1 advanced accounting autumn 2015 chapter 2 stock investments – investor accounting and reporting...

1

Advanced Accounting

Autumn 2015

• Chapter 2• Stock Investments –

Investor Accounting and Reporting

Bill Myer – Autumn 2015

2

Agenda

• Homework

• Chapter 2: Stock Investments – Investor Accounting and Reporting


3Bill Myer – Autumn 2015

Homework

• You should have already read chapters 1 and 2

• You should have already completed Exercises and Problems assigned for chapter 1

• Be prepared for a quiz on chapter 1

• Also, please complete:

Chapter 2, Exercises E2-1 (5); E2-2 (1, 3, 4, 5); E2-5; E2-15


Vocabulary – Important Vocabulary for Chapter 2

• Cost method• Fair value method• Equity method• Investor• Investee• Nonmarketable• Available-for-sale securities• Trading securities• Held-to-maturity securities• Unrealized gain• Other comprehensive income

• Book value / carrying value• Liquidating dividend• T-account• Treasury stock• Step acquisition (or step-by-step

acquisition)• Accounting Standards

Codification (ASC)• Reporting unit• Implied fair value• Impairment loss

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Agenda

• Homework

• Chapter 2: Stock Investments – Investor Accounting and Reporting


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Investor Accounting – Focus Questions


• How do levels of influence affect accounting for investments?

• How do you account for investments when you lack significant influence?

• How do you account for investments when you have significant influence?

• What is a differential?

• How do you account for changes in influence, and for sales of investments?

• How do you test goodwill for impairment?

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Stock Investments: Objectives


• Recognize investors' varying levels of influence or control, based on the level of stock ownership

• Anticipate how accounting adjusts to reflect the economics underlying varying levels of investor influence

• Apply the fair value/cost and equity methods of accounting for stock investments

• Identify factors beyond stock ownership that affect an investor's ability to exert influence or control over an investee

• Learn how to test goodwill for impairment

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Levels of Influence


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Accounting for the Investment


* The investor could manipulate its own investment income if income is measured by dividends.

Degree of influence

Investment's carrying value

Investment income

Lack of significant influence

Fair value (cost, if nonmarketable)

Dividends declared

Significant influence

Original cost adjusted to reflect periodic earnings and dividends, e.g., a proportionate share of investee's net assets

Proportionate share of investee's periodic earnings*


• Investments are classified as: Trading Securities Available-for-Sale Securities Held to maturity

• 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 (i.e., not included in net income)

The Cost Method


• At the time of purchase, the investor records its investment in common stock at the total cost incurred in making the purchase

• The investment account is adjusted to fair-market value (if readily determinable at report date) until the time of sale

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

• Income from the investment is recognized as dividends are declared by the investee (see important exception next slide)

The Cost Method

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Cost method – liquidating dividends


• Declaration of dividends in excess of earnings since acquisition

Liquidating dividends – Dividends declared by the investee in excess of its earnings since acquisition by the investor from the investor’s viewpoint

The investor’s share of these liquidating dividends is treated as a return of capital, and the investment account balance is reduced by that amount

These dividends usually are not liquidating dividends from the investee’s point of view

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Fair Value (Cost) Method


• FASB Statement No. 115

• Pal buys 2,000 shares of Sid for $50,000 and does not have significant influence over Sid

• Pal receives $4,000 in dividends from Sid

Investment in Sid (+A) 50,000

Cash (-A) 50,000

Cash (+A) 4,000

Dividend income (R, +SE) 4,000

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Fair Value (Cost) Method, at Year-end


• Reduce dividend income recognized, if needed

• Adjust investment to fair value

Dividend income (-R, -SE) 500

Investment in Sid (-A) 500If Pal determines that cumulative dividends exceed its cumulative share of income by $500.

Allowance to adjust available-for-sale securities to market value (+A) 10,500

Unrealized gain on available-for-sale securities (+SE) 10,500

If fair value of the stock increases to $60,000 and the Investment in Sid account balance is $49,500.

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Equity Method


• At acquisition: Pal buys 2,000 shares of Sid for $50,000

• Pal receives $4,000 in dividends from Sid


Cash (-A) 50,000

Cash (+A) 4,000

Investment in Sid (-A) 4,000

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Equity Method, at Year-end


• Pal determines that its share of Sid's income is $2,500

• The ending balance in the Investment in Sid is:

$50,000 cost - $4,000 dividends + $2,500 income

= $48,500


Income from Sid (R, +SE) 2,500

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Review questions


• When are investments in common stock accounted for using (a) the equity method and (b) the cost method?

• How is the receipt of a dividend accounted for under the cost method?

• How is an increase in fair value of an investment accounted for under the cost method?

• How is an increase in fair value of an investment accounted for under the equity method?

• What is a liquidating dividend?

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Cost method – practice problem


ABC Company acquires 20 percent of XYZ Company’s common stock for $100,000 at the beginning of the year but does not gain significant influence over XYZ. During the year, XYZ has net income of $60,000 and pays dividends of $20,000.

• What are the journal entries to record the purchase of XYZ?

• What are the journal entries to recognize income from XYZ?

• What would be the entries if the dividend were $60,000 and net income were $20,000?

• What would be the entries if ABC has significance influence over XYZ?

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Exercises


• E2-1, question 5 (page 50)

• E2-2, question 1




• Additional practice:



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Significant Influence


• 20% to 50% voting stock ownership is a presumption of significant influence. Generally use the equity method

• Don't use equity method if there is a lack of significant influence:

Opposition by investee

Surrender of significant shareholder rights

Concentration of majority ownership

Lack of information for equity method or

Failure to obtain board representation

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Control


• More than 50% voting stock ownership is presumptive evidence of control. Generally prepare consolidated financial statements

• Don't consolidate if the parent lacks control

Legal reorganization or bankruptcy

Severe foreign restrictions

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Applying the Equity Method


• Investor’s equity in the investee

– The investor records its investment at the original cost

– This amount is adjusted periodically:

Reported by Investee Effect on Investor’s AccountsNet income Record income from investment

Increase investment account

Net loss Record loss from investmentDecrease investment account

Dividend declaration Record asset (cash or receivable)Decrease investment account

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Review questions


• When is the equity method used?

• When could an investor own less than 20% but still exert significant influence?

• When could an investor own 20% or more and not be able to exert significant influence?

• What is the effect of a dividend declaration by an investee under (a) the cost method and (b) the equity method?


The equity method - illustration

• How is income recognized?

• What is the effect of the dividend?

• What is the carrying amount of the investment at the end of the period?

ABC Company acquires significant influence over XYZ Company by purchasing 20 percent of the common stock of the XYZ Company for $100,000, XYZ earns income of $60,000 and pays dividends of $20,000.

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Applying the equity method – differential


• Differential

– The difference between the cost of the investment to the investor and the book value of the investor’s proportionate share of the investee’s net assets

– Example: River Corporation acquires 30% of the common stock of Rock Company for $100,000. Rock Company has net assets on the acquisition date with a book value of $250,000 and a fair value of $300,000. What is the amount of the differential?

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• Reasons for the differential– Investee’s assets worth more than their book values– Existence of unrecorded goodwill

• Ascertain the portion of the differential pertaining to each asset of the investee, including goodwill– The portion of the differential pertaining to limited-life assets,

including identifiable intangibles, must be amortized over their remaining economic lives

– Any portion of the differential that represents goodwill is not amortized or written off because of impairment

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• Amortizing the differential

– Reduce the income recognized by the investor from the investee and the balance of the investment account:

Income from Investee XXXInvestment in Common Stock of Investee XXX

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1) What are the entries to record the purchase of Barclay in 20X1?

2) What are the entries to recognize Ajax’s share of Barclay’s 20X1 net income?

3) What are Ajax’s entries to recognize the dividend paid by Barclay?

4) How much is the differential?

5) What are Ajax’s entries to amortize the differential?

Ajax Corporation acquires 40% of the common stock of Barclay on January 1, 20X1 for $200,000. Barclay has net assets on that date with a book value of $400,000 and fair value of $465,000. The $65,000 excess consists of a $15,000 increase in the value of Barclay’s land and a $50,000 increase in the value of equipment. The equipment is amortized over its remaining life of five years (land has an unlimited economic life). Barclay declares dividends of $20,000 during 20X1 and at year-end reports net income of $80,000 for the year.

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Applying the Equity Method


• Acquisition Cost > FV net assets, and FV net assets > BV net assets

• Payne acquires 30% of Sloan for $5,000. Sloan's identifiable net assets (assets less liabilities) are (in thousands):

• Fair value: A – L = $18,800 - $2,800 = $16,000

• Book value: A – L = E = $15,000 - $3,000 = $12,000

$5,000 > 30%(16,000) > 30%(12,000)

$5,000 > $4,800 > $3,600

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Differences between FV and BV


• Fair value: $16,000

• Book value: $12,000

• The $4,000 difference ($16,000 - $12,000) is due to:

$1,000 undervalued inventories sold this year

$200 overvalued other current assets used this year

$3,000 undervalued equipment with a life of 20 years and

$200 overvalued notes payable due in 5 years

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Acquisition of Sloan Stock


• At acquisition, Payne pays $2,000 cash and issues common stock with a fair value of $3,000 and par value of $2,000. Payne also pays $50 to register the securities and $100 in consulting fees

Investment in Sloan (+A) 5,000

Cash (-A) 2,000

Common stock, at par (+SE) 2,000

Additional paid in capital (+SE) 1,000

Additional paid in capital (-SE) 50

Investment expense (E, -SE) 100

Cash (-A) 150

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Cost/Book Value Assignment


Investment in Sloan $5,000Less 30% book value = 30%(12,000) 3,600Excess of cost over book value $1,400

Assigned to: Amount AmortizationInventories 30%(+1,000) $300 1st yearOther curr. assets 30%(-200) (60) 1st year

Equipment 30%(+3,000) 900 20 years

Note payable 30%(+200) 60 5 years

Goodwill (to balance) 200 NoneTotal $1,400

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Dividends and Income


• Payne receives $300 dividends from Sloan

• Sloan reports net income of $3,000

• Payne will recognize its share (30%) of Sloan's income ($900), but will adjust it for amortization of the differences between book and fair values

Cash (+A) 300

Investment in Sloan (-A) 300

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Amortization and Investment Income


• Investment income is 30% of Sloan's net income – amortization

30%($3,000) – $297 = $603

Cost/book value differences:

Initial amount

1st year amort.

Unamortized excess at year-end

Inventories $300 ($300) $0

Other current assets (60) 60 0

Equipment 900 (45) 855

Note payable 60 (12) 48

Goodwill 200 0 200

Total $1,400 ($297) $1,103

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Year-End Entry & Balance


• Record the investment income (single entry)

• The ending balance in the investment account is:

5,000 – 300 + 603

= 5,303

Cost – dividends + investment income

Investment in Sloan (+A) 603

Income from Sloan (R, +SE) 603

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Exercises


• E2-5 (page 52)

• P2-3

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More on Cost/Book Value Assignment


• On acquisition date, compare:

Cost of acquisition

Book value of net assets and

Fair value of identifiable net assets

• Cost of the investment includes cash paid, fair value of securities issued, and debt assumed

• The book value of the investee's net assets

= assets – liabilities or

= stockholders' equity

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Fair Values Used in Assignment


• Identifiable net assets include all the investee's assets and liabilities, whether recorded or not

Fair value of research in progress

Fair value of contingent liabilities

Fair value of unrecorded patents

• Exception: use book value for pensions and deferred taxes

• If cost > fair value, goodwill exists

• If cost < fair value, a bargain purchase exists

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Bargain Purchase


• When the acquisition cost is less than the fair value of the identifiable net assets, a gain is recognized on the acquisition

• The investment is recorded at the fair value of the identifiable net assets

Investment in ABC XXX

Cash, CS, APIC XXX

Gain on bargain purchase XXX

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Other considerations


• There are other special considerations when:

The investment is purchased at an interim date

Acquisition is done in stages

Equity interest is sold

Treasury stock transactions / stock purchased from investee

Investee with preferred stock

Investee reports discontinued operations or extraordinary items

Investment balance goes to zero

• We will only cover acquisition done in stages and sale of equity interest

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Acquisition in Stages


• Also called a step-by-step acquisition

• Fair value (cost) method equity method

Restate prior-period statements

Investee's growth in retained earnings is

Excess of income over dividends declared

Investment account desired balance using equity method = original cost + share of growth in investee’s retained earnings – amortization, if any

Investment in XYZ (+A) XXX

Retained earnings (+SE) XXX

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Sale of Equity Interest


• Sale of investment that results in a lack of significant influence over the investee

• Equity method fair value (cost) method

Prospective treatment

1. For the sale

Reduce the investment account for a proportionate share of the stock sold

Record a gain or loss on the sale

2. Apply the fair value (cost) method to remaining investment

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Review questions


• What is the accounting treatment…

• …If a company sells part of an equity method investment that results in a lack of significant influence over the investee?

• …If a company buys additional shares in a cost method investment that results in significant influence over the investee?

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Disclosures


• For significant equity investees

Name, percent ownership

Accounting policy

Difference between investment carrying value and underlying equity in net assets

Aggregate market value

Summarized assets, liabilities, results of operations

• Related party disclosures

FASB ASC 850-10-50-5

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Disclosures – example (1 of 2)


Source: BGCP 10-K, year ending 12/31/2014

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Disclosures – example (2 of 2)


Source: BGCP 10-K, year ending 12/31/2014

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Goodwill Impairment


• Test annually, and if significant events occur, two-step process [FASB ASC 350-20-35]

1. If the fair value of the whole reporting unit < the carrying value of the reporting unit including its goodwill, there might be impairment

If no implied impairment, step 2 is not needed

Use quoted market prices of reporting unit, or valuation techniques applied to similar groups of assets and liabilities

2. If the implied fair value of the goodwill < the carrying value of the goodwill, record an impairment loss for the difference

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2011 Amendment by FASB


• Gives companies an option of making a qualitative evaluation to determine if the first step is needed

• If it is more likely than not that FMV < carrying amount, the company need not perform the two-step test

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Impairment of Equity Investments


• Goodwill implied in equity investments is not tested for impairment

• The investment itself is tested for impairment

• Example: Sam has a 30% interest in Lake, Investment in Lake, with a carrying value of $4,200; this includes implied goodwill of $350

The $350 implied goodwill is not tested for impairment

If Sam’s interest has a fair value of less than $4,200, an impairment loss on the Investment in Lake is recorded

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Goodwill impairment – example


• Paul owns 80% of Surly Corporation

• Paul carries $5 million of goodwill related to Surly

• Paul estimates that Surly has a total fair value of $36.25 million if he purchased Surly today

• The fair value of Surly’s total net assets are $31.25 million

• What is the implied fair value of goodwill?

Paul’s 80% investment would have a total fair value of $29 M

Paul’s 80% interest in net assets is $25 M

Therefore, the implied FV of goodwill is $4 M

Paul must record a $1 M impairment loss

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Exercises


• E2-15

• Additional Practice:

E2-16

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New Equity Method Guidance


• In June 2015, FASB issued a proposal to simplify the equity method of accounting

• The proposal would eliminate the requirement that the investor identify and account for the difference between its cost basis of an investment and its proportional interest in the equity of the investee

• The proposal would also eliminate the requirement that an investor account for an equity method investment retrospectively when it increases its ownership to a level that qualifies for the equity method

• However, this is still only a proposal

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Investor Accounting – Review Questions


• How do levels of influence affect accounting for investments?

• How do you account for investments when you lack significant influence?

• How do you account for investments when you have significant influence?

• What is a differential?

• How do you account for changes in influence, and for sales of investments?

• How do you test goodwill for impairment?

1 advanced accounting autumn 2015 chapter 2 stock investments – investor accounting and reporting...

Documents

reportingbill myer autumn

objectivesbill myer

investmentbill myer

advanced accounting

reporting bill myer

sales of investments

agendahomework chapter

common stock