© the mcgraw-hill companies, inc., 2004 slide 1-1 mcgraw-hill/irwin chapter one the equity method...

© The McGraw-Hill Companies, Inc., 2004

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McGraw-Hill/Irwin

Chapter One

The Equity The Equity Method of Method of

Accounting Accounting for for

InvestmentsInvestments


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McGraw-Hill/Irwin

Reporting Investments in Corporate Equity Securities

Note: These 3 approaches are not interchangeable. The characteristics of each

investment will dictate the appropriate accounting approach.

GAAP allows 3 approaches to reporting investments.


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Fair Value Method

Details in SFAS No. 115Details in SFAS No. 115 Initial Investment is recorded Initial Investment is recorded

at cost.at cost. Investments in equities of Investments in equities of

other companies are other companies are classified as either classified as either Trading Trading SecuritiesSecurities or or Available-for-Available-for-Sale SecuritiesSale Securities..

Income is only realized to the Income is only realized to the extent of dividends received.extent of dividends received.

Details in SFAS No. 115Details in SFAS No. 115 Initial Investment is recorded Initial Investment is recorded

at cost.at cost. Investments in equities of Investments in equities of

other companies are other companies are classified as either classified as either Trading Trading SecuritiesSecurities or or Available-for-Available-for-Sale SecuritiesSale Securities..

Income is only realized to the Income is only realized to the extent of dividends received.extent of dividends received.


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Equity Method

Defined by APB Opinion 18 and SFAS No. 142.

Requires that the investment is sufficient to insure significant influence.

Generally used when ownership is between 20% & 50%. Influence can be present with

much smaller ownership percentages.

Defined by APB Opinion 18 and SFAS No. 142.

Requires that the investment is sufficient to insure significant influence.

Generally used when ownership is between 20% & 50%. Influence can be present with

much smaller ownership percentages.


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Consolidation of Financial Statements

Governed by ARB No. 51, SFAS No. 141, and SFAS No. 142.

Required when investor’s ownership exceeds 50% of investee.

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


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Criteria for Determining Whether There is Influence

Representation on the investee’s Board of Directors

Representation on the investee’s Board of Directors

Participation in the investee’s policy-making process

Participation in the investee’s policy-making process

Material intercompany transactions.Material intercompany transactions.

Interchange of managerial personnel.Interchange of managerial personnel.

Technological dependency.Technological dependency.

Extent of ownership in relationship to other ownership percentages.

Extent of ownership in relationship to other 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 Investee Shares

Outstanding

0% 20% 50% 100%

Fair Value

Equity Method

Consolidated Financial Statements

The Significance of the Size of the Investment


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{Significant influence is generally

assumed with 20% to 50% ownership.

Significant influence is generally assumed with 20% to 50%

ownership.


Outstanding


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


0% 20% 50% 100%

Fair Value

Equity Method



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Fair Value Method (Revisited) – using Available for Sale (AFS) securities

Purchase Dr Investment in AFS XXXXX Cr Cash XXXXX

Dividend Income Dr Cash XXXXX Cr Dividend Income XXXXX

Change in Value of Security (Increase)1

Dr Market Value Adj. – AFS XXXXX Cr Unrealised inc/dec in AFS2 XXXXX

1 - The reverse is true for a decrease2 – This account appears in stock holders equity. If it were a

“Held for Trading” security the gain would have appeared in the income statement as an “Unrealized loss on Trading Securities”


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Equity Method

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

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

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


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Equity Method

Step 2: The investor recognizes its proportionate share of the investee’s

net income (or net loss) for the period.


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McGraw-Hill/Irwin

Equity Method

Step 2: The investor recognizes its proportionate share of the investee’s

net income (or net loss) for the period.

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 dividends received from the investee.


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Let’s do an equity method

example.


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Equity Method Example – Step 1

On January 1, 2005, Big Corp. buys 20% of Small Inc. for $2,000,000 cash.

Record Big’s journal entry.


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On December 31, 2005, Small reports net income for the year of $300,000.



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Big owns 20% of Small and gets credit for 20% of Small’s income.

20% × $300,000 = $60,000

60,00060,000


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On December 31, 2003, Big received a $25,000 dividend check from Small.


25,00060,000 25,000


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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.

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 - Example

Assume that Exxo Company acquires 5% of Assume that Exxo Company acquires 5% of LipGloss Inc. on January 1, 2004 for $2,000,000. LipGloss Inc. on January 1, 2004 for $2,000,000.

There is no significant influence. The investment is There is no significant influence. The investment is recorded at the time as an Available-for-Sale recorded at the time as an Available-for-Sale

Investment.Investment.In 2004, LipGloss had net income of $300,000, and In 2004, LipGloss had net income of $300,000, and paid dividends of $140,000. Exxo would report the paid dividends of $140,000. Exxo would report the

investment as indicated in the table below:investment as indicated in the table below:

Assume that Exxo Company acquires 5% of Assume that Exxo Company acquires 5% of LipGloss Inc. on January 1, 2004 for $2,000,000. LipGloss Inc. on January 1, 2004 for $2,000,000.

There is no significant influence. The investment is There is no significant influence. The investment is recorded at the time as an Available-for-Sale recorded at the time as an Available-for-Sale

Investment.Investment.In 2004, LipGloss had net income of $300,000, and In 2004, LipGloss had net income of $300,000, and paid dividends of $140,000. Exxo would report the paid dividends of $140,000. Exxo would report the

investment as indicated in the table below:investment as indicated in the table below:


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Fair Market Value entry

The entries for adjustment to FMV would also have been required. E.g. Assume that the FMV @ 31/12/2004 was $2,400,000. Then the following entry would have been made (as per SFAS115):

Dr Market Value Adjustment - AFS 400,000

Cr Unrealized inc/dec in value of AFS 400,000


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On January 1, 2005, Exxo buys an additional 15% On January 1, 2005, Exxo buys an additional 15% interest in LipGloss, raising the total investment to interest in LipGloss, raising the total investment to 20%. The first thing that Exxo must do is restate 20%. The first thing that Exxo must do is restate

the 12/31/04 numbers by applying the equity method the 12/31/04 numbers by applying the equity method to the 5% investment in LipGloss.to the 5% investment in LipGloss.

We have to RESTATE the Investment account, put a We have to RESTATE the Investment account, put a balance in Equity in Investee Income, and eliminate balance in Equity in Investee Income, and eliminate

the Dividend Revenue balance.the Dividend Revenue balance.

On January 1, 2005, Exxo buys an additional 15% On January 1, 2005, Exxo buys an additional 15% interest in LipGloss, raising the total investment to interest in LipGloss, raising the total investment to 20%. The first thing that Exxo must do is restate 20%. The first thing that Exxo must do is restate

the 12/31/04 numbers by applying the equity method the 12/31/04 numbers by applying the equity method to the 5% investment in LipGloss.to the 5% investment in LipGloss.

We have to RESTATE the Investment account, put a We have to RESTATE the Investment account, put a balance in Equity in Investee Income, and eliminate balance in Equity in Investee Income, and eliminate

the Dividend Revenue balance.the Dividend Revenue balance.


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An adjustment is recorded to the Investment An adjustment is recorded to the Investment account and to Retained Earnings (since Dividend account and to Retained Earnings (since Dividend

Revenue has already been closed out).Revenue has already been closed out).

An adjustment is recorded to the Investment An adjustment is recorded to the Investment account and to Retained Earnings (since Dividend account and to Retained Earnings (since Dividend

Revenue has already been closed out).Revenue has already been closed out).


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Removal of Fair Market Value related accounts

The FMV related accounts would also have to be removed. i.e. :

Dr Unrealized inc/dec in value of AFS 400,000

Cr Market Value Adjustment - AFS 400,000


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Reporting Investee Income from Other Sources

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

Examples include: Extraordinary items Discontinued operations Prior period adjustments


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Reporting Investee Income from Other Sources

Big owns 30% of Little. Little reports net income for 2005 of $120,000. Little’s Income includes

operating income of $135,000 and an extraordinary loss of $15,000.

Big’s equity method entry at year-end is:

Big owns 30% of Little. Little reports net income for 2005 of $120,000. Little’s Income includes

operating income of $135,000 and an extraordinary loss of $15,000.

Big’s equity method entry at year-end is:


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Reporting Investee Losses

Permanent Losses in Value

A permanent decline in the

investee’s market value is recorded as a reduction of the investment

account.

Permanent Losses in Value

A permanent decline in the

investee’s market value is recorded as a reduction of the investment

account.


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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.

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

The balance remains at $0, until subsequent profits eliminate all UNRECORDED 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. (as is the case when switching from FV to Equity method)

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. (as is the case when switching from FV to Equity method)


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Reporting the Sale of an Equity Investment

Alice Co. 30% (300,000 shares) of Sam, Inc.. The balance in Alice’s Investment account at March 31, 2005, is

$268,000.

If Alice Co. sells 10% of its shares (30,000 shares) on April 1, 2005 for $100,000, what entry should Alice

make on April 1, 2005?

Alice Co. 30% (300,000 shares) of Sam, Inc.. The balance in Alice’s Investment account at March 31, 2005, is

$268,000.

If Alice Co. sells 10% of its shares (30,000 shares) on April 1, 2005 for $100,000, what entry should Alice

make on April 1, 2005?

This brings the Investment account to a balance of $241,200

$268,000 × .10% = $26,800


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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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On January 1, 2005, Big Corp. acquired 20% of Small Inc. for $2,000,000 cash.

Assume that Small’s assets had BV on January 1 of $8,500,000. Small owns a building with a BV of $500,000, and a FMV of $700,000, and a remaining useful life of 10 years. All other assets had BV = FMV.

Allocate the cost to fair market value adjustments and Goodwill acquired by Big.

On January 1, 2005, Big Corp. acquired 20% of Small Inc. for $2,000,000 cash.

Assume that Small’s assets had BV on January 1 of $8,500,000. Small owns a building with a BV of $500,000, and a FMV of $700,000, and a remaining useful life of 10 years. All other assets had BV = FMV.

Allocate the cost to fair market value adjustments and Goodwill acquired by Big.

Excess of Cost Over BVExample


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The Building has a remaining useful life

of 10 years. Goodwill is never amortized.

Compute the amortization expense

for Big at 12/31/05.

The Building has a remaining useful life

of 10 years. Goodwill is never amortized.

Compute the amortization expense

for Big at 12/31/05.


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Amortization of Cost Over BV Example

Big’s equity method entry will include an

adjustment to the investment account

of $4,000.

Big’s equity method entry will include an

adjustment to the investment account

of $4,000.


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Amortization of Cost Over BV Example


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Let’s look at some

intercompany transactions.


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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 need have unrealized,

intercompany profit that must be deferred.

If all 200 units are not sold to an outside party during the period, we will need 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%) are still “unsold” to a 3rd 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 (for both upstream and downstream) 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 in the period that the inventory is sold to an outside party.


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And this is only the FIRST

chapter?!

End of Chapter 1

© the mcgraw-hill companies, inc., 2004 slide 1-1 mcgraw-hill/irwin chapter one the equity method...

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