The Equity Method of Accounting for InvestmentsMcGraw-Hill/Irwin Copyright 2013 by The McGraw-Hill Companies, Inc. All rights reserved.

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

GAAP recognizes 3 ways to report investments in other companies: Fair-Value MethodConsolidationEquity MethodThe method selected depends upon the degree of influence the investor has over the investee.LO 11-*

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1-*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-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).Investments in equity securities are recorded at cost and subsequently adjusted to fair value.1-*

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Required when: Investors 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.

1-*1-*

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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. 1-*LO 21-*

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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.

1-*1-*

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0%20%50%100%Fair ValueEquity MethodConsolidated Financial StatementsSignificant influence generally assumed (20% to 50% ownership).Usually lack of control or significant influence.Financial statements of all related companies must be consolidated.1-*

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Fair ValueEquity MethodConsolidated Financial Statements1: Same as Fair Value

2: Investor recognizes its share (% of owner-ship) of investees net income (net loss) as an increase (decrease) in the investment account and 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 31-*

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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.1-*1-*

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When Cost > Book Value of an investment acquired, the difference must be identified.1-*LO 4Assets may be undervalued because:Fair values (FV) of some assets and liabilities on investees books are different than book values (BV).

Investor is willing to pay extra expecting future benefits to accrue from the investment.

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

1-*

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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 51-*

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Downstream SaleUpstream SaleSometimes affiliated companies sell or buy inventory from each other in intra-entity transactions that necessitate special accounting procedures.1-*LO 61-*

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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 71-*

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Investment that can otherwise be accounted for under the equity methodInvestment in non-marketable equity securitiesAfter 2007, under the Fair-value Option, changes in the fair value of these assets are reported in earnings.1-*

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2At present, generally accepted accounting principles (GAAP) recognize three different approaches to the financial reporting of investments in corporate equity securities: The fair-value method. The consolidation of financial statements. The equity method.The financial statement reporting for a particular investment depends primarily on the degree of influence that the investor (stockholder) has over the investee, a factor typically indicated by the relative size of ownership.1 Because voting power typically accompanies ownership of equity shares, influence increases with the relative size of ownership. The resulting influence can be very little, a significant amount, or, in some cases, complete control.3Initial investments in equity securities are recorded at cost and subsequently adjusted to fairvalue if fair value is readily determinable; otherwise, the investment remains at cost. Equity securities held for sale in the short term are classified as trading securities or available-for-sale securities. Equity securities not classified as trading securities are classified as available-for-salesecurities and reported at fair value with unrealized gains and losses excluded from earnings and reported in a separate component of shareholders equity as part of other comprehensive income. Dividends received are recognized as income for both trading and available-for-sale securities.4Consolidation of Financial Statements is required when Investors ownership exceeds 50% of investee except when control does not rest with the majority investor. One set of financial statements is prepared to consolidate all accounts of the parent company and all of its controlled subsidiaries AS A SINGLE ENTITY.

5The equity method is used when the investor has the ability to exercise significant influence on the investee operations (whether influence is applied or not). It is generally used when ownership is between 20% and 50%. Significant Influence might be present with much lower ownership percentages. 5The International Accounting Standards Board (IASB), similar to the FASB, recognizes the need to take into account the significant influence that can occur when one firm holds a certain amount of voting shares of another. The IASB 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 an investor holds, directly or indirectly (e.g., through subsidiaries), 20 per cent or more of the voting power of the investee, it is presumed that the investor has significant influence, unless it can be clearly demonstrated that this is not the case. Conversely, if the investor holds, directly or indirectly (e.g., through subsidiaries), less than 20 per cent of the voting power of the investee, it is presumed that the investor does not have significant influence, unless such influence can be clearly demonstrated. A substantial or majority ownership by another investor does not necessarily preclude an investor from having significant influence.Under the equity method, the investment in an associate is initially recognized at cost and the carrying amount is increased or decreased to recognize the investors share of the profit or loss of the investee after the date of acquisition. The investors share of the profit or loss of the investee is recognized in the investors profit or loss. Distributions received from an investee reduce the carrying amount of the investment.8The Fair Value or Cost method is used to account for the investment with less than 20% ownership, and the investor lacks the ability to significantly influence the investee. With the ability to significantly influence, 20%50% ownership, the equity method is used.

With control, more than 50% ownership, the investor prepares Consolidated financial statements.

8The Fair Value or Cost method is used to account for the investment with less than 20% ownership, and the investor lacks the ability to significantly influence the investee. With the ability to significantly influence, 20%50% ownership, the equity method is used.

With control, more than 50% ownership, the investor prepares Consolidated financial statements.

Special procedures are required in accounting for each of the following:1. Reporting a change to the equity method.2. Reporting investee income from sources other than continuing operations.3. Reporting investee losses.4. Reporting the sale of an equity investment.21When Cost > Book Value of asset acquired, the difference must be identified.Assets may be undervalued on the investees books because:The fair values (FV) of specific assets and liabilities are different than their book values (BV).The investor may be willing to pay extra because future benefits are expected to accrue from the investment.

At any time, the investor can choose to sell part or all of its holdings in the investee company. If a sale occurs, the equity method continues to be applied until the transaction date, thus establishing an appropriate carrying value for the investment. The investor then reduces this balance by the percentage of shares being sold. After the sale is completed, the investor continues to apply the equity method to this investment based on the new percentage of ownership. However, if the sale had been of sufficientmagnitude to cause the investor to lose its ability to exercise significant influence over the investee, the equity method ceases to be applicable. ADD : No retroactive adjustment is recorded28Sometimes affiliated companies sell or buy inventory from each other in intra-entity transactions that necessitate special accounting procedures. When the investor sells to the investee, it is called a downstream sale. When the investee sells to the investor, it is called an upstream sale.

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.

3In 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.