chapter one the equity method of accounting for investments mcgraw-hill/irwin copyright © 2009 by...

Chapter One

The Equity Method of The Equity Method of Accounting for Accounting for

InvestmentsInvestments

McGraw-Hill/Irwin Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved.

Reporting Investments in Corporate Equity Securities

These 3 approaches are not interchangeable. (The appropriate method depends upon the characteristics of the particular investment)

GAAP allows 3 approaches to reporting investments:

Fair Value Method

Equity Method

Consolidation

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Fair Value Method

Initial Investments are recorded at Initial Investments are recorded at cost. (Subsequently adjusted to cost. (Subsequently adjusted to fair value only if readily fair value only if readily determinable)determinable)

Dividends received are recognized Dividends received are recognized as income.as income.

Investments in equities of other Investments in equities of other companies are classified either as companies are classified either as TradingTrading or or Available-for-Sale Available-for-Sale SecuritiesSecurities..

Initial Investments are recorded at Initial Investments are recorded at cost. (Subsequently adjusted to cost. (Subsequently adjusted to fair value only if readily fair value only if readily determinable)determinable)

Dividends received are recognized Dividends received are recognized as income.as income.

Investments in equities of other Investments in equities of other companies are classified either as companies are classified either as TradingTrading or or Available-for-Sale Available-for-Sale SecuritiesSecurities..

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Fair Value Method (continued)

Trading securities are held for the Trading securities are held for the purpose of re-sale in the short purpose of re-sale in the short term. Unrealized holding gains term. Unrealized holding gains and losses are and losses are included in included in reported earningsreported earnings..

Available-for-sale securities are Available-for-sale securities are those those notnot classified as trading. classified as trading. Unrealized holding gains and Unrealized holding gains and losses are reported in losses are reported in shareholders’ equity as shareholders’ equity as other other comprehensive income. comprehensive income. (They are (They are not not included in earnings.)included in earnings.)

Trading securities are held for the Trading securities are held for the purpose of re-sale in the short purpose of re-sale in the short term. Unrealized holding gains term. Unrealized holding gains and losses are and losses are included in included in reported earningsreported earnings..

Available-for-sale securities are Available-for-sale securities are those those notnot classified as trading. classified as trading. Unrealized holding gains and Unrealized holding gains and losses are reported in losses are reported in shareholders’ equity as shareholders’ equity as other other comprehensive income. comprehensive income. (They are (They are not not included in earnings.)included in earnings.)

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Consolidation of Financial Statements

Required when investor’s ownership exceeds 50% of investee, except “where control does not actually rest with the majority shareholders” Legal reorganizations Bankruptcies Foreign government restrictions

A single set of financial statements is produced, reporting the consolidated assets, liabilities, equities, revenues, and expenses for the parent company and all controlled subsidiary companies.

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WARNING!!!! WARNING!!!

FASB Interpretation No. 46-R, Consolidation of Variable Interest Entities [FIN 46] expands the use of consolidated financial statements: Includes entities controlled through

“special contractual arrangements” 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

Required when an investor has the ability to “significantly influence” the investee.

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

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

Required when an investor has the ability to “significantly influence” the investee.

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

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

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Criteria for Determining Whether There is “Significant” Influence

Representation on the investee’s

Board of Directors Participation in the investee’s policy-

making process Material intercompany transactions. Interchange of managerial personnel. Technological dependency. Extent of ownership in relationship to

other investor ownership percentages.

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{

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

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.

Significant influence is generally assumed with 20% to 50%

ownership.


Outstanding

The Significance of the Size of the Investment

0% 20% 50% 100%

Fair Value

Equity Method


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{Financial Statements of all related Financial Statements of all related companies must be consolidated.companies must be consolidated.

Financial Statements of all related Financial Statements of all related companies must be consolidated.companies must be consolidated.


Outstanding

The Significance of the Size of the Investment

0% 20% 50% 100%

Fair Value

Equity Method


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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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Equity Method

Step 1: The investor records its investment in the investee at cost.

Journal entry:Debit – Investment in Investee

Credit – Cash (or other assets/stock)

Cost can be defined by cash paid or the Cost can be defined by cash paid or the

fair value of stock or other assets given up.fair value of stock or other assets given up.

Cost can be defined by cash paid or the Cost can be defined by cash paid or the

fair value of stock or other assets given up.fair value of stock or other assets given up.

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Equity Method

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

net loss) for the period.

Journal entry at end of period:

Debit – Investment in Investee

Credit – Equity in Investee Income

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

income statement.

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

income statement.

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Equity Method

Step 3: The investor reduces the investment account by the

amount of cash dividends received from the investee.

Journal entry when cash dividends received:

Debit – Cash

Credit – Investment in Investee

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Equity Method Example

Little Company reported a net income of $200,000 during 2008 and paid cash dividends of $50,000. These figures indicate that Little’s net assets have increased by $150,000 during the year.

Investment in Little Company. . 40,000 Equity in Investee Income .. . . . . . . . . . 40,000

To accrue earnings of a 20 percent owned investee ($200,000 × 20%).

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Equity Method Example

Cash . . . . . . . . . . . . .. . . . . . 10,000 Investment in Little Company . .. . . . 10,000

To record receipt of cash dividend from Little Company ($50,000 × 20%).

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Special Procedures for Special Situations

Reporting a change to the equity method.

Reporting a change to the equity method.

Reporting investee income from sources other than continuing

operations.

Reporting investee income from sources other than continuing

operations.

Reporting investee losses.

Reporting investee losses.

Reporting the sale of an equity

investment.

Reporting the sale of an equity

investment.

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Reporting a Change to the Equity Method. (Retroactive Adjustment)

An investment that is too small to have significant influence is accounted for using the fair-value method.

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 Opinion 18

. . . 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 Opinion 18

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Restatement (Retroactive Adjustment) - Example

Giant Company acquires a 10 percent ownership in Small Company on January 1, 2008. Officials of Giant do not believe that their company has gained the ability to exert significant influence over Small. Giant properly records the investment by using the fair-value method as an available-for-sale security.

Subsequently, on January 1, 2010, Giant purchases an additional 30 percent of the Small’s outstanding voting stock, thereby achieving the ability to significantly influence the investee’s decision making.

The readjustment follows on the next slide.

Giant Company acquires a 10 percent ownership in Small Company on January 1, 2008. Officials of Giant do not believe that their company has gained the ability to exert significant influence over Small. Giant properly records the investment by using the fair-value method as an available-for-sale security.

Subsequently, on January 1, 2010, Giant purchases an additional 30 percent of the Small’s outstanding voting stock, thereby achieving the ability to significantly influence the investee’s decision making.

The readjustment follows on the next slide.

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Restatement (Retroactive Adjustment) - Example

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Reporting Investee Income from Other Sources

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 percent of the voting stock of Tiny Company and accounts for this investment by means of the equity method. In 2008, Tinyreports net income of $200,000, a figure composed of $250,000 in income from continuing operations and a $50,000 extraordinary loss. Large Company accrues earnings of $80,000 based on 40 percent of the $200,000 net figure.Larges equity method entry at year-end is:

Large Company owns 40 percent of the voting stock of Tiny Company and accounts for this investment by means of the equity method. In 2008, Tinyreports net income of $200,000, a figure composed of $250,000 in income from continuing operations and a $50,000 extraordinary loss. Large Company accrues earnings of $80,000 based on 40 percent 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 reduction of the investment account to the fair

value.

A permanent decline in the investee’s fair market value is recorded as an impairment loss

and the reduction of the investment account to the fair

value.

A temporary decline is ignored!!!

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Reporting Investee Losses

Investment Reduced to Zero When the accumulated losses

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

The balance remains at $0, until subsequent profits eliminate all UNREALIZED losses.

Investment Reduced to Zero When the accumulated losses

incurred by the investee and dividends paid by the investee reduce the investment account to zero, 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.

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

Top Company owns 40 percent of the 100,000 outstanding shares of Bottom Company, an investment accounted for by the equity method. Although these 40,000 shares were acquired some years ago for $200,000, application of the equity method has increased the asset balance to $320,000 as of January 1, 2008. On July 1, 2008, Top elects to sell 10,000 of these shares (one-fourth of its investment) for $110,000 in cash, thereby reducing ownership in Bottom from 40 percent to 30 percent. Bottom Company reports income of $70,000 during the first six months of 2008 and distributes cash dividends of $30,000.

Top Company owns 40 percent of the 100,000 outstanding shares of Bottom Company, an investment accounted for by the equity method. Although these 40,000 shares were acquired some years ago for $200,000, application of the equity method has increased the asset balance to $320,000 as of January 1, 2008. On July 1, 2008, Top elects to sell 10,000 of these shares (one-fourth of its investment) for $110,000 in cash, thereby reducing ownership in Bottom from 40 percent to 30 percent. Bottom Company reports income of $70,000 during the first six months of 2008 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 and accounted for.

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Excess of Cost Over BV Acquired

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.

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 percent 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.

After investigation, Big determines that Little’s equipment (5 year remaining life) is undervalued in the company’s financial records by $60,000. One of its patents (10 year remaining life) is also undervalued, but only by $40,000.

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 offers $90,000 for a 30 percent share of the investee’s outstanding stock.

Big Company is negotiating the acquisition of 30 percent 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.

After investigation, Big determines that Little’s equipment (5 year remaining life) is undervalued in the company’s financial records by $60,000. One of its patents (10 year remaining life) is also undervalued, but only by $40,000.

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 offers $90,000 for a 30 percent share of the investee’s outstanding stock.

Excess of Cost Over BVExample

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Excess of Cost Over BVExample

Book value of Little Company (assets minusliabilities [or stockholders’ equity]). . . . . . $200,000Undervaluation of equipment .. . . . . . . . . . . . 60,000Undervaluation of patent .. . . . . . . . . . . . . . 40,000Value of net assets . . . . . . . . . . . . . . . . . . . $300,000Portion being acquired . .. . . . . . . . . . . . . . . . . 30%Acquisition price .. . . . . . . . . . . . . . . . . . . . $ 90,000

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Amortization of Cost Over BV Example

Payment by investor. . . . ……………..…….. . . . . . . 90,000Percentage of book value acquired ($200,000 × 30%) . . …………….……... . . 60,000Payment in excess of book value …………………..… 30,000Excess payment identified with specific assets:Equipment ($60,000 undervaluation × 30%). 18,000Patent ($40,000 undervaluation × 30%) . . . . . 12,000 30,000Excess payment not identified with specific assets—goodwill . . –0–

Payment by investor. . . . ……………..…….. . . . . . . 90,000Percentage of book value acquired ($200,000 × 30%) . . …………….……... . . 60,000Payment in excess of book value …………………..… 30,000Excess payment identified with specific assets:Equipment ($60,000 undervaluation × 30%). 18,000Patent ($40,000 undervaluation × 30%) . . . . . 12,000 30,000Excess payment not identified with specific assets—goodwill . . –0–

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Amortization of Cost Over BV 1-33

INVESTORINVESTORINVESTORINVESTOR

INVESTEEINVESTEEINVESTEEINVESTEE

INVESTORINVESTORINVESTORINVESTOR

INVESTEEINVESTEEINVESTEEINVESTEE

Downstream Sale

Upstream Sale

Unrealized Gains in Inventory

Sometimes affiliated companies sell or buy inventory from each other.

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Let’s look at an Investor that has 200 units of inventory with a cost of

$1,000.

INVESTOR sells 200 units

of inventory with a total

cost of $1,000.



cost of $1,000.

Let us assume that the Investor

sells the inventory to a

20% owned Investee for

$1,250.

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INVESTEE buys 200 units

of inventory and pays a total of

$1,250.



$1,250.

Intercompany Sale of 200 units

20% ownership




cost of $1,000.



cost of $1,000.

Let’s look at an Investor that has 200 units of inventory with a cost of

$1,000.

Note that there is $250 of intercompany profit. At this point it is considered UNREALIZED.

Note that there is $250 of intercompany profit. At this point it is considered UNREALIZED.

If all 200 units are not sold to an outside party during the period, we will have unrealized, intercompany profit that must be deferred.

If all 200 units are not sold to an outside party during the period, we will have unrealized, intercompany profit that must be deferred.

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$1,250.



$1,250.

Intercompany Sale of 200 units

20% ownership




cost of $1,000.



cost of $1,000.

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%).

Investee sells only 140 units to a 3rd

partyOutside Party

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Compute the deferral by multiplying:

The required journal entry is:

$250 × 30% × 20% = $15

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

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

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

The equity method is applied to an investment whenever significant influence appears to exist.

Significant influence is presumed whenever ownership is between 20 and 50% (however, each situation must be examined separately.)

Investee income proportionately increases the investment, while dividends decrease it.

The equity method is applied retroactively once significant influence is apparent.

Excess payments of acquisition are assigned either to specific assets and liabilities or to goodwill. Assigned costs (other than to land or goodwill after 2001) are systematically amortized. This is applied until the date of disposal

Intercompany markups 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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HomeworkP1.12, P1.14, P1.16, P1.17 P1.22, P1.25

chapter one the equity method of accounting for investments mcgraw-hill/irwin copyright © 2009 by...

Documents

investors ownership

extent of ownership

investor ownership percentages

reporting investments

smaller ownership percentages

equity methodrequired

shareholders equity

sale securities