Chapter One

The Equity The Equity Method of Method of

Accounting Accounting for for

InvestmentsInvestments

McGraw-Hill/Irwin Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved.

Reporting Investments in Corporate Equity Securities

GAAP recognizes 3 ways to report investments in other companies:

Fair-Value Method

Consolidation

Equity Method

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

Fair Value Method1-3

Used when the investor holds a small percentage of the investee’s outstanding stock, and is not able to significantly affect the investee’s operations.Investment is made in anticipationof dividends and/or market appreciation.Investments will be classified as either Trading Securities or Available-for-Sale Securities.

Fair Value Method (Trading vs Available-for-Sale)

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

Available-for-Sale Securities Any Securities not classified as Trading.Unrealized holding gains and losses are reported in shareholders’ equity as other comprehensive income (ie, not included in net income).

Consolidation of Financial Statements Required when the investor’s ownership exceeds 50% of investee,

except where control does not actually rest with the majority investor

Contractual agreementsBankruptciesGovernment restrictions

One set of financial statementsis prepared which consolidates all accounts of the parent company and all of its controlled subsidiary companies, as though they were a single entity.

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Consolidation SPECIAL!!!!

FASB ASC Subsection 810-10-65, Variable Interest Entities, expands the use of consolidated financial statements: includes entities that are controlled

through special contractual arrangements (rather than through voting stock interests).

Intended to combat misuse of SPE’s (Special Purpose Entities) by firms like Enron

Part of the accounting defense against “off balance sheet financing”

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Equity Method

Used when the investor has the ability to exercise significant influence on theinvestee operations

Generally used when ownership is between 20% and 50%.Significant Influence might be

present with much lower ownership percentages. (The accountant must consider the particulars!!!)

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What is “Significant” Influence?? (FASB ASC Section 323)

Representation on the investee’s Board of Directors

Participation in the investee’s policy-making processMaterial intercompany transactionsInterchange of managerial personnelTechnological dependencyExtent of ownership in

relation to other investor ownership percentages

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{

In some cases, influence or control may exist with less than 20% ownership.

Investor Ownership of the Investee’s Shares

Outstanding

0% 20% 50% 100%

Fair Value

Equity Method

Consolidated Financial Statements

Size (of the Investment) Matters!!!1-9

{Significant influence is generally

assumed with 20% to 50% ownership.

Investor Ownership of the Investee’s Shares

Outstanding

The Significance of the Size of the Investment

0% 20% 50% 100%

Fair Value

Equity Method

Consolidated Financial Statements

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{Financial Statements of all related companies must be consolidated.

Investor Ownership of the Investee’s Shares

Outstanding

The Significance of the Size of the Investment

0% 20% 50% 100%

Fair Value

Equity Method

Consolidated Financial Statements

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Remember:

The ability to exert significant influence is the determining factor in applying the equity method

No actual influence need have been applied!!

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Fair-Value Method – Applied(SFAS No. 115)

Step 1: Investor records investment in the investee at “cost”.

Journal entry:Debit – Investment in Investee

Credit – Cash (or other Assets/Stock)

Cost can be defined as cash paid or the Fair Market Value of other assets given up.

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Fair-Value Method – Applied (continued…)

Step 2: Investor recognizes dividend

income for the amount of cash

dividends received from investee

Journal entry:Debit – Cash

Credit – Income from Investment

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Fair-Value Method – Applied (continued…)

Step 3: Investor adjusts the investment

account to fair-market value (if

readily determinable at report date)

If FMV is higher than current carrying balance in account…

Journal entry:Debit – Investment

Credit – Unrealized Gain on Investment**** This will appear on the income statement for

Trading Securities, or in Other Comprehensive Income for those classified as Available-for-Sale.

Equity Method - Applied

Step 1: Investor records investment in the investee at “cost”.

Journal entry:Debit – Investment in Investee

Credit – Cash (or other Assets/Stock)

Cost can be defined as cash paid or the Fair Market Value of other assets given up.

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Equity Method – Applied(Continued…)

Step 2: The investor recognizes its proportionate (pro rata) share of the investee’s net income (or net loss) for the period.

Journal entry:

Debit – Investment in Investee

Credit – Equity in Investee Income

This will appear as a separate line-item on the investor’s

income statement.

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Equity Method – Applied(Continued…)

Step 3: The investor reduces the

investment account by the

amount of cash dividends

received from the investee.

Journal entry:

Debit – Cash

Credit – Investment in Investee

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Equity Method Example

Little Company reported net income of $200,000 during 2010 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 using the equity method.

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

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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

An investment that is too small to have significant influence is recorded using the fair-value method, but…

When ownership grows to the point where significant influence is established . . .

. . . all accounts are restated so that the investor’s financial statements appear as if the equity method had been applied from the date

of the first [original] acquisition. - - APB FASB ASC (para. 323-10-35-33)

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Reporting a Change to the Equity Method (Retroactive Adjustment)

Giant Company acquires a 10% ownership in Small Company on January 1, 2010. Giant does not believe that their company has gained 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, 2012, Giant purchases another 30% of Small’s outstanding stock, thereby achieving the ability to significantly influence Small’s decisions.

How should this additional acquisition be recorded?

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Reporting a Change to the Equity Method (Retroactive Adjustment)

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YearEquity in Investee

Income (10%)Income Reported from Dividends

Retrospective Adjustment

2010 $7,000 $2,000 $5,000

2011 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

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 operations Extraordinary items Prior period adjustments

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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 2010, 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.

Larges Equity Method entry at year-end is:

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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 Zero When the accumulated losses incurred

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

The balance remains at $-0-,

until subsequent profits eliminate all UNREALIZED losses.

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Reporting the Sale of an Equity Investment

If part of an investment is sold during the period . . .

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

At the transaction date, a proportionate amount of the Investment account is removed.

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

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Reporting the Sale of an Equity Investment (Continued…)

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

The 40,000 shares were acquired several years ago for $200,000, and under the equity method, the asset balance has increased to $320,000 as of January 1, 2010.

On July 1, 2010, Top elects to sell 10,000 of these shares (1/4 of its investment) for $110,000 in cash, thereby reducing ownership in Bottom from 40% to 30%. Bottom Company reports income of $70,000 during the first six months of 2010 and distributes cash dividends of $30,000.

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Excess of Cost Over BV Acquired

When Cost > BV acquired,

the difference must be identified.

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Excess of Cost Over BV Acquired(Continued…)

The amortization of the difference associated with the undervalued assets is

recorded as a reduction of both the Investment account and the Equity in

Investee Income account.

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Big Company is negotiating the acquisition of 30% of the outstanding shares of Little Company.

Little’s balance sheet reports assets of $500,000 and liabilities of $300,000 for a net book value of $200,000.

Upon review, Big determines that Little’s equipment is undervalued in the financial records by $60,000, and of its patents is also undervalued, but only by $40,000.

How much should Big offer Little??

Excess of Cost Over BV - Example

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By adding these valuation adjustments to Little’s book value, Big arrives at an estimated $300,000 worth for the company’s net assets. Based on this computation, Big should offer $90,000 for a 30% share of the investee’s outstanding stock.

Excess of Cost Over BV - Example Solution

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Excess of Cost Over BV –Example Amortization

Payment by investor . . . . . . . . . . . . . . . . . . . $90,000Percentage of book value acquired ($200,000 30%) . . . . . . . . . . . . . . 60,000Payment in excess of book value . . . . . . . . . . . 30,000

Excess payment identified with specific assets:Equipment (30% of $60,000 undervalued). . .$18,000Patent (30% of $40,000 undervalued) . . . . . . . 12,000 30,000Excess payment not identified with specific assets—goodwill . . . . . . . . . . . . . . –0–

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Amortization of Cost Over BV Example Amortization (Continued)

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Amortization of Cost Over BV Example Amortization (Continued)

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Note, that any ADDITIONAL amount paid in excess of the book value of $90,000 would be the cost of the goodwill purchased – and would not be amortized like the other assets.

Downstream Sale

Upstream Sale

Unrealized Gains in Inventory

Sometimes affiliated companies sell or buy inventory from each other.

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Unrealized Gains in InventoryExample

Let’s look at an Investor that has 200 units of inventory with a cost of $1,000.

Let us assume that the Investor sells the inventory to a 20% owned Investee for $1,250.

Note that there is $250 of intercompany profit. At this point it is considered UNREALIZED because we are reporting as a SINGLE-ENTITY.

We will DEFER this profit in the financial reports until the goods are sold to an OUTSIDE PARTY.

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INVESTEE buys inventory and pays a total

of $1,250 to investor.

INVESTEE buys inventory and pays a total

of $1,250 to investor.

Unrealized Gains in InventoryExample (Continued…)

INVESTOR sells 200 units

of inventory with original

cost of $1,000.

INVESTOR sells 200 units

of inventory with original

cost of $1,000.

If 60 of the original 200 units (30%) remain “unsold” to an “outside” party, we must defer

our share (20%) of the original $250 of intercompany profit that is unrealized (30%).

Outside Party

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Unrealized Gains in InventoryExample (Continued…)

Compute the deferral by multiplying:

The required journal entry is:

$250 × 30% × 20% = $15

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Unrealized Gains in InventoryExample (Continued…)

In the period following the period of the transfer, the remaining inventory is often sold.

When that happens, the original entry is reversed . . .

The reversal takes place during the period that the inventory is sold to an outside party.

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Summary

There are three methods to account for an investment in another company, depending on the size of the investment and level of influence the investor is able to exercise over the investee.

If the investor pays more than the Book Value of the investee, the excess payment is assigned to specific assets and liabilities, or to goodwill.

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

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Possible Criticisms:

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

Possibility of “off-balance sheet financing”

Potential manipulation of performance ratios

WHAT DO YOU THINK?????

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