation and amortization of costs are presented below:

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Excess of Cost Over Book Value (Continued…)

Amortization of the difference associated with the undervalued assets reduces both the Investment account and the Equity in Investee Income account.

The investor amortizes the cost of the assets over their remaining useful lives. At the end of the year, the investor in Short Company will record the following journal entry:

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Reporting Sale of Equity Investment

The equity method continues to be applied up to the date of the transaction.

At the transaction date, the Investment account balance is reduced by the percentage of shares sold.

If significant influence is lost, NO RETROACTIVE ADJUSTMENT is recorded, but the equity method is no longer applied.

If part of an investment is sold during the period:

LO 5

Reporting the Sale of an Equity Investment (Continued…)

Top Company owns 40% of the 100,000 outstanding shares of Bottom Co., and accounts for it using the equity method.

The 40,000 shares were acquired for $200,000, and under the equity method, the asset balance increased to $320,000 as of January 1, 2012.

Bottom Company reported income of $70,000 during the first six months of 2012 and distributed cash dividends of $30,000.

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Reporting the Sale of an Equity Investment (Continued…)

On July 1, 2012, Top sells 10,000 of the shares (1/4 of its investment) for $110,000 in cash, reducing ownership in Bottom from 40% to 30%.

Debit CreditCash . . . . . . . . . . . . . . . . . . . . . . . . . . 110,000Investment in Bottom Company . . . . . . . . . . . .84,000 Gain on Sale of Investment. . . . . . . . . . . . . . . . .26,000To record the sale of ¼ of the investment. (1⁄4 X $336,000 = $84,000).

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Downstream Sale

Upstream Sale

Unrealized Profits in Inventory

Sometimes affiliated companies sell or buy inventory from each other in intra-entity transactions that necessitate special accounting procedures.

LO 6

Unrealized Profits in Inventory

The seller of the goods retains a partial stake in the inventory for as long as the buyer holds it.

The earning process is not considered complete at the time of the original sale.

Reporting the profit is delayed until the inventory is consumed within operations or resold to an unrelated party.

At the disposition of the inventory, the original sale is culminated and gross profit is recognized.

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Unrealized Profits in InventoryExample

An investor owns 40% interest in an investee to which it sells inventory at a cost of $50,000 (a downstream sale). The price includes a gross profit (GP) of 30% or $15,000.

Investee sells $40,000 of the inventory to outside parties, but retains $10,000 at the end of the year.

Gross profit on the $10,000 of remaining inventory will be DEFERRED in the financial reports until the goods are sold to an OUTSIDE PARTY.

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Unrealized Profits in InventoryExample

The intercompany profit of $1,200 [(30% GP X $10,000 inventory)] X 40% ownership] is unearned and recorded as UNREALIZED intra-entity gross profit for the accounting period.

The deferral decreases the investor’s current equity income and the investment account by $1,200 to reflect the unearned portion of the intra-entity profit.

When the inventory is eventually sold to unrelated parties, the earnings process is complete. The investor will recognize the $1,200 by reversing the deferral entry and recognize the profit in the appropriate time period.

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Criticisms of the Equity Method

Over-emphasis on possession of 20-50% voting stock in deciding on significant influence vs. control

Allowing off-balance sheet financing

Potential manipulation of performance ratios

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Fair Value Reporting Option

In 2007, FASB introduced a fair-value option

An entity may irrevocably elect fair value as the initial and subsequent measurement for certain financial assets and financial liabilities including investments accounted for under the equity method.

Under the fair-value option, changes in the fair value of the elected financial items are included in earnings.

LO 7

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Fair Value Option

Investment that can otherwise be accounted for under the equity method

Investment in non-marketable equity securities

After 2007, under the Fair-value Option, changes in the fair value of these assets are

reported in earnings.

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Summary

Accounting methods used for investments in other companies depend on percentage of ownership and level of influence investors can exercise over investees.

If an investor pays more than book value of the investee, the excess payment is assigned to specific assets, liabilities, and goodwill.

Intercompany profits on transferred assets are deferred until the items are consumed or sold to outside parties.

Since 2008, firms may irrevocably elect to report significant influence investments at fair value instead of using the equity method.